Why ground leases? Most ground leases result from landowners who are unwilling or legally unable to sell their land, for whom an unsubordinated ground lease offers the possibility of the professional development of the property with little expense or risk, secure long-term income, and the eventual reversion, perhaps with still valuable improvements.
Landowners and developers approach ground leases from starkly different perspectives. The tenant’s view is more ambivalent. The ground lease creates a separate interest in the property—the leasehold estate—that can be held in a separate ownership structure and encumbered, sublet, and sold separately from ownership of the land. The tenant also knows, however, that under most ground leases the landowner will become involved in many aspects of the project, potentially including permitting, construction, insuring, altering improvements and uses, and even financing and sale.
Some ground leases, especially those by public agencies, are intended to encourage particular types of development on land controlled by the landlord. They may provide attractive economic terms to developers, but with similar limitations relating to improvements, uses, and landlord approvals designed to ensure the landlord’s policy objectives are met. Most developers, concerned with transaction costs and the cost of delays attendant to ground leases, would rather own the land. As a result, most ground leases occur during peak development periods, when developers are chasing limited desirable sites, especially in locations where there is high demand and little available land (e.g., Manhattan and Hawaii).
From an economic standpoint, the landowner and the developer “must either have different costs of capital or different expectations about future value growth in order to motivate a ground lease.” S. Mandell, Lessor and Lessee Perspectives on Ground Lease Pricing, 19:2 J. Prop. Research 145 (2002). Dedicated landowners, who see the land as the safest long-term investment, are usually conservative investors looking for stable rates of return on secure capital, for whom an unsubordinated ground lease may be likened to an investment-grade corporate bond. Chris Carneghi, MAI, Determining Ground Rental Rates, Appraisal J., 256, 262–3 (Apr. 1994). The landowner may be willing to sell the property, if at all, only for a price that the developer believes is much too high. The developer is usually seeking double-digit returns on a new project in a relatively brief few years and is not too concerned with paying ground rent at a rate the landowner finds attractive. A transaction that has failed as a purchase can therefore succeed as a ground lease.
Most ground leases begin with the brief agreement of the principals on the initial base rent for the land and, in the case of a developmental ground lease, the general nature and size of the project to be built. For the landowner, these are the key ingredients for a deal assuring a secure long-term income stream or a desirable development objective. As the negotiations proceed, the issues become more complex and granular, including such items as the lease term and any options to extend; subsequent ground rental adjustments; the tenant’s feasibility period and project schedule; and rights of first offer or first refusal on the sale of the land or the project. These are all important decisions affecting the value of the transaction for both the landowner and the tenant-developer.
Value: A Zero-Sum Game
Landowners have often been wooed by developers with an attractive initial rent proposal and seductive project renderings and might like to think that they are in the project together, as partners, but they are not. The ground lease—at least as to the values of their respective interests—is a zero-sum game. The finished project, together with the land, will have a determinable market value. The terms of the lease that primarily determine how much of that value accrues to the landlord and how much to the tenant. In effect, the landowner has exchanged the fee interest in the land, including most rights of possession, for a different bundle of rights, principal among them being the right to receive the ground rent. Thus, it becomes something like a financial instrument.
The value of that instrument depends at any point in time on the net present value (NPV) of the future rental stream (and the NPV reversion when the remaining lease term is short enough), which in turn will depend upon the security of the rent and market rates of return for similar investments. The value of the landlord’s interest subject to a ground lease may be greater or less than the value of the land free of the lease. Ideally, the tenant’s improvements will enhance the value of the land.
An unsubordinated ground lease—where the ground lease has priority over any mortgage and most other liens against the land and the improvements—is sometimes compared to an AA+ or AAA bond. The value of the developer’s leasehold estate—for purposes of mortgage financing and equity investment—will be determined after subtracting the ground rent payable to the landlord from the project’s operating results and accounting for other provisions of the lease that may affect the tenant’s ability to finance, improve, maintain, and realize upon the value created by the project. In other words, the value of the developer’s leasehold estate is the value of the entire project including the land, less the value of the landlord’s interest.
A major tenant priority is the ability to finance the development of the project. An unsubordinated ground lease with the proper leasehold mortgagee protection provisions (and a well-conceived project) should be financeable in today’s commercial real estate markets, although for principal amounts less than a comparable fee mortgage and probably at somewhat higher interest rates and fees, and with greater transaction costs. See J. D. Whalen, On Financing an Unsubordinated Ground Lease in the Twenty-First Century, 33 Prob. & Prop. 26 (Mar./Apr. 2019).
