May 01, 2017

Reappraisal of Ground Lease Rentals

Jerome D. Whalen

With most ground leases, the parties agree to the initial base rent even before the letter of intent, typically as a percentage return on the value of the land. That’s the easy part. Over the following decades, the landlord knows that inflation will seriously erode the value of that rent unless there is some provision for periodic adjustment. The tenant, on the other hand, is concerned that increases in the rent will diminish the value of the leasehold and, even more importantly, endanger project financing. Potentially unlimited increases in ground rent, by either indexing or appraisal, are unacceptable to most leasehold mortgage lenders, at least for new development projects. For the first 10 or 20 years of the lease term, this issue can be finessed by either scheduled fixed rent increases or indexed adjustments with a cap, or both. But after 20 years or more, most prudent landowners will insist on some sort of reappraisal of the land value as a means of assuring that the ground rent will be a fair return to them and their heirs. So, in many long-term ground leases there is a provision for resetting the basic ground rent at some point or points during the term or on the exercise of an option to extend the term by the tenant.

Fixing the value of the land alone when it has been substantially improved is a highly theoretical exercise. The appraisal process usually involves a current determination of the value of the land and also may require setting a rate of return, although many leases will specify a rate to be applied to the newly determined land value. This is probably the single most common subject of arbitration and appraisal proceedings between the parties to ground leases, and sometimes a lot of money is at stake. Some years ago a hotel ground lease rental in Waikiki reportedly went from $187,000 per year to more than $3.5 million as a result of an arbitration that the tenant won. Alan W. Weakland, Hawaiian Hospitality, Hospitality Rep. (Paul, Hastings, Janofsky & Walker LLP Jan. 1997), at 1, www.paulhastings.com/Resources/Upload/Publications/417.pdf.

Most of these disputes are resolved by arbitrators or appraisers. In the relatively few instances resulting in judicial decisions, the dispute is usually whether the land valuation should be based on the “highest and best” use of the property or on a “use assessment,” that is, as used by the tenant and subject to any restrictions on the use contained in the lease.

This article will focus on the determination of land value for unsubordinated ground leases in which the landlord owns the land and the tenant built or purchased the improvements. For a more detailed discussion of ground lease appraisals and other ground lease topics, see the author’s treatise, Jerome D. Whalen, Commercial Ground Leases (3d ed. 2013, Supp. Mar. 2016).

The Legal Context

Legally, the issue is the intent of the parties when the lease was written. The courts often maintain this to be a matter of interpreting the lease as a whole to determine the parties’ intent, but that is not always what happens. At least in the two states that have shaped most of the relevant law, discussed in further detail below, courts have identified specific language that dictates one of two results.

No two clauses in the reported cases are the same, and the generalized, nonspecific nature of the language suggests that the parties may not have had any mutual understanding on the point. It is fairly easy to write a clear statement of intent: “value the Land at its highest and best use, vacant and unimproved, and unencumbered by this Lease”; or, if that is not the agreement, then “value the Land as used by the Tenant under this Lease.” The language in the contested cases (and many other ground leases that have not made their way to the public record) is seldom so clear. The lease may say only something like “value the Land at its fair market value” and might continue to say “unimproved and unencumbered,” without defining any of the terms. Separate provisions in the lease often limit the tenant to the original use anticipated by the parties and may prohibit any demolition and rebuilding.

It may be that clarity did not serve the interests of sophisticated parties when they were trying to complete a complex ground lease, which often consumes months of negotiations and drafting. Generally in lease negotiations, the attention given to any matter is inversely proportional to its proximity in time. In many cases it is likely that at least one party to the original lease, and perhaps both, did not fully understand the legal significance of the terminology employed concerning future reappraisals.

