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Home , Condominium, Ground rent, Leasehold estate

Techniques For A Developer To Structure “For-Sale” In A Leasehold Project

Joshua Stein

Here’s how a ground —and a leasehold —can provide a solid foundation for a “for sale” development.

If an apartment project relies on a ground lease structure, can the developer sell individual apart- Joshua Stein, ment units to individual owners? Or does the use of a author of ALI-ABA’s “A Guide to Ground single ground lease for an entire (or for the apart- (With Forms and Checklists),” is a real and finance partner with Latham & ment component of a larger building) preclude individual Watkins LLP, and a member of the American apartment sales? College of Lawyers. His articles on These questions cause concern and trepidation ground lease financing, leasehold mortgagee protections, and other commercial real among lawyers and their clients in structuring develop- estate topics have been widely published. ment projects from coast to coast. That’s particularly true For copies of many of them and information for mixed use or government-assisted projects, or other about his book on ground leases, visit www. real-estate-.com. The author acknowledges projects driven by nonprofit owners. with thanks the contributions of his clients The answers to these questions are not simple, but who asked the questions that produced a developer and its counsel will usually like the answers. the memos that became this article (and consented to publication of this article); This article offers some analysis, suggestions, and options his partners Richard L. Chadakoff, James I. for anyone trying to structure a for-sale apartment build- Hisiger, Bruce P. Shepherd, David M. Stewart, ing that uses a as its legal foundation. and Leonard A. Zax; Donald H. Oppenheim of Meyers Nave PC, Oakland, California; and Rather than seek to define a single “best way” to structure his editorial assistant, Michael D. Mosley. a project of this type, though, the following article only Copyright © 2007 Joshua Stein. offers some suggestions and ideas to consider and discuss in structuring any particular project, and introduces some issues counsel will need to consider. This article starts from the following set of somewhat typical facts.

The Practical Real Estate Lawyer | 51 52 | The Practical Real Estate Lawyer May 2007

A non- institutional owner (the • Long-term . Owner wants to ensure that “Owner”) owns land (the “site”) near its main cam- it has a long-term ownership interest in the pus headquarters. Both the headquarters and the site, so that “we will never have to assemble it site are prime coastal locations, with commanding again”; ocean views and excellent transportation. They • Adverse legislation. Owner fears legislation that represent about a third of Owner’s entire real es- would entitle holders of long-term leaseholds tate portfolio. to acquire the underlying fee estates based on Owner takes a very long-term view of its real considerations of “fairness,” “public policy,” estate ownership, a commercial activity that it re- and the like. Owner is well aware of Hawaii’s gards as secondary to its charitable, educational, various “leasehold conversion” , which governmental, public service, or religious goals (its allowed ground tenants to acquire the underly- “mission”). Today, Owner does not believe it needs ing fee estates at prices that allegedly reflected their fair market value. Owner does not want the site for its mission. At some point in the dis- to find itself the victim of the next such legisla- tant future, Owner may very likely want to expand tive improvement of . (This article its headquarters onto the site or construct related discusses the Hawaii experience below, along facilities on the site, such as a conference center, with the court cases that validated it); library, athletic field, or special-purpose facilities, to • Control. Given the site’s proximity to Owner’s try to better serve its mission. main campus headquarters, Owner wants to The site was not easy to acquire. Owner wants prevent site occupants from taking actions to retain unquestionable long-term control of the that could cause controversy, embarrassment, site. For the moment, Owner wants to develop on annoyance, interference, or bad publicity for the site a mixed-use commercial project (the “proj- Owner, or would disserve Owner’s mission. ect”). The project will contain a high-end mall; Therefore, Owner wants some ability to con- parking; rooftop parks; an athletic club; quasi-- trol what people do on the site; lic circulation areas; residential towers (the “Tow- • Marketing. Any ownership structure for units ers”), each, if possible, containing for-sale apart- should pass without objection in the unit mar- ment units (the “units”); a supermarket; a high-end ket (including the market for unit mortgages), wine bar; and other facilities. so Owner will not find its marketing program This article explores Owner’s agenda and goals, impaired as a result of the unit ownership some ownership structures that Owner might con- structure; sider for the Towers and the units, and some (but • Future community relations and public relations. certainly not all) advantages, disadvantages, and Owner wants to avoid future financial sur- practicalities of those various options. prises for owners of individual units (the The article concludes by suggesting a path “unit owners”), because these may produce Owner might best take for the project, although bad publicity and complaints, or even politi- any other option suggested here may also make cal pressure within Owner’s various internal sense for any particular project. constituencies. • Mission-related use. Owner may want to retain Owner’s Goals • In defining any ownership some units for purposes related to its mission, structure for the units, Owner wants to achieve at such as to provide for its leaders, visit- least these goals: ing scholars, or management; “For Sale” Apartments | 53

