“Examining Key Concepts in Ground Leases” by Imran Naeemullah appeared in edited form in the January/February 2018 issue of Probate & Property (Vol. 32 No. 1), published by the American Bar Association Section of Real Property, Trust and Estate Law.
Mentioning the words “ground lease” can cause the reader to envision a convoluted transaction whose terms are difficult to translate into a document that is agreeable to all parties. Without diminishing the obstacles that typically face parties to a ground lease transaction, this is an overstatement. Like any other real estate transaction, a ground lease is fundamentally a business deal. One of the main advantages of a ground lease is that it offers the parties predictability over a long period of time. Consequently, the drafting process can and should flow directly out of the business terms that the parties have negotiated. In other words, the lawyer’s job is to apply the economic terms of the deal to structure a document that reflects the parties’ bargain. By adhering to this understanding, the lawyer can simplify even the most complex ground lease transaction into the task of assembling numerous parts into a coherent whole.
Three of the key concepts that arise in ground leases are: (1) rent adjustment and other economic terms, (2) “financeability”, and (3) eminent domain and allocation of condemnation proceeds. This article addresses core issues relating to those concepts that every lawyer should be familiar with when negotiating and documenting the transaction. It is not intended to be an exhaustive guide nor does it identify every issue; rather, it is a starting point for the attorney who is looking to expand or refresh his or her knowledge of ground leases.
Rent Adjustment and Other Economic Terms
By its nature, a ground lease splits the economic interests of the affected property into two parts. The fee simple interest (“leased fee”) stays with the owner, who becomes a lessor entitled to a steady income stream from the lessee. The newly created leasehold estate (“leasehold”) goes to the lessee, frequently a developer who will transform the property into an engine of economic productivity, generating profit for itself in the process. At the outset of the transaction, the property is often vacant land (although there are sometimes existing improvements). The lessee will invest considerable sums into transforming the property; for its part, the lessor hopes that the lessee is successful so that the expected rent streams will materialize. One of the main terms that the parties will negotiate (as with any deal) is price. Because the ground lease is likely to span decades, though, and predictability of the rent amount is essential to (among other things) securing financing, the parties will need to agree upon rent over a lease term in advance. They must do so knowing that subsequent amendments to the ground lease will probably be difficult and costly to achieve when one or more mortgage lenders are involved. Similarly, the parties must also agree on other economic terms. The parties’ attorneys can mitigate the risk involved in anticipating the future by drafting rent adjustment and other economic terms that capture the essence of the underlying business deal.
The lessor will, of course, want the amount of rent to increase over time. There are various approaches to increasing rent over time, which is significantly influenced if construction of improvements on the land is initially involved. If the lease is for unimproved land, one approach is to divide the term of the lease into stages, such as pre-construction, construction, and occupancy periods. During the pre-construction and construction periods, when there is no revenue from the project, the rent is often significantly less than it will be during the occupancy period to facilitate investment and financing of the improvements to be constructed.
Once the leasehold property is in its occupancy phase, rent can be adjusted over time by a number of methods. A common approach is to tie the rent increases to an index, such as the Consumer Price Index, with periodic “resets” in the rent based on fair market value of the land at the time of the reset. Another approach is to structure the rent at step-ups of fixed amounts for a certain number of time periods and then provide for resets based on the then fair market value of the land. Still another variation is to set the rent for a certain number of periods, then have a reset based on the then fair market value of the land, and for the remaining periods set the rent to increase by a specified percentage over the rent established for the preceding period.
The above are just a few examples; the variations are many, depending on the type of project, the economic considerations (e.g., ease of obtaining financing, the competitive landscape), the parties’ relationship to each other, and a number of other considerations. Each party has its own economic objectives: the lessor wants a dependable income stream that justifies retaining the property instead of selling the fee, the lessee wants a predictable rent obligation that enables it to develop a profitable project, and the lessee’s mortgage lender wants a rent structure that ensures its lessee-borrower will be able to timely repay the debt while the lender’s loan is secured by a mortgage of a marketable lease should it ever need to foreclose.
Fair Market Value
Whether fair market value is used to establish rent upfront and/or at rent reset intervals, it is a key concept that merits separate consideration from rent adjustment in general. The lease should provide for how and when to agree upon fair market value. For instance, the lease should discuss how far in advance of the rent reset period the fair market value should be set, and if there is a disagreement between the parties’ valuations, then the lease should provide for how that dispute will be resolved (e.g., by use of a predetermined arbitration process).
