The Most Important Issue in Every Ground Lease By Joshua Stein

When a property owner and a de- more conservative than developers Although some commentators veloper negotiate a long-term ground and investors, will likewise fear that may have seen a trend toward this lease of a development site, one issue a massive increase in ground rent at type of formula, I have not seen overshadows almost all others: how some distant date will diminish or it. Like many of the comments in should ground rent adjust over time destroy the security for their loans. this article about “typical” practice, to protect the property owner, as les- Though “cowboy” developers may my failure to note the trend might sor, from infl ation? And how can the sometimes take risks, lenders rarely only refl ect the particular universe lessor participate in future increases have the same mindset, and they of ground lease transactions that I in value of this particular site, which never forget that the obligation to have personally been involved with may or may not correlate with infl a- pay ground rent is always structur- or seen recently. Or it could refl ect a tion? At the same time, though, how ally senior to any leasehold lender’s view in the market that in the long can the developer assure that its collateral.2 run—i.e., multiple business cycles— leasehold position will also maintain six or seven percent has worked In response to these concerns, its value without becoming over- reasonably well, and that there’s no a lender or prospective lessee will whelmed by rent payments that no reason to believe it will stop working sometimes suggest a “cap” on ground longer make any business sense? anytime soon. rent adjustments. Typically, though, a TYPICAL APPROACH • Lessors lessor will regard any such proposal Of course, if a “typical” rent reset and lessees typically resolve these as a non-starter, because it necessar- occurs in a real estate depression—or concerns by agreeing that every two ily undercuts the protection that the at any time when valuations use very or three decades, they will reappraise lessor wanted to achieve through the high capitalization rates—the lessee the development site that the lessor future ground rent adjustments. may get lucky. originally delivered to the transac- Applying a fi xed percentage tion. In my experience, the ground As an alternative, a ground to future land values will create rent will then adjust to equal six or lease could theoretically refer to problems for both a lessee and its seven percent of the then-current fair some objective third-party index for lender—and wonderful results for market value of the site, i.e., whatever long-term capitalization rates for real the lessor—if, at the moment of the someone would pay to purchase the estate investments at the time of the rent reset, valuations in the larger development site. Until that happens, rent reset. And, very occasionally, the real estate market use capitalization rent may go up a bit every year or revaluation might direct the apprais- rates signifi cantly below six percent. few years1—or not, especially in older ers to determine the new rent based At any such time, real estate values ground leases. In most cases, the rent generally on market conditions for will refl ect a capitalization of future never drops. newly negotiated ground leases at income at, say, four percent, but the the time of the rent reset. In other The reference to six or seven per- ground lease will require payment of words, the rent would adjust to equal cent in rent adjustment formulas has ground rent at, say, six percent of that “fair market rental value” at the time remained remarkably stable for quite capitalized amount, which may put of adjustment, without using any a while, even through the very low the lessee in an untenable position formula to derive the rent adjustment interest rates of the last few years. and undercut or destroy the value of from land value or anything else. The the lender’s collateral. drafters of the ground lease must still Although ground leases typically defi ne with absolute clarity how fair use the approach just described, pro- LINKAGE TO INTEREST market rental value is to be deter- spective ground lessees sometimes RATES? • Some ground leases try mined. They also must defi ne any worry that if a ground rent adjust- to mitigate these risks by replacing assumptions the appraisers should ment occurs in a low-interest rate pe- a fi xed adjustment percentage with consider in that process. riod like today’s, the typical approach a percentage tied to interest rates at may overcompensate the lessor, the time of the rent reset. The parties VALUATION ON A RANGE leaving the lessee paying ground rent might choose a long-term rate like OF DATES • Ground lease negotia- that may feel excessive. Once the ad- 20-year Treasury securities, or, more tors sometimes suggest that instead justment occurs, this approach might unusually, they might use a shorter- of valuing the site on a specifi c date, diminish or even destroy the value of term one like the prime rate. In either the valuation should look to a range the leasehold estate. case, they would look at the average of dates, using the average value level of that rate over some period over, say, a three- or fi ve-year period LENDER’S CONCERNS • and then add on some spread. whose midpoint is the intended rent Leasehold lenders, generally even reset date.