right to terminate a Tower lease. That fact • Simplicity. To the extent that Owner can keep should, in and of itself, mitigate most concerns the site’s ownership structure simple—with and risks (particularly to a mortgage lender) as few layers, moving parts, and documents that arise from using a ground lease in place as possible—this will save money; reduce the of fee ownership. (To a mortgage lender, the likelihood of inconsistencies, mistakes, and single most important attribute—and peril issues; prevent delays; and help Owner achieve — of any ground lease consists of the fact that its other goals. the can terminate the ground lease In considering how to structure the project, Owner for default.) Even without the risk of prema- will need to consider each of these goals as well ture termination, though, a ground lease still as some others (in particular, tax issues, which this has an expiration date—a date when every- article totally disregards). thing ends and everything reverts to the land- POSSIBLE OWNERSHIP STRUCTURES lord. As long as the parties can plan for the • Owner might consider one or more of these expiration date and it can’t come by surprise, ownership structures. they ought to be able to live with it; • Casualty and condemnation. Although a Tower Whole-Building Ground Leases lease will be terminable on casualty or con- (“Tower Leases”) demnation, these termination rights will Owner could ground lease each Tower to an contain typical lender protections. Also, each Owner affiliate (a “Tower Tenant”). Each Tower Tower lease will strongly lean toward recon- Tenant would ultimately both: struction and restoration regardless of the • Subject its interest in its Tower lease to a con- scope of any casualty or condemnation. This dominium regime; and bias is quite common in mixed-use projects, • Assign its Tower lease (whether before or after both leasehold and fee-owned; and condominiumization) to an “Association.” • Fully financeable. The Tower lease terms will (As a variation, Owner might enter into a single facilitate both financing of the entire leasehold Tower lease for all Towers with a single Association. (e.g., by the Association, if state law facilitates In that case, however, extra issues and complexity it) and financing by individual unit owners. within the condominium might outweigh the ben- Some of the preceding characteristics of the Tower efits of a single Tower lease.) Purchasers would buy lease would make sense only for a nonprofit Owner units within the condominium regime that governs of the type assumed here. A private sector investor their Tower. Tower leases could include any or of might not tolerate such terms. the following elements, all as appropriate under the circumstances: Single-Unit Ground Leases • Prepaid rent. Some or all rent could be prepaid; Owner could lease each unit to its unit owner • No adjustment. The rent will not be subject to by entering into a separate ground lease with each future adjustment, or any future adjustments unit owner, on the same terms as the Tower leases, will be minimal and predictable. No surprises; as applied to individual units (the “unit leases”). • No termination. Upon any tenant default, the Unit leases could include these elements: landlord will have meaningful remedies • Role of Association. All unit owners—as tenants against the Association and even against unit under unit leases—would appoint the Associa- owners, but those remedies will include no tion as their agent for all dealings with Owner. 54 | The Practical Real Estate Lawyer May 2007

