Completion Guarantees in Ground Leases: What Are They Good For?April 27, 2022 – Spring 2022 Development Whitepaper from Development Site Advisors
There is no shortage of discussion among lawyers about the utility of completion guarantees. In a typical development ground lease, the landlord selects a developer to construct new or substantially refurbish property and then operate that property for the production of income. Once completed and rented, the newly constructed building becomes collateral for the tenant’s long-term rental obligation (usually 99 years). Given the importance to the landlord of the new building, the landlord will want to be very careful in its selection of a developer to lease the land and will only consider experienced developers who are prepared to commit to build the new structure within a reasonable time period and to stand behind that commitment with "skin in the game." One way a developer may demonstrate commitment is by delivering to the landlord a completion guaranty; i.e., a guaranty from the sponsor of the project or a credit worthy equity partner, that the new building will be completed and operating when promised.
When a completion guaranty is used, there is usually some tension between the landlord and the tenant about the timing of its delivery. In most cases, the tenant will be obtaining a construction loan and expects to deliver a completion guaranty to the lender at the closing of the loan at which time it would also provide a similar guaranty to the landlord (the interplay between the guaranty delivered to the lender and the guaranty delivered to the landlord is a separate discussion beyond the scope of this article). The closing of the construction loan almost always occurs after the ground lease is signed. The guarantor will not want to make an unconditional commitment to the landlord to construct a new building costing tens of millions of dollars before a construction loan has been secured and all of the equity is in place. Given this reality, how can a landlord ensure that it will get the building it bargained for? It’s worth mentioning that as a practical matter, a completion guaranty does not actually translate into completion by the tenant of a new building let alone on time. If the tenant under a ground lease does not timely complete the new building, the landlord’s remedy against the guarantor is generally to sue for the cost of completing construction. A lawsuit against a completion guarantor is hardly an ideal remedy and probably not what the landlord envisioned when it demanded the guaranty.
What does all of this mean for the landlord? Since the tenant is likely a limited liability entity without substantial assets, has the landlord essentially given the tenant an option between the time it signs the lease and the time it closes on a construction loan? The answer is – sort of. But the option need not be free and can be structured to deliver enough compensation to the landlord to make the risk worthwhile and impose enough stress on the tenant to make sure the lease obligations are taken seriously. Instead of demanding a completion guaranty before the developer is prepared to deliver one, the landlord could approach the problem by looking at its end game. Since the purpose of the completion guaranty is to provide security for the tenant’s long-term rental obligation under the lease, the landlord might require substantial upfront rental payments and/or staggered prepaid rental until the completion guaranty is delivered. The prepaid rent could be applied after completion of the new building providing built in security. If the project does not succeed, it probably won’t pay for the cost of completion, but it may provide the landlord with a comfortable financial cushion while it seeks a new tenant.
Dena Cohen is a partner at Herrick, Feinstein LLP, New York, N.Y.
This article appeared in the April 27, 2022 edition of Development Site Advisors Spring 2022 Development Whitepaper.
This article originally appeared in the June 1, 2021 edition of New York Real Estate Journal.