These factors, consciously or unconsciously, drive the negotiations. The landowner, as noted, has exchanged the land for something akin to a financial instrument; however, many non-institutional owners do not like to see it that way. Before the ground lease, this was land owned in “fee simple absolute,” with deeds in the safe deposit box. It might be the land they inherited from their father, or the site of the old family business, or part of the assemblage that constitutes the family’s future for the next several generations. This reluctance to recognize the nature of the landlord’s interest can complicate financing negotiations of the tenant. One issue in financing, for example, is condemnation. If the landlord usually thinks of herself as the owner of the fee interest in land, then the concept that the fee is not subordinated to the leasehold mortgage leads to the conclusion that the first claim on any award should go to the landlord for the value of the land taken. If that value is defined in the lease or under local law as the land vacant and unencumbered, based on its highest and best use, then the landlord’s claim may potentially reduce the tenant’s share of any award and imperil the tenant’s equity and, most importantly, the leasehold mortgagee’s security. If, however, the value of the landlord’s interest is defined in the lease to be the NPV of the land as part of the existing project and subject to the ground lease, that should be consistent with the lender’s underwriting of the loan, but some landlords are unwilling to agree with that stipulation.
Term of the Lease
The term of the lease is an issue that affects the value of the interests of the parties. The landlord usually seeks a long-term lease. The tenant would like as long a potential term as possible but with flexibility in terms of multiple options to renew. Too often, however, the parties will agree to a 99-year term simply because it seems like an appropriate term for a ground lease. A leasehold mortgage lender will want a minimum financing term; the major rating agencies for securitized mortgage offerings require, for leasehold mortgages, a remaining lease term 10 years beyond the full amortization term of the loan—even if there is an earlier balloon—and 10 to 20 years beyond any balloon payoff date, but these standards are meaningless to the landlord and not very helpful to the tenant. Determining an appropriate term for any ground lease will depend on other factors.
Over the life of a ground lease, inflation will reduce the landlord’s rental return dramatically absent some provision for periodic review and adjustment. This usually involves two alternatives: indexing, often by the Consumer Price Index (CPI); and reappraisal of the value of the land. A common agreement (or requirement of the landowner) provides for early indexing, such as at intervals during the first 25 years of the lease term, subject to maximum and sometimes minimum adjustments (for instance, the actual CPI or a minimum of one percent and a maximum of three percent per annum, every five years); then at year 25, a reappraisal to determine a new land value and ground rent, the reappraisal to be repeated every 10 or 15 years thereafter, or when the tenant exercises an option to renew. These reappraisals are the most frequent occasions for contention between the parties, but because they are a remote concern at the time the ground lease is negotiated, they often receive less attention than they deserve. See J. D. Whalen, The Reappraisal of Ground Lease Rentals, 30 Prob. & Prop. 44 (May/June 2016).
Often there is more attention paid in the ground lease to the procedures of rental resets than to the substance. The later substantive disputes will then focus on with whether the land should be valued based on its then-current use or at its then highest and best use. The latter basis would take into account changes in zoning and market factors that might, hypothetically, permit a much larger project or more valuable uses of the land. For example, an old hotel might better be replaced with a 60-story office building, and the land might be many times more valuable for the latter. The classic case is Plaza Hotel Associates v. Wellington Associates, 55 Misc. 2d 483 (N.Y. Sup. Ct.), aff’d 28 A.D. 2d 1209 (N.Y. App. Div. 1967), holding, under the specific terms of that ground lease, that the land should be valued based on its use as a hotel.
In deciding whether the existing use or the highest and best use should control the valuation, many other issues arise. Would it be significant whether the tenant has the right under the lease to change the use or to demolish and rebuild, without the consent of the landlord? What if the remaining term of the lease, including extensions, would not justify the tenant’s investment in a different project? Would it be important whether the reappraisal arises during the continuing term of the lease, or upon the exercise of an option to extend by the tenant? What if the land and surrounding area have been downzoned so that the existing building constitutes a grandfathered conditional use that could not be built at the time of the reappraisal? Nearly four in 10 buildings in Manhattan could not be built under existing rules for density, height, setbacks, lot coverage, and the like. Quoctrung Bui, Matt A.V. Chaban & Jeremy White, 40 Percent of the Buildings in Manhattan Could Not Be Built Today, N.Y. Times, May 20, 2016.
