Ground Lease Tug of War

Unlike a building lease, even a triple net building lease, in which a landlord leases space in a building it owns to the tenant, a ground landlord typically leases only a leasehold estate and exclusive possession of land owned by the landlord, and the tenant is required to construct a building for its use on the land.

Jurisdictional Differences

Absent express language, different jurisdictions have interpreted and determined ownership of ground lease improvements in varying ways. California statutorily addresses ownership of improvements and, with some exceptions, grants landowners ownership over all property affixed to their land, unless there is an agreement in place preventing a party from removing the property. CAL. CIV. CODE ' 1013 (2013). The statute itself essentially allows parties to contract around the statutory default. For example, in County of Ventura v. Channel Islands Marina, Inc., 159 Cal. App. 4th 615 (Cal. App. 2008), the court granted ownership of improvements made by the lessee to the County/land owner, explaining that “[t]he rights and duties of the parties spring from the lease[,]” so “ [i]n the absence of an agreement to the contrary[,]“California Civil Code Section 1013 controls and grants ownership of improvements to the landowner. 159 Cal. App. 4th at 625.

Other states may not have statutes that address ownership of tenant improvements or may not follow a presumption in favor of landlord ownership. For example, in Wycoff v. Gavriloff Motors, Inc., the Michigan Supreme Court stated:

It is a general rule that buildings erected on the lands of another under leave or license so to do, in furtherance of the purposes of the permissive use and occupation, remain personal property and may be removed by the lessee or licensee at any time during his occupancy, or, if such occupancy or right of occupancy terminate on a contingency, within a reasonable time thereafter.

107 N.W.2d 820, 824 (Mich. 1961) (quoting McClintic-Marshall Co. v. Ford Motor Co., 236 N.W. 792, 796 (Mich. 1931)).

In Wycoff, the tenant did not have the express right to remove improvements that it constructed on the premises. The court held that the tenant was nevertheless entitled to remove the improvements and maintain ownership of them during the term of the lease because the tenant's construction of a garage and an office were constructed in furtherance of the lease purpose. This is consistent with another Michigan case holding that a tenant had a right to remove improvements even in the absence of a specific right in the lease to do so, based on the court's determination that the buildings erected by the tenant were in furtherance of the purposes for which the premises were leased. Hayward v. School Dist., 102 N.W. 999, 1000 (Mich. 1905).

If the parties do not expressly address ownership of improvements, Florida courts consider a number of factors in the lease, and give deference to the right of the parties to determine ownership contractually. In Broward County v. Eller Drive LTD Partnership, 939 So. 2d 130, 134 (Fla. Dist. Ct. App. 2006), the Florida Court of Appeals held that the tenant owned the building which it had constructed under a ground lease during the term, due to its “sufficient dominion over the building,” which included the tenant's rights to lease space of the building to other subtenants, rent abatement upon a condemnation, and a statement that ownership of the improvements would vest in the Landlord at the end of the term of the lease.

In First National Bank of Kansas City v. Nee, 190 E.2d 61 (8th Cir. 1951), a property owner in Kansas City, MO, entered into a long-term ground lease that gave the lessee the right to raze an existing building and erect a new office building. The lease provided that:

The lessee shall have the right to demolish and remove in whole or in part, any building or improvement now or hereafter erected on the leased premises, only for the purpose of remodeling, altering and/or repairing the same so as to be fireproof and as valuable as the building or buildings to be constructed by the lessee as herein provided, or to replace [the] same with new [fireproof] buildings and improvements to be [forthwith] constructed as herein provided.

The lease included a surrender provision that required the tenant to surrender possession of the premises and all building and improvements thereon to lessor. The U.S. Court of Appeals for the Eighth Circuit, applying Missouri law, held that, absent a provision stating otherwise, title to improvements constructed by a tenant vests upon construction in the owner of the land, unless the lease authorizes the tenant to remove such improvements from the premises during the term of the lease.

In National Cold Storage Co. v. Boyland, 16 A.2d 267 (N.Y. App. Div. 1962), a ground lessee leasing from the Port Authority of New York claimed that because it had no right to remove the leased buildings, such tenant was not the absolute owner, and therefore was not liable for the taxes assessed against the buildings. The New York Appellate Division, disagreed and held that the tenant must pay the taxes as a result of such tenant's ownership of the buildings. The court in dicta stated that the right of removal by a tenant was a significant index of ownership where the agreement of the parties was not expressly stated, but that it was not decisive of ownership.

Illinois case law regarding the ownership of ground lease improvements is limited, but appears to indicate that a court will give deference to ownership expressly provided for in a lease only if it is strongly supported by the facts of the case. In Coles-Cumberland Professional Development Corp. v. Department of Revenue, 672 N.E.2d 391 (Ill. App. Ct. 1996), the court did not consider the tax-exempt lessee to have ownership of the improvements it made to the land owned by a for-profit lessor for tax purposes despite the lessee's unrestricted right to build and own improvements and to remove them. According to the Appellate Court of Illinois, such rights of the lessee were insufficient “incidents of ownership” on the tenant's part.

