Rezoning, Conditional Use Permit, or Variance: Which One Can Solve Your Zoning Problem?

You’re considering the purchase of a particular property, but know it doesn’t conform to the city’s zoning ordinance. As such, you’ve negotiated the purchase contract so that closing is conditional upon you first being able to bring the property, and your intended use of it, into compliance.

What type of application do you make? Rezone it to a district that expressly permits the existing use or the one you desire? Seek a conditional use permit (“CUP”) under the current zoning district where your use is a permitted conditional use? Or is a variance from the ordinance’s regulations the right decision?

In covering the topics below for rezoning, conditional use permits, and variances, this article will help you understand which avenue might make the most sense for you. In this article we’ll cover:

  • How these three options differ
  • What purpose each is intended to foster
  • Examples of the options
  • Common issues faced by parties making these requests
  • Which governmental entities review your application, which one makes the final decision, and what are the procedures for each proceeding, and
  • If the decision is appealed to the courts, how the court makes its decision

It should be noted there are no universal laws, set of terms, or processes for zoning. They vary on a state-to-state and city-to-city basis. So while this article will give you an understanding of some widely used concepts and their application, you’ll have to work with a land use lawyer to determine how (or even if) your city implements these ideas.

Rezoning

A quick caveat: although there are two types of rezoning actions, (1) an amendment to the zoning ordinance’s text that impacts all properties, or (2) an amendment to the ordinance’s map to change the use district of an individual parcel, because the first action is less common, this article will consider only the second.

That being said, let’s get to work.

Definition of Rezoning

Rezoning is the act of changing a property’s use district (e.g., commercial, residential, industrial, agricultural, and sub-districts within each) to a different district with regulations permitting the applicant’s desired use.

For explanations of other zoning terms, you can check out our article on common zoning terms.

Purpose of Rezoning

The purpose of zoning is to regulate land uses to serve the health, safety and general welfare of the public. To achieve this purpose, zoning laws address the impacts of land uses, including such things as:

  • Protecting all properties from potentially negative consequences of neighboring, incompatible uses
  • Protecting the value of properties by permitting them the most appropriate land uses, and minimizing potentially negative impact of nearby uses
  • Controlling the location and negative impacts of nuisance-like uses, and
  • Providing adequate public services (e.g., transportation, water and sewers)

Accordingly, a rezoning might be allowed where one of these objectives (or similar ones) is no longer being met by the existing use designation, and the proposed use would further one or more of these goals.

Examples of Rezoning

Rezoning may be appropriate in a number of different circumstances. For example, where a city wishes to replace an undesirable use with a more attractive use, it may initiate a rezoning to a district that doesn’t allow the undesirable use. This can occur, for instance, when a city replaces an intensive multi-family residential district to a less-intensive single-family district to reduce potential strains on public infrastructure, or other general welfare objectives.

Similarly, a property owner can seek a rezoning to change the use district to permit a new use that has become more appropriate due to the city’s development. For example, where undeveloped ground on the edge of the city limits had been limited to agricultural uses, and the city’s growth resulted in residential uses approaching the agricultural district, a retail commercial use may be appropriate to support the shopping needs of these neighborhoods. So long as the comprehensive plan included objectives for the city’s development that address the public need being filled in a rezoning application (here, supporting residents’ shopping needs), the rezoning may comply with the plan even if it didn’t specifically project the particular growth.

Requirements for Approval of a Rezoning

First and foremost, the rezoning application must comply with the procedures described in the municipality’s zoning ordinance, including things like (1) meeting with neighborhoods potentially impacted by the change, (2) meeting with city staff prior to application to discuss potential issues and ensure the application is in proper form, and (3) that any application fees are paid.

Secondly, the rezoning generally must comply with the comprehensive plan. As the plan is a guiding, and not binding document, the city may exercise some flexibility in finding compliance. The retail scenario above is a good example: the plan didn’t project that retail would be appropriate in the subject parcel, but it did note that retail to support residents was one of the plan’s objectives.

The city will then determine if the proposed use is either a permitted use or a conditional use within the proposed district.

Common Rezoning Issues

Regulatory Taking

As described in our practical guide to zoning, if a city-initiated rezoning, and its attendant regulations, effectively deprive a landowner of all economically reasonable use or value of their property, it can be considered a regulatory taking. A taking occurs when the government exercises its power of eminent domain to acquire ownership of private property for a public use or benefit. While a government has this right, if it does so, it must compensate the landowner for the loss of its land.

In the case of a regulatory taking, although the government hasn’t taken title to the property, because its regulations rendered the land essentially worthless, the regulation is viewed as a taking, and the landowner must be compensated.

Spot-Zoning

As described in this article on zoning terms, spot-zoning occurs when a single parcel is zoned differently than surrounding uses for the sole benefit of the landowner. Such zoning is unlawful. Although property may lawfully be zoned differently than surrounding uses, pursuant to guiding planning documents (e.g., the comprehensive plan), policies and zoning ordinances, such varying uses are typically permitted only because they serve a public benefit or a useful purpose to the surrounding properties.

A simple test to determine if a rezoning is spot-zoning is to consider whether the rezoning complies with the comprehensive plan. If it does not, then it is spot-zoning. A fix for this scenario is to amend the plan and ordinance to allow for the proposed use before the rezoning occurs.

NIMBY Opposition

An acronym for “Not In My Backyard,” NIMBY is an organized opposition to a rezoning based on the assertion that the new use will negatively impact the objecting parties’ properties. Such protest can occur in all three of the zoning actions considered here, but for sake of brevity, we’ll consider it as applied to rezoning requests.

NIMBY participants are most often residential property owners, and object to uses they believe will negatively impact their homes, including uses like:

  • Landfills, quarries, and industrial or manufacturing uses
  • Roadways
  • Halfway houses and homeless shelters
  • Low-income housing
  • Adult uses, and
  • Large-scale commercial developments (e.g., office complex, shopping mall, sports complex)

In considering such protest, cities will try and balance what the public as a whole needs (e.g., residents generally need shopping centers and roadways) with the desires of neighboring residential property owners.

One way to balance these potentially incompatible needs is the imposition of conditions on the new use. For example, if residents oppose construction of a new sports complex on the grounds that it will create consistent and disruptive noise, the city could require the development to employ larger setbacks or construct noise-buffering structures.

Variances

Definition of Variance

A variance is an administrative, discretionary, limited waiver or modification of a zoning requirement. It is applied in situations where the strict application of the requirement would result in a practical difficulty or unnecessary hardship for the landowner. Typically, the difficulty or hardship must be due to an unusual physical characteristic of the parcel.

Types of Variances

There are two types of variances: an area variance and a use variance. Not all jurisdictions permit both (jurisdictions that don’t allow for use variances generally believe the proper remedy for such situations is a conditional use permit).

An area variance is an exception to the district’s applicable regulations to allow the landowner to enjoy the same use of similarly-situated owners who do not suffer the unusual physical characteristics of the subject land.

A use variance permits a landowner to enjoy a land use that is otherwise prohibited in the existing district. Because use variances are more rare, we’ll just consider area variances.

Purpose of Variances

Firstly, jurisdictions would prefer as an equitable matter that a landowner enjoy the same privileges and burdens of similarly-situated owners, provided the applicant didn’t cause the irregularity.

Secondarily, there is some risk that absent a variance option, where a strict application of the regulations would unreasonably deprive a landowner of all economically reasonable use or value of their property, it may be considered a regulatory taking. Better to allow small deviations where no substantial harm is caused than to risk having to compensate a landowner for a regulatory taking.

Examples of Variances

Likely the most common area variance requests relate to setbacks (the distance between a building and a street or other protected feature, e.g., river). For example, a variance reducing the setback from a roadway might be appropriate where a (1) residential parcel is shaped oddly, and (2) because of this physical irregularity the applicant could not build a home of similar size to its neighboring, regularly-shaped, residential properties, if (3) the full setbacks were required.

Requirements for a Variance

As with all zoning requests, a variance application must comply with the zoning ordinance (procedurally and substantively) and comprehensive plan (though, as noted above, not all jurisdictions require compliance with the plan, and not all jurisdictions require a plan).

The applicant must establish that its property (1) has an unusual physical characteristic the applicant didn’t cause, and (2) if the subject regulation were strictly imposed, it would result in a significant and unnecessary hardship to the owner’s use of its property.

Because the variance allows an owner to operate under less stringent regulations, a city will want to ensure the variance isn’t simply a favorable treatment of the applicant. In order to verify that this isn’t the case, cities will look to earlier, similar variance requests. If they were granted, this supports the validity of the current variance request.

Common Issues with Variances

Sometimes people protesting the issuance of a variance will argue that the owner purchased the property knowing its unusual physical limitation would require a variance. However, this alone will not prohibit the issuance of a variance.

If a city grants a variance that appears to be essentially a favor to the applicant, or the applicant failed to show the hardship created, some may argue it is an unlawful spot-zoning.

Conditional Use Permits (CUPs)

Definition of Conditional Use Permit (CUP)

Conditional use permits (often simply called CUPs) are uses permitted on a permanent basis within a district so long as the governing body’s conditions are met. Permitted conditional use permits are expressly listed for each district in the zoning ordinance. These uses require conditions because in their absence the use could negatively impact nearby properties. Conditional use permits are given at the discretion of the city.

Purpose of Conditional Use Permit

Similarly to the consideration of NIMBY protests, the city understands that some uses, while beneficial or necessary for the community, could cause certain negative impacts (e.g., increased traffic or noise). Imposing conditions that minimize such impacts allows the city to enjoy the needed use while also protecting the uses of nearby land.

Examples of Conditional Use Permits

A common conditional use permit allows for the operation of a home-based business within a residential district. Conditions designed to limit negative impacts of this business on the district could include such things as requiring traffic related to the business to park in certain areas (e.g., the home’s driveway) and limiting signage for the business. Another common conditional use is a church within a residential district, again with conditions to minimize the potentially negative impacts of the church (e.g., parking and additional traffic control improvements).

Requirements for Approval of a Conditional Use Permit

As with the above, a conditional use permit application must comply with the zoning ordinance and comprehensive plan. As relates to the ordinance, this primarily means the requested use is expressly permitted as conditional in the subject district. Where it does, where the applicant accepts the conditions imposed, and where all other ordinance requirements have been satisfied, the conditional use permit is granted as matter of right. If the owner ceases to comply with the conditions, it risks the revocation of the conditional use permit.

Common Issues with Conditional Use Permits

An applicant may argue the conditions imposed are too restrictive and unduly burden its use of his property. Alternatively, those opposing the grant of a conditional use permit may argue the regulations are insufficient to protect against the use’s negative impacts.

Additionally, if the conditional use permit is not in compliance with the ordinance, as with a questionable variance, it may be considered an unlawful spot-zoning.

Procedure for Approval & How Courts Examine Challenges to Zoning Decisions

Who Reviews Rezoning, Conditional Use Permit and Variance Applications

Generally an application for the three requests considered here start with the city’s zoning staff. They work with the applicant, explaining regulations under the ordinance, and modifying the application where necessary to make it compliant.

Though the process following staff’s review varies between jurisdictions, generally rezoning and conditional use permit applications are forwarded, along with staff’s recommendation, to the planning commission. The commission is an advisory board of residents who reviews applications with staff and counsel to determine if the request complies with the ordinance and, where required, the comprehensive plan. Following its review, the commission makes a recommendation to the city council, and the council gives the thumbs-up or thumbs-down. It should be noted, that in some jurisdictions the council may delegate its conditional use permit decision-making authority to the commission.

In the case of variance requests, the staff (following its review) forwards a recommendation to the board of zoning adjustment (“BZA”). In some jurisdictions the BZA will make the final approval or denial of a variance application, and in others the BZA will act like the planning commission, only making recommendations to the council. BZA decisions may, depending on the zoning ordinance, be subject to appeal directly to the courts or to the council.

Legislative vs. Administrative Review

Zoning decisions come in two different flavors: legislative and administrative (also referred to as quasi-judicial). Which flavor isn’t determined by which body makes the final decision (e.g., commission, council or BZA), but rather on the characteristics of the request itself. Because the procedural rules and protections are different as between legislative and administrative decisions, an applicant can expect different rules for different types of requests.

Legislative decisions apply to the community as a whole, and not only to an individual. In zoning the clearest example is the creation of, or a text amendment to, the zoning ordinance because it applies to all properties within the city. In contrast, administrative decisions impact only a single property or individual. For example, because a variance or CUP decision will only impact the individual property making the application, these decisions are generally considered administrative (however, some jurisdictions consider CUP decisions to be legislative).