NYSBA N.Y. Real Property Law Journal | Winter 2014 | Vol. 42 | No. 1 17 That approach may make some ed on the site when the parties signed ment potential of raw land (assumed sense. Suppose a rent reset used a their lease, or whatever improve- to be unimproved) and the actual single fi xed valuation date of October ments exist at the time of revaluation? physical development that exists on 1, 2008, two weeks after the Lehman This is a common disagreement. The the site at the time of any rent reset. Brothers bankruptcy fi ling. Given the lease should entirely pre-empt it. For example, changes in zon- state of the fi nancial and commercial In general, the appraiser should try ing or other law could change the real estate worlds on that date, the to replicate whatever existed when value of the site, if it were priced as lessor would probably feel victim- the parties signed the lease, usually hypothetical raw land. For the rent ized by a very low valuation. Going vacant land. To avoid confusion, the reset, though, the parties need to forward, that particular lessor might lease should say that as clearly as think about one minor detail: if the favor using an average of the val- possible. transaction played out as the parties ues on multiple dates over multiple GROUND LEASES OF MORE originally anticipated, then by the years. THAN JUST GROUND • If im- time of the rent reset the lessee will Valuation on a range of dates provements existed at lease incep- have already built improvements on would not need to require a complete tion, and the lessor initially demised the land. At the time of the rent reset, reappraisal each time; perhaps the those improvements to the lessee those improvements will probably only full appraisal would precisely tie along with the underlying “ground,” not be obsolete—i.e., ready for demo- to the midpoint date. The other dates the market will often still regard the lition or major redevelopment. could require only adjusted apprais- transaction as a “ground lease,” even If zoning at the time of the rent als, taking into account only certain though it covers existing improve- reset would allow much more de- elements of the appraisal analysis, ments and not just ground. The velopment than the building already such as then-current capitalization characterization as a “ground lease” in place at that time, then that up- and vacancy rates. would depend largely on whether the zoning does not help the lessee very lessee’s rights and obligations looked much. If the lessee must pay rent for Lessors and lessees generally more like ownership (an investment newly created development potential prefer, however, to avoid the time, transaction and typically regarded that the lessee cannot really use, then expense, and logistical diffi culties as a ground lease) or mere rights the lessee’s leasehold may no longer of dealing with multiple appraisal of occupancy not readily salable or make economic sense. Conversely, dates. They tend to feel that way fi nanceable in the market (a “space if zoning changes have reduced the even though an average of multiple lease”).3 appraisals might make the calcula- permitted development on the site, tion less arbitrary. The use of a single If a ground lease covers improve- but the lessee’s improvements are bright-line date introduces a greater ments that existed at the time of lease now overbuilt and can remain as a element of luck for both parties, but inception, the rent reset should usu- legal nonconforming use, then the both seem generally willing to take ally consider only the improvements lessor would argue that the revalua- their chances. as they existed at that time. The rent tion process should ignore the down reset clause might, however, require zoning. The need to periodically revalue the appraisers to take into account Another question along those the site for the purposes of ground any upgrading or expansion that the same lines: should newly discovered rent adjustment practically invites lessee accomplished. This effectively environmental issues affect the land litigation or arbitration. For obvious forces the lessee to pay rent in ex- value? The answer will depend in reasons, lessor and lessee will have change for value that the lessee rather part on which party bears the risk dramatically different ideas of the than the lessor created or provided. of unexpected environmental condi- value of the land, or of how the ap- Forcing the lessee to pay twice for tions, taking into account the terms praisers should proceed, particularly whatever (re)development the lessee of the ground lease. And what if as markets and other circumstances accomplished—once when doing some government decides to issue a change. The exact wording