The parties should decide what is included and what is excluded in calculating fair market value. For example, the use of the land is a common valuation factor; the parties should decide upfront whether the use will be defined as it existed when the lease was executed, the actual use of the premises at the time of valuation, the “highest and best use”, or some other measurement. Along those lines, the parties should determine whether to include the improvements, and if so, whether all improvements should be included or only those constructed by the lessor or lessee. Zoning is another important consideration: what happens if the zoning for the site has changed over time? Particularly if the zoning has become more permissive and the lessee has taken advantage of that to construct more extensive improvements than originally contemplated, the lessor may want the valuation to incorporate the zoning change. Underscoring the fair market value calculus is the desire for predictability: each party wants to take an approach to fair market value that allows that party to reasonably predict what will happen.
As with space leases, percentage rent is a possibility for ground leases. Percentage rent is somewhat disfavored for ground leases, however, because they are typically for longer terms and the unpredictability (and potential manipulability) of percentage rent is not necessarily conducive to reassuring the lessor of a steady rental income stream. Nonetheless, percentage rent can make sense depending on the circumstances of the parties’ deal. An example of this is a ground lease for unimproved land in a newly developing area. The likelihood of the project’s success may be less clear, so to incentivize the lessee to enter into the transaction, the lessor may agree to share in the risk by accepting percentage rent in addition to a portion of (or perhaps even in lieu of) fixed rent, at least for a certain period of time. It comes down to the economics of the transaction, including the competitive landscape; in some markets (such as Hawaii), commercial ground lessors typically enjoy a strong negotiating position due to the ownership of commercial lands being concentrated in relatively few hands.
On a related note, unless the lessor and lessee intend to create a partnership or a joint venture, the lease should include a provision stating that no partnership or joint venture is intended or created by the lease. Courts generally recognize that payment of percentage rent does not establish a partnership or joint venture; nonetheless, having such a provision bolsters a defense against a claim that the lease created such a relationship.
Because the lessor retains the fee interest in the land, it wants to ensure that it gets compensated for increases in the project’s value. Such a provision typically requires that as a condition to the effectiveness of the lessor’s consent to an assignment of the lease, the lessee must pay to the lessor an assignment premium. The formula for the assignment premium will vary, but it usually attempts to capture at least a percentage of the amount by which the sales price exceeds the amount of rent the lessor is entitled to receive. In other words, the lessor wants to share in the lessee’s gain as a result of the increase in the project’s value. This is especially reasonable if the lessor improved the financeability of the project by providing rent concessions during the pre-development and construction phases of the project.
As a drafting point, attention should be paid to what is and what is not subject to an assignment premium. The lessor will want the assignment premium to apply in as many circumstances as possible (e.g., during direct and indirect transfers of interests in the lessee as well as the leasehold interest); the lessee should consider whether and how to narrow this scope.
Financeability of the ground lease is an overarching issue. If it is not financeable, the market for prospective lessees is greatly diminished. Or if the lease will become not financeable down the road, then the lessee’s exit options are diminished—and this will reduce the likelihood that the lessee will enter the lease in the first place. There are many different factors that make a ground lease financeable, several of which are discussed below. Note that references to “lender”, unless otherwise indicated, mean the leasehold mortgagee.
The key to understanding how to make a ground lease financeable is to remember that the ground lease creates two separate pieces of real property: the leased fee (i.e., the lessor’s interest) and the leasehold (i.e., the lessee’s interest). Each piece of real property can serve as collateral for a loan and is therefore potentially financeable.
The lender’s concern will, of course, be to ensure that it will be repaid if the borrower defaults. For the respective parties’ interests to be properly addressed, the lessor’s mortgage needs to be subordinate to the lessee’s mortgage so that a foreclosure on the former does not terminate the ground lease. Otherwise, the lessee’s lender will be very unlikely to make the loan, given the risk of losing its collateral. Therefore, the leasehold mortgage needs to have priority over the leased fee mortgage. If the leased fee mortgage is already of record before the leasehold is mortgaged, then (under a typical race-notice statute) the appropriate reordering of the lender’s priorities will be accomplished by executing a subordination agreement.
More complicated priority issues arise when, for example, there are multiple leasehold mortgages; these are often addressed via an intercreditor agreement which establishes the rights and obligations as among the leasehold mortgagees.
Besides subordination, there are many other factors that make a ground lease financeable, too numerous to list in their entirety here. Each of the following paragraphs briefly discusses one of ten common concepts: (i) rent and term, (ii) right to mortgage, (iii) notice and opportunity to cure lessee defaults, (iv) use, (v) lender’s right to a new lease, (vi) purchase options, (vii) assignment, (viii) subletting, (ix) title to improvements, and (x) estoppel certificates.
