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Ground lease basic legal issues

GROUND LEASES: BASIC LEGAL ISSUES
Association of University Real Estate Officials
22nd Annual Meeting
September 24, 2002
Florence P. Mayne, J.D.
The University of Texas System
Office of Business Affairs
601 Colorado
Austin, Texas 78701
(512) 499-4517
email: fmayne@utsystem.eduC:\Documents and Settings\kbarron\Local Settings\Temporary Internet Files\OLK33E\ground leases_basic legal issues.doc
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TABLE OF CONTENTS
I. INTRODUCTION…………………………………………………………………………………….. 1
A. SCOPE ……………………………………………………………………………………………… 1
B. GROUND LEASES IN GENERAL………………………………………………………………… 1
II. SUBORDINATED AND UNSUBORDINATED GROUND LEASES………………… 3
A. THE DISTINCTION BETWEEN SUBORDINATED AND UNSUBORDINATED GROUND
LEASES…………………………………………………………………………………………………… 3
B. REASONS WHY A LANDOWNER MIGHT AGREE TO SUBORDINATION………………….. 3
C. PROTECTING THE SUBORDINATED FEE……………………………………………………… 3
D. UNSUBORDINATED GROUND LEASES AND LENDER PROTECTION PROVISIONS ……. 4
III. LEASE TERMS………………………………………………………………………………………. 5
A. CONSTRUCTION OF IMPROVEMENTS…………………………………………………………. 5
B. DURATION OF LEASE ……………………………………………………………………………. 7
C. RENT ……………………………………………………………………………………………….. 8
D. DEFAULT PROVISIONS ………………………………………………………………………….. 8
E. ASSIGNING, SUBLETTING, AND MORTGAGING THE LEASEHOLD ESTATE…………… 10
F. INSURANCE COVERAGE, CASUALTY LOSS, AND CONDEMNATION …………………… 12
G. USE RESTRICTIONS……………………………………………………………………………. 14
H. TAXES…………………………………………………………………………………………….. 15
I. MORTGAGING THE FEE INTEREST …………………………………………………………… 16
J. AMENDMENTS AND MODIFICATIONS TO GROUND LEASE ……………………………… 16
K. RECORDING THE LEASE OR MEMORANDUM OF LEASE ………………………………… 16
IV. CONCLUSION ……………………………………………………………………………………… 17C:\Documents and Settings\kbarron\Local Settings\Temporary Internet Files\OLK33E\ground leases_basic legal issues.doc
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GROUND LEASES: BASIC LEGAL ISSUES
I. INTRODUCTION
A. Scope
There are a myriad of legal issues involved in any ground lease transaction. This
paper focuses on some of the key legal issues in the context of the basic terms of a
ground lease. The intent of the paper is not to cover these legal issues in depth, but
rather to provide an overview of the issues.
This paper is not intended to give legal advice or to give legal opinions on
specific fact situations. The law in each state may vary, so please consult with
competent legal counsel for specific advice on the issues covered by this paper.
B. Ground Leases in General

  1. Characteristics of a Ground Lease. While purchase and sale
    transactions of real property may be more familiar, a significant portion of improved land
    in the United States is constructed on ground-leased land. Examples include the
    Empire State Building and the World Trade Center complex in New York.
    A ground lease is typically a long-term lease of unimproved land or
    previously developed property that requires the tenant to construct new improvements.
    Lease terms typically run 50 to 99 years, and generally no less than 30 years. The
    tenant typically holds ownership of the improvements during the term of the lease and
    the tenant has the obligation to pay all expenses attributable to the property except the
    mortgage on the landlord’s fee interest and income taxes owed by the landlord.
    Because of the significant improvements by the tenant, a mortgage of the leasehold
    estate is the norm.
  2. Reasons for Entering Into a Ground Lease. There are a variety of
    reasons why the parties may opt for a ground lease transaction rather than a purchase
    and sale. From the landowner’s perspective, the reasons may include one or more of
    the following:
    Š The owner retains ownership of the fee interest, which is particularly valuable in
    circumstances in which land is scarce and values are high or in which the owner
    is an institution of perpetual duration and may wish to reserve the right at a future
    point to put the land to another use.
    Š The owner avoids some of the significant risks inherent in development of real
    property.
    Š By leasing rather than selling the land, the owner may avoid replatting or
    subdivision laws. C:\Documents and Settings\kbarron\Local Settings\Temporary Internet Files\OLK33E\ground leases_basic legal issues.doc
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    A tenant may seek a ground lease for a variety of reasons that may include the
    following:
    Š The tenant avoids the large up-front cash payment required to purchase the
    property, allowing it to use its credit line to improve the property, rather than to
    acquire the land.
    Š Improvements are depreciable, whereas the land is a non-depreciable asset.
    Additionally, ground rent paid by the tenant is deductible as an ordinary business
    expense.
    Š The owner is unwilling to sell the land.
    There are disadvantages for the owner and tenant, however. Disadvantages to
    the landowner include the following:
    Š The long-term lease deprives the owner of the use of the land for an extended
    period of time.
    Š Because of the significant improvements to be made by the tenant, the landlord
    will likely need to permit the tenant more flexibility than an ordinary space tenant
    would be granted.