Instead, the court focused on the fact that there was no testimony that the improvements made to the land, a building and parking lot, could be removed at all despite the tenant's express right to remove them. Furthermore, the court viewed the absence of a provision requiring the landlord to pay for any improvements on the land essentially to indicate that “construction and maintenance of a building on landlord property is part of the rent” and ownership of the improvements remained with landlord.

Note, however, that the court in Cole Hospital, Inc. v. Champaign County Board of Review, 446 N.E.2d 562, 565 (Ill. App. Ct. 1983), reached the opposite conclusion of Coles-Cumberland in finding that a lessee hospital proved “sufficient incidents of ownership” in the leased property so as to qualify the property for a tax exemption the hospital sought. 446 N.E.2d 562, 565 (Ill. App. Ct. 1983). The court reasoned that “in Illinois the concept of 'ownership' is broader than the mere situs of legal title. ' [R]evenue collection is not concerned with refinements of title but with the realities of ownership, and although title is to be considered as one factor, it is not decisive. Control and the right to benefits of property are of far greater importance.”

In Cole Hospital, the lessee paid taxes, insurance, and maintenance costs of the property. It also had an absolute option to purchase the property on certain dates. Even though the lease prevented the lessee from making alterations without the lessor's consent and required the property be kept in good repair, the court determined the lessee had ownership over the property for tax purposes because it had adequate control over it. On a case-by-case basis, Illinois courts give credence to both “control and the right to benefits” carrying great weight with the lessee's right to destroy or alter the property being only one factor of many.

Necessity of Identifying the Owner of the Improvements

A common theme in the case law determining ownership of ground leasehold improvements is the importance of stating the parties' intent as to ownership. The requirement in a ground lease that the tenant construct specific improvements at its cost does not alone insure the tenant is the owner of such improvements. Instead, parties should specify the responsibility for, ownership of, and right to remove the building and improvements under the ground lease, which constitute among the most important provisions of the ground lease.

In drafting a ground lease, the parties should set forth: 1) the party that owns the improvements ' which will generally be the tenant, based on the tenant's payment for such improvements; 2) the date when title vests in the tenant ' whether immediately upon construction or installation or a later date; 3) the duration for such ownership throughout the term of the lease; 4) whether the tenant is entitled, at its discretion, to modify the building or improvements, and if so, whether such modifications are limited to those that enhance the value of the property or building overall; 5) whether, and the extent to which, the tenant may demolish improvements without the landlord's consent and whether the tenant is required to replace any removed improvements, including replacements of equal or greater value; 6) the condition in which the improvements must be surrendered and whether the tenant has any obligation to remove the improvements on the expiration of the lease; and 7) whether the landlord is required to pay the tenant for improvements at the expiration of the lease.

If the landlord anticipates residual value in the improvements at the end of the term or desires a specific operation throughout the term, the landlord may prohibit the tenant's removal of improvements without replacement obligations. Conversely, the landlord may prefer the removal of an obsolete or use-specific building by the tenant on the expiration of the lease.

Ancillary Lease Provisions

In conjunction with clearly stating in the lease ownership of the improvements, and rights and obligations for improvements, the ground lease should address issues ancillary to such ownership. The landlord and tenant should specify responsibility for repairs and reconstruction following casualty or property damage, and the entitlement to insurance proceeds following such damage; rights to condemnation awards, each party's role in eminent domain proceedings, and obligations for restoration; replacement of building systems and improvements, compliance with future regulations requiring alterations, and remedies and ownership of the building and improvements following a tenant default.

All such provisions should conform to the parties' expectations regarding ownership at the time of entering into the lease. Careful drafting in a ground lease of each party's rights to the improvements after construction will avoid future challenges of ownership.

Catherine Phillips is a member of Lewis, Rice & Fingersh, L.C., resident in its St. Louis office. She may be reached at [email protected]. Ms. Phillips acknowledges the contributions and assistance from Andrea Patton, Krista McCormack and Jie Ji.

Consider a hypothetical in which the “Landlord” leases certain land to the “Tenant” pursuant to a long-term ground lease. Landlord initially delivered the land to Tenant without any improvements, and Tenant constructed a warehouse/office building and surface parking lot on the land. For 15 years, Tenant operated its business on such parcel, but business has waned in the last few years.

