Introduction
Commercial mortgage-backed securities often rely upon collateral pools that include leasehold mortgages. Whenever that happens, the agencies that rate the securities will test each mortgaged ground lease against a set of criteria. (This discussion treats Fannie Mae’s and Freddie Mac’s published ground lease criteria as if they were additional rating agency criteria.)
Rating agency criteria for ground leases offer a reliable benchmark to evaluate any ground lease for acquisition or financing. That’s true even if a particular tenant or prospective tenant has convinced itself it will never either: (i) seek a leasehold mortgage destined for securitization or (ii) want to sell its leasehold position to anyone else who might need (or want to be able to obtain, if desired) such a mortgage.
If a ground lease flunks one or more rating agency criteria, a leasehold mortgagee might still accept it as collateral if the leasehold mortgagee considers the deficiency immaterial. If it is deemed material, the leasehold mortgage might cost more. It might require unusual personal guaranties, security measures, a ground lease amendment (often an ordeal, the easiest part of which consists of writing a large check to the landlord), or other less desirable terms. Or the leasehold mortgage might not happen at all.
Thus, rating agency criteria for ground leases give a ground lease negotiator or reviewer a good checklist to avoid problems—including potentially very substantial impairment of the value and salability of the leasehold estate—when negotiating a new ground lease or evaluating an existing ground lease.
A tenant, leasehold mortgagee, or B-piece buyer for a securitization might also have its own criteria for ground leases. Anyone negotiating or reviewing a ground lease must consider those internal criteria along with rating agency criteria. Internal ground lease criteria might likely address, for example: (i) required minimum length of remaining term; (ii) tolerable base rent reset formulas; (iii) requirements for involvement in, and approval of, any loss proceeds determination; and (iv) variations or acceptable deviations from ordinary rating agency criteria. Failure to meet internal criteria can be at least as serious as failure to meet rating agency criteria.
This model document offers a set of concise ground lease criteria (the “Model Ground Lease Criteria”) that summarize, consolidate, and slightly improve on current rating agency criteria for ground leases. These Model Ground Lease Criteria began as a compilation of all available rating agency criteria, followed by revision, reorganization, and addition of commentary.
The Model Ground Lease Criteria have three parts:
- Transactional Criteria. Standards for the business and financial terms, and other “nonlegal” terms, of the ground lease (all, collectively, the “Transactional Criteria”);
- Closing Criteria. Standards for the leasehold mortgage underwriting and closing process to the extent specific to leasehold loans (the “Closing Criteria”); and
- Minimum Protections. A set of baseline leasehold mortgagee protections (the “Minimum Protections”) that the parties could, at least in theory, incorporate verbatim into a ground lease and thereby satisfy the literal expectations of the rating agencies regarding what the ground lease should say.
The Model Ground Lease Criteria sometimes offer a bit less or more than rating agency criteria, as discussed in footnotes. Other footnotes explore rating agencies’ thought processes, alternatives to proposed language, and the author’s opinions.
The rating agencies’ criteria sometimes change, though only glacially. The descriptions of a particular agency’s criteria offered here may be incomplete, inaccurate, or outdated. Do not rely on them. Instead, check for updates and review current rating agency criteria, which are typically available online without charge but with a registration requirement.
The Model Ground Lease Criteria offered here: (i) omit criteria that apply to any mortgage loan, whether or not encumbering a leasehold estate, e.g., title insurance, which will always require adjustment for the particulars of any loan transaction; (ii) do not consider property or liability insurance issues, including any arising from overbuilt improvements; (iii) assume the landlord will not join in the leasehold mortgage (“subordinate the fee”) because landlords rarely do that in the 21st Century, unless perhaps they are affiliates of the tenant or unsophisticated and represented by inexperienced counsel; (iv) attempt to cover every criterion for ground leases established by any rating agency; (v) contain only a handful of defined terms; and (vi) leave most terms undefined where ordinary dictionary definitions suffice. (Items (v) and (vi), and other stylistic measures in these Model Ground Lease Criteria, take an approach very different from the other chapters in the author’s New Guide to Ground Leases.)
