United States: Ground Leasing From a Municipality for Retail Development

Retail development can be an impetus to the revitalization of commercial neighborhoods, particularly in the Northeast where cities and towns are trying to focus on older urban centers. Finding sites for retail stand-alone stores can, however, be particularly difficult in these typically dense urban areas where individual parcels are unavailable for development or parcels that are available are insufficient in size to support the needs of standardized store units. Opportunities do exist, however, to partner with municipalities in harnessing town or city-owned land as part of a revitalization effort. Often these opportunities occur not in the main business centers or commercial streets, but in smaller neighborhood shopping districts.

The search for a suitable site can often be found in and around municipal parking lots or other underutilized town-owned land. In exchange for reconstructing and maintaining a parking lot, adjacent park or other public land, and as a stimulus for improving the appearance and economic stability of a neighborhood, municipal officials can often be persuaded to ground lease some of the town-owned land to a retailer or developer for equivalent value. Such an arrangement can create a natural win-win situation between the developer and the municipality. The developer or retailer is provided with a site and an immediate environment that it can control and within which it can create an attractive shopping destination. The municipality gets to realize its goal of neighborhood revitalization without a significant outlay of cash. A number of problems must be addressed, however, before either side can accept such an arrangement. Chief among these are the economic terms of a ground lease, assignability of the lessee''s interest in the ground lease, permitted uses, the consequences of "going dark" and the application of prevailing wage laws to the construction of improvements on public property.

One of the essential objectives on the developer''s side in negotiating a municipal ground lease is to limit the opportunities for default. Prepayment of rent eliminates a major potential source of lease default and is therefore important to a project that can be financed. This can be accomplished by an agreement with a municipality that if the fair market value of the cost of improvements to public property (as proposed by the tenant), equals or exceeds the fair market value of the land to be ground leased, then the tenant''s obligation to pay rent will be relieved. The parties must first determine the total gross rent for the entire term of the lease, including options. The total gross rent is based on an appraisal using market data for the location and retail type. The longer the term, the greater the total gross rent. Total gross rent is then present valued. The cost to the developer for construction, maintenance and replacement of the public facilities portion of the project, such as the municipal parking lot, public plaza or adjacent park land, is estimated and present valued. Once the parties agree as to the present value, the tenant payment for public improvements, maintenance and replacement must equal or exceed the fair market rental value. If this occurs, no additional monies need be paid as rent, thus eliminating a potential source of monetary default throughout the term of the lease. Adjusting the length of the lease will affect this formula. A longer term may be encouraged by the municipality. A longer term also can be used to make a stronger public policy case for the municipality gaining a significant economic benefit. This is often necessary in order to capture the political backing necessary to marshal the votes of town officials for the disposition of town-owned land in this manner.

Issues of assignment of the tenant''s leasehold interest, critical to financing, and the question of prohibited uses and the requirement that a retailer continuously stay open for business pose additional challenges to the negotiation of a leasehold interest in municipal land. The establishment of a public purpose for the project is critical to the willingness of a municipality to agree to a ground lease. It is the motivating factor in underwriting retail projects of the kind needed for revitalization of commercial neighborhoods. Municipalities are looking for experienced developers to play the pivotal role in matching the municipality with a retailer. The municipality will generally require the retailer to be identified in advance of the execution of the ground lease and require the retailer to remain open continuously during the term of the lease. Allowing a store to "go dark" will, by all appearances, signal the failure of the revitalization effort and potentially embarrass the public officials who supported the project and authorized the ground lease. On the other hand, few retailers will agree to continuous operation for this type of development. Some municipalities have been persuaded to acknowledge a retailer''s right to "go dark" while retaining the right to terminate the lease if the developer tenant cannot find a replacement retailer that will provided services to the neighborhood and attract customers. The municipality may require that the tenant terminate the retail store lease if the retailer elects to stop operating and, if a replacement retailer is not found, to terminate the ground lease altogether. In some ground leases it has been possible to cushion the tenant''s obligation to find a new retail tenant by excluding from the termination right of the municipality some events which may be beyond the tenant''s reasonable control, such as certain economic conditions that may prevail generally in the region or fundamental changes in the retail tenant''s industry which changes the way in which certain retail tenants are prepared to do business. However, the loss of neighborhood vitality linked to the closing of a bargained for retail store is something the municipality needs to avoid and will go to great lengths in the ground lease to guard against.

