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.