Contributed By McGuireWoods LLP
Real estate law is increasingly multidisciplinary. Recent trends have seen a significant movement toward transit-oriented development, which typically takes on an urban form and often requires redevelopment of an existing asset. These projects demand expertise beyond traditional transactional real estate skills: knowledge of tax, environmental and land use law is fundamental.
Over the last twelve months major real estate transactions have been increasingly centered in areas along the region’s growing transit corridors, including the City of Alexandria, Crystal City, Rosslyn and the Rosslyn/Ballston corridor in Arlington County, the Silver Line corridor in Fairfax County inclusive of Tysons, Reston and areas proximate to Dulles Airport. These locations are market validated as proven locations for corporate headquarters and/or significant relocations. Evidence of this trend includes the Amazon HQ2 announcement in Crystal City/National Landing, the Nestlé relocation to Rosslyn, and the collective investment in Tysons made by Capital One and countless other major employers.
Congress enacted the Tax Cuts and Jobs Act (TCJA) with the intent of spurring economic growth and development. To this effect, TCJA introduced reduced corporate and individual tax rates, the immediate write-off of business capital expenditures, and new tax incentives under the Opportunity Zone program. The real estate investment landscape is impacted, directly and indirectly, by the overhaul of the tax code, as it presents many new opportunities and pitfalls.
One of the key enactments of TCJA was the Opportunity Zone program, whose objective is to bring new business capital to low-income and distressed communities. Fundamental to the program is the situs of where the businesses are to be located. Accordingly, real estate investors are determining how best they can participate in the program to achieve their tax objectives.
As of the first quarter of 2019, there has been limited regulatory guidance on Opportunity Zones providing precise certainty to taxpayers. While some questions remain open or unclear, there has been significant traction in the Opportunity Zone community, and funds have been forming to take advantage of the capital gains tax deferral and reduction available under the program. Given that the first set of regulatory guidance was taxpayer-friendly, additional guidance of a similar temperature is expected shortly to help fill in the gaps. Guidance is highly anticipated, due to take advantage of the 15% reduction on capital gains tax expiring at the end of 2019.
Single purpose entity (“SPE”) limited liability companies are a very prevalent ownership structure used in Northern Virginia to buy and sell real estate. Limited liability companies are prevalent because they combine the limited personal liability feature of a corporation with the tax advantages of partnerships. SPEs (or single asset entities) are prevalent because lenders often require these to insulate their collateral from the claims of other creditors.
In Virginia, all forms of property (eg, residential, industrial, offices, retail, hotels) use the same form of deed of conveyance. Section 55-48 of the Virginia Code sets forth the general requirements for a deed of conveyance. At common law, deeds in Virginia required a wax-imprinted seal or scroll. Section 11-3 of the Virginia Code, however, sets forth acceptable substitutes, which include: (i) a “scroll by way of seal”, (ii) an imprint/stamp of a corporate or official seal, (iii) the use in the body of the document of the words “this deed” or “this indenture” or other words recognizing a seal, and (iv) the notarization of the document.
There are four types of deeds used to convey property in Northern Virginia: a special warranty deed, a general warranty deed, a deed with “English Covenants of Title”, and a quitclaim deed. In a special warranty deed, the grantor warrants that neither the grantor nor anyone claiming by, through or under the grantor has done anything to defeat or diminish the grantee’s rights in the property. In a general warranty deed, the grantor generally warrants the title conveyed and promises to defend the title against the claims and demands of all persons, back to the beginning of time. If a deed contains “English Covenants of Title”, then the promises and representations set forth in Section 55-71 through 55-74 of the Virginia Code are incorporated into the deed. Lastly, in a quitclaim deed, the grantor makes no warranty or covenant of title, and merely conveys such title as the grantor has, if any. All such deeds are recorded in the land records of the county in which the property is located.
Due diligence for real estate acquisitions in Northern Virginia typically includes the following, at a minimum:
Items a) to c) above are typically handled by the buyer’s counsel at the buyer’s expense, while items d) to f) are typically handled by the buyer’s engineers at the buyer’s expense.
The representations and warranties provided in a purchase and sale agreement vary widely, depending on the agreement. Typical representations and warranties include the following:
The buyer’s remedies for a breach vary widely, depending upon what is negotiated in the purchase and sale agreement. In some agreements, it is merely a condition to closing that the representations and warranties be true and correct; in these agreements, the buyer may only recover its deposit and its third party out-of-pocket expenses. In other agreements, the seller may include a provision that prohibits the buyer from suing for any damages for a breach unless and until the aggregate amount of such damages exceeds a certain minimum threshold, whereupon the seller shall be liable for all damages up to a capped amount. In any event, recovery is usually limited to actual damages incurred, excluding consequential, exemplary, or punitive damages.
Recent years have seen considerable foreign investment in the region’s real estate economy. Such investment decisions involve a variety of practical tax and regulatory concerns that are most appropriately addressed on a case-by-case basis.
The Virginia Waste Management Act and the State Water Control Law are the state laws that govern oil and solid and hazardous waste liability issues in Virginia. The statutory language provides, as a general matter, liability for a person who caused or permitted contamination to occur, or for a person who is the owner or operator of a petroleum underground storage tank. This language can be used by the Virginia Department of Environmental Quality to hold an otherwise innocent purchase liable for pre-existing contamination, but the statutes provide defenses for bona fide prospective purchasers and innocent landowners who meet certain standards, which are similar to EPA’s “all appropriate inquiry” standard under CERCLA. Thus, before acquiring contaminated property in Virginia, it is advisable to obtain concurrence from DEQ that a purchaser will be considered a bona fide prospective purchaser.
