NEW YORK: An Introduction to Real Estate: Mainly Dirt

Some Distressed New York Real Estate Is More Distressed Than Others

By Thomas D. Kearns

While the COVID-19 pandemic hit all submarkets of New York’s commercial real estate industry, perhaps no niche has been harder hit than hotels operating on ground leased properties. Because of my firm’s robust ground lease practice, we have been involved in several hotel ground lease default scenarios since the coronavirus surfaced in New York. First, it is important to remember that the City’s hotel market had been struggling over the last several years due to over-building, the rise of Airbnb and its competitors and weak economic growth generally. Hotel room rates have been well below hoped-for levels. And then the coronavirus arrived.

Ground leases are generally very long term arrangements (99 year terms are typical) under which the fee owner typically gives wide latitude to operate and manage the property to the lessee in exchange for a steady, easy-to-manage rent stream. Ground leases have become more popular as property values have increased and families and investors act to maintain long term property ownership while shedding management headaches. But management headaches returned with the coronavirus, particularly where the lessee’s position has been mortgaged. New York ground leases typically permit the lessee to mortgage its and only its position – the fee owner typically does not submit the fee estate to the lien of the mortgage. Leasehold mortgages finance improvements and otherwise permit the lessees to leverage their investments.

The pandemic forced many hotels to cease operating due to low occupancies, restrictions on travel and the cancellation of in-person conventions and meetings. Hotels have struggled to make debt and, for ground leased hotels, lease payments. Defaults abound. Creative ways to forestall lease terminations and the resulting loss of equity have failed so far—we successfully handled a bankruptcy case on behalf of a fee owner where the leasehold mortgagee filed an involuntary bankruptcy against its own borrower rather than protect the collateral by paying the defaulted rent.

But opportunities also exist. In one matter we handled, a hotel lessee invested additional equity by buying out its mortgagee at a discount. To avoid lease terminations or bankruptcies, some fee owners have been willing to grant rent concessions or short- or long-term forbearance in exchange for commitments to upgrade the hotel or to reduce mortgage debt. In negotiating these issues, unexpected non-economic issues often come into play: Has the lessee or its mortgagee been litigious? Has the lessee or its mortgagee had a history of transparency? Has the hotel been well run? Have investments been made to keep the hotel in top condition? Is the mortgagee prepared to take its share of the pain? (In New York, leasehold mortgages are always subject to the terms of the lease so that as between the fee owner and the leasehold mortgagee, the rent payments must be paid before payments on the mortgage.) Many times these soft issues wind up causing a fee owner to strictly enforce the lease, thereby forcing the mortgagee to protect its collateral and, if it doesn’t, to terminate the lease so the fee owner can start fresh with a new operator.

In evaluating the possible workout paths after a default, the hotel operator must evaluate the cost of continuing to carry the hotel in the current economic and health environment, the extent of its guarantees of the leasehold mortgage debt and its ability to negotiate with the leasehold mortgagee to obtain a forbearance that makes sense. The leasehold mortgagee must determine whether the leasehold position that serves as its collateral has any value remaining. Is the ground rent too high for that position to ever recover? While leasehold mortgages in New York are typically non-recourse as to principal, varying levels of recourse against credit-worthy guarantors exist in the market, from carveouts for certain bad acts all the way to guarantees of carry costs (interest, real estate taxes, insurance, etc.). While the mortgagee may look closely for acts that trigger a guaranty obligation, the devastating impact on hotel profitability caused by the pandemic is a classic example of why non-recourse mortgages exist—the market risk shifts to the mortgagee.

A further complication in ground leases is the typical rent reset clause. Traditionally, New York ground leases have rent resets every 20 years or so, at which point the rent is adjusted to market through an arbitration proceeding. When evaluating the workout paths, the status of that reset is crucial. Did it occur when the market was strong so that the rent is high? Is the reset imminent, which may be helpful since the reset might occur during a moment of weakness in the market? A short horizon might also hurt the lessee since the arbitration process needs to be managed, and if there is a dispute among the hotel operator and the mortgagee, prosecution of the arbitration may be effected.

Other parties may lurk in the background. Hotels are often operated under franchise agreements. Both the lessee and leasehold mortgagee may want to terminate the franchise agreement due to poor performance, and working with the fee owner to arrange a cooperative lease termination or bankruptcy filing might be helpful to reach that goal.

What has been the most surprising aspect of our experience with ground lease hotels during this time of distress has been the mortgagees’ willingness to sell their positions at very significant discounts. This tendency reflects a judgment on the part of mortgagees that the costs of re-opening and the rent under the existing ground lease are both too high given that the hotel market may not recover sufficiently to provide a return on investment in the foreseeable future.

The pandemic may have a lasting impact on the way new ground leases are negotiated and drafted. Future ground leases may restrict mortgage debt to limit possible economic distress. Perhaps base rents will be lower but leases will include a percentage of gross revenue over a base, so that when times are good, the fee owner participates. Some hotels may be converted for other uses. While ground leases will no doubt remain popular, their terms may adjust to changing market conditions. In the meantime, the recovery of ground leased hotels in New York will involve a series of ongoing multi-party negotiations, litigation and bankruptcies.