Ground Lease Defaults - Acrel Program 10/21/2005 (00012432;3)

WHY ARE GROUND LEASE DEFAULTS DIFFERENT FROM

ALL OTHER LEASE DEFAULTS?

Ira Meislik

Meislik & Levavy

66 Park Street

Montclair, New Jersey07042

Ph.: 973.783.3000

Fax: 973.744.5757

Imagine a tenant who moves into its landlord’s brand new ten million dollar building on a two million dollar piece of land under a twenty year lease. Pretend that the tenant invests two million of its own dollars to adapt the space for its business, and that it expects to realize the value of its efforts for the entire twenty years. How upset would it be if, despite curable circumstances, it lost its two million dollar investment and the good will it had hoped would serve it well for whatever was left of its twenty year lease term.

Now imagine that the tenant built that ten million dollar building with its own money and had worked out a fifty year lease deal. Losing a lease because of a hair trigger default provision would be a great deal more painful.

And, not just to the tenant. Because, to spin the tale even more, imagine (and it’s not tough to do so) that the tenant borrowed most, if not all, of the twelve million dollars (not counting personal property such as furniture or inventory) from a risk adverse enterprise – a leasehold lender.

Now, multiply the numbers by ten.

From a lot of perspectives, the text of a ground lease is pretty much similar to that of a space lease. The differences are in the details, and they have to do with two vastly different economic models and a whole lot of risk shifting.

In the purest sense, and most commonly true, here’s how a ground lease works: In return for a tenant’s getting largely unrestricted use of an owner’s land for a long, long time, and for the tenant’s doing all construction and site improvements and taking over almost all the obligations and risks of ownership, the landlord gets a monthly payment. Most often, the tenant borrows what it needs for the project and mortgages its interest in the ground lease as security for that loan. There are a myriad of variations from that scenario, but the principle is pretty much the same.

So, there we have it. If a tenant loses its lease, it stands to forfeit the lion’s share of the property’s value and its lender loses its collateral. That’s why you can expect to see a whole different set of tenant default concepts in a ground lease than most landlords would tolerate in a space lease.

To start with, it helps to classify the various ways a tenant can breach its lease obligations. Although there are two broad categories – monetary defaults, and non-monetary defaults – it helps to break them out a little further. Assuming that all monies that a tenant is required to pay in connection with its lease and its underlying occupancy, other than basic rent (whatever the particular lease may call it), is called “additional rent.” Then, there are two kinds of monetary default: failure to pay basic rent and failure to pay additional rent. Additional rent comes in two flavors: what is owed to the landlord; and what is owed to third parties such as the tenant’s leasehold lender, utility companies, and contractors.

Non-monetary defaults can be broadly thought of in two ways: those that threaten an immediate problem, such as loss of insurance coverage or the imposition of criminal or quasi-criminal liability, and those that can wait a little, such as impermissibly deferred maintenance.

It’s useful to remember that the only business motivation that a ground landlord has is economic – the rent and (usually) keeping the improvements when the lease is over. If the rent isn’t paid, then the basic bargain between the landlord and tenant is broken. Thus, other than in the rare, rare non-terminable ground lease, if the rent stops, the lease is ended. Because terminating the lease is so economically draconian to a tenant, a typical ground lease usually includes one or more of the following safeguards.

For consistency of use, let’s define the kind of tenant breach that would allow a landlord to seek the lease termination remedy as an “Event of Default,” a defined term of art preferable to the plain, old, and dictionary word “default.” That way, a lease can stipulate that failure to pay rent is not an Event of Default unless left unpaid for more than a certain time after written notice that it is due and unpaid. Sometimes, that notice period is 10 days, and very often it is 30 days. Leaving out a notice provision or putting in a short trigger, such as 3 or 5 days, is much more common and acceptable in space leases than in ground leases.

The amount of basic rent to be paid is easily determined -- the lease recites the amount. But, what about additional rent? That’s not so easy. One thing is clear, and that’s that a tenant has to pay whatever is owed or it can’t keep its lease. Therefore, the only legitimate dispute is over a legitimate dispute. What if the tenant doesn’t think the charges are correctly billed or owing? It isn’t enough to leave this issue to a discussion of various dispute resolution procedures because that begs the question. What is more, this isn’t the best place to join that discussion. There is already enough literature on the subject. The real focus here, as in space leases, is to look at the effect of deferring payment of what is really owed. Basically, it comes down to three issues: will anything really bad or irreversible happen if the money isn’t paid on time; if the tenant doesn’t pay now, will it have the money later; and, who holds that part of the money that is in dispute?

