Chapter § 33.3 ISSUES UNIQUE TO GROUND LEASES

• Jurisdiction: Oregon

§ 33.3 ISSUES UNIQUE TO GROUND LEASES

§ 33.3-1 Due Diligence

Given the long-term nature of a ground lease and the fact that improvements will likely be constructed on the leased land, a tenant entering into a ground lease is strongly encouraged to conduct the same types of due diligence it would conduct were it purchasing the land (e.g., environmental assessment, boundary-line and topographical survey, soil testing, utilities availability, title review, entitlements).

To protect the time and money the tenant will spend on due diligence, the tenant should consider entering into a ground lease with an early termination right if the tenant is not satisfied with the results of its due diligence. Otherwise, the tenant will have to conduct its due diligence before entering into the ground lease and before it has a binding agreement with the landlord, which means the time and money the tenant spends on due diligence will be lost if the parties are not able to enter into a ground lease. If the ground lease includes the early termination right, the tenant may want to negotiate for reduced or no rent, real estate taxes, or other payments until the tenant's early termination right expires or is waived by the tenant.

The landlord and tenant could enter into an option to lease the premises in lieu of entering into a ground lease with an early termination right. This would save the time and expense of negotiating a ground lease should the tenant elect not to exercise the lease option based on the results of its due diligence. The landlord, however, is obligated to enter into a ground lease if the tenant exercises the lease option.

§ 33.3-2 Leasehold Financing

Most tenants will need to finance a portion of the cost of constructing improvements on the premises. Therefore, the ground lease must allow the tenant to subject its interest in the ground lease and the improvements constructed on the premises to the lien of a leasehold mortgage. The ground lease must also be financeable, meaning that (1) the ground lease is a subordinated ground lease (see § 33.2-3(e)), or (2) the ground lease includes terms and provisions intended to protect the lender from risks that could arise because the tenant has only a leasehold interest in the premises.

It is essential that the tenant either involve its lender in the negotiation of the ground lease, or become intimately familiar with current underwriting standards applicable to leasehold mortgages before negotiating the terms of the ground lease.

§ 33.3-3 Premises

As mentioned in § 33.1, a ground lease always involves the lease of land (although improvements are sometimes included). The enforce-ability of the ground lease depends in part on an unambiguous description of the premises. See High v. Davis, 283 Or 315, 326-30, 584 P2d 725 (1978). This requirement is generally satisfied by attaching the legal description of the land to the ground lease to identify the premises. A legal description of the premises is also required to record a memorandum of ground lease in the local county clerk's office. ORS 93.710(3)(a)(C).

§ 33.3-4 Term

Ground leases generally have a long initial term, such as 25 or 50 years, but the term is often as long as 99 years or more for a financing ground lease. The long initial term allows sufficient time for the tenant to recover the economic value of the improvements and protect the interests of the lender securing the loan used to construct the improvements with the tenant's interest in the ground lease.

§ 33.3-5 Rent

In a ground lease, rent is typically payable on a fixed schedule with increases at certain points throughout the lease term. While the tenant would like to have rent fixed for the entire term, akin to seller financing in a land sale contract, the landlord would like to include mark-to-market rent escalations (which are often tied to the consumer price index or fair market value calculations) to make sure that rent payments keep up with inflation.

If rent is adjusted periodically, the landlord may want to add a floor to each rent adjustment (such as: rent will not decrease), and the tenant may want to add a ceiling (such as: rent will not increase by more than five percent), to prevent unexpectedly large swings in rent.

If rent is to be adjusted based on a change in appraised value, the parties need to consider the following: (1) whether the appraisal will be of the land or the land and improvements; (2) whether the property will be appraised based on its current use, permitted uses under applicable zoning regulations, or highest and best use; and (3) whether the appraisal will take into account the ground lease as an encumbrance on the premises. In a typical ground lease (in which the tenant pays for the improvements), the appraisal is of the land only based on its current or permitted use (not highest and best use) and does not take into account the ground lease as an encumbrance.

Two cautions if rent is not fixed throughout the lease term. First, if the mechanism used for determining future rent increases makes it difficult to estimate the amount of future rent increases, the tenant's lender is likely to take a conservative approach when estimating future rent increases and reduce the tenant's borrowing ability accordingly. Second, Internal Revenue Code (IRC) section 467 may apply to the landlord if the landlord is deferring rent to reduce its income taxes. For a detailed analysis of the rules for IRC section 467, see Phillip Holthouse & Lisa Starczewski, Real Estate Leases F-1 to F-8 (2014), available at www.bna.com/real-estate-leases-p7612/ >.

§ 33.3-6 Property Taxes

Since a ground lease is typically intended to be an absolute net lease (see § 33.1), the tenant generally pays property taxes on the land and on any improvements constructed on the land by the tenant. But because property taxes have a superpriority lien that could result in the landlord losing its fee interest in the land by a tax foreclosure, the landlord needs to make sure that the tenant pays the property taxes on a timely...