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May 4, 2011

Firm News for May 2011: Best Practices: Leasehold Mortgage Financing

By: Joseph A. Ernst, Esq.

Where SBA loan proceeds are used to finance improvements on a leasehold estate, the SOP 50 10 5(C) (pg. 213) requires that the underlying ground lease include a right for the borrower/ground lessee to encumber the leasehold estate. This requirement is in line with SBA’s general requirement that a lender take a first lien on the collateral it is financing with the SBA loan. Since the loan is used to make improvements to the leasehold estate of the borrower/ground lessee, then the loan needs to be secured by a first lien on the leasehold estate, which lien is created by a leasehold mortgage or deed of trust.

Although the lender may obtain a first lien on the leasehold estate, the fee owner/ground lessor (“Owner”) still retains a superior interest in the property – namely, ownership of the fee interest. Consequently, lenders may request that the Owner subordinate its superior interest to that of the lender through its first lien on the leasehold estate. The purpose of the subordination by the Owner is to ensure that the lender’s collateral interest in the leasehold estate is preserved in the event of a foreclosure on the leasehold estate. Generally, there are two types of subordination in leasehold mortgage financing that can be requested from the Owner; each presenting significantly different challenges and often resulting in very different outcomes. It is critical that lenders are clear about the type of subordination they are seeking from the Owner at the outset to avoid confusion and unnecessary delays.

The first type of subordination is commonly referred to as “subordinating the fee” to the leasehold mortgage, whereby the Owner subordinates its interest in the fee estate to that of the leasehold mortgage. Basically, in this type of subordination the fee owner is essentially granting a mortgage on its fee interest in the property and, upon foreclosure of the leasehold mortgage, the lender succeeds to the fee interest in the property (i.e., the lender comes to own the property through the foreclosure process even though it has only encumbered the leasehold estate). From the perspective of the lender, this is the ideal situation because it can dispose of the property in the same manner as if it had foreclosed on a fee mortgage. However, from the perspective of the fee owner/ground lessor this type of subordination produces a draconian outcome, as the Owner may lose its ownership interest in the property. Consequently, this type of subordination is less common and is typically only seen in the context of a long term ground lease of vacant property where the ground lessee intends to make substantial improvements to the property, so that the value of the improvements is much greater than or exceeds the value of the land.

The second type and more common type of subordination in leasehold mortgage financing is where the Owner subordinates its interests in non-real estate collateral (excluding the fee interest) to lender’s security interest in the non-real estate collateral and the lease. The key difference in this second type of subordination is that when the lender forecloses its interest in the leasehold mortgage, it is only foreclosing on the leasehold estate and, because the fee interest in and of itself is not subordinated to the security interest of the lender in the leasehold estate, the lender will not end up owning the fee interest in the property. After foreclosure of the leasehold mortgage where the subordination is of the second type, the lender merely steps into the shoes of the borrower/ground lessee and is thereby able to preserve the collateral (i.e., the leasehold estate). However, the fee interest of the Owner remains unaffected, excepting that the Lender, as successor-in-interest to the borrower/ground lessor, now controls the leasehold estate. This type of subordination is less helpful for lenders because the lender’s security interest remains dependent on the existence of the leasehold estate, meaning that if the borrower defaults on the ground lease, lender must cure the default in order to step into the borrower’s shoes under the lease. This can be difficult for lenders to monitor, and can be expensive to protect the lender’s interest in the lease.

If the distinctions between the types of subordination in the leasehold mortgage context are understood and used appropriately, obtaining a subordination from a fee owner/ground lessor need not necessarily turn into a standoff between the lender and the Owner, thereby causing an otherwise good candidate for an SBA Loan to be disappointed when a loan cannot go forward because the subordination of the interests of the fee owner/ground lessor cannot be worked out. For more information on securing ground lease transactions and other commercial leasing matters, contact Joe at 215-542-7070 or jernst@starfieldsmith.com.