For the lender to be comfortable with the deal, it will need to review factors like the amount of rent and the length of the lease term. This goes back to the economic considerations discussed above. The lender needs to be satisfied that the economics are viable—for instance, that the lessee’s rent obligation (throughout the term of the lease) does not overly restrict the cash available to service the loan. The term of the lease is also important. Although there are exceptions, the lender will probably want the lease to outlive the mortgage by at least several years so that, if the lender forecloses, there is sufficient value left in the lease to satisfy the outstanding debt.
It may seem obvious, but the ground lease should allow the lessee to mortgage its leasehold interest. This will help the lessee to obtain upfront financing and, if needed, to refinance the leasehold down the road. This flexibility is also helpful in the event of foreclosure, as it will permit a buyer to obtain financing (and thus broaden the market of potential buyers).
The lender will want the right to receive notice of and the opportunity to cure lessee defaults. The lease should incorporate a provision to this effect; the wording varies, but a stronger provision (from the lender’s perspective) will state that a notice of default is ineffective unless the lender is also concurrently notified of such default. A frequent negotiating point is how long the lender should have to cure the default; the lender wants additional time beyond what is given to the lessee, but the lessor may not agree to additional time (after all, it wants the default to be cured as quickly as possible). The duration of the cure period may vary based on whether it is a monetary or non-monetary default. Another consideration is whether the lease can be terminated for default (as opposed to limiting the lessor’s remedies to things like injunctive relief and late charges and interest). From a practical perspective, the lawyer should keep in mind whether curing certain non-monetary defaults will require the lender to gain possession of the property and, if so, what steps must be taken (e.g., obtaining a writ of possession).
A broadly worded use clause will make the ground lease more financeable. Such a provision facilitates the lender’s ability to dispose of the property by, for instance, assigning the lease to a party whose intended use of the property is different from the lessee’s use. This may require rezoning the property; the clause should be drafted accordingly.
To enhance the financeability of the ground lease, it should include provisions that require the lessor, should the ground lease ever be terminated, to enter into a new lease with the lender (or its designee) for a term equal to the remainder of the then-existing term, and otherwise identical to the existing lease, including priority of then-existing encumbrances. In other words, the lender does not want its collateral (or the priority thereof) to be impaired or destroyed if circumstances require the lessor to terminate the lease, so it asks to be placed in the same position as it would have been had the original lease continued.
A ground lease often includes options for the lessee to purchase the leased fee. Common options include the right to purchase the property for a set amount (e.g., fair market value) at the end of the lease term and a right of first refusal or a right of first offer if the lessor sells the property during the lease term. The lender will want the ability to exercise the purchase options or rights on the lessee’s behalf if the lessee should default.
Permitting the lessee to assign the ground lease is desirable from a financing standpoint, as it enables the lessee to transfer the lease to a party who is willing or better able to continue operating the project. However, particularly if the ground lease is for a new construction project, the lessor will likely want to prohibit assignments for an initial period until the project is stabilized and generating regular revenue. This goes back to the business aspects of the deal; the lessor and the lender are probably entering the transaction based on the lessee’s experience, expertise, and related factors, so some limitations on assignability are to be expected.
As with permitting assignments, permitting subleases of the ground leased property improves the financeability of the lease. By subleasing space in the property, the lessee generates revenue to pay its rent and repay the loan. The lessor may insist, however, on certain restrictions, such as requiring sublessees to meet defined credit standards. Keep in mind that the lender will want to preserve its priority, and as such, may require the ground lease to include provisions that require the lessee to enter into subleases where the sublessee agrees to subordinate to any lender’s mortgage whether existing now or in the future. The ground lease may also require the lessor to execute subordination, non-disturbance and attornment agreements with sublessees upon their request.
Where the lessee constructs the improvements, the typical ground lease gives the lessee title to those improvements for the duration of the lease term. These improvements will also serve as collateral along with the leasehold itself.
Finally, the ground lease should obligate the lessor to deliver to the lender, upon request, estoppel certificates. These facilitate the lender’s periodic review of the lessee’s compliance with the terms of the ground lease.
Eminent Domain and Allocation of Condemnation Proceeds
Condemnation and allocation of condemnation proceeds are factors to consider in making a ground lease financeable. They are addressed separately here because although condemnation of a ground leased property is an infrequent occurrence, the drastic consequences of condemnation give lenders pause for concern. This makes sense when you consider that the typical ground lease has a term measured in decades. Much can change during that time, so the lawyer needs to draft condemnation language that provides considerable predictability.
