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GROUND LEASES
by Kimberly M. Reed, ATG Law Clerk

When an owner makes a long-term lease of land only, the lessee is said to have obtained a ground lease. Also called a land lease, a ground lease is commonly for a term of 50 to 99 years. The tenant usually is required to construct a building or maintain and use current improvements on the land as specified in the lease. Specific circumstances and the negotiations between the lessor and lessee significantly determine the make-up and contents of a ground lease instrument, but there are several elements that are typically present. In most cases, the lessee pays all expenses of the real property such as property taxes, insurance, maintenance and financing costs. Operating and related maintenance expenses are often called "pass-throughs" because they are costs that pass through from the owner to the tenant. As a result, the owner-lessor receives payment subject to no deductions. The lease also will likely include provisions regarding any improvements made to the property. For example if the lessee constructs an apartment building on the land, if agreed, at the end of the lease period both the land and the apartment building may revert back to the lessor.

Advantages and Disadvantages

There are several advantages that may motivate a prospective developer or tenant to seek a ground lease rather than a different form of ownership. First, the price of the property should be less than the purchase price of similar properties because the land is not being bought. Second, initial development costs should be drastically reduced, especially during the construction period. With a ground lease, the monthly expenses are fixed at the cost of the rent payment. The developer could also negotiate a rent abatement provision in the agreement that would suspend the requirement of rent payments during the construction period of the project. If the landlord provided a decorating allowance, a specific portion of the rent would be deducted allowing more funds to make improvements to the property. Finally, a ground lease may be the only method to attain a piece of property. The developer may be dealing with a party, such as a non-profit entity, that generally is not disposed to or even permitted to sell the land.

Certain disadvantages tag along with ground leases that otherwise would not be incurred; the importance of successful negotiations is evidenced here. Monthly rent payments may be higher than potential monthly mortgage and interest payments. The shorter the ground lease term, the more difficult it may be to obtain financing. If the lessee was not successful in negotiating the terms and restrictions of the agreement, the lessee may have less flexibility in the development and operation of the property because of the landowner's control. Finally, the lessee may experience difficulties or delay if the lessee later has to negotiate with the lessor's heirs or successors of interest.

Who Uses a Ground Lease?

A ground lease is most often used in the following situations: (1) when the property is leased to a developer who subsequently will make multiple subsidiary leases; (2) when a governmental body, e.g., a town or county, clears land under an urban renewal program and leases the cleared land to a developer; (3) when a non-profit entity, such as a church or charity, cannot sell the property and leases the land; (4) in sale and leaseback transactions, which are a form of financing; and (5) for estate planning purposes. Illinois Real Property Service §4:3 (1988).

Types of Ground Leases

The character of a ground lease varies depending on the needs and negotiations of the parties to the lease agreement. For example, the ground lease may involve a plot of land upon which there currently is no structure and the lessee intends to build one and lease space back to the lessor-owner. In this agreement, the lessor has a more active involvement with the lessee because instead of simply receiving payment on the leased land, the lessor has a substantial interest in the design planning of the building as well as in the future users or occupants of the building. IRPS § 4:1 (1988). The instrument would need to be drafted in a way to stipulate the extent of influence that the lessor would have on the tenant's development plans.

The three most common types of ground leases are single, multiple, and divisible ground leases. These variations are accomplished by rewording or adding provisions to the document. Depending on the circumstances of the specific project, the ground lease may vary in its autonomy from other adjoining ground leases. In cases such as department or grocery stores, office buildings or shopping centers, the best type of ground lease would be a single ground lease with no subsidiary ground leases on the land. This design contains a single leased parcel of land, and the lease does not overlap onto another adjoining fee or other ground lease parcels. In the simplest case, there would be no easements with adjoining parcels. If the lessee at a later point needs to acquire additional adjoining land for expansion purposes, some lessors would require the lessee to purchase the new parcel, convey it to the owner and allow the lessee to lease it back. The benefit of this arrangement is obvious if and when the lease is terminated. At the end of the lease, the lessor-owner acquires the entire developed project and will not have to negotiate additional arrangements for the remaining parcel or continuation of the project. IRPS § 4:6 (1988).

