SB28

Report Title:

Leasehold Rent Renegotiations

Description:

Permits the circuit court to determine whether a lease rent renegotiation based upon present fair market value of the land may result in an inequitable lease rent subject to a one-time adjustment.

THE SENATE	S.B. NO.	28
TWENTY-THIRD LEGISLATURE, 2005
STATE OF HAWAII

A BILL FOR AN ACT

RELATING TO LEASEHOLD.

BE IT ENACTED BY THE LEGISLATURE OF THE STATE OF HAWAII:

SECTION 1. The legislature finds that leasehold ownership in Hawaii is, has been, and probably will continue to be a common form of land ownership. Historically, the land ownership system in Hawaii has been characterized by the concentration of the fee title to lands in the hands of a few estates, trusts, and other private landowners. This pattern of land ownership on Oahu has led to the practice of landowners leasing, rather than selling, their land. The ownership of land beneath developments is consistent with this pattern of land ownership. Owners of property have refused to sell the fee-simple title to lessees and instead established long-term leases. These master leases have terms and conditions weighted in favor of the lessors or fee owners against the lessee developers. The pervasiveness of this practice has resulted in a serious shortage of fee-simple property and increased costs. It has also contributed to a malfunctioning real estate market that has helped to create undesirable socioeconomic impacts in Hawaii.

In the second half of the 1980s, land prices were driven up by speculative wealthy international buyers many of who were subsequently forced to sell their properties. Nevertheless, the artificially high property values have been used by lessors as a basis to calculate master lease ground rents. Many long-term leases have been set at an artificially high "floor" due to the Japanese "Bubble" valuations in the mid 1980s. Many of these leases do not allow any new rent to be set lower than the previous rent -- the "not less than" clause -- and the effect of these now above-market valuations has been devastating to business and residential lessees. These lessees have struggled to get by during the recession Hawaii experienced in the 1990s, and are doing their best to survive in the unexpected economic downturn following the September 11 tragedy. Being required to pay rent based on a highly-inflated and no longer applicable market jeopardizes their continuance.

Those with long-term commitments have had to pay the higher ground rents and suffer reduced or even negative cash flows. Others, who have not been able to pay the increased ground rents or pass them on to sublessees, have had to move out. Some have had to simply walk away from their properties, forfeiting the valuable improvements they have made to the landowners, and those individuals who were personally responsible for their lease or mortgage obligations, or both, have been faced with mortgage foreclosures and bankruptcy.

Practices and policies that result in the use of falsely inflated land values have serious economic consequences, as evidenced by the plight of commercial and condominium lessees in Hawaii who face tremendous increases in renegotiated lease rents, based upon exaggerated land valuations. The resulting uncertainty has had a paralyzing effect on transactions regarding these properties.

Hawaii businesses and their employees are suffering. Because of unrealistically high rental rates levied by landowners, businesses are forced to take cost-cutting measures, such as downsizing and converting full-time employees to part-time.

There have been many authoritative reports over the past several years that attest to the magnitude and seriousness of the problem for Hawaii's economy and its people.

In 2000, former attorney general Margery Bronster, representing leasehold reform efforts, wrote the governor stating the following:

The imbalance of bargaining power between current lessors and lessees indeed exists with respect to existing leases. The typical current lessee affected by this legislation is a long-term lessee who has made significant investments in the infrastructure and improvements on the land. Whereas, as newcomers can enter the market and take advantage of the 'buyer's market', bargain for a fair market rent and avoid the onerous provisions that would require him to pay lease rent based on the market value of a decade ago. The current long-term lessee simply cannot. The current lessee's choice is to pay an inflated or exorbitant rent or vacate and be in breach of the lease. The landlord's damages will be based on the inflated rent that would have been due under the lease. The tenants can neither avoid nor remedy their predicaments.

It is rare for the economic and land conditions to have as great an impact on the local businesses and commercial enterprises as in the State of Hawaii. There is probably no other community in the United States that experienced such a dramatic rise in real estate prices, coupled with a pervasive leasehold land tenure followed by such a sustained and enervating weakened economy. The impact on local business and individual tenants has been devastating. Many examples are available for consideration.

Other studies and reports similarly address these problems with respect to residential, condominium, cooperative, and commercial lessees. For example, in 1979, Dr. Laitila of the University of Hawaii observed that "there is a non-competitive market" in Hawaii's industrial real estate while the valuation process then in use "assumes a competitive real estate market." He predicted dire consequences for lessees whose approaching renegotiation deadline hung over a company's viability "like a short fused time bomb" -- a "little nightmare".