There is disagreement among jurisdictions as to whether the rezoning a specific parcel is legislative or administrative. Some treat it as legislative, and others, pointing to the fact that it affects only a single parcel, treat it as administrative. Where legislative, these decisions (like all legislative decisions) may only be made by the governing body, e.g., the city council, board of alderman or similar body. Administrative decisions may be made (limited by state and local laws) by non-legislative bodies, e.g., the planning commission or BZA.

Legislative vs. Administrative Review Procedures

Because legislative decisions are by definition those with broad application to the community, they are based on the city’s discretionary powers. They are subject to Constitutional limitations, but otherwise aren’t required to have any specific rules or standards.  Of course if the zoning ordinance requires certain procedures, they must be followed.

Administrative decisions, however, impact only the individual applicants, and thus provide some due process protections. These typically include the rights to:

  • Notice of a hearing
  • Present evidence and cross-examine witnesses
  • Legal representation, and
  • A written decision based on the evidence presented

Method and Standard of Reviews for Appeals to the Courts

If a council’s legislative decision is appealed to the courts, the court will generally look at any record of the council’s consideration, as well as making a “de novo” review. De novo is Latin for “anew” and means the court will consider evidence and arguments as if the council proceedings had never occurred. The court may even consider new evidence at trial that was not presented in the decision proceedings.

Based upon this review the court will determine if the proceedings violated Constitutional protections, either “facially” (meaning the ordinance on its face was unconstitutional) or “as applied” to the applicant aggrieved by the administrative decision. The burden of proof is placed upon the applicant, who will only prevail if it can establish “by clear and convincing evidence” that it suffered substantial detriment, and that the decision provided no benefit to the health, safety and welfare of the public.

Unlike the de novo review of a legislative decision, administrative appeals are based only on the record created at the proceeding. Following a review of the record a court will consider if the administrative body exceeded or abused its discretionary powers, or acted arbitrarily or capriciously regarding the applicant’s constitutional rights. If there is any evidence supporting the administrative decision, it will be upheld by the court.

Conclusion

So… you’re considering the purchase of property, know it doesn’t conform to the city’s zoning ordinance, but in your purchase contract you’ve negotiated a condition to closing your ability to bring the property, and your intended use of it, into compliance. Do you know now whether you should apply for a rezoning, conditional use permit, or variance? Hopefully this article gave you some idea, but in any case, because its only for informational purposes, and not to give legal advice, if you have any particular zoning issues, you should consult a licensed attorney!

 

Have you had any recent challenges when seeking a zoning change? Share them with us in the comments!

A Practical Guide to Understanding Zoning Laws

Why is zoning important? Zoning laws determine what kind of structures can be built, whether or not an existing property can be re-purposed, and even whether or not an existing structure can be replaced with something new at all. Of course, even if these aren’t changes you are currently considering, you might have a neighbor trying to make one of these changes… to the detriment of your own property.

Understanding zoning is important because it will in large part determine whether or not you get the change you want, and also whether or not you can prevent or modify the change you don’t want. In this article we’ll give you a practical guide to how zoning works, step by step.

I. The Purpose of Zoning

First of all, let’s start with the big picture. What exactly is zoning and what is its purpose? Zoning is the legislative process for dividing land into zones for different uses. Zoning laws are the laws that regulate the use of land and structures built upon it.

If you’ve ever dealt with a city, then you’ve probably heard some variation of the phrase “For the health, safety and general welfare of the public.” It means that every act of governance should (ideally) be made in the best interests of the people. Accordingly, zoning laws are created for the simple purpose of protecting the health, safety and general welfare of the people as relates to land use.

To achieve this purpose, zoning laws regulate the impacts of land use that may not be in the best interests of the people, generally including such things as:

  • Protecting the value and enjoyment of properties by separating incompatible land uses and minimizing their potentially negative impacts upon each other
  • Protecting the value and enjoyment of properties by allowing a property its most appropriate land use given its location and surrounding uses
  • Providing for the orderly development of a city, including making provisions for land uses in the best interests of its citizens, and
  • Providing adequate public infrastructure, e.g., roads, water and sewers

Cities want industrial uses for economic growth, but cities also want single-family residential areas for people to live. But will either the industrial users or residential users be happy if the two uses sit side-by-side? Not likely. When are neighboring uses happy? When they are compatible. This compatibility of the whole is the task of zoning; a sort of government-imposed “love thy neighbor as yourself.”

To accomplish this compatibility of uses, zoning gives the community a road map and a set of rules for driving. It considers how the city would like to grow. It then divides the city into different districts, limiting the uses allowed in each. It then creates laws regulating:

  • How each district can be used (e.g., commercial, residential, agricultural),
  • What types of buildings and other structures can be constructed within each district (e.g., size, number of stories, configuration)
  • Where those structures can be located (e.g., setbacks, green space), and
  • What measures the landowner must take to further compatibility with neighboring uses (e.g., buffers, flood control).

And then because the law recognizes life is not black and white, zoning laws provide flexibility for inevitable changes (who knew the state would construct that overpass, and make west-side ideal for retail instead of a quarry?) and also for inevitable special circumstances.

Let’s take a closer look at how zoning works.

II. The First Step: The Comprehensive Plan

How do you get from Boston to Los Angeles? Do you start driving in any direction and hope you’ll get there? Sure it might work, and sure a million monkeys banging on a million typewriters will eventually reproduce the entire works of Shakespeare. But you might have better chance of finding L.A. if you have a road map. A comprehensive plan (or “master plan”) is the road map a city creates to arrive at its desired social, economic, and physical development. Of course, because the growth of a city takes a little longer than a road trip across the U.S., comprehensive plans look long-term. Like five to 20 years long-term.

To create such plans a city considers what it wants regarding land use (including public infrastructure to support those uses), and how it will achieve it. For example, if a city decides it’s in the best interests of its population to be a hub for high-tech industry, it will designate areas within its boundaries for such industries.

The plan also acts as a guide for the creation of regulations that define what uses are permitted, what structures are permitted, their design, and where (both within a district and in relation to other districts) these uses and structures may be placed. The plan itself is not legally binging, but it’s the foundation for legally binding instruments like the zoning ordinance.

II.A. Creation of a Comprehensive Plan

A plan is created through a collaborative effort of planning professionals, the public, city staff, the city’s planning commission and the city’s governing body (and sometimes even neighboring communities).

The process is not universal, but creation generally begins by soliciting input from citizens and interested parties regarding how the city should evolve. If there is a developer who has, or wants to be, a part of the city’s growth, it makes sense to give them a place at the table. The city staff can then use this input to assemble, on its own or in concert with a planning consultant, a draft plan. The draft is given to the city’s planning commission, who reviews it with staff advice. If the commission finds the plan satisfactory, it is forwarded to the city council with a recommendation for approval (if the plan wasn’t ideal, the commission can put it back in staff’s hands for changes).

The council is the final decision-maker. Because the plan is supposed to be the vision and desire of the public, and serve their general welfare (and not the desires of a few commissioners or councilpersons), the council may seek further public testimony before it approves, approves with modification, or denies the plan.

II.B. What’s In a Comprehensive Plan?

Pictures and words, maps and text. Where streets, sewers and other infrastructure should go. Where different land uses should go. What are limitations on these uses and the structures supporting them? Again, the plan’s recommendations aren’t an instruction for the city to run out and grow, but rather a road map for getting to L.A…. over five to 20 years.

You may be wondering why should you care about the plan? Well, if you’re a landowner who may develop your property, or sell it to another to do so, you might want to let your voice be heard in the creation of a plan. Or if you are a resident who lives next to undeveloped land (or land ripe for redevelopment), or who believes the city should grow in a certain way, attract certain uses (remember that idea to become a hub for high-tech industry?), again you’ll want to make your voice heard.

What if a plan already exists? Then you better make sure you know what it says about the property you own, the property next to you, and the property across the city. The plan could play a large part in the value of your ground and the type of community you are (or might be) living in, building in, or running a business in.

Take a peek here at the City of Overland Park, Kansas’s Comprehensive Plan to see what one looks like

Often a city will maintain a copy of its plan on the city’s official website. If it can’t be found there, a call to City Hall (and likely a couple of transfers to get you to the planning department) will unearth the plan.

III. The Second Step: The Zoning Ordinance

You have the road map to L.A. Now what? How about you learn which roads have the highest speed limits, or are the most direct route, or which allow your type of vehicle? In zoning, the how-to details of the comprehensive plan are established in a city’s zoning ordinance. This ordinance is the local (e.g., county, city, township, etc.) set of regulations governing land uses and structures within the local government’s boundaries.

III.A. Creation of a Zoning Ordinance

How is the ordinance created? See above. Seriously. The creation of the ordinance is similar to the comprehensive plan’s creation and approval: staff and planning consultants (often lawyers) create a draft ordinance; a public hearing is held (or multiple hearings) for public input; the draft is modified by staff and consultants; eventually a draft ordinance is given to the planning commission for review; more public input; commission makes a recommendation to the council; more public input; approval, approval with modifications, or send it back to the commission. Rinse and repeat.

Unlike the plan, because the ordinance is a legally binding instrument, and provides the rules dictating how and where land can be used, its creation must clear certain legal hurdles. One of the principal hurdles is ensuring the ordinance complies with the law.

Why should you care? Well, unless you’re the city who will have to defend challenges to the ordinance, you shouldn’t, or at least won’t, until you believe you’ve been treated unfairly. Below are some of the laws to be considered:

  • Federal and state common law (court decisions; check out Village of Euclid, Ohio v. Ambler Realty Co., 272 U.S. 365 (1926) and Penn Central Transportation Co. v. New York City, 438 U.S. 104 (1978) if you want to impress your friends and know the stories behind two of zoning’s landmark cases)
  • State and federal statutes, codes and regulations
  • The Religious Land Use and Institutionalized Persons Act of 2000 (“RLUIPA” protects individuals, houses of worship, and other religious institutions from discrimination in zoning)
  • Federal Fair Housing Act (Title VIII of the Civil Rights Act of 1968)
  • Sections 332(c)(7) and 1455(a) of the Communications Act (which imposes limitations on state and local land use authority to make zoning decisions over certain wireless facilities), and
  • Endangered Species Act of 1973 (ESA; 16 U.S.C. § 1531 et seq.)

It should be noted that the ordinance, like all laws, is not set in stone. It can be amended, and generally mirrors the creation process.

One interesting issue that can occur in the amendment arena is when (1) a city wants to make a change to the ordinance, (2) hasn’t determined yet what that change should be, but (3) wants to temporarily halt development that, while lawful under the current ordinance, would be prohibited under the likely change, until (4) the city has had time to make well-reasoned analysis and planning decision. Such a temporary stop is referred to as a moratorium. While lawful, the moratorium must be reasonable because landowners seeking to develop their properties will be delayed (or prevented from developing if the ultimate change prohibits the use they intended).

Courts will consider whether the moratorium advances a legitimate governmental interest, is being made in good faith, and doesn’t deprive the landowner of all reasonable use for too long. If it fails these criteria, it may be characterized as a regulatory taking (we’ll talk about takings in a little bit). Again, if you want to impress your friends with your knowledge of landmark zoning cases, the Super Bowl of moratorium decisions is Tahoe-Sierra Preservation Council, Inc. v. Tahoe Regional Planning Agency, 535 U.S. 302 (2002).

III.B. What’s in a Zoning Ordinance?

Zoning ordinances generally cover three areas: (1) a zoning district section defining different types of use districts (e.g., commercial district, residential district) and the regulation of these uses; (2) a performance standards section defining regulations that apply uniformly to all districts (e.g., parking, noise, fencing and signage standards); and (3) an administrative section outlining procedures for requests under the ordinance (e.g., notices are required for a conditional use permit (“CUP”), the number of days a person has to approve a denial of rezoning).

Click here to see an example of a zoning ordinance (the City of Kansas City, Missouri’s)

As with a comprehensive plan, a city’s zoning ordinance is often found on the city’s official website (hint: click until you find the city code or the planning department’s page). If not, a quick call to City Hall should point you in the right direction.

III.B.1. The Zoning District Section

III.B.1(i). District Types and Uses

If the goal of land use-compatibility to serve the health, safety and welfare of the public can be met, the first step is defining land uses. The broad use categories are commercial, residential, industrial and agricultural. Of course, just as all ice cream does not come in the same flavor, all commercial uses are not the same, all industrial uses are not the same, etc. Accordingly, cities break down these broad categories into as many sub-categories and districts as needed. For example, the residential category may be divided into R-1 for single-family on less than 1 acre, R-2 for single-family on less than 0.5 acres, R-M1 for multi-family with a density of 50 units per acre, R-M2 for multi-family with 100 units per acre, ad infinitum.

