Basic Principles of Ground Lease Agreements – Yes, a Contract!
A lease is a lease is a lease – or so you may think. Yes, real property leases grant an estate in land to a tenant for a period of time. And yes, the tenant pays for that right of possession. But the action in a lease isn’t in the conveyance provisions; it’s in the contract provisions. Multiply out the rent and other annual monetary obligations by the length of the lease term (in years), and you’ll see that it might be (and often is) a big dollar contract. Even more important, unlike the vast majority of contracts whose obligations are satisfied in days or weeks, a lease contract goes unfulfilled for 50, 75, “99,” and even 500 years. That takes it beyond the life of the parties involved in its creation, and the future brings surprises. Neither Nostradamus nor Jules Verne got everything right.
Why a Ground Lease?
If a tenant has to build its own building (as is often the case), and has all of the burdens of ownership, why would it lease a property knowing that at the end of the lease term it has nothing left to show for its money and efforts? There are a number of common reasons, principal among them is that the owner won’t sell the land and the tenant has no alternative.
Real property often carries a long term unrealized gain, waiting to be taxed upon its sale.
Not every landowner is interested in making further active real property investments. This makes a like kind exchange unappealing.
Ground leasing the same land keeps ownership in the family. At the owner’s death, because of the current estate tax “stepped up basis” arrangement, the built in gain may never be taxed.
It may also be that the tenant needs only part of a tract, and the government won’t allow a subdivision. So, a ground lease is executed with a very, very long term. It could be 500 years. All of the rent is paid up front, amounting to the equivalent of what would have been the purchase price. If the tenant can get a subdivision later, it will have the right to buy the leased land for a nominal sum.
Approval of the sale of public land can make a government official uncomfortable. Leasing is easier to explain. A public entity can design financial incentives to motivate developers to undertake projects that might otherwise be unattractive. By contract (i.e. the ground lease), the governmental landowner can control the developer’s project in ways that go beyond restrictions in land use laws without being guilty of spot zoning. And, unlike land use laws, the provisions of a ground lease can be flexibly reached.
Setting the Rent
Rent is the dominant continuing connection between the landlord and the tenant. Almost always, all other expenses arising out of real estate development are paid by the ground tenant – taxes, insurance, maintenance and other operating costs, environmental costs, and the rest. Therefore, the challenge is to set an appropriate rent that will be acceptable at the outset and throughout a very, very long lease term. It needs to approximate a fair market rent (or a fair market return) for an initial period and then fairly adjust the rent (or return) to keep up with inflation and investment expectations.
Rent can be structured to lower the ground tenant’s initial burden while it develops the property to its economic potential. One way or another, after that point, the rent “deferral” will be collected by the landlord. One or both parties will resort to professional appraisals to estimate the fair market rental. Often, the parties think they are setting rent as a percentage of the land’s value, but that’s just a way of combining their estimate of the land’s fair market value with their agreement as to what then constitutes a fair market return.
Over time, the land’s value will change, almost certainly upwards even after eliminating the direct effect of any successful development on it. Inflation is also a historical certainty. Lastly, investment return rates fluctuate over time. So, the rent is going to change, but when, how often, and to what? Resetting ground rent every five or ten or twenty years is quite common.
There are three mainstream approaches to the rent “reset” – indexed adjustments (such as using a cost of living index); fixed rent increments; and fair market value resets. Each has its advantages and each has its limitations.
Fixed rate adjustments are predictable and provide a stable basis for financing. On the other hand, the further out in time rent is fixed, the more dangerous the result. The ground landlord’s return may turn out to be too low, or the rent may be more than even a successful project can sustain.
Finding “fair market rental value” at the time of renewal will call for appraisals. Thus, the lease must contain appraisal rules. Is the rent to be based on the land’s “highest and best” value or will it be based on the land’s actual use? Will the fair market rent have a relationship to the existing use or uses? Will the appraised value take into account the encumbrance of the ground lease itself? What appraisal method will be used and what qualifications will be required of the appraisers. That’s only a start, but will give the ground lease parties an idea of the challenge.