When the dispute reaches arbitration or the courts, however, a decision is required. If a court should determine that there was no meeting of the minds regarding the rent to be paid during an extended term, the option to renew might be invalidated, causing the tenant to lose the extended term and the use of the improvements. When the rental adjustment is to be made during the continuing term, the landlord may forfeit an increase in the basic rent. The majority rule among the several states is that, when the parties have failed to specify definite terms for the determination of renewal rent, the option to renew is unenforceable as an “agreement to agree.” Friedman on Leases (Patrick Randolph ed., 5th ed. 2005, Supp. July 2015) § 14:1.3, nn.79–84. The courts have more recently sought to avoid this result. Friedman on Leases § 14:1.3, n.87. In “a respectable minority of cases,” courts have held that renewal rights should be enforced even when little or no agreement is manifested regarding renewal term rent, often finding that a reasonable or market rent was intended, or declaring as a matter of law that a reasonable rent should be judicially determined to save the renewal rights. Id.; see, e.g., City of Kenai v. Ferguson, 732 P.2d 184, 187–88 (Alaska 1987). And virtually all states will enforce agreements to arbitrate rent revisions, even when the parties do not set forth the basis for the redetermination. Friedman on Leases § 14:1.3, n.74. If there is an applicable arbitration or appraisal provision, then asserting (or conceding) that there was no meeting of the minds regarding renewal rent should not affect the validity of an option to extend or a provision for the reappraisal of the ground rent during the term.

Approaches to Lease Interpretation

In New York and California the courts have adopted approaches to lease interpretation that presume certain intentions regarding ground rent adjustments when little or none is manifested. These interpretations do not usually turn on reading the lease as a whole but instead on presumptions attached to specific wording, attributing intent to the parties when the lease language is ambiguous.

First, there is agreement in the case law on this: if the lease clearly requires one or another basis of valuation, then that will control, even if disastrous for one party or another. If the lease requires valuation of the land at its highest and best use, unimproved, and free of the lease, then restrictions in the lease on use and the existence of the tenant’s improvements on the land will be disregarded. Ruth v. S.Z.B. Corp., 153 N.Y.S.2d 163, 165 (Sup. Ct. 1956). If the zoning has changed to permit a much larger and more valuable project, the tenant will face a new rent much greater than previously in effect and maybe more than the existing improvements can afford to pay, even if the tenant does not have the right under the lease to adopt the more valuable use or build the larger project, or if it is uneconomic to do so.

Inversely, if the property has been downzoned to permit only smaller, less valuable uses, at least in New York, the landlord will receive a lesser rent even though the project on the property constitutes a legal nonconforming use that will become the property of the landlord at the expiration of the lease. New York Overnight Partners v. Gordon, 673 N.E.2d 123, 125–26 (N.Y. 1996); 201–203 Lexington Ave. Corp. v. 205/215 Lexington L.P., 637 N.Y.S.2d 125, 126 (App. Div. 1996). Chances are that neither party to the original lease intended these results and that, if these possibilities had been raised before the lease was signed, some sort of clarifying language might have been included.

The “New York rule” might be described as presuming, absent a clear indication to the contrary, that the valuation of the land must take into account any restrictions on use and other relevant provisions of the lease. In New York, when the lease required the rent to be based on the value of the land “exclusive of the improvements,” but limited use to a hotel, that restriction controlled and not the “higher and better” use as an office tower. Plaza Hotel Assocs. v. Wellington Assocs., Inc., 285 N.Y.S.2d 941, 944, 946 (Sup. Ct. 1967), aff’d without opin., 293 N.Y.S.2d 108 (App. Div. 1968). A phrase like “free of lease” or “unencumbered by this lease” will overcome this presumption and require the land to be valued at its then highest and best use, even if the property has been downzoned or if the lease restricts the tenant to a less valuable use. In New York, when there is no use restriction in the lease, highest and best use will control absent some clear indication to the contrary. 185 Lexington Holding Corp. v. Holman, 189 N.Y.S.2d 269, 270 (Sup. Ct. Spec. Term 1959), aff’d, 197 N.Y.S.2d 404 (App. Div. 1960), aff’d, 204 N.Y.S.2d 345 (N.Y. 190).