Ordinances may include other types of districts for special circumstances, such as floating districts, mixed-use districts, or planned use districts (“PUDs”). Floating districts are those districts permitted under the ordinance, but haven’t yet been placed on the zoning map. They’re often employed for unique land uses (e.g., major entertainment centers, intense industrial uses) that are anticipated in the future, but for which no specific location has yet been identified, or districts to afford special protection when needed, such as historic or floodplain districts. Essentially the zone floats over the community until a use meeting its criteria materializes and a site is identified. At this point the zone floats earth.

Mixed-use districts allow for a combination of broader use categories (e.g., both commercial and residential), and are often used in downtown areas.

A PUD (Planned Use District) is a type of mixed-use development (often residential, retail and office) with a cohesive design plan. To encourage the feasibility of such developments, a city may waive or modify regulations that would otherwise be required of the individual uses. This is done to allow flexibility in the development’s design.

Historic districts are created to preserve structures that are significant historically, architecturally or culturally. Regulations in these districts limit the structures’ demolition or modification, or, if new construction is proposed, require that it conform to certain requirements (e.g., built in the same type of architecture).

Once district categories are established, the ordinance then spells out the uses permitted within each. Typical use types include:

  • Permitted Uses: Permits for these expressly listed uses are issued as a matter of right.
  • Conditional Uses: CUPs are given at the discretion of a city, on a permanent basis, so long as the attendant conditions are met. CUPs are needed where the use could negatively impact properties unless it operates under certain conditions.
  • Accessory Uses: These uses are, in addition to the parcel’s principal use, customary, appropriate, subordinate, incidental to, and serve the principal use. For example, typical accessory structures in residential districts include garages, decks, swimming pools and storage sheds.

One quick aside: annexation. Cities may be able to expand their boundaries through annexation of neighboring unincorporated land. The ordinance may include rules dictating how annexed property will be zoned when brought within city limits.

One more quick aside: legal non-conforming uses (“LNCU”). A non-conforming use is any use, structure or building that doesn’t comply with the zoning ordinance. Where the use was originally in compliance, but the regulations changed to make it non-compliant, the use became an LNCU. As the name suggests, these uses are lawful, and may continue, but under the ordinance they’ll face certain restrictions. Common restrictions are:

  • The use must be made compliant within a certain period of time (an “amortization period”)
  • The use cannot be expanded
  • If the LNCU is changed, it may not return to the prior use, and
  • Where the property is damaged beyond a certain point, it may not be repaired

III.B.1(ii). Regulation of Districts

Once you know your use is permitted, to determine what you can build you’ll have to check the regulations, i.e., ordinance’s details. The devil is in the details.

As a general caution, while a city has the right to regulate uses, if such regulation effectively deprives a landowner of all economically reasonable use or value of their property, it can be considered a regulatory taking. A taking in the real property arena refers to the government exercising its power of eminent domain to acquire ownership of private property for a public use or benefit. While a government has this right, if they use it they must compensate the landowner for the loss of his land.

In the case of a regulatory taking, the government hasn’t taken title to the property, but because its regulations rendered the land essentially worthless, the regulation is viewed as a taking. Time for the city to get out its checkbook.

With that said, regulations most commonly dictate the size, density and location of structures within a parcel, as well as parking and green space requirements. Size can relate to the footprint, height, number of stories, etc. Density refers to the amount of development allowed per acre, calculated either by the number of dwelling units per acre (for residential) or floor area ratio (for commercial). Location is governed in part by setbacks, the distance between structures and property lines.

The zoning ordinance may potentially regulate how property looks through “aesthetic” regulations. These are used to maintain aesthetic features within a district by permitting only uses, designs and structures that conform to or complement the area’s existing structures. Examples include limitations on parking, setbacks, the colors and architecture of structures, and types of landscaping, roofs and building materials.

The ordinance may also impose regulations to protect natural resources such as: (1) prohibiting building within floodplains, or requiring remediation if floodplains are eliminated; and (2) mitigating the impact of shoreline development by, for example, requiring larger setbacks from a shoreline.

Additionally, some ordinances will highly regulate uses the city wishes to minimize, such as the sale of alcohol, adult uses, and the operation of pay-day loan businesses. Such regulations often stipulate these uses must be a certain minimum distance from schools or churches, though other conditions appear. The zoning regulation of adult uses is especially complex as Constitutional issues of free speech are involved.

Lastly, as described below, the ordinance will allow for a “variance” from some of these regulations where circumstances merit.

III.B.2. Administrative Section

This section describes how actions under the ordinance are reviewed, approved, denied and appealed. It typically details:

  • Who is in charge of each action (e.g., city staff, planning commission, city council, or board of zoning adjustment (“BZA”; sometimes called a board of zoning appeals))
  • What form the applications must take
  • What steps are involved (e.g., public notice, hearings, adoption, etc.), and
  • Deadlines for each step

As these items vary among jurisdictions, it’s only appropriate to note here the two most important procedural directions: (1) follow the ordinance’s procedures, and (2) do it in a timely manner. Cities and courts generally strictly interpret these provisions. If the ordinance states appeals of denials must be made within 30 days of the council’s decision, and you file on the 31st day, well, there are smarter things you could do.

III.C. What Actions are Considered Under the Ordinance?

Zoning ordinances will typically govern applications for rezonings, conditional use permits, and variances.

III.C.1. Rezoning

In order to change a property’s zoning district, application must be made for a rezoning. Because this act is an amendment to the ordinance’s district map, the procedure for rezoning is the same as for an amendment to the ordinance. A rezoning application may be judged not only on its compliance with the ordinance, but in some cases its compliance with the comprehensive plan.

One situation that will fail this consideration is “spot-zoning.” Spot zoning occurs when a parcel is zoned differently than its surrounding uses for the sole benefit of the landowner. While property may lawfully be zoned differently than its surrounding uses, such varying uses are typically permitted because they serve a public benefit or a useful purpose to the other properties. For example, sound-planning policies would permit a school to be located in the center of a residential neighborhood. Locating an adult bookstore in the same neighborhood would not.

III.C.2. Conditional Uses

As noted above, conditional uses for each district are set forth in the ordinance, and are uses which need “special attention.” They may not be the primary intended use in a district, and may have some negative attributes, but if they comply with certain conditions, they can be beneficial. A common example is allowing a convenience store or gas station in a residential area. If the negative aspects of the use can be minimized through conditions, the use will be valuable to the area. If the use requested in a CUP application is one of the conditional uses specified in the ordinance, and if the conditions are accepted, the permit must be granted as a matter right.

III.C.3. Variance

Variances may be granted, at the city’s discretion, to relieve a party from strict compliance with zoning regulations where such compliance would result in a practical difficulty or unnecessary hardship for the landowner. Variances typically are only available for exceptions to physical regulations (e.g., setback requirements) and not to uses, but some jurisdictions allow for variances from the permitted uses.

IV. Who Makes the Zoning Decisions?

You’ve hit the road, road map in hand, a binder of all the details that impact your progress to L.A., and then you see the toll booth ahead. And the flashing blue lights of the police car behind. And the tow truck driver pulling a car that had gotten lost on his journey. The help and approval of all these people will determine if your drive is a success. In zoning, these gatekeepers are the city’s zoning staff, the planning commission, the Board of Zoning Adjustment (BZA) , and the city council.

IV.A. City Staff

An old adage for people who regularly work with public bodies is that elected officials change every couple of years, but staff is there forever. Accordingly, if you work well with staff, they can make the process easier and (providing your request is reasonable) become an unofficial advocate for project after project.

Staff are the first folks to touch a zoning request. They review the application and work with the applicant to ensure it’s compliant with the zoning ordinance. They then make a recommendation on the application, as well as advice to, the planning commission, city council or BZA depending on the request. Although staff has no authority to approve or deny applications, the other bodies often value their expertise and guidance, and may defer to their opinions.

IV.B. Planning Commission

Many cities have a planning commission, comprised of residents appointed by the city council (commissioners may, but are not required to have real estate, legal, engineering or other backgrounds valuable to land use decisions), who act in an advisory capacity to the city council. Depending on local and state law, planning commissions are often the first body to consider CUPs, rezonings, PUDs, and the creation of and amendments to the comprehensive plan and zoning ordinance.

Some planning commissions will consider applications for variances, though this responsibility can also fall to the BZA. The commission conducts public hearings, takes evidence, creates a record of the proceedings, and then makes a recommendation of approval, approval with modifications, or denial of the application to the city council.

IV.C. Governing Body

The city council is the final decision-maker on all zoning applications, though in some jurisdictions it may delegate its authority to another body (e.g., the planning commission). The council however cannot delegate its authority over rezoning decisions, as they are most often considered a legislative act, and only the governing body has legislative authority. In those jurisdictions that characterize rezoning as administrative rather than legislative, the council can delegate the decision-making authority to non-legislative bodies.

IV.D. Board of Zoning Adjustment (or Appeals)

Some jurisdictions create a BZA to (1) hear and act upon variance applications, and (2) hear appeals to rezoning denials where the basis for appeal is an alleged irregularity in the council’s application of the ordinance. In some cases the BZA will act like the planning commission, and make only recommendations to the council. BZA decisions may, depending on the zoning ordinance, be subject to appeal directly to the courts or to the council.

V. Conclusion

Now you understand the basics of the purpose of zoning, the creation of its guiding documents, its zoning ordinance, how zoning applications are made and appealed, and who makes these determinations. You have the road map and maybe even a GPS to get you to L.A…

And what is your take-away? Well, you can decide for yourself, but given the complexities and variations between jurisdictions of what you’ve just read, you might want to take a passenger along for the ride who has already made the trip many, many times. What I’m saying is, because this article is only for informational purposes, and not to give legal advice, if you have any particular zoning issues, please consult a licensed attorney.

Do You Know These Essential Zoning Terms?

The concept of zoning is fairly simple. A governing body enacts laws to create districts within its jurisdiction and regulations to govern the uses and structures inside those districts. The creation of these districts and regulations are designed to serve the jurisdiction’s general welfare by promoting growth and development in accordance with the body’s planning policies. To accomplish this, the body regulates the types of uses permitted, the design or layout of developments, and the design of structures within each district.

While the concept is straightforward, the terms used in the zoning world are numerous. Because being able to verify that an existing or proposed use of property is permitted (or if it isn’t, how it may become permitted) is at the heart of any commercial real estate transaction, a real estate professional must be well versed in the language of zoning.

Accordingly, this article sets out (alphabetically) many of the most common zoning terms, what they mean, and how they’re used.

A

Accessory Use. Accessory uses are land uses within a property that are, in addition to the parcel’s principal use, customary, appropriate, subordinate, incidental to, and serve the principal use. The governing body often includes in its zoning ordinance specific accessory uses it believes meet these criteria, but as an example, typical residential accessory uses include garages, decks, swimming pools and storage sheds.

Aesthetic Regulation. Aesthetic zoning regulations are used to maintain aesthetic features within a district by permitting only uses, designs and structures that conform to or complement the area’s existing uses and structures. Examples of aesthetic regulations are limitations on parking, setbacks, the colors and architecture of structures, and types of landscaping, roofs and building materials.

Agricultural Districts. These districts are limited to agricultural uses such as raising of crops, livestock grazing, and the raising of poultry. The permitted uses and regulation of such districts vary depending on the size of the parcel, e.g., an A2 district could be for parcels of at least 2 acres, and an A3 district for parcels of at least 3 acres. Typical conditional uses in these districts include the retail sale of agricultural-related products and storage of agricultural-related vehicles.

Amortization. When a building or use becomes non-conforming due to a change in zoning regulations, the property will be given a period of time to comply with the new regulations. This period of time is called the amortization period. If a property is not compliant within the amortization period, the use will be prohibited.

Ancillary Uses. Such uses are permitted land uses that are secondary and complementary to the principal use, but not accessory. An example of an ancillary use is an office supply store in an office park that only serves the principal office uses within the district.

B

Bulk Regulations. These regulations control the size and layout of structures, including regulations as to open space, lot lines, maximum building height, and maximum floor area ratio.

Buffer Zones. When two adjacent districts have incompatible permitted uses, in order to reduce the conflict between the uses, the governing body may require a buffer zone. Typically such zones will include park areas, grass, trees or berming. Such zones are commonly used when the development of a multi-family complex is proposed adjacent to a single-family district.

C

Commercial Use. These uses, permitted only in commercial districts, typically include wholesale, retail, or service business uses operating for profit, including office uses.

