We all know that ground leases, in which the tenant (Tenant or Ground Lessee) leases land for a very long term, present a special kind of challenge. The Tenant controls the improvements on the property during the lease term, but at the end of the term, ownership of the right to use the land and improvements reverts to the owner of the underlying fee interest in the ground (Landlord or Ground Lessor). The length of the term and the flexibility on the use and control of improvements can create a tension between the concept of fee ownership and a leasehold interest. There is a temptation to have the Tenant control all ownership rights, but, at the end of the term, the carriage turns back into a pumpkin and the Landlord and Tenant are left sorting out surrender issues and settling claims.
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The Landlord usually seeks to generate income (in somewhat passive fashion), while still retaining the ownership of a parcel of real estate. This allows the Landlord to monetize the value of the land without giving up long-term control. For the Tenant, a ground lease may be the only way to develop an iconic or important parcel of real estate if: (i) the Tenant doesn’t have the financial means to actually purchase the land; or (ii) the owner is unwilling to transfer ownership.
Unlike the development of a multitenant shopping center, a Landlord is typically leasing a parcel of land under one ground lease to a single-tenant user (obviously there can be a ground lease under a multitenant development as well, but those ground leases are not the subject of this article). Indeed, for certain landlord-tenant parties, a single-tenant ground lease may be the better option.
This article will address the distinctive characteristics of, and issues present in, the typical single-tenant ground lease. These are issues that will likely arise, and should be thoroughly considered, when determining whether the relationship will work whether as a Tenant or Landlord.
LANDLORD ISSUES
With great benefits and limited detriments, a Landlord may be incentivized to stay “single” through use of a ground lease. Before marrying itself to a single-tenant user under a ground lease, however, the Landlord and legal counsel should consider the following issues.
Due Diligence
Typically, the ground lease will have many contingencies and will afford the Tenant a long period to investigate and confirm its ability to use and develop the premises as anticipated (Due Diligence Period). These conditions are often expressed as a “pre-tender” term or a “due diligence” term and perhaps also a “construction term” distinct from the typical “operating” term of the lease in which the Tenant operates at the premises and pays full rent. This is because under a ground lease many of the development obligations (and thus many of the development risks) are transferred to the Tenant. Some considerations will include soil conditions, hazardous material present upon the parcel, zoning, building code requirements, anticipated cost of construction, and the like.
In addition to conducting pre-construction investigations and obtaining entitlements, the Tenant may also need to meet requirements imposed by the Tenant’s lender, while juggling the satisfaction of multiple involved parties like the local planning board, county, state, and federal regulators, and the local building department. The Landlord will need to exercise patience as this all plays out. In consideration of the contingency period, the Tenant may have to pay non-refundable monies to the Landlord until the overall contingencies have been satisfied or waived. While the Tenant would rather not incur additional costs, without such an agreement the Landlord may be unwilling to allow a long Due Diligence Period during which other offers are missed. A prudent Landlord will reserve the right to terminate the lease if not met or satisfied.
Construction Period
A similar issue will arise with respect to rent concessions during the Tenant’s anticipated construction period. If rent commences prior to the completion of construction of improvements, the Tenant will often seek reduced rent during such period with the understanding that Landlord’s return will be generated once the building is operating. The Landlord’s response will hinge upon its economics and expectations. What are the Landlord’s carrying costs? Does the rent under the ground lease justify a longer period without rent or with reduced rent?
Landlord Termination Rights
While Tenant, alone, may have the right to terminate the lease during the Due Diligence Period, it is quite likely that the entitlement process will afford both parties the opportunity to reconsider the deal. It should be expected that site plan approval will be required, and the approval process will require planning board approval. If neither is received in a reasonable period, both Tenant and Landlord might want the right to terminate.
If the parcel was pre-approved, there will likely be a set of conditions that the municipality has imposed, such as building height, the maximum size of the building, the footprint where the building can be constructed, the parking area, and use. Those restrictions should be acknowledged upfront, and Tenant should have no right to terminate for a known restriction. If the parcel was not pre-approved, the parties should be prepared to engage in full site plan approval (and the ground lease will need to be specific on the process). The parties will need to work in concert to obtain site plan approval and the Landlord may want to the right to seek approvals on behalf of the Tenant to ensure its property is not tied up for a long period of time without a right to “save the deal.”
Expectations for Due Diligence and Safe Harbor
The Tenant should know what entitlements it needs for its project, and if the entitlements come up short of the Tenant’s expectations, the Tenant (and probably the Landlord) will have the right to terminate the lease. However, the Landlord would be well-served if the ground lease contained a floor plan and site plan with specifications and a range of acceptable parameters as a safe harbor. If site plan approval is granted within the set parameters and the approved site plan is not materially different from the site plan attached to the ground lease, then the Tenant does not have the right to terminate the lease. Of course, the Tenant may not be able, or willing, to commit to safe harbor plans at the time of signing. In this case, the Landlord may alternatively seek to refer to an existing project as its “safe harbor,” with language to the effect that if site plan approval is granted as will permit Tenant’s project to be substantially similar to the existing project, then the Tenant shall not have the right to terminate the lease on entitlement grounds.
Termination Rights
Of course, once the due diligence is completed, the parties may desire to terminate the lease. Timing of the Due Diligence Period and entitlement process will vary. In some instances, this can be accomplished in a matter of months; in other jurisdictions, a matter of years. From the Landlord’s perspective, if entitlements are dragging on and there is not a strong likelihood that the deal will progress (and thus produce revenue), the Landlord may wish to terminate the lease and move on to an alternative plan. Presumably, however, there will be some reluctance to move on as the “alternate” deal is likely to be less attractive than the deal the Landlord initially chose to sign. From the Tenant’s perspective, there may be external pressures (e.g., if Tenant is a publicly traded company and not meeting store opening objectives) or internal requirements to pursue other opportunities if entitlements are not achieved within a reasonable period of time.
CLICK HERE to read the full article, which was originally published in ALI CLE’s The Practical Real Estate Lawyer.
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