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- Market Rent Adjustment Provisions in Long-Term Ground Leases
In this episode of Digging Into Land Use Law, Nossaman Real Estate Group Co-Chair David Graeler and associate Maya Hamouie discuss myriad problems that may arise when a market rent adjustment provision in a long-term ground lease is stated unclearly. David and Maya, along with guest speaker Scott Delahooke, MAI, review a recent market rent adjustment arbitration concerning a long-term ground lease, the key California case law at issue in the dispute, the different valuation approaches taken by the ground lessor and ground lessee, the differences in approaching valuations in California versus other jurisdictions and how the arbitration panel ruled. They also discuss ways to draft rent-adjustment provisions to more clearly lay out the adjustment process and to hopefully reduce the likelihood of litigation.
Market Rent Adjustment Provisions in Long-Term Ground Leases Transcript
0:00:00.2 David Graeler: Long-term ground leases almost always include a provision that enables the ground lessor to achieve a market-based return on the land over the course of the lease’s term. How these rent adjustment provisions are written will have a major impact on how the ground lessor and ground lessee will settle upon future rent many decades after the ground lease was executed. This episode will be of interest to anyone involved in long-term ground leases, including attorneys, lessors, lessees and appraisers.
0:00:35.2 Welcome to Digging Into Land Use Law, Nossaman’s podcast covering the development of all things in, on, or above the ground.
0:00:52.2 DG: Thank you for joining us today. I’m David Graeler, co-chair of Nossaman’s Real Estate Group and chair of its litigation department. I’m joined today by my colleague, Maya Hamouie, who is an associate in our real estate group, and Scott Delahooke, who is an MAI appraiser with the Delahooke Appraisal Company. Today we’re going to be discussing a real-world example of a market rent adjustment provision and a long-term ground lease that resulted in a hotly contested multi-day virtual arbitration before a panel of three arbitrators. Our client in the matter was the ground lessor, so please keep in mind that while we are going to be providing a balanced analysis of the two sides’ positions, we lived the case for a couple of years advocating for the ground lessor.
0:01:38.7 DG: Scott, thank you so much for joining Maya and me today. You were one of our appraisal experts in the arbitration, and we’re very excited to visit with you on a real-world example of what can happen when a rent adjustment provision in a long-term ground lease is, how shall I put it? Less than clear. As far as what we’re going to be covering today, we’re first going to start with a general overview of facts that gave rise to our arbitration, including the pertinent provisions in the long-term ground lease. We’ll next discuss how we approach the valuation in light of the governing lease documents. We’ll then discuss how the ground tenant approached the valuation, and then we’ll wrap up with how the arbitrators decided the case, the merits of our trading versus litigating in court and we’ll provide some thoughts on how the ground lease could have been written differently to avoid some of the problems that our client and the opposing party encountered.
0:02:36.0 DG: Alright, so let me set the stage for the case that we arbitrated. This was a long-term ground lease that was entered into back in 1980. It had a base term of 35 years and two options that would extend the base term out to a maximum of 50 years. The property was located in the North Hollywood area of Los Angeles and was unimproved at the time the ground lease was entered into. The ground tenant ultimately constructed some incubator or flex base buildings that still exist to the day. Our client is a public agency who acquired the property some years after the original ground lease was entered into. The original lessor was Southern Pacific Railroad. So, our client inherited its lease and really didn’t have anything to do with drafting the original lease, and as it turns out, had no one to talk about what they intended when the original lease was entered into. Scott, maybe you can talk a little bit about some of the characteristics of the property from an appraiser’s perspective.
0:03:52.6 Scott Delahooke: First of all, thanks very much for the opportunity to be part of the panel and to talk about this fascinating case. The property that was encumbered by a single lease was actually two separate sites, both of which were on a corner across the street from each other. As you noted, the sites were originally railway right-of-way, so they were relatively shallow in-depth and very long, but because they were corner sites, they were fairly functional, they had good access. The depth of the sites along the main right-of-way was about 80 feet, and that became an issue of both research and conversation during the arbitration. The underlying zoning on the date of value was PF or public facility zone. That also became an issue of great conversation. That is a very specific zone classification given only to sites that are owned by public agencies. It is not a classification that’s assigned to a private party that owns a site. The two sites were built with single story multi-tenant industrial spaces, you mentioned, David, incubator-type spaces.