Comprehensive/General Plan. A long-term planning instrument, these plans set forth policies for the future development of the jurisdiction in a manner that will satisfy the jurisdiction’s goals, e.g., maintain orderly growth and protect the general welfare. Comprehensive plans often include local area plans, land use-related resolutions by the governing body, maps, and policy statements.

Conditional Use. These uses are permitted on a permanent basis within a district so long as the governing body’s conditions are met. These uses require conditions because without them, they could negatively impact the parcel or bordering properties. Permits for conditional uses are given at the discretion of the governing body.

Contract Zoning. Contract zoning occurs when a property owner and the governing body enter into an agreement that the property will be rezoned and the owner will accept the body’s use and design restrictions.

Cumulative Zoning. Under this zoning scheme, property zoned for specific uses can be used for that use and for less intensive uses. For example, an area zoned for multi-family uses would also permit a single-family use within the parcel.

D

Density. Density is the amount of development allowed per acre, and typically calculated by the number of dwelling units per acre (for residential) or floor area ratio (for commercial).

Discriminatory/Exclusionary Zoning. This type of zoning refers to a community’s use of zoning regulations to exclude certain groups of people. Though it is unlawful to expressly exclude people based on race or ethnicity, regulations relating to development densities can still have exclusionary effects. For example, communities will limit the number of dwellings permitted, reducing the housing supply, and thus lowering opportunities for new buyers. Further, reducing the housing supply increases market prices, having the effect of excluding lower-income families. Similarly, zoning regulations that limit or prohibit low-income multi-family complexes have the direct effect of excluding lower-income households from residing in the community.

Down-Zoning. Down-zoning occurs when a parcel is rezoned to a classification permitting only less intensive uses. Communities will utilize down-zoning to limit less-desired intensive uses. For example, a community may rezone a parcel from a multi-family designation to a single-family district.

E

Exactions. New development will often increase the use of, and the need for, improved or new public infrastructure and facilities, e.g., water and sewer lines, road improvements, and parks. Exactions are how a community forces developers to contribute to the cost of such infrastructure. They can take the form of requiring a developer to pay for a portion of the infrastructure improvements necessitated by the development, impact fees, or the donation of a portion of the developer’s land.

F

Floating Zones. These are districts that are permitted under the zoning ordinance, but not placed on the zoning map. They are typically used for unique uses (e.g., major entertainment centers, intensive industrial uses) that are anticipated in the future, but no specific location has been identified within the community. When an application is made for such a use on a specific parcel, a floating zone can be established and located on the zoning map, provided the regulations set forth in the zoning ordinance are met.

G

Grandfathering Clauses. The term “grandfathering” is a misnomer for a legal prior non-conforming use. A “grandfathering” situation occurs when an existing use was in compliance with zoning regulations at the time it began, but changes to the regulations have caused the use to become non-conforming. If the owner sells the property, the buyer will have the right to continue the non-conforming use, causing people to label the use as “grandfathered.” However, because this situation is simply the transfer of a lawful non-conforming use, the laws related to such uses create certain limitations, e.g., the use may not continue indefinitely as it will be subject to an amortization period, and the use cannot be expanded.

I

Industrial Uses. These uses are non-residential, non-agricultural, and non-commercial uses such as mining, milling, and manufacturing. Zoning ordinances generally include many classes of industrial uses, and the regulation of each varies depending on the intensity and impact of the use. Common examples of light industrial uses are warehouses, manufacturing and distribution where they operate without negative impacts on the surrounding uses. Heavy industrial uses have the potential to create public nuisance conditions (e.g., noise, environmental impacts), and are thus more stringently located and regulated. Examples of heavy industrial uses include quarries, landfills, and asphalt or concrete mixing plants.

M

Master Plan. Master plans are the overall plan for a community’s development. They must be consistent with the goals and policies described in the comprehensive/general plan and other local plans, e.g., an area plan. Generally master plans include the location of proposed land uses, description of the types of uses, intensities of uses, and building and structure limitations, though they may also include descriptions of desired parking, open space, and layout.

Mixed-Use Designation. This designation allows for the integration of multiple types of uses within a single district. For example, a development that includes multi-family residential, retail and office uses.

Moratorium. When a governing body is considering the amendment of its zoning ordinance or planning documents, it may decide to enact a temporary ban, a “moratorium,” on zoning applications for the uses being considered. Though it is generally accepted that a body has the right to use moratoriums in order for to have time to make sound planning decisions, because landowners seeking to develop their properties will be delayed (or, prevented from developing in the event the ultimate change prohibits the use they intended), the moratorium must be reasonable. In determining reasonableness, courts have considered whether the moratorium advances a legitimate governmental interest, is being made in good faith, and doesn’t deprive the landowner of all reasonable use for too long.

N

New Urbanism. New urbanism is a planning and design concept based primarily on two objectives: neighborhoods should have a sense of community and be environmentally friendly. To affect these goals, new urbanists lobby and work with communities to create or amend planning and zoning laws to allow neighborhoods with multiple uses, require communities to be designed for pedestrian and car traffic, and require environmentally conscious building designs and construction.

NIMBY. An acronym for Not In My Backyard, NIMBY refers to groups that oppose a new land use near their residential property. NIMBY efforts are directed at every type of use they deem incompatible with their residential use, including commercial retail or office uses, industrial or more intensive housing uses. The arguments against such uses near residential neighborhoods include that they will increase car and truck traffic, noise and crime, and lower property values. The power of such opposition is largely political, with a group appealing to their elected officials to deny approval of the opposed project.

Non-Conforming Use. A non-conforming use is any use, structure or building that doesn’t comply with the applicable zoning regulations. Where the use was originally in compliance, but  a regulations change made it non-compliant, the use became a lawful prior non-conforming use (LPNCU). As the name suggests, LPNCUs are lawful, and may continue, but they face certain restrictions. Common restrictions are (1) the use must be made compliant within a certain period of time (an amortization period), (2) the use cannot be expanded, (3) if the LPNCU is changed, it may not return to the prior use, and (4) where the property is damaged beyond a certain point, it may not be repaired.

O

Open Space. Open spaces are utilized in zoning ordinances to allow for public or private uses for enjoyment, such as park areas or simply green space. Open space requirements are often calculated as a certain percentage of a parcel’s size.

P

Planned Unit Development (PUD). A PUD is a mixed-use development (often residential, retail and office) with a cohesive design plan. To encourage the feasibility of such developments, zoning regulations, otherwise required of the individual uses, may be waived or modified to allow for flexibility in the development’s design.

Primary Use. A primary use is the principal or dominant use of the land, such as residing in a home, running business or manufacturing a product.

R

Regulatory Taking. A taking in the real property arena refers to the government exercising its power of eminent domain to acquire ownership of private property for a public use or benefit. A taking is lawful, but the government must pay for the land acquired. A regulatory taking occurs where a governing body enacts regulations that effectively deprive a landowner of all economically reasonable use or value of their property. While the government doesn’t actually take title to the property, because the regulations have made the property essentially worthless, it is viewed as a taking, and thus requires compensation to the landowner.

Residential Districts. These districts permit residential uses, and typically vary depending on lot size and the number of families that the dwellings in the district are meant to house (e.g., single-family, two-family, etc.). Residential districts for multi-family apartments typically consider the number of units within a defined space (e.g., up to 50 units per acre).

Rezoning. Rezoning is simply a change in the zoning district applied to a parcel of land, and thus a change to the permitted uses and accompanying regulations within that parcel.

S

Setbacks. Setbacks are distances between structures and property lines, and vary depending on the zoning district.

Smart Growth. Similar to New Urbanism, smart growth is an urban development and planning concept stressing mixed-used neighborhoods, walkability and environmentally conscious development and design.

Spot Zoning. Spot zoning is unlawful, and occurs when a single parcel is zoned differently than surrounding uses for the sole benefit of the landowner. While property may lawfully be zoned differently than surrounding uses, in those cases the uses are typically permitted because they serve a public benefit or a useful purpose to the surrounding properties. For example, sound planning policies would permit a school to be located in the center of a residential neighborhood. Locating an adult entertainment store in the same neighborhood would not.

Standard State Zoning Enabling Act (SZEA). Federally developed in 1921, SZEA was a standard act on which states could model their own zoning enabling acts. SZEA provided that legislative bodies could divide their jurisdictions into different districts, made a statement of purpose for zoning regulations, and created procedures for establishing such regulations.

T

Temporary Use. A temporary use is the use of property permitted for a specified period of time, provided that the use complies with required conditions of use.

V

Variance. A variance is a discretionary, limited waiver or modification of a zoning requirement. It is applied in situations where the strict application of the requirement would result in a practical difficulty or unnecessary hardship for the landowner. Typically, the difficulty or hardship must be due to an unusual physical characteristic of the parcel.

Vested Rights. The vested rights doctrine permits a landowner to build pursuant to a prior zoning regulation when there has been a substantial change of position or expenditures by an innocent party in reliance upon the issuance, or probable issuance, of a building permit. However, where no permit had been issued, and the owner has only an anticipation that it could develop their land under the existing zoning, then a change in zoning prohibiting their anticipated development doesn’t create a vested right. Put simply, there is no guarantee that zoning classifications or regulations will stay the same.

Z

Zoning Ordinance. Created in compliance with a governing body’s comprehensive plan, zoning ordinances are comprised of maps showing the zoning districts and text setting forth the regulation of uses and structures within each type of district.

And now you’re ready to tackle that next zoning discussion. As always though, this article is only for informational purposes, and not to give legal advice. So, if you have any particular issues, you should consult a licensed attorney. And if we’ve missed a term, let us know in the comments below!

10 Boring Boilerplate Commercial Lease Clauses You Should Understand

You’ve read the first ten pages of the proposed commercial lease and are satisfied that it reflects the deal points. And then you get to the last three pages and the section titled “Miscellaneous.” Your eyes glaze over and you consider pouring that fourth cup of coffee. Or, you think, these are just “boilerplate” terms and you don’t really need to read them.

This would be a mistake. Commercial leases are important contracts that must be read thoroughly in order to be fully understood. While most people read the important contract clauses such as rent amount, term, and escalations, some people ignore the common “boilerplate” lease clauses such as force majeure or jurisdiction. However, since these common lease clauses can and do vary, it’s also important that they are read thoroughly and understood, in addition to the rest of the contract. In this article we’ll take a closer look at 10 common “boilerplate” commercial lease components with examples and items to look out for.

Boilerplate Legal Definition

The term boilerplate, as it’s used in law, has been defined as “A description of uniform language used normally in legal documents that has a definite, unvarying meaning in the same context that denotes that the words have not been individually fashioned to address the legal issue presented.”

The problem though is that virtually all the language in commercial real estate leases has been individually fashioned, and while it may reflect the desires of the drafting party, it may not meet the needs or intentions of the second party. Since these terms can dramatically affect your rights and duties under the lease, understanding their purpose and pitfalls is vital.

Let’s take a look at 10 common “boilerplate” provisions in commercial real estate leases (and in fact, in most commercial contracts), their purpose, examples of each, and items to consider when reviewing them.

1. Notice

How can you terminate the lease? How can you renew? How and when can rent be increased? While the right to do any of these may include many conditions, one will almost always be that you gave proper notice to the other party. Failure to follow the terms of the notice provision can thus deprive you of a right you would otherwise have, or subject you to an obligation you wished you did not have.

A typical notice provision will include (1) to whom and where notice must be addressed, (2) by what methods must it be sent, and (3) when notice is deemed received. Here is an example Notice provision:

“Notice. (a) Form of Notice. All notices provided for under this Lease must be in writing and addressed to the following: (i) Landlord: John Smith, ABC Company, 1234 Main Street, City, State, (ii) Tenant: Jane Smith, XYZ Company, 5678 State Street, City, State. (b) Method of Notice. Notices must be given by (i) personal delivery, (ii) a nationally recognized, next-day courier service, (iii) first-class registered or certified mail, postage prepaid. (c) Receipt of Notice. A notice will be effective upon receipt by the party to which it is given or, if mailed, upon the earlier of receipt or the fifth business day following mailing.”

Notice Clause: What To Watch For

Email: A common modification will allow for notice by email. To avoid the loss of an email to a spam filter (or simply overlooked because of the massive amount of email one receives in a day), a notice provision may also require that hard-copies of the notice be provided along with the email. Where this is the case, the section should clarify when the notice is deemed received (e.g., receipt of the email or receipt of the hard copy).

All Communications: Often a notice clause refers to “notices provided for under this Agreement,” but it may be wise to broaden the clause to include all communications between parties. While this may take a little more effort to comply with, it can reduce arguments as to what qualifies as a “notice.”