Association would handle billing (if any) and (a “Co-op”) all other aspects of the landlord-tenant rela- Each Association could consist of a co-op, tionship. But any unit owner would be respon- which would hold its own Tower lease and then is- sible only for its own defaults; sue corporate shares and proprietary subleases to • Combination. Owner could initially use a single each unit owner. Each co-op would have a board of Tower lease for each Tower (or, less desirably, directors, running its own Tower. The board might the Towers as a group, as noted). Once the have the right to approve unit transfers. project was complete or if certain conditions were satisfied, a Tower lease would terminate Fee Estate With Repurchase Option (or be chopped up into little leases, one for Owner could convey to each unit owner a fee each unit) and unit leases could take its place. estate in and to the particular unit. Owner would (Tower lease(s) and unit lease(s) are referred to reserve the right to repurchase the unit at specified collectively as “lease(s)”); date(s) (e.g., 50 years after initial conveyance and • Estate for a Term of Years. Instead of using a every 25 years thereafter). This repurchase option Tower lease, Owner could convey each Tower would probably be at fair market value (“FMV”). to an Association, or each unit to a unit owner, As is always true, defining “FMV” would require in but terminating on a fixed date great detail and thought. Would it assume fee own- (e.g., after 100 years). The grantee would own ership? A long-term leasehold? A leasehold with a a “term of years” in and to its Tower or unit. 30-year remaining term? On what terms? Some That “term of years” could then be sliced and other formula? All of this is manageable. Real es- diced in any way this article suggests. An “es- tate lawyers manage it all the time. The key is to tate for a term of years” is much like a prepaid recognize the issue and draft in a way that defines ground lease; fair market value with absolute clarity. (The pricing • In the handful of states that have adopted the formula might—or might not—set a “floor” equal Uniform Common Interest Ownership Act to the amount secured by any bona fide first mort- (or similar condominium statutes) state law gage on the unit provided, for example, that the requires the functional equivalent of Unit loan did not exceed 80 percent of the value when Leases. Section 2-106 of the Uniform Act closed.) If Owner decided to structure a fee estate says that if any particular Unit Owner pays its with a repurchase option, here are some issues share of the rent under a Tower Lease, then Owner would want to consider: any termination of the Tower Lease can’t ter- • Timing of exercise. The documents could allow minate that particular Owner’s interest in the Owner to postpone any option exercise date, project. In effect, the Owner loses the benefit perhaps for decades at a time. Over time, of having an entire building as “,” Owner could use this right to protect unit and instead must be willing to proceed as if owners from the instability that such a pur- each unit were demised under a Unit Lease. chase option might create; • Notice period; effect of exercise. The documents Single-Unit Subleases could require a very long notice period (e.g., Instead of subjecting the entire leasehold to a 25 years) of any exercise of Owner’s repur- condominium regime, the Associations could sub- chase option. If Owner ever chose to exercise lease units to unit owners, through subleases similar its option, this could impair marketability of to the proposed unit leases. units during the notice period. Therefore, the “For Sale” Apartments | 55

