Transferable development rights are a useful tool in a government's zoning regulation toolbox that can take different forms and serve different purposes across the country. For example, the granting of such transferable development rights can be used to encourage developers to construct affordable housing units within a municipality without requiring the municipality to pay the developer for such construction or causing the municipality to construct such units itself.

One such law is New York City's inclusionary housing program, which grants transferable floor area ratio (FAR) bonuses to developers in New York City that include affordable housing units in their development projects. These FAR bonuses allow developers to exceed the maximum density levels allowable under applicable zoning laws by up to 33 percent in some areas and are evidenced by certificates issued by the New York City Department of Housing Preservation and Development (HPD) which may be sold and transferred by developers to other projects in selected areas. A recent New York Supreme Court case serves as a cautionary tale for mortgage lenders, and their attorneys, who make loans to borrowers who may own such FAR bonuses.

'CB Frontier'

In CB Frontier v. Wilmington Trust, National Association, 2018 WL 3995969 (N.Y.Sup. 2018), a developer earned a FAR bonus for providing affordable housing units within a development project in Manhattan pursuant to a regulatory agreement with HPD. The developer used a portion of this FAR bonus on the project itself, bringing the property up to the maximum permitted FAR and leaving the developer with excess FAR bonus rights to be used at other properties. After selling a portion of these excess FAR bonus rights, the developer obtained a loan secured by a mortgage on the completed building.

The collateral secured by the mortgage did not expressly include the developer's FAR bonus rights, however, it did include all “air rights and development rights…belonging, relating or pertaining to the land and the improvements.” When the developer informed its lender that it intended to sell another portion of the remaining FAR bonus rights (the “remaining FAR bonus”), the lender objected, claiming that the remaining FAR bonus constituted collateral for the loan, and that the lender would not release its lien without adequate compensation. The developer commenced an action seeking a declaratory judgement to determine the parties' rights with respect to the remaining FAR bonus. The court concluded that “the remaining FAR bonus [did] not 'belong' or 'pertain' to the property” because “[t]he FAR bonus is not attached to the land or development, but, rather, is granted to developers and is owned and transferable independent of any property.”

The court also concluded that “the remaining FAR bonus [did] not relate to the property” because “the term 'relating to' refers to rights that can be used on the property or affect the use of the property.” Since the property was built to its maximum FAR before the loan was negotiated, and the remaining FAR bonus could not be used at the property, the remaining FAR bonus's only value was due to the developer's ability to use it at a different property. Further, the court also gave some weight to the fact that the lender was not aware of the remaining FAR bonus when it underwrote the loan, thus, it could not have been relying on such collateral for repayment of the loan. Therefore, the court concluded that the lender did not have a mortgage lien on the remaining FAR bonus and the developer was permitted to sell the remaining FAR bonus without any compensation to the lender.

Since the issue was not before the court, the court did not decide whether the lender had a claim based on the developer's breach of its representation included in the loan documents that developer did not own and would not acquire any material assets that were not pledged as collateral for the loan. Typically, in a non-recourse loan, a breach of such representation causes an event of default under the loan documents and triggers recourse causing the borrower and guarantor to be liable for either the full amount of the loan or for any losses incurred by the lender as a result of such breach.

However, given the CB Frontier court's determination that the lender did not have a collateral interest in the borrower's remaining FAR bonus, if lender's recourse were limited solely to lender's losses, the court would likely conclude that the lender would not have suffered any loss.

Conclusion

Therefore, if lender's counsel discovers any development rights, such as certificates evidencing FAR bonuses, such rights, and the certificates evidencing them, should be specifically referenced in the mortgage's collateral. If no FAR bonus is uncovered during the course of due diligence, lenders should revise their generic collateral descriptions covering air and development rights to expressly include any such rights attaching solely to the borrower. A revised version of the collateral description that was the subject of the CB Frontier case follows, the italicized phrase being added language: “air rights and development rights… in any way now or hereafter belonging, relating or pertaining to the Land and the Improvements or owned or held by mortgagor.”

Jeffrey B. Steiner and Dino Fazlibegu are partners at McDermott Will & Emery. Sean Thorsen and John Bauco, associates at the firm, assisted in the preparation of this article.