A ground lease is both a conveyance and a contractual agreement
between a landlord (the ground lessor) and a tenant (the ground
tenant) pursuant to which the ground lessor, as the fee owner of
the real property, conveys a leasehold interest in the property to
the ground tenant subject to the terms and conditions of the ground
lease. Ground leases are often entered into to facilitate the
development of an unimproved parcel of land by the ground tenant
and are therefore usually long-term leases (typically at least 50
years, often 99 years) given the time and costs associated with the
construction and maintenance of the site improvements; and because
at the expiration of the term, title to the land, and usually also
the improvements thereon, revert back to the ground lessor. From a
lender’s standpoint, the remainder of the term of a ground
lease should be long enough to amortize the loan and permit
refinancing. The minimum rule of thumb is that the expiration of
the ground lease should not be less than 20 years after the fully
extended maturity date of the loan. The term of the ground lease
also has an effect on the marketability of the property after a
foreclosure sale. Other reasons why property owners may decide to
ground lease their property include restrictions on the ability to
sell land owned by certain governmental entities, issues relating
to subdividing the property, tax concerns (i.e., transfer
taxes and capital gains) and sometimes the owner of the property is
simply not interested in developing and operating the building.
Ground leases present a host of financeability concerns in addition
to the term of the lease, and this article will address two of
these issues pertaining to limitations on permitted uses and
subletting. 

Among other related factors such as zoning, the value of a
property that is subject to a ground lease is directly tied to the
uses that are permitted under the ground lease. Generally, the
permitted use will impact the improvements that may be constructed
on the parcel and the income the ground tenant is able to realize
from tenants (which are effectively subtenants in the context of a
ground lease) and may also be a determining factor in the rent and
rent resets under the ground lease itself. To the extent that the
ground lessor has any right of consent over the permitted uses of
subtenants, this will likely render the ground lease unfinanceable
since such a consent right could severely impact the ability of a
property to generate cash flow.

An overly restrictive use clause would limit the ground
tenant’s ability to market and lease the property to tenants
that engage in certain types of businesses. For obvious reasons,
limiting the types of tenants to whom the property may be leased
will likely have a negative impact on the income that a ground
tenant/borrower is able to be generate from the property. The
permitted use clause should also be broad enough to allow a lender
to realize sufficient value from the sale of the borrower’s
leasehold interest in the event the borrower’s intended use
proves not to be viable. If the borrower defaults under the loan
and there is a foreclosure, it is important that the pool of
prospective purchasers is not limited because this may have a
negative impact on the purchase price, the proceeds of which the
lender will use to pay down the remaining balance of the
loan. 

Given the lengthy term of ground leases and the relative
unpredictability of market forces, the use clause should be broad
enough to allow the ground tenant (and, therefore, also the lender
or prospective purchaser at a foreclosure sale) to reposition the
property if needed due to changes in market conditions.
Consequently, a leasehold lender would want the permitted use
provision to be as broad and permissible as possible –
ideally, “for any lawful purpose.” If the ground lessor
insists on certain prohibited uses (i.e., adult
entertainment businesses and operations involving hazardous
materials), such uses should be expressly set forth in the ground
lease. To the extent that a ground lessor does have any type of
consent right, if it is not qualified by a requirement of
reasonableness, then the ground lessor need not be reasonable and
may condition its consent on any number of requests, including the
payment of money. Even if qualified by a reasonableness standard,
such consent would nevertheless be unacceptable and unfinanceable
due to the time delays and administrative hurdles of consent and
the “chilling” effect on any tenants not wanting to
spend the time on negotiating a lease which is subject to consent
rights.

The use clause is closely tied to the right of the ground tenant
to sublet. A ground lease should also not impose restrictions on
the ground tenant’s ability to sublease the property. The
ground tenant should be permitted to sublet the property without
having to first obtain the consent of the landlord, even if such
consent is not to be unreasonably conditioned, withheld or delayed
by the ground lessor. Lease provisions that are subject to the
ground lessor’s consent are problematic for a host of reasons
as noted above and often invite prolonged negotiations and
litigation based on disagreements on what is considered reasonable,
which may result in the ground tenant losing a prospective tenant
that needs to take possession of the property and start operating
its business. Also as noted above, as a practical matter, it is not
uncommon for ground lessors to use the request for consent as an
opportunity to require various concessions and additional
agreements from the ground tenant that are unrelated to the request
for consent and outside the scope of the lease.

Another function of ground leases having long terms is that it
is unlikely that the ground lessor that originally entered into the
lease is the same person or entity that the ground tenant has a
working relationship with when it’s time to obtain the ground
lessor’s consent, and unreasonable and difficult ground
lessors are not uncommon in the marketplace. Further, upon a
foreclosure the lender steps into the shoes of the ground
tenant/borrower and will therefore be subject to the limitations
contained in the ground lease, including any restrictions on
subletting. Therefore, flexibility on subletting is critical, and
there should be complete freedom for the ground tenant to rent its
space. 

Another requirement (and needed provision in a ground lease) is
the obligation of the ground lessor to provide a prospective
subtenant with a subordination, non-disturbance and attornment
agreement (an “SNDA”) whereby the ground lessor agrees
that in the event the ground lease is terminated prior to its
stated expiration date, the subtenant’s tenancy at the
property will not also be extinguished (i.e., so long as
the subtenant is not otherwise in default of its sublease the
ground lessor will agree to recognize the subtenant as a direct
tenant). Such an agreement by the ground lessor will typically be
conditioned upon the subtenant agreeing to attorn to the ground
lessor if the ground tenant’s tenancy under the ground lease
is terminated. Most sophisticated tenants will not enter into a
lease at a property that is subject to a ground lease unless they
have a non-disturbance agreement from the ground lessor. This is
also a financeability requirement to ensure that the property is
going to continue to have tenants and generate rental income to pay
the debt service. To protect ground lessors, many ground leases may
condition the provision of an SNDA on minimum leasing parameters or
other economic conditions as well.

While there are many financeability concerns when it comes to
ground leases, for the reasons noted herein it is critical that the
permitted use clause in a ground lease is as permissive as possible
and there are no restraints on the ground tenant’s ability to
sublet the property, along with the requirement for the ground
lessor to provide an SNDA.

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.

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