0:05:11.2 SD: So, each one of the spaces was about 1000-1500 square feet, and there were local mom and pop stores or storage users in them. Buildings were built after the lease commenced, so it was at the discretion of the ground tenant as to what they built and what they have continued to manage today. They are both level sites, and they are in an area of North Hollywood where there was a huge trend towards building, even on sites of this configuration, four, five and six story multi-family, high density developments with ground floor parking and commercial. So, the trends were away from the type of use that was initially built on the sites, and that also played into a lot of the conversation of this matter.
0:06:04.8 DG: Yeah, in fact, one of the things that I presented at the arbitration was evidence that the land uses were changing in response to some of the transit stations that were put in place in recent years, including light rail and bus transit. And so there had been a lot of transit-oriented development in that area, which influenced your opinions in this case, right?
0:06:32.7 SD: Absolutely, yes. And whether they were in this specific overlay of transit or proximate to it, developers were building like crazy as much residential housing as they could because of the subway station and the bus station facilities that were proximate to this particular site.
0:06:58.3 DG: Okay, so here we are, we got retained by our client, who was the lessor in this case. One of the first things we did was read the lease to understand how we were going to go about figuring out what the rent should be as of the rent reset period. And I should mention that the rent reset period we were looking at was as of June 1st, 2015, and while we didn’t arbitrate the case until late 2020 into early 2021, it was all about what rent would be retroactive to June 1st, 2015. Maya, I know you spent quite a bit of time reading these leases, maybe you can tell our audience about some of the key provisions in the lease that helped inform our approach with respect to this rent adjustment.
0:07:50.6 Maya Hamouie: Thanks, David. I’m excited to be here today. So as David mentioned, the rent revision in the ground lease was really the key provision that the dispute centered around. And the rental revision provision provided that the rent shall be the reasonable and fair rental value of the premises at the time of each such revision as determined by the lessor and lessee, but not less than the rental rate then in effect. And reasonable and fair rental value of the premises are really the key terms here that David will get into. And as David mentioned, this provision also allows for retroactive payment of the revised rent amount. And the lessor here is the one who has the power to allow for the arbitration to commence or allow for the appraisal of this in order to determine the rental revision, and here the lease provided for a panel of three arbitrators with each party choosing one and the third being selected by the two arbitrators.
0:08:44.7 DG: Thanks, Maya. And so here, after reading the lease, I made the determination that reasonable and fair rental value necessarily was going to require an appraisal expert, and so I reached out to you, Scott, first to see if you were interested in participating in this appraisal assignment, and then ultimately to value it. And I, of course, sent you the underlying lease documents. How did you interpret reasonable, fair rental value of the premises when you first read those words?
0:09:17.2 SD: Great question. And the term reasonable is a term of art, not an appraisal term. Certainly, an appraiser is to collect data and analyze the data in a fair and reasonable manner and pay attention to the definitions of value and the scope of the assignment. But I have not seen that word used in a lease of any kind, including a ground lease, so you and I talked through that issue of what does reasonable actually mean in this context. The lease was also silent as to whether or not the terms and conditions of the underlying lease were to be considered, so absent a specific directive that the lease was to be considered including the remaining term of the lease, it was my view that the property should be looked at as if vacant and available for its highest and best use for a developer that would work in conjunction with the underlying ground lessor or a private property owner who had developed the property to its highest and best use. You and I talked that through at great length in the very beginning, and I think we both saw that as the appropriate way to move forward.
0:10:31.8 DG: Yeah, absolutely. And part of what helped inform my decision on this was the conversation we had about what the purpose of this ground rent recent provision was, and as we discussed, any time a lessor agrees to encumber its land with a long-term lease, it’s taking significant risk that the appreciation of the land is going to outpace the rents it’s generating, in terms of what a reasonable return on the value of the land would be, and so it’s prudent in all kinds of long-term ground leases to incur these types of market rent adjustment provisions to ensure that over time, the owner of the property will continue to generate a reasonable market-based return on the value of the land. I assume you agree with all of that?
