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<b><i>In the Spotlight: </i></b>Navigating the Long-Term Ground Lease/Turnkey Sublease Transaction

By Richard N. Steiner
July 02, 2015

The fact is, sometimes land is simply not for sale. For many reasons ' ranging from local custom to estate planning to tax considerations ' the most desirable real property is often available only through long-term ground leases and is usually developed and subleased to retail tenants. The long-term ground lease turnkey sublease transaction (referred to in this article simply as the “Turnkey Sublease”) is thus a much-used device.

At first glance, the structure seems simple enough: The fee owner leases vacant land to the developer, who builds a store and subleases it to a retail subtenant. But deeper examination reveals complexities: 1) multiple lease negotiations must take place in close synchronization; 2) there are likely to be multiple lenders involved; and 3) both the fee owner and the subtenant need to be protected in the event that the developer goes belly-up.

The Turnkey Sublease structure brings together multiple parties with vastly different deal perspectives. The fee owner seeks protection of its ground rent income, as well as minimal risk and no obligations. The developer intends to pass through its ground lease obligations to its subtenant(s), receiving its profit (the building rent) with minimal risk. The sublessee seeks assurance that the ownership structure up the chain of title will have no impact on its rights and remedies. Lenders seek to fully preserve the value of their collateral and require all the standard mortgagee rights and remedies.

Balancing these various interests in the Turnkey Sublease is difficult ' but not impossible. Counsel for all parties need to work together to ensure that the transaction, taken as a whole, achieves this balance. In that regard, this article focuses on: 1) the proper structure of the chain of title; and 2) sensible alignment of ground lease and sublease terms.

Structuring the Turnkey Sublease Transaction

Chain of Title

A successful Turnkey Sublease transaction requires that each party enters the chain of title in the proper order, and while it appears simple on its face, several competing interests among the parties require thoughtful consideration and appropriate documentation. To ensure that the ground lease continues in the event of a mortgage default by the fee owner, the fee mortgagee and ground lessee will typically require a Subordination Non-Disturbance Agreement (the Ground Lease SNDA), and the retail subtenant and ground lessee's mortgagee will require similar protection in a separate SNDA (the Sublease SNDA). Finally, the prudent subtenant will require a Consent and Non-Disturbance Agreement (CNDA), discussed herein in detail, to ensure protection in the event the ground lease is terminated by default of the ground lessee.

Taking all interests into consideration, the chain of title should adhere to the following paradigm (in order of recording from first-to-last): 1) fee owner's vesting deed; 2) fee owner's mortgage; 3) memorandum of ground lease; 4) Ground Lease SNDA; 5) ground lessee's mortgage; 6) memorandum of sublease; 7) Sublease SNDA; and 8) CNDA.

The CNDA

A CNDA is an agreement among the subtenant, the ground lessee and the fee owner, providing for a continuing leasehold relationship between the subtenant and the fee owner in the event the ground lease is terminated due to the ground lessee's default. CNDAs typically provide that in the event of termination of the ground lease due to the default of the sublessor, then either: 1) the subtenant will step into the shoes of the sublessor (the ground lease becomes the operative document); or 2) the fee owner will step into the shoes of the sublessor (the sublease governs).

Which of these two CNDA options is used in any particular deal is usually the subject of negotiation between the fee owner and subtenant. At stake in the negotiation is receipt of the “windfall” represented by the value of the building constructed by the now-defunct ground lessee. Not surprisingly, all other things being equal, the subtenant typically prefers: 1) above (occupying a building for the price of ground rent) and the fee owner typically prefers; 2) above (receiving the sublease rent without having constructed the building).

The structure of the CNDA can also be dictated by other factors. For example, either the ground lease or the sublease may contain terms and conditions that one party or the other may be unwilling to assume (e.g., subtenant may not agree to assume ground lessee's indemnity obligations if they are more extensive than those set forth in the sublease). Or perhaps, the ground lease premises is larger than the sublease premises (e.g., the subleased premises are a part of a larger shopping center). In that event, the parties will usually prefer CNDA option (2), because termination of the ground lease affects multiple tenants in the shopping center, and the parties will generally prefer that the fee owner manage the entire center, and step into the landlord's position in each sublease.

Proper Alignment of Ground Lease Terms and Sublease Terms

By far, the most problematic issue with Turnkey Sublease deals is when the ground lease and sublease terms are incompatible. This usually occurs when the parties negotiating the ground lease fail to communicate with the parties negotiating the sublease, and vice versa. Timely and careful review of the ground lease and sublease terms to make sure they are aligned is critical to the success of any Turnkey Sublease transaction.