“Developer” approaches Tenant, offering to assume the ground lease, pay Tenant a premium for the lease, remove the existing building and construct a parking structure for Developer's project on an adjacent parcel. Prior to Developer's commencement of demolition, Landlord notifies Developer that the building constructed by Tenant cannot be removed, at least not without Landlord's consent and payment to Landlord of the value of such building. The ground lease requires Tenant to construct the initial building at Tenant's cost, pay all real estate taxes, and insure and maintain the building.

The lease further allows Tenant to enlarge or modify the building, but there is no specific right to demolish the building and no requirement to remove improvements on the expiration of the lease term. The determination of whether Tenant or Developer may remove the existing building and either construct a new building or different improvements or leave it vacant may depend on where the property is located.

Unlike a building lease, even a triple net building lease, in which a landlord leases space in a building it owns to the tenant, a ground landlord typically leases only a leasehold estate and exclusive possession of land owned by the landlord, and the tenant is required to construct a building for its use on the land.

Jurisdictional Differences

Absent express language, different jurisdictions have interpreted and determined ownership of ground lease improvements in varying ways. California statutorily addresses ownership of improvements and, with some exceptions, grants landowners ownership over all property affixed to their land, unless there is an agreement in place preventing a party from removing the property. CAL. CIV. CODE ' 1013 (2013). The statute itself essentially allows parties to contract around the statutory default. For example, in County of Ventura v. Channel Islands Marina, Inc. , 159 Cal. App. 4th 615 (Cal. App. 2008), the court granted ownership of improvements made by the lessee to the County/land owner, explaining that “[t]he rights and duties of the parties spring from the lease[,]” so “ [i]n the absence of an agreement to the contrary[,]“California Civil Code Section 1013 controls and grants ownership of improvements to the landowner. 159 Cal. App. 4th at 625.

Other states may not have statutes that address ownership of tenant improvements or may not follow a presumption in favor of landlord ownership. For example, in Wycoff v. Gavriloff Motors, Inc., the Michigan Supreme Court stated:

It is a general rule that buildings erected on the lands of another under leave or license so to do, in furtherance of the purposes of the permissive use and occupation, remain personal property and may be removed by the lessee or licensee at any time during his occupancy, or, if such occupancy or right of occupancy terminate on a contingency, within a reasonable time thereafter.

107 N.W.2d 820, 824 (Mich. 1961) (quoting McClintic-Marshall Co. v. Ford Motor Co. , 236 N.W. 792, 796 (Mich. 1931)).

In Wycoff, the tenant did not have the express right to remove improvements that it constructed on the premises. The court held that the tenant was nevertheless entitled to remove the improvements and maintain ownership of them during the term of the lease because the tenant's construction of a garage and an office were constructed in furtherance of the lease purpose. This is consistent with another Michigan case holding that a tenant had a right to remove improvements even in the absence of a specific right in the lease to do so, based on the court's determination that the buildings erected by the tenant were in furtherance of the purposes for which the premises were leased. Hayward v. School Dist. , 102 N.W. 999, 1000 (Mich. 1905).

If the parties do not expressly address ownership of improvements, Florida courts consider a number of factors in the lease, and give deference to the right of the parties to determine ownership contractually. In Broward County v. Eller Drive LTD Partnership , 939 So. 2d 130, 134 (Fla. Dist. Ct. App. 2006), the Florida Court of Appeals held that the tenant owned the building which it had constructed under a ground lease during the term, due to its “sufficient dominion over the building,” which included the tenant's rights to lease space of the building to other subtenants, rent abatement upon a condemnation, and a statement that ownership of the improvements would vest in the Landlord at the end of the term of the lease.

In First National Bank of Kansas City v. Nee , 190 E.2d 61 (8th Cir. 1951), a property owner in Kansas City, MO, entered into a long-term ground lease that gave the lessee the right to raze an existing building and erect a new office building. The lease provided that:

The lessee shall have the right to demolish and remove in whole or in part, any building or improvement now or hereafter erected on the leased premises, only for the purpose of remodeling, altering and/or repairing the same so as to be fireproof and as valuable as the building or buildings to be constructed by the lessee as herein provided, or to replace [the] same with new [fireproof] buildings and improvements to be [forthwith] constructed as herein provided.

The lease included a surrender provision that required the tenant to surrender possession of the premises and all building and improvements thereon to lessor. The U.S. Court of Appeals for the Eighth Circuit, applying Missouri law, held that, absent a provision stating otherwise, title to improvements constructed by a tenant vests upon construction in the owner of the land, unless the lease authorizes the tenant to remove such improvements from the premises during the term of the lease.

In National Cold Storage Co. v. Boyland , 16 A.2d 267 (N.Y. App. Div. 1962), a ground lessee leasing from the Port Authority of New York claimed that because it had no right to remove the leased buildings, such tenant was not the absolute owner, and therefore was not liable for the taxes assessed against the buildings. The New York Appellate Division, disagreed and held that the tenant must pay the taxes as a result of such tenant's ownership of the buildings. The court in dicta stated that the right of removal by a tenant was a significant index of ownership where the agreement of the parties was not expressly stated, but that it was not decisive of ownership.