0:11:23.5 SD: I do, and I’ve worked on assignments where there are certain constraints that the reset provision has. For instance, a reset provision may say that you’re supposed to appraise the value of the land, assuming you could build only a 20,000 square foot office building or an industrial building of a certain size. So that there’s a consistency between the use of the property and the value of the underlying land, but without that constraint, which we did not have in this case, in my mind, it clearly puts the onus on the appraiser to look at market trends, to look at the highest and best use, to look at the underlying zoning or the most probable zoning and move forward and value the site accordingly, and that’s what we did, and I think that was the appropriate approach to take.
0:12:16.0 DG: Now, the magic words in this lease were reasonable and fair rental value of the premises. It does not say market. There’s no reference to a market-derived value. I know we had some discussions early on whether rent needed to be a market derived value. What caused you to conclude that it should be?
0:12:36.1 SD: So not only was the word reasonable unique, but the rental value is unique. Usually, it’s market rent or some phraseology like that. Rental value is kind of a unique term, but you and I talked it through, and I think ultimately, it’s the ground lease reset in this case, and in all the cases I’ve worked on, have provisions there to allow for appropriate return to the ground lessor position. And so, I used and all of the experts in this case also used the definition of market rent put forward by the Appraisal Institute’s Dictionary of Real Estate Appraisal. So there actually wasn’t a disagreement in the underlying definition of market rent that we all apply, we just all applied it differently.
0:13:26.1 DG: Yeah, and I remember not knowing how the tenant was originally going to take it or interpret that in taking the deposition of the tenant’s person most qualified, who conceded that it would be a market-derived value. So, it ended up not being an issue. So, we know we’re going to derive a market-based value, and you mentioned earlier that you concluded based on the language of the lease that you are going to derive a value that was based on the highest and best use to the land. What was a necessary step after that in order to assist you in generating your valuation opinion?
0:14:08.6 SD: So, we talked a little bit earlier about the market trends and the higher density residential development that was taking place, I also mentioned earlier that the underlying zoning was public facilities, which is a very unique classification given by the city, two sites that are owned by agencies. I went to the city and said, “If this was being developed by a private developer to its highest and best use, would the PF zoning be the applicable zoning that the city would use?” And they said, “No, that’s just in place because of a public agency’s ownership of that site.” So, then I asked the question, “Well, what is the reasonable, reasonably probable zone classification to consider when I’m looking at this site? Whether the public agency keeps the site and ground leases it to a new ground tenant or sells it, what is the right way for me to look at this as an appraiser? How would the city look at this?” And they confirmed that the surrounding zoning, which was commercial, it was C2 and C4 would be the zone classification the city would use to establish what would be permitted on these sites. So that was... And it was a conversation with the city planners. It was... We also brought on another expert that you and I will talk about in a moment, but it was clear that the PF zoning was a constraint that was not what should be considered when looking at a market value, market rental rate for this particular property.
0:15:41.8 DG: And in assessing your highest and best use conclusion that you would ultimately reach, one of the important things was what would be legally permissible on the property, and that’s why you were looking at whether the PF zoning would prohibit legally the kind of use that you are envisioning. Is that an accurate characterization?
0:16:04.3 SD: Absolutely.
0:16:05.4 DG: Okay, and then one of the other things that you would look at with your highest and best use analysis is whether or not the property could physically accommodate the kind of use that you thought would be the highest and best use, which was some kind of a multi-family development. And as you mentioned earlier, this property only was about 80 feet deep, which potentially caused or created a development constraint, and as you just mentioned, we brought in a second expert who was an engineer who actually designed a mixed use development on this site and laid it out with a floor plan for both parking and residential units above in order to demonstrate that there was no development constraint based on the depth of the site, and also to help support how many units could ultimately be developed on the site. And how did you use that opinion?
0:17:00.0 SD: Yeah, so that opinion was really important. I’ll take a step back very quickly. There was actually a site adjacent south to the subject properties, which was only about 90 feet deep, which had been developed with a high density, five or six-story multi-residential development. So, I already had market evidence which showed that that type of structure could be put on a site that had similar depth to the subject site, but I went a step further because I wanted to engage an engineer who did design site plan, architectural work as well. And have them put a hypothetical development on our site and tell me based on setbacks and height limitations and all of that, if our site could be developed in a manner consistent with my comparables, from a density standpoint, from a placement standpoint, and from a construction cost standpoint. So that if our site would have taken a higher construction cost for underground parking or some other construction cost like that, I need to take that into account in my adjustment process, but he was able to go in and look and design a building very similar to what was being built around the subject property, and that the site depth was not a constraint and not a limiting factor on the density of development, or again, on the cost of construction.