These also are “uncommon” methods, such as tying ground rent to the results achieved by the ground tenant, but there is no single, easy approach. A ground landlord might accept a share of its ground tenant’s rental income, cash flow (before or after debt service), refinancing proceeds or sales proceeds. The implications of such sharing or joint venture-type arrangements are many.
The initial term of a ground lease reflects the economic life of the project, the minimum time required for financing, and the jurisdiction’s legal requirements. Part of the “implied” rent is the residual value of the improvements at the end of the lease term, in effect, a “lump sum” final payment in the form of a used building. So, the parties have to agree as to the number and length of any renewal options. The preconditions for exercise of a renewal option aren’t very different than for space leases. How much notice will be required? Can the tenant exercise the option at any time? What form must the notice of exercise take?
Most leases do not permit a tenant to exercise a renewal option if in default: sometimes at the time of exercise; sometimes when the renewal term would begin; and, sometimes both times. Tenants, especially those with bargaining power, resist such tests and say that if they are in default and their landlord doesn’t want them, it should evict them and not mess around with a renewal right. A valuable investment would be lost – in essence, a default that doesn’t go to the heart of the bargain could work a forfeiture. Also, to enhance leasehold financeability, it is common for a ground tenant to exercise a renewal option well in advance. Thus, ground lease renewal provisions frequently omit or seriously modify the “no default” precondition and commonly impose a “reminder notice” obligation on the ground landlord.
Getting ownership of the ground tenant’s improvements at the end of the ground lease term may be a valuable component of the ground landlord’s economic reward. If the improvements are generally usable and not obsolete, the ground landlord will “inherit” a pot of gold at the end of the lease. The bonus might even come early if the ground lease ends early. But, if the improvements were for a special purpose, or were economically obsolete, they would be a burden, the removal of which would eat into whatever the landlord had received as rent.
The parties need to remember that the ground lease might terminate early by reason of a taking or major destruction. In such cases, instead of getting the improvements into the ground landlord’s hands, the battle shifts to how the resulting insurance proceeds or condemnation award is handled. Not only will the improvements require repair or razing, the lenders will be looking for all or a share of the award.
If restoration is feasible, the ground lease and corollary financing documents must give primacy to use of the insurance proceeds and condemnation award for that purpose.
A convenient concept about the reversionary interest rests on the changing ratio of “ownership” interests between the ground landlord and the ground tenant. It is most easily understood by looking at some extremes. Make the assumption that the ground lease term is 30 years beyond the day that the improvements are complete. On day one the ground tenant “owns” the entire set of improvements. At the end of 30 years, the ground landlord expects to “own” all the improvements. Midway, at the 15 year mark, the ground landlord’s “ownership” interest is 50%. Here’s how to apply the principle. If the property were taken by eminent domain at the 15 year point, half of the value of the improvements would reflect the ground tenant’s interest and the other half would reflect the ground landlord’s reversionary interest. Various subtleties, depending on the nature of the lease and the nature of the project, will fine tune such an approach, but the basic principle remains valid.
Another reversion concern to be addressed is providing for turn-over of the improvements in some form of good condition. Often, the ground tenant is a special purpose entity with no significant assets beyond its leasehold interest which will be zero once the ground lease has terminated. Consequently, a ground landlord must insist on inspection rights throughout the term and be willing to prosecute a ground tenant’s default if its tenant doesn’t satisfy ongoing maintenance obligations.
A ground lease is founded on a very different economic model than one finds in the common space lease. A ground tenant can expect to enjoy largely unrestricted use of the ground landlord’s land for a lengthy lease term. Often, it will borrow a great deal of money from a lender that wants its loan to be secured by the tenant’s interest in the ground lease and in the building and other improvements
to be built with that money. As previously stated, the ground landlord looks forward to a dependable stream of rent income and to get the improvements when the lease’s term comes to an end. That pits the ground landlord against the pairing of tenant and leasehold lender, for unlike the case of a space lease, the landlord can get a windfall if the lease’s term ends early. In this zero sum game, the ground tenant forfeits a very valuable building and other improvements and, absent some other protection, the lender would be wiped out.
