Basic Ground Lease Drafting Issues I

Sanford A. Weiner

Vinson & Elkins, L.L.P.

FirstCityTower

1001 Fannin Street

Houston, Texas 77002

Ph.: 713.758.2558

Fax: 713.615.5268

I.Reversion Issues

At the end of the term of a Ground Lease, whether on its stated expiration date or as a result of termination following default or some other significant event, title to the building and other improvements becomes vested in (or reverts to) the Landlord. Depending on the term of the Ground Lease and the nature of the improvements, the improvements may be very valuable to the Landlord. The ability to own the improvements at the end of the lease term may be an important part of the Landlord’s economic incentive to enter into the Ground Lease.

On the other hand, if the improvements have been designed for a specific purpose, and the universe of operators of the special purpose improvements is relatively small, or the improvements are economically obsolete at the end of the lease term, the improvements may have a negative impact on the value of the land at the end of the lease term. For example, if the Tenant constructs a power plant on the land, and the Tenant does not exercise a renewal option or the technology or fuel source makes the plant no longer economically feasible to operate, the Landlord may want an option to require the Tenant to remove the improvements and return the land to grade level. The cost of removing improvements may be very significant and the Tenant typically tries to resist this obligation. Even if the Tenant agrees to remove the improvements and return the land to grade level if the Landlord so elects, the covenant to remove may be of little or no value if the Tenant is a single purpose entity.

The lease term may end early as a result of a partial condemnation or a significant casualty wherein the Tenant elects not to reconstruct the improvements. If the improvements have been significantly damaged and the Tenant is not obligated to (and/or does not elect to) reconstruct the improvements, the damaged improvements are likely to have a significant negative impact on the value of the land.

Later portions of this program will deal more fully with insurance and reconstruction issues and financing issues, so the following issue will be mentioned only in passing. Regardless of whether the improvements are likely to have a positive or negative value at the end of the lease term if they are in reasonably good condition, the Landlord should require, at a minimum, that if the improvements are not reconstructed, insurance proceeds must be made available to

Sanford A. Weiner is a Partner in Vinson & Elkins L.L.P., Houston, Texas; he is co-head of its real estate practice group.
remove the damaged improvements and return the land to grade level. If the Tenant is a special purpose entity, it is particularly important for the Landlord to get the commitment from the leasehold mortgagee that insurance proceeds will be used to either reconstruct the improvements or demolish the improvements and return the land to grade level. As one would anticipate, lenders may be unwilling to commit to do so if the Tenant is in default under its leasehold financing and the insurance proceeds are insufficient to both pay the demolition cost and pay off the leasehold financing.

In the case of a substantial condemnation that results in significant damage to the improvements, the Landlord not only loses the value of the land actually taken and perhaps a portion of the value of the remaining land, but also risks losing the reversionary value of improvement that may have been an important part of the Landlord’s economic incentive to enter into the Ground Lease. Therefore, a Landlord should consider requiring, in the event of a condemnation, that it receive not only the value of the land but also Landlord’s share of the value of the improvements (generally based on a fraction, with the remaining term of the Ground Lease being the numerator and the original scheduled term of the Ground Lease being the denominator). Of course, the leasehold mortgagee will want its right to condemnation proceeds with respect to the improvements to have priority over Landlord’s share of the value of the improvements.

II.Determining Rent

The initial base rent is typically established by negotiation between the parties. Regulatory reasons relating to the particular type of use, or the nature of the Landlord or the Tenant, may require use of third party appraisals to verify that the base rent is the fair market rental value of the leased property. The appraiser should take into consideration all relevant issues, such as the escalation factor for base rent, any parking rights on the Landlord’s adjacent property, any services to be rendered to the Tenant by the Landlord and its affiliates, and any free or deferred rent during the construction and/or lease-up period.

In a long term Ground Lease, the Landlord needs periodic adjustments in the amount of the base rent to avoid having inflation seriously erode the value of the rental stream. Increases in property taxes, insurance premiums, operating expenses, and the like are typically not an issue for the Landlord because almost all Ground Leases are structured as completely net leases (i.e., all taxes, insurance premiums and expenses of operating and maintaining the land and improvements are borne directly by the Tenant).

A.Timing of Rent Adjustments

One issue is agreeing when the adjustment process starts and how often the base rent will be adjusted. The Ground Lease may provide for no rent during the construction period (and perhaps an initial lease-up period) or for rent during the construction period and/or lease-up to accrue without required current payments and then be capitalized at the end of the free rent period and amortized over all or a portion of the remaining lease term. The Landlord and the Tenant may agree that the adjustments in base rent will not occur until after the free rent (or accrual) period has expired.