of the the work, a second time by paying landmark designation for the existing ground lease, and how it addresses adjusted rent based on the completed improvements? those possible changes, becomes work—hardly seems “fair.” Fair or crucially important in determining not, the lease language should resolve Lessors and lessees might also what exactly the appraisers should that question and not leave it to fi nd themselves fi ghting over wheth- appraise and how they should go courts, appraisers, and arbitrators. er any appraisal of the land should, about it. in appraising the land, “consider the FUTURE CHANGES IN THE terms of the lease,” a concept that For instance: should the apprais- SITE • Any ground lease negotiator appears in many older ground rent ers appraise raw land, or should they also should consider possible future adjustment clauses and a few newer include improvements? Should they disconnects between the develop- include the improvements that exist- ones. The whole concept seems

18 NYSBA N.Y. Real Property Law Journal | Winter 2014 | Vol. 42 | No. 1 circular. That’s because the value fun and deep thought resolving them. sors and lessees often still take their of the lessor’s land, if considered We shouldn’t give them the chance. chances, recognizing that there may subject to the terms of the lease, will Again, the words of the lease should be surprises while comforting them- depend largely on the amount of the leave no uncertainty. selves by knowing that this is the way ground rent, assuming the lessee is everyone does it (or at least many If the lease has only a decade or reasonably likely to actually pay that people do it), and that lenders have two remaining in its term, then an ap- ground rent. Thus, it may not make underwritten and fi nanced similar praisal “considering the terms of the sense—it seems circular—to con- leaseholds for decades. lease” should perhaps consider the sider the ground rent in measuring fact that, as an economic matter, the IS THERE A BETTER WAY? • the value of the land for purposes of lessee doesn’t have enough “useful Lessors and lessees do sometimes try determining the ground rent. life” left to justify a major construc- to fi nd a logically superior and per- One can eliminate the circularity tion or redevelopment project. Should haps less risky way to handle ground by deciding that the parties probably the appraisers consider that as a rent adjustments. They often start meant that any valuation should take negative in measuring the value of by suggesting that the ground rent into account any lease terms that the land “subject to the lease”? Isn’t should refl ect the lessee’s revenues, at limit permitted uses or other rights of the short remaining life of the lease a least in part. The lessor could receive the lessee. term that ought to be considered? some percentage of “gross revenues,” perhaps after modest deductions, and For example, land will have a Over an extended period of time, perhaps with a fl oor. That percent- higher value if it can be used for “any differences of opinion on these and age might refl ect the expected ratio permitted use.” If, on the other hand, similar issues translate directly to between the value of the land and the lease says the lessee can use the dollars—lots of them. Any careful the value of the lessee’s completed site only to construct a “car wash lease drafter should prevent the is- development project. with ancillary coffee shop,” regard- sue by avoiding any suggestion that less of what the law might then allow, the appraisers should “consider the It sounds reasonable. But what if then that limited range of uses—if ap- terms of the lease.” Instead, the ap- the lessee does not try very hard to plied to the land value as part of the praisal clause in the lease should state rent space in the completed develop- appraisal process—will drive down exactly what circumstances warrant ment project? Or occupies the space the value of the land. In this case, consideration, and what assumptions itself to conduct business? Or sub- “considering the terms of the lease” the appraiser should make. If the leases the space to a chain store at means accounting for how much appraiser should consider the narrow below-market rents while simultane- those terms decrease the value of the scope of uses permitted under the ously entering into an above-market land. It makes sense: if the lease only lease, that’s what the appraisal clause lease with the same chain store in allows the lessee to construct a car should say. If other particular provi- another state? What if the lessee does wash with an ancillary coffee shop, sions of the lease should increase or a lousy job with subleasing, or fails to the lessee should