Is the dispute over the amount owed or about whether the tenant would be liable in the first place? Given that in the typical ground lease, the tenant is responsible for everything, as if it were the true owner of the parcel, it makes sense for the tenant to be required to pay everything, failing which results in the land being lost or in a loss well beyond reason. Taxes, municipal charges, lien secured charges, and insurance premiums are in that category. These items are almost all of the kind that require payments to parties other than the landlord. In each case, it really doesn’t matter that the tenant is wealthy enough to make the payment at any time – the property can still be lost even when the tenant has ample means. Therefore, a ground lease tenant almost always is required to make these payments or to avail itself of any bonding or alternative consequence-avoiding device that would short circuit a loss of the land or of significant improvements. Further, a ground landlord needs a mechanism to monitor whether these risk-related charges are being paid. The safest way is to require that payments that would otherwise go directly to third parties pass through the landlord’s hands. For example, a ground landlord would receive the original tax bills (with duplicates to the tenant if possible) and pay real estate taxes, when due, using payments from its tenant, whether accumulated monthly or collected just before the taxes are due. Similarly, it might behoove a landlord to maintain the property insurance and collect the premiums from its tenant. There are a variety of other, obvious mechanisms, but their central feature is that the ground landlord gets notice directly from the payee and is not reliant on the tenant’s telling it whether critical payments have been made.

Truly creditworthy tenants don’t always remain so. Most often, ground leases are freely assignable, thus leaving a landlord with “whomever” and the right to chase the original tenant from 50 years earlier. For either reason, or for a host of others, objective and psychological, landlords will want to “see the money,” even if the tenant is given the right to hold back on paying a disputed charge. So, the landlord can hold the money or a trustee can hold it. If there is an undisputed portion, then tenants are almost always willing to pay that amount on time and reserve the rest for later resolution. In all cases, we are assuming that the dispute hasn’t arisen as a substitute for a tenant’s not having the money (i.e., it is not manufactured by the tenant as a stalling tactic). The disputed portion (or the entire amount withheld) should be held in an income-earning account. The parties might want to consider investments that pay more than bank interest rates, such as repurchase obligations. The rate of return won’t match either party’s internal rate of return, but that’s the cost of the deal. The basic rent is what the landlord gets to keep for itself. Additional rent doesn’t line the landlord’s pockets. So, the entire earned interest usually goes back to the tenant, and the tenant should be given deference in choosing the investment vehicle (all within reason).

Frequently, a lease (ground or space) will define “additional rent” as any payments (other than percentage rent or basic rent) required to be made by the tenant. Whether “additional rent” should be limited to only those payments that go to the landlord rather than to third parties is outside the scope of this analysis. But, if payments to third parties are included within the definition, then creating a subset of “non-payment” might be in order. Aside from the question of creditworthiness, how much does it matter to the landlord that the tenant isn’t paying its landscaper or a utility provider? What does it matter if the tenant isn’t paying its leasehold lender? Given that ground leases often are freely assignable, then, to the landlord, the leasehold lender becomes just another tenant, and a financially strong one at that. The real risks that a ground landlord takes arise out of any separate agreements it makes with the leasehold lender. That, too, is outside the scope of this analysis. Obviously, there is a point where the property is threatened, but usually not where the problem is that the bills are being paid late. Conceptually, where “additional rent” is involved, landlords and tenants are invited to think about longer cure periods and about converting this kind of breach into one where the landlord is owed the money.

That’s our segue. How do you balance the risks of ownership and long term leasing between the landlord and the tenant, knowing that one or more lenders have a stake and are watching closely? Here, we’re not going to pay close attention to the needs and desires of those lenders, because others have contributed program material dealing with financing issues. Suffice it to say that “notice and an opportunity to cure” is the cornerstone of each lender’s protection. A recognition agreement is another.

In the typical space lease situation, the real property belongs entirely to the landlord. With a ground lease, the land belongs to the landlord and the value of the building belongs to both landlord and tenant in accordance with a sliding scale. At first, the tenant “owns” all of the improvements. As the lease term declines, the “residual” value of the building and other improvements increases to the point where, at lease maturity, it’s all the landlord’s. So, what should happen if the lawn isn’t mowed? The landlord thinks it should be mowed, and the tenant doesn’t. The status quo in such a situation is that the grass grows long. Should a landlord be entitled to evict its ground tenant in such a circumstance? As trivial an example as this presents, it expresses the issue about all non-monetary breaches that can be cured by spending money – what does it really matter? What does the landlord want – to get the lawn mowed, the building painted, the snow removed, the roof replaced? Or, does the landlord really want to get the leased property back because the deal doesn’t look as good after 20 years as it did two decades earlier.

