On Financing an Unsubordinated Ground Lease in the Twenty-First Century

Jerome D. Whalen
Landlord & Tenant

Landlord & Tenant

A look at the issues raised for the landlord, tenant, and lender when the developer seeks mortgage financing for a project on a leasehold estate, and how a mortgage of the fee by the landlord may affect the leasehold.

One consequence of a new ground lease is the creation of two distinct estates in the same parcel of land: the landlord’s fee interest and the tenant’s leasehold. With an unsubordinated ground lease, the landlord’s fee and the tenant’s leasehold can be separately bought, sold, or encumbered, and each will support separate ownership and financing structures without materially affecting the other.

It was once common in ground lease negotiations for developers to ask the landowner to “subordinate the fee.” The phrase is an oxymoron but persists as shorthand for acknowledging that the landlord’s fee interest would be mortgaged to secure the tenant’s development financing. Subordination helps the developer avoid the difficulty and expense of obtaining a mortgage loan with only a leasehold to offer as collateral. But while the subordination remains in effect, the landlord will be at risk of a tenant loan default and will not have an asset the landlord can easily sell or mortgage. Moreover, any additional ground rent payable for a subordination often represents some sharing of the developer’s interest savings from the fee mortgage it enables; it is virtually never sufficient to compensate for exposing the land to the risks of the tenant’s development. Thus, most landowners today should not agree to subordinate except under the most compelling circumstances.

This article will look at issues raised for the landlord, tenant, and lender when the developer seeks mortgage financing for a project on his leasehold estate and how a mortgage of the fee by the landlord may affect the leasehold.

Forty years ago the requirements for a ground lease acceptable for leasehold mortgage financing seemed to be the closely-held knowledge of a small coterie of New York City lawyers representing national commercial real estate lenders and developers, a knowledge so specialized that one could say that a ground lease was not financeable until the lender’s attorney said it was. Today leasehold financing has become more accessible. In 1980, the American Bar Association (ABA) published a model form of leasehold mortgagee protection provisions that can serve as a reliable basis for a financeable ground lease. Model Leasehold Mortgage Provisions, 15 Real Prop. Prob. Tr. J. 395 (1980). Rating agencies, Moody’s and Standard & Poor’s, have issued criteria for leasehold mortgages to be included in commercial mortgage-backed securities pools. The criteria are not onerous and can be satisfied by the ABA model provisions and probably by any ground lease accepted by a knowledgeable mortgage lender. There remain, however, several matters affecting the landowner, developer, and lender that require thoughtful consideration and resolution. Every development project is unique and therefore every developmental ground lease is (or should be) unique in order to reflect the specific project conditions.

Basic Protections for the Leasehold Mortgagee

The foremost legal risk to the lender is the possibility that the leasehold estate, the primary collateral for the loan, can disappear or terminate, most probably because of the default of the tenant-borrower. In most jurisdictions, the lender cannot afford a race to the courthouse with the landlord because the landlord can terminate a lease upon default months faster than a mortgagee can foreclose a mortgage or effect a sale under a deed of trust.

The ABA model leasehold mortgagee protection provisions—and most similar forms in use by experienced attorneys—provide the basic protections required by institutional mortgage lenders, usually in great, even excruciating, detail. The lender is entitled to receive all notices delivered by either party under the ground lease and, in the event a tenant default is not cured in a timely manner, the lender will require another notice from the landlord and an additional period to cure. If somehow the lease is terminated nevertheless, the lender is entitled to yet another notice and another opportunity to reinstate the lease as a new lease between the landlord and the lender (or its nominee or designee) as the new tenant. Any cure by the lender requires the full payment of all monetary sums due under the lease with interest and remedies for all material non-monetary defaults that are “susceptible of cure” by the lender. The ground lease may not be amended in any material respect, cancelled, or terminated without the consent of the lender. Any amendment will not be effective against the lender without its consent. The lease grants the lender the right to exercise any option to renew or extend the lease term if the tenant fails to do so; and subordinates any lien rights of the landlord with respect to sublease rentals and the tenant’s personal property to the leasehold mortgage as long as the ground lease is not terminated and the mortgage is in effect.

Frequently, landlords resent the extent of these basic protections; especially the multiple bites at the apple provided the lender in the event of a tenant default. Why can’t the lender cure a default during the same period allowed to the tenant to cure? Why multiple chances to fix things? The answer has to do with the consequences of default. An institutional lender would not fund a loan if the result of a possible inefficiency or neglect by one of its agents would result in the complete loss of the lender’s investment in the project. For the landlord, the additional delays usually just mean waiting a few more weeks to be paid with interest. In effect, a leasehold mortgage is virtually a guaranty of the tenant’s performance under the ground lease; landlords should probably accept leasehold mortgage protection provisions with a little more grace.

