Imagine constructing an elaborate ice-fishing cabin on a lake in Minnesota, complete with a flat screen TV, kitchen and all the comforts of home, only to suddenly hear a crack beneath you – the ice breaking…

Similarly, entering into a poorly structured ground lease can feel fine initially, but can quickly compromise the value of your investment.

In many locations and industries, like medical office buildings on a hospital campus, ground leases are normal and expected, while in others they are virtually unheard of.

Ground leases can function almost identically to holding fee simple title from a financial perspective, but there’s one critical issue that holds it all together: the ability to obtain leasehold financing. Ensuring a lease is financeable is by far the most important component, from a legal perspective, of negotiating a strong ground lease, even if you don’t plan on getting financing. Others in the future may get financing, and it greatly affects value.

Below are seven key legal issues to watch out for in ground leases:

1. Lender Notice and Cure Provisions. Lenders want as many second, third and fourth chances as they can get to make things right with the landlord before the landlord takes action to enforce its remedies. All of the typical bells and whistles for notice and cure periods should apply, including extensions of time if the original period is not sufficient to reasonably cure. In addition, if a cure by lender requires foreclosure of the leasehold interest, the lender should be afforded the opportunity to do so before the landlord takes action.
2. New Lease Provisions. Related to #1 above, lenders want the ability to get a new lease between the landlord and the lender if the ground lease is terminated (or under threat of termination) due to a tenant default or bankruptcy. Because bankruptcy laws may allow a tenant to reject a ground lease, lenders need to have a way to revive it to ensure the preservation (and even existence) of their collateral. Under the new lease provisions, the landlord should waive defaults personal to the prior tenant and allow the lender an opportunity to fix things that it can fix. Both #s 1 and 2 ensure that the lender’s collateral cannot evaporate into thin air because of a foot fault by the tenant.
3. Term. The term of a ground lease should be a minimum of 30 years after the end of any potential loan term, however, longer is better. An owner must also be thinking about what the term of the ground lease will be upon ultimate sale of its interest, not just at the time it is underwriting an acquisition. It is common for new ground leases to provide for 99-year terms.
4. Rent Escalations/Economics. There are many ways to structure ground lease economics, whether lease payments are prepaid all upfront or paid over time, often with escalation clauses. Each ground lease is different in this regard, and custom in the industry and location will often dictate how they are structured. Theoretically, buyers will be agnostic as to how lease payments are spread out or paid upfront, as long as the purchase price for the ground lease adjusts accordingly and the pro forma works. However, problems arise when rent escalations in the future are based on a market rent reset or some factor that is unknown at the time of underwriting. There is a natural tension between landlords wanting to protect themselves against inflation and tenants wanting to maintain the value of the leasehold interest and have certainty. Market conditions at the time of a potential rent reset can also affect the parties’ positions on the topic.
5. Assignment and Sublease Rights. Overly restrictive assignment or sublease provisions can strangle flexibility and reduce marketability. Ensure ground lease tenants can freely mortgage, assign, or sublease their interests without cumbersome landlord consents, especially after construction. A transfer of the lease through foreclosure of a leasehold mortgage should never require landlord consent, and lenders want the ability to freely assign to anyone after foreclosure without landlord consent.
6. Priority of Interests and Mortgages. Leasehold mortgages should have priority over any fee mortgages (if any). Mortgages on the fee interest and the leasehold interest should each only encumber the applicable interest. The space lease concept of the lease being subordinate to the fee mortgage does not apply to ground leases. In addition, the tenant should have freedom to mortgage its leasehold interest without landlord consent. The landlord may have an interest in controlling who holds any leasehold mortgages, making sure it’s an “institutional” lender/investor, however, be careful not to make these restrictions overly restrictive. As an example, CMBS trustees sometimes do not technically qualify under certain institutional lender definitions, but they should.
7. Use Restrictions. Often, the reason that a ground lease is established in the first place (instead of an outright sale of land) is the landlord’s desire to control ongoing use of the land post-transfer. Examples include a university wanting to control activities on its college campus or a hospital system wanting to control ancillary medical office facilities on its hospital complex. However, lenders want maximum flexibility with respect to property use in order to maximize the potential value of the collateral.

Structuring your ground lease carefully with these considerations transforms it from potential pitfall to robust financial foundation.

The list above is not all-inclusive. For a robust checklist for ground lease financeability, including on provisions relating to condemnation, casualty and CMBS/rating agency standards, please reach out directly

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