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.