Negotiating Selected Ground Lease Provisions

by Michael A. Dean

[Originally published in The Wendel Report, Fall 2008 issue.]

This Article is Part III of a three part series on commercial ground leases. Part I of this series (The Wendel Report, Spring 2007) noted that commercial ground leases differ substantially from other types of commercial leases (such as leases for space in office buildings and retail centers). Part II of the series (The Wendel Report, Winter 2008) summarized the ground lease provisions that are essential to permit the tenant to obtain leasehold financing. This article discusses some of the differences between certain selected provisions found in both ground leases and other commercial leases.

SELECTED GROUND LEASE PROVISIONS

Length of Term.
The term of a ground lease is significantly longer than the term of a commercial lease depending upon the contemplated use. For example, it is not uncommon for the term of a ground lease for a commercial development to range from 50 to 99 years (usually structured as an initial term with a series of options to extend).

If the term exceeds 35 years (taking into account any options to extend) a county transfer tax will be payable under California Revenue and Taxation Code Section 11911. A local municipal transfer tax may also be payable. Typically, the ground lease will require the tenant to pay any transfer tax(es) given the so-called “triple net” nature of most ground leases.

Adjustments to Rent.
Because of the length of the term, rent is subject to periodic adjustments. This is an extensively negotiated provision, very deal specific, and often complicated. It is not unusual to provide for periodic adjustments every 5 to 10 years (either stipulated amounts or adjustments based on one of the Consumer Price Indexes, with or without a floor and ceiling), with additional fair market reappraisals of rent less frequently (for example, every 25 or 30 years).

An open ended rent adjustment provision may have an adverse effect on the tenant obtaining lease hold financing because lenders must be able to reasonably determine the amount of rent payable during the term of the loan; therefore, it is important to consult with potential lenders to determine what rent adjustment provisions will be acceptable.

Changes in Use.
Because of the length of the term, tenants attempt to obtain broad rights to change the initial permitted use without the landlord’s consent, which includes also the right to demolish existing improvements and construct new improvements consistent with the new use. If the ground lease provides the landlord with percentage rent or some other form of participation rent, this provision should be modified to be consistent with the anticipated revenue generated by the new use.

Assignment, Subletting, and Nondisturbance.
A tenant will want to require broad rights to assign the ground lease without the landlord’s consent in connection with a sale of the underlying project and to be released from future liability under the ground lease after such a sale. This is an extensively negotiated provision and is very deal specific. Often, landlords will agree that the tenant can assign the lease without landlord’s consent only after the underlying project is constructed and operating successfully for a specified period of time.

In a ground lease where the underlying project is a commercial development (for example, a retail center) the tenant will often require the landlord to agree upfront to recognize subleases upon the early termination of the ground lease and to execute nondisturbance agreements with subtenants. This is an extensively negotiated provision for obvious reasons, as landlords are reluctant to encumber the property with subleases if the ground lease terminates before the end of the term. On the other hand, most major subtenants, for example retailers, will absolutely require a nondisturbance agreement protecting their tenancy in the event the ground lease terminates.

Conditions to Effectiveness of Ground Lease.
Because a ground lease is akin to purchasing real property, ground leases often contain a number of conditions and requirements to be satisfied by the tenant prior to the commencement of the term, similar to due diligence provisions found in purchase and sale agreements. Depending upon the nature of the underlying project, some of the conditions and requirements found in ground leases are: state of title and title insurance; environmental investigations and remediation; financing commitment; preleasing requirements; physical inspections, soils reports, and surveys; land use entitlements; construction permits and approvals; and California Subdivision Map Act compliance.

CONCLUSION
The provisions discussed in this Article are just a few of the many provisions to be negotiated, agreed upon, and properly drafted in a commercial ground lease. Commercial ground leases are extensive, very complicated, and require significant time and expense to consummate. Nonetheless, in certain cases a ground lease will be a favorable alternative to sale and purchase.