The Legal Corner
Ground Leases - A basic primer for landlords and tenants
Tue Nov 20 2012
This article has been contributed by Darrell Gold LLB with Robins Appleby & Taub LLP
What Is It: A long term lease (e.g. 30 – 999 years) of: unimproved lands; or previously improved lands in need of major re-development at significant capital expense where the tenant gets rights/benefits and liabilities/obligations as if it was the landowner BUT is not the landowner. Some examples include the Empire State Building, New York, First Canadian Place, Toronto, Pinewood Studios, Toronto and the Colonnade on Bloor St., Toronto.
- The landlord does not want to sell its lands and wants to avoid the risk in land development.
- It frees up “trapped cash” where the landlord does not want to sell or cannot afford or have the experience to develop.
- The landlord may own adjacent lands and as ground leased lands are developed, the remaining land values increase for the benefit of the landlord.
- If the landlord is a municipality, ground leasing lands may spur the development of other municipal lands in the vicinity e.g. City of Toronto Economic Development Corporation’s ground leases to Toronto Film Studios (now Pinewood Studios) and to Corus Entertainment in Toronto’s Port Lands (the author represented the landlord on the finalization of each lease).
- The landlord may be able to avoid large capital gains otherwise occurring on a sale where lands have appreciated significantly in value.
- The landlord is unwilling to sell a desirable piece of property which the tenant desires.
- The tenant cannot afford to buy outright because of the cost of a sale;
- The tenant does not want to tie-up capital needed for a purchase and development.
- The tenant can depreciate the costs of its improvements.
- The ground rent is deductible as a business expense.
- It is more complex than a purchase.
- Tenant default means the risk of losing the lease AND the improvements constructed.
- The landlord loses use of the land for an extended period.
- Rents negotiated may not protect the landlord for market changes in rent over the term of the lease.
- The landlord risks a tenant failure to complete improvements and being left with a half-finished building.
- More flexibility/autonomy to the Tenant because of the nature and extent of its investment, so less control for the Landlord.
- Ground leases over 49 years attract land transfer tax (“LTT”) i.e. tenant pays the tax as if it was buying the lands.
- Possible Planning Act, Ontario issues for lease over 21 years where the landlord owns abutting lands so Committee of Adjustment consent may be required subject to certain exceptions.
- If the lands are in undeveloped area, servicing issues require involvement of municipal authorities and co-ordination of timing to provide those services to the development.
- Possible significant environmental remediation costs where lands have a history of hazardous uses and a change in use is being carried out for the development.
Two Main types of Ground Leases
Subordinated v. Un-subordinated
- A subordinated lease provides that the landlord will permit financing against its freehold interest to secure the construction loan for the tenant improvements. The Lender will have a lien against BOTH the freehold and leasehold interests. It is done if it will be almost impossible or cost prohibitive for the tenant to obtain leasehold only financing OR if Landlord will have a participating interest in the project being developed.
- An un-subordinated lease means the lease serves as the primary security for the lender so the landlord has less risk but the lease is harder to finance. Still viable where there is confidence in the developer/tenant and protections in place so that if the tenant defaults, the lender has an opportunity to take over and transfer the lease to new tenant who will complete/manage the Project. The lender (and tenant) will need an agreement with the landlord and its lenders to ensure that if the landlord defaults, the landlord’s lenders will honour the ground lease and correspondingly, if the tenant defaults, the landlord and its lenders will let the tenant’s lender transfer the lease to a new tenant.
Common Ground Lease Terms:
- Term – usually 30 - 999 years.
- Improvements – If tenant builds, it will own them and they revert to landlord at end of the term unless tenant has incurred large rent costs in which case it may have some flexibility to remove certain improvements or sell them to landlord.
- Obligation to Construct - Either party can have the obligation to build the project but usually the tenant does. It factors into what the rent will be. If the landlord funds it then rent will be higher. At some point, the improvements are paid for and if the term continues afterwards, or an extension is entered into and the new rent is set, then it may or may not take into account the value of the improvements (although often not since the tenant will argue that the landlord is being paid twice for the same improvements).
- Rent – Usually low in the beginning given the tenant is funding the cost of the improvements and then rent escalates over fixed periods as negotiated – It can be tied to formulas like CPI/re-appraisals of the property at intervals (e.g. current v. highest and best use is better for tenant/lender). It may also include a participation rent for the landlord. A lender may want caps on rent escalations given its exposure if it has to step in.
- Use – Tenant will expect broad uses without limitation (other than hazardous ones or those which compete with uses on adjacent lands owned by the landlord).
- Leasehold Financing – Complex provisions to accommodate rights of a leasehold tenant lender and requiring a separate agreement between landlord, tenant and lender to address matters including: landlord transfers in order to bind a new landlord, getting notice of tenant defaults and an opportunity to cure tenant defaults; a right to transfer the lease to a new tenant with landlord consent on tenant default; rights on tenant bankruptcy/insolvency.
- Default – Notice and cure periods will be long given what is at stake if default is not cured.
- Damage/Destruction – Expect an insurance trustee to be involved given the size of the project as parties have significant time and monies invested. Tenant will usually have the obligation to rebuild.
- Transfer Rights – Restrictions will apply given landlord may have wanted specific financial covenant of tenant who is building. Objectives of development can also be important e.g. identity and public recognition of tenant such as 'landmark" tenant. Subletting rights often don’t require consent but landlord may want some control over sub-tenants especially if it has other lands in the area with other tenant mixes.
- Naming Rights – Tenant will want to consider reserving naming rights to the project.
- Rent Set-off Rights – Given tenant's investment, tenant and its lender may require them and the landlord may agree to it against the base rent but not additional rent items such as taxes.
The Lesson: Ground Leases are far more complex than ordinary commercial leases and invariably involve more parties due to the need to accommodate both the freehold lenders and leasehold lenders. The parties are tied together for a very long time and there is a need to try and anticipate future events and the market for rent which necessitates the need for careful consideration and drafting.
Disclaimer: This article is for general information purposes only and not intended as or to be relied upon for legal advice. Consult with a lawyer for your unique situation.
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