The Model Ground Lease Criteria vary from the rating agency norm by offering specific and complete language for the Minimum Protections that, if incorporated in any ground lease, would satisfy and fully conform to the literal words of typical rating agency requirements for generic leasehold mortgagee protections. In contrast, rating agency criteria offer general conceptual descriptions of what the ground lease should say, leaving specific wording to the writer of the ground lease. That approach opens the door for unnecessarily complex and overthought language and negotiations far beyond rating agency expectations. The Minimum Protections eliminate any such general conceptual directions in favor of clear, succinct, and minimalistic language ready for parties to insert into a ground lease if they dare. If they don’t dare, then they can instead treat the proposed language as a useful thought experiment and reference point.
The Minimum Protections provide only the essential protections the rating agencies want to see. The words of the Minimum Protections match the essential leasehold mortgagee protections as promulgated by the rating agencies. The Minimum Protections go no further. They paint with a broad brush. For example, they offer time periods or deadlines only where both: (i) the market consistently expects a certain minimum time period or deadline; and (ii) leasehold mortgagees and rating agencies typically consider it important.
The Minimum Protections consider only the interests of leasehold mortgagees and not landlords, who will often seek to dilute some protections, particularly on transfers. Just how much dilution a rating agency or leasehold mortgagee might tolerate lies outside this discussion.
Parties negotiating a ground lease can—and (their counsel) often will—massively complicate the Minimum Protections with clarifications, conditions, exceptions, and so on. This is where the problems arise. The more clarifications, conditions, exceptions, and so on, the greater the chance for mistakes and disputes, and the more protracted the negotiations.
In contrast, any ground lease could, at least in theory, incorporate the Minimum Protections verbatim because they are straightforward, don’t invite overthinking, and require less editing and negotiation than typical leasehold mortgagee protections. For all those reasons, they reduce the likelihood of mistakes and disputes.
The Minimum Protections do, however, omit and disregard a significant number of details that parties typically include in leasehold mortgagee protections in modern ground leases, going far beyond the minimum words sufficient to track rating agency criteria. Any resulting risks should be considered in light of both the infrequency with which leasehold mortgagees actually exercise any leasehold mortgagee protections and the tendency of reasonable parties to work things out if a problem arises. During the Great Financial Crisis and real estate recession of 2008-2009, or in today’s commercial real estate downturn, did many leasehold mortgagees activate their leasehold mortgagee protections or request new ground leases? How many parties actually had to read the lengthy and often unnecessarily complex leasehold mortgagee protections in their ground leases? Not many.
If a ground lease adequately covers each base suggested by the Model Ground Lease Criteria, the ground lease reviewer can reasonably conclude that the ground lease contains minimally adequate leasehold mortgagee protections. The Model Ground Lease Base Case does cover all those bases. So the Model Ground Lease Base Case, or any ground lease that includes the Minimum Protections, should pass muster with the rating agencies, subject, of course, to: (i) unique transaction details; (ii) compliance with general rating agency criteria for mortgage loans and any party’s internal criteria; (iii) compliance with the Transactional Criteria, the Closing Criteria, and ordinary mortgage loan closing procedures; and (iv) general unease in the market and legal profession regarding simple, succinct language.
Acknowledgments. The author acknowledges with thanks helpful comments from Joseph Philip Forte of McCarter & English, LLP; Bradford Lavender of Haynes and Boone, LLP; Alfredo R. Lagamon, Jr.; an anonymous rating agency analyst; and Daniel Caplow, Alexa Klein, and Lauren Silk of the author’s legal staff.
An earlier version of these Model Ground Lease Criteria appeared in the May 2021 issue of The Practical Real Estate Lawyer, published by ALI CLE. The author acknowledges with thanks the contributions made to these Model Ground Lease Criteria by the late Joseph DiPietro of The Practical Real Estate Lawyer. Other versions of these Model Ground Lease Criteria have appeared in other real estate law publications.