Specificity of Time: Because notices must be received by a certain date, it is important to clarify when that date ends. At the end of the business day? At midnight? What if the parties are located in different time zones? Specificity is your friend (e.g., “Notices must be received no later than 5:00 p.m. CST on [date].”)

Language: With an increasing number of commercial leases occurring between parties of different nations, it may be appropriate to state that all notices will be in a certain agreed-upon language.

2. Attorneys’ Fees

Most commercial leases include an attorneys’ fees provision that provides that where a lawsuit is brought relating to the lease, the party that prevails in court may recover its attorneys’ fees from the losing party. In the absence of such a clause, the general rule will apply, meaning that each party will bear its own litigation costs, win or lose. Here is an example attorneys’ fees provision:

“If either Party brings legal action to enforce its rights under this Lease, the prevailing party will be entitled to recover its expenses, including reasonable attorneys’ fees, incurred in connection with the action.”

Attorneys’ Fees Clause: What to Watch For

What Suits are Subject to the Clause: This clause can be written to cover all or only specific types of suits. For example, does the clause state fees are recoverable for “breaches” of the lease, or all claims “related to” or “arising from” the lease. The broader language could include non-contract based claims such as fraud.

Do Both Parties Have the Right: Although generally leases with an attorneys’ fees provision will grant each party the right to recover litigation costs if it prevails, some leases may allow only the landlord to recover its fees.

What Kind of Suits are Likely: What kinds of claims are you most likely to make, and for what amounts? If the amount of potential recoveries is small, and thus less than potential attorneys’ fees, then in the absence of a prevailing party clause the other party may simply ignore the claim, believing you won’t sue for less than your costs. Accordingly, if small damage claims are likely, a prevailing party clause would be beneficial.

What Costs are Covered: Many clauses grant not only attorneys’ fees to the prevailing party, but all litigation costs, expenses, court fees, etc. Additionally, one should check to see if the clause relates only to litigation, or if it also applies to other dispute resolution processes (e.g., arbitration, mediation).

3. Merger/Entire Agreement

Right before you sign the lease you ask the other party to confirm an email they sent that morning, “you’re paying for all HVAC repairs, right?” They agree. Or, you hand them a piece of paper stating that they’re responsible for these costs, they agree and place the paper in their briefcase. The lease is then signed, the HVAC dies, and you look to them to fix it. Must they? Maybe. Maybe not. Look at the lease. If the lease included a merger clause (also called an entire agreement or integration clause), and if the lease states that you are responsible for such repairs, then that conversation, that email, and that briefcased piece of paper may not help.

The merger clause provides that all agreements, representations, warranties, etc. regarding the lease are set forth within the “four corners” of the documents. Any terms outside of the lease are of no force or effect. Put simply, the words in the lease overrule any other agreements you think you had.

The purpose of the clause is to ensure that all of the agreements between parties are contained in one place, and give certainty to the terms of a contract. An example clause is as follows:

“This Lease and exhibits attached hereto constitute the entire agreement between the parties concerning the subject matter of the Lease. All prior agreements, discussions and representations are merged herein. There are no agreements, discussions or representations, express or implied, between the parties except those expressly set forth in this Lease.”

Merger Clause: What to Watch For

Multiple Agreements: One common issue is where parties have multiple agreements relating to the same subject matter. Where this clause appears, it may have the unintended consequence of ignoring or conflicting with some of the terms of the prior agreements. For example, where a lease is in place, a new issue arises, and a separate agreement relating to the property is executed with this clause, will a court recognize terms in the lease? Maybe, maybe not. To avoid this issue, prior agreements can be referred to in, and attached as exhibits to, the new agreement.

Attach Everything: Because the merger clause means all agreements outside the lease are unenforceable, the most important practice is to make sure every agreement, whether it established in an email, conversation, or a separate document, is included in the body of the lease or incorporated as an exhibit.

4. Choice of Law/Governing Law

A choice of law provision establishes what law will be used to interpret the lease (e.g., the laws of the State of New York). Because laws vary from state to state (or country to country), this gives the parties clarity as to how the lease will be constructed, and how it is likely to be interpreted. Here is a sample choice of law provision:

“The provisions of this Agreement shall be governed by and construed and enforced in accordance with the laws of the State of __________.

Choice of Law/Governing Law Clause: What to Watch For

Know the State Law: Not every state interprets leases the same way. There are different presumptions, standards of review, and calculations and limitations on damages. So understanding how your lease would be interpreted under the chosen law will help you not only assess the risks under that law, but also understand how to write the lease to minimize those risks.

Many corporations elect to use Delaware law in their contracts’ choice of law clause. While there are a number of reasons for this (the State regularly updates its corporate laws for clarity, and has a special court for corporate law issues), one of the primary benefits is that Delaware’s laws have been well-parsed, removing some uncertainty as to how a dispute will be resolved. Of course, selecting Delaware may not be the right fit for your lease, and some courts may require a connection to the state before allowing the choice (e.g., if one of the parties is incorporated in Delaware), but it is a good example of companies understanding the importance of which law will govern an agreement.

5. Jurisdiction/Forum Selection

The jurisdiction (or forum) selection clause stipulates where suits relating to the lease must be brought. Selecting a single forum reduces the time and cost that would otherwise be spent arguing over where an action should be filed, as well as preventing two simultaneous actions in different jurisdictions. A simple forum choice clause is as follows:

“The Parties agree that all actions or proceedings arising in connection with this Lease shall be tried and litigated exclusively in the state courts located in the County of __________, State of __________, and that each Party is and shall continue to be (i) subject to the jurisdiction of the state courts in the County of __________, State of __________, and (ii) subject to service of process in the County of __________, State of __________.”

Jurisdiction/Forum Selection Clause: What to Watch For

What Suits are Subject to Clause: The above language requires that “all actions or proceedings arising in connection” with the agreement must be litigated in the chosen forum. However, as with the attorneys’ fees clause, some leases will use less encompassing language, such as “actions regarding the breach of the Lease.” This narrower language could then allow a non-breach actions (e.g., fraud), to be brought in a different jurisdiction.

What are the Costs: If you agree to forum in a state other than your own, be aware of the practical costs that will arise if litigation occurs. You may have to find local counsel who is familiar with the state’s laws and local courts. And of course, consider the time and cost of traveling out-of-state for what could be an extended period of time.

6. Force Majeure

A force majeure clause (meaning “superior force”) provides that a party is relieved of its obligation to perform a certain act when it is prevented from doing so by a circumstance beyond its control. A typical force majeure clause provides:

“In the event that either Party is delayed or prevented from the performance of any act by reason of strikes, lockouts, unavailability of materials, failure of power, restrictive governmental laws or regulations, riots, insurrections, war or other reason beyond its control, then performance of such act shall be excused for the period of the delay and the period for the performance of such act shall be extended for a period equivalent to the period of such delay.”

Force Majeure Clause: What to Watch For

Are All Obligations Subject to Force Majeure: A party may want to carve out some lease obligations from the force majeure clause, meaning that these duties must be performed regardless of external forces. One common carve-out is a tenant’s obligation to pay rent.

What Duty is Required if a Delay Occurs: Even when an unforeseeable event prevents or delays a party from timely performance, it should not simply throw up its hands if there is some way mitigate the delay. Some courts may require that the party made reasonable efforts to perform its duty despite the event. For example, if there is a material or labor shortage in the area preventing a timely build-out, the party may have to look to other areas to see if similarly-priced options are available.

In leases dealing with construction, one should pay special attention to the force majeure language regarding labor and materials to ensure it is not to broad or narrow for their interests.

Catch-All: Many clauses will list numerous specific events that will qualify as a force majeure, and then end the list with a catch-all phrase to the effect of “and all other unforeseeable events beyond the Parties’ control.” Because some courts have held that where there is a specific list followed by a catch-all, the catch-all will not be enforced. This does not mean a catch-all shouldn’t be used, but rather reinforces the need to make sure the clause reflects the specific events you would want to excuse timely performance.

7. Definition of Premises

The definition of the leased premises not only identifies where the tenant will conduct its business, but may also be used to determine tenant costs under the lease. Understanding the precise boundaries and dimensions of the premises can reduce confusion and unnecessary litigation. The following is a sample boundary description:

“The Premises, located at __________, and legally described on Exhibit __________, consists of __________ square feet, calculated by measuring: (i) from and to the interior midline of the interior walls, and (ii) from the ceiling tiles to the top of the slab, the perimeter boundary of which is outlined on Exhibit __________. The Premises shall not include the exterior walls or roof of the Building.”

Definition of Premises Clause: What to Watch For

Approximations: Because the lease will likely tie certain tenant costs to the square footage of the premises, the lease should state a specific square footage verified and agreed to by both parties.

Common Areas: If the tenant will be leasing or have the right to use common areas, interior or exterior, these areas, and what rights and obligations the tenant has to them, should be included in the definition of the premises. For example, if the tenant has a duty to repair carpeting in the premises, does that include carpeting in common areas.

CAM: Many CAM charges will be based on the tenant’s proportionate square footage of the total leasable area. Accordingly, the parties will want to establish that other tenants’ premises within the total project area are measured in the same way.

8. Dispute Resolution

Disagreements happen, and this provision outlines the steps each party must take to resolve the disagreement. A common progression (referred to as a multi-tiered dispute resolution clause) is (1) informal negotiation, (2) mediation, (3) arbitration, and then (4) litigation. The benefits of such a provision is that if the first steps can resolve the issue, it will reduce the time and cost involved in a lawsuit, and hopefully allow the parties to maintain a cordial commercial relationship. The following is a sample clause:

“Any dispute relating to the Agreement which cannot be resolved by negotiation between the parties within __________ days of either party giving notice to the other party that a dispute has arisen shall be submitted to mediation pursuant to the mediation rules of the __________, and failing settlement of that dispute by mediation within __________ days thereafter, the dispute shall be submitted by any party for final resolution by arbitration by __________ arbitrator in accordance with the arbitration rules of __________, and failing settlement of that dispute within __________ days thereafter, the dispute shall be submitted by any party for final resolution by the courts of __________ County, __________ State.”

Dispute Resolution Clause: What to Watch For

Time-Sensitive Issues: Because some disputes will need a fairly quick resolution, one of the benefits of this approach is that a party has options other than filing suit. Litigation can be a very slow process, and thus not effective where time is critical.

Abuse by Delay: Although the tiering can allow for quick resolution, where one party has no intention of changing its position absent litigation, and it believes that it will benefit from a delayed resolution, a poorly drafted clause can allow them to drag the other party through all the steps. The best way to avoid this issue is simply to be very clear in when one of the tiers begins (e.g., within five days of notice), when it ends (e.g., within 30 days of the mediation beginning), and what time is allowed for each step.

Optional or Mandatory: The clause should specify whether the steps are optional or mandatory. If you agree that they are mandatory, then understand that suit can’t be brought until the other steps are taken first, otherwise a court may be without jurisdiction to hear your claim.

9. Tenant Self-Help

Because landlords may not always perform their duties as quickly as possible, a self-help provision allows a tenant to take corrective measures in an emergency. A landlord may not want to include this provision because it risks the tenant making repairs instead of the landlord, and gives the tenant control over the costs. A sample self-help provision is as follows:

If Landlord shall default in the performance of any agreement of this Lease, and Landlord shall not cure such default within thirty (30) days after notice from Tenant, Tenant may, at its option, at any time thereafter cure such default, and Landlord agrees to reimburse Tenant for any amount paid by Tenant in so doing. If Landlord fails to reimburse Tenant for any amount paid by Tenant, this amount may be deducted by Tenant from the next or any succeeding payments of Rent.

Self-Help Clause: What to Watch For

Can Tenant Still Sue: The above provision states that the tenant can offset rent due if the landlord doesn’t reimburse them. However, simply getting paid back for repairs may not make the tenant whole. For example, where the landlord is responsible for access to tenant’s store, the access is damaged and preventing customers from patronizing the store, and the tenant is forced to repair the damage, a reimbursement for repair will not reflect lost sales. Accordingly, a tenant will want to ensure that self-help doesn’t waive their right to pursue damages for breach.

When Does Tenant Get Reimbursed, and for What: Again, specificity avoids conflict. The provision should state not only that the landlord will reimburse the tenant for its self-help costs, but also (i) specify what costs are reimbursable, (ii) when repayment must occur, (iii) and if a penalty or interest charge should arise if timely payment is not made.

What if There is no Self-Help Provision: If tenant doesn’t have an express right to self-help, and does so anyway, it risks (among other things) not being able to recover its costs and opening itself up to a claim for improper repair from the landlord.