not pay rent for the decrease value, identify those. And invest the capital necessary to achieve right to build a 50-story offi ce build- if the appraiser should disregard the the highest rents? And what should ing, even if zoning law might allow it. terms of the lease entirely, that’s what the lease allow the lessee to deduct? the appraisal clause should say. Leasing costs? Capital expenditures But “considering the terms of the necessary to attract space lessees? If lease” could also mean something Anyone writing a land value rent the lessee borrowed money to im- more. It could also mean the apprais- reset clause in a lease should consider prove the property, should the lessee ers should consider anything else in asking appraisers whether they can have the right to deduct debt service? the lease, except ground rent, that understand and apply the language Interest? At what rate? How does the increases or decreases the value of the as written. After all, the hope is that lessor know the lessee is not lying lessor’s position. For example, if the appraisers rather than lawyers or or artifi cially reducing its revenues? lease gives the lessee a below-market courts will be the parties charged Before long, the exercise reinvents the purchase option, this will lower the with interpreting and applying the Internal Revenue Code. value of the lessor’s position. And words in the lease. what if the lease requires the lessor If a lessor and a lessee do decide Even if the lease handles the to deliver to the lessee some nonstan- to go down that road, then they (par- panoply of appraisal issues correctly, dard but expensive service? Is that ticularly the lessor) should take a few the “standard formula” described a term of the lease that the apprais- measures to prevent disputes. Keep above—six or seven percent of land ers should consider in valuing the it dumb and simple, avoiding exclu- value—will never precisely correlate land “considering the terms of the sions, complex characterizations, and with what the adjusted rent “should lease”? Again, these are fascinating fi ne lines whenever possible. They be” according to some “fair” view of questions. Litigators and courts and all provide fertile ground for misun- the world. It is a crapshoot. But les- expert witnesses could have a lot of derstandings, mischaracterizations,

NYSBA N.Y. Real Property Law Journal | Winter 2014 | Vol. 42 | No. 1 19 strategizing, gaming the system, and SMALL PERCENTAGES—NOT actual earnings, with all the head- disputes. Try to give the lessor a low SO SMALL • Setting aside the many aches that entails, but instead based percentage of a broadly defi ned vari- opportunities for dispute that arise on how much the lessee reason- able without too many deductions. in measuring any contingent rent, ably “should have earned” based Gross revenue with no deductions even a very low percentage of the on market conditions at the time of has a lot of appeal to it. Paint with lessee’s gross revenues, can place a determination. a broad brush. Think about every very signifi cant burden on the lessee, If the project consists of a an up- possible circumstance that might oc- and give the lessor a correspondingly to-date offi ce building, for example, cur and how it might play out given signifi cant stream of contingent rent. the contingent rent determination the lease language and defi nitions. Suppose, for example, that the lessee could assume the lessee achieves Finally, ask an appraiser and a lender agrees to pay the lessor three percent the same occupancy rate and rental how they would interpret, and react of a truly gross measure of revenue, levels as other comparable buildings to, whatever “brilliant” contingent with no meaningful deductions at in the market, and expense levels rent clause the parties think they all. Three percent sounds like a really consistent with similar buildings. In want to perpetrate. small percentage. each case, the measurement would Any contingent rent formula in Assume, however, that the les- disregard the lessee’s actual fi nancial a ground lease might also award the see’s operating expenses, real estate performance. The lessee would then lessor a small percentage of capital taxes, and insurance consume 50 pay contingent rent based on these transactions—lease assignments, percent of gross revenue. Assume benchmark market-based numbers. refi nancings, or other transactions ground rent consumes another 10 Although this idea may sound tantamount to either. Here, too, the percent and debt service another 20 practical or at least creative, the par- principles and issues above will arise, percent. ties still must consider the possibility including the risk of recreating the After those deductions, the