A Landlord typically wants the adjustments to occur annually whereas, depending on the type of improvements and the economics of the Tenant’s subleases (i.e., leases to occupants of space in the improvements), the Tenant may prefer that adjustments be made once every five or ten years. Obviously, adjustments done every five or ten years will result in a larger increase at the time of the adjustment than if the adjustments were done annually. The Tenant will want a mechanism for passing through to subtenants all or a significant portion of the increases in the ground rent (such as by treating ground rent like an operating expense). Having adjustments every five or ten years creates a more significant “sticker shock” issue for the subtenants than if the adjustments occur annually, but some subleases have built-in bumps in their base rent. Local market conditions may not allow the Tenant to pass through to subtenants the periodic increases in base rent under the Ground Lease.

While the Tenant may be able to pass through to its existing subtenants all of the increases in ground rent under the operating expense provisions of the subleases or otherwise, that may be little comfort if the market for space (e.g., office space) is depressed at the time of sublease expirations such that market rents do not permit a Tenant to recoup its increased ground rent expense in second or third generation subleases.

B.Types of Base Rent Adjustments

While there are numerous ways to address the adjustment in base rent, three commonly used mechanisms are: (a)fixed annual adjustments, (e.g., 2% to 4% per annum); (b)a consumer price index (“CPI”) adjustment factor; and (c)adjustment to fair market rental value based on appraisal.

Fixed annual percentage increases provide the greatest predictability for the parties. Typically, such adjustments are cumulative (e.g., base rent during the third lease year is 102.5% of base rent during the second lease year, and base rent during the fourth lease year is 102.5% of base rent during the third lease year). One downside is that the fixed percentage may significantly underestimate or overestimate the rate of inflation as measured by the CPI.

An annual CPI adjustment is more likely to allow the Landlord to keep up with inflation (assuming that the CPI chosen ends up being a good measure of inflation). But, this creates less certainty for the parties. Furthermore, Tenants typically fear major unpredictable increases during certain years as a result of major inflationary pressures (e.g., 1979-1982). One way to address the “one year spike” problem is to put a cap on the amount of the increase in any year (e.g., CPI adjustment, not to exceed 5% in any lease year). If the Landlord agrees to that type of cap, the Landlord will typically want a make-up provision in later years with lower inflation rates so that, on a cumulative basis, the Landlord has “kept up with inflation.” In the earlier example, where the one year adjustment has a 5% cap, the increase during later years may continue at 5% per annum until the Landlord has recouped the amount of the CPI adjustment that it was not entitled to receive during the inflationary spike year. Having a cap may be particularly helpful for the Tenant in dealing with its ability to pass through to the subtenants all of the increases in ground rent.

A third approach to periodically adjusting base rent is to make periodic adjustments based on appraised fair market rental value of the land. This is more typically done at the beginning of each renewal term or at major points in the primary term (e.g., in the 26th year of a 50 year ground lease term). These provisions typically provide for the Landlord and Tenant to attempt to agree on fair market rental value and if they fail to agree, provide an appraisal procedure. “Baseball arbitration” is often used because of the perception (which is probably untested by empirical data) that baseball arbitration is likely to keep the parties more honest and cause them to reach agreement themselves.

In the case of CPI adjustments or appraisal adjustments, the Landlord typically wants the new rent to be no less than the rent in the previous lease year. If the theory of periodic adjustments is either: (i)for the Landlord to keep up with inflation; or (ii)for base rent to reflect the true fair market rental value of the land, a “floor” of the prior year’s base rent may appear to create the best of both worlds for the Landlord. Typically Landlords are unwilling to commit in advance to reductions in base rent.

C.Landlord’s Participation in the Project’s Success

The Ground Lease may provide the Landlord with a share of the net cash flow, refinancing proceeds and/or sale proceeds as an important part of the economic incentive to enter into the Ground Lease. The Landlord’s participation in the success of the Tenant’s project may be a trade-off for base rent that is below initial fair market rental value or may be in lieu of all or a portion of the periodic adjustments in base rent. The Ground Lease may indeed be the mechanism for a joint venture between the Landlord and the Tenant. Drafting the provisions for participation in net cash flow, refinancing proceeds or sale proceeds is not terribly different from drafting the distribution provisions of a partnership agreement or an LLC operating agreement. A discussion of the nuances of the Landlord’s participation and the success of the project is beyond the scope of this presentation.

III.Options to Renew

Ground Leases typically include a renewal option or options. Depending on the initial term and the number and length of option terms, the Ground Lease may provide for the option to be exercised by the Tenant by giving notice to the Landlord between 18 months and 36 months prior to the expiration of the then effective term (either the initial term or then effective renewal term). The right to renew is typically conditioned on the absence of an Event of Default (i.e., an event which would entitle the Landlord to terminate the Ground Lease), rather than the absence of a Default (i.e., an event which, with the giving of notice or the passage of time, could ripen into an Event of Default). Typically, there can be no uncured Event of Default at the time of the exercise of the renewal option but the Ground Lease may also require that there be no uncured Event of Default at the commencement of the renewal term.