documents might give unit owners the option apply not only to the option indicated but also (to to “put” their units to Owner at FMV during some degree) to some of the others. that time. In that case, Owner would need to plan ahead for multiple acquisition of multiple Tower Leases (And Unit Leases units over a long period, including the possible As Appropriate) need to rent them out on an interim basis. • Familiarity. Ground leases are familiar creatures Would such rentals make financial sense? throughout the , although this is • Pricing for “put.” Any “put” right would require somewhat less true of “leasehold condomini- Owner to pay fair market value for units, ums.” considered as if Owner had not exercised its • Surprise Prevention. In its marketing materials repurchase right. As noted, the definition of and documentation, Owner can and should fair market value creates a huge minefield for fully disclose and announce that the transac- any ground lease or other long-term interest in tion relies on leases, all of which will terminate . on a date certain. Some suggestions: __ Clear termination date. All documents should “Trust” Structure clearly state the termination date as a specific cal- Owner could establish a “trust” to hold lease(s) endar date, not a more typical defined term that or fee estates along the lines suggested above, or cross-references an interacting maze of a dozen or some combination. The “trust” documents would more other defined terms. No one should ever be create beneficiaries and rights designed to give unit able to say the actual termination date was buried owners and their lenders the package of protec- in legal complexity; tions they need (much like the rights of a Co-op __ Document titles. The name of each significant shareholder/lessee), but only for the period con- document might even include a reminder, right un- templated. Owner would also be a beneficiary of der the heading, such as: “(Expiration Date: De- the trust and would automatically be entitled to the cember 31, 2110)”; rights contemplated above, when and as provided __ Disclosure of effect on value. The offering ma- for above. A “trust” of this type would amount to a terials should disclose how this structure might af- variation on the theoretical “trust” established un- fect the long-term value of units. Disclosures of this der a “ of trust.” If set up correctly, a “trust” type are common for apartment sales materials in structure might give Owner some benefits from New York and other states with significant disclo- the fact that a “trust” cannot file bankruptcy. The sure requirements for sales of condominium units structure might also underscore the limited nature or ; of the rights of unit owners. One could also struc- __ Conveyance documents. The governing docu- ture such an arrangement instead as a limited li- mentation should require that any future convey- ability company with various classes of members. ance documents include a disclosure/reminder of COMMENTS ON PARTICULAR OWNER­ the termination date, and that unit owners coun- SHIP STRUCTURES • The preceding ownership tersign this disclosure/reminder when they acquire structures all raise a number of issues, including their units; “pros” and “cons” of each. These issues would __ No surprise. Generally, unit owners should not include the following points, some of which may be able to claim surprise. 56 | The Practical Real Estate Lawyer May 2007

Risk Of “Leasehold Conversion” to pay . The Association would have Any leasehold structure carries with it the po- all the usual powers to collect assessments, includ- tential that some governmental authority may de- ing the right to enforce against delinquent cide the leaseholders would be better off if they unit owners. The Association could engage a third- also owned the fee estate, a decision that the Hawaii party management company whose responsibilities legislature made about 40 years ago. This article would include committing to pay ground rent if the discusses the Hawaii legislation separately below. Association suffered a temporary liquidity crisis. (The manager would act in part like a liquidity pro- Declining Value vider in a , injecting quick cash when In the last 30 or so years of any lease, it be- needed to prevent a default, based on a determi- comes a “wasting asset.” Its value automatically nation that the cash would be recoverable in the declines every year, based on the shorter remaining short term. Such measures would give unit lend- lease term, even if the lease does not require pay- ers more comfort.) If any such “liquidity provider” ment of rent. This will impair marketability and were creditworthy, that might give Owner comfort financeability during those years, and cut the unit that would justify forgoing a right to terminate the owner’s incentive to repair and maintain the unit lease for monetary defaults. (particularly capital items). Owner might address this risk by building into any lease measures like: Nonterminability • A streamlined structure for the parties to agree As suggested above, Owner might make lease(s) to extend the lease and to price the extension nonterminable upon default (particularly a non- period; monetary default). The lack of a termination right • Equitable allocation of capital expenditures would vary dramatically from “industry standard,” made near the end of the lease; and/or but may make sense under these facts. Owner will • If any lease is not extended, then an option have already collected all its rent. Owner’s main or obligation for Owner to buy back units at concern relates to long-term site control and re- FMV. Any such repurchase would be funda- ceiving back the site at the end of any lease term. mentally inconsistent with the usual structure Owner is not so much motivated by the investment of any leasehold transaction, in which Owner potential of any lease or the ability to prematurely always receives back the leased asset, “for “get back” the site. free,” at the end of the lease. Owner probably Everyone always assumes that any tenant’s de- does not need to offer such measures as part fault under any lease should allow the landlord to of the initial marketing of the project, because terminate, but why should that always be true? On initial unit owners will rarely pay all that much the other hand, the lease(s) will contain nonmon- attention to the distant future expiration of etary covenants, such as maintenance obligations, any lease. restoration obligations, and operating rules (e.g., no banners, whether or not controversial, hang- Lease Preservation ing out windows). Will Owner be satisfied with the Owner should structure any lease to mini- right to enforce those covenants and obligations mize any risk that the Association might default solely through injunctive relief and claims for dam- on ground rent payments, or otherwise default ages? Should Owner insist, for example, on having on or lose the lease. For example, the Association at least a senior on the leasehold estate under could maintain a two-year cash reserve dedicated any lease, to secure performance of nonmonetary “For Sale” Apartments | 57