lessee of future changes in circumstances, Internal Revenue Code. And, again, really gets to keep only 20 percent of starting with a change of use of the any uncertainty about line drawing the gross revenue. The lessor’s three building. And the lessee will worry or inclusions or exclusions will breed percent share of that gross revenue that circumstances or issues pecu- disputes down the line. represents almost one-sixth of the les- liar to this property will prevent the For example, does a “refi nanc- see’s bottom line. Moreover, a lessee lessee from achieving strong enough ing” include the case where a lessee might operate at a loss even though actual results to match the bench- holds its leasehold free and clear, and gross revenue seems substantial. In mark-based contingent rent the lease places an entirely new mortgage on other words, instead of adding up requires the lessee to pay. the leasehold? Can it be a “re”-fi nanc- to 80 percent of gross revenue the Yet another possibility: the ing if no fi nancing existed before the lessee’s expenses could add up to 105 developer might agree to give the transaction closed? Does “refi nanc- percent. lessor a small “carried interest” in ing” refer to placing any form of In all these cases, paying even a the lessee entity. Any carried interest fi nancing on an asset that had previ- very small percentage of gross rev- will, however, raise another host of ously been fi nanced in some other enue to the lessor can put quite a dent issues, some of them variations on way at any time, or does it merely in the lessee’s bottom line. Assuming the problems discussed earlier in this refer to replacing one mortgage with the lessee will consider the concept at article. Many of the carried interest another? Should the lessee’s fi rst all, the lessee might respond in part issues will arise from the fact that the construction loan be “exempt” from by trying to credit one ground rent developer will probably invest sub- any payment to the lessor? First stream against another—similar to stantial additional capital to generate permanent loan? If multiple sales of the operation of a natural breakpoint the anticipated value and return from the leasehold occur, should the lessor with percentage rent in a retail lease the project. Another set of problems participate only in the “profi t” since or a right for a space lessee to offset might arise from the lessor’s concern the last sale? What about multiple real estate tax escalations against that the developer could somehow refi nancings over time? If the lessor percentage rent. Similar consider- redirect or dilute project income in a participates only in the “new loan ations arise if the lessor will receive way that makes the carried interest proceeds,” what if some of those loan a percentage of refi nancings, lease worthless. Those two groups of issues proceeds arose only as a result of assignment proceeds, or other capital only scratch the surface of what a car- amortization of the previous loan? transactions. ried interest might entail.4 These questions only scratch the As a variation, the parties could If the parties do not want to agree surface of the issues that can arise conceivably measure the lessor’s to any form of contingent ground once lessor and lessee start down the participation in the lessee’s operating rent, the question then becomes: how contingent rent road. revenue based not upon the lessee’s else can the lease protect the lessor

20 NYSBA N.Y. Real Property Law Journal | Winter 2014 | Vol. 42 | No. 1 from infl ation and equitably compen- increases given the ever-increasing Although recalibrating relative sate the lessor, while protecting the dollar value of gold, i.e., the plum- values has a theoretical appeal to it, it lessee from destruction of its lease- meting value of the dollar as against is not at all market standard. In fact it hold through an unaffordable rent gold. is unheard of. And its appeal is com- increase? plicated by the need to consider ad- Lessees, however, would fear a ditional capital investment the lessee OTHER INDEXES • One might disconnect between the price of gold will make in the project, to upgrade it tie periodic major rent adjustments and the “right” rent, in dollars, for a and increase its value, or even just to to an index. For example, rent might given site over time. During the last keep it functional and rentable on at- rise with the consumer price index. few decades, any such fear would tractive terms. If the property’s value People in real estate, particularly have been entirely justifi ed. Looking as a whole increases as a result of the lenders, usually think the CPI goes ahead, however, a lessor may worry lessee’s investment and