GlobeSt.com: Are any particular geographic regions hotter than others? Major cities? Suburbs?

Neale: New development is pretty much confined to New York. Some major cities such as San Francisco are seeing lots of sales activity. A number of high-end properties have traded. REITs have played a big role and now Asian buyers are beginning to step up with New World Development out of Hong Kong recently acquiring several upscale properties. But these all involve existing projects. REITs aren’t generally providing construction financing, and except for some projects relying on EB-5 investors, foreign investors want established properties. Also, the recent downturn in the stock market will make it much more difficult for REITs to continue their buying.

GlobeSt.com: What are you seeing as an alternative? I have heard that it is to secure a ground lease instead of purchasing the property? If so, why is that beneficial or seen as a good alternative?

Neale: A ground lease can be a viable alternative. I see two primary advantages. First, it can open up land for development that might not otherwise be available. For example, many public agencies and non-profits own prime parcels of land that they may be legally restricted from selling, but not from leasing. Second, the use of a ground lease reduces the amount of cash a developer will need to get a new hotel project off the ground. Instead of putting money into purchasing land (typical 15%-25% of the cost of a hotel project), it could put it into construction. This could facilitate financing for some new hotel projects. There are other advantages, as well. For example, ground lease rent payments are deductible, while land is not depreciable.

GlobeSt.com: What are key steps to negotiating the ground lease agreement? What should developers keep in mind?

Neale: The landowner and developer need to start off their relationship with a common desire to achieve a successful hotel development on the land. That means, first and foremost, that the ground lease must be financeable. It must contain certain lender protections built into it that will allow a lender to obtain a leasehold mortgage (or deed of trust) and enforce its rights under the mortgage (i.e., takeover the lease) in the event of a default under the loan. Without this, a developer will be unable to obtain financing for a hotel project. Lenders and rating agencies have strict requirements for lender protection provisions. It is important that the developer understand these requirements before negotiating the ground lease.

GlobeSt.com: What are key elements that should be in every ground lease?

Neale: There are many key elements relating to financing. A ground lease must be of sufficient duration (including option periods) such that, when a loan matures there will be enough time left on the lease to allow the tenant to refinance the loan. Typically, a lender will want to see 20 to 30 years remaining on the lease after the loan matures. Starting off, a developer will want to see a term of 50 to 99 years. The ground lease must specifically allow a tenant to grant a leasehold mortgage without the landlord’s consent. Assignment provisions must be sufficiently liberal in order to allow the lease to be assumed by a lender or other purchaser in a foreclosure sale, or by a party who may thereafter wish to purchase the hotel from such lender or purchaser. Other lender protections include the right to control insurance proceeds to allow the tenant to rebuild after a casualty, the right of the lender to demand a new lease in the event the original lease is terminated due to bankruptcy of a tenant or an incurable default, the right of the lender to receive notice of and cure the default of the tenant, and the right of the lender to approve any lease amendments. Aside from lender protections, rent provisions are, of course, important. Typically, rent is some percentage (say 4% to 8%) of the value of the land, plus a percentage rent of gross revenues over a certain level. There are many issues involved in calculating percentage rent.

GlobeSt.com: What are some potential pitfalls related to ground leases?

Neale: For the developer, the failure to negotiate adequate lender protections at the time the lease is entered into could be a critical mistake. It is always more difficult to negotiate these afterwards when the landlord may have less incentive to be accommodating. A landowner will want to avoid subordinating its fee interest to a construction loan, which would put it at risk of losing the land to the developer’s lender. The landowner may also want some approval rights over the hotel operator in order to insure a quality project.