One way to find out is to make all non-monetary breaches into monetary ones or into a violation of a court order, such as one providing injunctive relief. This approach basically requires that a landlord “put its money where its mouth is.” If curing a particular non-monetary breach is important to the ground landlord, then let it use self-help. Let it replace the roof. Turn the breach into a dispute over money. Then, treat it like any other item of “additional rent” owed by the tenant to its landlord. Doing so essentially creates a threshold test – is the alleged breach important enough, at any given stage, for the landlord to advance its own funds? If a roof needs repair or replacement, then there usually is some point in time where both the landlord and tenant see it that way. Sometimes, it’s just at a later point than the landlord would elect to have the work done. Usually, it’s not about whether something needs to be done, it’s about when. If the landlord is willing to advance the money, then it can force the issue.

The preceding approach sidesteps two key issues – was it a breach in the first place, and was the amount spent necessary and reasonable? Each issue can be addressed through a dispute resolution procedure included within the lease. If the landlord was right and advanced a reasonable and necessary amount, then it will get an arbitration or court award, including its attorney’s fees and other dispute related expenses and appropriate interest. If it was wrong, then it will have gotten the result it wanted (a repair, a repainting, etc.), but at its own expense.

What if a landlord doesn’t want to take the risk of being wrong or doesn’t have the funds to advance? Interestingly enough, that’s the flip side of the risk a tenant sees when it turns out that it should have fixed the roof or the parking lot, but didn’t think so – it’s a big problem and it can lose its lease without a second chance. If the parties deal honestly with each other, then they should be willing to resolve a disputed breach first, and then give the tenant the opportunity to cure those that are adjudicated as such. That’s easily done by incorporating an alternate dispute resolution provision in the ground lease, i.e., letting an arbitrator or a panel make the call. If the landlord is correct, then the tenant will either remedy the breach or face loss of the lease. Properly drawn, the dispute mechanism will eliminate further litigation over whether there was a breach in the first place. The issue will become whether the tenant abided by the award or judgment, or not. That way, the landlord gets the work done when the work was really required, and the tenant doesn’t face the risk of being found “guilty” by an eviction judge with no opportunity to cure the breach.

Is this approach really different? Can’t the dispute be resolved in an eviction proceeding? Not really. The suggested approach eliminates the brinksmanship. Here’s an illustration. Assume that each party acts in absolute good faith. They just disagree about whether the tenant has breached a non-monetary obligation. The landlord sues for possession. If the landlord is wrong, it apologizes to its tenant and covers the litigation costs. After all, it might have been a close call, but one of them had to be wrong. In this case, it was the landlord. No harm, no foul. But, what about the reverse situation? It was a close call; even the judge says so. The tenant legitimately, and in genuine good faith, believed that there was no breach. It was wrong. It loses the lease. There is no redemption for a non-monetary dispute. That’s the (huge) difference.

Speaking of redemption, why not? Theoretically, what a landlord wants is to get paid. That’s the bargain described on the first page of this discourse. So, what should happen if a tenant, in absolute good faith, feels that it doesn’t owe the money. We’re not talking of a situation where there has already been an alternate resolution, such as an arbitration proceeding. We’re talking about a dispute that has gone directly to a court. What if “it was close, but no cigar”? The tenant was almost right. Should it lose the lease? Why not include a contractual “redemption” period? If the landlord’s object is to get paid what it is owed, then what’s wrong with waiting three more days? The tenant will cover the legal fees and pay interest.

By this time, the thorough reader has discerned that this presentation is fundamentally a conceptual one. If that has become obvious, then it will have served its purpose. All leases are the result of negotiation – ground leases even more so because the stakes are higher. In any given deal, the outcome will be based, in large measure, on the relative bargaining strength of the parties and their respective willingness to accept risk. What further makes a ground lease different is the ubiquity of third party lenders who are always risk-averse and without whose participation the deal doesn’t happen. It is obvious that the leasehold lender dreads a lease termination, but so does a fee lender. Fee lenders have settled for an acceptable return and don’t care about the “upside.” They don’t get a better return on their loan when a property gets re-let, but they certainly have apoplexy when the rent stream is interrupted. Recognizing that both kinds of lenders are necessary in the first place, and that they don’t want to see a broken lease, both landlord and tenant, like it or not, are forced to reach agreement on default and remedy provisions that work. That’s the reason for the advocacy displayed above.