10. Parties/Signature Blocks

The parties to a lease are typically set forth at the beginning of the lease, and then again in the signature blocks. The named parties are the ones responsible for performing the duties outlined in the lease, and the parties against whom recovery can be sought. Accordingly, it is critical to ensure the right parties are named.

Parties/Signature Blocks: What to Watch For

Is the Right Company Named: This is mostly self-explanatory, other than to note that where companies are often divided into many entities, one should verify that the correct entity is named in the lease. Of course, it doesn’t hurt to verify that the named landlord actually owns the property being leased.

Authorized Signatories: Where a business entity is the responsible party, the individual signing the lease must be authorized to bind the company. This may require a formal act of the company. Further, to avoid personally binding the person signing on behalf of the company, the signature block should include the entity’s name, state of formation, and the signator’s title. Some states have mandated the proper form for signature blocks by statute.

Conclusion

What should be clear from this article is that there are no true “boilerplate” provisions. Rather, there are concepts (e.g., attorneys’ fees) common to many leases, but what the parties agree to regarding these concepts can vary widely depending on the language used. Accordingly, it is vital that these “miscellaneous” provisions be read carefully, and where necessary, modified with the help of an attorney to meet the parties’ expectations. As always, this article should not be taken as legal advice and on all legal matters you should consult with a qualified real estate attorney.

How to Analyze Tax Increment Financing (TIF) Projects

A commercial real estate developer identifies a property ideal for its use, but because he can’t find a way to make the project financially feasible, he considers looking elsewhere. The city though wants the developer to undertake the project because it would replace property that generates negative social and economic impacts with a property that offers positive ones. What is a possible solution?

Tax increment financing, or “TIF.”

What is Tax Increment Financing (TIF)?

In its simplest terms, TIF:

(1) redirects the incremental increase in certain tax revenues generated by a redeveloped property from taxing districts to the redeveloper

(2) to cover a portion of the project’s costs

(3) in order to make the project financially feasible.

It is the marriage of private (the developer’s) and public (the taxing districts’) monies to facilitate a project that will benefit both private and public, where the project would not otherwise happen.

TIF revenue is only created if the proposed project will generate an increase in tax revenue over that generated by the existing use (or non-use). For example, where a retail center has lost tenants, whether because of changing demographics, moves to newer centers, or other reasons, the tax revenue generated from this property decreases. A fall in rental income reduces the owner’s ability to maintain and repair the property, its real property value goes down, and real property taxes fall. Likewise, the loss of tenants reduces sales and the consequent sales taxes. Further, fewer tenants results in less taxable personal property and personal property taxes.

When a project will rehabilitate the center (or demolish it and construct a new one) and locate new tenants, real and personal property value, sales, and the related tax revenue, all increase. The difference between the increased taxes resulting from the redevelopment and the taxes generated by the existing property is the “increment” potentially available to incent and facilitate the redevelopment.

How Do Cities and Developers Determine if TIF is Appropriate for a Project?

TIF redirects tax revenue from taxing districts to the redeveloper. Accordingly, as part of a city’s determination as to whether the use of TIF is appropriate, it will consider whether the amount redirected is necessary for the project to move forward, and whether the project benefits outweigh the potential impact to taxing districts. This consideration is accomplished through different financial analyses. This article outlines common analyses, and how to decipher them.

It should be noted that while TIF projects generally create benefits other than just increased tax revenue (e.g., new jobs, elimination of blighting conditions such as crime, impairing potential redevelopment of surrounding properties, etc.), this article examines only the financial analyses.

The statutes governing TIF vary by state. Accordingly, this article uses the general framework of TIF within the State of Missouri, and the analyses often considered by local governing bodies and taxing districts within the State. The principles outlined however are applicable to many other jurisdictions.

The three analyses considered here are (1) TIF revenue projections, (2) tax revenues to the taxing districts with the project and the use of TIF compared to revenues with no project (Tax Impact Analysis), and (3) an analysis to determine if the amount of TIF requested is necessary to make the project financially feasible (this can be referred to as part of a “but for” requirement, i.e., that “but for” the use of TIF, the project would not occur).

TIF Revenue Projections

From the developer’s perspective, the determination of how much TIF revenue is available to offset project costs is paramount. It determines, when coupled with the developer’s private monies, the expected return on its investment. Which incremental tax revenues can be redirected most commonly involve real property taxes. Some jurisdictions also permit TIF to capture taxes from increases to activity with the project, such as sales tax. Other activity taxes may also include an incremental increase to individual and corporate income taxes where the local jurisdiction has imposed them.

The starting point for all projections are the assumptions. Below are typical assumptions pages for real property, sales, and personal property. Although personal property is not captured by TIF in Missouri, because the tax revenues created by new property impacts the taxing districts, its assumptions are included.

Real Property Tax Revenue Assumptions

Tax Increment Financing TIF Real Property Assumptions

In order to determine the incremental increase to real property tax revenue, the developer estimates the fair market value (FMV) of the project when completed, and compares it to the FMV of the current property. The FMV is the estimated price that a buyer would pay to a seller for property in the current marketplace, provided both parties are knowledgeable, willing and not under duress. In this case, the projected FMV is calculated by adding to the purchase price 50% of the redevelopment costs ($10,000,000 + (50% x $7,500,000) = $13,750,000). Simplified valuations like this are not uncommon, though cities and developers may use other agreed upon methods, such as the three appraisal approaches to value (i.e., cost, income and comparable sales).

The existing property’s FMV is taken from the tax rolls ($5,000,000). The governing body and taxing districts may challenge such calculations, or require an appraiser to determine projected and existing FMVs. Of course, all the assumptions noted in these analyses can be a point of contention between the public and private parties.

The FMVs are then converted into assessed values (AV). Assessed value is a property’s dollar value, determined by the local government, which is used to calculate real property taxes. Generally the assessed value is determined by taking the FMV and multiplying it by an assessment rate. These rates may differ by land use (e.g., assessment rates could be 15% of FMV for industrial property, and 10% of FMV for agricultural uses).

Real property values are not static over time, and TIF is captured for a period of years. Accordingly, TIF revenue projections will include inflation factors rates for the new project (2%) and depreciation factors if the new project does not occur (-2%). Guidance on all real and personal property valuation assumptions, including inflation and depreciation factors, is often sought from the local tax assessment department, which will determine valuations for tax purposes.

Lastly, the above assumptions note that 100% of the real property increment will be redirected to offset project costs (“captured” by TIF). Because only the incremental increase is captured, the taxing districts will continue to receive the real property taxes generated by the property’s current use through the term of the TIF.

Sales Tax Revenue Assumptions

Tax Increment Financing Sales Assumptions

As with real property, the sales tax revenue projections must establish starting points for existing and post-redevelopment sales. The above assumptions provide that current sales are $500,000, and the projected sales in Year 1 of the redeveloped project will be $3,000,000. New sales are further projected to grow at an annual rate of 3%. Often construction and tenancy will occur in stages. In such cases, more detailed assumptions will show phased-in sales, and then a fixed growth rate upon completion of the phases.

Because the analysis relating to the impact of the project on taxing districts will compare district revenue with the project and TIF vs. no project, the assumptions estimate that if no redevelopment occurs, sales will decrease by 3% every year. A decrease in sales in a blighted property is often supported through sales tax data for the declining property, and the assumption that this decline will continue absent redevelopment.

In the above, the starting increment is projected at Year 1 new sales of $3,000,000 less existing sales of $500,000 = $2,500,000.

The assumptions further note that only 50% of the incremental increase to sales tax revenue (as opposed to 100% of real property taxes) will be captured by TIF.

Personal Property Tax Revenue Assumptions

Tax Increment Financing Personal Property Assumptions

As with the real property assumptions, FMVs are determined for the existing personal property (Initial FMV $100,000) and completed project ($2,000,000), and then multiplied by the assessment rate for personal property (35%).

These projections assume that all personal property, whether redevelopment occurs or not, will annually depreciate at a rate of 10%. Depending on the new project use, however, this assumption will vary. For example, technology companies may frequently update equipment to keep pace with the industry, meaning that because depreciated personal property is regularly replaced with new property, there is no projected decrease in value (and in some cases, there may even be an increase).

Lastly, these projections state that no part of the personal property increment will be captured by TIF. The taxing districts will retain all revenue.

Taxing District Levy Rates

Tax Increment Financing TIF Impact Analysis Totals

The above detail of taxing district levies stresses the importance of understanding not only which types of tax revenue the districts receive, but also whether under the applicable state law those revenues are subject to TIF capture. For this example five districts were used to illustrate four different revenue treatments.

The City and County can levy real property, personal property and sales, but its personal property taxes are not subject to TIF. The State can levy only sales taxes, but they are not subject to TIF. The School District can levy only real and personal property, and only the real property taxes are subject to TIF. And, lastly, while the Blind Pension District can levy real and personal property, none of its tax revenue is subject to TIF. Understanding how state law treats taxing districts differently is vital to projecting a redevelopment’s potential TIF revenue, and the impact of the project on all districts.

TIF Revenue Projections – Real Property Increment

Tax Increment Financing Real Property Revenue Projections

TIF revenue is captured over a period of years. In Missouri it can be redirected for up to 23 years. For space reasons, this example runs for six. The first two columns pull the existing AV and projected AV of the real property from the assumptions page. The initial value remains constant through the TIF term, and the taxing districts will continue to receive tax revenue based on this assessed value. As the projected property value grows at the assumed rated, the incremental AV grows too. The incremental real property tax revenue is simply the incremental AV multiplied by the total levy rate. In Year 1: $2,625,000 x 6.9% = $181,125.

The annual real property increment is then totaled for the TIF’s term. Many analyses will determine the net present value (NPV) of the TIF revenue stream, as developers may borrow funds secured, in part, by such revenue. In the example, the total gross projected revenue over six years is $4,006,895, and the NPV is $3,429,624.

TIF Revenue Projections – Sales Increment

Tax Increment Financing TIF Sales Tax Revenue Projections

The calculation of incremental sales tax revenue is similar, though it must account for, in the case of this example, the limitation that only 50% of the sales tax increment is captured. The initial (existing) sales are shown in the first column, and remain fixed through the term. Taxing districts will receive all tax revenue calculated on this base. The estimated sales increase annually at the assumed growth rate (3%), resulting in a growing sales increment. The revenue calculation is then the total sales levy subject to TIF capture x incremental sales x 50% (in Year 1: 2.25% x $2,500,00 x 50% = $56,250).

The table then reflects the gross and NPV incremental sales tax revenues available to offset project costs. Adding the real property and sales tax increments estimates the total available TIF funds (gross $5,261,185, NPV $4,502,563).

These revenues will be used in the “but for” analysis to determine if the redevelopment, with the assistance of TIF, is projected to generate an acceptable IRR. Additionally, some municipalities may cap TIF revenue at a certain percentage of total project cost. In this example, total TIF revenue divided by total project costs (TIF $5,261,185 / (purchase price $10,000,000 + redevelopment costs $7,500,000)) means that TIF is available to fund 30% of the project. In all cases, however, TIF revenues must exceed the costs the developer is asking be reimbursed by TIF.

Tax Impact Analysis

The purpose of the tax impact analysis is to quantify the projected impact of a TIF project on all affected taxing districts. This requires looking at each type of tax for each district, with and without the project. It should be noted that this type of analysis does not consider the scenario where redevelopment occurs without TIF, as the presumption is that the developer, and all other developers, would not take on the project without TIF revenues.

No Project – Real Property Tax Revenues

Tax Increment Financing TIF Impact Analysis Real Property

This sheet considers real property taxes in the event the project does not happen. The State is absent from this calculation as it has no real property levy. Based on the assumptions discussed above, it is assumed that absent redevelopment, the property’s FMV will decrease annually. The revenue per year per district is simply the initial AV times the district levy rate (Year 1 for the City: $1,500,000 x 1.3% = $19,500).

No Project – Sales Tax Revenues

Tax Increment Financing TIF Impact Analysis Sales

Similarly, the sales tax revenues projected to the three districts with the authority to tax sales (City, County and State) decrease over the six year period as retail sales decrease in the declining property. Revenue per year per district is projected sales multiplied by district levy rate (Year 1 for the City: $500,000 x 3% = $15,000).

No Project – Personal Property Tax Revenues

Tax Increment Financing TIF Impact Analysis Personal Property

While personal property is not captured by TIF in this example, it is impacted by the project, and thus included in the tax impact analysis. Revenue per year per district equals the personal property AV (decreased annually by 10%) multiplied by the district levy rate (in Year 1 for City, $35,000 x 1.3% = $455).