In 1987, a report prepared for the housing finance and development corporation stated:

A significant number of condominium and cooperative housing projects are scheduled for their first lease rental negotiations starting in 1990, and the ability to obtain long term fixed rate financing for leasehold condominium purchases will diminish as lease terms progress. Therefore, it is anticipated that motivations of lessees and lessors may change significantly as these negotiations draw closer, and that support for leased fee conversion relief will increase.

In a 1991 report entitled "A Summary of the Research Findings from the Office of the Lieutenant Governor" it is stated that regarding condo and cooperative units, "the majority of units are in leasehold projects."

In 1994, the business leasehold task force created by H.C.R. No. 312, H.D. 2, S.D. 1, chaired by Representative Calvin Say and made up of lessees, lessors, and concerned citizens, found that the rising cost of lease payments plays a major role in the viability of Hawaii's retail commercial and industrial businesses.

The task force report goes on to say:

Commercial lease rents have increased in recent years. Contracts negotiated some twenty or thirty years ago are coming up for renegotiation and some of the lessees have found themselves facing increases in excess of 200 per cent. Some are mom and pop operations and neighborhood shops. Increasingly, however, larger businesses, retail chains and other local commercial operations have been forced to shut their doors as their business becomes nonviable. Sadly, many jobs are lost, the goods and services they provided in our neighborhoods and communities are lost, their businesses and entrepreneurs are lost.

The task force also found fault with the practice of settling disputes over value by use of arbitration and recommended change.

In 1995, the United States Department of Housing and Urban Development financed a study by the Hawaii real estate research and education center of the University of Hawaii. The report resulting from the study states: "A mounting leasehold crisis exists in Hawaii's leasehold system and is the motivation for this study." The study also cites international monetary policies that resulted in a stronger Japanese yen and major investment in Hawaii causing residential land prices to increase 367.8 per cent by the early 1990s.

The 1985 to 1990 period has been referred to as the "Japanese Bubble Period" or the "Japanese Bubble Economy Years". The Japanese Ministry of Finance defines the bubble: "In view of its underlying connotations in the contemporary Japanese vernacular, we have opted in this report to use bubble as a term referring to a deviation between actual and theoretical asset prices, but of such magnitude that it has an impact on the livelihoods of many people and interferes with a nations [sic] normal economic management."

Robert Hastings, an appraiser in Hawaii, describes the impact of the bubble on Hawaii's real estate markets as follows:

"Between 1985 and 1990, exogenous and artificial forces created the explosive spiral in real estate prices in certain locations in Hawaii that were of interest to foreign investors. These increases were created by forces that result from the interaction of five banking and governmental policies in Japan during a period now characterized as the 'Japanese Bubble Economy Years'". During the period of years, the Japanese invested $80,000,000,000 in U.S. commercial and development real estate of which, around $15,000,000,000 was invested in Hawaii properties. "The impact on Hawaii, with only one half of one per cent of the population of the United States, was much more significant than it was in other U.S. jurisdictions because, during 1988 and 1989, Hawaii received approximately 25 per cent of the total Japanese investment in U.S. real estate... The impact on commercial and residential economics are enormous and the resulting dislocations and economic crises to residents, industry and banks are already occurring."

In 1996, the Hawaii Financial Services Associations, a trade association with twenty-five members operating under chapter 412 of the Hawaii Revised Statutes, testified as follows:

The HFSA supports passage of House Concurrent Resolution 130. We believe it's only reasonable and appropriate that all appraisals should be prepared using the Uniform Standards of Professional Appraisal Practice (USPAP). In our view, there is no legitimate reason for deviating from USPAP in evaluating the value of the property.

As financial institutions, we are required by the Financial Institutions Reform, Recovery and Enforcement Act (FIRREA) to use only appraisals which are prepared for us and meet USPAP. Under FIRREA, we cannot use appraisals prepared for our customers even if they meet USPAP requirements. Customers who have obtained and paid for appraisals which do not meet USPAP, have not only wasted their money, but are further confused and upset by the different values between their non-USPAP and USPAP appraisals. Typically, the non-USPAP appraisal has a higher value and the customer cannot understand why the financial institution's appraisal is lower. While it may be a good sales tool for some appraisers to give the customer the highest value, it is really a disservice to them.

Appraisals should not be bargaining devices between parties negotiating new leases or purchase contracts. Appraisals should be based on a common yardstick that is the USPAP. Within these standards, some deviation of valuation may occur, but the differences should be small and the cause for the difference should be clearly identifiable.

