Ground Leases in General: At its most basic, a ground lease is a lease of bare, unimproved land. The essential characteristics of a ground lease are that the tenant constructs a building and other improvements on the property and all expenses attributable to the land are paid by the tenant (i.e. a net lease).
A tenant may choose to ground lease property rather than purchase a fee simple interest because the property is unique and cannot be purchased or because the expense of purchasing the property is too great. A landlord may be inclined to enter into a ground lease, viewing it as a secure investment. A tenant who builds an expensive building on the property is less likely to default on rent and the term of a ground lease is typically long, which can assure a landlord a steady stream of income on the property. In addition, the tenant improvements add value to the property that reverts to the landlord upon termination of the ground lease.
Ground Lease Forms: Ground leases lend themselves less to form leases than traditional office or shopping center leases, and they usually have to be tailored to the particular property and leasing arrangement. Some of the typical components of a ground lease include (i) tenant covenants, (ii) the right to mortgage, (iii) the obligation to build, (iv) structures for escalating and reappraising rent, and (v) insurance issues. Because the tenant is bearing all of the risk and cost of the project, the tenant can expect much greater flexibility and tenant rights in a ground lease than in other types of leases.
Key Ground Lease Terms: Described below are some of the key terms in a typical ground lease and some of the considerations that landlords and tenants must take into account in negotiating such a lease.
Ground leases typically have significantly longer terms than other types of leases. Often the ground lease term is for 99 years, although the 99 year term may be stated in the form of a shorter initial term, with multiple renewal options. A tenant will want to ensure that the renewal options are not illusory, i.e. not subject to the whim of the landlord (e.g. provisions that the option lapses if the landlord and tenant cannot agree on rent for the renewal term). The ground lease should provide that if the landlord and tenant cannot agree on a rental rate for the renewal term, the rent is determined by an appraisal or arbitration method, described below.
Because ground leases are for longer terms, it is essential that a method be outlined in the lease for adjusting rent to keep up with inflation and the market over time. Typically, rent is adjusted by determining the fair market value of the property and then multiplying such value by the capitalization rate set forth in the lease to determine the rent for the renewal term.
Commonly, the fair market value of the property is determined by an appraisal process. A tripartite appraisal process in which the landlord and tenant each choose an appraiser (or arbitrator) and the two appraisers select a third appraiser is not unusual. There are several variations on how fair market value is determined by the appraisers, such as:
i. Landlord chooses an appraiser first who determines fair market value. Tenant can accept the first appraiser’s determination or select a second appraiser to do another fair market value determination. If the second appraisal is within a certain percentage of the first appraisal, the two are averaged and the average is the new rental rate. If the second appraisal and the first appraisal differ by more than a certain percentage, then a third appraiser is appointed. Either the third appraiser’s determination or a determination by agreement of two of three appraisers will serve as the fair market value.
ii. A variation of this is the “baseball” approach in which the third appraiser must select the decision of one of the first two appraisers.
iii. Another variation is for both the first and second appraiser to be selected at the same time and require them to mutually agree on the fair market value.
The appraisal processes can be time consuming and expensive, especially as the number of appraisers involved increases. Accordingly, a tenant will want to lengthen the intervals between which appraisals are required. Landlords and tenants also will attempt to shift the appraisal costs between them in the lease.
c. Completion of Improvements
The landlord will be particularly concerned with providing in the ground lease adequate safeguards to ensure that the tenant actually completes all of the tenant improvements so that the landlord is not left with a hole in the ground or a partial structure. A thorough investigation of the tenant’s financial strength and the terms of construction financing is necessary. A landlord should consider providing in the ground lease that construction cannot commence until the tenant delivers to the landlord: (i) an executed copy of the construction contract with a well-reputed contractor that provides for a fixed construction cost (to the extent possible), (ii) a commitment for a construction loan from a well-reputed lender, and (iii) a letter of credit or other security equal to the difference between the construction cost set forth in the construction contract and the amount of the construction loan. The extent to which the plans and drawings for the improvements must be pre-approved by the landlord is a matter of negotiation.