    Š Because of the extended term of the lease, lease rates may not protect the
    owner over the entire term of the lease.
    Š Because the tenant is responsible for making substantial improvements, the
    landlord has a potential risk that the tenant will not complete the improvements
    and the landlord will be faced with the need to expend funds to complete or
    demolish the partially completed improvements.
    Š Finally, because of the likelihood of leasehold financing and the “lender
    protection” provisions a mortgagee will require, the transaction will likely be more
    complicated than a sale would have been.
    For the tenant, the risks include the following:
    Š The tenant must make a significant financial commitment over an extended
    period of time.
    Š If default occurs under the lease, the tenant risks losing its leasehold estate and
    the improvements the tenant constructed on the land with none of the protections
    afforded a mortgagor of land.
    Š Also, as noted above, the ground lease transaction is often significantly more
    complicated than a purchase, since it involves not only a complicated ground
    lease, but also complicated loan documents. C:\Documents and Settings\kbarron\Local Settings\Temporary Internet Files\OLK33E\ground leases_basic legal issues.doc
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    II. SUBORDINATED AND UNSUBORDINATED GROUND LEASES
    A. The Distinction Between Subordinated and Unsubordinated Ground
    Leases
    The term “subordinated ground lease” refers to a ground lease in which the
    landowner has agreed to permit a lien to be placed against the owner’s fee simple
    interest in the land to secure the payment of the loan made by the construction lender or
    a subsequent lender to the tenant. The lender has a lien against both the fee simple
    interest of the landowner and the leasehold estate of the tenant. If there is a default
    under the loan, the lender may foreclose against both the fee title and the leasehold
    estate, in which case the owner loses its land.
    In an unsubordinated ground lease, no lien is placed against the fee simple title
    to the land. Instead, the leasehold estate is the primary security for the loan.
    B. Reasons Why a Landowner Might Agree to Subordination
    It is not typical in current arms length transactions for the owner to subordinate its
    fee interest, but there may be instances in which an owner is willing to do so. For
    example, an owner may be willing to subordinate its fee in order to enable the tenant to
    obtain financing to develop the property, particularly if the financing will permit
    enhanced development of the property or development of the property in a manner that
    will enhance the value of the owner’s adjacent or nearby property. Or, the owner may
    be willing to mortgage its fee interest in exchange for participating in the project’s
    profits.
    C. Protecting the Subordinated Fee
    Before agreeing to permit a lien against its fee interest, the owner should
    consider the following:
  3. Evaluate why a lender is unwilling to finance a project without a lien on the
    fee simple interest. That unwillingness may indicate questions about the
    project’s viability. The landlord might therefore want to require that the tenant
    contribute a specified amount of equity or that a certain number of significant
    subleases be signed as a precondition to subordinating the fee interest.
  4. Place a limit on the maximum principal amount, interest rate and term of the
    loan. That limit might be in total dollars or as a percentage of total
    construction costs. For added protection for the owner, those limitations
    should be included in a recorded memorandum of the lease.
  5. Require that loan disbursements be made through a third-party escrow agent
    and that the owner’s consent be given before each disbursement.
  6. Make certain that the lease and the deed of trust expressly provide that the
    loan is non-recourse to the owner. The owner should not sign the promissory C:\Documents and Settings\kbarron\Local Settings\Temporary Internet Files\OLK33E\ground leases_basic legal issues.doc
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    note and should obtain the written agreement of the lender to not seek a
    money judgment against the landlord.
  7. Require additional security from the tenant, such as a performance bond or
    personal guaranty.
  8. Require notice of the tenant’s default under the loan documents and the right
    and adequate time for the owner to cure the default.
  9. Limit the subordination to the construction period only. Or, in the alternative,
    require that the loan be repaid well in advance of the expiration of the ground
    lease.
  10. Allow only one mortgage and prohibit renewals, extensions or modifications of
    the permitted mortgage.
    D. Unsubordinated Ground Leases and Lender Protection Provisions
    If an owner is unwilling to permit a lien on the fee interest, financing will
    nonetheless be a big issue in the ground lease transaction. Lenders view a lien on the
    leasehold estate of the tenant as a second lien because, if the lease terminates, the
    lender loses its security. Consequently, for a ground lease to be financeable, the lease
    must provide “lender protection” provisions.
    Because of the inevitability of financing of the ground lease, a landlord would be
    well advised to require that, from the outset of negotiations, both the tenant’s and the
    lender’s positions be represented. Otherwise, the landlord will find itself first negotiating
    the lease with the tenant, only to have to subsequently renegotiate many of the
    significant lease provisions with the lender. By the time the landlord begins to negotiate
    with the lender, the landlord may have already committed so many resources to the
    project that it feels pressured to agree to otherwise unacceptable provisions.
    The lender protection provisions are not provisions separate and apart from the
    basic terms and conditions of the ground lease. Rather, they represent modifications to
    “standard” lease terms that a lender requires for the lender’s protection, such that the
    lender is willing to make a loan secured only by the leasehold estate. The lender’s
    concern is that it may need to foreclose on the project, thus becoming the owner of the
    leasehold estate and responsible for complying with the terms of the lease.