The “California rule” can be described as presuming that the “value” of the land means fair market value in a standard appraisal at its highest and best use, not limited by any use restrictions in the lease or by the nature of the existing improvements, unless a clear intention to the contrary appears from the lease. This approach grew out of two early cases in which there were no applicable use restrictions. The first held that “value” meant fair market value and not “use” value and that if the parties had meant anything else “they would have said so expressly.” Bullock’s, Inc. v. Security-First Nat’l Bank of L.A., 325 P.2d 185, 188–89. (Cal. Ct. App. 1958). The second followed this approach and specifically refused to consider the New York Plaza Hotel opinion. Eltinge & Graziadio Dev. Co. v. Childs, 122 Cal. Rptr. 369, 372 (Ct. App. 1975). Two later decisions expressly affirmed this approach while avoiding its application, both relying on “all the facts and circumstances.” Humphries Invs., Inc. v. Walsh, 248 Cal. Rptr. 800 (Ct. App. 1988), and Wu v. Interstate Consol. Indus., 277 Cal. Rptr. 546, 548 (Ct. App. 1991).

So, California presumes that “value” means the fair market value of the land at its highest and best use, and in New York use restrictions in the lease must be taken into account in the valuation, unless there is a clear indication to the contrary. In either jurisdiction the parties are free to reach whatever agreement they like. When the circumstances indicate the absence of any real agreement on the issue, which is commonly the case, then these presumptions will control even when the result is unreasonable in terms of economic fairness and common sense. Courts are fond of saying that “a poor bargain may not be made good by judicial construction or recasting of the contract,” 185 Lexington Holding Corp., 189 N.Y.S.2d at 270; see also Eltinge & Graziadio Dev. Co., 122 Cal. Rptr. at 371 (“it is not our function, nor do we have the power, to make a contract for the parties other than the one that they themselves have entered into”), even though these rules are not statutes but judicial declarations, often made long after the lease in question was written, ascribing to unsuspecting landlords and tenants intentions that they never had.

The Economic Substance

“Highest and best use” or “use value”? The answer should depend on when during the term of the lease and the life of the improvements the reevaluation occurs. Ideally, a developmental ground lease would have an initial term coincident with the anticipated economic useful life of the project to be constructed by the tenant.

In a financially viable project, lenders, developers, and investors develop a common idea of the period needed for the projected net cash flow and other financial benefits of the project to service debt and provide reasonable returns to project participants. See Whalen, Commercial Ground Leases § 8:7.1. A strip mall or low-rise commercial structure may need an initial term of 25 years, but a high-rise office building or hotel might require 50 years or more.

Before the end of the anticipated useful life, any reappraisal of the land value for purposes of ground rent should require consideration of the existing use and improvements, that is, a “use value” appraisal to reflect the fact that the parties, by entering into the lease, expected that the land would be committed to the project for at least the period required to make the original project economically viable. Appraisal Institute, Dictionary of Real Estate Appraisal § 2:5.4 (3d ed. 1993). A use value appraisal should give some comfort to leasehold mortgage lenders that a reappraisal will not result in an unreasonable increase in ground rent for an established project. Even if zoning and land use patterns have changed so that other, more valuable uses might now be possible (or only less valuable uses are permitted), the revised land rent should be based on the use value of the existing improvements until the expected useful life is over. Interviews with Anthony Gibbons MAI, CRE, in Bainbridge Island, Wash. (discussion of perspectives and observations on the issues in ground rent reappraisals from an appraiser’s standpoint).

Sometimes a landowner with a valuable piece of property may insist on premature re-evaluations of the ground rent based on the then-highest and best use. If so, the lease should clearly state that understanding in words like “highest and best use.” One should not infer or presume that an uneconomic result was intended in the absence of a clear statement of the intent of both parties. In that circumstance, if the parties actually contemplated this result, one might expect the tenant to have some right to cancel the lease, change the use, or redevelop the property as evidence of his understanding of its terms.

If the tenant has any options to extend beyond the end of this ideal initial term, which is also often the case, rent should then be based on the highest and best use. The tenant at that time should either renovate or redevelop the property to its highest and best use, or sell to someone who will. If the tenant wants to wring the last drop of profit from the existing improvements, he should not do so at the expense of the landowner if a more valuable use is available for the property. If the existing improvements are a more valuable nonconforming use than the then-permitted uses, that should be a consideration in the valuation.