Legislation introduced in 1996 noted that:

[S]mall business operations in Hawaii -- operations with 100 employees or less -- make up approximately ninety-eight per cent of the estimated 30,000 businesses operating in the State today. Small business operations generate two out of every three new jobs in Hawaii and disburse fifty-five per cent of the private workforce payroll and further that the high cost of renegotiating lease rents in Hawaii represents one of the major hurdles to the continued growth of small business operations in the State. The current formula for renegotiating lease rents which is based on 'highest and best use' of the property -- threatens to displace those businesses that cannot afford to pay high increases in lease rents.

After the "bubble" period created a problem, Anthony Downs, Ph.D., senior fellow at the Brookings Institute, stated as follows:

There are two basic causes of these unexpectedly high values. One is just the shortage of available and desirable land in Hawaii – especially of fee simple land – in comparison with the demand for it. This results in part from the general prosperity of the Hawaiian economy, plus the widespread ownership of land by a few big estates that have leased it to lessees who subsequently built improvements on it.

The second cause is the extraordinary influx of the Japanese investment funds in the period from 1985-1989 that drove land prices to levels unsustainable from economic uses built on the land. Several circumstances affecting Japanese investors were unprecedented and unique. As a result, Japanese investors could and did pay huge prices for land that cannot be supported by any conceivable uses put on that land. I will refer to this period from 1985-1990 as the "Japanese bubble period".

The result was a series of land sales, or sales of both land and improvements, at extremely high prices. An example is the sale of a downtown office site for $1,200 per square foot -- when no previous site had ever sold for more than $400 per square foot.

Appraisers in Hawaii have used these sales as comparables in lease renegotiations and arbitrations. The result is a setting of land values so high that the rents based on those values surpass the earning power of the improvements on the land. They not only cannot be supported by the existing improvements, but they also cannot be supported by any improvements including the theoretically highest and best uses.

Fair rents based upon fair value was the purpose of Senate Bill No. 2633, which was enacted as Act 180, Session Laws of Hawaii 1998, of which the Conference Committee stated: "The purpose of this bill is to protect consumers who lease land by requiring that the fair market value of renegotiated rental amounts for lease be determined in conformance with the Uniform Standards of Professional Appraisal Practice." However, the legislature finds that not all of the entities that are bound by Act 180 are currently complying with the requirements of that Act and, therefore, there is a need for additional clarification.

Finally, the city and county of Honolulu's Ordinance 91-95, which provided a mechanism for converting leasehold interests in condominium units to fee interests through the city's condemnation power, was subsequently upheld by the United States Court of Appeals for the Ninth Circuit in Richardson v. City and County of Honolulu, 124 F.3d 1150 (9th Cir. 1997), cert. denied, 119 S.Ct. 168 (1998). In particular, the Court of Appeals noted that, in enacting that ordinance, the city found that landowners had refused to sell proportionate shares in their fee simple titles, that the few sales that occurred involved exorbitant prices, and that this refusal to sell fee simple titles, along with other factors, had caused a dramatic increase in the price of housing in Honolulu.

The Ninth Circuit further noted the city's finding that persons wishing to reside on Oahu were forced to sign long-term leases that provide for periodic rent renegotiation. These conditions led to "the acute recent inflation of land costs (that) has adversely affected lease rent negotiations of persons who have purchased leasehold multi-family units as their homes: in some instances renegotiations have resulted in lease rents that have increased over 1,000 percent. Under the burden of increased lease rents, many owner-occupants of residential condominium apartments ..., especially those on fixed incomes, have found, and will continue to find themselves unable to afford to continue living in their homes." Finally, the court noted the city's findings that these defects in the housing market would adversely affect the city's economy: There is a close relationship between the monetary values accorded land on Oahu and the stability and strength of Oahu's economy as a whole. Residential condominium ... land values, artificially inflated by concentrated or single ownership, market conditions or other factors, skew Oahu's economy toward unnecessarily high levels. The pervasive and substantial contribution made to inflation by high residential condominium ... land values creates a potential for economic instability and disruption on Oahu. Economic inflation, instability and disruptions on Oahu have real and potential damaging consequences for all members of an affected society.

The legislature similarly finds that there is a need to reduce the potential for economic instability, not only on Oahu, but with respect to the entire State. To accomplish the public purpose of using and managing the property wisely in the community interest requires changing the present practices involved in leasing property. The leasing of property at fair and reasonable prices will alleviate the negative conditions discussed in this section while promoting the economy of the State and the public interest, welfare, and security of its citizens. Changing the practice will help to satisfy the pressing public necessity for a secure, strong, and stable economy in Hawaii. Therefore, the legislature finds that making the leasing of property viable for lessees is a valid public purpose.