    The scope and nature of the lender protection provisions will depend on the
    parties’ relative bargaining strengths and perceived risks and on the business deal that
    the landlord and tenant strike. A landlord that receives prepayment at the time the
    lease is signed of all rentals coming due over the life of the lease has much less at risk
    and will therefore be willing to provide more favorable lender protection provisions.
    Thus, in an unsubordinated ground lease transaction, there are competing
    interests: the landlord’s, the tenant’s, and the lender’s. The discussion of the basic
    ground lease terms below will consider issues related to the financeability of a ground
    lease as they arise with respect to the specific lease terms. C:\Documents and Settings\kbarron\Local Settings\Temporary Internet Files\OLK33E\ground leases_basic legal issues.doc
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    III. LEASE TERMS
    A. Construction of Improvements
  11. Commencement and Completion of Construction. The construction of
    improvements by the ground tenant is one of the distinguishing features of a ground
    lease. The construction period is also the time at which the landlord has the most at
    risk. Consequently, greater controls on the tenant are justified during the initial
    construction period and when alterations and additions (as opposed to normal
    maintenance and repairs) are made.
    The landlord needs assurance that the improvements will be built within a set
    time frame. To that end, the landlord may wish to require in the lease that no
    construction begin until financing is in place. Depending on the specific facts, it may be
    appropriate to prohibit construction until a specified percentage of the project is
    preleased. In phased projects, the landlord may wish to limit the number of sites that
    may be under development at any one time.
    The lease should specify both the date for commencement of construction and
    the date for completion of construction and should specify that rent will begin on the
    completion date (even if improvements are not completed). The landlord may also wish
    to reserve a right of reentry if the construction is not completed in a specified time
    period. In general, a right of reentry will be enforceable if it does not constitute a
    forfeiture by the tenant. If the tenant is compensated for the value of improvements it
    has made to the land, then there will not be a forfeiture.
    On the other hand, if the incomplete improvements are in such a state that it
    would be more advantageous to the landlord to demolish the improvements rather than
    to complete them, the lease should grant the landlord the authority to demolish the
    improvements and charge the cost to the tenant. The lease should also prohibit the
    tenant from demolishing the improvements without the landlord’s consent, since the
    improvements constitute substantial security to the landlord.
  12. Construction Standards. The lease should specify the standards for
    construction. Those standards could be as broad as simply requiring that the
    improvements be of a first-class nature and consisting of a minimum square footage, or
    the lease may require the approval of the landlord on all key aspects of construction,
    including architectural design, budget, and plans and specifications. The extent of the
    landlord’s approval rights will depend on a variety of factors, including whether the
    landlord is participating in the construction cost or giving a rent credit, whether the
    landlord has contiguous property, whether the tenant has experience in such projects,
    whether the construction plans were reasonably complete at the commencement of the
    lease, and whether the useful life of the improvements is likely to exceed the term of the
    lease. C:\Documents and Settings\kbarron\Local Settings\Temporary Internet Files\OLK33E\ground leases_basic legal issues.doc
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    The lease should require that the construction be undertaken in substantial
    accordance with the plans and specifications and in a good and workmanlike manner.
    The tenant should be required to furnish to the landlord a complete set of plans and
    specifications, and, if appropriate, an as-built survey on completion of construction.
  13. Lien-free Construction. It is also important that the lease provide that
    the improvements are to be constructed in a lien-free manner. The lease should
    expressly negate the authority of the tenant to serve as the landlord’s agent and to bind
    the fee interest of the landlord. These prohibitions should also be included in a
    memorandum of lease so that all potential lien claimants are on notice of the tenant’s
    limitations.
  14. Ownership of Improvements on Lease Termination or Expiration. The
    lease should provide that on expiration or earlier termination of the lease, all
    improvements become the property of the landlord without payment, free and clear of all
    liens, and in good condition, reasonable wear and tear excepted. There is, however, a
    risk in providing that all improvements become the property of the landlord on expiration
    or earlier termination of the lease. Because of the potential for environmental liability,
    the landlord would be well served to reserve the right in the lease to exclude any of the
    improvements and to require an environmental audit prior to the expiration of the lease.
    Further, the landlord should retain the right in the lease to require the tenant to
    demolish the improvements and clear the site at the landlord’s request. Particularly in
    the case of lease improvements that are expected to have nominal value at the end of
    the term, such a provision is desirable. Use caution in drafting the demolition
    provisions. If the tenant is permitted to demolish the improvements after the lease
    expires, the tenant’s obligations under the lease, including the obligation to indemnify
    the landlord and to carry insurance, will not apply during the demolition period. The
    lease should therefore require the tenant to complete the demolition before the lease
    expires or should specify those provisions that will apply to the demolition period and
    survive the lease’s expiration.
  15. Other Landlord Protection Provisions During Construction. Other
    protections during the construction period that the landlord may wish to place in the
    lease include the following:
    Š Require a personal guaranty from the tenant until construction is complete
    and all lien waivers have been received.
    Š Prohibit assignment of the leasehold estate during the construction period.
    Š Require payment or performance bonds in favor of the landlord.