Consider the following hypothetical transaction among Joe Landowner (“Landowner”), Tom Developer (“Developer”) and Mike Retailer (“Retailer”). The proposed Turnkey Sublease deal was typical: Landowner and Developer will execute a long-term ground lease of an outparcel in Landowner's shopping center; Developer will construct Retailer's store, and sublease the outparcel and building to Retailer. Counsel for Developer and Retailer endure an excruciating 15-round sublease negotiation, arguing every point in fine detail. After negotiating the sublease to final form, counsel for Developer sends Retailer's counsel a copy of the ground lease between Landowner and Developer, which was executed four months earlier. Developer's counsel's e-mail to Retailer's counsel stresses the need to execute the sublease immediately, because the ground lease due diligence period expires in three days.

After reviewing the ground lease, Retailer's counsel requests that the parties schedule a conference call, because Retailer's counsel thinks critical amendments to the ground lease are needed. Neither Landowner nor Developer are willing to entertain a ground lease amendment, and as a result, Retailer walks away from the transaction. The following is a list of some of the issues raised by Retailer in its termination letter:

1. Term/Options. Retailer's management approved the transaction with a 25-year firm term and five-year extension options. While the length of both the sublease and ground lease term were correct, the commencement dates under the ground lease and sublease were not aligned. Specifically, the ground lease term was to commence on the date that Landowner delivered possession (of the ground) to Developer, while the sublease term was to commence on the date that Developer delivered possession (of the fully constructed store) to Retailer. Bringing this misalignment into sharp focus was the fact that, due to a lengthy underground storage tank and soil remediation process, Developer anticipated it would take four years to develop and construct the store. Retailer raised the concern that, during the four-year construction period, the ground lease term would be ticking away, and by the time Retailer's sublease commenced, there would be only 21 years of firm term left and a total remaining term of 46 years under the ground lease, rather than the 50 years of term expected.

2. Rent. The sublease was drafted with a bifurcated rent. Retailer agreed to pay the ground rent directly to Landowner, as and when due under the ground lease, and pay the remaining building rent to Developer. The ground lease provided for increases in the ground rent every five years of the ground lease term, a business term that was reviewed and approved by Retailer's management team. But due to the four-year construction period and the misaligned commencement dates, Retailer would now be obligated to cover the ground rent bump four years earlier than anticipated. Retailer was unwilling to accept such an early rent increase, and Developer was unwilling to cover the difference.

3. Permitted Use. Retailer is a men's clothing outfit with a constantly evolving product and service line. The sublease included a use clause, and the permitted use of the premises was “the operation of a store similar in nature to a majority of Retailer's other stores, offering such products and services as Retailer sells and offers in a majority of its other stores from time to time.” However, the use clause under the ground lease executed four months earlier said something entirely different. The permitted use under the ground lease was “the operation of a men's clothing store,” and further, the ground lease prohibited “the performance of hair cutting and styling services” at the Leased Premises.

As it turned out, just prior to executing the ground lease, Landowner had granted an exclusive use restriction to a hair salon in the center. At the time, neither Landowner nor Developer were aware that Retailer was rolling out a new “Men's Makeover” concept whereby customers receive haircuts, manicures and massages while purchasing entire new wardrobes (and drinking beer and watching sports). With the restriction on hair cutting and styling services in the ground lease, Retailer would be unable to implement the Men's Makeover concept.

While a bit extreme, this hypothetical illustrates the importance of coordinated negotiation of the ground lease and sublease. If Landowner, Developer and Retailer had all been fully informed, and afforded meaningful opportunity to comment upon both leases, all of the foregoing issues (and many others) could have been identified at a time when the parties, motivated to get a deal done, would be able to explore and negotiate creative solutions. For example, perhaps the misaligned commencement dates (and rent bumps) might have been resolved if the ground lease provided for the term to commence on the commencement date under the sublease, or alternatively, an additional four years of term might have been added to the 50-year term to address the anticipated four-year construction period. And, while it is perhaps understandable that Landowner and Developer were unaware of Retailer's Men's Makeover concept, a complete and timely discussion of use restrictions with Retailer would have opened the opportunity to resolve the permitted use issue as well. Perhaps, if Retailer's presence in the shopping center was important enough, Landowner may not have granted an exclusive use to a small shopping center tenant which conflicted with Retailer's operations.

Additional Sublease Protections

In addition to ordering the chain of title properly as described above, the well-drafted sublease will contain several additional provisions to preserve the subtenant's extension options and protect the subtenant in the event the fee owner files for bankruptcy.

Conclusion

In summary, the long-term ground lease/sublease transaction brings together many diverse and competing interests, and finding the right balance among them is difficult, but not impossible to achieve. The success of this deal type is dependent on: 1) properly structuring the chain of title with adequate protections for all parties, and 2) closely coordinated negotiation of the ground lease, sublease, SNDAs and CNDA.


Richard N. Steiner is a Director and Managing Counsel for Walgreen Co. In this role, Steiner counsels and directs employees with respect to all substantive legal matters relating to Walgreens' real estate law practice, and also engages in all aspects of real estate legal practice on behalf of the company.