The allocation of environmental liabilities among purchasers and sellers is a matter of negotiation, so it is hard to state what is a “typical” allocation, other than to say that the most common split is for a seller to retain liability for pre-existing liabilities and for a buyer to be responsible for post-closing environmental liabilities that did not arise before the closing.
Most purchase and sale agreements have a provision wherein the seller represents and warrants that they have not used any portion of the property to store, handle or dispose of hazardous waste. This representation and warranty is usually limited (i) so it does not extend to the period before the seller acquired the property, and (ii) to the seller’s actual knowledge, which is typically defined as the actual knowledge of a specified individual without the duty to investigate or review the due diligence provided. Aside from this express representation and warranty, a buyer typically acquires the property in its “AS-IS, WHERE IS, CONDITION.”
The Code of Virginia provides localities with the ability to classify and determine the use and other characteristics of territory in its jurisdiction. A prospective buyer generally ascertains the uses permitted for a parcel of real estate by reviewing the jurisdiction’s zoning map, and consulting the related provisions of the locality’s zoning ordinance and comprehensive plan. The zoning ordinance will typically provide a range of uses, with qualifications where applicable, which may be permitted on the parcel either by right, or through one or more legislative approval processes. An owner seeking uses not typically permitted under the applicable zoning may seek a rezoning of the parcel, which typically requires the owner to agree to appropriate development conditions or proffers, all dependent on and related to the development proposal.
Local governments enjoy the ability to potentially condemn property for public purpose; this authority is derived from Va. Code §15.2-1901. Prior to any condemnation, the locality must hold a public hearing and adopt a resolution or ordinance approving the proposed public use in directing the acquisition of the property. There are also jurisdictional procedures and prerequisites to filing a condemnation action (ie, notice, appraisals, offers and negotiations) under the applicable law: the property condemned must be for a “public use”, which requires the property to be within the control of the condemning authority. Said differently, there must be a right by the public or some public agency to use the property as a matter of right as opposed to a favor or a license. A taking is generally not for public use “if the primary use is for private gain, private benefit, private enterprise, increasing jobs, increasing tax revenue or economic development.” However, the fact that the property may also incidentally benefit some private individuals does not destroy the public use. Ultimately, the public interest must dominate any private gain. The condemnor has the burden of proving public use but courts generally do not inquire into the locality’s good faith in initiating condemnation proceedings if the locality’s purpose is clearly stated in the resolution or ordinance.
The Grantor Tax (Section 58.1-802 of the Virginia Code) is a tax imposed on each deed by which realty is conveyed. The amount of this tax is 50 cents for each $500 or fraction thereof of consideration (exclusive of assumed debt). Section 58.1-811C of the Virginia Code lists certain exemptions. This tax is typically paid by the seller.
The Regional WMTA Capital Fee (Section 58.1-802.3 of the Virginia Code) is a tax imposed on each deed by which realty located in any county or city that is a member of the Northern Virginia Transportation Authority is conveyed. The amount of this tax is 15 cents for each $100 or fraction thereof of consideration (exclusive of assumed debt). The same exemptions that apply to the Grantor Tax apply to this tax. This tax is typically paid by the seller.
The State Recordation Tax (a/k/a “Grantee Tax”) (Section 58.1-801 of the Virginia Code) is imposed on every deed admitted to record, except those that are exempt by law. The amount of this tax is 25 cents for every $100 or fraction thereof of the consideration of the deed or the actual value of the property conveyed, whichever is greater. Section 58.1-811A of the Virginia Code lists certain exemptions. This tax is typically paid by the buyer.
The Local Recordation Tax (Section 58.1-814 of the Virginia Code) is a tax that localities are authorized to collect in addition to State Recordation Tax. This tax is equal to one-third of the amount of state recordation tax, and is typically paid by the buyer.
Recent years have seen considerable foreign investment in the region’s real estate economy. Such investment decisions involve a variety of practical tax and regulatory concerns that are most appropriately addressed on a case-by-case basis.
Similar to financing in other States, acquisitions of commercial real estate in Virginia are usually financed through both debt and equity transactions. Installment sales and sale leasebacks are not commonly used for financing transactions. Sources of debt include commercial banks, insurance companies, investment funds and other lending institutions that provide term loans, bridge loans, lines of credit and construction loans. Loans are secured by liens on real estate and other related assets. Equity can come from various sources, including REITs, equity investors, funds and individual investors. Subordinate and mezzanine debt are also common in large real estate financing transactions.
Commercial real estate loans are typically secured by a deed of trust, which creates a lien on the real property and permit non-judicial foreclosure actions, rather than a mortgage, which requires a longer judicial foreclosure process. Deeds of trust and mortgages are both filed in the land records of the County or City where the real property is located. Deeds of trust and mortgages also typically include an assignment of leases and rents, although separate assignment documents may also be recorded in the land records. Depending on the type of loan, lenders may also take assignments of construction agreements and construction-related documents, management agreements, etc. In addition to a real property lien, lenders also take a security interest in the personal property related to the real property. Liens on personal property are perfected by filing a UCC financing statement filed at the State level and in the County land records for fixtures (although the deed of trust can also be used as a fixture filing). The Virginia Code specifies certain document requirements for deeds of trust and mortgages. Most lenders also require guaranties in connection with commercial real estate loans in Virginia.
A foreign out-of-state lender who just makes a loan in Virginia is not deemed to be doing business in Virginia. A foreign lender would not have to qualify to do business in Virginia and there are no restrictions that would apply to foreign lenders. However, other actions may result in a lender being deemed to be doing business in Virginia.