A leasehold lender expects two sets of protections against the lease being lost. Its final backstop is a recognition agreement from the ground landlord, a device that will be discussed later. Its first line of defense is the same arrangement that a ground tenant prefers – setting a very high threshold before the tenant’s breach of the ground lease can be grounds for eviction.
A tenant can breach its lease obligation in two fashions. It can fail to pay rent or rent-like items to its landlord, those being monetary breaches, or it can do something it shouldn’t have done or fail to do something it should have done, those being non-monetary breaches. Monetary breaches are easy to deal with. The ground tenant or its leasehold lender can just make the payment or post security.
So, with appropriate protective notice provisions and with a mechanism for resolving disputes, such as through the use of arbitration, a ground landlord’s legitimate interest in being paid can be properly balanced against its ground tenant’s (and the leasehold lender’s) legitimate fear of forfeiture.
Non-monetary breaches are less easily handled. They can range from trivial to serious. Sometimes, it isn’t clear whether there is a breach at all. If the ground landlord legitimately wants to see its tenant’s ground lease obligations fulfilled, rather than enjoying the reversion early, it could cure the alleged breach itself and convert the claimed non-monetary default into a monetary one, or it could seek injunctive relief or some other determination that the alleged breach is real and one that needs to be cured by the ground tenant (or, acting for the ground tenant, the leasehold lender).
Insurance Issues / Dealing with Damage and Destruction
Everybody cares that a ground leased building is adequately insured. Throughout the course of the lease, the landlord, tenant, and their respective lenders each have an economic interest in the physical improvements, with their value shifting, over time from tenant to landlord. So, all of them want to make sure the leased improvements are adequately insured.
Full replacement cost coverage is the gold standard and “Agreed Amount” coverage may be the higher, platinum standard. If the replacement cost is adequately covered and an Insurance Services Office “Causes of Loss – Special Form” policy form is used, the cost to rebuild will be paid by the insurer except for losses resulting from specifically excluded perils. Coverage gaps can be filled by extra-cost endorsements such as one that covers a situation where a change in law precludes rebuilding the improvements as originally constructed, i.e. an Ordinance Or Laws Endorsement. Other endorsements might include extra demolition coverage or coverage for losses from earthquakes, wind storms or flooding.
To keep the rent stream coming to the ground landlord, its tenant should have Business Income coverage as a form of “rent insurance.” That is important because almost no ground lease provides for a rent abatement following a fire or other cause of property damage. A ground tenant may be required to carry a “Utility Services – Time Element” policy endorsement which covers an off- premises interruption in utility services.
A “full replacement coverage” policy only pays the full amount if the insured building is rebuilt after the loss. Otherwise, the policy will only pay the building’s replacement cost, adjusted downward for physical depreciation. That makes it extremely important for the lease to provide that the damaged property must be restored. Insurance proceeds might be made payable to a special insurance trustee to protect the parties.
If the ground landlord doesn’t actually carry the project’s property insurance, it will want to be named as a “loss payee” under the ground tenant’s property insurance policy. Each fee and leasehold lender will want to be named as an “insured mortgagee.”
Where the ground leased premises are part of a larger complex, especially one with shared facilities such as parking garages, power stations, sewerage treatment buildings, or pumping or sprinkler standby sheds, the ground tenant will want its ground landlord to carry the same kind of property insurance discussed above.
It isn’t always clear that the parties will want to rebuild substantially damaged improvements. In the early years of a long-term ground lease, the ground landlord’s residual interest in the improvements is slight. If the improvements are not rebuilt and what remains is razed with the ground restored to a level reusable condition, a ground landlord may be willing to accept that for what would have been the residual value of the improvements. Near the end of the term, the landlord will “own” nearly all of the value in the improvements, but they may be quite obsolete. Add the interests of competing lenders, and it will become clear that each situation will need to be analyzed on its own before the ground lease can be signed. A useful general approach may be to require restoration of the damaged improvements by the ground tenant except near the end of the term when the insurance proceeds would be paid to the landlord.
