Sunday, November 20, 2005

Island Lease Extensions - Redux

In the bad old 'frontier' days of island development... many believed the good ol' boys got the 99-year leases with automatic renewal clauses while outsiders, Yankees, and other riff-raff got the shaft. Island residents should know that the same thing may be happening to them once again.
Hardly anyone on Pensacola Beach is paying attention to this, but the recurrent problem of a lease extension policy for Pensacola Beach businesses is back on the SRIA stove -- if not the front burner. The issue has importance for every property owner on Pensacola Beach, not just the few businesses that may be most immediately affected.

Julie B. Connerley has the latest news story in this week's issue of the Gulf Breeze News. Under the terms of the federal land transfer of Santa Rose Island to Escambia County, no one but the state or county government can hold title to Pensacola Beach property. Instead, it is leased for durational terms up to 99 years.

Differing Business Lease Structures

Beach commercial lease contracts cover a diverse range of businesses from Portofino Towers to seasonal watercraft rental services like Radical Rides; from Hemingway's restaurant to those coin operated telescopes along the fishing pier (if any survived Ivan). All island commercial leases require that business tenants pay either the "monthly minimum" or a percentage between two and five percent of monthly average sales, whichever is greater.

About half of all existing commercial leases have a termination date which conceivably could come to pass in this lifetime. The other half were initially let to larger, wealthier, politically well-connected businesses who had the good sense to lawyer-up before signing on the dotted line. These properties are covered by what appear to be iron-clad renewal clauses that grant a 99-year lease term with an additional 99-year extension on the same terms.

So, any commercial lease policy the SRIA adopts is likely to immediately affect only short-term leases held by smaller beach businesses. From time to time the owners of one of these less favorable leases becomes aware that the remaining lease period is too short to inspire confidence in its lending bank. Even worse, on occasion the lease expires before anyone notices.

Almost no one seems to care what the SRIA does about this, other than the business owner himself. But the deeper reality is that the agency's actions set a precedent, of sorts, for every leaseholder on the beach.

Ad Hoc Policy at the SRIA

In the past, when faced with such a circumstance the business has applied to the SRIA for a lease extension. Unguided by any island-wide governmental policy, the SRIA inevitably winds up fashioning an ad hoc solution.

In some cases, the tenant business has promised to pay any lease increase when-and-if the SRIA ever gets around to determining what it should be. In other instances, the business has been awarded a renewal in exchange for agreeing to pay a substantial one-time-only renewal fee -- after which, it immediately sold out to someone else.

In a nation that demands its governmental officials observe due process and equal protection of the law, ad hoc governance is a prescription for disaster. In fact, it's what got the SRIA into this jam to begin with.

In the bad old "frontier" days of island development, from the 1950's into the 1990s, the SRIA was accused not infrequently of playing favorites. Many believed local good ol' boys got the 99-year leases with automatic renewal clauses while outsiders, Yankees, and other riff-raff got the shaft. Island residents should know the same thing may be happening to them once again.

Two Proposals for a Renewal Policy

To bring due process into the picture, as Connerley now is reporting:
"[T]he SRIA has been trying to adopt a policy, unsuccessfully, since 1994 to determine the parameters of renewal once a commercial lease has run its course. Since then, two different advisory committees have worked several months each to produce two completely separate draft policies. The matter has been tabled twice ... ."
The earlier advisory committee came up with a formula for charging a lease renewal fee based on the actual market value of each expiring business lease. It was an elegant solution, and eminently defensible in a rapidly rising real estate market where businesses often changed hands at great profit. But it would have resulted in such a tremendous increase in business lease expenses that it was deemed politically unpalatable.

Smaller businesses, it was feared, as they neared the end of their lease period would let their properties deteriorate, the businesses would go to hell, and others would suffer the consequence of a decaying beach image. Other business owners, who professed no intention of selling and feared greatly increased renewal lease fees, threatened to revolt. (It's hard to imagine what form such a revolt would take, but apparently the threat was enough.)