Subject to limited exemptions, the recording of most deeds, including deeds of trust and mortgages, requires the payment of recording tax in Virginia (at a rate of 25 cents on every $100 or fraction thereof of the principal amount secured, as such rate reduces incrementally for each $10 million up to $40 million, and thereafter at 13 cents) plus local recording tax equal to one third of the state recording tax. On deeds of trust or mortgages securing the refinancing of an existing debt secured by a deed of trust or mortgage on which the tax was paid, the rate for the state recording tax is 18 cents on each $100 of the principal amount secured, declining to 10 cents for amounts at or above $40 million, plus the local tax equal to one third of the state tax. In addition, there are administrative filing fees charged by the recording offices. In connection with enforcing its lien, a lender will incur administrative fees and attorneys’ fees, and will often need to cure any unpaid taxes.
Granting a security interest in both real and personal property is subject to typical legal requirements and the requirements of the borrowing entity’s organizational documents, such as receiving consideration, having legal capacity and authority, taking all necessary action to authorize the grant of a security interest, and having a valid interest in the real property. For individual borrowers, spousal counsel rules apply.
Both the non-judicial foreclosure of a deed of trust and the judicial foreclosure of a mortgage must comply with the applicable Virginia Code procedural requirements, including notice of default and acceleration, applicable opportunities to cure, and public sale notices. Judicial foreclosure proceedings are less common, as deeds of trust are used most commonly in Virginia. In addition, default notices must comply with the requirements of the applicable loan financing documents.
Existing lenders can agree to subordinate their debt and lien rights to newly created debt. Such arrangements may be done by various agreements, such as subordination agreements or intercreditor agreements. Although not lenders, mechanics’ and materialmen’s liens in Virginia can gain priority over a pre-existing recorded deed of trust or mortgage. Tax liens also have priority over liens of existing lenders.
Similar to other States, lenders who take title to real property through foreclosure have potential liability as an owner of a property with environmental liability, or as a lender if they actively participate in the management of the property. Such liability under federal and Virginia law is subject to standard exemptions available to lenders. Most lenders will obtain an updated environmental review of the real property prior to taking title to the property by foreclosure. Most commercial loan documents require both borrower and guarantor to indemnify the lender for all environmental matters, and such indemnity survives both foreclosure or payment in full of the loan.
If a borrower becomes insolvent, it will typically be the subject of a bankruptcy action, the filing of which creates an automatic stay to any foreclosure or enforcement action being taken by a lender. The lender should be able to get relief from the automatic stay as a secured creditor with a valid lien on the real property. A lender should protect itself from any challenges by avoiding being under-secured and not actively managing the property before foreclosure to avoid lender liability claim.
Typically, questions of design and appearance – insofar as these are subjective aesthetic criteria – are not raised or adjudicated by the language of a local government’s zoning ordinance in Virginia, with exceptions made for those portions of the locality that are deemed to be a historic site, structure, or similar. In practice, these sorts of aesthetic questions arise primarily during the public process for development proposals seeking legislative action by the local government. Local government employees, elected officials and residents often make requests for certain concessions that may or may not arise from local planning documentation, such as a comprehensive plan.
Local governments, such as a county’s Board of Supervisors, are given the authority to enact and enforce comprehensive planning, and to regulate the use and development of land through the adoption of a zoning ordinance. Local ordinances will typically detail uses permitted in a geographically bound district and ascribe certain requirements to permit the conduct of that use, and may also restrict the density, height, and size of a parcel.
Based on its enacted local ordinances, each local jurisdiction will feature distinct documentary and procedural requirements for subdivisions, amendments to the zoning ordinance, and development permits, with a local lexicon of established terms to match. In practice, a project will typically be entitled either through a “by right” process, wherein a development is allowed under existing local zoning rules and is processed by that locality as an administrative matter, or as a discretionary act of the local government. By right entitlements are generally not subject to public input or public hearings.
Discretionary approvals are typically the more time-intensive and costly of entitlements to obtain. The Virginia Code sets out mandatory notice provisions in § 15.2-2204, and others. Depending on the specific nature of the development proposal, a discretionary approval may include significant fees and public hearing appearances before one or several local bodies, and in limited circumstances can involve the negotiation of contributions or other proffers to offset the public cost of proposed development.
As subdivisions of the State, localities have the benefit of sovereign immunity. Appeals against a locality’s decision must be purely statutory in nature. Administrative decisions of a local zoning administration can typically be brought to a locality’s Board of Zoning Appeals, which is empowered under the Virginia Code to, in part, hear appeals of a zoning official’s decisions, determinations, orders, and requirements, per § 15.2-2311. Other matters, such as appeals of a local government’s zoning ordinance decision, may be heard by the Circuit Court.
Depending in part on the geographic location of the proposed development, and the local ordinances adopted by the local jurisdiction, larger-scale development projects by private developers may require agreements setting out certain parameters of development, and providing for the terms and conditions under which the development proposal may proceed.
In some jurisdictions, a series of proffers may be required to secure approval of a proposal, which may include terms and conditions for the provision of certain public benefits, inclusive of transportation improvements, public parks, and affordable or workforce housing. Often, these conditions must be fulfilled to a degree that is satisfactory to the local government prior to the issuance of permits required for development or occupancy.
Subject to variations in local ordinances, most local governments have a series of options at their disposal to ensure restrictions on development or use are enforced. These options range from the issuance of notice violations that identify violations and assign fines, to the denial of critical construction-related or occupancy-related permits, to the denial of future redevelopment or expansion opportunities to properties or structures deemed to be nonconforming with the local zoning ordinance.
Real estate assets are typically held by limited liability companies (LLCs), corporations, and limited partnerships (LPs). Each of these types of entities offers varying degrees of liability protection to the individual investor. From a tax perspective, LLCs and LPs are preferred because corporations impose two layers of taxation – once at the corporate level and once at the shareholder level. LLCs and LPs typically elect to be taxed as partnerships for tax purposes, passing through the income to be taxed only once, at the partner level. In addition, partnerships offer significant flexibility in structuring the economic terms of a deal, whereas corporations are often restricted to the type and quantity of stock issued. There are also real estate investment trusts, which are corporations (or business trusts) that pass through the income to be taxed at the REIT shareholder level.