Options to Buy
In a ground leased scenario, we are almost always looking at a single tenant property complex – a project fully divorced from its neighbors. That makes it workable for the parties to reach agreement on the tenant’s right to own the property. If the raison d’кtre for the ground lease in the first place is the landlord’s unwillingness to sell the property, a right of first refusal scheme may be the only mutually acceptable lease provision. Once the landlord decides to sell, it should not care to whom the sale is made so long as it winds up with substantially the same economic outcome.
Of lesser value to a ground tenant would be a right of first offer. Of course, the parties could theoretically agree on a true purchase option, but given the most common reasons for using a ground lease, that’s probably unappealing at any point other than the end of the lease term. Such purchase options, however, are common where the ground lease is a financing device.
Financing the Lease – A Critical Issue
Unlike land, a tenant’s leasehold interest is not tangible. A lease can be terminated and thus is risky collateral. So, lenders need protection from premature termination, including by default or by bankruptcy. If the tenant’s loan goes unpaid, its lender needs to step into a lease it can handle. It needs to “resell” the lease (i.e. assign it) and thereby get its money out. Without special lease provisions, a leasehold lender would be like any other assignee and be left (unsatisfactorily) at the mercy of the landlord. For that reason, common approval criteria and other restrictions need to be eliminated if the leasehold lender were to become the tenant. One less than obvious example is that the lender will only be willing to have lease liability while it “owns” the lease, not after it “resells” it.
There are some circumstances where the lease will be terminated and neither the lender nor the landlord can stop it, such as where a tenant rejects the ground lease in bankruptcy. For that reason, a leasehold lender will want a recognition agreement that the landlord will enter into the very same lease with the lender for whatever term would have remained but for the bankruptcy rejection.
Subtenants and Transfers
In a ground lease where a tenant is constructing substantial improvements, the tenant usually has a greater financial interest in the real property than does its landlord. Thus, the landlord should not have approval or similar rights that are anywhere near what one usually sees in a space lease. Once the improvements are finished, the landlord has a great deal of “collateral” behind the tenant’s promise to pay rent. Basically, absent special circumstances, don’t expect to see much of the way of “requirements” imposed on a ground tenant’s free right to assign or sublet. It would be appropriate, however, to require that the improvements be completed before any assignment takes place.
No lease is changing the Bankruptcy Code. Thus, each party and each lender needs to protect itself against a party’s bankruptcy. This is a complicated area of law. The protective provisions found in a sophisticated space lease are routinely the same as those in a ground lease. A major difference comes in the case of (the no longer rare) landlord bankruptcy. When a bankrupt landlord rejects a lease, the lease is over, but the tenant may remain in possession. It needs to provide all of the services that its landlord would have furnished, but it can deduct the cost of replacing those services from the rent itself. In the “absolute net” ground lease, this isn’t a tremendous burden, but still will constitute a hassle. What a ground tenant has to watch for, however, is that its post-landlord bankruptcy acts or omissions don’t put it in the same position that Qualitech, a very unhappy ground tenant, found itself in Precision Industries, Inc. v. Qualitech SBQ, LLC, 327 F.3d 537 (7th Cir. 2003).
One of the ways a fee owner can monetize the value in its side of a ground lease is to get an advance on the future rents by way of a mortgage loan secured by the lease, the land, and the ground tenant’s improvements. For much of the lease term, the tenant will have a more financial interest in those improvements than does its landlord. Thus, a ground lease must include very strong non-disturbance protection for the tenant and even a provision giving the tenant the right to pay the mortgage from the rents if the mortgage goes into default. Where a tenant has unusually strong bargaining power, the ground lease may not be subordinate to fee mortgages.
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