Advanced Mortgagee Protections

There are at least three other issues that may need to be addressed in financing an unsubordinated ground lease. One is the landlord’s recognition of subleases entered into by the tenant that, in most commercial projects—office, industrial, residential, retail—are the primary source of income available to pay project expenses, ground rent, and debt service. In the event the ground lease is terminated due to the tenant’s default, the lender does not want the subleases to be automatically terminated (as would happen in some states). The lender would like to pick and choose the surviving leases or, if that is not possible under local law (and it frequently is not), the lender would probably choose to have them all survive. That option requires that the landlord agree to recognize and not to disturb any occupancy subtenants as long as they are not in default under the terms of their subleases. The landlord may be concerned with “bad” subleases, such as below market leases to favored subtenants or poor deals made by a ground lease tenant desperate to fill space. Sometimes the parties agree that subleases need to be market rate, with a creditworthy occupancy tenant, perhaps with an arbitration clause if they disagree, but many lenders will insist that if they approve the sublease, the landlord must grant recognition.

A second issue concerns a boilerplate term of the leasehold mortgage: the “spreader to the fee” clause. This clause provides that if the tenant acquires the fee interest in the land, that after-acquired interest will become part of the lender’s collateral; that is, the leasehold mortgage will become a fee mortgage. Tenants often have a right of some sort to purchase the fee, which is typically in the form of a right of first refusal or first offer or first negotiation if the landlord decides to sell.

If that right is exercised, many if not most tenants will require financing to complete the purchase. One way to manage this transaction is to have the purchase completed by a separate entity from the ground lease tenant, which usually requires the landlord’s and the lender’s consent to assignment of the right to purchase by the tenant. If an assignment is permitted, the leasehold lender should still be concerned that the tenant might exercise the right to purchase the fee and then default in the purchase, potentially creating a default under the ground lease. The ground lease should provide that a purchase default is not a default permitting termination of the ground lease, allowing the landlord only a monetary claim against the tenant (and the tenant without any further right to purchase the fee). Exercise of the right to purchase should then require a substantial deposit by the purchaser as potential liquidated damages.

A third matter involves ground lease rental reserves. Usually a lender will require reserves for critical expenses such as insurance premiums and real estate taxes, if not initially, then following any loan default by the tenant, even if cured. With a leasehold mortgage, it is typical to require ground lease rental reserves from the initial funding of the term loan. (Any construction period ground rent should be covered by the construction financing.) The reserves usually are in the amount of one or two years’ basic ground rent and will increase over the term of the loan if the basic rent increases, for reasons such as inflation or reappraisal adjustments. The reserves will be held by the lender, who will reserve a first lien security interest in the funds. The lender may allow some interest credit or not, and the reserves may or may not be held in a separate account. The lender may agree to use the funds to pay delinquent ground rent or other default-related costs, or not, but the funds will be available to the lender if needed and will be an important element in the lender’s evaluation of a leasehold mortgage. If the ground lease is terminated for an uncured default and there is no new lease, then the lien of the leasehold mortgage on the property will terminate. In the unlikely event any reserve funds remain at that point, the lender will take them under its security interest.

Valuation Issues

Ground rent reserves highlight the primary economic risk for the lender looking at a leasehold mortgage loan. If the tenant/borrower defaults on the loan or the lease or both and the lender realizes on the collateral or obtains a new lease, then the lender (or, more likely, a subsidiary or other affiliated entity) will become the tenant under the ground lease. Thus, the landlord will assume all the tenant’s obligations, including the payment of rent and all other necessary expenses of the property (taxes, insurance, and more). There may be reserves to cover ground rent, taxes, and insurance for a year or two, but those are most often burned up while the tenant and the lender are trying to work through the problems. With this in mind, when initially appraising the project as collateral for the loan on an income approach, the ground rent must be deducted from the operating income before capitalizing the income stream. This results in a significant reduction of the appraised value for loan purposes and a smaller loan amount for senior financing.

This issue is exacerbated if the ground lease provides for rental increases during the term of the loan (or afterward if the later adjustment might affect the tenant’s refinancing of the loan balance when due). Often the landowner is simply unwilling to enter a long-term ground lease without some assurance that at some point during the life of the lease, for example, after 20 years or more, the ground rent will be adjusted to reflect the value of the land, at least the land’s value as a component of the existing project. This is a subject where words matter. See Jerome D. Whalen, Reappraisal of Ground Lease Rentals, Prob. & Prop., May/June 2016, at 44, 50. Stated or capped increases can be taken into account, normally at the maximum permitted amount. But rent adjustments by indexing (e.g., CPI) or by reappraisal that are not effectively capped introduce potential increases that cannot be calculated and render the project appraisal problematic.