    If the landlord retains property adjacent to the leasehold tract, it will also be
    important to the landlord to minimize interference with the adjoining property. The
    landlord may therefore require that the tenant: C:\Documents and Settings\kbarron\Local Settings\Temporary Internet Files\OLK33E\ground leases_basic legal issues.doc
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    Š Minimize noise and dust.
    Š Coordinate placement of trailers and materials.
    Š Coordinate parking areas.
    Š Coordinate trash removal.
    Š Coordinate safety plans.
    If the landlord has leases on the adjacent property, the landlord should also take
    care to avoid conflicts between the new ground lease and the existing leases. Those
    existing leases may have specific provisions dealing with construction, type of
    improvements, and related matters.
    B. Duration of Lease
  16. Length of Term. Because of the significant investment of the tenant in
    making improvements to the land, the duration of a ground lease is typically for a long
    term. If the term is less than 30 years, the ground lease is probably not financeable
    because the debt service requirement will be too high to make the project economically
    feasible. Because the duration of the ground lease is quite lengthy, often 50 to 99
    years, the lease terms are critical and must anticipate various contingencies over the full
    term of the lease.
    The lease term will typically extend beyond the maturity date of the loan secured
    by the leasehold estate. In some states, laws and regulations specify the lease term for
    certain types of lenders. For example, life insurance companies regulated by the State
    of Texas may make a loan on a leasehold estate only if the loan term does not exceed
    4/5th of the remaining lease term, and only if the remaining lease term extends at least
    ten years beyond the term of the loan. Tex. Ins. Code Ann. art. 3.39, Part II.A.2.
    The parties may wish to negotiate a preliminary lease term for preconstruction
    matters and construction work. Preconstruction matters may include title investigation,
    site inspection, and obtaining subleases and governmental approvals. Then, the actual
    term of the ground lease will commence on the completion of construction or the date
    that the lease requires construction be completed.
  17. Renewal Options. Often the tenant will seek renewal options. A lender
    will want the right to exercise the renewal options if the tenant fails to do so and the
    tenant will want the right to exercise the renewal options at any time so that the tenant
    may exercise a sufficient number of the renewal options at the time of the loan closing
    to provide for a satisfactory term for the lease in relation to the maturity date of the loan.
    A lease with an option to renew rather than an extended initial term may be
    attractive to a tenant because the tenant has some control over when its rent obligations
    end. For the landlord, there is the reality that if a tenant’s management is not profitable,
    the lease may end in default, so there is the potential that the lease will not last for the C:\Documents and Settings\kbarron\Local Settings\Temporary Internet Files\OLK33E\ground leases_basic legal issues.doc
    8
    full term. Whether renewal options, rather than a simple initial long term, will satisfy
    state law is a question that must be addressed in each jurisdiction.
    An alternative to a renewal option is a longer term with the tenant having a right
    to cancel periodically. The lender will, however, require that the termination right not be
    exercisable without the lender’s consent. The tenant may prefer an early termination
    right over an option to renew because the tenant may thus avoid conditions that a
    landlord may seek to impose on renewal options, such as the requirement that there be
    no defaults by the tenant.
    C. Rent
    The long duration of a ground lease poses challenges with respect to setting the
    rental over the length of the term. Typically a ground lease will provide for rental
    adjustments at periodic intervals. The concern of such rental adjustments to the
    leasehold lender, however, is the increasing risk that the tenant will have insufficient
    cash flow to pay the mortgage.
    Rental adjustments can be based on a variety of methods, such as indexing to
    the consumer price index, reappraising the property at periodic intervals, or applying
    new capitalization rates. In any event, the lender will want limits placed on the
    maximum escalations. For example, a maximum percentage increase would be
    specified for increases based on the consumer price index. For adjustments based on
    reappraisal of the property, the lender and tenant will want to require that the
    reappraisal be based on the property as currently improved and not the then-highest
    and best use of the property.
    A lender will also seek to obtain a waiver by the landlord of any rent escalations
    after the lender has foreclosed on the property or taken a deed in lieu of foreclosure and
    before the lender has transferred the property to a third party. The landlord, however,
    should require a maximum time limitation on such a deferral.
    D. Default Provisions
  18. Space Leases and Ground Leases Compared. Default provisions in a
    ground lease will often vary substantially from those in a typical, short-term commercial
    lease. These variances arise because of the basic differences between a short-term
    commercial lease and a long-term ground lease. As noted previously, in a ground
    lease, the landlord owns the land only and it is the tenant who has made a significant
    investment in constructing the improvements. In a commercial lease, however, the
    landlord is usually the party that constructed the improvements. A ground tenant will
    want to limit the types of events that will give rise to default and termination of the lease
    to protect the tenant’s considerable investment in the improvements. C:\Documents and Settings\kbarron\Local Settings\Temporary Internet Files\OLK33E\ground leases_basic legal issues.doc
    9
    Moreover, for the lease to be financeable, the tenant must obtain certain rights
    for the lender on default. Many of the key lender protection provisions that the tenant’s
    lender will seek pertain to the default provisions because of the lender’s concern that
    the lease might be terminated for a default before the loan is repaid.