Corporate income is subject to two layers of taxation, resulting in a significant reduction in return, due to the structure. Furthermore, shareholders are often restricted in how profits can be shared. Despite these drawbacks, corporations are often utilized by foreign investors seeking to avoid withholding issues and tax-exempt investors seeking to jeopardize their exempt status. The pass-through nature of partnerships, though a benefit in many cases, serves the opposite in such instances.
LLCs and LPs offer the equity holders significant flexibility in how profits can be shared. In addition, the single layer of taxation allows investors to maximize returns. Because of the pass-through nature of partnerships, this allows for tax-planning opportunities whereby often the purchase of partnership interests effectuates an asset sale, allowing the buyer to take advantage of increased basis in assets acquired.
The primary drawbacks of electing to be classified as a corporation (as opposed to a partnership) is the double layer of taxation – once at the corporate level, and again at the shareholder level when receiving corporate dividends. There may be ways to achieve the same objective by being classified as a partnership for tax purposes. A key tax benefit is removing one level of taxation by forming a pass-through entity such as a partnership. Partnerships generally also allow for flexibility in allocating income among the partners, whereas a corporation is restricted to the stock it has issued. For example, in a partnership setting, different distributions of profits and losses allow for parties to arrange economics without corporate tax law rigidity getting in the way.
Articles of incorporation and corporate bylaws typically provide how a corporation operates. The articles of incorporation filed in a jurisdiction list the name, registered office and address of the corporation. Corporate bylaws provide how shareholders vote for members and how the board elects officers, among other things. Real estate investors should carefully review corporate and partnership governing documents to understand the rights and liabilities associated with such investment.
The primary arrangement in Virginia to document the use of real estate for a limited period of time is a lease, in which a property owner (as “landlord” or “lessor”) grants a leasehold estate to an occupant or user (as “tenant” or “lessee”) for a stated period. This may also take the form of a sublease, where an existing tenant/lessee grants a “sub”-leasehold estate to another occupant or user (as “subtenant” or “sublessee”). The sublease is often on separate written terms and conditions, and is typically subject and subordinate to the primary (or “master”) lease.
Alternatively, parties may elect to enter into a license agreement, which is a contractual arrangement that can be similar in nature to a lease, depending on the terms negotiated by the parties. The primary difference between a lease and a license is that, at common law, a license is revocable by the grantor and does not grant any formal “property” rights. Licenses are typically utilized for more short-term uses where the parties do not wish to establish a formal leasehold estate.
Finally, parties may also enter into an easement for this purpose. Like a lease, an easement grants an interest in real property, and for this reason easements are most commonly used to grant rights of a permanent nature (eg, utility easements, rights of way, etc). However, temporary easements are utilized in certain circumstances (eg, temporary access/construction easements, crane swing easements, etc). Easements may be exclusive or non-exclusive in nature.
Commercial leases may be classified in several ways. A common means of distinguishing between different types of leases is with regard to rent structure. For example, in a “gross” lease the tenant pays a single rental amount that is inclusive of all of its monetary obligations to the landlord. Gross leases are often also “full service” leases, meaning that the landlord provides all utilities and other services to the premises, all of which are included in the base rent. Alternatively, in a “triple net” lease, the tenant pays a base rent and also its proportionate share of real estate taxes, insurance, and common area expenses pertaining to the property, such that the base rent payment is the “net” rent received by the landlord. There are numerous variations of these categories, all of which are subject to negotiation and modification by the parties to the lease. In one typical variation, sometimes referred to as a “modified net” lease, the tenant’s obligation to pay for a share of taxes, insurance and operating expenses applies only to the increases in those sums over the amounts payable by the landlord in a “base year” (typically the first year of the lease).
Another example is a “percentage” lease, in which the tenant pays base rent and additional rent as noted above, and also pays the landlord a percentage of its gross sales earned during a particular period, which may sometimes be limited to only a percentage of sales above a certain “break point”. Percentage leases are typically limited to certain kinds of retail leases, and the terms are heavily negotiated (including the applicable percentage and break point, the required accounting and reporting periods, the identification of what sales are to be included/excluded from the calculation, etc).
Leases may be also categorized according to the nature of what is being leased. For example, “space leases” are those in which the tenant leases space in an existing building or property, or perhaps even an entire existing facility. In contrast, in a “ground lease” the tenant leases only the land owned by the landlord. In that case, the tenant typically constructs all of its own improvements and owns those improvements during the term, including for tax and accounting purposes.
It should be noted that each of the foregoing categories are just general examples of typical categories and arrangements, and that parties are generally free to negotiate any manner of variations to suit their particular needs.
Rents and lease terms for commercial leases are not typically regulated in any material way. However, note that leases in which a city or county is the landlord are limited to terms of 40 years (except leases of air rights, which may be for 60 years). See Virginia Code § 15.2-2100. Also, creditor’s rights laws may impact certain lease terms, including the imposition of interest, etc.
As described above, the terms of a lease may vary depending on the identity of the parties, the nature of the use, the property being leased, and the various needs of the parties. Because commercial leases are not heavily regulated, the parties are free to negotiate virtually unlimited variations, depending on their particular circumstances. However, the following are examples of typical lease terms.
Length of Term: terms are sometimes as short as one year when needs are temporary, or even “month to month”. For most small retail and office leases, a typical term may be three to five years in length, often with one or more renewal options for similar periods. In contrast, leases in which significant renovations or investments are made, or in which significant incentives are offered (eg, anchor retail leases, headquarters office leases, etc), may have terms closer to ten years or more, also with renewal options. Ground leases are typically much longer, for at least 20-30 years (with options to extend), and sometimes as long as 99 years.
