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Peter E. Fisch and Mitchell L. Berg Peter E. Fisch and Mitchell L. Berg

Due to the long-term nature of ground leases, the rent that was initially negotiated between the parties may lag behind market ground rents after a period of time, even with fixed or consumer price index (CPI)-based increases.  As a result, ground lessors often insist on rent reset clauses on a periodic basis so that the ground rent captures some of the increase in land values.  While there are many variations, a “typical” rent reset clause provides that at predetermined times during the term of the lease (e.g., every 20 or 25 years), the rent will be increased to an amount equal to a percentage (typically 5-6%) of the then fair market value of the land (usually determined as if free and clear of liens and encumbrances, including the lease, and vacant and exclusive of the improvements).  The purpose behind rent reset clauses is simple—to capture any change in the fair market value (and fair market rental value) of the leased property.  However, the application of rent reset clauses in practice is anything but simple, and the consequences of such clauses can be significant. While landlords favor rent reset clauses because they believe fixed percentage or CPI adjustments rarely keep pace with increases in the value of real property over the long run, tenants and their lenders[1] are increasingly objecting to typical rent reset clauses in ground leases because of the risk and uncertainty that they can pose.  While the parties would ideally negotiate to reach settlement on the fair market value of the leased property, and therefore, the new rent, this often does not happen in practice.  When the parties are unable to agree on the new rent, an arbitration or litigation usually ensues and the parties become subject to the unpredictability of a third-party decision.  The consequences of a rent reset can be dire, resulting in the tenant not being able to finance its interest in the property[2] or even losing its lease.[3]

Interpretation and Implementation

One set of complications in the application of typical ground rent reset clauses relates to the interpretation of such clauses.  Some considerations may not have been addressed in the lease provisions while others, even though addressed, may not have been thought through or are otherwise unclear, leading to disputes between the parties. For example, the parties are not always explicit as to just what is being valued.  Is it just the land, or the land with the improvements that the tenant constructs on the land?  If it is just the land, should it be valued vacant and unencumbered, as if the lease did not exist, or should the lease be somehow taken into account?  If the lease makes clear that the leased property is to be valued unencumbered by the lease, then an appraiser will likely value the land assuming it will be used for its unrestricted “highest and best use,” which can result in a large increase in the rent payable for the rent reset period at issue since the highest and best use is not always consistent with what has actually been constructed on the land and the use and other restrictions in the lease.  However, note that unless the parties have explicitly provided that the land is to be valued unencumbered by the lease (or words of similar effect),  a court will likely determine that the land is to be valued as encumbered by the lease.[4]  This is evident in several New York court rulings, including in United Equities v. Mardordic Realty,[5]  936 Second Avenue L.P. v. Second Corporate Development Co., Inc.,[6] and Plaza Hotel Associates v. Wellington Associates, Inc.[7] If the parties decide that the fair market value of the leased property is to be determined as encumbered by the lease (or do not provide for the contrary), the parties should also carefully consider what terms of the lease should matter for purposes of valuing the property.  For example, should only the use provisions of the ground lease matter, or should the remaining term of the ground lease (including rights to extend or renew), purchase options, preemptive rights (such as rights of first refusal) and other restrictions or requirements (e.g., that the improvements cannot exceed a certain size) in the ground lease also be taken into account? Beyond the considerations described above, there are additional issues that may not have been considered during the lease negotiations and may only be brought to light when the rent reset period is imminent.  Some examples are:

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