Ground Leases: Capping Rents to Protect Lenders

By Alvin Arnold

Although inflation seems no threat for the immediate future, sophisticated landowners entering into long-term ground leases are not likely to make the mistake of agreeing to a fixed ground rental. Instead, a landowner will anticipate receiving a growing income stream tied not only to future increases in the inflation rate but more specifically to the increasing value of the leased site. The three methods utilized by landowners to capture the capital appreciation of ground-leased properties are:

• Escalation keyed to a price inflation gauge.
• Periodic reappraisals.
• Participation rents.

Escalating base rents with an inflation measure provides the landowner with at least a hedge against a rising price level. However, considering the paucity of prime development sites in many cities today, the increased value of well-located real estate is likely to exceed the inflation rate over the full term of a ground lease Thus the landowner is more likely to want the rental stream adjusted periodically based on independent appraisals of the leasehold (with the provison that in no event will the rent ever be decreased).

The frequency and parameters of the appraisals will be a matter for negotiation. Also negotiated will be the basis of the appraisal The landowner will want the property appraised for its highest and best use, regardless of the current use, while the developer will want the appraisal to be based on the current use, even if the zoning regulations in effect at the time of the appraisal permit a more profitable use. Yet a third approach in the case of a shopping center or other rental project is to tie the ground rent to rises in the lessee’s rental income.

Each of the escalation methods just described creates a problem when the fee interest is not subordinated to a mortgage taken out by the ground tenant. In the event the ground tenant defaults on its mortgage and the lender takes over the lease, it would be responsible for complying with all lease obligations, including rent payments. The lender most likely would try to sell the leasehold promptly in order to recoup as much as possible of the balance of its loan. However, if no sale can be negotiated, the lender might have the burden of substantial rent payments. For this reason, the ground tenant might be unable to obtain financing, thus frustrating the ground lease transaction at its inception.

There are a number of ways to reduce the risk to a lender of excessive rent escalations. One is to place a fixed ceiling on the escalator, whether it is tied to an inflation index or periodic reappraisals. The lender then knows the maximum rent amount and can determine its loan accordingly. The landowner, however, may not want to assume the role of prognosticator in estimating the level of prices decades in the future.

A second solution that may satisfy both the landowner and the leasehold lender is to cap rent increases or establish a fixed rent schedule during the term of the leasehold mortgage. This provides the lender with the certainty it requires while giving the landowner the ability to extract the true rental value of its property when the leasehold loan expires. Alternatively, a lender may require that the rent escalators in the lease be subordinated to its loan so that if the lender ever takes possession of the leasehold, it need pay only the initial ground rent (or a rent calculated under a more favorable escalation provision.)

Another way for a landowner to capture the future appreciation of the land while protecting the leasehold lender from excessive rents in the event it takes possession is by substituting a rent participation clause for ground rent escalation. A typical method, because easiest for the landowner to monitor, is to tie increases in the ground rent to gross rentals paid to the ground tenant by sublessees. This may be acceptable to the leasehold mortgagee since increases in the ground rent will be matched by the increase in rents received by the subtenant.

Alvin Arnold is the editor of the Monitor. He can be reached at (212) 885-8235.

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Alvin L. Arnold at (212) 885-8235.