Model Ground Lease Criteria For CMBS And Other Lenders
Any ground lease encumbered by a leasehold mortgage should: (i) comply with the Transactional Criteria and Closing Criteria below; and (ii) contain provisions equivalent to (or more protective than) the Minimum Protections below (requirements (i) and (ii) together, the “Model Ground Lease Criteria”).
Any party that deposits a leasehold mortgage into a securitization (a “Depositor”) will need to represent and warrant compliance with the Model Ground Lease Criteria, in addition to making ordinary representations and warranties for any mortgage loan not encumbering a leasehold estate. If a particular leasehold mortgage loan does not fully comply with the Model Ground Lease Criteria, then the mortgage loan file should recognize, identify, and analyze the noncompliance, explaining why it should not impair successful securitization.
1. Transactional Criteria
The ground lease and its terms should comply with these criteria (collectively, the “Transactional Criteria”):
1.1 Investment Standards.
The premises are located in a market where ground leases are an accepted form of real estate investment. The lease at issue is a ground lease, not a space lease, as those terms are commonly understood in commercial real estate. It contains no unusual or burdensome provisions outside the range of typical provisions in ground leases in the market.
1.2 Prohibitions.
The ground lease does not: (i) give a leasehold mortgagee any shared appreciation rights or equity (or revenue) participation, such as percentage rent; or (ii) trigger a default based on a default under the leasehold mortgage. The ground lease is not a sublease.
1.3 Rent Increases.
Base rent will increase taking into account only: (i) a fixed schedule; (ii) fixed percentage increases; or (iii) CPI increases capped at up to 3.5% per year, expressed as either an annual cap or a cap compounded over multiple years. The ground lease does not adjust base rent based on any formula involving appraisal, valuation, revenue or income participation, or other contingent value-based review.
1.4 Term.
Assuming exercise of all remaining extension options, the ground lease term extends at least [30] years beyond the scheduled maturity of the leasehold mortgage loan.
1.5 Use.
The ground lease allows the present use of the existing building. The leasehold mortgagee’s appraisal of the leasehold estate fully considers all use and other restrictions in the ground lease.
2. Closing Criteria
The documentation and underwriting should comply with these requirements (the “Closing Criteria”):
2.1 Documents.
The ground lease and each amendment, or a memorandum of each, has been recorded. The loan file contains all documents referred to in the previous sentence. They match the documents listed in the landlord’s estoppel certificate. Any change in the ground lease necessary to satisfy the Model Ground Lease Criteria was accomplished through a ground lease amendment, signed by the landlord and the tenant with all necessary fee mortgagee consents. An estoppel certificate constitutes a sufficient ground lease amendment only if it: (i) was countersigned by the tenant; (ii) includes consent by all fee mortgagees; (iii) expressly modifies the ground lease; and (iv) was recorded.
2.2 Estoppel Certificate.
The landlord delivered an ordinary and customary estoppel certificate, without material exceptions, dated within the last 30 days before the leasehold mortgage closing.
2.3 Mortgage.
The leasehold mortgage requires the tenant/mortgagor to comply with the ground lease. The leasehold mortgagee has met all conditions or requirements for leasehold mortgages in the ground lease. The landlord has confirmed in writing receipt of any required notice of the leasehold mortgage and all its assignments, if any.
2.4 Status; No Default.
If the borrower/mortgagor is not the original tenant, then it acquired its leasehold estate in compliance with the ground lease, and the landlord has recognized the tenant as such. The ground lease is in full force and effect. Its term and the tenant’s obligation to pay rent (subject to any contractual free rent periods) have commenced. No uncured default exists under the ground lease. To Depositor’s actual knowledge, no condition exists that, but for the passage of time or the giving of notice, or both, would result in such a default.
2.5 Title.
Except for permitted exceptions: (i) the leasehold estate is subject to no lien or encumbrance superior or equal in priority to the leasehold mortgage; and (ii) the fee estate is subject to no lien or encumbrance, including any fee mortgage, superior or equal in priority to the ground lease.
2.6 Underwriting.
The underwriting of the leasehold mortgage loan: (i) treats ground rent as a priority expense like real estate taxes and insurance premiums; and (ii) fully considers any ground lease terms that impair the value of the leasehold estate.
