Avoid litigation whenever possible. That is a mantra that real estate investors should live and die by. However, not all litigation is voluntary. Aside from when others may sue you, there are times where you may be wronged so severely, your only recourse is litigation. That is an experience that I had over the past two years, and one that I'd like to shed light on in this post. And before we start, keep in mind that 95% of suits end in some sort of settlement, and US courts are incredibly reluctant to award legal fees to the victorious party, as not to discourage wronged parties from filing suit.
This saga begins in 2019 when I received an offering memorandum for a leasehold interest in a shopping center located in an affluent area of northern New Jersey. The way a leasehold interest purchase works is different from that of a convention fee simple real estate purchase that most people are used to. When you buy a leasehold interest, you "own" and manage the property for the long term while paying rent to the land owner, but at the end of the lease (typically 49 or 99 years) the property, inclusive of any improvements you've made to it are, returned to the land owner. That is, unless you extend the lease.
The deal which was sent my way was an existing ground lease with a 14,000 square foot shopping center on it with 25 years remaining. To some extent, this deal was easier to model than other deals since there's no guessing when it comes to the terminal value or exit. It's difficult to sell leasehold interests in the first place, especially when the remaining term is under 25 years, so this would mean I'd hold it until expiration. That means that I would finance it with a mortgage with 25 years of amortization, and instead of capitalizing the loan amortization, I would write it off because at the end of 25 years, I wouldn't own the property. Nothing to guess in terms of exit cap rates or interest rates.
We proceeded towards closing with a conservative pro forma 30%+ cash on cash return in our model. At the closing table (literally) the land owner put us on notice that they intended on increasing the ground rent from $60,000/year to $220,000/year and hinged the increase on a clause in the original lease. However, a subsequent amendment set forth nullification of the fair market reset increase contingent on certain conditions being fulfilled. We were now at the beginning of a debate as to whether those conditions were satisfied or not. We clearly believed they were, and we felt that the land owners did as well. After all, had the conditions not been fulfilled, they would have invoked the fair market reset 10 times over the previous 30 years.
We had two options. A) Close on the deal and wait for the land owners to sue us, or B) sue for declaratory judgement, where the court interprets the lease and issues a decision prior to the closing. I took the second option. While there was a strong chance that the land owners were bluffing and never would have sued, I was not comfortable gambling with other people's money on the line.
In the days after the cancelled closing, prior to us suing the land owners, a number of settlement offers were put forth with different rent structures. However, I was confident that I would do better in court than I would with any of the proposed settlements. So I began to vet litigators. I interviewed over a dozen litigators, all with specialized commercial real estate and commercial leasing experience. When I spoke with the attorneys, I presented the facts without stating which side I was on, and I gave over the pertinent documents. Aside from one lone attorney, there was unanimous agreement that we were going in with the stronger position.
After speaking with some of the biggest names in real estate law, I went with a solo practitioner. Part of the reason was his forty years of experience in the field, and part of it was the fact that he is selective enough in his cases that I would be receiving direct attention. It didn't hurt that he was referred to me by a true name in the real estate world with broad name recognition.
We put forth our case, and received a reply from the land owners. The land owners basically claimed that the triggers for the market rent resets were triggered prior to the execution of the lease amendment, and therefore they had the right to exercise those increases. Basically, there was enough minor development on the land between 1976 and 1986 to meet the requirements of the lease. In a nuanced way, their defense may have held validity depending on what occurred over those few years. However, it was evident that at the time of the execution of the amendment, the land owners were not of the belief that they had the right to exercise the market rent resets. However, the people who executed the amendment had already passed and I was dealing with their heirs.
The first place I went to was the building department to obtain the building records for the time period in question. Of course, those records were destroyed in a flood. We were now in a position of weakness, because we were unsure as to what evidence the other side might hold, and gave them the benefit of the doubt that maybe some development was done in the interim period. I went down a different path, and located the attorney who had drafted the amendment back in 1986. He had become a judge and had retired in Florida. Unfortunately, while he remembered drafting the amendment, he had no recollection of the mean of the ambiguous clause.
I had one potential trick up my sleeve. A while back, in an adverse possession case, I was able to look back at historic USDA aerial photography to establish land occupancy over the decades. I went back and mined the imagery stock, and I found exactly what I needed. I have a series of photographs establishing that the development which would have triggered the market rent resets did not occur during the requisite time period. We now have a pretty strong case and were ready to proceed. This is when we began to get requests for settlement conferences from the land owners.
Initially, the judge was pushing for a small rent increase and CPI increases subsequent to that in the interest of an equitable resolution. He explained that while the facts strongly supported our case, the current rent structure was far below what the fair market would demand. We countered that we had nothing to gain by accepting such a settlement, and proposed a counteroffer. We would allow the other side to buy us out of the lease, or we would buy the land from them. I had no interest in having a long-term relationship with them after the 11th hour bombshell which they dropped.
In the end, we negotiated a price on the land that was 36% below the appraised value as unencumbered by the ground lease, or $800,000 below the appraised value. We closed on the land and building, terminated the lease, and created for ourselves a perpetual asset with cash on cash returns in the mid-teens.
While we bought the land at a 4.5% cap rate (assuming the lease payments would have stayed the same), we picked up the terminal value of the building and land at the expiration of the ground lease, which in reality was equal to or greater than the price we paid for the land, unexclusive of rent payments. The end result was our acquisition of a $4.5 million building for just around $3 million.