Sadly, long-term ground leases are seldom, if ever, written this way. Instead, the initial term may be for 10 or 20 years with five or more options to renew for five or 10 years each. Or there might be a single term of 99 years because that seemed like the right length for a ground lease. Often the developer wants options to extend well beyond the useful life of the initial improvements. Sometimes the tenant is restricted to a specific use of the land, but sometimes not. The tenant may have a right to demolish the improvements and redevelop the property, or not. Usually there is a single provision in the lease for reappraisal of the land rent that would apply whenever a reappraisal is called for, both during the initial term and on exercise of extension options. A reappraisal at highest and best use may be compelled at a point long before the original (and still existing) use has justified its cost of investment; or a use valuation may apply to remote extensions of the term when the original improvements should be demolished and replaced with more valuable structures. For these uneconomic results, there seems to be no judicial remedy.

Most cases dealing with this issue have come from either New York or California. There is a sprinkling of decisions from other jurisdictions, mostly holding that use restrictions in the lease, or the landlord’s knowledge or approval of the tenant’s intended use and improvements, require a use valuation, including consideration of any legal nonconforming use. See, e.g., The Warwick Corp. v. Hartel, 516 So. 2d 1340, 1343 (La. Ct. App. 1987); Certain v. Kovens, 314 So. 2d 184, 187 (Fla. Dist. Ct. App. 1975); Moolenaar v. Co-Build Cos., Inc., 354 F. Supp. 980, 984 (V.I. 1973); City of Kenai v. Ferguson, 732 P.2d at 188. In effect, the California “rule,” presuming a highest and best use valuation in the absence of a compelling indication to the contrary, is the outlier; California’s is the “minority rule.” No other jurisdiction has followed California’s lead (except New York when there is no use restriction in the lease). Most states where this issue might arise in the future should have no controlling precedent to follow, and arbitrators or appraisers in a private proceeding in many jurisdictions also may have greater latitude. See, e.g., Blvd. Assocs. v. Seltzer P’ship, 664 A.2d 983, 988 (Pa. Super. Ct. 1995).

So there may be hope, in many jurisdictions, if not in New York or California, that courts (or arbitrators or appraisers) might adopt approaches to these issues that do not impel uneconomic results. It would not be unreasonable to presume that the original parties to the lease, in the absence of some clear statement to the contrary, anticipated that any reappraisal of the land for the purpose of redetermining the ground rent would reflect their economic expectations from the transaction. One might further reasonably presume that the parties intended that the tenant would build and maintain a certain project with a determinable useful economic life, and when that life had expired the land rent would be adjusted to reflect the then-highest and best use of the property (including consideration of any legal existing nonconforming use); and that any reappraisals before that would reflect the value of the land as a component of the project to which the land was committed (not to say “residual land value,” a technique rejected for reasons described in Medical Towers, Ltd. v. St. Luke’s Episcopal Hosp., 750 S.W.2d 820 (Tex. App. 1988)). See Commercial Ground Leases § 2:5.4.

Deconstructing the Terminology

In the real world, the only sure way to resolve these problems is to draft a well-written ground lease. If left to their own devices, appraisers will do what they normally do, and that is usually a highest and best use valuation. As suggested above, the necessary language is simple and clear and should be a part of the parties’ understanding at the letter of intent or term sheet stage. Even then care is required in the drafting. Too often long, complex ground leases contain inconsistent terminology, such as capitalized terms like “Property,” “Premises,” and “Project,” that unintentionally confuses what elements are to be appraised or ignored.

The appraisal provision in many modern ground leases may say something like “the Land should be valued as vacant and unimproved, unencumbered and free of this Lease.” This choice of words has the appearance of legal significance but really does not address the core issues, at least not directly or unambiguously.

The term “free of lease” has been held in New York to require a highest and best use valuation even when the lease does not allow the tenant to adopt that use. Ruth v. S.Z.B. Corp., 153 N.Y.S.2d at 167. There are cases in which the parties agree to a highest and best use valuation long before the anticipated useful life of the project has run, but then they should be clear, as suggested above, in words that do not require presumptions to be understood, to demonstrate that both parties understand that agreement. In the absence of such clarity, “free of lease” or “unencumbered by this lease” might stand for the unexceptional proposition that the appraisal for the purpose of establishing the ground rent should ignore the financial terms of the lease, that is, that the land should not be valued based on the net present value of the ground rents. Trying to base the value of the land for purposes of determining ground rent using an income approach based on the existing ground rent involves a hopeless circularity. Springer v. Borden, 71 N.E. 345 (Ill. 1904); Hirt v. Hervey, 578 P.2d 624, 628 n.1 (Ariz. Ct. App. 1978). In New York, as explained above, the underlying assumption is that use limitations in the lease should control the appraisal; so “free of lease” is a critical change. There is nothing inherent in the phrases “free of lease” or “unencumbered by this lease” that indicates either a highest and best use or current use analysis.