brilliant de- up faster than real estate values and that gold has run its course, or that velopment, leasing, and management rents; hence, they may propose a cap during the ground lease term gold 5 strategies, how does one slice up the on the adjustments. But if the parties might no longer function as a reli- resulting profi ts? The issue becomes “cap” any periodic rent adjustment, able repository of value. A lessor may particularly troublesome if the lease then the lessor will not achieve its also worry that a gold clause may not demises a vacant site; it may be easier goal of protecting itself from infl ation. accurately refl ect the future value of in an existing building. But the issues this particular site. The lessor might Perhaps the parties can fi nd an involved may not be all that differ- care more about that value than about ent from those that arise whenever index better than CPI; Class A offi ce the general value of the dollar. rents, average daily rate for hotel a ground lease requires appraisal of rooms in a certain market stratum, RECALIBRATION OF RELA- anything other than the actual build- real estate tax assessments, or retail TIVE VALUES • The parties could ing (and underlying land) on the site rents are all possibilities, in each case also try to devise a rent adjustment at the moment of appraisal. for some defi ned local geographical structure in which, over time, the Because of the ever-shortening area. Real estate professionals may lessor and the lessee will each main- duration of the remaining lease term, have varying degrees of confi dence tain a position whose value always however, the lessee’s leasehold estate in any possible index. They would equals about the same percentage of is “supposed to” decline in value need to choose accordingly. Future the value of the project as a whole. In over time, requiring some further changes in the chosen index would other words, whatever rent reset for- adjustment, particularly in the last drive changes in the ground rent, mula the ground lease used, it would few decades of the lease term. This regardless of what a particular lessee contemplate a valuation of both the could take various forms—each with does or earns in the demised prem- lessor’s and the lessee’s position, its own unique bundle of trouble—all ises. Such an index could make sense, after taking into account the contem- beyond the scope of this article, and especially if it matched likely uses of plated adjustment. Then the ground most requiring substantial consump- the site. A combination of multiple lease would also add a requirement— tion of aspirin. indexes might also work, though it and, to assure it, perhaps another rent might not ultimately differ signifi - adjustment—that at the end of the Instead of looking at relative cantly from measuring contingent day each party would maintain about shares of value, the parties might rent based on a marketplace bench- the same percentage of the value of look at their relative shares of overall mark of what the lessee “should have the project as a whole. property income. The lease might earned,” as suggested above. start out by providing for a fi xed For example, if the initial ground rental stream with fi xed bumps. But Ground leases once required rent were calibrated to give the lessor it could also say that if the lessor’s lessees to pay rent equal to the dollar a position worth 34 percent of the share of overall gross revenue (or, equivalent of a certain amount of project as a whole, then any future less desirably, net operating income gold. The federal government out- ground rent would need to be cali- before ground rent) ever drops below lawed such clauses in the 1930s as brated to maintain that percentage, a certain percentage, then the lessor part of the New Deal. Gold clauses taking into account market conditions can require an increase in ground became legal again for any “obliga- at the time of any rent reset. This ap- 6 rent to bring that percentage back to a tion issued after October 27, 1977.” A proach would still require appraisals certain level. This approach is not too federal court validated such a clause and the headaches and uncertainties 7 different from the percentage rent dis- as recently as 2008. Gold clauses they create. It would, however, at cussed earlier. It is also a variation on certainly would have protected les- least address each party’s fear that, the technique of “debt service cover- sors from infl ation in the recent past. over time, the rent adjustment would age ratio” from real estate fi nancing, In the last few decades, gold clauses shift too much value into the other except it refers instead to a “ground would have produced dramatic rent party’s pockets.

