Despite the relative return of liquidity in the credit markets, many real estate owners and developers are still facing an uphill battle to obtain sufficient funding for their projects. One way to move that project from the drawing board to the construction site is eliminate the high property acquisition costs and turn to ground leasing as an alternative. Before you get started, here are a few issues to consider before signing the lease.
Don’t Be Fooled By The Name Ground Lease
From the legal, financing and deal perspective, a ground lease is more akin to real property acquisition than it is to a lease. Careful consideration should be given to the terms of the deal and the scope of the due diligence undertaken in order to ensure that the lease will be a good fit for your long-term business needs and acceptable to your construction lender.
Term and Title
The time duration of a ground lease is typically 50 – 99 years, but should be no shorter than the time needed to fully amortize the costs associated with your newly constructed or renovated improvements.
Title to the property should be reviewed as though you were purchasing the land. I recommend that you request a Leasehold Title Policy Commitment and obtain a title insurance policy covering your leasehold interest, provided such policy is available in the state where the property is located. If you do not have legal counsel to review the status of title (which I always recommend you do), a few items to consider include:
- The title company should deliver copies of all documents referenced in the commitment.
- The entity or individual listed as the grantee on the last deed of record should match the entity named as landlord on your ground lease. Even minor variations in the name (such as missing commas or a different entity type being listed) can prove problematic. You can double check the correct entity name and the status of that entity with the Secretary of State for your jurisdiction.
- Make sure that the title premium is paid and the title company delivers the leasehold title policy once the lease is executed. The insured party should be the tenant entity listed in the lease and any guarantor required by the lease.
- Review applicable mortgage documents listed on the commitment to determine if lender approval of the ground lease is necessary. Existing loans will need to be subordinated to the ground lease, and those documents recorded in the real property records in the county in which the property is located. An attorney can assist you with preparing the appropriate subordination forms.
Survey, Zoning and Condition of the Property
As previously mentioned, the type of due diligence being undertaken prior to entering into a ground lease is similar to a property acquisition. Major review items include:
- Survey – An ALTA survey of the property should be completed and reviewed prior to lease execution. The location of existing utility facilities and public rights of way should also be reviewed in light of the proposed construction plans.
- Zoning/Approvals – Applicable zoning designations and regulations should be confirmed by the city planning and zoning department. If the current zoning of the property will not permit your planned use, you will need to seek a zoning variance. The lease documents should account for termination of the lease if the correct zoning or any necessary or desired city approvals of the project are not acquired.
- Environmental/Condition of Property – Completion of a Phase I and Phase II investigation of the property, as applicable, is strongly recommended, as well as an on-site inspection of the property.
A Few Final Negotiation Considerations
- It is often appropriate to request a Right of First Offer or Right of First Refusal from the owner, and this should be negotiated at the letter of intent stage.
- Negotiate up front the condition of the improvements at the end of the term and how title to the improvements will be transferred (i.e. “As Is”, without warranty, with no obligation to remove or restore, with the transfer by Bill of Sale or Deed as appropriate for the jurisdiction).
- If the rent for the entire term is not determined up front (i.e. if there is a period in which rent shall be determined based on the “market”), it is important to carefully craft the terms of how “market” will be determined – based on the then-current use of the premises (favorable to us), or based upon the then highest-and-best use (less favorable).
- Ensure that the lease allows for easy assignment and subletting to third parties.
- You will want to record a Memorandum of Ground Lease or Short Form Ground Lease (depending on the location of the project) in the real property records to provide notice to future lenders or potential purchasers of the property of the existence of the ground lease.