“Unencumbered” seems ambiguous in this context. No one suggests that applicable zoning should be ignored in determining highest and best use. It also seems obvious that certain encumbrances must be considered, such as an easement for light and air restricting building height on the land, or conditions, covenants, or restrictions binding the land and adjacent properties. Certainly financial liens, mortgages, and the like should be excluded as well as encumbrances created by the tenant without the participation of the landlord. For better or worse, subleases by the tenant affect the value of the leasehold but should usually be ignored in the valuation of the land. But these conclusions would follow from a standard appraisal; “unencumbered” doesn’t seem to add anything, unless it is shorthand for “free of lease.”

“Vacant and unimproved” may be more meaningful, although in this context redundant. “Vacant and unimproved,” like “free of lease,” says nothing to indicate either a highest and best use or a current use analysis. Generally the language is understood to exclude the value of the tenant’s improvements in calculating the new rent. Still, the existence of the improvements may affect the value of the land, one way or another. “Unimproved” may exclude consideration of that effect on value, not necessarily to the landlord’s benefit. When the existing improvements are a legal nonconforming use of greater value than the then-permitted highest and best use, they could add to the land value. Under most jurisdictional permitting schemes, entitlements run with the land; the issue becomes murky when the tenant has created the entitlement, but the land is to be valued “unimproved.” No other jurisdiction has followed New York’s example of ignoring the more valuable nonconforming use. An existing legal nonconforming use should be considered part of the zoning, but may require explicit language in the lease to reach that result. If the lease states no more than that “the value of the buildings (or improvements) shall be excluded,” that should permit consideration of the improvements to the extent their existence affects land value.

“Fair market rental value” has taken on magical qualities, at least in California. Wu v. Interstate Consol. Indus. basically assumed without explanation that “rental value” and “use value” are the same. 277 Cal. Rptr. at 550. The term should be either avoided or used only when there is a clear definition of the basis of reappraisal.

Even “use value” may be ambiguous. Should it reflect the value as actually used by the tenant, or the land value for the same sort of use in the current market and under current zoning, so that, if the zoning had changed to permit a larger project, or only a smaller project, of the same kind, the land value would be based on the then-permitted size rather than the tenant’s actual improvements? The court in Medical Towers opted for the then-permitted size. 750 S.W.2d at 823–24. An “economically useful life” approach would opt for the tenant’s actual improvements (including consideration of any legal nonconforming use) unless the tenant had the right under the lease to build the larger project and it was economically practicable to do so in the circumstances, considering the remaining term of the ground lease and other relevant factors. To be fair, the Medical Towers court pointed out that the tenant had had the option of building the larger project. Id. at 824.

Conclusion

One of the challenges of long-term ground leases is our inability to anticipate all of the changes that may affect the property over the following decades. But the matters discussed here are clearly capable of being understood by the parties when drafting and signing the lease. Presumptions attached to terminology that is not clear in itself (does “free of lease” mean highest and best use, or does “fair market rental value” mean use value?) are trip wires for the unsuspecting landlord or the overanxious tenant, sometimes leading to unfortunate results. Drafters and courts should look to the underlying economics of the transaction.