Partial Condemnation or Temporary Taking
If the ground leased property is condemned in its entirety, the matter is relatively simple. Although the property will no longer be usable, the condemning authority will pay compensation in exchange. That compensation is then allocated between the parties, as discussed below.
Things get considerably more complicated when only a partial condemnation occurs or there is a temporary taking. The lawyer needs to consider the ways in which a partial condemnation could affect the project. For instance, a relatively benign partial condemnation—such as one that does not materially affect the gross leasable area, development on the gross leasable area, or the operation of improvements on the property—may not warrant any reduction in the rent payable under the lease. By contrast, a more substantial taking might be addressed by reducing the rent payable for the remainder of the term for which it is fixed in proportion to the reduction in fair market value compared to the value before the taking. The lessor will want the ground lease to provide that in such a scenario the lessor is entitled to seek compensation from the condemning authority for the loss of rent and to retain any compensation obtained.
Another consideration is where the ground leased property is vacant land and the taking occurs prior to the commencement of improvements. Provided the taking meets a certain threshold (e.g., a percentage reduction in the gross leasable area), the lease might provide the lessee with the option to surrender to the lessor its interest (and that of the lender) in the ground lease, with compensation payable as set forth elsewhere in the lease.
Similar considerations apply in the case of a temporary taking. The lawyer should consider how a temporary taking affects the parties’ economic interests and draft language accordingly. For example, if the project is a new construction, a temporary taking could jeopardize the construction of the project or, depending on the timing of the taking, the commencement of operations on the newly constructed improvements. The impact of the temporary taking should dictate the remedy. A potential solution is that during the time of a temporary taking, the ground lease remains in full effect without any rent abatement; however, the lessee receives the entirety of any compensation proceeds, except to the extent that any portion of those proceeds is attributable to a taking whose duration exceeds the remaining term of the lease, in which case such proceeds are payable to the lessor.
Allocation of Condemnation Proceeds
The allocation of condemnation payments can be subject to substantial negotiation. To avoid potential obstacles, the lawyer should analyze the parties’ business deal and tailor the allocation process based on the specifics of the deal—the goal is to put the parties in as close a position as possible to where they would have been had the condemnation not occurred.
A common approach is for the parties to share in the condemnation payment based on a formula. That formula can be quite complex, taking into account issues such as rent, the remaining term of the ground lease, the lessee’s cost of constructing the improvements, and the cost of the land. The premise behind such a formula is that it helps to calculate the fair market value of each party’s position at the time of condemnation.
Another approach is to calculate each party’s pro rata contribution to the transaction and tie this to the amount of condemnation proceeds that party receives. This could be on a blanket basis (e.g., x percent of all compensation goes to the lessor). The ground lease could also be separated into its components and then the condemnation proceeds allocated accordingly. For instance, the lease could give the lessor all the compensation for the land and have the lessor and lessee share in the compensation for the improvements. Alternatively, the lessee could be entitled to compensation for the fair market value of the leasehold plus the fair market value of the improvements constructed and paid for by the lessee (less the lessor’s reversionary interest in the improvements), with the lessor being entitled to the remainder of any compensation. There is plainly room for creativity in the drafting process; recognizing this may help the parties to reconcile their competing priorities and move on to the next issue.
On a financing-related note, the ground lease should address the lender’s entitlement to a share of the compensation. For example, the lease could provide that the lender’s interest is limited to the lessee’s interest to the extent of the then-outstanding indebtedness secured by the lender’s mortgage. Additionally, where there are multiple lenders, the ground lease could provide that the mortgagees’ interests to compensation be determined by the respective priorities of their mortgages. Depending on the circumstances of the transaction, the lawyer may need to focus on drafting appropriate language for the compensation to be paid to the lender(s) (including, if there are multiple lenders, language in the intercreditor agreement).
The author hopes that this article has provided a useful overview of key concepts associated with ground leases. There are quite a few issues not covered here that merit further study for those who need to know more, such as casualty and insurance considerations. Of course, even the concepts discussed here only received relatively cursory treatment. For instance, use restrictions vary widely—beyond obvious points such as an institutional lessor being more likely to have extensive use restrictions than a “mom and pop” lessor, there are other influences such as a lessor’s potentially being subject to deed restrictions that limit the use of the property. Each ground lease transaction should be analyzed to determine what approach to take in representing the client’s particular interests, both at closing and in the long-term.