In a typical ground lease transaction, a lessor leases property to a lessee for several decades. At the outset of the lease, there are many factors that both the lessor and lessee consider as they negotiate the lease terms and conditions, perform due diligence, and otherwise prepare to enter into a long-term real estate transaction. Although the parties, in drafting a new lease, contemplate end-of-lease matters, such as negotiating surrender clauses that address what happens to the property when the lease term comes to an end, those events are typically so far into the future that the parties who negotiated the lease may no longer be involved at the conclusion of the term.
At Cades Schutte, we often represent lessors and lessees in negotiating ground leases. That likely comes as no surprise. Perhaps less well-known is that we also frequently assist clients with the ground lease termination process. For instance, many ground leases in Hawai’i were negotiated decades ago and they are now approaching the natural expiration of their terms. Whether representing the lessor or the lessee, we have found that both parties have much to consider as the lease comes to an end. Essentially, the end of the lease is like a closing, with various conditions that must be satisfied before the parties can finalize the transaction.
This article discusses some of the most common issues that arise during the process.
Title to the property is a significant issue. The lessor’s expectation at the time it enters into a ground lease is that unless the lease term is extended or the lessee exercises an option to acquire the fee simple interest in the property, the lessor will regain control and possession of the demised premises at the conclusion of the lease term in accordance with the terms specified in the lease. This usually means the lessor will expect title to the premises to be free of liens and other encumbrances except for those which existed prior to the effective date of the lease or were otherwise approved in writing by the lessor during the lease term. The lessor is particularly focused on this issue because title encumbrances could affect the marketability of the property.
The process begins by carefully reviewing what the lease says. For instance, a “no liens and encumbrances” requirement in the surrender clause typically works in concert with a general prohibition on liens and encumbrances. The combined effect is that at the end of the lease term, the lessor will review title (by ordering a title report from a title insurance company) to verify that the recorded encumbrances are consistent with what the lessor is expecting to see. Some encumbrances often need to be cleaned up. For instance, many lessees obtain financing during the lease term using the leasehold interest as collateral for the loan. The lender will in turn record a leasehold mortgage. However, it is not uncommon for a lender to forget to record a release of mortgage upon the full repayment of the loan. In those circumstances, the lessee will need to work with its former lender to record a release of mortgage prior to lease expiration. This can be time-consuming so it is generally advisable to begin working on this several months before lease expiry.
We also assist lessor clients with preparing and recording a document that confirms the expiration of the lease by its terms. That document helps to ensure that a title insurance company searching the fee simple title to the property no longer shows the lease—or the leasehold encumbrances—as affecting the title to the property. Ideally the lessee will voluntarily cooperate in signing such a document (or will otherwise be required to do so by the lease terms). If not, a lessor can still consider signing a unilateral confirmation of lease expiration. Under certain circumstances, title insurance companies in Hawai’i may accept a unilateral confirmation recorded in the Bureau of Conveyances (recordation may be an issue for Land Court registered property) in lieu of a written affidavit from the lessor in order to remove the lease as an encumbrance upon the fee simple interest.
Upon the expiration or earlier termination of the lease, the lessor expects the premises to be surrendered in the condition required by the lease. For example, the lease might require the premises to be returned in the same condition as at the beginning of the lease except for reasonable wear and tear. Alternatively, the premises may need to be returned in “good” condition, “broom clean” condition, or some other standard—such as by removing the improvements altogether and restoring the surface of the land to its former state. The variety of potential requirements emphasizes why it is important to carefully review the lease. Just assuming that the lease surrender process uses “common sense” may not be enough; the contract language must be analyzed.
Depending on the required standard, the lessee may need to perform repairs to the premises. For instance, if the roof has developed leaks then, depending on the lease requirements, the lessee may need to repair or even replace sections of the roof. The extent and quality of the necessary repairs (or the need to perform replacements) will depend on the exact language of the lease. This can also end up being the subject of end-of-term negotiations between the parties.
Environmental issues can cause particular concern, especially where the lessee’s use of the premises is likely to have caused environmental contamination. To help address this risk the lease may require the lessee to perform an environmental site assessment before the lease terminates, provide a copy of the report to the lessor, and pay for necessary remediation. This, too, can be a time-consuming exercise and it is advisable to begin it as early as possible in the termination process.
Selected Other Issues
The issues discussed above are just a few key considerations that frequently arise at lease end. Other common issues include, but are not limited to, ensuring that any required real property taxes have been paid (including rollback taxes), identifying any lessee permits and licenses to be transferred to the lessor (assuming they are transferable), performing walk-throughs and key returns, transferring utility services, and considering insurance needs (for instance, identifying policies that can be terminated versus those that must be kept in force to satisfy continuing lease obligations). The potential complexity of this process underscores why, just as with a real estate closing, using a “checklist” approach is helpful. Note that if the lessee refuses to vacate at lease expiration, a complaint filed in the Circuit Court (not the District Court) is likely required.