Unless the parties agree explicitly to the contrary, ground rent reappraisal clauses should be written so that:

  1. Ideally, the initial lease term reflects the expected economic useful life of the tenant’s project, in effect memorializing the understanding of the parties.
  2. Any reappraisals arising during the expected useful life are based on the tenant’s actual use of the property (or as it should be used in accordance with the lease, for instance, meeting maintenance and repair requirements).
  3. Any reappraisals after the expected useful life are based on the land’s then-highest and best use; a corollary would hold that the tenant should have the right, at that time, if not before, to adopt the better use and redevelop the improvements as necessary to do so.
  4. Any reevaluation includes consideration of any existing legal nonconforming use on the land. n

 

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A Note on Rates of Return in Ground Leases

Ground leases often state a single rate of return to be applied throughout the life of the lease to the reappraised value of the land. Friedman on Leases opines that this practice is “objectionable” because the stated rate may not reflect a fair rate of return at the time of the reappraisal and that the lease should provide instead for “the then current return on comparable investments.” Friedman on Leases § 14:1.3, n.101. The landlord’s position on an unsubordinated ground lease, at least once the initial development has been successfully completed, is very much like a financial instrument. Chris Carneghi, Determining Ground Lease Rental Rates, The Appraiser, Apr. 1994, at 256, 262–63. Once construction is completed, the landlord under the typical ground lease has little or no operating or maintenance responsibility, is not subject to depreciation of her investment because she did not pay for the improvements, and is something like a passive investor collecting a secured return. Of course, “subordination of the fee” is a major game-changer.

But the landowner is not in the same position as the holder of a bond or a CD. Even an unsubordinated ground lease is qualitatively different from a financial instrument; the real estate risks will exist from the beginning to the end of the term. Construction and initial development will involve substantial risks that, at their worst, may be catastrophic. At the end of the lease, the landowner may inherit another host of issues—operational, environmental, or holdover tenancies. In between, there are still casualty and operating risks inherent in real estate, including tenant default. Each ground lease and each ground lease project is unique. The only actual comparable rate of return for a ground lease would be other ground leases, but very few places outside of Manhattan or Hawaii would provide much of a basis for a ground lease market rate of return. In most locales, there would be very few recent actual ground lease transactions to compare. Carneghi, supra, at 256. In most market areas, it will be feasible to establish the fair market value of the land but not a ground lease rate of return.

Initial ground lease rates are generally determined by the then-current demand for developable land in the area of the property, the location and characteristics of the site, and, to a lesser extent, the terms of the lease itself. Carneghi, supra, at 259–61; Whalen, Commercial Ground Leases § 2:1. In a reappraisal, the appraisers or arbitrators cannot change the terms of the lease, but the relevant terms might have some effect on the rate they choose, such as the frequency of reappraisals and other interim rent adjustments. If there is a determinable ground lease rate of return in the locale at the time of the reappraisal, demand for developable sites and the landlord’s risk profile after completion of development may have changed dramatically, so that the landlord might want the assurance of a fixed rate.

Over the last several decades, financial market rates have fluctuated to an unprecedented degree. In 1981 the 10-year Treasury rate reached 15.8%; in 2012 the rate sank to 1.6%. See Sam Ro, An Annotated History of the 10-Year US Treasury Note Since 1790, Bus. Insider (Apr. 23, 2013, 8:44 p.m.), http://businessin sider.com/the-10-year-us-treasury-note-since-1790-2013-4. The “long term average rate” has been 6.39%. See YCharts, 10 Year Treasury Rate (Feb. 12, 2016), https://ycharts.com/indicators/ 10_year_treasury_rate. Setting a ground lease rate of return by reference to market interest rates in 1981 or in 2012 would have produced results that were very likely not in the contemplation of the original parties to the lease. If reappraisals under the lease are frequent, say every five years or so, or if there are frequent inflation adjustments between reappraisals, then reference to market rates might be more justifiable. But if reappraisals are every 10 years or more, as is often the case, then financial or ground lease market rates are problematic.

Anecdotally, it seems that historically rates have run anywhere from 3% to 12%, probably forming something like a bell curve with the peak between 6% and 9%. Carneghi reports that ground lease rates of return in the San Francisco Bay area during the 1980s were in the range of 8% to 12% with the preponderance between 9% and 10%. Carneghi, supra, at 260–61. Given the increasing volatility of financial markets, it seems prudent that the parties should establish a rate of return in the lease. If they feel compelled to give a nod to financial markets, such as 10-year Treasury rates, they should at least fix a “window,” say between 6% and 9%, to protect against extreme changes in market conditions.

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