a leasehold. Both suffer from the same funda- covenants? Or should Owner have a right to termi- mental infirmity, though: a termination date. nate a lease if a court determines, beyond right of further appeal, that the tenant is in default beyond • Local law. Does state law where the project applicable cure periods? (Most leases purport to is located recognize an “estate for a term of give the landlord a king-like power to “terminate” years”? a lease as soon as the tenant defaults, typically be- • Nonterminability. The essential fact of an “es- yond some short cure period. In practice, unless the tate for a term of years” is that it cannot be tenant intends to abandon the lease or the default is terminated. It represents absolute ownership absolutely clear-cut, substantial, and monetary, the through the termination date. This may be courts may vitiate the landlord’s king-like termina- why most don’t like them. An Own- tion power by preserving the lease until the court er like this one, in contrast, should not care. decides whether the tenant actually defaulted.) Any Owner will want to consider questions like these as Single-Unit Subleases it structures the project. • Market understanding. Will unit owners under- stand what a sublease is? Will it make them Unit Leases even more nervous than might a ground lease? • Fee forfeiture. If the project faces any meaningful • Nondisturbance. Owner might agree to “recog- risk of “leasehold conversion” (a la Hawaii), nize” and “nondisturb” any subtenants if their the risk may be slightly higher for unit leases, underlying Tower lease expired or terminated because the legislators could readily identify a for default. At that point, the subleases would single fee owner that is allegedly “oppressing” become unit leases, or Owner would enter into a specific single leaseholder. With a Tower a new (direct) unit lease with the unit owner. lease, the alleged “oppression” may become A typical Owner might hesitate to grant such less tangible and direct. protections (because of fear of litigation, com- • More paper. The use of unit leases would mul- plexity, disputes, and so on), but this Owner tiply the amount of paper required for the has different motivations and may well decide transaction, and hence Owner’s transaction to offer such protection. Nondisturbance ar- costs and likelihood of mistakes or inconsisten- rangements are quite common in the world cies. Would the change increase marketplace of real estate. Once Owner starts granting acceptance of the units? If so, this could justify nondisturbance protections, Owner will need the incremental cost and much more. Owner to consider the fact that any subtenant will not might mitigate some of the cost by only need to have its rights protect- a “master document” to act as a template for ed under its sublease, but will also need com- all unit leases (if state law permits). Each unit fort that its interests in the rest of the project lease would, for the most part, merely incorpo- and all project amenities will remain in place rate by reference the recorded “master docu- and available. ment.” Cooperative Corporation “Estate For A Term of Years” • New and unusual. A Co-op, though common • Fee vs leasehold. A “fee simple” estate, even if (and commonly hated, at least by many) in time-delimited, may be more appealing than New York, is rare outside New York. Assuming 58 | The Practical Real Estate Lawyer May 2007

