The typical non-recourse real estate loan is easy to describe. The borrower is the owner in fee simple of a piece of property. A lender agrees to lend money to the borrower, after satisfying itself that the value of the property is sufficiently greater than the loan the borrower seeks (to comply with the lender's required loan-to-value ratio) and performing other customary physical and documentary due diligence with respect to the property. The loan is secured by a mortgage on the property and other security documents, and the mortgage is recorded in the appropriate local land records. The borrower makes payments of interest and principal to the lender until the loan is paid in full, at which time the mortgage is released of record. While this description vastly oversimplifies most commercial real estate loans, in recent years the level of variation from this archetype has increased markedly, creating challenges for both lenders and their counsel.
Many of these challenges are the result of more complex debt structures. Lenders may spread credit risk by creating syndicates of multiple institutions or participating out portions of the loan. Loans may be segregated into tranches with various interest rate types and periods. The borrower may be required to enter into interest rate collars and caps in order to provide protection against fluctuations in interest rates over the term of the loan - often secured on a parity basis with the loan itself. Subordinate loans may be provided, including mezzanine loans secured by equity interests in the borrower itself. Intercreditor agreements of varying complexity may be required.
However, lenders are increasingly finding that the structures that complicate mortgage loans are arising on the borrower's side as well. As developers and other borrowers seek to achieve various tax or business goals, theymay split title interests in various ways such that lenders do not hold a mortgage or deed of trust on the standard fee simple interest. In those instances, lenders need to analyze how the intricacies of a divided title structure can affect the loan and the lenders' security.
A typical (and relatively commonplace) example is a ground lease structure. Perhaps the developer or a tenant obtained tax benefits that require that fee title be held by a governmental agency and leased back to the beneficial owner. Such a mechanism would likely involve payments in lieu of taxes (PILOT) that might differ significantly from the general tax structure with which lenders are familiar. Alternatively, the ground lease might be from a private-sector landowner that wishes to receive ground rent payments instead of selling the property, but wants to maximize the value of the property by having a third party develop it. In each case, lenders need to satisfy themselves (in addition to the inclusion of suitable mortgagee protective provisions) that the other provisions of the ground lease - including provisions as to use, assignment, casualty and condemnation - satisfy the standards for a financeable ground lease.
Another increasingly common example occurs in multi-use development projects involving separate retail, entertainment, office and/or residential components. These properties are often subjected to condominium regimes, sometimes before construction is completed. While the condominium structure enables each of the various segments to be held in separate ownership, it requires that lenders (as in the ground lease context) analyze not only any mortgagee protective provisions in the condominium documents, but also the various rights and obligations to which each unit owner is subject. In that regard, lenders will need to determine whether renegotiation of those rights and obligations is necessary (and feasible) to provide lenders with suitable security for their loans.
A further example, which lenders are increasingly facing in the residential context, is property that is the subject of sophisticated estate planning. Title companies report seeing more life estates, fees on limitation and other structures that most lawyers thought they left behind at the bar exam. Other structures of growing popularity are family limited partnerships, and the alphabet soup of QPRTS, GRIC's and GRAT's.
As loan structures move further and further from the fee simple model, complex title arrangements require that lenders analyze the documentary structure creating the estate as carefully as the property itself. In short, lenders must not lose sight of the fact that their security is technically the rights afforded to their borrower under the documents creating the borrower's estate in the property, not the property itself. In other words, lenders' rights are never greater than the instruments creating the borrower's interest. In this regard, provisions that contradict or otherwise are not in accordance with those in the loan documents can radically alter the arrangements that lenders intended to be in place.
Since the loan documents cannot, standing alone, alter the underlying arrangement between the borrower and other interest holders, lending against complex title structures often necessitates the negotiation of agreements with other interest holders - ranging from amendments to condominium structures, subordination and non-disturbance agreements with ground lessors and consents from other tenants-in-common. Each situation will require unique crafting, since each set of underlying or operative documents is likely to differ. Care also needs to be taken in the recording of these documents, to insure that the lenders' successors and assigns are afforded the benefit of the protections negotiated with third parties, and that the appropriate estates - which may exceed the borrower's estate in the property - are bound by the agreements.
The confusion which arises in lending against an estate short of fee simple is demonstrated clearly by the misuse of the concept of subordination. It is not uncommon to read in a ground lease that the fee and the fee mortgagee will not be "subject and subordinate" to a leasehold mortgage. As to the fee itself, the ground lease is presumably saying that the fee interest will not be encumbered by the leasehold mortgage. As between a fee mortgage and a leasehold mortgage, the concept of subordination is actually a misnomer, since the two mortgages are on entirely different estates.
Understanding that their security is as much paper as property, and proceeding accordingly, lenders can avoid unpleasant surprises down the road. Lenders in complex title scenarios may never have the clarity of a fee simple interest, but a clear-eyed view of the security they do have can indeed be quite valuable.
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.
We operate a free-to-view policy, asking only that you register in order to read all of our content. Please login or register to view the rest of this article.