  19. Notice and Cure Periods. Consequently, there are typically extended
    notice and cure periods for the tenant, with additional cure periods allowed for the
    lender. The lender will want the lease to require notice to the lender that is separate
    from that sent to the tenant and to provide that notice to the borrower does not
    constitute notice to the lender. The landlord, however, will not want to be obligated to
    give notice to a lender until it has first received written notice of the existence of the
    lender. The lease should require that the tenant promptly give notice to the landlord
    when the leasehold mortgage is extinguished.
  20. Types of Default. The lender will also want the right to cure the default
    if the tenant fails to do so, provided that the default is capable of being cured by the
    lender. Defaults may be broken down into three categories: monetary; non-monetary
    and capable of being cured by the lender; and non-monetary and not capable of being
    cured by the lender. With respect to the latter category, the lease should specifically
    identify such defaults, which may include items such as the tenant’s bankruptcy or the
    tenant’s failure to keep books or file tax returns. Ground leases take different
    approaches with respect to the latter category. A lender may seek to have such items
    omitted from the list of events that constitute default under the lease. In the alternative,
    the lender will want a grace period to enable the lender to obtain possession of the
    leasehold estate.
    If the landlord agrees that certain nonmonetary defaults will not cause a
    termination of the lease, the landlord should include in the ground lease the right for the
    landlord to cure such nonmonetary defaults and then bill the tenant for the cost of that
    cure. In that way, the landlord can convert a nonmonetary default into a monetary
    default if payment is not timely made by the tenant and then proceed to termination of
    the lease.
  21. “Pickup” Lease. The lender will also seek the right to obtain a “pickup”
    lease. Typically, a lender will be given 30 to 90 days after the lease terminates to enter
    into a new lease with the landlord on the same terms as the prior lease and for the
    remaining unexpired term of the prior lease. The right of the lender to enter into such a
    lease is often conditioned on the lender curing any outstanding defaults that are capable
    of being cured by the lender.
    There are questions about the enforceability of pickup leases that involve arcane
    rules regarding the vesting of interests in real property. There is also the risk to the
    lender that the new lease may be subject to intervening mortgages of the fee interest or
    other intervening encumbrances. C:\Documents and Settings\kbarron\Local Settings\Temporary Internet Files\OLK33E\ground leases_basic legal issues.doc
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    E. Assigning, Subletting, and Mortgaging the Leasehold Estate
  22. Consent to Assignment or Sublease. An assignment is a transfer of
    the tenant’s entire interest in the leasehold. A sublease is a transaction in which the
    tenant grants an interest in the leasehold estate that is less than the tenant’s entire
    interest. A “sublease” that extends for the entire term of the lease is most likely an
    assignment instead.
    The ability of the tenant to assign its leasehold interest and enter into subleases
    must be addressed in the ground lease. In some states such as Texas, statutory
    provisions prohibit subleases or assignment unless the lease allows it.
    The type of project and the size and nature of the sublease space will be factors
    that determine how much autonomy the landlord will allow the tenant in subleasing
    space in the improvements. If the tenant is the end user, the landlord will want approval
    rights with respect to the subtenant or assignee. Similarly, if it is anticipated that there
    will be major subtenants or if there is to be an assignee of the entire project, the
    landlord will want to retain the right to approve the subtenant or assignee.
    Lease provisions requiring that the landlord’s consent “not be unreasonably
    withheld” are not very useful, as they merely invite disagreements on what is
    “reasonable.” Ideally, specific standards of minimum net worth and appropriate
    experience should be specified in the assignment and subletting provisions.
    Because construction is a core element of a ground lease, it is not unusual for
    there to be an outright prohibition on assignment during the construction period. It is
    that period during which the landlord is at the greatest risk and is most reliant on the
    abilities of the ground tenant.
    Another factor that may need to be considered in drafting provisions for
    subleases and assignments is whether the landlord is retaining adjacent property and
    how that property will be affected by the ground leased site. If the landlord has
    concerns about competing for tenants or other issues related to protecting the landlord’s
    interest in the adjacent property, the assignment and subletting provisions will need to
    address those concerns.
    Finally, a tenant will want to be released from continuing liability once the tenant
    has assigned its interest in the lease. Having more than one party liable for
    performance of the leasehold obligations will be appealing to the landlord, but especially
    if the landlord has significant approval rights over any assignment, the landlord will more
    likely be willing to release the former tenant from liability accruing after the assignment
    to, and the assumption of future liability by, the assignee.
  23. Form of Sublease. The form of the sublease document may be
    important to the landlord, particularly where covenants of the ground lease are to be
    applied to subtenants. It may be appropriate, therefore, to give the landlord approval C:\Documents and Settings\kbarron\Local Settings\Temporary Internet Files\OLK33E\ground leases_basic legal issues.doc
    11
    rights over the sublease or to specify the form of the sublease or certain provisions in
    the sublease.
    One important provision to the landlord will be the agreement of the subtenant to
    attorn to the landlord. In an attornment agreement, the subtenant agrees that if the
    ground lease terminates, the subtenant will recognize the ground lessor as the
    subtenant’s landlord and make rental payments directly to the ground lessor. In
    exchange, however, the subtenant will want a nondisturbance agreement in which the
    ground landlord agrees not to terminate the sublease so long as the sublessee is not in
    default under the provisions of the sublease.
