Reset Clauses In Ground Leases

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 are increasingly objecting to typical rent reset clauses in ground leases because of the risk and uncertainty that they can pose. (If there is an unanticipated increase in ground rent payments, the revenues from the property may not be able to support the ground rent payments or both the ground rent payments and the mortgage payments. This can cause the ground tenant to default under the ground lease and/or the leasehold mortgage.) 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 or even losing its lease. A couple recent examples of this are the difficulty that RFR Realty had in securing a refinancing of its mortgage loan for 390 Park Avenue (commonly known as the Lever House) due to the fact that the ground lease was coming up for a renewal in 2023, at which time the annual rent would be reset and increase from $6 million to $23 million. Lois Weiss, “Park Avenue’s Lever House CMBS loan lost $68.3M: report,” New York Post (Feb. 19, 2019). Another example, although not a ground lease, is the Barneys New York rent reset, which, after an arbitration proceeding, resulted in Barneys having to pay a new rent of almost double its prior rent. Barneys has since filed for bankruptcy and will be closing its retail stores. Lisa Fickenscher, “Rising rent at Barneys’ flagship store led to Chapter 11 filing,” New York Post (April 6, 2019).