Know Retail Ground Lease Issues

Colorado Real Estate Journal, July 7, 1999

The first leases were ground leases; they were agricultural. The landlord fulfilled all of the landlord's covenants by conveying a leasehold interest to the tenant. The tenant then "owned" the property for the term of the lease. Termination for breach of the covenant to pay rent was not an option for the landlord, and since the landlord made no ongoing covenants, the tenant didn't need it. Some modern ground leases are still structured this way. The tenant argues, "If I don't pay you can get a judgment against me, but I can't let you terminate."

The term of a ground lease is long-at least 20 years and usually, with renewal terms, more like 50 or 60 years. The length and relative permanence of the leasehold estate makes it much more valuable than a shorter term lease of less property. The tenant will expect to have more of the incidents of ownership-the right to a portion of condemnation proceeds or even to take a lead role in condemnation proceedings, a right to protest taxes, and, always, a right to encumber its leasehold estate. There is, or should be, a leasehold title insurance policy, whether or not there is a leasehold mortgage.

A. Financing

It is essential to have a separate notice and right to cure provision for the lender. The lease should provide that it can't be terminated while the lender is pursuing a cure, and should include the right to foreclose on the ground lease mortgage (and require the lessor to wait) as part of the cure right.
 

B. Go-dark

The landlord wants the tenant to covenant to build the store within a certain amount of time, to open it, and to keep it open. The tenant would rather not have to commit to any of these things. A compromise position on any of these issues is possible. If the tenant won't covenant to open, perhaps the landlord can buy back the leasehold estate if the tenant does fail to open. An alternative to a covenant to operate after construction is to put in another buyback right. Then the parties can negotiate how long the tenant gets to take to find a subtenant or assignee before the right is triggered. Pay attention to definitions. What do you mean by operating continuously? What percentage of the store has to be stocked? What do you mean by "open?"
 

C. Building ownership

Some ground leases do not address what happens to improvements at the end of the term. If the tenant owns the building, does that mean the tenant may remove it at the end of the term? Does it mean the landlord can require removal? What if it's a gas station with leaking underground storage tanks? The parties usually seem to be assuming that the building, if one is still standing, will be fully depreciated and of no further value at the end of the term, so they don't focus on it. The tenant's lender will want the tenant to own the building, so that is a good "default" if no one has a better idea. And the building won't necessarily have zero value at the end of the lease.
 

D. Assignment and subletting

The ground lease tenant feels like the "true" owner of the property, and wants to have complete control over the space. The landlord still wants all the things a shopping center developer always wants, which includes control over tenant mix and all of the monetary profits. Landlords always worry about tenants "competing" with them. A buyback provision presents a solution to this conflict. The landlord agrees to buy back the property if the tenant wants to assign or sublet to a qualified user and the landlord doesn't want to permit that.
 

E. Default, notice, and right to cure

If the lease can be terminated for default, the ground lease tenant will want abnormally long notice and cure periods, as will the tenant's lender. Another issue is self-help in case of the landlord's default. This can be very important to the operation of the ground lessee's business. Road and parking lot maintenance are examples of landlord duties that the tenant will want to make sure get done well and on time.
 

F. Build-to-Suit

A build-to-suit is a ground lease where the landlord builds a building to the tenant's specifications and then the tenant leases it from the landlord once the building is completed. A variation is the "reverse build-to-suit," where the ground lease tenant builds the building and sells it to the landlord, then leases it back. The tenant pays rent just for the ground while the building is going up, then the rent increases. The rent for the building is usually calculated at an amount per rentable square foot, and cannot be established until the square footage exists and is certified.

The construction schedule, methods, financing, and remedies for default are set forth in a work letter. The work letter must be very comprehensive. It is like a combination of a construction loan agreement and a construction contract. It must set forth in detail all of the steps to completion of the building (or even just a finished lot, if the tenant is doing its own construction), and must give each side enough control over the process to keep them comfortable that the other side will hold up its end of the bargain. Negotiations on the work letter usually take much longer than writing the rest of the ground lease.