  24. Mortgaging the Leasehold Estate. Because financing is such a key
    element of a ground lease, the ground lease should also address the ability of the
    ground tenant to mortgage its leasehold estate. The landlord will want to specify that
    the leasehold mortgagee must be an institutional lender (such as a bank or insurance
    company) not affiliated with the tenant. The ground lease should define what
    constitutes an institutional lender. In addition, the landlord will want to set a minimum
    net asset level for the lender so that the landlord is assured of the financial viability of
    the lender. The lease should prohibit non-amortizing or balloon payment loans and,
    depending on the circumstances, the landlord may also wish to set maximum loan
    amounts.
    If the landlord may want to take back the project, rather than permit the leasehold
    estate to be transferred at foreclosure, the landlord should seek to require that the loan
    documents give the landlord notice and an opportunity to cure the tenant’s default. Any
    such payments on the loan by the landlord on the tenant’s behalf should constitute an
    immediate monetary obligation of the tenant and result in a default under the lease if the
    tenant fails to promptly pay the amount due.
    Difficulties arise when the ground tenant wishes to obtain financing from more
    than one lender, as the lenders will want to address priority issues. The landlord will not
    want to be placed in the position of determining priorities of the various liens on the
    leasehold estate or giving notices to multiple lenders.
  25. Assignments After Foreclosure. The lender will want special provisions
    permitting assignment by the lender in the event the lender forecloses on the leasehold
    estate. The lender will not want to be at risk of being unable to transfer the project once
    the lender has foreclosed. Thus, the lender will seek to include provisions permitting
    the lender, after foreclosure or the acceptance of a deed in lieu of foreclosure, to freely
    assign the leasehold estate without the landlord’s consent. If the operation of the
    leasehold improvements is of such a nature that the experience or creditworthiness of
    the assignee is important, the landlord may nevertheless need to include criteria for an
    acceptable assignee.
  26. Waiver of Ground Rents After Foreclosure. A lender that is
    unsuccessful in obtaining the landlord’s agreement to subordinate its fee interest to the
    mortgage may seek a waiver by the landlord of ground rents after foreclosure by the C:\Documents and Settings\kbarron\Local Settings\Temporary Internet Files\OLK33E\ground leases_basic legal issues.doc
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    lender. The landlord should carefully consider such a proposal for the obvious reason
    that it may result in the landlord receiving no rents on the property for some period of
    time. Under no circumstances should the landlord agree to an unrestricted waiver of
    rents — the waiver should include certain parameters:
    Š The waiver should expire after a certain number of months following the
    foreclosure or on the sale or assignment of the ground lease to a new lessee
    after the foreclosure, whichever occurs first.
    Š Notwithstanding the waiver, the lender should be required to apply all rents
    received by the lender from subtenants in the following order: (1) the payment of
    all taxes, assessments and insurance premiums required under the lease to be
    paid by the tenant, the payment of all utility charges on a current basis, and the
    performance of all other of the tenant’s obligations for maintaining the premises
    or maintaining the improvements in good repair; (2) the payment of normal
    amortization payments under the loan as they become due; (3) the payment of
    any ground rents that are in arrears and the payment of rents next coming due;
    and (4) the payment of additional amounts to further reduce the principal amount
    of the leasehold mortgage.
    F. Insurance Coverage, Casualty Loss, and Condemnation
  27. Insurance Coverage. Because of the importance of the improvements
    to the ground lease transaction, the tenant should be required to insure the
    improvements for full replacement cost. The lease should require periodic reappraisals
    of the improvements so that insurance coverage may be adjusted accordingly over the
    long term of the ground lease. The tenant should also be required to carry rental loss or
    business interruption insurance to pay ground rentals during the period of rebuilding
    after a casualty loss. The property insurance carried by the tenant should include
    coverage for the cost of demolition and for changes in building codes, given the longterm nature of the ground lease.
    Both the landlord and tenant should be named as insureds as their interests
    appear, with a third party as the loss payee. The landlord should be entitled to notice of
    changes or termination of a policy and should receive copies of the actual insurance
    policies.
  28. Casualty Loss. The tenant should have an absolute obligation to
    rebuild in the event of a casualty loss, except perhaps towards the end of the term. If
    there is an estimated shortfall in the insurance proceeds, the tenant should be required
    to pay the difference before any insurance proceeds are disbursed. All proceeds should
    be disbursed for construction only.
    Although the lender might push to receive the insurance proceeds, to do so
    would provide the lender with a windfall. To allow the proceeds to be used for
    rebuilding the improvements maintains the status quo. Consequently, the lease and the C:\Documents and Settings\kbarron\Local Settings\Temporary Internet Files\OLK33E\ground leases_basic legal issues.doc
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    loan documents should make clear that the lender agrees that the insurance proceeds
    will be available for rebuilding and will not be applied to debt reduction.
    If the ground lease requires rebuilding within a specified time, the tenant will want
    to include a force majeure clause to allow for contingencies beyond the tenant’s control.
    The same construction controls that are included in the ground lease for initial
    construction should apply with equal force to any rebuilding of the improvements.