0:18:29.1 DG: And just for the audience, I’ll summarize that based on the input of that other expert, and based on your own investigation that you made with the city’s Planning Department, you satisfied yourself that the subject property could be developed in a manner consistent with what you felt was its highest and best use which would be a multi-family development.
0:18:53.5 SD: Absolutely.
0:18:54.9 DG: And ultimately, you rendered an opinion of value for the land based on that type of development, which you then applied a rate of return to which was market derived as well, to conclude that rent should be $400,000 per year as of our June 1st, 2015 reset date, right?
0:19:15.4 SD: Correct.
0:19:17.0 DG: And I should mention that the tenant had been paying $116,000 per year in rent under the lease. So that just goes to show you how divergent the contract rent can become when real property values go up over the term of a long-term ground lease like this. I’m going to now talk a little bit about what the other side did. I would say that because the lease, ground rent reset provision in the lease was written the way it was, it allowed for the ground tenant to get creative about how it approached value. The first thing they argued, I think this was the tenant’s primary argument at the arbitration, was that rent doesn’t even need to be market-based, and this was despite the fact that the tenant got two appraisers to appraise the property using a market derived value, and it’s despite the fact that this is the way that two parties have always approached this issue throughout the history of the lease.
0:20:20.3 DG: But nonetheless, the ground tenant argued that the rent should be based on 25% of the gross rents the tenant generated from its sub-tenants. Again, the lease doesn’t say that, there’s nothing to indicate that the parties ever approached setting rent that way, but because the lease used the word reasonable, the ground tenant argued that that’s a reasonable way to set rent. The second thing the ground tenant argued was whatever the market rent would be or the reasonable rent should be as of June, 1st, 2015, it shouldn’t be applied retroactively because our client took too long to increase the rent. So, they argued against retro activity. And then finally, the ground tenant, as I mentioned, retained two different appraisers who approached valuation in a way, very differently than you did Scott and I’ll summarize their approaches.
0:21:19.7 DG: The first appraiser that the ground tenant retained was actually retained all the way back in 2015, and he focused heavily on the PF zoning of the property and concluding that the PF zoning really didn’t allow for any development on-site consistent with its highest and best use. And as a consequence, He discounted downward or adjusted downward his sales data by 50% or 75% at times, even though he was pulling comparable data that was very similar to what you relied on, in terms of being residentially oriented. And as a consequence, among other things he did, including initially believing that there was a parking covenant that damaged value, which he later conceded was a mistake. He concluded that the rent for the property should only be $100,000 a year, which was lower than the contract rent, and therefore he felt the contract rent should just remain in place. Our client obviously wouldn’t agree with that, so we ended up in the arbitration process. Once the arbitration process was underway, the ground tenant secured a second appraisal and much like the first appraiser, this second appraiser also approached value by looking at a market derived value, market rent definition and looked at highest and best use, he too took into account the PF zoning, but his biggest impact on value was the 80-foot depth of the site.
0:22:56.9 DG: He concluded that because of the 80-foot depth on the site, you really couldn’t make any kind of meaningful development on the property because it was development constraint. And he reached that conclusion without consulting any engineering experts like you did, Scott, and ultimately, because of that development constraint that he felt existed, searched for land sales that were acquired by a buyer without any plans for development, buyers who purchased properties for surface storage or surface parking with no plans for development. And in order to find those sales, he went very far away to get them in all inferior markets, and he admitted that. The closest sale was several miles away, I think two, three miles away, and the farthest, think I was 10 or 15 miles away, and he ignored a lot of sales that were much, much closer, and through those sales, he rendered a value conclusion that resulted in rent being $150,000 per year, so a nominal increase from the contract rent. So those were the differences in value as stated in the appraisal reports, then we got to taking depositions, and once I started taking the opposing appraisers depositions, I learned for the very first time that not only did they take into account what was written in the reports, but they also took into account the amount of time remaining on the lease at the time of the rent reset, specifically 15 years.