For a term loan, one approach to the issue is an agreement with the landlord that certain elements of the ground rent will be waived or deferred if the lender or an affiliate becomes the owner of the leasehold following a borrower default. This agreement may be included in the lease itself or in a separate contract. The latter is common because the issue often arises after the ground lease has been executed when the tenant seeks project financing. It should then be contained in a lease amendment to the basic rent provisions and properly recorded to assure its enforceability (for example, if the landlord files for bankruptcy and rejects the contract or the lease).

The waiver, if any, can be for any specified element of the ground rent, such as indexed or appraisal increases in excess of a certain amount. It can be for a determinable time period, a number of months or years or until a determinable event (for example, payment of all past due debt service). If, instead, the rental element is deferred, it may become payable at a fixed or determinable time, with or without interest, as a lump sum or in installments. In theory, the landlord could agree to waive all the rent as long as the lender holds the property—an unlikely concession—but these agreements are usually for much more limited relief. Sometimes, the parties negotiate a “waterfall,” providing for the distribution of project cash flow in excess of defined operating expenses in an order of priority to the landlord and lender, for instance, first to base rent, followed by current debt service, back rent, past due debt service, and finally, rent increases. The alternatives and variables are potentially unlimited. Everyone expects and hopes that the agreement will never come into effect, but it may facilitate an acceptable loan appraisal allowing the lender to make the leasehold loan in the first place and still permit the rental adjustments required by the landlord. This sort of provision might be called a partial subordination, where certain defined rights of the landlord are made subject to rights of the lender under specific, limited circumstances but still without any right of the lender to foreclose on the landlord’s fee.

Construction Issues

Partial subordination also can be useful to resolve problems in construction financing. The greatest risk of loss to both the landlord and the leasehold lender is during the construction phase before the project is substantially complete, when a failure by the tenant-borrower and his contractor to complete and pay for the project threatens the interests of everyone concerned. In a major construction failure where the lender is required to step in and take over the project, the issues may be associated less with payment of ground rent (although that might also be involved) and more with ground lease provisions relating to design, construction, project completion and uses, lease assignment, and any other requirement the foreclosing lender may be unable or unwilling to meet as originally contemplated by the lease. The lender may simply need more time to find a new contractor or design professionals, or a new developer to act as tenant, or more significant changes may be necessary in terms of project design and economic uses.

Some of these issues may have very important effects for the landlord beyond time delays and are usually not addressed in advance. But a “partial subordination” agreement in the ground lease may allow the construction lender more time to complete the project and the right to substitute a new tenant, contractor, or design professionals. If the more difficult issues of changes in design or use arise, the landlord will have to determine if, under the then circumstances, it is in the landlord’s best interest to resist proposed changes to the project; terminating the ground lease will not of itself solve any of these problems and will eliminate further efforts by the lender and tenant to fix things.

Another construction period issue may arise if, under the law in the jurisdiction where the project is located, construction liens for labor and materials (perhaps including design fees and other costs) may attach to the landlord’s fee. A construction project that goes seriously off the tracks may produce millions of dollars of related liens for nonpayment of contractors and others. Under local law in some states, liens for costs incurred by the tenant may attach to the landlord’s fee interest in the land as well as to the tenant’s leasehold. The construction loan mortgage is a lien only on the leasehold, and, if the liens attach to the fee, the problem is not technically a title priority issue but a matter of lease default. The ground lease will require that liens affecting the fee be discharged immediately. If the tenant is under water, this becomes an issue for the lender. There may be means under local law to limit liens to the leasehold. If not, another approach may lie in loan administration; requiring proof of payment each month before advancing additional funds; engineering estimates of project completion; partial lien waivers from contractors of every tier to the extent practicable; title insurance updates; and all the other payment procedures typically employed by diligent construction lenders. Any liens should be promptly settled or at least discharged against the fee by bonding. The landlord and the lender both should require and monitor this process. These procedures require careful management by experienced personnel and therefore cost money; the landlord should have her own independent professional assistance and should require the tenant to pay for the service as a project cost.

Major construction failures can happen for any number of reasons: underbidding by the contractor; excessive change orders by the developer; labor issues; failure of suppliers; design errors in major building systems; and more. The lender, the tenant, and the contractor will all perform due diligence to protect against mistakes, and so should the landlord, who may need professional assistance to monitor the development process to protect her interests. Ultimately, the best assurance for the landlord and the lender is a project team with demonstrated experience in completion of similar projects, comprising not only the tenant-developer, but his contractor, major subcontractors, design professionals, and, for the landlord, a construction lender with the ability to manage a loan of this scope. A development project on a ground lease is no place for beginners.