    If the casualty loss occurs in the latter years of the lease term, the lease may
    excuse the tenant from rebuilding the improvements or give the tenant the option to
    terminate the lease instead of rebuilding. The lender will have one primary concern with
    respect to the lease terminating as a result of a casualty loss: the lender will want to
    require that the leasehold estate not be terminated until the loan is paid in full. The
    landlord, on the other hand, will want the insurance proceeds to be used first to clear
    the site. How the proceeds are applied will depend on the relative bargaining strengths
    of the parties, but the lease should specify the order in which the proceeds will be
    applied and the application of any excess proceeds.
  29. Condemnation. The potential for condemnation is greater with a longterm ground lease precisely because of the length of the term and the likelihood of
    changing conditions over that time period. The ground lease should address the effect
    of a total taking, in which the entire leased premises is taken, and a partial taking, in
    which the premises can be reconstructed and used in an economic manner.
    As to a total taking, the lease should provide that the lease will terminate. The
    question then arises as to how to divide the condemnation award. How the award is
    apportioned in the lease will depend on the relative bargaining strengths of the parties,
    but if there is a lender involved, the lender will want to make sure that the amount
    awarded to the tenant will be no less than the principal balance owing on the loan at the
    time of the total taking.
    There are a variety of approaches to apportionment. One approach is to base
    the apportionment on the value of the respective estates of the landlord and the tenant
    immediately prior to the condemnation and apply the ratio to the total amount of the
    award. A second approach is to give to the landlord the value attributable to the land
    and give to the tenant the remainder, except toward the end of the term, at which time
    the landlord would be awarded the residual value of the improvements.
    In a partial taking, it is typical for the award to be apportioned with the landlord
    receiving the amount of the award attributable to the value of the land and the tenant
    receiving the amount of the award attributable to the improvements and any
    consequential damages, such as those pertaining to the tenant’s ongoing rental
    obligation. If the tenant receives such consequential damages, then there should be no
    rent abatement. Another approach to apportioning the condemnation proceeds is to
    award to the tenant the amount equal to the cost of restoration or repair, then to the
    landlord the present value of the income stream taken, plus the present value of the C:\Documents and Settings\kbarron\Local Settings\Temporary Internet Files\OLK33E\ground leases_basic legal issues.doc
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    landlord’s reversionary interest in the land and the improvements, with the tenant
    receiving the remainder amount.
    If the landlord is willing to provide for an abatement of rent to the tenant in the
    event of a partial taking, then the lease should address how that abatement will be
    calculated. One approach is on a per-square-foot basis, but that approach may not
    consider the true value of the use of the remaining property. Thus, another approach is
    to provide in the lease that the abatement will be on a “just and proportional” basis.
    The lease should address disbursement of the condemnation proceeds for
    rebuilding. The process should be similar to that for the disbursement of insurance
    proceeds for the rebuilding after a casualty loss. Similarly, the construction
    requirements and controls should be those that are applicable to initial construction.
    G. Use Restrictions
  30. Scope of Permitted Use. Because of the extended term of a ground
    lease, it is common for the use provision in the ground lease to permit “any lawful use.”
    A leasehold lender will certainly prefer that broad use provision because it maximizes
    the marketability of the ground lease should the lender foreclose on the leasehold
    interest.
    Use and value, however, are interrelated and past uses may affect future zoning,
    so a landlord should consider including more stringent use controls in the lease. While
    the use provision should be reasonable and allow for adjustment for changed conditions
    over the extended term of the lease, there are various restrictions that may be
    appropriate:
    Š Prohibiting noxious or nuisance uses.
    Š Restricting uses that involve hazardous materials or including significant
    controls on the use of hazardous materials.
    Š Prohibiting uses that have the effect of diminishing the fee estate, such as
    mining.
    Š Restricting uses that require improvements with limited reuse potential.
    Š Prohibiting rezoning without the landlord’s consent.
    Š Prohibiting uses that would compete with the landlord’s adjacent property.
  31. Enforcement of Use Clause. The lease should give the landlord the
    right to enforce the restrictions without terminating the lease. In other words, the
    landlord should have the right to enjoin prohibited uses or to specifically enforce the use
    provisions. Use restrictions in the ground lease should also be made specifically
    applicable to any sublease and should be required to be included in the sublease. C:\Documents and Settings\kbarron\Local Settings\Temporary Internet Files\OLK33E\ground leases_basic legal issues.doc
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  32. Applicability of Use Clause to Lender. A landlord should use caution
    when signing documents consenting to the tenant’s financing. The consent document
    may include a waiver by the landlord of the use restrictions if the lender succeeds to the
    tenant’s leasehold interest. Indeed, any consent to financing should be carefully
    reviewed by the landlord and its attorney because it is common for the consent
    document to contain numerous provisions that contradict the lease.
  33. Changes in Use. If the lease permits changes in use, consideration
    should also be given to whether rent should be adjusted based on the economic value
    of the changed use. The landlord will want to be protected so that any changed use
    that diminishes the economic value does not adversely affect the landlord. On the other
    hand, if a changed use results in increased economic value, the landlord will want to
    share in that increase.