0:24:33.1 DG: And what they said is, even though the appraisal reports didn’t talk about this issue, the amount of time remaining on the lease would be a major impact on the ability of a tenant to develop the site because you would never realize a return on your investment in a 15-year time period. And therefore, as of June 1st, 2015, you couldn’t make any meaningful use of the property and that that had a major impact on their value conclusions, again, no reference to this in their appraisal reports, but it’s an argument they put forth at the arbitration, after testifying to it in deposition. So that kind of lays out the two sides appraisals. One thing that was not present in, Scott, your appraisal or the two appraisals obtained from the ground tenant was any notion that anybody was appraising rent based on the existing use. It was really not an issue that anybody was focused on based on the lease language, and then to our surprise, we received a motion in limine shortly before the arbitration began that sought to exclude your entire opinion because you failed to appraise rent according to the existing use, and instead appraised rent according to the highest and best use.
0:25:56.0 DG: It was a fascinating motion because I thought, if the arbitration panel was going to grant it, then necessarily the ground tenant’s two appraisers who also didn’t appraise rent according to the existing use would also need to be tossed, and there would be no valuation opinions left. In any event, we did have an in-use appraisal for our client as well, I should mention that. Back in 2015, when our client was in negotiations with the ground tenant over what market rent should be, my client... Our client decided to retain an appraiser to value rent according to the existing use as kind of a check on value. It was not what it really believed rent should be or how it should be set, but it obtained that appraisal and that appraisal set rent at $225,000 per year based on the existing use, which was, again, higher than the landlord’s two other appraisals. And ultimately, we decided to exchange that in-use appraisal because of the word reasonable in the lease, I felt that the word reasonable would make it very difficult for our arbitration panel to come in at a number that would put the ground tenant upside down in terms of what it had to pay for the ground lease versus what it was able to receive in its sub-tenant rents.
0:27:25.0 DG: And so, coming in with a number in between seemed like a good strategic approach to give the panel an alternative choice on value. And because our client had offered to settle for less than that $225,000 per year figure. So, being where we are at this point, we really encountered two distinct legal issues that we had to run to ground, the first was whether it was appropriate to take into account the terms and restrictions in the lease, namely the amount of time remaining on the lease, and I’m going to ask Maya, who did all the research for us, she did great research in this case, including finding some articles that talked about the California rule, which was instructive on that issue. And the second was whether or not it was appropriate to appraise rent according to the land’s highest and best use, or its existing use, and Maya found four published cases on that, which also were instructive. So Maya, maybe you can talk about those two different legal issues.
0:28:31.2 MH: Sure, thanks David. So, I did find four published cases that addressed ground rent resets on long-term ground leases in several articles that discuss rent resets based on those cases. In one article the author coined the term and referred to the California rule as presuming that the value of the land means the fair market value in an appraisal as at its highest and best uses, not limited by any use restrictions in the lease or by the nature of the existing improvements, unless a clear intention to the contrary appears from the lease. And this was actually perfect for us because we’re in California, and this allowed us to argue that our appraisers could value rent as... At the highest and best use without any regard to the terms and restrictions in the lease. And the tenant was actually trying to apply the majority or the New York rule where if the lease is silent, you should consider the terms and restrictions of the lease.
0:29:24.4 DG: And you said you found four published court of appeal decisions that were instructive on whether to value rent based on the existing use or the highest and best use. What did those cases show?
0:29:37.2 MH: That’s right. So, in three of the cases, the leases had broad use provisions that allowed for valuing the highest and best use of the land for any particular purpose. In the last case, it was different, it had a lease that restricted the tenant to a single use, which was a theater, and so in that case, the land had to be appraised taking into account the used provision.
0:30:00.7 DG: So, based on that law that Maya so capably found, we argued that since we were in California and since the lease was silent on whether to take into account the terms and restrictions of the lease, it would be inappropriate to apply the remaining term of the lease in restricting the available uses. Interestingly, the tenant obtained a rebuttal expert from Canada who had written an article on this topic, but the article wasn’t specific to California and focused on the majority or New York rule, which said that when the lease is silent, you still take into account the terms and restrictions of the lease. And when I push that expert about it in deposition, he conceded that California was different, which I thought was a really, really key admission. And then finally, as Maya mentioned, the four cases she found, one of them called for an appraisal based on the existing use, because the use provision was only a single use. That didn’t exist in our lease, our least had a very broad use provision which allowed the ground tenant to put the property to any number of different uses, and it was much more similar to the other three published cases that allowed for value to be set based on highest and best use.