d. Protection From Liens and Liabilities
One of the risks of a ground lease to a landlord is the possibility that the tenant will cause liens to be placed on the property that could result in the landlord losing the fee interest or the improvements. Two common ways in which this could happen are failure to pay taxes or failure to pay for work in connection with the construction of improvements, resulting in mechanic’s or materialmen’s liens being placed on the property. In addition, the Comprehensive Environmental Liability Response Act of 1980 (CERCLA) (42 U.S.C. § 9601 et seq.) holds the landlord and tenant jointly and severally liable for contamination of the property when a hazardous substance is present on the property during the term of a lease. Landlords should insist upon such provisions in a ground lease as (i) affirmative covenants to pay all taxes on time, keep the property free and clear of all liens (other than a leasehold mortgage, described below) and to post a bond if the tenant has a bona fide dispute with respect to an assessment, (ii) restrictions on hazardous wastes, (iii) broad insurance requirements, and (vi) indemnification of the landlord from and against any and all third party claims.
A tenant will want the ability to sublease the property freely. This is a reasonable expectation since subleasing will provide the return on the tenant’s investment in the improvements. A landlord is advised, however, to ensure that the ground lease requires that any sublease obligate the subtenant to, at the election of the landlord, attorn to the landlord and continue to perform all of its obligations under the sublease upon the termination or expiration of the ground lease. This is essential to the value of the property to revert to the landlord upon termination of the ground lease.
f. Mortgagee Protection Clauses
One of the most critical parts of a ground lease, and often one of the most heavily negotiated, is the mortgagee protection clause. A tenant will need to obtain financing secured by its leasehold interest in the property. As a condition to providing such financing, a lender/mortgagee often requires extensive mortgagee protection provisions in the ground lease. These can include:
- Broad permitted use provisions so that, if the mortgagee has to step in and take over an unsuccessful project, it can convert it into a successful one;
- No limitation on subletting and assignment of the ground lease and a required release of each tenant from further liability under the ground lease upon assignment;
- Insurance and condemnation proceeds to be paid to the lender or to a trustee for use only for restoration of the building;
- Required notice to the mortgagee and liberal opportunity to cure any tenant default;
- The right of the mortgagee to take over the lease upon foreclosure;
- If the landlord has the right to terminate the lease, the right of the mortgagee to receive notice of termination and to receive a new lease on all of the same terms for a designated period of time; and
- Requirement of obtaining the mortgagee’s prior written consent to any termination, cancellation or amendment of the lease.
g. Subordination of the Fee
It is not uncommon for a leasehold mortgagee to require the landlord to subordinate the landlord’s fee interest in the property, and any fee mortgage, to the ground lease and the leasehold mortgage. If the fee mortgage is not subordinated to the ground lease and the leasehold mortgage, then a successful foreclosure of the fee mortgage will operate to terminate the ground lease. Although landlords and their lenders often balk initially, a request for such a subordination is not unreasonable. It is the leasehold mortgagee’s funds that are being used to improve and add value to the property. The landlord is not bearing the risk, but reaping ultimately the gain of such improvement. Moreover, any fee mortgage is just an added bonus to the landlord, enabling the landlord to take a portion of the present value of the rental stream early and tax free. Moreover, the ground lease is generally valuable to the fee mortgagee who, under most circumstances, should desire to keep it in place following foreclosure.
h. Recourse Versus Nonrecourse Leases
A tenant will want to insist that a lease be absolutely nonrecourse such that the tenant’s obligations under the lease are secured solely by the tenant’s business on the premises. This is not an unreasonable position since the value of the project is generally of more interest to the landlord than the credit worthiness of a particular individual. A landlord, in some circumstances, may succeed in securing certain nonrecourse “carve outs” – a type of limited personal guaranty by the principals of the tenant upon the occurrence of certain defaults, such wrongful diversion by the tenant of rent from subleases.