  34. Continuity of Operations Clause. Finally, the landlord should consider
    whether to include a continuity of operations clause in the lease. Such a clause is
    particularly important if the landlord has nearby property that benefits from the use to
    which the ground lease property is put or in situations in which the rental under the
    ground lease is based on total sales volume. (One point to note with respect to rental
    based on sales volume, however, is that for an entity that is exempt from income tax,
    structuring the ground lease to provide for rent based on net profits may result in
    unrelated business taxable income to the landlord.)
    It will be of some concern to a lender if the lease contains a continuous operation
    clause. The lender will seek to be excused from the obligation for continuous operation
    if the lender forecloses on the leasehold estate. If the landlord agrees to a waiver of the
    application of the continuous operation clause after foreclosure, the waiver should
    include a specific time limit and an earlier expiration date should the lender sell or
    assign the leasehold after foreclosure.
    H. Taxes
  35. Lease Should Specify Payment Obligations. The lease should clearly
    identify whose obligation it is to pay taxes on the land and on the improvements. State
    law will address how a leasehold estate is to be valued. There are often special laws
    pertaining to the taxation of leaseholds when the land is owned by a tax-exempt entity.
  36. Separate Tax Parcels. If the parties agree that the land is to be taxed
    to the landlord and the improvements are to be taxed to the tenant, the lease should
    require the tenant to obtain separate tax parcels so that the tax obligations are clearly
    separated. The lease should also require the tenant to give to the landlord evidence of
    payment of taxes and notice of the tenant’s intent to pursue a tax protest and should
    permit the landlord to participate in those tax protests. C:\Documents and Settings\kbarron\Local Settings\Temporary Internet Files\OLK33E\ground leases_basic legal issues.doc
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    I. Mortgaging the Fee Interest
    If the land that is subject to the ground lease is subject to a mortgage, the
    leasehold estate is probably not financeable and may not be insurable from a title
    insurance perspective unless the lien on the fee interest is subordinate to the ground
    lease and to the leasehold mortgage. A nondisturbance agreement whereby the lender
    holding the mortgage on the fee interest agrees not to disturb the possession of the
    ground tenant should the fee lender foreclose will likely not remedy the situation.
    Rather, the leasehold lender will insist that the lien on the fee be subordinate to the
    leasehold estate and the leasehold mortgage. The tenant and leasehold mortgagee
    may also require that the fee mortgage loan documents grant to the tenant and
    leasehold mortgagee the right to notice and an opportunity to cure any defaults under
    the fee loan.
    J. Amendments and Modifications to Ground Lease
  37. Lender Consent to Amendments. The leasehold mortgagee will want
    to prohibit amendments to the ground lease without the lender’s consent. The landlord,
    however, should require that it be the tenant’s sole responsibility to obtain the lender’s
    consent. The ground lease should also contain a provision for automatic approval of
    any amendment or modification if the lender fails to issue an objection within a set time
    period.
  38. Lender Modifications to Lease. The lender will also want the right to
    require amendments to the ground lease. Such a broad right, however, puts the
    landlord in jeopardy. Consequently, the lease should provide that the lender’s right to
    require an amendment is conditioned on the amendment making no adverse change in
    any of the substantive rights, duties, or obligations of the landlord and not causing the
    landlord to be in violation of restrictive covenants, land use controls and other similar
    matters affecting the fee estate. Further, the ground lease should stipulate that any
    lender-required amendment must be reasonable. A requirement of reasonableness
    does not set a definitive parameter, however.
    K. Recording the Lease or Memorandum of Lease
  39. Recording Memorandum is Preferable. While it is generally not
    desirable for the complete terms of the lease to be made public through recording the
    ground lease in the real property records, it is beneficial to the landlord, the tenant, and
    the lender for some of the basic terms of the ground lease to be stated in a
    memorandum of lease that is recorded in the real property records because the
    recorded memorandum constitutes notice to third parties of the rights and obligations
    stated in the memorandum. A memorandum of lease identifies the parties, the property,
    the term and any other significant elements of the ground lease.
  40. Description of Leased Premises. The description of the leased
    premises should include any common areas that the tenant has the right to use and any
    easements or other special access rights that the tenant has. As with all real property C:\Documents and Settings\kbarron\Local Settings\Temporary Internet Files\OLK33E\ground leases_basic legal issues.doc
    17
    descriptions, a satisfactory, on-the-ground survey should be the basis for the
    description.
  41. Other Rights and Obligations to Include in Memorandum. It is also
    important that the memorandum of lease expressly state that the tenant has no ability to
    place liens on the property. The memorandum should also give notice of other
    restrictions affecting title to the property, such as any option on the part of the tenant to
    purchase the property or to extend the term of the lease or any right of first refusal in
    favor of the tenant to purchase the property. If the landlord has agreed not to mortgage
    its fee interest or to make any mortgage subordinate to the leasehold mortgage, the
    memorandum of lease should also give notice of that fact.
    IV. CONCLUSION
    A ground lease differs in significant ways from a short-term commercial space
    lease. It represents a complex transaction and, oftentimes, involves three-way
    negotiations between the landlord, the tenant, and the leasehold lender. The complexity
    is intensified by the long-term nature of the ground lease and the resulting need to
    anticipate events often far in the future. Consequently, a ground lease should be
    carefully drafted with due consideration to the basic issues discussed above. Simply
    adapting a standard form of commercial space lease will not serve the parties’ best
    interests.