0:31:17.7 DG: So, we argued, number one, that the tenants argument that you had to take into account the terms and conditions that the lease was wrong under the California rule, and number two, that it was appropriate to appraise according to highest and best use, based on the three cases that said that where the least provisions had broad use permission. So, what did the arbitration panel ultimately do here? As we suspected, because our arbitrators were all trained lawyers, they focused heavily on the word reasonable in the rent reset provision, and ultimately, never really addressed whether it was appropriate to appraise rent, by taking into account the terms and restrictions of the lease. Instead, based on the word reasonable, and based on the fact that the lease called for rental value, they concluded that that must mean that the parties should appraise rent according to the existing use, they didn’t touch the fact that the use provision was broad, they did talk about how the parties later amended the lease after the improvements were built and therefore confined the tenant into a single use. But there was no case law that said that because the cases all spoke to what different uses were allowed under the lease.
0:32:41.6 DG: But by doing that, effectively the arbitration panel tossed the other, the ground tenants appraisals because they didn’t really appraise based on existing use, and in one instance, when they thought maybe he did, they noted that that appraiser’s comparable sales came from very far away. They also decided not to focus on Scott’s appraisal because he appraised based on highest and best use, and instead they focused on the second appraisal we exchanged and discounted it by 10%, and that was their value. I think it came out to a little over $202,000 per year, we had offered $200,000 per year on rent to settle, so we did better than that. And that could have been the end, and everybody could have gone away less than happy, but our arbitration panel decided to construe the lease as allowing for the prevailing party to receive attorney fees, and expert fees, and arbitrators fees, and none of that is present in the ground rent reset clause of the governing lease. So, number one, we felt that that was a mistake, but number two, even if it did provide for the prevailing party to receive attorney’s fees, the client, our client, the ground lessor, achieved an outcome that was based on an appraisal that it exchanged.
0:34:08.8 DG: Not one that was based on an appraisal that the tenant exchanged. It was within 10% of that appraisal in fact, and yet, the panel nonetheless concluded that the ground tenant was the prevailing party and awarded attorney’s fees, expert fees, and the arbitrators fees. The panel did allow rent to be increased retroactively, and so what that effectively did was wipe out the back rent that was owed and set the new rent going forward from the present time, it was less than a desirable outcome from our perspective, and one where I thought the arbitrators made some mistakes. Alright, Scott, so obviously, you’re not a lawyer, you’re an appraiser, you can’t really weigh in on the legal conclusions that were reached by our arbitration panel. I am curious to know your thoughts from an appraisers perspective on the ultimate determination of market rent at a little over $202,000 per year. And perhaps you could also comment on the overall underlying purpose of market rent adjustment provisions and long-term ground lease such as this one.
0:35:29.7 SD: Yeah, I think that’s a really important issue to discuss, because even though the appraisers for the ground tenant did not say the remaining term mattered, or had any impact on their conclusions in their reports, they did argue that in the depositions. And it just on its face, seems to me, to be both unfair and unreasonable to the ground owner. When a ground lease is started, a 55-year, 50-year ground lease, or longer, there’s a base provision of usually 30 to 40 years before the first reset, and all the appraisers in this case agree that to do a new development, you’ve gotta have at least 30 to 40 years to be able to recapture the cost of the improvements that you would build. And that anything short of that was just not enough time to recoup your outlay for building buildings. So in this case, there was a 35-year beginning term of the total 55 years before a reset, the rent was set, the ground tenant built their building, and got the return on and of those improvements they built.
0:36:42.3 SD: The fact that they were arguing that at the rent reset, we could only consider the remaining term, which was 10 to 15 years, and that nothing could be feasibly developed on the site, and the return generated over that 10 or 15 years meant that the value of the land was constrained to some open storage use. It is not market value of that land, based on its highest and best years. It actually is a less desirable piece of property at the first rent reset than it was in the original beginning of the lease, and it makes no sense to me that a ground owner would agree to a lease provision that actually results in a lower return, lower rent at the first rent reset than at the original beginning of the lease.
