§25.7 - Leasehold Lending

• Jurisdiction: Washington

§25.7 Leasehold Lending

Construction and permanent loans are available in the financial markets for commercial projects that are constructed on a long-term ground lease. In some cases, the lender may require that the ground lessor's fee simple interest be "subordinated" to the mortgage loan. In other circumstances, the lender may agree to make its loan on an "unsubordinated fee" basis; that is, the lender's mortgage will encumber only the ground lessee's leasehold estate, and the ground lessor's title remains paramount to the lender and its mortgage.

(1) Subordinated feein general

The simplest and most effective way to "subordinate" the ground lessor's fee ownership is to have both the lessor and lessee join in the execution of the mortgage. The ground lessor need not sign the lender's promissory note or subject itself to personal liability on the lessee's debt. A mortgage may secure the obligation of another, and the mortgage is valid as to the ground lessor even though it is not personally liable on the underlying obligation. Seattle-First Nat'l Bank v. Hart, 19 Wn.App. 71, 573 P.2d 827 (1978). The loan may be made on a "nonrecourse" basis as to the ground lessee without affecting the validity of the mortgage. Weikel v. Davis, 109 Wash. 97, 186 P. 323 (1919); RCW 61.12.050. The mortgage should contain an exculpatory clause relieving the ground lessor of personal liability for the secured note, irrespective of whether the same is done for the lessee. Ground Leases and Their Financing, 4 A.B.A. REAL PROP. PROB.& TR. J. 437, 452 (1969).

Practice Tip: In drafting an exculpatory clause as to the fee owner lender's counsel should consider whether and to what extent the fee owner ought to bear personal liability for the covenants of title and similar covenants of the mortgagor under the mortgage.

A leasehold interest in real property for a term less than life is personal property and is not extinguished by the foreclosure of a mortgage subsequently executed by both the lessor and lessee, unless the lease is specifically described in the mortgage. Nat'l Bank of Commerce v. Fountain, 9 Wn.App. 727, 514 P.2d 194 (1973). Therefore, a "subordinated fee" mortgage should describe not only the land and its improvements, but also the lessor's and lessee's respective interests in the ground lease as expressly included among the property interests encumbered by the mortgage.

(2) Subordinated feesuretyship issues

When a loan to the ground lessee is secured by a mortgage executed by a subordinated ground lessor, the fee owner may claim that it is no more than a surety of the lessee, and, as such, the fee owner is entitled to the rights and defenses of a surety.

Suretyship is a contractual relation in which one person, the surety, agrees to be answerable for the debt of another, the principal. If the surety performs the obligation of the principal, or if the surety's property is used to satisfy the principal's debt, the principal is required to reimburse the surety. Honey v. Davis, 131 Wn.2d 212, 218, 930 P.2d 908 (1997) (citing RESTATEMENT OF THE LAW OF SECURITY §104 (1941)); Leuning v. Hill, 79 Wn.2d 396, 400, 486 P.2d 87 (1971).

In addition to the right of reimbursement from its principal, the surety has a number of potential "suretyship defenses" against the creditor, which, unless effectively waived, are grounds for excusing the surety's obligations. These defenses include, for example:

• The lender's release of the principal (the lender's borrower) without the surety's consent.
• The lender's release of other collateral it holds from the principal without the surety's consent.
• The lender's extension of the principal's time for payment without the surety's consent.
• Modifications to the loan that create a fundamentally different contract, made without the surety's consent. This may discharge the surety or reduce its liability.

See RESTATEMENT (THIRD) OF SURETYSHIP AND GUARANTY §§39—42 (1996).

In some jurisdictions, the ground lessor's property has been deemed released from a subordinated fee mortgage on the basis of the lessor's successful assertion of surety defenses. E.g., Am. Mortgage & Safe Deposit Co. v. Rubin, 168 So.2d 777 (Fla. App. 1964) (ruling the "subordinated fee" mortgage is deemed released where the lender struck one of the cosigners from the note without the lessor's consent).

The Washington Supreme Court has...