In some instances, a more problematic situation exists where the lessee, usually a developer, is forced to negotiate multiple ground leases to acquire enough property. This happens most often in situations where the developer cannot acquire the entire parcel or when the developer acquires pieces of the parcel at different times. The lessee then must obtain multiple ground leases that may be contingent upon one another. Multiple ground leases may cause many difficulties. First, and most importantly, multiple lease parcels are harder to finance. The lender will want to be absolutely certain that none of the other leases can be terminated, to prevent it from losing its security on the loan. Other problems include resolving the effect of multiple leases upon all of the sublessees, and obtaining appropriate cross-easements and reciprocal agreements between the various parties.

The vast majority of lenders will only approve financing when the mortgaged parcel has a single status or position. As an example, assume the construction of a development will be done in stages as three separate projects. In this case, it will be easier for the developer to obtain financing if the ground lease is divided into separate leases. Each lease would cover a different stage of the development. In this situation, rent is usually apportioned to the underlying land according to size, per square-foot for example, and it is practical for all the ground leases to have identical terms. In this case, divisible ground leases would be appropriate. In a divisible ground lease, none of the individual divided leases can have cross-default provisions. A cross-default clause provides that if the lessee defaults on or terminates the lease containing that provision, that default will trigger a default or termination on some or all of the other leases of the development. Linking the termination of a single lease to the termination of some or the rest of the leases destroys the purpose of having separate leases. At the same time that the separate ground leases are executed the lessor-owner should be required to enter into cross-easements or reciprocal agreements, such that the project will be operated as one unit in spite of the separate leasing and financing. This agreement will provide parking, access, or the operation and management of the entire development. For example, assume that a project involves four adjacent parcels of land that are leased via four separate ground leases. The four parcels of land all share one access road and common parking facilities. There should be a provision in each lease that identifies the access and parking arrangement and provides that default or termination of any of the other ground leases will not affect the right to use the easements or rely upon the reciprocal agreements. This way in the event of the termination of even one ground lease, the entire project may still be a single integrated real estate project. IRPS § 4:8 (1988).

Drafting a Ground Lease

A ground lease, like any other lease, must meet the requirements of a contract. Ground leases, being long-term agreements, always have a term longer than one year. Therefore they must be in writing to satisfy the statute of frauds. 740 ILCS 80/2. Even if a lease meets all the contract requirements, the landlord cannot include provisions that violate another body of law or are contrary to public policy. For example, a lease provision that indemnifies the lessor for any and all damages to the property, even those arising from the lessor's own negligence, is void on public policy grounds regardless if brought under tort or contract theory. 765 ILCS 705/1; Economy Mechanical Industries Inc v T J Higgins Co, 294 Ill App 3d 150, 689 NE2d 199, 228 Ill Dec 327 (1st D 1997). Although ground leases typically run from 50 to 99 years, shorter lease terms of 10-25 years have been successfully negotiated. Citizens National Bank of Downers Grove v Mormon, 78 Ill App 3d 1037, 398 NE2d 49, 34 Ill Dec 374 (1st D 1979). Financing is harder to obtain, however, for leases that have terms of fewer than 50 years.

As mentioned above, there is no typical or traditional form of ground lease instrument. The inclusion or exclusion of specific lease provisions ultimately depends on the needs of the transaction and the negotiations by the parties to the document. A commercial ground lease instrument should always be drafted with the needs of actual or potential lenders in mind. At some point the lessee will probably use the property as security for a loan, for example if intending to make improvements to the property. The opinion of the lender is so important that, if possible, the lender should participate in the lease negotiation process or approve the form of the lease before it is executed.

Guidelines and sample ground lease instruments are available on the websites of many lending institutions, organizations such as the American Land Title Association (ALTA), and in form books. For an example of a ground lease for a condominium project, see Illinois Forms, § 7:46 (2000).

Financing a Ground Lease

Many competing interests must be balanced to finance a ground lease: the needs of the owner-lessor, the owner-lessor's lender, the tenant and the leasehold lender. As mentioned above, if agreed, the leasehold lender should participate in the lease negotiation to ensure that its needs are met. In reality, the leasehold lender is often presented with an executed ground lease and is forced to try to negotiate changes and amendments. Eugene A DiPrinzio, Leasehold Financing and Mortgagee Protections, Probate & Property (July/August 2000).

There are three important lender concerns: (1) the status of the title to the fee underlying the ground lease; (2) that ground leasing is permitted on the property; and (3) determining the rights that the owner's lender might have in relation to the tenants. The lender's primary goal is to secure payment in the event of default or termination of the ground lease. Id. The leasehold lender "will usually insist on subordination of the ground lease to the leasehold mortgage." Id.