Most ground leases address few, if any, of these matters; their resolution may be left to the arbitrators or appraisers. Unless there is some clear direction to the contrary (and sometimes even if there is), professional appraisers will perform a highest and best use analysis. That may result either in a higher rent than the existing project can afford to pay, even though the ground lease continues in effect, or in a lower rent than is appropriate for the tenant’s conditional use that is still legally maintained.
Project Useful Life
An element missing from the previous discussion is the useful life of the initial improvements to be constructed by the tenant. The concept requires a mixture of engineering, economic, financial analysis, and crystal-gazing. One of the most important elements is the tenant’s and his lender’s and investors’ expectations of the period required for the project, if reasonably successful, to repay the mortgage financing and capital investment and return a reasonable profit to the tenant and the investors. Those parties, in the process of putting together the project financing, will need to arrive at some consensus on the point. For a low-rise strip retail development or a motel, it might be 20 years; for a high-rise office tower, 50 or 60 years.
For both the landlord and tenant, the compromise that protects their vital interests—the tenant’s ability to finance the project and the landlord’s requirement of a fair rental rate—would result in any reappraisal of the ground rent arising before the end of the anticipated useful life of the project being based on the then-current use of the land—a “use value” assessment as defined by the Appraisal Institute. The landlord should recognize that by executing the ground lease, the land must be committed to the project at least for the period necessary to justify the investment in the project. After the end of that useful life, rent reappraisals should be based on the then highest and best use, including any grandfathered conditional use. At that point, the tenant should not expect to retain the lease at a bargain rent if the land can be put to a higher and better use. The author has seen one ground lease, written in the 1980s, providing for a reappraisal of the land after 35 years based on the greater of the original project built by the tenant or the improvements existing on the land at the time of the reappraisal; and at 45 years and thereafter, based on its highest and best use. It can be done (but usually is not).
One of the challenges of constructing a ground lease is the inability of the parties to anticipate all the various conditions and events that may arise over the many decades during which the lease will be effective and which may affect the rights of the parties. These issues regarding reappraisal provisions are perfectly foreseeable and capable of being addressed, however, and they are intimately related to the lease term and the respective values of the parties.
The most perilous time in the life of any ground lease is the construction period. As long as the landlord has not subordinated the fee, the landlord need not worry about a mortgage foreclosure against the land but should still be watchful that the project progresses to completion according to schedule and without labor or material liens attaching to the fee, as can happen in some states. The landlord, the tenant, and the leasehold mortgagee all need lien-free completion and initial marketing to produce a project that will pay the ground rent, the mortgage, and a return to investors. This means the landlord should require an initial economic analysis of the project before agreeing to the lease, engineering review of the plans and specifications for the improvements as they are developed, and monitoring during construction, including budget updates and lien releases. Most landlords need professional assistance to do this.
The construction lender has the same concerns, and so the landlord may be able to benefit from the information the lender receives every month through inspections and monthly loan draw packages (if the lender is doing its job and is willing to provide access), but the landowner should still have independent assistance to review the information. The landlord’s interests are not perfectly aligned with the lender and, in the event of serious trouble, may be antagonistic. The landlord might insist that the tenant’s project budget provide an allowance for the landlord’s consultant fees, a relatively minor sum.
The tenant’s concern is the potential cost of the landlord’s interference in the development process, especially in terms of delays. The landlord often wants—and to a certain extent needs—review of building plans and specifications and approval of later significant changes. The tenant fears the time and expense of dealing with every possible concern the landlord might raise in the process, especially objections to changes made by the tenant to keep the project within budget. A separate provision for landlord review in the development of the plans is a concern. This could be avoided by having the landlord’s architect or other consultant attend regular plan reviews, but developers often resist having outsiders (and especially the landlord) at these events. In a large project, hundreds of revisions to plans will be made before and after construction begins, with varying degrees of formality. Time is a significant project cost in terms of interest expense alone. One possible solution is to identify the project elements that are of particular concern to the landlord, such as building exteriors and public spaces, give the landlord reasonable approval of schematic plans and preliminary specifications related to those elements, and allow reasonable review and approval, in defined time frames, of material changes to those elements. As a practical matter, building systems and structure will be designed in great detail by the tenant’s own engineers and reviewed by the permitting authority’s and the project lender’s engineers at a level of detail most landlords could not hope to duplicate.
For the landowner contemplating a ground lease, the most important matter is not the words in the lease but the ability and integrity of the prospective developer-tenant and his team, including the general contractor, the major subcontractors, and the design professionals. They should all have experience at successfully delivering comparable projects, without too much drama and litigation. A ground lease is no place for beginners.