Project With TIF – Real Property Tax Revenues – Real Property Tax Revenues

Tax Increment Financing TIF Impact Analysys Real Property

The “Project with TIF” pages reflect only those tax revenues received by the districts under TIF, and thus do not include any revenues redirected by TIF. Accordingly, in the case of real property, the above table shows that the City, County and School District receive tax revenues equal to the initial AV multiplied by their respective levies. The AV is held static over the term of the TIF. All revenues generated from the increase in real property value over the initial AV is redirected to the project.

Note that the Blind Pension District revenues increase over the period. This is because this district’s levy, in this example, is not subject to TIF capture. Thus, its revenue is equal to the actual real property AV, growing each year, times its levy rate.

Project With TIF – Sales Tax Revenues

Tax Increment Financing TIF Impact Analysis Sales

In this example, 50% of the incremental increase in sales taxes is redirected to TIF. Accordingly, the two districts subject to TIF capture, the City and County, receive 100% of their levy against the initial sales, plus 50% of the increase from this initial amount. The calculation in Year 1 for the City is (initial sales x City tax rate) + (sales increment x City tax rate x 50%) = ($500,000 x 3%) + ($3,000,000 x 3% x 50%) = $52,500.

Note that the State, because its levy is not subject to TIF, receives 100% of its levy against 100% of the projected sales. In Year 1, the State sales tax revenue equals $3,000,000 x 3% = $90,000.

Project With TIF – Personal Property Tax Revenues

Tax Increment Financing TIF Impact Analysis Personal Property

The calculation for personal property tax revenue with TIF is the same as without TIF. In either case, personal property tax revenue is not captured by TIF. However, because the redevelopment assumes that it will include an increased amount of personal property, the related tax revenues to the districts have increased in the With Project calculation.

Tax Impact Analysis – Totals

Tax Increment Financing TIF Impact Analysis Totals

Totaling the above tables by district and tax type, this table details the increase in tax revenues to the affected districts projected to occur as a result of the project with the use of TIF.

“But For” Feasibility Analysis

Tax Increment Financing TIF IRR

A common method to determine whether the use of TIF is necessary for a project’s financial feasibility is through an analysis of internal rates of return (IRR) with and without the use of TIF. Above is a simplified pro forma and unleveraged IRR calculation using the TIF revenues projected above.

The reasonableness of the proforma assumptions is a large part of examining the reasonableness of this analysis. Was the cap rate of the proposed purchase reasonable (10%)? What about the projected cap rate for the reversion calculation (6%)? Rent, vacancy and rent escalation rates? Operating costs? Whether the “Without TIF” IRR is insufficient to incent a private developer to make the investment given the risk of redevelopment (7.14%)? Is the “With TIF” sufficient to incent the investment (13.51%)?

A common method to answer these assumption questions is to look for guidance from third party consultants engaged by the city, the developer, or both. Additionally, for assumptions relating to the valuation of the property for tax purposes, many will look to the local assessment department.

The above analysis begins with a calculation of net operating income (NOI) over the term of the TIF. In order to calculate the IRR, it sets the developer’s initial outlay ($17,500,000) and the projected TIF revenue ($4,502,563) available to offset the developer’s cost. The analysis projects that the gross reversion proceeds ($19,414,965 = Year 6 NOI $1,164,898 / cap rate 6%), less a selling expense of 4%, results in net reversion proceeds of $18,638,366.

The “With” and “Without” TIF IRR calculations are identical except for the initial developer expense. Without TIF utilizes the full project cost ($10,000,000 purchase price + redevelopment costs $7,500,000), and for With TIF, this amount is reduced by the NPV of TIF revenues ($4,502,563). The resulting IRRs are then compared against industry benchmarks and comparable projects to determine (1) if the developer would pursue the project without TIF (is 7.14% worth the risk?), and (2) if the amount of TIF revenue being redirected to the developer is too great (e.g., if 13.51% is unreasonably high in this market, then TIF revenues should be limited).

Consideration as to whether the IRRs do or do not reflect acceptable levels of return to the developer may consider factors like the nature of the project (e.g., including the life cycle of the property, local market conditions such as new development, major employers and their plan, and demographics), the overall risk associated with the property, inflation expectations, and other factors.

A Common Misconception Relating to TIF Analyses

A common challenge to TIF is that the taxing districts will lose tax revenues. The misconception is that if there was no redirection of taxes, the revenues to the districts would be greater because property values and sales would increase. The problem, however, is in the premise that there is the potential for the project occurring without the use of TIF. As discussed above, TIF is generally not available unless the developer can establish that the project is not feasible, and would not happen in the absence of TIF assistance.

Taxing districts can, nonetheless, challenge this assertion through a critique of the “but for” analyses provided (e.g., the IRR analysis above). Additionally, parties can consider how long the property has been on the market, and surrounding properties, to weigh the likelihood of its future development without TIF.

The district’s concerns should also take into account how the TIF is calculated to determine if a reduction in non-captured tax revenue is projected to occur. This of course varies by state, but in the example above, because the districts will continue to receive taxes based on the existing assessed value of the real property during the term of the TIF, and because the projections assume that the property, if not redeveloped, will continue to decrease in value, the taxing districts will actually receive greater real property tax revenue with TIF. Similarly, those taxing districts with the right to tax sales, will receive an increase in revenue owing to the increase in taxable sales if the project occurs, even though 50% of the sales tax increment will be redirected to the project.

Can the Analyses be Manipulated?

This article raises the question, “can developers or cities manipulate the analyses to reach the conclusion they desire?” While it is possible to change the method of each analysis (e.g., change the holding period in the Feasibility Analysis to return different IRRs), because many local governments tend to require similar formats for the analyses (e.g., in Kansas City, most TIF applications provide a Feasibility Analysis covering a 10-year period), such manipulation is less common.

However, results for each analysis can be changed fairly significantly by changes to the assumptions. Attached are the Excel sheets used for this article. Make a change to any of the assumptions and see what happens to the results.

Download TIF Excel Analysis

Fill out the quick form below and we'll email you the Tax Increment Financing (TIF) Analysis Excel worksheet used in this article.

For example, if the post-redevelopment FMV is changed from $13,750,000 to $18,000,000, the available TIF revenue increases from $5,261,185 to $7,171,489, and the “With TIF” IRR rises from 13.51% to 16.58%. Or, if the cap rate for reversion calculation is changed from 6% to 8%, the “With TIF” IRR drops from 13.51% to 9.37%. And these are only two of many of assumptions (e.g., redevelopment costs, calculation of real and personal property FMV, real and personal property and sales inflation and deflation rates, projected sales, NPV rate, projected project income (and all the assumptions within projected income and expenses like rent rate, vacancy rate, CAM charges, insurance costs, management fees, etc.), selling expenses, cap rates, etc.

Accordingly, any party interested in understanding or challenging a TIF analysis may want to focus their attention on the reasonableness of assumptions. For this very reason, of course, developers and cities will look to third-party consultants to provide supportable assumptions.

Conclusion

We’ve discussed common projections and analyses used to determine whether tax increment financing is appropriate, as well as underlying assumptions and how to determine if they’re reasonable. Given that TIF law varies by state, it’s best to consult with an experienced public incentives attorney if you are dealing with TIF. Have you ever prepared, reviewed or challenged any of these analyses? Let us know in the comments below!

How The Equity Multiple Works In Commercial Real Estate

The equity multiple is a commonly used performance metric in commercial real estate, and yet it’s not widely understood. In this short article we’ll take a look at the equity multiple as it’s used in commercial real estate and we’ll also walk through several examples step-by-step.

What Is The Equity Multiple?

First of all, what exactly is the equity multiple? In commercial real estate, the equity multiple is defined as the total cash distributions received from an investment, divided by the total equity invested. Here is the equity multiple formula:

Equity Multiple

For example, if the total equity invested into a project was $1,000,000 and all cash distributions received from the project totaled $2,500,000, then the equity multiple would be $2,500,000 / $1,000,000, or 2.50x.

What does the equity multiple mean? An equity multiple less than 1.0x means you are getting back less cash than you invested. An equity multiple greater than 1.0x means you are getting back more cash than you invested. In our example above, an equity multiple of 2.50x simply means that for every $1 invested into the project, an investor is expected to get back $2.50 (including the initial $1 investment).

What’s a good equity multiple?  As always, this depends. Context is required in order to determine what a “good” equity multiple means. Typically, the equity multiple is most relevant when compared with other similar investments.

Equity Multiple Proforma Example

Let’s take a look at an example of how to use the equity multiple in a commercial real estate analysis. Suppose we have an acquisition that requires $4,300,000 in equity and we expect the following proforma cash flows:

equity multiple real estate example

If we add up all of the before tax cash flows in the proforma above, then we’ll end up with total profits of $9,415,728. This results in a calculated equity multiple of $9,415,728/$4,300,000, or 2.19x.

What does a 2.19x equity multiple mean? This simply means that for every $1 invested into this project an investor is expected to get back $2.19 (including the initial $1 investment).

Is 2.19x a good equity multiple? As mentioned earlier, the fact that it’s higher than 1.0x means the investor is getting back more money than initially invested. However, the equity multiple alone doesn’t say anything about the timing because the equity multiple ignores the time value of money. In other words, a 2.19x equity multiple is much better if the holding period is 1 year versus 100 years. This is why the equity multiple is most relevant when compared to equity multiples of other similar investments.

Equity Multiple vs IRR

What’s the difference between the equity multiple and the internal rate of return? This is a common question since the equity multiple is often reported along with the IRR.

The major difference between the IRR and the equity multiple is that they measure two different things. The IRR measures the percentage rate earn on each dollar invested for each period it is invested. The equity multiple measures how much cash an investor will get back from a deal. The reason why these two indicators are often reported together is because they complement each other. The IRR takes into account the time value of money while the equity multiple does not. On the other hand, the equity multiple describes the total cash an investment will return while the IRR does not. Let’s take a look at an example of how these two measures can be used together.

The equity multiple is a performance metric that helps put the IRR into perspective by sizing up the return in absolute terms. The equity multiple does this by describing how much cash an investment will return over the entire holding period. Suppose we have two potential investments with the following cash flows:

Equity Multiple vs IRR

As you can see, the first investment produces a 16.15% IRR while the second investment only produces a 15.56% IRR. If we were using the IRR alone then the choice would be clearly be the first set of cash flows. However, the IRR isn’t a silver bullet and doesn’t always tell the full story. This can be seen by looking at the equity multiple for both investment options. Although the second potential investment has a lower IRR, it has a higher equity multiple. This means that despite a lower IRR, investment #2 returns more cash back to the investor over the same holding period.

Of course there are other factors to consider. For example, Investment #1 returns $50,000 at the end of year 1 whereas with Investment #2 you have to wait for 4 years to get $50,000 of cash flow. Depending on the context of these deals, this may or may not be acceptable. For example, if you plan on putting all of the cash flow from Investment #1 into a checking account earning next to nothing, then perhaps Investment #2 would make more sense since your cash will be invested longer. On the other hand, perhaps the cash flows from Investment #2 are more uncertain and you’d prefer the peace of mind that comes with getting half of your investment back in Year 1 with Investment #1.

These are issues that would be addressed in a full investment underwriting and there are also several other metrics and qualitative factors that could be considered. With that said, the equity multiple allows you to quickly understand how much cash a project will return to the investors, relative to the initial investment. It also adds some additional context to the IRR when looking at a set of cash flows to help you quickly size up an investment’s absolute return potential.

Conclusion

The equity multiple is commonly used in commercial real estate investment analysis. In this article we defined the equity multiple, discussed what it means, and the walked through an example step by step. We also compared the equity multiple to the internal rate of return since these two metrics are commonly reported side by side. We showed an example of how the equity multiple can add some context to the IRR by indicating an investment’s absolute return potential.

How The Mortgage Constant Works In Real Estate Finance

The mortgage constant, also known as the loan constant, is an important concept to understand in commercial real estate finance. Yet, it’s commonly misunderstood. In this article we’ll take a closer look at the mortgage constant, discuss how it can be used, and then tie it all together with a relevant example.

What is The Mortgage Constant?

First of all, what exactly is the mortgage constant? The mortgage constant, also known as the loan constant, is defined as annual debt service divided by the original loan amount. Here is the formula for the mortgage constant:

Mortgage Constant Formula

In other words, the mortgage constant is the annual debt service amount per dollar of loan, and it includes both principal and interest payments.

