Disputed internal DLNR analysis estimates state losing millions in lease extensions

When a ground lease expires, the buildings or other improvements on the land typically become the property of the landowner.

If a lease is extended, many landowners will assess the value and condition of the improvements and require compensation for essentially deferring ownership of those assets and allowing the lessee to use them and the land during the extension period.

The concept is known in real estate circles as deferred reversionary interest.

Many landowners in Hawaii — especially those in the private sector — insist on compensation for such deferred interest when extending ground leases.

The Department of Land and Natural Resources is not among them.

The agency says Hawaii law regarding lease extensions does not require a lessee to pay the state for deferral of reversionary interest. And for the department’s board to successfully seek such compensation, the agency and board believe statutory authority ought to be in place, according to DLNR. If the Legislature intended the board to seek compensation, lawmakers would have specifically required or authorized such action, the department added.

The agency is guided by another statute that enables the board to grant 10-year extensions on 55-year leases as long as the lessee commits to making substantial improvements to the property.

Denying lease extensions places lessees in a difficult position of not knowing whether they can continue at their locations past the expiration date and makes them reluctant to expend funds on repair and maintenance of aging buildings, according to DLNR. And allowing leases to expire so the state can maximize rents is an overly narrow view of the public-trust doctrine, the agency added.

But there has been disagreement historically within DLNR about the issue.

When the board started approving 10-year extensions to 55-year leases in a Hilo industrial park several years ago, a 2014 analysis by several staff members noted the extensions for just five leases — among the first to be approved in a park with over 70 DLNR leases — would potentially cost DLNR an estimated $10 million in forfeited revenue over the 10-year period. Other leases in the park have since been extended.

The department disputed the accuracy of the analysis, saying it was merely conjecture, wasn’t supported by appraisals of the land and improvements, and lacked studies by licensed professionals with relevant expertise.

The staffers recommended the department consider the pros and cons of extending leases and whether in some cases the state’s interest would best be served by allowing the agreements to expire so DLNR could issue new leases for the land and buildings, commanding higher rents.

In some cases the board approved extensions just weeks or a few months before the leases expired.

Frequently, lessees seek extensions in order to obtain financing for planned improvements. An extension makes the lease more valuable to the lessee and a lender more likely to issue a loan.

Seth Kaplowitz, a real estate attorney and law professor at San Diego State University, said Hawaii taxpayers are being shortchanged when the land agency does not evaluate whether the state’s interests would be better served by terminating a lease and, if extensions are granted, seeking compensation for the deferred reversionary interest.

“The citizens are being (cheated),” Kaplowitz told the Honolulu Star-Advertiser in a phone interview.

Unlike DLNR, the Port of San Diego is a public landowner that requires lessees to compensate the agency for its deferred reversionary interest, either in a one-time premium payment or incorporated into rent payments over the remaining years of the lease.

The port used to waive the premium if a tenant came in with a redevelopment proposal with more than 20 percent of the lease period remaining, according to Tony Gordon, real estate director for the port.

But the policy was changed last year, eliminating the waiver and requiring the lessee to compensate the port for the full value of the reversionary interest in the improvements, Gordon said.

“We’re just trying to be fully compensated,” he said.

The port also allows a lessee to purchase additional time on a lease without investing in capital improvements if the existing improvements are in great shape, according to Gordon.

The port’s board in some cases has decided not to extend leases, often because it desires other uses for the property.

The port, for instance, recently allowed a lease to expire for a specialty retail center because the board envisions combining that property with adjacent ones for a large redevelopment project.

FORFEITING MILLIONS IN REVENUE?

After the Department of Land and Natural Resources’ board approved 10-year extensions for five ground leases in the Kanoelehua Industrial Area in Hilo, an analysis was done by two DLNR staff members in 2014 maintaining that the department was forfeiting an estimated $10 million in rents just for those five extensions. The five were among the first of what were expected to be many extensions in that industrial park. The department disputed the analysis, saying it was conjecture and not backed by professionals with the necessary expertise. Here’s the analysis:

Source: Two DLNR Land Division workers in 2014