Maintenance and Repair: in a multi-tenant facility, a tenant is typically responsible for all interior, non-structural repairs and maintenance of its particular premises, while the landlord is responsible for maintaining the roof, foundation, exterior walls and other structural elements, and also the common areas (eg, parking, landscaping, common stairwells and elevators, etc). In multi-tenant facilities, landlords will often also be responsible for the maintenance of HVAC, electrical, plumbing, and other similar “systems” that serve the entire property, while tenants are typically responsible for any systems that exclusively serve their premises. In contrast, in a single-tenant facility the tenant may be responsible for all repair and maintenance for the entire property, including common areas, although landlords often remain responsible for certain key structural elements (eg, the roof). In some cases, landlords may also remain responsible for major capital replacements, including for HVAC or other systems. Finally, in a ground lease the tenant is typically responsible for any and all required maintenance or repairs.
Frequency of Rent Payments: m,ost commercial leases specify an annual base rent that is payable in equal monthly installments. However, parties are generally free to negotiate this, and rent may be paid quarterly, annually, or in any other manner. Similarly, in triple net leases or other leases with “additional rent” components, the tenant’s share of taxes, insurance and operating expenses are often paid monthly, based on the landlord’s estimated costs (and later adjusted when actual costs are determined). However, in some cases landlords reserve the right to charge these amounts in lump sums or as costs are incurred (eg, when taxes or insurance premiums are actually paid). In contrast, percentage rents are normally paid less frequently (eg, quarterly or bi-annually), depending on the negotiated reporting periods and given the administrative burden of calculating and reporting sales on a monthly basis.
Parties are generally free to negotiate variations in base rent as they see fit. However, under most commercial leases the base rent will increase at regular intervals over the course of the term, typically on an annual basis (ie, on each anniversary of the rent commencement date). However, these adjustments sometimes occur less frequently (eg, every three to five years, or at the time an extension option is exercised, etc).
In contrast, operating expenses and other “additional rents” are typically based on the landlord’s actual expenses incurred in a given year, so they typically do not vary on a regular schedule. Rather, tenants typically pay a fixed amount each month, based on the landlord’s estimated costs, and the parties make an annual adjustment once all final costs are known. However, in each new lease year the landlord may reserve the right to modify or increase its estimates, and thereby increase or modify the tenant’s monthly estimated contribution.
Parties are generally free to negotiate the manner in which rent may be changed or increased. A typical approach is to impose a fixed increase (usually expressed as a percentage of the existing rent) on an annual basis, usually effective on each anniversary of the rent commencement date. Another common approach is to calculate the increase based on the increase in CPI (if any) over the prior year. Parties may also wish for the rent to be fixed for several years at a time, but then for rent to be adjusted every three to five years, or at any time an extension option is exercised.
Parties may also require the rent to be adjusted to the “fair market rental value”. The means of determining the FMV can be negotiated, but the most common approach is some variation of a “three-appraiser” method, where each party selects an appraiser to calculate the FMV, and if they cannot agree then the two appraisers select a third appraiser, and the FMV is the average value of the three calculations, or the median value, or the value selected by the third appraiser, or some other variation on the foregoing. Adjustments of base rent for a renewal period are often determined in this manner.
At the time of writing, Virginia does not impose any tax specifically on the payment of rent, but it is not uncommon for a lease in Virginia to provide that, if such a tax is ever imposed, it will be paid by the tenant (particularly in the context of a triple net lease). However, landlords and tenants are of course subject to ordinary federal, state and local income taxes, franchise taxes, business taxes, and other similar levies.
Tenants will incur various costs at the start of a lease, which will vary depending on the nature of the lease, the condition of the space, and the nature of their business. At a minimum, tenants must typically deliver a security deposit (usually in cash, but sometimes in the form of a letter of credit) and also the first one or two months of base rent and additional rent, although this will vary depending on the creditworthiness of the tenant.
Tenants may also incur costs for the buildout or upfitting of their space, to prepare the premises for use and occupancy. In many commercial leases, landlords will offer an “improvement allowance” that may be utilized by the tenant for the performance of its work. The terms of these allowances are heavily negotiated, but common features include requirements that (i) the landlord must approve all plans and specifications, and the identity of all contractors, (ii) the allowance may be drawn down by the tenant at regular intervals (usually monthly) only upon the delivery of invoices, lien waivers, and other customary documentation, and (iii) the allowance must be utilized within a fixed period (eg, one year). In addition, many landlords require that the allowance may be applied only to the “hard costs” of construction, as opposed to soft costs such as architects’ fees, moving costs, or furniture costs. In some cases, however, parties may negotiate for all or part of any unused allowance to be applied to offset the base rent or to be applied as a “refresh” allowance later in the term.
The maintenance and repair of the common areas in multi-tenant properties are typically performed by the landlord. However, the costs of that work are usually passed along to the tenants as part of their additional rent obligations, where each tenant pays a proportionate share of these expenses based on its square footage. In some cases, a tenant may only be responsible for its share of the increase in these costs above the amount incurred by the landlord in a base year. However, tenants may negotiate detailed exclusions to the list of includable expenses, so that they are not required to reimburse the landlord for certain itemized costs.
Unless a particular service or utility exclusively serves a particular tenant’s premises, the provision of services and utilities to multi-tenant facilities is typically the obligation of the landlord. However, the means in which the costs of these services and utilities are paid depends on the nature of the lease. In a gross or full-service lease, the landlord provides and pays for all services and utilities, and the tenants pay only the base rent. In a “triple net” lease, the landlord will provide common area utilities and building-wide services, the costs of which are reimbursed by the tenants in proportion to their square footage. Tenants typically pay for their own premises-specific services, although this can also be negotiated.
