Article by Chris Huband, ©2005 Blake, Cassels & Graydon LLP
This article was originally published in Blakes Bulletin on Real Estate & Mortgage Financing - March 2005
In some cases, a borrower may not be the freehold owner of real property, but instead will hold its interest pursuant to a long term ground lease. Ground leases give rise to particular challenges for mortgage lenders.
Land may be held under a ground lease in cases where an institutional or municipal owner is unwilling to relinquish its ownership interest in a key parcel of real estate, but may be willing to lease it. Under a typical ground lease, the tenant is solely responsible for all capital and operating costs and has the right and obligation to construct and maintain buildings on the property. The term of the lease may extend for a lengthy period of time, often as long as 99 years but more often for less than 50 years. In consideration for this, the tenant pays annual rent to the landlord that may be a fixed amount (usually subject to escalation based upon current land value) or a stated proportion of the income generated by the property or both. Ground tenants often have considerable freedom in granting subleases and mortgages of their leasehold interest.
From the lender’s perspective, there are several unique issues that arise in financing such an interest. Obviously, the term of the loan must be safely within the existing term of the ground lease. If the term of the ground lease expires before the loan is fully repaid, the lender has no security. The lender may require the tenant to exercise any available options to extend the term and will wish to ensure that any outstanding options to renew are not personal to the tenant, but can be exercised (if necessary) by the lender or its assigns. The provisions of the ground lease must be carefully reviewed to identify any restrictions on financing or transfer (which might limit realization) and any limits imposed on the tenant’s ability to operate the property. The ground lease must be registered against title to the property so that the leasehold mortgage may be similarly registered. If the term of the lease, including renewals, exceeds 21 years in Ontario, the lender must be careful to ensure that the subdivision restrictions of the Planning Act (Ontario) have been complied with.
Charge by way of Sublease
The lender must be careful to ensure that it does not inadvertently become responsible for the obligations of the tenant under the ground lease. This is accomplished by providing that the leasehold mortgage is a charge by way of sublease, rather than by way of assignment. A charge by way of sublease is effected by the tenant reserving the last day of the term of the ground lease. The last day is usually held in trust by the tenant for the lender.
Risk of Tenant Default
Because the tenant remains responsible to the landlord for the performance of all of the tenant’s obligations under the ground lease, the lender is exposed to the risk that the tenant might default in the performance of one or more of those obligations, thereby entitling the landlord to terminate the ground lease. For a leasehold lender, the consequences of this would be fatal: its security would disappear. In some cases, the landlord may be prepared to agree that the leasehold mortgage will survive notwithstanding any termination of the ground lease. This effectively constitutes a mortgage of the landlord’s freehold interest and may be accomplished by registering a separate, usually non-recourse, mortgage against the freehold estate. Alternatively, the landlord may simply agree not to terminate the ground lease for any reason, including a tenant default, for so long as the leasehold mortgage remains outstanding.
Leasehold Mortgage Agreement
However, most landlords will not agree to subordinate their freehold interest to the leasehold mortgage. A more usual approach is for the parties, including the tenant, to enter into a leasehold mortgage agreement whereby the landlord agrees to give the lender notice of any default by the tenant and an opportunity to cure the default, often within an extended time frame. If the default is of an incurable nature (such as the bankruptcy of the tenant), the lender will usually negotiate the ability to obtain a new lease directly from the landlord upon the same terms as the former ground lease for the balance of its term. Although the ground lease may contain provisions contemplating such an arrangement, the lender will wish to ensure that it has privity of contract with the landlord, which can only be accomplished by a separate agreement. The tenant should be a party to the agreement as well because it may be necessary for the lender to enter onto the property in order to cure defaults.
The leasehold mortgage agreement typically also addresses several other matters. The lender will be concerned to establish the trigger point at which the lender becomes responsible for the obligations of the tenant under the lease in a default scenario. The lender will wish to ensure that this trigger is an event firmly within its control, such as the delivery of written notice to the landlord. The lender will also wish to ensure that, upon assuming responsibility for the tenant’s obligations, the lender does not thereby become burdened with liability for previous defaults by the tenant arising prior to the trigger point. Furthermore, the lender will want to provide that it is clearly released as soon as it disposes of the tenant’s interest in a realization. The leasehold mortgage agreement will also restrict the ability of the landlord to amend the ground lease or to consent to an assignment of the lease by the tenant without the lender’s consent, contain estoppel language with respect to the current status of the ground lease and include provisions designed to ensure that the agreement becomes binding on successors and assigns of both the lender and the landlord. If there is a renewal option still outstanding, the lender may require that it receive notice from the landlord if the option goes unexercised and be granted an opportunity to exercise it on behalf of the tenant. If the ground lease contains restrictions on transfer by the tenant, the leasehold mortgage agreement must permit the lender to assign the tenant’s interest under the ground lease in the course of realizing on its security without the necessity of obtaining the landlord’s consent.
Form of Security
With the exception of the leasehold mortgage agreement and the reservation of the last day of the term of the ground lease, the security for a leasehold mortgage loan is very similar to that for a freehold mortgage loan. In Ontario, the Land Registration Reform Act provides for certain implied covenants in mortgages of leasehold land, which will apply in the leasehold mortgage document unless they are specifically excluded. Unless there is a separate leasehold parcel for the tenant’s leasehold interest under the Land Titles Act (Ontario), leasehold mortgages are registered under Ontario’s electronic registration system, not in the familiar Charge/Mortgage form, but as notices of a charge of lease, to which the form of leasehold mortgage can be attached.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.