Although not without unique challenges, a long-term ground lease may be an appropriate structure for facilitating financing for some new hotel projects, especially in the current atmosphere of ongoing tight credit.
A ground lease is typically a long-term lease of land (at least 30 years, and often 99 years) upon which a tenant will construct a commercial building. While land owners may have their own reasons for wanting to lease rather than sell their property (such as steady cash-flow, legal restrictions on sale or subdivision or the desire to benefit from long-term appreciation), the primary advantage for the hotel developer in entering into a ground lease is that it will typically decrease the amount of cash the developer will need to get a project off the ground. The cost of land is often 15% to 25% of the total cost of a new hotel project. There are other advantages as well; for example, rent payments are deductible, while land is not depreciable.
The key issue for a developer to consider in entering into a ground lease is that it be “financeable.” This means that the ground lease must have certain lender protections built into it, or in a separate document, that will allow a lender to obtain a leasehold mortgage (or deed of trust) and enforce its rights under the mortgage (in other words, take over the lease) in the event of a default. Any lender lending on a ground lease will have detailed requirements for these provisions.
These provisions may be even more stringent with respect to a securitized loan. In that case, specific rules regarding ground leases have been developed by the rating agencies. The complexity of lender protection provisions and the difficulty in negotiating them can be among the most challenging aspects of a ground lease.
Here are the basic lender protections that should be in every ground lease:
Lease term: The term of the ground lease must be long enough so that when the loan matures there will be sufficient time left on the lease (at least 20 years, but sometimes more) to allow the tenant to refinance the loan. If the tenant has options to extend the term, the lender may want the right to exercise such options on behalf of the tenant.
Assignment and encumbrances: The ground lease must specifically allow the tenant to grant a leasehold mortgage without the landlord’s consent. Also, assignment provisions must be liberal enough to allow the lease to be assumed by a lender or other purchaser in a foreclosure sale, or by a party who may thereafter wish to purchase the hotel from such lender or purchaser. A lender needs to be able to sell the hotel and assign the ground lease after a foreclosure.
Casualty: If the hotel is damaged due to a fire or other casualty, the landlord must not have the right to cancel the lease, and the insurance proceeds must be made available to rebuild the hotel or pay down the loan.
Land (fee) mortgage: Any mortgage on the land obtained by the ground landlord must be subordinate to the ground lease so that if the mortgage is foreclosed upon, the ground lease would remain in effect.
New lease: The lender must have the right to enter into a new ground lease on the same terms as the old ground lease if the old lease is terminated for some reason, such as due to the bankruptcy of the tenant or an incurable default.
Notice and cure: A lender will want to be notified of any default under the ground lease and have the right and opportunity to cure the default.
No merger: If the ground tenant acquires the land, the leasehold interest and the fee interest must not merge. Otherwise, the lender could lose its security.
No amendments: The ground landlord must agree that the lender will not be bound by any amendment or modification to the ground lease made without its consent.
Estoppel: The ground tenant must have the right to demand that the landlord sign and deliver to the tenant’s lender an estoppel certificate confirming certain aspects of the ground lease.
In addition to complicated provisions relating to leasehold financing, other downsides of ground leases include the monthly rental payments, the possibility of losing the leasehold in the event of a default and the fact that at some point in the future the property will return to the ground landlord. Despite these drawbacks, however, considering the difficulties of financing new hotel projects under current market conditions, a ground lease could be a valuable tool for the hotel developer.
Kenneth Neale is a real estate attorney with Howard Rice’s Food, Beverage and Hospitality Practice in San Francisco.