0:37:39.0 SD: And so, just on its face, it made no sense that this argument is what the parties intended, especially the ground owner intended. But again, the appraisers all... We all agreed, including me, that you need at least 30 to 40 years to recover the cost of new development. So that argument just made no sense. The other thing that we did is as the panel was beginning to lean towards the existing use, we could tell by the questions they were asking and by the way the ground tenant was presenting the information. We came up with rebuttal documents based on their actual profit and loss statements to show that the ground tenant was receiving or should have been receiving sufficient net income to be able to pay the rent I estimated and still have a return left over to their position as a ground tenant. And the panel completely disregarded that as well. So, this outcome for me was reasonable, but only as it applied to the ground tenant, not the ground landlord.
0:38:49.6 DG: So, Maya... And thank you, Scott. Maya, I’m going to create a hypothetical time machine and put you in it and go back in time and you’re now the lawyer for Southern Pacific Railroad about to enter into a lease with this tenant, and you have the ability to tell your client what you think they should do with the rent reset provision. With the benefit of hindsight, how would you have approached things differently?
0:39:19.8 MH: So, the first thing that I would tell my client to do is to definitely not use the word reasonable. Reasonable is problematic because it allows the trier of fact to really do whatever he or she wants, and we really can’t predict the outcome. I would say stay away from that word. Second, I would that if you intend for rent to be based on the highest and best use of the land, without regards to the terms and restrictions of the lease, say that clearly, or if you don’t want to say that, say the rent will be based on 10% of the fair market value of the land, at its highest and best use. So, any of those options, I think could have helped avoid some of the issues that we faced in this case and the parties would have been on the same page had the lease rental revision been drafted differently.
0:40:03.3 DG: Yeah, I completely agree with that. Clarity is key, give the parties clear direction on what they should do so that when you disappear after signing that lease, whoever is going to be left having to deal with what you wrote 30, 40, 50 years down the road, has some sense about what they are supposed to do. And doesn’t end up in a situation where our tenant appraised apples, basically land that was constrained by the existing term of the lease, and our client appraised oranges. You want to make sure that everybody is appraising the same thing because that better ensures that the two sides are going to come together, it reduces the likelihood that there will be a contested process, and ultimately it saves everybody time and money. The benefit of hindsight, definitely stay away from the word reasonable, and if you want it to be based on highest and best use, without regard to the terms and conditions or restrictions of the lease, say it.
0:41:10.0 DG: Let’s talk a little bit now about arbitrating disputes and whether if we could go back in our time machine, we would have not used an arbitration provision that called for a panel of three arbitrators and instead maybe called for a single arbitrator, or maybe even no arbitration at all, and instead to just have these kinds of disputes litigated in court. Scott, I know you have personally served as an arbitrator before in valuation disputes, and I know you’ve also been an expert witness in similar types of disputes, and you’ve obviously testified in court quite a number of times. Do you have any thoughts on this issue?
0:41:51.4 SD: Yes, so, I would say being involved in, on several levels in arbitrations and also being in court in front of juries and judges, my preference is to be in a courtroom, whether before just a judge or a jury. It allows for... I like getting up and moving around and engaging with, especially juries to see if what I’m explaining is making sense, because if it’s not, then I can go back around and kind of get another stab at the apple and try and re-explain it until the lights seem to go on. In an arbitration setting, especially one that’s by Zoom, it’s much more difficult to get a sense of what’s going on. The other pieces, in my experience as an arbitration panel member, very often there is... There is the desire to get consensus to get all three panel members to sign off on the award, which means that, there isn’t necessarily... ‘because you have two-party appointed plus a neutral, there isn’t necessarily the desire to get it right, but to move it to some midpoint or some consensus, and I would prefer... And I think the outcomes where I’ve testified in arbitration and there’s a single arbitrator, there is more risk, but I think the outcome is much more likely to award the stronger case, the better experts, the better legal arguments.
0:43:26.8 SD: The single arbitrator will be able to follow, usually the best presented and most well-documented case, without having to reach a consensus and compromise with other panel members that may have agendas and try and pull them in a different direction. So that’s kind of my experience in this and David, I don’t know, you could talk about the economic piece of this and the speed, but just from a process standpoint, I would say single arbitrator or court of law.