More recently, a second advisory committee recommended a policy that deliberately ignored market value. Instead, the policy it proposed would substantially hike the "minimum" monthly fee in exchange for a like-term extension. The thinking is that this would create an incentive for short-term leaseholders to continue making capital improvements to their businesses because they would have some assurance the expense could be financed, and eventually recovered, over the renewal period.

Normally, all but a handful of island businesses pay far more based on the sales percentage lease fee component than the monthly minimum amounts to. While the Island Authority would not directly reap any financial advantage from increased market value under this proposal, the second advisory committee subscribed to the economic reasoning that the agency would see higher revenues based on the percentage lease fee income because the policy encourages owners to reinvest, expand, and improve their businesses even if they hold only short term leases.

Another Ivan Casualty

The recommendation was still pending when Hurricane Ivan came along and exposed what might be a fatal flaw in that thinking. Beach businesses rarely pay the "minimum fee" because in "normal" times the so-called "SRIA perentage lease fee" is far higher than the stated minimum. But Hurricane Ivan -- and widespread predictions of increased hurricane activity over the next decade or more -- raise the question, "just what are normal times?"

In the aftermath of Ivan, a very large majority of beach businesses simply could not reopen. Some failed, others remained closed for many months. In more than a few cases, they're still closed. Unless they had truly superior business interuption insurance, nearly all of the smaller island businesses are struggling to pay even the monthly minimum.

Even insurance benefits can run out before rebuilding is finished when multiple storms, such as we've had over the past year and a half, delay or prevent a business reopening. And, as everyone in the universe knows by now, hurricane experts are predicting increased tropical storm activity for at least the next ten to fifteen years.

The Residential Elephant in the Room

As politically difficult as the business lease extension issue has been for the SRIA, there's a very large elephant living inside the room that everyone has been ignoring: whatever policy the agency adopts governing business leases is also likely to influence renewal policy for residential leases.

As with business leases, not all island leases are the same. Over the decades, potentially troublesome variations have been introduced among residential house, condo, and townhouse leases. Most older leases were written for a 99 year term and a majority of them initially had a generous renewal clause. But from time to time small changes with large potential consequences were made in the lease forms the SRIA used.

Further complicating things, misguided SRIA actions in the 1990's forced some changes in lease language on properties that were being sold to buyers who financed the purchase with a conventional mortage. Moreover, some of the newer residential leaseholds, for example in the vicinity of LaFitte Cove, among others, are known to have initial durational terms as short as 30 years or even less.

The oldest residential leases, originally sold in the earliest years of Island development, have a diminishing number of years remaining. A few are barely longer, now, than a standard 30 year mortgage. Other residential lease contracts have murkier renewal terms written into them. Still others were designed to expire in just a few more years.

The Residents' Stake in Business Lease Policies

Historically, business leases have been structured in distinctly different ways than residential leases on Pensacola Beach. The business lease has a two-tiered fee system, as explained earlier: a set monthly minimum or a percentage of sales, whichever is higher. By contrast, residential lease fees have been calculated strictly according to the set monthly fee described in the lease contract.

That difference has been used in past years to assure residents that they are unaffected by whatever business lease extension policy the SRIA may adopt. That is a false assurance. Yet, it has been successful in deluding residents into supposing that they have no personal stake in the SRIA business lease extension decisions.

In all of the half dozen or so meetings of the second advisory committee the year before Hurricane Ivan struck, apart from one token resident representative from the Pensacola Beach Residents & Leaseholders Assn. not one resident showed up to take part in the discussions.

Given the new imposition of county ad valorem taxes on island residences as well as business leaseholds, it seems inevitable that whatever lease extension policy the SRIA adopts for commercial leases will inform, even if it does not directly govern, residential lease renewal policies. Questions will be raised such as --
  • If a capital market value approach (such as the first advisory committee relied upon) is used for business lease extensions and renewals, why should it not apply to residential leases as well?

  • Isn't the value of a residential lease determined by the same economic forces in the same market? If a substantial hike in the minimum monthly fee is imposed as the cost for extending business leases, then why not apply it to expiring residential leases, too?
The above questions and arguments almost certainly will arise once the SRIA adopts a business lease extension policy. If those who own residential property continue to slumber through the current debate, they risk having the answers to those questions already answered by the time they awaken.

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