A "ground lease" is defined (via a simple online search) as a long-term (typically 50-99 years) lease agreement where a tenant (the lessee) rents land from a landowner (the lessor) and builds structures or improvements on it, after which the land and all improvements revert to the landowner. In terms of the commercial mortgage-backed securities (CMBS) sector, mortgage loans secured by individual ground-leased properties have been securitized in the past and included within conduit and standalone transactions. However, of late, S&P Global Ratings has received proposals to rate securitizations of pooled ground leases themselves, a novel approach involving a familiar asset. As such, we explore the legal aspects, asset quality considerations, and servicing we view as risks inherent in a pooled ground lease securitization.

While the characteristics of the assets themselves in a pooled ground lease transaction--and our approach to analyzing the risks–-will naturally share many similarities with those in a CMBS transaction, there are important distinctions that we discuss in the following sections. For pooled ground lease transactions, unlike in a CMBS transaction, the cash flow collateral would be the ground leases themselves, and not loans secured by liens on ground-leased properties. Credit on individual ground leases or pools with significant concentration can be associated with more direct linkage to creditworthiness of the lessee, whereas well-diversified pools offer greater protection against idiosyncratic risk.

Legal Risk

To begin, pooled ground lease structures typically contain no mortgage loan, and no requirement of ownership (by the issuing special-purpose entity [SPE]) of the leased properties. The security interest is a contractual right to the pledged lease revenues (ground rent) from the leased properties as collateral for the debt. The ground lessee's obligation to make the pledged lease payments will typically be senior to their mortgage payments (if any), operating expenses, and other obligations, although it's possible that the lender's claim takes precedence in subordinated ground leases. Upon a default, the securitization trust would not be entitled to enforce its claim against the property itself, but rather only against the ground lease. As a result, recoveries would be limited to any post-default resumption of payments. If the servicer has the power to re-lease the property after a default (see the Servicing Considerations section below), cash flow could resume following re-tenancy if there's an agreement in place to allow future cash flows to be pledged to the trust.

Chart 1

With this in mind, we'd consider the following legal risks, and any mitigants, to evaluate the sustainability of the cash flow:

• First, does the owner have the right to sell the land at any time? If so, we would need to consider whether provisions in the documentation mitigate the risk that the transfer of the title disrupts the continued pledge of revenues (other than payments in lieu of taxes) to the rated debt.
• Next, is the pledged revenue provided by a head lease or a sublease? Subleasing introduces more counterparties, complexities, and cost in the case of default. To that end, what are the noteholders' (or the trust's) rights to future cash flow and obligations following the default of the ground lessee? Can the trust sell the future cash flow rights post ground lease default as a recovery remedy? Is the trust entitled to seek the re-lease of land to another ground lessee?
• Finally, there may also be jurisdiction-specific risks to be aware of.

Asset Quality

A discussion of asset quality is perhaps where we'd expect to see similarities to our approach in the context of CMBS transactions and other structured finance asset classes. Namely, we typically have evaluated the factors in chart 2.

Chart 2

Specifically:

• Where are the properties located?
• What is the diversity of ground leases in the portfolio (count, geography, property types, etc.)?
• What is the potential utility of the land? Is it special use or fungible to multiple use cases?
• Would the existing or future improvement potentially lower the re-leaseability of the land or cause environmental degradation?
• What are the remaining lease terms in the portfolio? (For example, if the lease term is shorter than the debt term, what is the likelihood that the tenant will exercise an option to purchase the fee, enter into a new lease, or leave that location?)
• What is each property's annual ground lease base rent? What is the amount of contractual rent increases, if any?
• What is the credit quality of the respective ground tenants? Does the location have any strategic significance for the tenants' operations? What is the historical performance of the tenants? What is the operating cushion to pay their respective ground rents?
• Are the assets currently paying, or expected to come online at some future date?
• For liquidity risk, what are the mitigants? Will there be a reserve or some other liquidity source?
• What type of environmental risks are associated with the underlying properties?
• What is the debt service coverage?
• Is there long-term historical data for the types of ground leases being securitized?
• What is the useful life of the asset(s) and is it at risk of obsolescence over the term of the rated notes? What is the level of investment that the ground lessee has made in the improvements on the land?
• Does the transaction have unusually long tenor, exceeding what's commonly seen in long-term mortgage or government bonds (30 years)?

In the case of the last point, we have considered introducing limitation to the lease term credit and stressing the base cashflows to account for the uncertainty despite the portfolio's long maturity profile. In a prior transaction, we have evaluated the break-even point based on this cash flow stress and compared it against the stresses applied to the closest peers for these transactions (typically CMBS and triple net leases).

Servicing Considerations

Our evaluation of the servicing of the pooled assets revolves around the roles and responsibilities of a lease administrator. In general, this entity would likely collect and retain rent payments, have the ability to re-lease the land in case of credit issues with current tenants (and make sure all subsequent lease cash flows are also pledged to the issuer), and more. Hence, the lease administrator's experience and ability to re-lease the properties is key. Naturally, we'd also expect some mechanism to replace the administrator, if necessary, and allow a clear legal pathway for a new third-party servicer to step in within the deal/asset documents. We generally don't expect the lease administrator to repossess the land or the improvement if the SPE does not have ownership to the leased properties.

The Old And The New

The securitization of a pool of ground leases would represent a novel approach to an asset class that is already familiar to many structured finance market participants, especially in the context of CMBS. The credit profile of such a transaction, in our view, would center on certain legal risks, asset quality, and servicing considerations. It follows that the risks associated with such collateral bear similarities to, and important differences from, other structured finance sectors, including the analysis and timing of cash flows, obligor credit, diversification, and lease provisions. We will continue to monitor this nascent sector, and report our observations as it develops.