Gimer Law

MD and DC real estate law

REI

Subject-to transactions on the rise

As interest rates continue to rise, the “Subject-To” method of acquiring real estate will increase in popularity. We’re seeing an uptick in inquiries about subject-to. The extremely low mortgage interest rates we’ve experienced over the past decade are simply too low for investors to ignore. Investors who use the subject-to method keep the seller’s existing mortgage(s) in place in order to keep acquisition and holding costs low. Buyer closing costs are reduced significantly as there are no new lender fees and pre-paids. Monthly payments typically stay low as well.

An investor-friendly title company can facilitate subject-to transactions. And yes, as a buyer in a subject-to deal, you CAN get owners title insurance. The parties simply execute a few extra documents than in the typical sale.

But back to the subject of this post. While interest rates are still historically pretty low, they are now increasing rapidly. Many homeowners who purchased or refinanced recently have mortgages carrying the lowest interest rates in history. Many would-be sellers are deciding to stay where they are due to those favorable existing loan terms. But that isn’t always possible. Some owners falls on hard times and can no longer afford even the mortgage with that low rate. That’s where this investing method can come into play. If the parties can structure a deal which leaves the cheap financing in place, it can often be a win-win for both buyer and seller. The buyer gets great terms and lower closing costs (no new loan, points, fees, escrows, etc.) The seller finds someone to take over payments, put some cash in his/her pocket, and avoids foreclosure. And the seller’s interest is secured… he/she can foreclose or take back title if the buyer stops making payments.

Of course there are pitfalls to avoid when investing with this method. In our experience the major risks are (1) undercapitalization and buyer default, (2) failure to have a good exit strategy in the event the loan balance is accelerated by the lender, and (3) the seller filing for bankruptcy. Plus, making sure the property is properly insured can be tricky. We’ll go into each of these issues in more detail in the next few posts.

Ground rent: an overview

This post should provide some good background information about Ground Rent to potential buyers who are not familiar with how ground rents work.

Leasehold estates

A property that is subject to ground rent is referred to as a leasehold estate. How does a property become leasehold? At some point in the chain of title, a fee simple property owner creates and records a ground lease, taking on a long-term tenant. Ground leases are typically 99-year leases which renew in perpetuity (forever) when the rent is paid. Ground rent payments are most often made in two semi-annual installments, each 6 months apart with the due dates depending upon when the ground lease was created.

Surprise, the property you are interested in has ground rent

When it is discovered that a property is subject to ground rent, some buyers become concerned. They really shouldn’t be. Ground rents have been in existence in Maryland and elsewhere since the mid-1800s. Leasehold property owners may technically have a landlord, but the lease does not contain any rules or regulations, just a promise to pay the rent. And except to the extent there are covenants, conditions and restrictions (CCRs) recorded among the land records, the property can be freely used just like a fee simple estate. For example, leasehold properties can be pledged as security for mortgages; and they can be refinanced and re-sold like any other real estate, with no limitation on the number of transfers or any landlord notice or approval requirements. Settlements on leasehold properties are just like those on other properties except for the instrument of conveyance is an Assignment (or Deed of Assignment) wherein the seller assigns the new buyer its rights under the ground lease. This gets recorded in the land records just like other deeds. Also, ground rent is prorated as of the settlement date. Ground rents are paid in arrears, meaning the rent you pay now covers the prior 6 months.

Registration and collection

Ground rents now need to be registered with the state to enable the owner of the ground to collect rent. So while a property may be still technically a leasehold estate and each subsequent transfer will be a transfer of the leasehold interest, if the owner has not registered the ground rent, there can be no ground rent collected. Why wouldn’t a ground rent owner register the ground rent? The registration requirement is relatively new. So when the owner of a ground rent dies, if the rent is not registered, his or her heirs will be unaware of the existence of the lease. So the right to collect rent essentially dies with the decedent. If the owner of a registered ground rent is unable to be located at the time of a transfer of the property, three years of rents (the maximum amount allowed to be pursued by the owner of a ground rent for past due rent) are collected and held in escrow. An additional $650.00 is escrowed above and beyond the three years to cover potential attorney fees and costs of collection. As of October 1, 2020, this escrow is not required for an unregistered ground rent.

What happens if you don’t pay ground rent?