The legislature further finds that there is a need to alleviate the negative results of past economic conditions by allowing lessees under a long-term master lease of property to lease at fair market value the land on which their developments are sited. Lease agreements generally contain a lease rent renegotiation provision that utilizes real property appraisals to determine a critical component in the renegotiation process, namely, the fair market value of the land. Residential and commercial leases are commonly structured whereby the fee simple owner leases the land to the lessee, who as a sublessor then subleases the land or a portion of the land to a sublessee. Leases commonly prohibit a reduction in rent at renegotiation even though a resale property appraisal determines that the lease rent based on the land's fair market value is less than the current lease rent. The legislature finds that it is in the public interest that the lease rent and sublease rent should be based on the fair market value of the land.

The legislature believes that reasonable businessmen of good faith expect reasonable results from contract negotiations. If unreasonable or unforeseeable inequitable results arise due to events beyond the control or foresight of the parties, this could evidence a force majuere event or a lack of an initial meeting of the minds of the parties, an elemental ingredient of any binding contract, that in either case requires a judicial review and possible remedy.

Accordingly, the purpose of this Act is to permit a one-time lease rent readjustment if a circuit court, exercising its equitable powers, finds that, in any lease rent renegotiation, a rent based on fair market value results in an inequitable lease rent if the fair market determined lease rent is lower than the lease rent of the previous rental period, notwithstanding the existence of a "not less than" clause.

SECTION 2. Section 519-1, Hawaii Revised Statutes, is amended to read as follows:

"[[]§519-1[]] Lease renegotiations; calculation of rent; definition. (a) Whenever any agreement or document for the lease of private lands provides for the renegotiation of the rental amount or other recompense during the term of the lease and [~~such~~] that renegotiated rental amount or other recompense is based, according to the terms of the lease, in whole or in part upon the fair market value of the land, or the value of the land as determined by its highest and best use, or words of similar import, [~~such~~] the value, for the purposes of determining the amount of rental or other recompense, shall be calculated upon the use to which the land is restricted by the lease document.

(b) Subsection (a) notwithstanding, any lease in existence on the effective date of this Act that has been renegotiated after January 1, 1990, shall be allowed a one-time adjustment upon application of the lessee to the circuit court in the circuit the subject property is located and the finding of the court that the renegotiated lease rent resulted in an inequitable lease rent based on the terms of the lease. The circuit court, exercising its equitable powers, shall determine if the renegotiated lease rent is inequitable due to circumstances beyond the control of and unforeseen by the parties to the lease. The one-time readjustment shall reflect fair market rental value as determined by a real property appraisal in conformance with the Uniform Standards of Professional Appraisal Practice. This adjustment shall be a one-time correction to the lease and shall prevail over any existing contract provision to the contrary. The new adjusted rent shall be prospective and shall become effective upon the determination of the fair market rental value as determined by the appraisal. To the extent that the lease rent amount is reduced pursuant to this subsection, a sublessor shall adjust any sublease to a sublessee for the premises or portion thereof covered by the sublease to the extent necessary to achieve fair market rent.

(c) At the option of either party, any disagreement over fair market value per square foot that cannot be resolved by negotiation may be settled by an appraisal process that is in conformance with the Uniform Standards of Professional Appraisal Practice and shall not be subject to arbitration under chapter 658.

If a party does not agree with the value produced, that party may appoint and pay for the services of an appraiser of its choice, who shall perform an appraisal. If the two appraisers cannot resolve the differing valuations, by mutual agreement or, failing agreement, by the senior judge of the circuit court of the circuit in which the real property is located, a third appraiser shall be appointed to review the work done and the issue shall be settled by a decision of two of the three appraisers. The two appraisers shall provide in writing their findings, conclusions, methodology, and reasoning, clearly showing how they arrived at their decision. The cost of the third appraiser shall be divided and paid equally by the lessee and lessor.

[~~(b) The term "lease",~~] (d) As used in this section:

"Lease", "lease agreement", or "document" [~~as used in this section,~~] means a conveyance leasing privately-owned land by a fee simple owner as lessor, or by a lessee as sublessor, to any person, for a term exceeding five years, in consideration of a return of rent or other recompense.

"Uniform Standards of Professional Appraisal Practice" means the current Uniform Standards of Professional Appraisal Practice approved by the director of commerce and consumer affairs pursuant to section 466K-4(a)."

SECTION 3. If any provision of this Act, or the application thereof to any person or circumstance is held invalid, the invalidity does not affect other provisions or applications of the Act, which can be given effect without the invalid provision or application, and to this end the provisions of this Act are severable.

SECTION 4. Statutory material to be repealed is bracketed and stricken. New statutory material is underscored.

SECTION 5. This Act shall take effect on July 1, 2005.

INTRODUCED BY:	_____________________________