NYSBA N.Y. Real Property Law Journal | Winter 2014 | Vol. 42 | No. 1 21 rent coverage ratio,” with the goal of those cases, the lessee can’t so easily nifying glasses and apply them to the keeping it within a certain band. threaten to walk away from the lease, lease. It is a reasonable form of free- so the lessee truly realizes a benefi t fl oating anxiety when trying to create Conversely, if as a result of those by knowing the adjusted rent before something new and different that will increases in ground rent the lessor’s the deadline to exercise the renewal work correctly for 99 years. share ever rose beyond a certain option.8 percentage, then ground rent would My own many recent experiences drop, but never below the fi xed rent A more balanced approach might as an expert witness suggest that the schedule. Arrangements like these require the lessee to exercise each op- commercial real estate industry and can give the lessor a form of partici- tion before knowing the outcome of the lawyers who serve it categorically pation in future upside without open- the rent determination process, with overestimate their own intelligence ing up the possibility of making the no right to withdraw the exercise and ability to “get everything right” leasehold estate uneconomic. But, like of the option, only the right to walk in the context of ever-more-complex so many other alternatives discussed away from the lease. The renewal deal structures and terms.9 The more in this article, these arrangements options would be disconnected from complex and creative the various come with tremendous defi nitional the rent determination or renegotia- gradations and nuances become, the issues and hence possible disputes. tion process, putting the parties in more likely the parties will get them Moreover, they tempt the lessee to the same position—and giving each wrong, leaving land mines in the game the system in any number of the same leverage—as if the rent lease to produce unpleasant surprises ways. adjustment occurred part of the way when applied in the real world. The through the lease term, rather than as incredibly complex language and RENT ADJUSTMENT TIMING part of the renewal process. multi-page sentences that are so com- • Anyone who negotiates future con- mon in today’s real estate documents tingent rent adjustments in a ground Except for the possible need to often manage to include some im- lease should also consider how the conform to “tradition,” it seems un- perfection. And, whenever writers of timing of those rent adjustments necessary and perhaps even inap- legal documents try to use words to interacts with the timing of a lessee’s propriate to tie the timing of rent defi ne some future hypothetical that renewal options. In a lessee’s perfect adjustments to the timing of renewal is intended to replicate a set of pres- world, each rent adjustment period options. In any case, it is not “obvi- ent known conditions—pretty much would correspond to an option term. ous” that adjustment periods should what one does in a land valuation The lessee would know the adjusted conform to renewal terms. rent reset—the fallibility of lawyers rent before needing to exercise a REAL ESTATE DERIVATIVES? often becomes particularly apparent. renewal option. As an equivalent • Ground lessors and lessees might alternative, the lessee could have the Legitimate fear of complexity, eventually hedge some risks of real right to withdraw the exercise of an legitimate fear of change, and the estate infl ation and ground rent ad- option if the lessee didn’t like the rent constant need to satisfy future lend- justments through insurance or real as ultimately determined. ers will often drive ground lease ne- estate futures markets, in much the gotiators back to the traditional rent Both of those approaches, though same way farmers hedge commod- adjustment formula described early perhaps typical, convert each option ity prices. But commercial real estate in this article. into a one-way negotiation in which is not as fungible as pork bellies and the rent can only go down from what- corn. And, after some false starts ever number the rent determination with real estate derivatives during Endnotes process produced. Of course, the le- the boom that ended in 2008, it’s safe 1. These annual increases, typically small, verage they give the lessee is roughly to assume that brilliant new deriva- add up in a signifi cant way over time. They sometimes take the form of a CPI equivalent to the lessee’s right to tive products are not at the top of increase, annually or every few years, walk from the lease at any time. That anyone’s list. Great fi nancial minds subject to a low cap. That cap may apply walk-away right always gives any may bridge part of that gap, perhaps to either: (a) each increase or (b) all lessee the ability to try to negotiate by insuring against infl ation through increases, considered as a whole, since the start date. Which party will benefi t the rent downward at any time. The puts and calls involving long-term more from which type of cap will not ability to not exercise—or withdraw TIPS bonds. That too has its risks and always be obvious. The measurement the exercise of—a renewal option cre- costs. of that cap can create room for ates much the same leverage. misunderstandings. Lease negotiators typically worry 2. This assumes, of course, that the lessor The dynamic changes, of course, that creative structures like those does not agree to join in the leasehold if the lessee has signifi cant credit or proposed in this article will not work mortgage, sometimes referred to a creditworthy guarantor, or if credit right because of some problem or gap colloquially and incorrectly (and, in the eyes of some courts, almost humorously) enhancement measures, such as a that no one notices until the litigation as “subordinating the fee.” In today’s security deposit or a letter of credit, or arbitration begins and the parties market, that assumption is almost always back the lessee’s obligations. In and their counsel take out their mag-