Most ground rent owners will take action. They will make written demand for the rent and, if it remains unpaid for several months, they will then hire an attorney and pursue an action for ejectment. This is essentially an eviction and the landlord, if successful, will retake possession of the property. Since everyone with an interest in the property (such as a lender) will receive notice of the suit, most ground rents get paid before possession of the property is lost. Most ground rents of residential properties are of modest amounts — $30-$300 annually — but additional fees and expenses will also become due if the process gets that far.

Buying out the ground lease

If you’re not interested in paying ground rent forever, you don’t have to. The process of buying out ground rent (extinguishing the lease and returning the property to fee simple) is called “redemption”. Maryland law provides for the right of redemption (except in the case of irredeemable ground leases — quite rare) by the leasehold title owner at any time upon 30 days notice. The ground rent owner’s interest is said to merge with that of the lessee when a Ground Rent Redemption Deed is executed and recorded in the land records and the leasehold is extinguished. The purchase price for the ground (redemption amount) is fixed by Maryland law at a capitalization rate dictated by statute, based upon the annual rent and the date the lease was created. Just pay for a GRR redemption deed to be prepared, add transfer and recordation taxes based upon the redemption amount plus the deed recording fee and the property will be yours in fee simple.

Judgments and liens

A property which is subject to a ground rent is treated the same as a property which is not subject to a ground rent as concerns judgmens, liens and title searches. The documentation which is provided by the title company differs only in the wording of the estate on the commitment, which will read “Leasehold” rather than “Fee Simple” plus the amount and due dates of annual rent are included. The lease itself appears as an exception on Schedule B, Section II of the title commitment and the final title policy. This is necessary because a lease is a related collateral document that runs with the land just as in the case of covenants, conditions, restrictions, etc. Judgments and liens attach to leasehold interests the same way as fee simple properties.

Hopefully this information proves helpful to you in your analysis of transactions involving leasehold properties. Please do not hesitate to reach out to me if you should require any clarification or additional information on this subject.

Tenant estoppel certificates

Real estate investors should be using tenant estoppel certificates (aka tenant estoppel letters) in connection with acquisitions of all tenant-occupied properties… even if they are not required to do so by a lender in connection with obtaining financing.

Why? Because you don’t want to find out after closing that some material fact about the tenancy has been hidden from you as a buyer taking title with a tenant in place. And you need to be able to get a tenant on the record regarding the status of the lease and “estop” them from making a different claim later.

Estoppel is a legal doctrine that says a person is prohibited from taking a different position later due to detrimental reliance upon representations previously made. The purpose of the tenant estoppel certificate is therefore to legally prevent the tenant from changing his or her story and denying the certifications made to the new landlord (you) at a later date.

Here are some common certifications to include in your tenant estoppel document:

  • That the Lease is in full force and effect and has not been modified, supplemented or amended in any respect.
  • That the commencement date of the Lease is X, and the expiration date of the Lease is Y. That the Tenant has/has no option to renew the term of the Lease.
  • That the Tenant has not paid rent or additional rent beyond the current month and agrees not to pay rent or additional rent more than one month in advance at any time.
  • That the rent has been paid through X date.
  • That there are no defenses to or offsets against the enforcement of the Lease or any provision thereof against Tenant.
  • That the tenant has deposited $X as a security deposit with Landlord pursuant to the terms of the Lease.
  • That the Landlord has not agreed to grant Tenant any free rent or rent rebatement.
  • That the Tenant is not in default under the Lease and to the best knowledge of Tenant, there exists no default by Landlord.
  • That the Lease is the entire agreement between the Landlord and Tenant pertaining to the property.
  • That the Tenant has no right of first refusal with respect to the property, option to cancel or terminate the Lease, or option to purchase all or any portion of the property.
  • That the Tenant agrees that no future amendment of the Lease shall be enforceable unless such amendment has been consented to in writing by a third party (such as a lender).
  • Since the date of the Lease, there has been no material adverse change in the financial condition of Tenant, and there are no actions, whether voluntary or otherwise, pending against Tenant under the bankruptcy, reorganization, arrangement, moratorium or similar laws of the United States, any state thereof or any other jurisdiction.

If the tenant cannot or will not make these certifications, you’ve got a problem. Each of these material certifications should be given by the tenant(s) during the investor’s due diligence/study period. If they cannot be obtained, the contract should be terminated or amended.