Originally published Fall 2004
Part I of a Two-part Series
Leasehold mortgages have traditionally secured ground
leases, but can also secure space leases of all types, and can add value to a
wide variety of deals. However, there are pitfalls for the unwary: only when
all parties to a deal fully understand the functioning of a leasehold mortgage
is it possible to safely take advantage of this powerful and valuable
mechanism.
Part I of this two-part series addresses the following three
topics that are important to understand when putting together a leasehold
finance arrangement:
(i) What is a “leasehold mortgage?”
(ii) What makes a lease “marketable?”
(iii) How is the lien of a leasehold mortgage filed and
perfected?
Part II of this series will address lender protection issues
related to leasehold financing, including important terms that the landlord,
tenant and lender must negotiate and draft into a lease in order for that lease
to be “financeable.”
This article conveys the major concepts involved in
leasehold financing, and provides a good starting point for subsequent drafting
and negotiation. The legal practitioner should also rely on appropriate
documentation, coordination with the local title company and all other
resources that are typically used in a practice setting.
What Is a Leasehold Mortgage?
When a tenant needs to obtain a loan, a “leasehold mortgage”
can secure the loan with the tenant’s lease and can be a powerful way to add
value to a deal. The most obvious use for a leasehold mortgage is in connection
with a ground lease in order to secure the financing of a purchase of a
leasehold interest or a related construction project. However, a leasehold
mortgage can also be used in connection with office, retail or industrial
leases in order to provide security for lines of credit, financing of a
corporate merger, or to serve as extra collateral to supplement a traditional
fee mortgage on another property. Using a leasehold mortgage, borrowers entice
lenders with extra security and lenders safely diversify their portfolios with
loans that would otherwise be too risky to consider. A leasehold mortgage even
benefits a landlord by helping commercial tenants to secure loans that improve
their financial positions and overall business operations, thus increasing
overall stability and allowing for a more reliable stream of percentage rent
payments to the landlord as well.
By suggesting and properly carrying out a leasehold
financing, a lawyer can “add value” to a transaction. However, there are
dangers to consider: unlike a fee property, which is a tangible piece of real
estate, a valuable lease can disappear in an instant as a lease can terminate
for a variety of reasons, and such termination will cause the value inherent in
the lease to extinguish. In order to accomplish a leasehold financing safely
and smoothly, the borrower, landlord and lender must all understand the basics
of how leasehold lending functions, as well as how to draft and incorporate the
essential lender protections. (Part II of this series will explain these lender
protection issues in greater detail.)
What Makes A Lease “Marketable?”
A “marketable lease” is a lease that has “value,”
and a lease is valuable when a purchaser is willing to “buy” it. “Buying”
a lease simply means that a purchaser pays consideration in order to take over
(i.e., be assigned) the tenant’s position. The sale price for the lease
is a product of negotiation between a seller and a purchaser. In the case of a
space lease, when the rent due under the lease is “below market,” a
purchaser may be willing buy the lease in order to enjoy the “bargain
rent.” The purchase price is often based on the differential between rent due
under the lease and market rent, calculated over the remainder of the lease
term and discounted to present value. Calculating the value of a long term
ground lease can be similar to the process of calculating the value of a fee
estate: factors such as the presence of valuable improvements and actual or
potential cash flows from the property affect the value of a ground lease. A
lease also has value if it is uniquely suited to a certain prospective
purchaser. For example, retail tenants often place a premium on location, while
industrial tenants often value access to specialized transportation and
facilities. A lender should rely on financial experts and expert real estate
appraisers to determine the value of any particular lease.
How Is the Leasehold Mortgage Filed and Perfected?
Although filing requirements vary by locality, a leasehold
mortgage is usually filed on the public record in the same manner as a fee
mortgage, subject to a few subtle but important distinctions. In a fee mortgage
situation, the description of the property interest encumbered by the mortgage
would normally consist of a legal description of the fee estate. In a leasehold
finance situation, the description of the property will instead contain a reference
to the leased premises. For example, “That certain lease by and between
_____ as Lessor and _____ as Tenant entered into as of _____, 2004 covering the
Premises described as follows: [insert Premises description from lease,
including any exhibits such as legal descriptions and ‘cross-hatched’ floor
plans, if applicable].” In addition to filing the mortgage document itself,
many jurisdictions also require the filing of a “Memorandum of Lease.”
The Memorandum of Lease typically contains the key information from the lease,
such as date, parties, term, renewal provisions, purchase options, if any, and
a definition of the premises, while financial information, such as rental
amounts, is usually excluded to avoid disclosing to the public record.
Practitioners should consult local law to confirm that the lien can be recorded
and enforced. The lender should obtain a “Lender’s Policy of Title Insurance”
to protect the value of the lien.
A Preview of “Lender Protections”
“Lender protections” are substantive terms drafted into a
lease that allow the lender to foreclose by taking over the tenant’s position,
and to quickly “sell” the lease by assigning it to a third party for value.
Lender protections are critical in a leasehold financing, because without them
the lease cannot function as collateral. The major lender protection topics,
which Part II of this series will address in detail, are as follows:
assignability to lender, assignability by lender, lender’s performance/cure
rights, new lease, standard tenant protections, proper definition of “lender,”
collusion or mistake, estoppel, title, and finally, tips for balancing the
lender’s needs against the landlord’s business interests.
A Final Thought About Business
Many major United States rental markets continue to be
relatively “soft,” with significant vacancies and landlords unable to raise
rents. In a slow rental market, one is not likely to find many suitably
marketable leases. However, a slow economy is a great opportunity for “bargain
hunters,” and some tenants are indeed signing long term leases at relatively
low rents. As rental markets improve, these leases will become more valuable
and many leasehold financing opportunities will begin to appear.
In Conclusion
With a proper understanding of the leasehold finance
process, a healthy respect for the benefits and pitfalls involved, and a spirit
of cooperation among all relevant parties, leasehold finance can add value and
safety to a wide variety of finance and leasing transactions.
Originally published in the Fall 2004 issue of the Real
Estate Finance Journal
The content of this article does not constitute legal advice and should not be relied on in that way. Specific advice should be sought about your specific circumstances.