Owner’s site is outside New York, does Owner SOME HISTORICAL BACKDROP: THE want to break new ground? RISK OF “LEASEHOLD CONVERSION” • Legislative risk. The use of a Co-op may some- (HAWAII LEGISLATION) • Any discussion of what mitigate the risk of “leasehold conver- using leases for a project anywhere in the United sion” legislation, because the poor oppressed States takes place in the shadow of some “lease- unit owners would be one further step re- hold conversion” legislation that the Hawaii legis- moved from Owner, and the alleged oppres- lature enacted in 1967. That legislation, broadened in 1975, was called the “Hawaii Act” sion would be somewhat more difficult to (Hawaii Revised Statutes 516). It gave leaseholders explain and identify. the right to acquire the fee estates of their lessors, allegedly at “fair market value,” through the exer- Fee Estate With Repurchase Option cise of the state’s powers of . The • Rule against perpetuities. A repurchase option U.S. Supreme Court upheld the constitutionality may create issues under the “Rule Against Per- of the Hawaii legislation in Hawaii petuities” or other legal principles that disfavor v Midkiff, 467 U.S. 229 (1984), a leading precedent long-term interests in real property that are heavily relied upon in the recent Kelo eminent do- not fully defined and vested. In the author’s main case in Connecticut. experience, these problems can almost always be solved by identifying them and drafting (or Risk Mitigation sometimes structuring) around them. Failure To mitigate the risks of “leasehold conversion” to identify them, however, can create a disas- legislation at the site, Owner might consider the ter. following: • Bankruptcy issues. A repurchase option may con- • Investment vs mission property. The risk of any ceivably be deemed an “executory ,” eminent domain is probably higher for invest- subject to rejection in bankruptcy. If Owner ment property than for property Owner has wishes to go down this road, bankruptcy issues dedicated toward its mission. Owner may, would require further exploration. however, have trouble identifying a mission- • Other. Owner would also need to explore gen- related use for fee estates underlying long-term ground leases. If Owner has mission-related eral state law issues regarding “enforceability” plans for the site after the leases terminate, of an option to purchase, as well as any tax Owner may want, as a form of “insurance issues the arrangement might create. policy,” to document those plans in the project documents. Owner could also seek to ensure Newness And Complexity that the fee estate remains owned by an entity For better or worse, any investor in real prop- that is directly related to Owner’s mission, as erty, and its counsel, will typically shy away from opposed to a more “business” oriented entity. anything new, different, or complicated. Some The former type of entity may amount to a of the structures suggested here might readily be less attractive target for eminent domain or considered new, different, or complicated. That “leasehold conversion”; alone may rule out some of them, • Watch your flank. Like any other property owner, although everything depends on circumstances and Owner should watch political trends and local history and experience. threats affecting its property. Owner should “For Sale” Apartments | 59

act quickly and preemptively to try to “head affect units. Those additional issues would include off ” any well-intentioned plans to redistribute at least the following. Owner’s fee interest in the site;

• Higher fair market value. Owner might seek to Reciprocal Agreement establish facts to support the highest possible The interests of all unit owners and Associations value for Owner’s interest in the site. For will be subject to (and largely defined in) one or more example, Owner might reconsider having the reciprocal easement agreement(s), declaration(s), or rent prepaid. On the other hand, prepaid rent set(s) of covenants, conditions and restrictions (any eliminates any risk of future “unconscionable of the foregoing, including any related bylaws, an rent increases,” leaving only the fully disclosed “REA”). Owner would need to record the REA be- inevitability of lease termination at some fixed fore any lease(s), other transfer documents, mort- future date; gages, or other liens. The REA could provide for • Lease drafting. The lease(s) might seek to antici- the following, and might raise these issues: pate any “leasehold conversion” legislation • Repurchase option. Owner may reserve a right to by giving Owner an option to terminate the repurchase any or all of the site under certain lease(s)—by paying fair market value—if any circumstances, such as enactment of lease- such legislation were ever enacted. Although hold conversion legislation or occurrence of such a provision should do no harm, most a major casualty or condemnation. Any such legislation that seeks to rewrite marketplace repurchase option would probably require relationships also purports to invalidate any payment of fair market value; private contractual measures that “try to • Master association. The REA will provide for an get around” the legislation. The fact that an overall association or other entity (the “Master Owner will pay fair market value to the “vic- Association”) to govern the site and operate timized” tenant might help, though. any common elements. A separate Associa- Although any of these measures might mitigate the tion will operate each Tower. As a practical problem, the risk of eminent domain of any sort matter, the individual Tower Associations may ultimately cannot be removed from any . It goes with the territory, whether a amount to nothing more than bookkeeping transaction is structured as a leasehold, fee-owned, entries in the Master Association’s books and or in any other manner. Any governmental author- records; ity can assert eminent domain against any interest • Use restrictions. The REA will prohibit all site in real estate that any politicians who listen to their occupants from doing objectionable things, constituents can be persuaded to destroy. It is ul- such as hanging window banners, making timately a political risk. Owner can probably not excessive noise, smoking in common areas, structure around the risk, but can certainly seek to and so on. The REA will probably not restrict mitigate it through measures suggested here. who may live in the units or what they may do within their units (other than restrictions typi- OTHER CONSIDERATIONS • Regardless cal of a “garden variety” of how Owner ultimately decides to structure the interest structure). If Owner chooses to dedi- project, Owner will also need to consider a few oth- cate certain units or other parts of the project er structural issues that go beyond whether to uses to Owner’s mission, the REA may contain leases, what they might say, and how they might appropriate protections for all parties; 60 | The Practical Real Estate Lawyer May 2007

