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Considerations for Ground Rent Reset Provisions

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Considerations for Ground Rent Reset Provisions Real Estate Trends WWW. NYLJ.COM VOLUME 262—NO. 118 WEDNESDAY, DECEMBER 18, 2019 TRANSACTIONAL REAL ESTATE Considerations For Ground By And Rent Reset Provisions Peter E. Mitchell L. Fisch Berg ue to the long-term nature the consequences of such clauses can been thought through or are otherwise of ground leases, the rent be significant. unclear, leading to disputes between that was initially negotiated While landlords favor rent reset the parties. between the parties may lag clauses because they believe fixed For example, the parties are not behind market ground rents percentage or CPI adjustments rarely always explicit as to just what is being Dafter a period of time, even with fixed keep pace with increases in the value valued. Is it just the land, or the land or consumer price index (CPI)-based of real property over the long run, ten- with the improvements that the tenant increases. As a result, ground lessors ants and their lenders1 are increasingly often insist on rent reset clauses on a objecting to typical rent reset clauses periodic basis so that the ground rent in ground leases because of the risk The purpose behind rent reset captures some of the increase in land and uncertainty that they can pose. clauses is simple—to capture any values. While there are many varia- While the parties would ideally nego- change in the fair market value tions, a “typical” rent reset clause pro- tiate to reach settlement on the fair (and fair market rental value) of vides that at predetermined times dur- market value of the leased property, ing the term of the lease (e.g., every 20 and therefore, the new rent, this often the leased property. However, the or 25 years), the rent will be increased does not happen in practice. When the application of rent reset clauses to an amount equal to a percentage parties are unable to agree on the new in practice is anything but simple, (typically 5-6%) of the then fair market rent, an arbitration or litigation usually and the consequences of such value of the land (usually determined ensues and the parties become subject clauses can be significant. as if free and clear of liens and encum- to the unpredictability of a third-party brances, including the lease, and vacant decision. The consequences of a rent constructs on the land? If it is just the and exclusive of the improvements). reset can be dire, resulting in the tenant land, should it be valued vacant and The purpose behind rent reset clauses not being able to finance its interest in unencumbered, as if the lease did not is simple—to capture any change in the the property2 or even losing its lease.3 exist, or should the lease be somehow fair market value (and fair market rental taken into account? If the lease makes Interpretation and Implementation value) of the leased property. However, clear that the leased property is to be the application of rent reset clauses in One set of complications in the valued unencumbered by the lease, practice is anything but simple, and application of typical ground rent then an appraiser will likely value the reset clauses relates to the interpre- land assuming it will be used for its PETER E. FISCH and MITCHELL L. BERG are partners tation of such clauses. Some consid- unrestricted “highest and best use,” at Paul, Weiss, Rifkind, Wharton & Garrison. STEVEN SIMKIN, of counsel, ALLEN M. WIEDER, counsel, and erations may not have been addressed which can result in a large increase RUOBING CHEN, associate, assisted in the prepara- in the lease provisions while others, in the rent payable for the rent reset tion of this article. even though addressed, may not have period at issue since the highest and In some jurisdictions, this reprint may be considered attorney advertising. Past representations are no guarantee of future outcomes. WEDNESDAY, DECEMBER 18, 2019 best use is not always consistent with been able to obtain the additional may also have realized reduced cash what has actually been constructed on development rights and increase flow (for example, by agreeing to an the land and the use and other restric- the size of its development. On the affordable housing requirement) in tions in the lease. However, note that other hand, the tenant may have order to obtain the tax abatement. unless the parties have explicitly pro- paid for the additional development Regulatory Requirements: Should vided that the land is to be valued rights and done the leg work in cre- the fair market value be subject to unencumbered by the lease (or words ating the assemblage. regulatory requirements (such as of similar effect), a court will likely Construction Issues: Should con- rent stabilization and rent control determine that the land is to be val- struction issues due to site limita- laws, landmark regulations, etc.), ued as encumbered by the lease.4 This tions (e.g., difficulty due to limited which can reduce the fair market is evident in several New York court street space for trucks, etc.) be value of the leased property? On the rulings, including in United Equities v. taken into account? On the one one hand, regulatory requirements Mardordic Realty,5 936 Second Avenue hand, construction issues can to are often tied to what is ultimately L.P. v. Second Corporate Development some extent be managed by the ten- built on the leased land, in which case Co., Inc.,6 and Plaza Hotel Associates ant in its construction staging and they should not affect the value of v. Wellington Associates, Inc.7 development plans, and may even such land if it is to be valued vacant If the parties decide that the fair mar- be caused by the tenant. On the and unimproved. On the other hand, ket value of the leased property is to be other hand, site limitations can be not taking into account the regula- determined as encumbered by the lease fundamentally tied to the land itself. tory requirements may be viewed as (or do not provide for the contrary), the Timing of Valuation: Instead of set- unrealistic and punitive to the tenant parties should also carefully consider ting the valuation date as the rent since what has been built will con- what terms of the lease should matter reset date, should there be multiple tinue to be subject to such regulatory for purposes of valuing the property. valuation dates to account for the requirements. For example, should only the use pro- possibility of the rent reset date fall- Zoning Changes: Should a change in visions of the ground lease matter, or ing in the middle of a real estate zoning (whether it is an upzoning or should the remaining term of the ground recession or boom? Choosing a a downzoning) affect the fair market lease (including rights to extend or single valuation date can result in a value of the leased property? Should renew), purchase options, preemptive rent that is drastically different from it make a difference if the tenant can rights (such as rights of first refusal) and the one that was previously being or cannot alter its development or other restrictions or requirements (e.g., paid, and the results of such valua- building to take advantage of an that the improvements cannot exceed tion have long term consequences upzoning? Conversely, if a build- a certain size) in the ground lease also as the next rent reset period may ing is a legal nonconforming use, be taken into account? not be for another 20 or more years. should the fair market value of the Beyond the considerations described Tax Abatements: Should tax abate- land be reduced because of a down- above, there are additional issues that ments, which would make a property zoning? On the one hand, zoning may not have been considered during more valuable while the abatement regulations are an integral factor in the lease negotiations and may only be is in effect, be taken into account in determining the value of a piece of brought to light when the rent reset determining the fair market value land. On the other hand, what the period is imminent. Some examples are: of the leased property? On the one tenant has built will most likely not Assemblage Value: If the leased hand, the landlord may have cooper- be affected by a change in zoning. property is a part of an assemblage ated with the tenant in obtaining the Another set of complications that or combined zoning lot, should tax abatement and, but for the land- arise in the application of typical the fair market value of the leased lord’s cooperation, the tenant would ground rent reset clauses relates to property include the value of any not have been able to obtain such tax how (or the process through which) additional development rights that benefit. On the other hand, the ten- the fair market value is ultimately the site is then entitled to use? On ant may have been the one to apply determined. Assuming the parties the one hand, without the leased for, and do all the work necessary to do not initially agree on a fair market property, the tenant would not have obtain, the tax abatement. The tenant value, the parties will undoubtedly WEDNESDAY, DECEMBER 18, 2019 obtain appraisals of the property, increase. While, as mentioned above, provisions to get a sense of how they with the appraisers making their landlords do not believe that such would interpret such provisions.) Ulti- own interpretations of what the lease an adjustment adequately takes into mately, this should lead to the parties’ requires to be valued and, based on account increases in the value of real respective appraised values being their reading of the lease, what factors property, long-term studies that have closer, which would, in turn, result in to take into account in performing their compared CPI data to real estate values a higher likelihood that the parties will valuations.
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