A ground lease is a long-term lease of unimproved land between the owner of the property and a tenant where the tenant leases the land and constructs a building and other improvements on it. Lease terms generally run between 50 and 99 years. The tenant owns the improvements during the term of the lease and is obligated to pay the expenses except for the landlord’s mortgage and income taxes. While this description is straight forward, ground leases are complex contracts.
This article discusses the key considerations that a lawyer should be familiar with when negotiating and preparing a ground lease. This article is intended as a starting point and there are other issues that may need to be considered in a transaction.
Why Parties Choose a Ground Lease
There are several advantages to landlords and tenants when entering into a ground lease instead of a purchase and sale agreement. From the landlord’s perspective, the advantages include:
- Stable and predictable income with minimal risks.
- Retention of the fee interest for future generations.
- Passing the risk of development of the property to the tenant.
On the other hand, a tenant may desire a ground lease for the following reasons:
- Avoidance of the upfront cost to purchase the land.
- Tax benefits to the tenant as far as the depreciation of the tenant improvements and deduction for the rent.
- The owner may be unwilling to sell, however, the business reasons for the specific site justify entering into the ground lease instead of a purchase.
As with any business relationship, there are risks to a ground lease for each party as well. Risks to the landlord include:
- The tenant’s business plan fails, and the landlord is left with an incomplete building and a foreclosing mortgage holder.
- Loss of use of the land for an extended period.
The tenant risks include:
- Taking on substantial debt to finance the improvements.
- Loss of the investment in the improvements in the event of a default and termination of the tenant’s leasehold interest.
Financeable Ground Lease
A ground lease creates two separate interests: (a) the landlord’s interest in the leased fee and (b) the tenant’s interest in the lease. Whether a lease is financeable should be a primary consideration for both parties. The parties should consider lender protections at the outset of the lease negotiation. Preparing and signing a lease without said protections could result in lost time and expenses because there is a strong likelihood the lease terms will be renegotiated when the tenant’s lender reviews the executed lease.
Terms that address the concerns of the tenant’s lender include a provision allowing the tenant to use its leasehold interest as collateral; a term no less than 30 years; a broad permitted use so that the lender has options in the event of a foreclosure; requiring the landlord to provide the tenant’s lender with notice and cure rights in the event of a tenant default and permitting the lender to cure the default; permitting the lender to enter into a new lease on the same terms and for the remainder of the existing term if the initial lease is terminated or rejected in a tenant’s bankruptcy case; and determining the rights of the tenant’s landlord to insurance proceeds and the allocation of condemnation compensation.
Other Key Terms
Rent: There are a few options when negotiating the rent. One option is to increase the rent as the project moves though the development phases with the front end of the lease including a much lower rent amount compared to when the tenant takes possession of the new space and is operating. At that time, the lease may provide for escalation based on the Consumer Price Index, similar to increases in rent in a standard commercial lease. An alternative is to determine the amount of increase at certain intervals and then recalculate the rent based on the adjusted fair market value of the land followed by increases based on a set percentage. There are numerous variations on these methods and other methods depending on the project and financing.
Construction: A ground tenant’s construction of the improvements on the landlord’s property is a period of elevated risk to the landlord. If the project fails, the landlord is left with an incomplete construction site and claims by the tenant’s creditors. Several lease terms can mitigate this risk including:
- Requiring the tenant to have its financing in place before construction beings. In a multi-phased site, requiring that a certain number of units be sold or leased before a construction for that phase begins.
- Reserving a right of reentry if construction is not complete by a certain date.
- Specifying the minimum standards of construction.
- Requiring a personal guaranty until construction is complete and all lien waivers are received.
- Specifying that upon the termination of the lease or the expiration of the lease, all improvements are deemed property of the landlord without payment and free and clear of all liens. The landlord should consider including a reservation to exclude certain or all improvements in its sole discretion, particularly if there is a risk of environmental issues.
Use: Unlike a standard commercial lease, the use provision of a ground lease is often broad because of the length of the lease. As discussed above, a lender may require a broad use provision. However, the landlord should not agree without limitations, including restricting a use that involves hazardous materials, prohibiting rezoning without the landlord’s consent, and prohibiting uses that would compete with the landlord’s abutting property or conflict with the landlord’s obligations to other tenants.
Insurance: The longevity of a ground lease creates additional considerations regarding the tenant’s insurance requirements. In addition to requiring the tenant to insure the improvements at the full replacement cost, the lease should require the tenant to obtain updated appraisals at predetermined internals and to adjust the insurance coverage accordingly.
The above list is not exhaustive and there are several other terms that require counsel’s careful attention.
Conclusion
When negotiating or drafting a ground lease on behalf of a client, consideration must be given to the terms that make the lease different from a standard commercial lease, including the fact that the lease involves the tenant’s lender interests in addition to the landlord and tenant. Understanding this complexity at the outset should avoid delays in renegotiating the lease as the project advances.