Alterations and Changes of Use
Economic changes are occurring at an ever-accelerating pace. Abandoned shopping centers have been redeveloped as power centers or internet call centers, and then again as Amazon warehouses or residential towers. The tenant and the leasehold lender will want the tenant to have the right to alter the improvements and change the primary uses if economics so require, but often the tenant must agree to maintain the project and uses he has promised the landlord. If so, the construction lender and initial term lender may insist on the ability to make changes if the project encounters so much trouble that one or the other of them forecloses or otherwise acquires the leasehold.
Later changes may be desirable in the decades after the project is built. A building that the parties expected to stand for 60 years may be economically obsolete in 25. In such a case, it will be in the landlord’s interest to see changes made to make the project more competitive. These changes may be subject to the landlord’s reasonable approval, and the landlord should have the right to request a new look at the ground rent—a reappraisal—if there is a material change in the improvements or their use, to ensure that the rent is appropriate to the new conditions. This right needs to be spelled out in the lease or else, under local law. Insisting on a rent adjustment in connection with the approval of changes may be deemed unreasonable.
A ground lease for a modest project that might, with options, extend for 99 years, where the tenant can change the use and redevelop the property at will, and the initial rent is only adjusted every five or 10 years for a cumulative one percent per annum or the like, is really a virtual sale of the land for a fixed price payable in installments and terminable at the will of the buyer. The tenant will develop the initial project and sell it to an investor, and one element of the sale price will be the virtual ownership of the land for whatever purpose may be profitable in the future, to the exclusion of the landowner.
Rights of first offer or first refusal to purchase the land or the leasehold estate are quite common in ground leases. The tenant has a perfectly sound argument that, if the landlord wants to sell the land, the tenant might be the most logical buyer and should have the first opportunity to purchase. In the case of a first offer, if the tenant does not accept the initial offer, the landlord is free to sell to another, but if at a materially lower price, the tenant should have the right to purchase at the new lower price, exercisable very quickly. The landlord’s interest, as noted several times above, is something like a financial instrument and would not usually require extensive due diligence by a potential buyer. The tenant will know more about the property than anyone and ownership of the fee can enhance the value of the leasehold estate to buyers of the project from the tenant.
It is common for the landlord to insist on a square deal: that is, the same rights of purchase if the tenant proposes to sell the leasehold estate. It is a very different proposition, however, to manage a second look purchase right for the leasehold. The tenant will have to convince any potential buyer to take the risk that a deal may be taken away after months of due diligence and thousands of dollars of professional fees and other expenses. It may require a break-up fee for the potential buyer in an amount even greater than its out-of-pocket expenses and will very likely have a detrimental effect on the market for the project.
Also, it is worth noting that institutional purchasers of projects subject to ground leases tend to be more aggressive in pricing those interests than most real estate developers, so that the tenant may not be willing to meet a third party offer made by a professional investor, for the same reasons that can produce a ground lease in the first place: a tenant-developer is usually both seeking a much higher rate of return on investment, and willing to accept greater risk, than is a landowner or an institutional investor.
In the early years after initial development has been completed, it is much more likely that the tenant-developer will want to sell and move on to the next project than will the landowner, who did not want to sell the land in the first place. If the landlord cannot accept the disparity in the impacts of the preemptive rights on the parties, the best course for the tenant may be to water down both preemptive rights to something like a right of first negotiation with no contractual second look that may be very expensive in terms of the proceeds realizable from the sale of the leasehold.
As noted above, one of the unique effects of a ground lease is the creation of two distinct estates in land: the landlord’s fee interest and the tenant’s leasehold. In a well-constructed ground lease, each of these interests can be separately mortgaged, sold or assigned, or bequeathed or gifted without materially affecting the other. It may be best for both the landlord, and especially the tenant, to consider the value of this before granting burdensome preemptive rights to anyone.
Like condemnation, the rest of the ground lease issues, the stuff lawyers will spend a few months arguing about, are mostly about locking down the deal the parties have crafted—insurance, damage and reconstruction, subletting and assignment, bankruptcy, arbitration, etc., to try to anticipate the contingencies that might either affect the values that the parties hope to achieve from the transaction or might change the allocation of values between them. No article can hope to cover all the issues and their possible resolution. For a more comprehensive survey, see J. D. Whalen, Commercial Ground Leases, 3d Ed. 2013 (Supp. Aug. 2019).