Overview
Credit Tenant and Ground Lease financings provide opportunities for some of the lowest-cost, long-term financing available. This article addresses typical aspects associated with such financing.
I. Credit Tenant Leases
Credit Tenant Leases (CTLs) are transactions where debt is supported by both the lease and the underlying asset. Typically, the lessee is a highly rated obligor, creating a strong likelihood that the creditor will be repaid on time and in full from the lease alone. Furthermore, after a few years, the value of the underlying asset exceeds the related debt, providing creditors with two avenues for repayment: the lessee and the underlying asset.
To properly model an analysis of credit quality, it is helpful to mirror the bankruptcy process. Although bankruptcies are rare in the CTL area, if one were to occur, the typical approach would be for the creditor to assume control of the asset and sell it in the open market. However, since the asset is often essential to the underlying obligor, leases are often affirmed even in bankruptcy, as the obligor typically needs the asset to support its operations.
Back to the bankruptcy analysis: if the obligor defaults, the first step is typically for the creditor to liquidate the asset and then to seek repayment of whatever remains, as an unsecured creditor of the obligor’s estate. Below is a simple example. As can be seen, the “Info” Column provides basic information of the transaction. In the Base case, line 9, the assumption is that there is a 75% recovery against the $100M asset (note, this recovery rate is probably too low for most assets) resulting in a $75M recovery. Hence there is a $25M unsecured claim against the lessee (i.e., $100M less the $75M recovered). Assuming a 60% recovery rate with $25M recovered and a 2.0% Default Friction Factor (listed in line 12), the total Recovery Given Default is $88M listed in line 13, and the Cumulative Estimated Loss is $12M listed in line 14 (i.e., $100M less the $88M recovered). Given the fact that the 4.66% Probability of Default listed in line 9 implied by the BBB rating, multiplied by the LGD of $12M results in a Cumulative Estimate Loss of $0.56M listed in line 15. Now for the allocation of loss, the bulk is allocated to the Equity portion, with the Debt absorbing 35% of the Sum Estimated Loss. One could argue that all the loss should be absorbed by the Equity, but to facilitate an exit from bankruptcy, the Debt side often absorbs some of the loss. Per line 17 below, the EL is $0.20M for the Base Case and $0.37M for the Pessimistic Case. Converting the EL to a percentage EL, based on the $90M invested, the Percentage EL is 0.22% and 0.41% and the implied ratings are A+ and A. The last step is adjusting for the probabilities for each case (80% and 20% here) resulting in a Blended Implied Credit Rating of A.
Figure I: Terms, Probability of Default, Expected Loss, & Implied Ratings
The above analysis is helpful at the onset of the transaction but falls short, particularly as the transaction matures. The notion is that, over time, the value of the assets typically increases, and the debt declines via amortization. A corollary is the case of a home mortgage; as the mortgage balance declines via amortization and the value of the house increases, the creditor’s exposure declines. Hence, the asset values listed above would be adjusted upward and the debt downward. Typically, after several years, the value of the asset exceeds the outstanding debt, and therefore, from a credit quality perspective (i.e., ignoring interest rate risk), the exposure becomes minimal, provided the usual bankruptcy and creditor protection norms are observed.
II. Ground Leases
Ground leases are often viewed as one of the most secure forms of financing because of the massive amount of capital supporting the providers of debt in a ground lease. (It is rare to find a default in this area.)
A few notable examples in New York:
The Chrysler Building: The land under the Chrysler Building in Manhattan is owned by Cooper Union, a private university, and is leased to the building's owners.
Hudson Yards, New York City: Much of the land beneath this massive mixed-use development is leased from the Metropolitan Transportation Authority (MTA), as it was originally part of the West Side Rail Yards.
Rockefeller Center, New York City: Initially developed through a ground lease with Columbia University.
The World Trade Center Site, New York City: The land under the World Trade Center is owned by the Port Authority of New York and New Jersey and leased to Silverstein Properties for redevelopment.
The landowners in ground-lease deals typically have long investment horizons such as sovereign entities, municipalities, or non-profits (including universities). The building owner leases the land for an extended period, typically over 30 years, during which the landowner receives a 'Land Lease Fee.' The contract often includes a purchase price for the improvements at the end of the lease period, if applicable.
An example: Assume that the entire property costs $100M. The value of the land is $20M, and the value of the improvements is $80M. The landowner borrows $15M, supported by (A) the value of the land, (B) the value of the improvements, and (C) the ground lease. Notably, the stability of cash flows from the ground lease is a function of the creditworthiness of both the building tenant and the building owner. Below is an illustration of a typical transaction. There is high-level structural subordination for ground leases, which reflects the low level of defaults.
If the landowner defaults on its $15M debt, the lender assumes ownership of the land and the improvements. The above figure indicates that the ground lease has a cumulative LTV of 15% on a property valued at $100M. Hence, the value of the property can decline from $100M to $15M (which is typically highly unlikely) and still be made whole.
Further, the value of the property typically increases while the outstanding debt declines, thereby providing additional protection.
III. Summary
We hope this subject area piece is helpful. Please contact us for additional information or for an indicative rating. Sales@Egan-Jones.com
Note
The purpose of this installment was to provide an overall view on the typical approach for assessing litigation finance. It is only illustrative; we strongly suggest contacting the Ratings area for a more precise assessment of the likely credit quality and corresponding rating.