For Tenants, Ground Leases are Akin to Purchases

Guest columnist Dina Tecimer, partner at Manatt, Phelps & Phillips, explains both the motivations and the viewpoints of tenants and landlords entering into a ground lease.

Dina Tecimer, partner, Manatt, Phelps & Phillips

When representing a tenant, entering into a long-term ground lease should be viewed as a purchase of the property.  In order to understand why, it is important to clarify the motivation of the parties in entering into a long-term ground lease in the first place. From the landlord’s viewpoint, frequently ground leases are used where the land is unimproved and the tenant will construct, at the tenant’s cost, a building which may be used by the tenant itself or later subleased to smaller space tenants.  The landlord has a reversionary interest in the buildings such that the buildings are returned to the landlord at the end of the lease term.

Therefore, in addition to the income stream to which the landlord is entitled during the term of the lease (rent), the landlord cares about the condition of the buildings which will revert to the landlord at the end of the lease term.  Finally, the landlord is often interested in controlling the use of the property during the lease term in order to maintain complimentary, non-competitive uses that will generate not only ground lease rent for the landlord, but also business revenue for the adjacent commercial property.

From a tenant’s point of view, the right to use the land for up to 99 years allows for payment of the “purchase price” over time, or ground rent.  Construction of buildings on the land creates a separate ownership interest in the tenant.  Importantly, this ownership interest is financeable by a third-party lender given the right terms in the ground lease.  Further, the buildings can be depreciated over time, providing tax incentives to the tenant as well.  Finally, the right to use adjacent property owned by the landlord, either for underground infrastructure, parking and/or access, frequently provides a financial benefit onto the ground tenant and its commercial subtenants.

Just as in a purchase of real estate where a buyer is concerned that the seller has legal title to the property, a tenant entering into a ground lease should review the title carefully to determine that the person who is shown by the public records to be the owner, is, in fact, the landlord under the ground lease.  Buyers rely on title insurance and vesting deeds in order to buy property.  Likewise, a tenant entering into a long term ground lease should obtain a leasehold title insurance policy upon consummation of the lease transaction.

Further, a real estate buyer always would be concerned about the nature of title; whether there are any covenants, liens, easements, mortgages or restrictions that may affect the tenant’s use of the property. Importantly, the existence of a mortgage recorded against the fee estate owned by the landlord is a critical fact which the tenant should determine prior to entering into the ground lease.  Either the landlord must pay off the fee mortgage (which is unlikely) or the lender must agree to give the tenant a non-disturbance agreement which basically provides that a foreclosure of the fee mortgage will not wipe out or terminate the ground lease.

Once the ground lease is consummated, the tenant should insist that a memorandum of ground lease is recorded in order to give notice to any future lenders that there is a leasehold estate granted to the tenant.  Finally, deed restrictions used by the landlord to control usage of the property by the tenant and its ultimate condition should be reviewed carefully to confirm that the restrictions do not overly burden the tenants’ intended use or development.  Just as the purchase is contingent upon the purchaser’s approval of those items, so should the consummation of the ground lease be contingent on those items as well.

Dina Tecimer is a partner in Manatt, Phelps & Phillips’ Los Angeles office and a member of the real estate practice group. She has extensive experience in providing general real estate advice to a variety of clients, from major developers to healthcare providers. Dina regularly represents industrial, office, commercial and multifamily apartment developers, landlords, tenants, corporate end users, high-net-worth individuals, entertainment companies, oil refineries, as well as hospitals and hospital affiliates.