22 NYSBA N.Y. Real Property Law Journal | Winter 2014 | Vol. 42 | No. 1 correct, so this article accepts it as part of exposure” may not be all that great. Joshua Stein practices commer- the territory. Most leases, including ground leases, cial real estate law in New York City. allow a lessor only two major forms of 3. Can a ground lease demise part of a recovery upon a lessee’s default. First, He chaired the Real Property Law building? Must a ground lease demise the lessor can sue for the rent every Section for the year ending in May at least some ground as part of the month. Second, the lessor can sue the transaction? To defi ne a transaction as 2006. For more on the author, visit lessee for the excess, if any, of the fair a ground lease, the author would look www.joshuastein.com. The author market rental value over the reserved to the character of the leasehold estate rental for the remaining lease term, appreciates helpful comments created—the terms of the ground lease— discounted to present value. In a typical received from Stevens A. Carey of and not place great emphasis on whether ground lease, almost by defi nition, no the lease demises any ground. Others, Pircher, Nichols & Meeks, Los Ange- such excess exists: the lease has value to including perhaps Black’s Law Dictionary, les; Alfredo R. Lagamon, Jr., of Ernst the lessee precisely because the ground disagree. rent is below fair market value rather & Young LLP, New York; Donald 4. Many of these issues also arise in than above fair market value. That fact H. Oppenheim of Berkeley, Califor- negotiating a joint venture. See Joshua precludes the lessor from suing for a nia; Robert M. Safron of Patterson Stein, Agenda for a Joint Venture Agreement, large and attention-getting lump-sum Belknap Webb & Tyler LLP, New THE PRACTICAL LAWYER, April 2010, at 36, award if a creditworthy lessee decides (www.pdf2go.org/165.html). to walk away. To recover, the lessor York; Lawrence Uchill of Uchill Law, 5. Historically, over any extended period must leave the lease in place and keep PLLC, Newton, Massachusetts; and the CPI has actually risen only 2% to 3% a suing the lessee every month for unpaid Elizabeth T. Power, of the author’s year, despite perceptions of wild infl ation rent, which the lessor might not fi nd too staff. Blame only the author for any appealing. The comments in this footnote over many years. Some periods of very errors. high infl ation did occur, of course, but may imply that lessors and their counsel should think more about the measure of looking back over the long term the CPI An earlier version of this article has not grown all that dramatically. It has damages if a creditworthy lessee does certainly not been “out of control” over decide to walk away from a ground lease. appeared in the January 2013 issue the long term. Commercial real estate Of course, the lessor may happily recover of The Practical Real Estate Lawyer. values considered as a whole over the possession of a completed building and Shorter versions appeared in the call it a day. entire United States have trailed the CPI [New York] Commercial Observer, (except in Manhattan, where they have 9. For more on this topic, see Joshua Stein, June 2012 supplement on mortgage barely matched it). These statements It’s Complicated, But is it Right?, THE are all wild overgeneralizations—they MORTGAGE OBSERVER, February 2013, fi nancing, at page 16, and in the should not be relied upon in any way at 12. The author’s expert witness December 2012 issue of the Ameri- or even taken very seriously—but assignments mostly involve complex can College of Real Estate Lawyers they do summarize the author’s non- and nuanced documents for large Newsletter. Readers are encouraged authoritative but also nontrivial research transactions. Aside from ground leases, in the area. Further insights on these the line-up often includes joint venture to comment on and respond to this issues will be welcomed. agreements; development agreements; article by sending email to joshua@ 6. 31 U.S.C. § 5118(d)(2)(1997). intercreditor agreements; and loan joshuastein.com. Copyright (c) 2013 documents, particularly nonrecourse Joshua Stein. All rights reserved. 7. 216 Jamaica Ave., LLC v. S & R Playhouse clauses and carveouts. With the help Realty Co., 540 F.3d 433, 441 (6th Cir. of great minds, these documents cover 2008). every possible eventuality perfectly 8. In a typical ground lease, the except, it seems, the one eventuality that creditworthy lessee’s “walk-away actually occurs; hence, the litigation.

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