Illinois case law regarding the ownership of ground lease improvements is limited, but appears to indicate that a court will give deference to ownership expressly provided for in a lease only if it is strongly supported by the facts of the case. In Coles-Cumberland Professional Development Corp. v. Department of Revenue , 672 N.E.2d 391 (Ill. App. Ct. 1996), the court did not consider the tax-exempt lessee to have ownership of the improvements it made to the land owned by a for-profit lessor for tax purposes despite the lessee's unrestricted right to build and own improvements and to remove them. According to the Appellate Court of Illinois, such rights of the lessee were insufficient “incidents of ownership” on the tenant's part.

Instead, the court focused on the fact that there was no testimony that the improvements made to the land, a building and parking lot, could be removed at all despite the tenant's express right to remove them. Furthermore, the court viewed the absence of a provision requiring the landlord to pay for any improvements on the land essentially to indicate that “construction and maintenance of a building on landlord property is part of the rent” and ownership of the improvements remained with landlord.

Note, however, that the court in Cole Hospital, Inc. v. Champaign County Board of Review , 446 N.E.2d 562, 565 (Ill. App. Ct. 1983), reached the opposite conclusion of Coles-Cumberland in finding that a lessee hospital proved “sufficient incidents of ownership” in the leased property so as to qualify the property for a tax exemption the hospital sought. 446 N.E.2d 562, 565 (Ill. App. Ct. 1983). The court reasoned that “in Illinois the concept of 'ownership' is broader than the mere situs of legal title. ' [R]evenue collection is not concerned with refinements of title but with the realities of ownership, and although title is to be considered as one factor, it is not decisive. Control and the right to benefits of property are of far greater importance.”

In Cole Hospital, the lessee paid taxes, insurance, and maintenance costs of the property. It also had an absolute option to purchase the property on certain dates. Even though the lease prevented the lessee from making alterations without the lessor's consent and required the property be kept in good repair, the court determined the lessee had ownership over the property for tax purposes because it had adequate control over it. On a case-by-case basis, Illinois courts give credence to both “control and the right to benefits” carrying great weight with the lessee's right to destroy or alter the property being only one factor of many.

Necessity of Identifying the Owner of the Improvements

A common theme in the case law determining ownership of ground leasehold improvements is the importance of stating the parties' intent as to ownership. The requirement in a ground lease that the tenant construct specific improvements at its cost does not alone insure the tenant is the owner of such improvements. Instead, parties should specify the responsibility for, ownership of, and right to remove the building and improvements under the ground lease, which constitute among the most important provisions of the ground lease.

In drafting a ground lease, the parties should set forth: 1) the party that owns the improvements ' which will generally be the tenant, based on the tenant's payment for such improvements; 2) the date when title vests in the tenant ' whether immediately upon construction or installation or a later date; 3) the duration for such ownership throughout the term of the lease; 4) whether the tenant is entitled, at its discretion, to modify the building or improvements, and if so, whether such modifications are limited to those that enhance the value of the property or building overall; 5) whether, and the extent to which, the tenant may demolish improvements without the landlord's consent and whether the tenant is required to replace any removed improvements, including replacements of equal or greater value; 6) the condition in which the improvements must be surrendered and whether the tenant has any obligation to remove the improvements on the expiration of the lease; and 7) whether the landlord is required to pay the tenant for improvements at the expiration of the lease.

If the landlord anticipates residual value in the improvements at the end of the term or desires a specific operation throughout the term, the landlord may prohibit the tenant's removal of improvements without replacement obligations. Conversely, the landlord may prefer the removal of an obsolete or use-specific building by the tenant on the expiration of the lease.

Ancillary Lease Provisions

In conjunction with clearly stating in the lease ownership of the improvements, and rights and obligations for improvements, the ground lease should address issues ancillary to such ownership. The landlord and tenant should specify responsibility for repairs and reconstruction following casualty or property damage, and the entitlement to insurance proceeds following such damage; rights to condemnation awards, each party's role in eminent domain proceedings, and obligations for restoration; replacement of building systems and improvements, compliance with future regulations requiring alterations, and remedies and ownership of the building and improvements following a tenant default.

All such provisions should conform to the parties' expectations regarding ownership at the time of entering into the lease. Careful drafting in a ground lease of each party's rights to the improvements after construction will avoid future challenges of ownership.

Catherine Phillips is a member of Lewis, Rice & Fingersh, L.C., resident in its St. Louis office. She may be reached at [email protected]. Ms. Phillips acknowledges the contributions and assistance from Andrea Patton, Krista McCormack and Jie Ji.