Landlords may also provide utilities directly to a tenant’s premises, including electricity, plumbing and HVAC service, the costs of which are also reimbursed by the tenant. These reimbursements may be made on the basis of a tenant’s square footage, but in cases where these services are separately metered, or where the landlord deems that a tenant’s use is unusual or excessive, then the tenant may be required to pay based on its actual usage, or in some other manner. Similarly, in some cases (most commonly in large multi-tenant office buildings), landlords will often limit the provision of certain services to regular “business hours”, and charge additional costs for after-hours usage, especially for HVAC.
Telephone, internet and other similar telecommunications services are often obtained and paid for directly by a tenant, given that each tenant often has particular or specific needs. Tenants often have their own telecommunications systems installed at their own expense (including cabling and wiring, which must often also be removed at great expense) and will contract directly with the appropriate service providers.
In commercial leases for multi-tenant facilities, the landlord is usually responsible for obtaining and maintaining an “all risk” casualty insurance policy with respect to the improvements, and commercial general liability insurance with respect to its operation of the common areas. In a gross lease, the landlord bears all costs for such insurance. In a triple net lease, each tenant will reimburse the landlord for its proportionate share of the costs of such insurance.
In some circumstances, tenants will carry the casualty insurance on the improvements. This is especially true for long-term leases of single-tenant facilities, and also for virtually all ground leases (where the tenant is the actual owner of the improvements). In cases where the tenant insures any improvements, the tenant will typically name the landlord and its lender as additional insureds or loss payees, as their interests may appear.
Finally, tenants are often required to maintain insurance on their personal property, and also on any leasehold improvements or alterations made to the premises during the term. Tenants are also almost always required to maintain commercial general liability insurance, including coverage for personal injury and property damage, and including the landlord and its lender as additional insureds.
Most commercial leases limit the permitted use of the leased premises, whether for retail, office, warehouse, or other use. Office and warehouse leases may typically refer only to “general” office or warehouse use, while other kinds of leases are much more specific. For example, retail leases may contain very specific descriptions that address particular details of what may be sold, or how much space may be devoted to the sale of particular items, often to protect exclusive use rights that may have been granted to other tenants. These leases may also include a list of prohibited uses that are forbidden within a particular shopping center or development. Similarly, leases for industrial or manufacturing uses are often tightly controlled, given landlords’ desire to protect their property from environmental problems and nuisances.
In addition to limitations imposed by a lease, parties are subject to the zoning ordinances and regulations of the jurisdiction in which the premises is located. These may limit the permitted uses, or specify more prohibited uses. They may also include regulations on the number of required parking spaces, building codes, signage restrictions (size, height, etc), and any other number of issues.
Finally, a property may also be subject to recorded covenants, conditions or restrictions that impact its use or development. For example, properties located in retail shopping centers, office parks and industrial parks are often encumbered by a declaration of easements or covenants that control permitted uses, require approval of new development (typically by an architectural committee or other governing body), or grant utility, access or other easements to adjacent owners.
The extent of a tenant’s right to alter or improve its premises depends on the identity of the tenant and the nature of its lease. In a long-term ground lease where the tenant owns the improvements, there are typically few limitations (if any) on the tenant’s right to make alterations, provided they do not adversely affect the fair market value of the landlord’s property. Similarly, a credit tenant under a relatively long-term lease, or a tenant in a single-tenant facility, will have wider flexibility than a tenant under a short-term lease in a multi-tenant facility.
Where restrictions exist, there are some common features. Most landlords prohibit exterior or structural alterations, or any alterations that impact the HVAC, electrical or other building systems, without their consent. Even interior, non-structural alterations may be prohibited without consent if they are substantial in nature (eg, if they require a building permit, or if they exceed a certain dollar threshold). For permitted alterations, landlords typically require the right to approve the plans and specifications for the work, and also the identity of the contractor(s) performing the work. In the case of substantial additions, landlords may also require final plans or as-built surveys upon completion. In many cases, landlords also reserve the right to require tenants to post bonds or other security in advance of performing the work, and also that lien releases and other similar documentation be provided upon completion.
Finally, most commercial leases provide that the landlord may elect to require the tenant to remove the alterations at the end of the term, at the tenant’s expense, although the tenant may request that the landlord makes this election earlier in the term (eg, at the time the landlord consents to the alteration).
All residential leases in Virginia are governed by the “Landlord and Tenant Act” codified at Va. Code §§55-217 et seq. This Act also applies to non-residential leases, unless they specifically provide otherwise.
Note that residential leases are also subject to the Virginia Residential Landlord and Tenant Act, at Va. Code §§ 55-248.2 et seq.
Leases made by cities, counties and other governmental agencies are subject to various other laws and regulations that are too numerous to list here, but may be found in Title 15.2 of the Virginia Code, or in other enabling legislation for the particular agency or authority in question.
Many commercial leases provide that a tenant’s insolvency will give rise to an event of default under its lease. In some cases this is “curable”, but in many events it constitutes an automatic default, giving rise to all rights or remedies granted to the landlord under the lease or otherwise available at law.
Separately from the terms of a lease, an insolvency on the part of the tenant, and any rights of the landlord arising in connection with such event, will be subject to the applicable federal bankruptcy laws.
The most common form of security in a commercial lease is a cash security deposit. The amount of the deposit is negotiable and will depend on the credit of the tenant, the length and nature of the lease, the amount (if any) invested by the landlord in the space, and other factors. Deposits equal to one or two months of rent are common, although for large, credit tenants it is common for the deposit to be waived altogether. Landlords under commercial leases are typically permitted to comingle the deposit with other funds, and are not required to hold the deposit in a separate account. Deposits typically do not accrue interest. When a landlord is required to utilize any portion of a deposit, the tenant is often required to immediately restore the deposit to its full amount.