Related to the issue of continuous operation is the right of the leasehold tenant to assign the ground lease. Having relied upon the particular tenant and its reputation, the municipality is generally loathe to accept absolute assignment rights of the ground lease without some control over successor tenants. One solution to the assignment problem for a municipality is to require certain qualifications of the assignee with respect to being experienced as a commercial landlord and requiring any assignee to pass a "character" test so that a municipality is not embarrassed by winding up being the landlord of a "disreputable" developer with whom the municipality would not have done business in the first place. The issue of assignability gets further complicated when negotiating a subordination non-disturbance agreement between the municipality and the financing entity. While the municipality generally recognizes the consequences of a lender foreclosure on its ability to control the holder of the leasehold interest, there will be pressure exerted by the municipality on the lender to allow it to cure defaults and to find a replacement tenant who then may be able to refinance the existing loan.

When the revitalization project includes a former parking lot, unless the lot has ample parking for the public as well as the targeted retailer, conflicts over allocation of the parking spaces frequently arise, particularly where other existing and established retailers wish their customers to have equal priority with the targeted retailer for parking spaces. These issues frequently boil over during the project approval process and can be particularly nettlesome when the targeted retailer wishes to have some spaces reserved for its customers alone and further wishes to restrict what may be historic use of the parking lot for other municipal purposes, such as farmers'' markets, snow emergency vehicles and metered parking. These issues generally result in detailed negotiations between the parties and may present the hardest problems to resolve. However, failure to resolve them during the permitting process prior to execution of the ground lease may create significant risk to the successful negotiation of the lease and its approval by town officials.

Two prosaic but often overlooked issues related to ground leasing with municipalities are (1) the availability of insurance proceeds to restore and repair the municipal facilities following a casualty, and (2) the requirement by a municipality that the tenant adhere to prevailing wage and salary laws in the construction, repair and maintenance of those portions of the ground lease premises which are public property. The latter issue may significantly affect the cost of the project and of ongoing maintenance. The issue of prevailing wage laws are often a question of state law, which a municipality may miss in the negotiation of a ground lease or until the construction of the project is underway. This does not mean, however, that the issues of the payment of prevailing wages in contracts for the construction on municipal property can be ignored.

The insurance issue largely focuses on the use of insurance proceeds after a casualty. Lenders generally reserve the right to require that insurance proceeds be used to pay down the loan, particularly if an event of default has occurred. This can be untenable to the municipality which will insist on restoration so that the project can continue to serve its revitalization goals. Solving this problem often requires direct negotiation between the municipality and the lender and often results in the municipality having the right to require proceeds to be used to satisfy the tenant''s restoration obligations. Since no ground lease rent obligation exists, rent interruption insurance or other security may be employed to satisfy ongoing loan repayment obligations until the retail unit can reopen for business.

On the whole, partnering with a municipality can be profitable and achieve each party’s objectives in retail development. Ground leasing publicly-owned real estate implicates economic, political and legal issues that private contracting parties can often avoid. However, the failure of the municipality to raise some of these issues at the time of lease negotiation does not mean that they will not emerge over time, as sometimes they emerge even after improvements have been partially or fully completed. While the mantra of the real estate industry is "location, location, location," the mantra of leasing land from a municipality should be "anticipate, anticipate, anticipate."

The content of this article does not constitute legal advice and should not be relied on in that way. Specific advice should be sought about your specific circumstances.