Investing In Ground-Leased Or Net-Leased Real Estate

This article briefly looks at an issue that continually arises in connection with the financing of ground leases (as well as long-term triple net leases generally), of which any real estate fund looking to invest in such instruments or in property subject to such instruments should be mindful. Unfortunately, as Moody's guidance on the subject1 points out, while "neither new nor cutting edge," this issue "arises again and again" — namely, the priority of the landlord/fee lender's position vis-a-vis the tenant's leasehold financing. Most real estate lawyers, whether operating in the "dirt" real estate or real estate finance field, know this issue to be pervasive. But somehow, the solution often seems not quite "within the grasp" when fashioning definitive lease documentation.

Basics

First, a brief primer. Ground leases, among other forms of so-called triple net leases, serve an important function in real estate ownership. Often, real estate owners, seeking to monetize unimproved or otherwise developable land but desiring to retain a residual ownership interest, will enter into a long-term "ground lease" under which the tenant typically will lease land and construct improvements upon or otherwise develop the land and then itself operate, sublease or otherwise monetize the land (as so improved or otherwise developed) for the tenant's own benefit; in return, the tenant may pay the landlord upfront consideration and/or periodic rental payments for the duration of the lease term. At the end of the lease term, all interest in the land and improvements reverts to the landlord.

The possible reasons that an owner may ground lease property rather than sell the same outright are numerous and varied, and include tax considerations, a familial or institutional desire to retain underlying control of the land, or simply a desire to collect a stable coupon and generate long-term value. In New York City, in particular, ground leases are an enduring part of the real estate landscape.2 Ground leases usually are of lengthy duration, often with terms of up to 99 years or even longer, and accordingly are complex, nuanced creatures.

Among other issues that the typical ground lease must address is the financeability of the leasehold position. In particular, because ground leases often involve significant upfront investment by the tenant in connection with construction and/or development of the leased property, the extent to which the tenant's possessory interest in the property for the duration of the term of the lease may be financed and collateralized is of significant concern, and a ground lease's failure to provide the protections that lenders ordinarily require in order for a ground lease to be financeable will sound its death knell. To be sure, numerous tomes have been written on the ways to make a ground lease financeable; the essentials include ensuring the lease expressly allows the tenant's leasehold interest to be financed and collateralized as a separate interest; providing the leasehold lender with sufficient notice and cure rights in the case of tenant default under the lease (after all, should the landlord simply terminate the lease following the tenant's default, the lender's leasehold collateral will immediately disappear — thus, leasehold lenders ordinarily demand extensive notice and cure periods); granting...