Security deposits may also be in the form of a letter of credit. Landlords typically require approval of the issuing bank and the form of the letter of credit, which can be heavily negotiated. In some cases, the parties may negotiate for the letter of credit to be reduced or returned to the tenant upon certain occasions (eg, the passage of time without a default, etc). Alternatively, the tenant may have the right to convert the deposit to cash.
Another form of security is a parent guaranty or personal guaranty, often issued by a parent company of the tenant, or a personal stakeholder in the tenant.
Finally, although less frequently required, some landlords may require additional security in the form of a lien on the tenant’s fixtures, furnishings, equipment and other personal property, which may be perfected by the filing of a UCC-1 financing statement. Also, landlords sometimes reserve the right to require additional or separate security in specific instances (for example, the posting of a bond or additional security before permitting a material alteration).
In some instances, parties may negotiate for a tenant to have a limited period of time to remove its property after a lease expires, but most leases require a tenant to vacate the premises and remove its property on or prior to the expiration date. Accordingly, in most cases a tenant does not have the “right” to occupy its premises after termination or expiration.
If a tenant fails to timely vacate the premises, it becomes a “holdover tenant”, which may result in the tenant becoming a month-to-month tenant, a tenant at will, or a tenant at sufferance, which enables the landlord to exercise varying degrees of termination rights (for example, a month-to-month tenancy may be terminated on 30 days' prior notice). In all cases, commercial leases typically provide that “holdover rent” will immediately begin to accrue at an increased rate, often as much as double the base rent that was payable at the expiration date. In addition to holdover rent, many landlords reserve the right to pursue a holdover tenant for other damages that may be suffered on account of the holdover, including consequential damages.
Finally, most commercial leases also specify that if the tenant fails to remove its personal property by the expiration date, the property will be deemed abandoned. In such cases, landlords usually reserve the right to remove, store and/or sell the property at auction, all at the tenant’s cost.
Commercial leases typically grant the landlord and the tenant limited rights of termination in the event of a material casualty or a condemnation. Also, long-term ground leases often include due diligence periods, permitting periods, and other contingencies in favor of the tenant that may allow the tenant to terminate upon the occurrence of certain conditions.
Otherwise, tenants typically do not receive a termination right, and in fact many commercial leases expressly provide that the tenant waives any right to terminate, even upon a landlord default.
In contrast, landlords often have broad termination rights in the event of a default of the tenant. Many defaults will not arise until after the expiration of a limited notice and cure period in favor of the tenant. However, some defaults are usually “automatic” in nature and may give rise to a termination right in favor of the landlord without any opportunity for the tenant to cure. Examples of “automatic” defaults include prohibited assignments or subleases, a failure to maintain insurance, abandonment of the premises, events of bankruptcy, and other similar, material breaches that are not easily curable.
A tenant can be forced to vacate its premises following a default, provided that the terms of the lease are first observed. As noted above, most commercial leases provide that a default will not occur until after the tenant has received a written notice and an opportunity to cure its breach. For payment defaults, there may be no cure period, or perhaps merely a grace period of five to ten days (ie, no notice to the tenant is required). For non-payment defaults, a notice/cure period of 30 days is typical, although sometimes the lease will permit additional time to cure breaches that by their nature cannot be cured within 30 days. However, as noted above, most leases also describe some non-payment events that result in an “automatic” default, with no grace period and no opportunity to cure.
After the procedures in the lease are observed, if the proper notice(s) have been given and no cure has occurred (if applicable), the process for evicting a tenant is typically the pursuit of an action for unlawful detainer. The basic elements of this action are as follows:
For more information on the foregoing, see, inter alia, Va. Code § 8.01-174 et seq., Va. Code §§ 8.01-470 et seq., and Va. Code §55-237.1.
One circumstance in which a third party may cause a lease to be terminated is a foreclosure by a lender of a deed of trust encumbering a landlord’s property. If a property owner defaults under a deed of trust and the lender forecloses, then any leases subordinate to the deed of trust are automatically terminated as a matter of law in the absence of a written agreement to the contrary. To prevent this, parties have a number of alternatives. This may be accomplished in the lease, and indeed many commercial leases expressly provide that the tenant will attorn to the lender, or that the tenant will even agree to allow the deed of trust to be subordinated to the lease at the lender’s election. Another approach is for the parties to enter into a subordination, non-disturbance and attornment agreement (“SNDA”) that expressly protects the tenant’s leasehold interest for so long as it is not in default under the lease. This is more commonly sought by tenants under longer-term leases, as landlords are often not incentivized to pursue SNDAs for smaller or short-term leases. In some cases, when negotiating a loan for a property with existing leases, landlords and lenders themselves may insist on the execution of an SNDA prior to making the loan, to ensure that the leases are subordinate but also to ensure that critical leases are not “wiped out” in the event of a foreclosure.
Leases may also be terminated in the event of a condemnation of all or part of the property by a governmental authority. Most commercial leases describe in detail the rights of the landlord and tenant to terminate the lease, including their rights to any condemnation proceeds. Most leases provide that all proceeds are the property of the landlord, but that the tenant may separately make a claim for lost property, lost profits, moving expenses, etc, as long as the amount payable to the landlord is not reduced.
There is no dominant price structure used for private projects in Virginia. Projects tend to be structured as either fixed-price or cost-plus-fee contracts. Cost-plus-fee contracts can include a cost plus a fixed fee, but can include a variety of incentives that will up the contractor’s fee to incentivize quality of work, timeliness of completion and the like, and will introduce a variable post-construction fee.