0:44:00.3 DG: Yeah, you know, my thought on this, I would say has evolved over time and probably will evolve again in the future. But where I currently stand on this is the cost of an arbitration, particularly one like this, where we have three arbitrators, I don’t think is all that much less than litigating a case in court, and that’s supposed to be one of the reasons in favor of arbitration, you’re paying the hourly rates of three highly compensated professionals on top of the lawyers and the experts. The other thing is from a timing standpoint, there’s lots of discovery that takes place in arbitration, just like there would be in court. In the absence of a pandemic, I think that the timing is probably pretty comparable. Because we had a pandemic, I think we were able to arbitrate our case by a Zoom more quickly than we otherwise would have been able to try a case in court. But I don’t know that that was necessarily a good thing under the circumstances.
0:45:00.8 DG: And I agree with you, Scott, about the inherent tendency for a panel of arbitrators to compromise on an outcome, which probably takes away the ability of one party to really win. Here, each party designated one arbitration panelist, and those two designated panelists appointed the chair, which was the third panelist, all of our panelists came from the same ADR firm, which I think created its other challenges because I think there was even greater tendency for them to want to have a unanimous outcome. If all three neutrals came from different firms, maybe that would have helped with the problem a little bit. But all things being equal, I think in the future, I would want to adjudicate this kind of dispute in court, particularly because of the ruling the arbitration panel made on attorney’s fees. I think that was a clear legal error, I know the other side of undoubtedly disagrees, maybe they do now. But the reality is, throughout the case, nobody was thinking they would be entitled to recover attorney’s fees as a prevailing party.
0:46:12.4 DG: And with an arbitration, unless the contract that sets forth the arbitration provides for a right to appeal, there’s very little you can do to correct this kind of mistake. You can ask the arbitration panel to correct the error, not likely going to happen. You can then file a petition to the Superior Court to correct the error, but the law is pretty darn clear about the limited circumstances when those kinds of petitions to vacate an arbitration award will actually be granted. And so here, if we had been in court and the judge had made the mistake on awarding attorneys fees, we’d have the ability to seek review by the Court of Appeal. And then in...
0:46:57.3 SD: David, A quick comment on that. Something like that can be used in horse trading as well, to try and pull one arbitration panel member into a consensus, and it shouldn’t be a chip, it should be an independent decision, and I’m not speaking as a lawyer, but it seems to me that it should be an independent decision of the outcome and the award. And in this case, I don’t know if it was a chip, but I have seen and been involved in other cases where it was.
0:47:29.7 DG: And then I’ll just wrap up with a comment on my experience doing this arbitration via Zoom. It went better than I thought, but there were definite limitations with it, and not being in the same room with the triers of fact, there’s just not an ability to pick up on the non-verbal communication that people inherently will give you when you’re in a room with them, when you’re looking at a computer screen. And Scott, you and I have worked together quite a few times over the years in court, and I think one of your strongest skills beyond being a technically excellent expert and appraiser, is your ability to communicate in lay person’s terms and connect with your trier of fact. And doing it through Zoom limited your ability to do that, as compared to being in person. Ultimately, I don’t think that’s what swayed the panel one way or another, I think they were going to probably reach the same conclusion, even if we were there in person. But it was something I definitely noted. Any final thoughts from Scott or Maya?
0:48:41.5 SD: One funny recollection in this era of Covid is my deposition was in person and it was in my backyard, and unfortunately it happened to be on a day when it was 105 degrees, and I think it went, beginning to end, the deposition was maybe six to seven hours and counsel for the ground tenant, who happens to be a client of mine as well, wanted to stay and chat. So, we were probably sitting in the backyard at very high temperatures for a very long time, I think we almost lost the court reporter at one time, so anyway... [laughter]
0:49:18.5 DG: Yeah, the court reporter...
0:49:21.7 SD: These are the kinds of moments that we tend to remember. The unique moments.
0:49:26.3 DG: Yeah, great, great memories for sure that we will keep with us and tell more stories on for... Well, Scott, thank you very much for spending a little bit of time with us talking about this case.
0:49:37.6 SD: My pleasure.
0:49:37.7 DG: And Maya, thank you for your participation as well. And most of all, thank you to our listeners for joining us for this episode of Digging Into Land Use Law. For additional information on this topic or other environment and land use matters, please visit our website at Nossaman.com, and don’t forget to subscribe to Digging Into Land Use Law, wherever you listen to podcasts, so you don’t miss an episode. Until next time.
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