• Beneficiary.Owner will be a party to the REA containing a separate unit for each Tower, as well and entitled to enforce it. Owner may also as other units for the various other major uses. The want to give certain of its affiliates similar master condominium regime would generally in- rights. Exactly how to accomplish this goal will corporate the same terms as a possible REA. Some primarily reflect tax and state law consider- lenders may prefer such a structure to an REA. ations; • Obligors. Although the REA will bind all parties Common Elements with an interest in the site, it will also require The project will include common elements that that all Association documents and unit docu- serve all (or at least more than one of the) Tow- ments (however structured) contain provisions ers, owned and operated by a Master Association obligating all Associations and unit owners under the REA, or similar entity. In structuring the to comply with the REA, and not to trans- project, Owner may want to consider the following fer their interest in the project unless: (a) the points about the common elements: transfer complies with any requirements in the • Minimization. Owner will probably prefer to REA, and (b) the transferee agrees to com- minimize the need for the Master Associa- ply with the REA. The second requirement tion (or, for that matter, any other Associa- reflects the practicalities of many state-law tion) to manage and operate amenities. Such limitations on whether any can “run management and operation creates higher with the land”; monthly carrying costs, complaints, manage- • Nonmonetary covenants. The REA may provide a ment burdens, and a need for more attention good vehicle for nonmonetary covenants and on every level, i.e., overall friction. Where rights and remedies for breach. These might possible, Owner will probably be well advised include, for example, a lien for noncompli- to convert any particular amenities (e.g., a ance. The enforcement procedures for any health club) into a stand-alone condominium such lien would need to ensure ample notice to or leased unit to be owned, leased, and oper- all mortgagees, as well as a protracted foreclo- ated separately, as a profit center for someone sure procedure much like that for unpaid real estate taxes. This process will be slower (and rather than as a management burden; much “safer” for a lender) than a typical lease • Market segmentation. If units are sold to different termination mechanism. Hence lenders may segments of the market, unit owners may not prefer it; want to share amenities or lobbies. • Bankruptcy. Although an REA would probably • Overall strategy. Owner may want to make an not face rejection in bankruptcy, this issue may early policy decision to try to minimize com- require further consideration depending on mon elements, for reasons suggested above. the facts of any specific transaction, particu- Where common elements cannot be avoided, larly to the extent that the REA goes beyond Owner may still want to try to incorporate as traditional affirmative and negative covenants much space as possible into individual project regarding real property. components, making the owner of that com- ponent responsible for operating the particular Master Condominium space (perhaps with reimbursement rights via As an alternative to the REA, Owner may sub- a Master Association). The less the Master As- ject the entire site to a master condominium regime, sociation actually does, the better. “For Sale” Apartments | 61