Responsibility for design and construction often depends largely on the financing available to the owner, the owner’s past experience and relative risk attitude, the timeframe for completion of the project, and the contractor involved in any particular project. Such issues can involve the owner contracting with an architect, who is responsible for design, who can then subcontract with engineers and other design professionals as needed. Separately, the owner would contract with a general contractor independently, who is responsible for construction. Alternatively, owners can employee a construction manager or issue design-build contracts.
Construction contracts in Virginia manage risk in a wide variety of ways, including limitations of liability, waivers of consequential damages, insurance, bonding, pricing, scheduling, indemnification, and the like. Contractors can limit their own risk by incorporating a damages cap within the contract, which can help to limit their exposure. Virginia allows indemnification for one’s own negligence in certain circumstances. See, eg, Estes Express Lines, Inc. v. Chopper Express, Inc., 273 Va. 358, 641 S.E.2d 476, 2007 Va. LEXIS 25.
Construction contracts in Virginia can incorporate a variety of provisions in order to help manage schedule-related risks. This starts, first and foremost, with a cooperative approach to formulating the initial project schedule, including the design professionals and the construction contractors. A contract can include incentives for early completion, penalties for late completion, and incentives for reaching schedule-related milestones along the way. Contracts must be carefully drafted to limit and define what constitutes a force majeure event, and must define and create a procedure for delay claims.
Owners often seek additional forms of security to guarantee both the timely performance of a project and the quality of performance of a project. The type of security will vary largely, based on the financial assets of the contractor and the contractor’s track record for project completion and claims. For larger projects, performance and completion bonds are almost always required. For smaller projects, bonds may be difficult or costly for a contractor to obtain, so contracts will often resist posting them or attempt to pass along the cost of said bonds to the owner. Owners often seek additional security by increasing the amount of retention held. In Virginia, the threshold varies depending upon the type of project.
Contractors and designers are entitled to file a mechanics lien against the property in the event of non-payment for a project. A Virginia mechanics lien relates back to the day work commenced on the project and is therefore given a degree of super-priority over after-imposed liens, though only to the extent a lien is recorded after the work commences.
Prior to a property being inhabited or used for its intended purpose, certificates of occupancy or similar permits are a requirement of most local jurisdictions. The nomenclature varies from jurisdiction to jurisdiction. Certificates of occupancy or similar approvals are evidence that the premises is compliant with the applicable zoning and building code requirements. In most cases, certificates of occupancy are also required any time there is a change in use or tenancy of the premises in question.
Gains generated from the sale of real estate are typically subject to a 20% federal capital gains tax. The gains may also be subject to tax at the state and local level, where the rates vary greatly among the states and municipalities. At the state and local level, the sale or purchase of real estate may also be subject to a transfer tax, unless any exemptions apply. Parties often negotiate to determine who will bear the transfer tax costs, as they may be significant in certain jurisdictions.
A commonly employed method for reducing federal, state, and local taxes is utilizing tax-efficient structures. In some cases, it may be advantageous to structure a real estate sale as a sale of equity interests rather than a sale of the real estate asset itself. Given the nuances of state and local tax laws and particular deal terms, tax-efficient structures are designed for the transaction at hand. Often, such structures can achieve tax deferral and, in some cases, reduction.
Municipal taxes (and the exemptions thereto) vary greatly among the municipalities.
Foreign passive investors are generally subject to US income tax withholding on their “FDAP” (fixed, determinable, annual or periodic) income, which includes dividends and rents from real property. The 30% withholding rate on FDAP income is reduced if there is an applicable income tax treaty between the US and the foreign investor’s home country. Foreign active investors, on the other hand, are generally subject to the same rates as US taxpayers: 21% for corporations, and 37% for individuals.
When a real estate asset is sold in either an asset deal or an equity deal, tax withholding should be considered regardless of whether the foreign investor is active or passive. The Tax Cuts and Jobs Act imposed additional withholding requirements when a foreign investor sells a partnership interest. Given the heightened concerns on withholding, foreign investors may find it advantageous to invest in US real estate through a “blocker” corporation (including REITs) to alleviate withholding and other tax concerns.
There are a number of tax benefits available from owning real estate, including deductions for depreciation, property taxes, and mortgage interest payments. The latter two deductions have been curtailed under the Tax Cuts and Jobs Act but remain available in limited circumstances. Furthermore, depending on how the real estate asset is held, there may be a 20% business pass-through deduction available.
More than just tax deductions, taw law is abound with several real estate-specific tax incentives, like tax deferral for “like kind” exchanges, and more general ones, like the rehabilitation tax credits, energy infrastructure tax credits, and capital gains tax deferral under the Opportunity Zone program. Identifying key tax benefits applicable to owning certain real estate through certain investment vehicles potentially leads to greater economic returns.
The Tax Cuts and Jobs Act brought sweeping changes to federal tax law at the end of 2017. One of the key areas affecting commercial real estate investment was the advent of the Opportunity Zone program, which allows investors to defer the capital gains tax by rolling over such proceeds into a qualified opportunity fund. In turn, the fund mustinvest its capital directly (or indirectly) into business property located in an opportunity zone, which is a designated tract in the US, generally identified as low-income and distressed areas. Depending on how long the investment is held in the fund, the investor may reduce 10%, 15%, and even 100% of the capital gains tax that was owed on the initial capital gains tax.
As the Department of Treasury and Internal Revenue Service continues to roll out regulatory guidance on the new Opportunity Zone program, real estate investors are finding ways to participate in the redevelopment of the areas designated as opportunity zones. Many real estate investors are seeking to invest in a qualified opportunity fund this year to take advantage of the 15% capital gain tax reduction available.