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
Austin, Texas 78701
email: email@example.comC:\Documents and Settings\kbarron\Local Settings\Temporary Internet Files\OLK33E\ground leases_basic legal issues.doc
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
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
GROUND LEASES: BASIC LEGAL ISSUES
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
- 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.
- 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 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.
The owner avoids some of the significant risks inherent in development of real
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
A tenant may seek a ground lease for a variety of reasons that may include the
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.
Improvements are depreciable, whereas the land is a non-depreciable asset.
Additionally, ground rent paid by the tenant is deductible as an ordinary business
The owner is unwilling to sell the land.
There are disadvantages for the owner and tenant, however. Disadvantages to
the landowner include the following:
The long-term lease deprives the owner of the use of the land for an extended
period of time.
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.
Because of the extended term of the lease, lease rates may not protect the
owner over the entire term of the lease.
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.
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:
The tenant must make a significant financial commitment over an extended
period of time.
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.
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
II. SUBORDINATED AND UNSUBORDINATED GROUND LEASES
A. The Distinction Between Subordinated and Unsubordinated Ground
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
C. Protecting the Subordinated Fee
Before agreeing to permit a lien against its fee interest, the owner should
consider the following:
- 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.
- 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.
- Require that loan disbursements be made through a third-party escrow agent
and that the owner’s consent be given before each disbursement.
- 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
note and should obtain the written agreement of the lender to not seek a
money judgment against the landlord.
- Require additional security from the tenant, such as a performance bond or
- Require notice of the tenant’s default under the loan documents and the right
and adequate time for the owner to cure the default.
- 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
- 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
III. LEASE TERMS
A. Construction of Improvements
- 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.
- 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
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.
- 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
- 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.
- 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:
Require a personal guaranty from the tenant until construction is complete
and all lien waivers have been received.
Prohibit assignment of the leasehold estate during the construction period.
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
Minimize noise and dust.
Coordinate placement of trailers and materials.
Coordinate parking areas.
Coordinate trash removal.
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
- 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.
- 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
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.
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
- 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
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.
- 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.
- 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
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
- “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
E. Assigning, Subletting, and Mortgaging the Leasehold Estate
- 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
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.
- 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
rights over the sublease or to specify the form of the sublease or certain provisions in
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.
- 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
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.
- 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
- 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
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:
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.
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
- 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
- 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
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.
- 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
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
- 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
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
Prohibiting noxious or nuisance uses.
Restricting uses that involve hazardous materials or including significant
controls on the use of hazardous materials.
Prohibiting uses that have the effect of diminishing the fee estate, such as
Restricting uses that require improvements with limited reuse potential.
Prohibiting rezoning without the landlord’s consent.
Prohibiting uses that would compete with the landlord’s adjacent property.
- 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
- 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.
- 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.
- 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.
- 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.
- 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
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
- 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
- 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
- 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.
- 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
descriptions, a satisfactory, on-the-ground survey should be the basis for the
- 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.
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