Landlord Fee Mortgages

The ground lease landlord holds an estate that should be mortgageable separately from the leasehold, and it should be a prime concern of the landlord that the lease does not prohibit her financing. Protection of the leasehold, however, requires that any mortgage or other lien on the landlord’s fee is specifically subordinated to the ground lease itself (but not to any leasehold mortgage), to any amendments, renewals, or extensions of the ground lease, and to any new lease replacing the ground lease. It should be a requirement in the ground lease that any mortgage of the landlord’s interest sets forth this subordination in any document creating or evidencing a lien on the fee. If there is an existing landlord’s mortgage in place when the ground lease is executed, there should be a recorded subordination agreement with the landlord’s lender (not a “non-disturbance” or similar recognition agreement that might be rejected in a bankruptcy proceeding). A mortgage in place when the ground lease is executed may require some negotiation. If the fee lender is looking at the ground lease rentals as the principal means of repaying the landlord’s debt, the lender may want restrictions on changes to the ground lease that might adversely affect its collateral. It may be prudent for the leasehold lender to require an intercreditor agreement among the landlord, her lender, and the leasehold mortgagee to clearly identify the rights, priorities, and obligations of the parties.

Bankruptcy Issues

The ground lease should address the possible bankruptcy of either the landlord or tenant. A debtor in bankruptcy has the right to reject any executory contract or unexpired lease, which is sometimes the primary reason for entering Chapter 11 reorganization (for instance, for retailers who have hundreds of store leases all over the country they need to avoid). The landlord of a rejected lease is left with an unsecured claim for unpaid rent in an amount significantly limited by the Bankruptcy Code. If the tenant is a single purpose entity with the project as its primary asset and the project debt exceeds its value, the trustee (usually the debtor in possession) will reject the ground lease, and there is likely no way under the Bankruptcy Code to enforce a waiver of the right to reject the lease. Recent lending practice, however, has required contingent loan guarantees by principals of the borrower, such as principal equity owners or solvent parent companies, which become effective under an ever-expanding number of circumstances, including a bankruptcy filing by the borrower. These guaranties have generally been enforced. As a result, bankruptcies of the borrowers under these guaranteed loans have become less frequent. J. Stein, Moody’s Clamps Down on Two Ground Lease Issues, Comm’l Observer, May 4, 2016.

For the leasehold lender, the ultimate protection if the tenant rejects the lease is the new lease agreement with the landlord. Even when the project debt exceeds its value, it does not mean that the project is worthless, at least not to the lender or the landowner. If the ground lease is terminated, the landlord would succeed to the project without the debt, which is probably a windfall. Then the new lease may be the only means for the lender to maintain any remaining value of the collateral.

The bankruptcy of the landlord is now also generally recognized as a real concern for the leasehold lender, one that Congress has tried to address several times over the past few decades. The current Bankruptcy Code provides that if the landlord rejects a lease in bankruptcy, the tenant then has the option to either remain as tenant under the lease terms, with some limitation of the liability of the landlord thereafter, or to accept the rejection, terminating the lease. The Code further allows the tenant to restrict its right to accept rejection by agreement with lenders or others. So the borrower can agree with the lender not to accept a rejection without the consent of its leasehold mortgagee and the ground lease itself should so provide.

To complicate this picture, in the past few years landlords in bankruptcy, instead of rejecting a lease under one provision of the Bankruptcy Code, have sold the property “free and clear” of adverse interests, including leases, under a different provision. This practice has been upheld by several federal courts but, so far, only under circumstances where the tenant’s and leasehold mortgagee’s rights under the lease have been subject to prior liens or other impairments that could have caused a lease termination in any event. See Precision Industries v. Qualitech, 327 F.3d 537 (7th Cir. 2003). A properly structured ground lease should survive this maneuver, but any bankruptcy event of the landlord under a ground lease should be closely monitored to ensure that the tenant’s and the leasehold mortgagee’s interests are adequately protected.


Ground lease projects costing up to hundreds of millions of dollars are regularly undertaken by parties who are willing to work constructively through the matters identified in this article, to understand the concerns of the other participants, and to avoid seeking unfair advantage. As should be apparent, a substantial degree of diligence and patience is required of all parties involved. For more complete consideration of any of the subjects discussed in this article, see the author’s book. Jerome D. Whalen, Commercial Ground Leases (3d ed. 2013 & Supp. Aug. 2018).

Jerome D. Whalen

Jerome D. Whalen is a real estate consultant to attorneys and their clients in Seattle, Washington.