Ground Lease Risks in Municipal Bond Projects: ArentFox Schiff

Ground lease structures have become a common feature of conduit financings in the municipal bond market. They provide tax advantages to projects and can be structured several different ways depending on the tax-exempt status of the parties involved.

The majority of the projects involve tax-exempt lessor structures. Since government entities and nonprofit organizations are exempt from real property taxes in most jurisdictions, a ground lease between such entities and a borrower-sponsor provides a project the opportunity to either be exempt from property taxes or subject to a payment-in-lieu of taxes arrangement, both of which can provide significant savings over the life of a project.

In higher education, universities usually utilize conduit financed ground lease structures to build student housing projects. These projects include a ground lease between a university, as landlord, and the borrower-sponsor, as tenant. The university agrees to the ground lease because, since the borrower-sponsor is responsible for repayment of the bonds and the mortgage is on the leasehold, the university can build a project on campus without incurring debt and keep the project for free once the ground lease is terminated. During the term of the ground lease, the provisions of the ground lease provides a means for the university to regulate or supervise the project and receive an annual ground lease rent.

In other industries, the issuer often owns the land and ground leases the land on which the project is to be built to the borrower-sponsor, who constructs the project and subleases it back to the issuer. Such a project qualifies for a real property tax exemption because it is owned by a government entity, and since the government entity is also tenant under the sublease, the project qualifies for sales tax exemptions on materials during construction. The issuer, as tenant under the sublease, is responsible for payment of the bonds, while the borrower-sponsor develops and operates the project pursuant to terms and conditions of agreements with the issuer. The borrower-sponsor usually has an opportunity to purchase the land and project once the bonds are paid.

These structures present unique risks to bond buyers. The bonds are generally secured by mortgages on the leasehold and/or subleasehold estates. Bondholders should be mindful of the rights of parties to terminate the ground lease or interfere with their ability to exercise remedies. If the ground lease is terminated or the trustee cannot take possession of the project, the corresponding lien on the physical project is extinguished and the collateral package has no value.

With that in mind, bondholders should seek the following protections in any ground lease that is part of a municipal bond financing:

In our experience representing bondholders, most of the ground leases we have reviewed have included the foregoing provisions. As we have encountered more complex financings, we have seen the following serious issues:

Before investing in a ground lease project, bondholders must fully understand the project and its risks. While reviewing the official statement and engaging with the underwriter, this client alert should serve as a comprehensive checklist of issues that should be addressed. In the context of a limited offering, perspective purchasers of the bonds have leverage to request our suggested changes to the ground lease. In those transactions, most landlords are related parties that directly benefit from the conduit financed project. It would generally benefit landlords for the projects to succeed, and a failure to negotiate in good faith or a termination of the ground lease with a leasehold mortgage would negatively impact their reputation and rating in the bond market. If any of these protections are not included when the bonds are issued, it is critical to obtain them in a workout as a condition for forbearance or refinancing.

by Mark Angelov & Sterling Johnson

March 9, 2023

ArentFox Schiff



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