Third-Party Owner consider all possible consequences. Owner may de- Owner may engage a developer or marketing cide to segment the project between full-time Own- company to help with: (a) construction (and re- ers and other types of Owners. sponding to any construction defects litigation); (b) unit marketing; and/or (c) long-term management Secondary Market Requirements of Tower leases, unit leases, REA, etc. The use of Any ownership/leasing structure should be such an entity would provide a “buffer” between tested against the standards of the secondary mar- an Owner entity (and its various constituents) and ket (e.g., ). private unit owners. This “buffer” would make it easier to operate the project on a businesslike basis. Condominium Regulatory Concerns One more layer would separate the project from State condominium regulations often require unhappy unit owners, who might try (and might Owner to give up Association control at a particu- still try) to use Owner’s internal political channels lar stage in unit sales. What happens if Owner or to voice their complaints. As a variation on this its affiliate happens to own many units for its own theme, Owner or a related entity might provide use and occupancy (or for use and occupancy by its construction financing to a third-party developer. personnel)? If Owner or its affiliate owns a major- ity of units through its ordinary ownership and in- Fractionals And Timeshares vestment activities, would Owner still need to give The project may include fractional ownership up control? Owner will want to consider these and units and/or units. Regulatory restric- other regulatory issues with local counsel. tions for such projects will often be significantly more burdensome than for “pure” Unit Pre-Emptive Rights (condominia?), and will sometimes also suffer feder- Does Owner want to obtain a “right of first re- al regulation, but fractional and timeshare projects fusal” or “right to match” for any unit sales within are still quite common throughout the united States. the project? Typically, measures like these will im- Owner could add fractionals and/or timeshares to pair saleability and hence impair value, but Owner the mix regardless of which ownership structure might structure them in a way to mitigate those Owner employed. Timeshare and fractional buy- consequences. ers are, if anything, probably less interested in (or concerned about) underlying ownership structures Parking than condominium buyers might be. They may, Unit owners will park their cars within the proj- however, represent a higher (or lower) “market ect garage, not part of any Tower(s). How best can segment” than pure unit owners. Moreover, they Owner ensure that the unit owners have the per- might more likely purchase for “vacation” owner- manent right to use their specific parking spaces? ship as opposed to “year-round” ownership. For all A condominium may be overly complex. A perma- these reasons, they may have higher (or lower) ex- nent or easement may work. In any case, pectations on amenities, finishes, furnishings, and Owner will probably want a third-party garage the like. The existence of timeshare, fractional, or company to operate the garage. Owner will want “second ” buyers may change the flavor of to consider these issues further. In a mixed-use the project and its populace, perhaps discouraging project, Owner may find that different components the purchase of units by full-time residents. Thus, have incompatible (or at least competing) expecta- before going down that road, Owner will want to tions for the use of parking. Owner may ultimately 62 | The Practical Real Estate Lawyer May 2007 need to slice and dice the parking in a manner not privately owned real property should be owned or all that different from the rest of the project. used. “Leasehold conversion” just amounts to a variation on that theme. HOW TO STRUCTURE THE PROJECT From that starting point, Owner may want to • Although many of the options described above adopt these extra measures (as well as some of the are interesting and some are creative, any Owner others suggested above): will probably be well advised—at least in the first • Full disclosure of the lease termination date, instance—not to stray from the “usual” and “typi- as suggested above. cal” way that one would expect any project like this • A repurchase option at FMV within the REA, one to be structured: multiple Tower leases held by triggered by specific adverse events. multiple Associations, with each unit owner hold- • To the extent reasonable and possible, inte- ing a condominium unit within a leasehold. The grate mission-related uses and ownership into “marketplace” would also probably expect to see an the future for the project, in a clear and unam- REA (or perhaps a master condominium regime) biguous way. in place, before the various Tower leases, to define With these measures, Owner should be able to the relationship among project components. The satisfy itself that a ground lease—and a leasehold risk of “Leasehold conversion” seems fairly similar condominium—can provide a solid foundation for to any risk of eminent domain, and Owner should a “for sale” apartment development. Owner could probably not make it the driving force, or even a also reach a similar result through other alterna- major force, in structuring the project. Every inves- tives this article suggests. Some of those alterna- tor in real estate faces the risk that some future poli- tives vary quite dramatically from industry stan- ticians will decide they have a better idea for how dards, though, and hence may invite objections.

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