The fact is, sometimes land is simply not for sale. For many reasons ' ranging from local custom to estate planning to tax considerations ' the most desirable real property is often available only through long-term ground leases and is usually developed and subleased to retail tenants. The long-term ground lease turnkey sublease transaction (referred to in this article simply as the “Turnkey Sublease”) is thus a much-used device.

At first glance, the structure seems simple enough: The fee owner leases vacant land to the developer, who builds a store and subleases it to a retail subtenant. But deeper examination reveals complexities: 1) multiple lease negotiations must take place in close synchronization; 2) there are likely to be multiple lenders involved; and 3) both the fee owner and the subtenant need to be protected in the event that the developer goes belly-up.

The Turnkey Sublease structure brings together multiple parties with vastly different deal perspectives. The fee owner seeks protection of its ground rent income, as well as minimal risk and no obligations. The developer intends to pass through its ground lease obligations to its subtenant(s), receiving its profit (the building rent) with minimal risk. The sublessee seeks assurance that the ownership structure up the chain of title will have no impact on its rights and remedies. Lenders seek to fully preserve the value of their collateral and require all the standard mortgagee rights and remedies.

Balancing these various interests in the Turnkey Sublease is difficult ' but not impossible. Counsel for all parties need to work together to ensure that the transaction, taken as a whole, achieves this balance. In that regard, this article focuses on: 1) the proper structure of the chain of title; and 2) sensible alignment of ground lease and sublease terms.

Structuring the Turnkey Sublease Transaction

Chain of Title

A successful Turnkey Sublease transaction requires that each party enters the chain of title in the proper order, and while it appears simple on its face, several competing interests among the parties require thoughtful consideration and appropriate documentation. To ensure that the ground lease continues in the event of a mortgage default by the fee owner, the fee mortgagee and ground lessee will typically require a Subordination Non-Disturbance Agreement (the Ground Lease SNDA), and the retail subtenant and ground lessee's mortgagee will require similar protection in a separate SNDA (the Sublease SNDA). Finally, the prudent subtenant will require a Consent and Non-Disturbance Agreement (CNDA), discussed herein in detail, to ensure protection in the event the ground lease is terminated by default of the ground lessee.

Taking all interests into consideration, the chain of title should adhere to the following paradigm (in order of recording from first-to-last): 1) fee owner's vesting deed; 2) fee owner's mortgage; 3) memorandum of ground lease; 4) Ground Lease SNDA; 5) ground lessee's mortgage; 6) memorandum of sublease; 7) Sublease SNDA; and 8) CNDA.

The CNDA

A CNDA is an agreement among the subtenant, the ground lessee and the fee owner, providing for a continuing leasehold relationship between the subtenant and the fee owner in the event the ground lease is terminated due to the ground lessee's default. CNDAs typically provide that in the event of termination of the ground lease due to the default of the sublessor, then either: 1) the subtenant will step into the shoes of the sublessor (the ground lease becomes the operative document); or 2) the fee owner will step into the shoes of the sublessor (the sublease governs).

Which of these two CNDA options is used in any particular deal is usually the subject of negotiation between the fee owner and subtenant. At stake in the negotiation is receipt of the “windfall” represented by the value of the building constructed by the now-defunct ground lessee. Not surprisingly, all other things being equal, the subtenant typically prefers: 1) above (occupying a building for the price of ground rent) and the fee owner typically prefers; 2) above (receiving the sublease rent without having constructed the building).

The structure of the CNDA can also be dictated by other factors. For example, either the ground lease or the sublease may contain terms and conditions that one party or the other may be unwilling to assume (e.g., subtenant may not agree to assume ground lessee's indemnity obligations if they are more extensive than those set forth in the sublease). Or perhaps, the ground lease premises is larger than the sublease premises (e.g., the subleased premises are a part of a larger shopping center). In that event, the parties will usually prefer CNDA option (2), because termination of the ground lease affects multiple tenants in the shopping center, and the parties will generally prefer that the fee owner manage the entire center, and step into the landlord's position in each sublease.

Proper Alignment of Ground Lease Terms and Sublease Terms

By far, the most problematic issue with Turnkey Sublease deals is when the ground lease and sublease terms are incompatible. This usually occurs when the parties negotiating the ground lease fail to communicate with the parties negotiating the sublease, and vice versa. Timely and careful review of the ground lease and sublease terms to make sure they are aligned is critical to the success of any Turnkey Sublease transaction.

