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.
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.