What’s the Rent?

Don’t let the term “ground lease” fool you. Negotiations for this kind of contract necessitate a different approach than does a lease for regular space, requiring crucial considerations. Otherwise, the parties involved could find themselves involved in unnecessary litigation.By Lawrence Teplin & Heather SternWhen it comes to typical leases for space, landlords and tenants can generally draw on predictions of fundamentals in order to develop reasonable terms. A similar approach to ground leases, however, would require predicting rents decades in advance. Thus, parties to a long-term ground lease must take a different route.That path usually begins with an agreement to a process for subsequent rental rate adjustments. Settling on the process, though, requires the negotiation of details, which, if not addressed, could lead to unfair results, however unintended, and even unnecessary litigation.A typical process for future rent adjustments requires one or more appraisers to solve for a certain value as of a specified date of value—the 10-year anniversary of the commencement date, for instance—and then describes how that value will be applied to adjust the rental rate. The lease language should contain all the information the appraiser needs in order to establish an opinion of value.The upfront, negotiated agreement on what to value forms the critical starting point. Among elements crucial to the initial negotiations:What is to be valued? The land? The land as improved? With the improvements depreciated?What is the test for value? Is it the use specified in the lease? Is it the highest and best use?What method of appraisal, if any, must the appraiser follow? Comparable rentals? Return on investment? Residual value?What is the date of value?What is the rate to be used? Fixed for the term? Based on LIBOR? Prime?What are the dates for valuation? Five years? 10? 15?Is there an alternative calculation? If so, should it be a percentage of value or the U.S. Consumer Price Index increase—or the highest of either?Is there a floor or a cap?A failure to address these issues in the initial negotiations and to set them forth in the lease can result in unforeseen economic consequences. In one example, when the time came to readjust the ground-rental rates for the land under a San Francisco movie theater, the landlord claimed that the rental value should be based on the landlord’s highest and best use—in this case, high-end retail or office. The tenant, though, claimed that the value should derive from the land’s use under the lease: as a movie theater. The value difference—and thus the disparate rental rates from the two appraisals—was enormous. In this case, the court agreed with the tenant, basing its decision on the particular language used in the lease.So Who Applies the Price Tag?The next concern is what appraiser will be appointed to render a valuation finding. The parties in a ground lease can certainly agree to litigate the value before an arbitrator or court, but most parties prefer to hire an appraiser or panel of appraisers, usually empowering them under the lease to enter a determination of value that is binding on all parties.The prospective tenant and landlord also need to address the appraisal method used. In one option, known as “baseball valuation” because it mimics the arbitration between players and teams, each party selects an appraiser that arrives at a reasoned, written conclusion of value. The two appraisers mutually agree on the appointment of a third, neutral appraiser that makes a binding selection as to which of the two valuations most closely approximates the true value.The “appraiser average method” also calls for two separate appraisals. If the two appraisers are then unable to agree on a determination of fair market rent, together they must pick a third appraiser to conduct yet another appraisal. Then, a majority of the three must agree on fair market rent. If they still cannot agree, the average of the three is binding on the parties. A variation allows the parties, before averaging the results, to disregard any appraisal that varies from the middle valuation by more than 25 percent.Still another option grants the landlord the power to unilaterally adjust the rent after engaging an appraiser that meets certain qualifications to determine fair market value. If the tenant disagrees, they can demand arbitration within a specified time period: The parties employ either one of the appraisal methods described above or standard arbitration, in which an arbitrator—usually a judge or real estate lawyer—hears testimony and argument and then renders findings of fact and conclusions of law that are binding on the parties.The lease should address how the parties will appoint an appraiser or appraisers and set forth the parties’ agreement on at minimum the following issues:How many appraisers will the parties appoint?What qualifications, if any, must the appraiser(s) possess (Member of the Appraisal Institute, for example)?What party will appoint the appraiser(s)? If there are multiple tenants, for example,will one tenant act on behalf of the others?What party will pay for the services of the appraiser(s)?What parties are bound by the determination of value?Because many of these factors depend on the type of property being appraised and the type of appraisal that would best serve the parties’ interests, counsel for the landlord and tenant may each find it worthwhile to engage an appraiser to assist in drafting and negotiating these key lease terms.By following these principles, a landlord and tenant can establish a fair process that will help both achieve their economic objectives, avoid lease disputes and preserve the long-term viability of their relationship.Lawrence Teplin is a litigation partner and Heather Stern is a litigation associate in real estate law firm Cox Castle & Nicholson L.L.P.