An extreme example of the results that can arise because of the failure of a leasehold lender to insist on a minimum amount of protection in the ground lease is a California case, Glendale Federal Bank v Hadden, 73 Cal App 4th 1150 (Cal App Ct, 1999). In Hadden, the leasehold mortgagee did not negotiate a right to cure a tenant's default in the ground lease. The tenant defaulted and the landlord terminated the lease and failed to join the leasehold lender in his unlawful detainer action. The lender claimed that it maintained interest in the terminated leasehold. The court ruled in favor of the landlord and the lender appealed. On appeal, the court held that the mortgagee was not an indispensable party to the unlawful detainer action. The court stated that the mortgagee could have avoided this result by protecting itself against termination of the lease with an agreement with the landlord or an amendment to the lease.

If a ground lease is already negotiated and executed, the lender usually will require a collateral agreement or a collateral assignment of the ground lease to provide certain minimal protections to the lender in case of a default under the lease. These protections may include "the lender's right to cure any tenant default under the ground lease, appropriate notice provisions, exculpation of the lender from liability to the landlord and the exercise of the lender's possessory rights." DiPrinzio, Probate & Property (July/August 2000). Additional protections may be required if the collateral includes items other than real estate interests, such as personal property or equipment. Id.

Title Insurance on a Ground Lease

The majority of leasehold lenders do not require title insurance as a condition for making the loan. However, many of the same reasons for acquiring title insurance for a fee interest carry over to a leasehold interest and make title insurance a worthwhile investment for lessees.

"A title search, and the subsequent issuance of a policy, offers answers to as well as insurance against questions that are important to someone contemplating a lease of real property:

1. Is the landlord named in the lease the true owner of the premises?
2. Is the consent of a mortgagee needed to lease the premises?
3. Are there any covenants or restrictions of record that prohibit or limit the tenant's intended use, such as might be found in prior leases?
4. Will the tenant's possession of the premises be at risk due to foreclosure of a mortgage?
5. Who are necessary parties to nondisturbance agreements?
6. Are the leased premises subject to any easements or restrictions that may limit development or use of the leased premises?"

Matthew J Cholewa, Leasehold Policies: Title Insurance's Neglected Child, ALTA Title News (March/April 1999).

Answers to the above questions will eliminate many of the risks that otherwise would be overlooked until after the agreement and signing of the lease when the leasehold lender makes an investigation into the property and decides whether to approve the financing. Title insurance will provide these answers in advance and provide additional protection for the leasehold lender.

The leasehold policy will contain all of the same Insuring Provisions, Exclusions from Coverage, and Conditions and Stipulations that are contained in a fee owner's title insurance policy but there are two notable additions. A leasehold policy redefines the value of the insured property and adds several items of loss that are not found in a fee owner's policy. The value of a leasehold estate is computed as the difference between the fair market value (undiminished by claimed title defects) and the rent reserved to the lease, all brought to present value. The leasehold is valued at the time of loss, not at the time of entering into the lease. Second, a leasehold estate will include the following items of loss in addition to the lost value of the leasehold estate:

1. The cost of removing, relocating, and repairing the insured's personal property within a 25 mile radius;
2. Rent or use and occupancy payments that the insured may be obligated to pay a party having paramount title to that of the landlord;
3. Post-eviction rent that the insured may be obligated to continue to pay the landlord for the land from which the insured has been evicted;
4. Fair market value of the insured's interest in any subleases; and
5. Damages that the insured may be obligated to pay a sublessee for breach of a sublease.

Coverage of these costs resulting from an unlawful termination of the lease can be comforting to the leasehold lender as well as to the terminated tenant.

Conclusion

Ground leases provide a long term and often less costly alternative to ownership; however the extent of the benefits directly stems from well-planned and well-executed negotiations between all of the parties involved. One of the major benefits of a ground lease is its flexibility in meeting the needs and requirements of each leasing situation. Just as in a mortgage for a fee interest, the interests of leasehold lenders must be taken into consideration in the planning and drafting of the lease instrument. Lender's counsel, just as lessor and lessee's counsel, must go into negotiations knowledgeable of which needs must be protected above others. Finally, having a title insurance policy on the leasehold proves to be beneficial to the prospective ground lease tenant as well as for a potential lender. The tenant now can enter into a long-term relationship with better security and knowledge about the status of the property, and the lender has a large portion of the background research for its financing decision made without additional expense and hassle.

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