How to Calculate the Mortgage Constant

There are two commonly used methods to calculate the mortgage constant. The first simply divides annual debt service by the total loan amount. The second allows you to calculate the mortgage constant for any loan amount by solving for the payment based on a loan amount of $1. Let’s take a look at both methods.

Suppose we have a $1,000,000 loan based on a 6% interest rate and a 20 year amortization. With this information you can simply find the annual debt service using the above assumptions, then divide the annual debt service by the loan amount. On our financial calculator, if we plug in 240 months for N, -$1,000,000 for PV, .50% for I (6%/12), and 0 for FV, then we can solve for the monthly payment. To convert this to an annual payment amount we simply multiply by 12.

mortgage constant calculation

Since the mortgage constant is simply the ratio of annual debt service to the total loan amount, this calculation is just simple division. In this case we take $85,972 / $1,000,000 to get a mortgage constant of 0.085972. As a percentage this would be 8.5972%.

The method above works if you already know the loan amount, but what if you want to find the mortgage constant for any loan amount? If you only know the amortization period and the interest rate, then you can easily solve for the mortgage constant. This is accomplished by plugging this information in on a financial calculator, while using $1 as the present value. For example, consider the same loan terms above of a 20 year amortization (240 months) and a 6% interest rate (0.50% per month). Since we don’t know what the loan amount is (present value), we can simply use $1 as the present value:

Mortgage Constant Calculation 2

When we solve for payment we get 0.007164. Since this is a monthly payment we can multiply by 12 to get an annual mortgage constant of .085972. Notice this is the same 8.5972% mortgage constant we found above. Two different approaches that will result in the same result.

Mortgage Constant Example: Band of Investment

Once you have calculated the mortgage constant, it can be used in a variety of ways. Let’s take a look at a mortgage constant example that uses the band of investment approach to calculate the cap rate, which is commonly used by appraisers.

The band of investment method is a popular appraisal approach to deriving a market based cap rate. It’s frequently used by appraisers to support a market cap rate used in the income approach to valuation. The band of investment method is simply a weighted average of the returns to both debt and equity. These returns can be found by surveying lenders to find out their typical loan terms for a particular property, and also surveying investors to find out their required cash on cash returns for a particular property. Let’s take a look at how the mortgage constant is used with the band of investment.

Suppose we want to find an appropriate cap rate to value an office property in Orlando, FL. First, we can call around to several lenders in the area and ask them what their current loan terms are for this kind of property. If lenders are currently underwriting office properties at a 75% loan to value, with a 25 years amortization, and a 5% interest rate, then we can calculate the mortgage constant using one of the methods above. When we do this the resulting annual mortgage constant is 0.07015.

Next, we can survey local investors to see what their required cash on cash return would be in order to invest in a property like ours. Suppose our investor survey reveals an average 11% cash on cash return requirement. Now we can use these debt and equity returns to estimate a market based cap rate using the band of investment method.

To do this we simply take a weighted average of the two rates of returns to get 8.01%. This is found by taking the mortgage constant times the LTV ratio, then adding this result to the cash on cash return times 1 minus the LTV ratio: (7.015% x .75) + (11% x .25) = 8.01%.

Of course there are pros and cons to using the band of investment method to estimate a market based cap rate, but it’s frequently used in the commercial real estate industry and the mortgage constant is a critical component.

Conclusion

The mortgage constant, sometimes called the loan constant, is a commonly used calculation in real estate finance. In this article we defined the mortgage constant, discussed two common approaches to calculating the mortgage constant, and then we showed how the mortgage constant is used with the band of investment approach to calculating the cap rate.

 

Mezzanine Financing Basics and The Intercreditor Agreement

Financing short falls within the commercial real estate market have become a common occurrence. The great recession has made traditional lenders more sensitive to risk, frequently leaving developers and project investors with large financing shortfalls. Sponsors can seek out family and friends financing or a larger joint venture (JV) equity injection, but sometimes this gap may be too large to overcome through traditional methods of financing. Mezzanine financing is designed to fill this gap.  In this article we’ll give you a broad overview of mezzanine financing, common mezzanine loan structures, and we’ll also cover the importance of an intercreditor agreement.

What is Mezzanine Financing?

First of all, what exactly is a mezzanine (mezz) loan? Mezzanine financing is a unique financing instrument which doesn’t cleanly fall into a specific category of the capital markets financing quadrant. It’s a general term that refers to any financing vehicle (debt or equity but typically issued by private sector participants) that bridges the gap between senior debt and sponsor equity. It can be structured as preferred equity or as debt.

mezzanine financing

In general, traditional mezzanine financiers are not entitled to receive returns on their investments until senior debt holders are fully compensated.   Because of its subordinate position, the mezzanine loan assumes a higher risk profile than senior debt but retains a less risky position than preferred equity. With this understanding, Mezzanine debt investors seek returns between senior debt lenders and preferred equity investors but this will largely depend on how the deal is structured.

mezzanine financing capital stack

Basic Mezzanine Financing Structure

Mezzanine deals that are structured as debt instruments usually have one of the following forms of collateral:

  • Second deed of trust – This is the most desirable form of collateral to the mezzanine lender because it provides the most tangible form of security. It allows the mezzanine lender to foreclose on the property if the borrower defaults on payments. This type of security is rare since the first mortgage lender typically does not allow this type of arrangement.
  • Assignment of partnership interest – This is the most common form of debt security in the mezzanine finance universe. An assignment of partnership interest gives the mezzanine investor the option to take the borrower’s ownership interest in the property in the event of default. Effectively the mezzanine lender becomes the equity owner and assumes the obligations to the first mortgage lender. This type of arrangement is supported by an intercreditor agreement with first mortgage lender. This intercreditor agreement is discussed in detail below.
  • Cash flow note – This gives the mezzanine lender an assignment of all cash flow from the property in exchange for the mezzanine loan proceeds as well as a percentage of the proceeds from sale of the property. The cash flow note is not a recorded instrument and typically does not need an intercreditor agreement. This is also sometimes called a soft second.

Deals structured as equity have a different set of characteristics. Equity deals are joint ventures between the equity/owner and the mezzanine lender that are guided by the partnership agreements. Major provisions in the partnership agreements cover decision-making authority and specify decisions that require approval from the mezzanine partner. In the event of default with respect to the mezzanine loan, the mezzanine provider may foreclose on the pledged equity interests, not on the underlining property itself, and become the owner of the equity interests in the property-owning entity. Therefore, the owner/sponsor has significantly less control over the project and may lose all control if the property does not perform as expected. These rules are typically enforced by Uniform Commercial Code (UCC) article 9.

With mezzanine financing, owners sacrifice flexibility, control, and upside potential, and will ultimately pay a higher price for the capital. However, in return, owners won’t be required to contribute as much cash and they also gain a partner who might step in to help if the property starts to falter. What actually determines what a mezzanine provider will and will not do in a default scenario is dictated by the intercreditor agreement, a key link between the senior debt lender and the mezzanine financing provider.

Mezzanine Financing and The Intercreditor Agreement

The intercreditor agreement is negotiated by the first mortgage lender and the mezzanine provider. The purpose of the intercreditor agreement is to outline communication channels and provide guidance between the first mortgage lender and the mezzanine investor. More importantly, the agreement gives certain rights to the mezzanine financing provider in the event of a borrower default.

Many first mortgage lenders, mainly conduit lenders, refuse to negotiate intercreditor agreements, especially if the loan has already closed. In fact, conduit loan documentation routinely prohibits selling or transferring more than 49% equity ownership in the property to a partner. Some non-conduit lenders take the attitude that their interests are already covered in the agreement with the borrower and there is no need to complicate matters by bringing in an additional financial partner with different and potentially conflicting objectives.

Other lenders see value in what mezzanine financing providers can bring to the deal. The additional capital can allow the borrowers to purchase the desired property, pay leasing commissions, tenant improvements and pursue other value-adding strategies. In this case, and especially when the mezzanine financing provider is an experienced real estate investor, the first mortgage lender will often welcome their participation. The depth of experience of a reputable mezzanine financing provider can be advantageous for senior lenders, especially if the borrower defaults.

According to David E. Watkins of Heitman Real Estate Investment Management in Chicago, the mezzanine financing provider typically negotiates for several elements in the intercreditor agreement. The big three are listed below:

  • Notification of non-payment or default on the first mortgage. The mezzanine lender wants to know, from someone other than the owner, that the property is being managed professionally.
  • The right to cure any default on the first mortgage. The mezzanine position wants to protect itself by taking over the property and not allowing the first mortgage to foreclose and take possession.
  • The right to foreclose on the property if the owner fails to pay the mezzanine position. First lenders rarely agree to this clause, as a building that is in foreclosure creates uncertainty among existing tenants (who might elect not to pay rent) and prospective tenants (who might view the property as tainted and unstable).

Mezzanine Financing Example Structure

What makes the intercreditor agreement unique is how the instrument secures the mezzanine investor’s interest. It’s common that the agreement secures a 100% interest in the company which owns the underlying property through a bankruptcy remote “special purpose entity”  holding company. This entity will be loaded with special covenants and restrictions and would be structured to ensure the borrower is limited in its ability to file for bankruptcy. An independent director may be appointed as well in order for the special purpose entity to maintain neutrality. The diagram below illustrates what this hypothetical structure might look like:

mezzanine financing intercreditor agreement

 

As shown above, Plaza Building Holdings LLC is the special purpose entity which secures a 100% interest against the borrower, Plaza Building LLC.  Plaza Building LLC holds the ownership interest in the subject property. The borrower will then make payments to both the mortgage lender and the mezzanine financing provider.

Conclusion

Mezzanine financing can provide borrowers the necessary financing to get a deal done, but it doesn’t come without risk. If a project experiences cash flow shortfalls or otherwise gets stuck in a down market, sponsors/owners will have less control and flexibility in the deal. This article outlined mezzanine financing basics and also covered the importance of the intercreditor agreement.

U.S. Employment Growth Trends by State – December 2012

Here is the December 2012 edition of our employment growth trends data. If you’d like to access more data like this, complete with interactive charts and graphs for every state, MSA, and county in the United States, sign up now for a free trial.

December2012EmploymentRates

When Will Commercial Real Estate Fully Recover?

The recession officially ended back in 2009 and the economy has been growing ever since, yet it still feels like a recession to most people.  Why is this and how long will it take to get back to normal?  More importantly, what does this mean for commercial real estate? 

First, let’s take a look at the dent made by the 2008 recession. Employment peaked in December 2007 and bottomed out in February 2010, eight months after the recession was officially over.  

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Progress is being made and we’ve added back about half of all jobs lost.  If employment growth continues at its current pace, then it will take another 40 months to regain all of the jobs lost since the start of the recession. That would take us out to about 2016, assuming that we don’t have another recession before then, which would result in additional job losses.

However, this doesn’t take into account population growth.  The above analysis shows that it will take at least 4 more years to get back the number of jobs we had in 2007, but since our population continues to increase every year, the hole we have to climb out of keeps getting bigger.  As shown below, the employment-to-population ratio appears to have bottomed out, but it hasn’t started growing quite yet.  This will likely extend out the 4+ years required for a full jobs recovery by several more years.

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This is also reflected in the labor participation rate, which has been in a free-fall since the official end of the recession.

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And of course while we are slowly adding jobs, the above charts don’t show the kinds of jobs being created, the median wages being accepted, or how many people are underemployed, which we’ll dive into in a future post.

But what does all this mean for commercial real estate?  The CCIM Institute has a nice demand cycle flow chart that illustrates how employment drives demand for commercial real estate. As shown below, demand for commercial real estate is directly or indirectly driven by employment growth.  

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Employment growth drives population growth and disposable income.  Office and industrial demand is driven by employment growth. Industrial, residential, and hospitality demand is driven by population growth. And hospitality and retail demand is driven by disposable income.

Since it will take at least 4 more years to get back to the level of employment we had in 2007, it stands to reason that it will take at least as long for commercial real estate demand and construction to recover as well, based on the above demand cycle.  Dr. Glenn Mueller’s latest Cycle Monitor Report tracks where each asset class is in the market cycle and confirms that all property types are indeed still in the recovery phase or just entering the expansion phase.  

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In future posts we’ll continue to track employment growth and the cycle locations of various property types. Of course, this analysis is at an aggregate level for the entire U.S. and growth in local markets is uneven.  Our market analysis tools allow you to see exactly where individual states, MSAs, and counties are at in the employment cycle and exactly how fast they are growing. We also publish rankings of local areas each month so you can track all U.S. markets in real-time. Later in this series we’ll dig into specific local markets to see how they are doing relative to the U.S. If you want to keep up be sure to subscribe to our mailing list on the top right hand side of this page.