While a typical office lease may provide for a renewal option only if the original named Tenant or one of its affiliates continues to occupy all or a portion of the space, it is not customary for the renewal option in a long-term Ground Lease to run in favor of only the initial named Tenant. Most Tenants envision selling the leasehold estate (i.e., the improvements and all of the Tenant’s rights under the Ground Lease) well in advance of the expiration of the initial term of the Ground Lease. The Landlord’s protection is discussed in materials prepared by others for this program.

The Ground Lease may provide that the annual or periodic base rent adjustment mechanism (e.g., CPI adjustment or 2.5% annual increase) is to continue during each renewal term. Or, the Ground Lease may provide for base rent during the first year of the renewal term to be the then fair market rental value of the land, perhaps with the minimum rent being the base rent during the last year of the initial term or during the last year of the immediately preceding renewal term. See the discussion above regarding fair market rental value determinations. Fair market rental value determinations make more sense at the beginning of a renewal term rather than as part of an adjustment made every five to ten years. The Landlord will want the periodic base rent adjustment mechanism to apply again starting the second year of the renewal term.

IV.Purchase Options, Rights of First Offer and Rights of First Refusal

A Tenant under the Ground Lease will often want an option, right of first offer or right of first refusal to purchase the underlying land if the Landlord elects to sell the land even though any sale of the land to a third party will, of course, be subject to the Tenant’s leasehold estate. The Tenant may view the Landlord’s sale of the land as a good opportunity to rethink whether the Ground Lease is better than fee ownership. Also, it may decide that the cumulative annual adjustments in base rent makes leasing the land less attractive than ownership. Or, the Tenant may merely want some mechanism to avoid having an “undesirable” new Landlord.

At a minimum, the Landlord will want to exempt certain types of transfers from the right of first offer or right of first refusal. Some typical exclusions are: (a)a transfer to an affiliate of the Landlord; (b)a transfer in connection with the foreclosure or a deed in lieu of foreclosure of the fee mortgage (assuming that the Ground Lease is an unsubordinated Ground Lease); (c)a transfer of the land together with the rest of the project in which the land is located (e.g., the “campus” or the shopping center in the case of the Ground Lease of a pad site); and (d)a transfer as part of a portfolio sale that includes other properties owned by the Landlord or the Landlord’s affiliates. If a given transfer is exempt from a purchase right, the next non-exempt transfer should be subject to the purchase option, right of first offer or right of first refusal.

If the Ground Lease provides for a true, fixed price option to purchase at a date or at dates certain, the major issue is how to set the price. For the same reasons that base rent is typically adjusted periodically, either the purchase price is stated as a fixed price subject to escalation or the purchase price is based on the fair market value of the land (to be determined by appraisal if the parties cannot agree). A true option to purchase may reflect the parties’ plans to have a deferred sale of the property (e.g., the Tenant has the right to purchase the land at approximately the time the Tenant would be refinancing its construction loan or mini-perm loan).

A Landlord may be unwilling to agree to a fixed purchase option, especially if the Landlord has a very long term view (e.g., the property has been in the Landlord’s family for generations or the Landlord is motivated by the residual value of the land and improvements). A right of first offer or right of first refusal may be more acceptable because the Landlord, rather than the Tenant, controls the triggering event (i.e., the proposed sale to a third party).

A detailed discussion of rights of first offer and rights of first refusal is beyond the scope of this paper. Nonetheless, one issue that can cause considerable trouble is the transfer of equity ownership interests in the Landlord as a mechanism for effectively selling the land. A transfer of 100% of the equity ownership interest in Landlord (other than transfers to affiliates) should be treated as a sale of the underlying land. What happens if less than 100% of the equity ownership interests are transferred? Does the Tenant then have a right to acquire the equity ownership interests that are being transferred? Would the other equity owners be willing to have the Tenant as an investor in the Landlord? Would the Tenant want to be the owner of only a portion of the equity in the Landlord? How many transfers of equity ownership interests, on a cumulative basis, should trigger the right of first offer or right of first refusal (e.g., after 51% of the equity ownership interests have been transferred)? One possible solution is for the triggering event (e.g., the transfer of the majority, but not all, of the equity ownership interests in Landlord or Tenant) to trigger an option to purchase the land or the leasehold estate, as applicable, at its appraised fair market value. Of course, that results in a forced sale with respect to the equity owners who did not transfer their interests or otherwise cause the triggering event.