Consider the following hypothetical transaction among Joe Landowner (“Landowner”), Tom Developer (“Developer”) and Mike Retailer (“Retailer”). The proposed Turnkey Sublease deal was typical: Landowner and Developer will execute a long-term ground lease of an outparcel in Landowner's shopping center; Developer will construct Retailer's store, and sublease the outparcel and building to Retailer. Counsel for Developer and Retailer endure an excruciating 15-round sublease negotiation, arguing every point in fine detail. After negotiating the sublease to final form, counsel for Developer sends Retailer's counsel a copy of the ground lease between Landowner and Developer, which was executed four months earlier. Developer's counsel's e-mail to Retailer's counsel stresses the need to execute the sublease immediately, because the ground lease due diligence period expires in three days.

After reviewing the ground lease, Retailer's counsel requests that the parties schedule a conference call, because Retailer's counsel thinks critical amendments to the ground lease are needed. Neither Landowner nor Developer are willing to entertain a ground lease amendment, and as a result, Retailer walks away from the transaction. The following is a list of some of the issues raised by Retailer in its termination letter:

1. Term/Options. Retailer's management approved the transaction with a 25-year firm term and five-year extension options. While the length of both the sublease and ground lease term were correct, the commencement dates under the ground lease and sublease were not aligned. Specifically, the ground lease term was to commence on the date that Landowner delivered possession (of the ground) to Developer, while the sublease term was to commence on the date that Developer delivered possession (of the fully constructed store) to Retailer. Bringing this misalignment into sharp focus was the fact that, due to a lengthy underground storage tank and soil remediation process, Developer anticipated it would take four years to develop and construct the store. Retailer raised the concern that, during the four-year construction period, the ground lease term would be ticking away, and by the time Retailer's sublease commenced, there would be only 21 years of firm term left and a total remaining term of 46 years under the ground lease, rather than the 50 years of term expected.

2. Rent. The sublease was drafted with a bifurcated rent. Retailer agreed to pay the ground rent directly to Landowner, as and when due under the ground lease, and pay the remaining building rent to Developer. The ground lease provided for increases in the ground rent every five years of the ground lease term, a business term that was reviewed and approved by Retailer's management team. But due to the four-year construction period and the misaligned commencement dates, Retailer would now be obligated to cover the ground rent bump four years earlier than anticipated. Retailer was unwilling to accept such an early rent increase, and Developer was unwilling to cover the difference.

3. Permitted Use. Retailer is a men's clothing outfit with a constantly evolving product and service line. The sublease included a use clause, and the permitted use of the premises was “the operation of a store similar in nature to a majority of Retailer's other stores, offering such products and services as Retailer sells and offers in a majority of its other stores from time to time.” However, the use clause under the ground lease executed four months earlier said something entirely different. The permitted use under the ground lease was “the operation of a men's clothing store,” and further, the ground lease prohibited “the performance of hair cutting and styling services” at the Leased Premises.

As it turned out, just prior to executing the ground lease, Landowner had granted an exclusive use restriction to a hair salon in the center. At the time, neither Landowner nor Developer were aware that Retailer was rolling out a new “Men's Makeover” concept whereby customers receive haircuts, manicures and massages while purchasing entire new wardrobes (and drinking beer and watching sports). With the restriction on hair cutting and styling services in the ground lease, Retailer would be unable to implement the Men's Makeover concept.

While a bit extreme, this hypothetical illustrates the importance of coordinated negotiation of the ground lease and sublease. If Landowner, Developer and Retailer had all been fully informed, and afforded meaningful opportunity to comment upon both leases, all of the foregoing issues (and many others) could have been identified at a time when the parties, motivated to get a deal done, would be able to explore and negotiate creative solutions. For example, perhaps the misaligned commencement dates (and rent bumps) might have been resolved if the ground lease provided for the term to commence on the commencement date under the sublease, or alternatively, an additional four years of term might have been added to the 50-year term to address the anticipated four-year construction period. And, while it is perhaps understandable that Landowner and Developer were unaware of Retailer's Men's Makeover concept, a complete and timely discussion of use restrictions with Retailer would have opened the opportunity to resolve the permitted use issue as well. Perhaps, if Retailer's presence in the shopping center was important enough, Landowner may not have granted an exclusive use to a small shopping center tenant which conflicted with Retailer's operations.

Additional Sublease Protections

In addition to ordering the chain of title properly as described above, the well-drafted sublease will contain several additional provisions to preserve the subtenant's extension options and protect the subtenant in the event the fee owner files for bankruptcy.

Conclusion

In summary, the long-term ground lease/sublease transaction brings together many diverse and competing interests, and finding the right balance among them is difficult, but not impossible to achieve. The success of this deal type is dependent on: 1) properly structuring the chain of title with adequate protections for all parties, and 2) closely coordinated negotiation of the ground lease, sublease, SNDAs and CNDA.


Richard N. Steiner is a Director and Managing Counsel for Walgreen Co. In this role, Steiner counsels and directs employees with respect to all substantive legal matters relating to Walgreens' real estate law practice, and also engages in all aspects of real estate legal practice on behalf of the company.

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