What is a Recapture Agreement?
The most basic and fundamental description of a recapture agreement is the provision of a legally enforceable agreement that allows the landlord or the grantor of a real property interest (the parcel) to adopt a specific forfeiture provision relating to the use of the parcel. The recapture agreement is to be specifically and distinctly incorporated into a lease or deed to render it an enforceable agreement or covenant that runs with the land, over time, in perpetuity. Landlords and grantors seek out recapture agreements for a variety of reasons, but oftentimes a primary purpose is the provision of a form of insurance or protection against unforeseen developments adversely affecting the long term use of the parcel, including market demand for a specific use, government requirements for a specific use, and site conditions allowing for a specific use . Practically speaking, recapture agreements allow for flexibility and adaptability to changing market or economic conditions affecting the parcel.
In the context of a lease, a recapture agreement is used by a landlord to protect or "recapture" its investment in a tenant’s buildout improvements or other infrastructure on the parcel with a prescribed recapture value or calculation, and to later allow the tenant a negotiated right to use the improvements for an alternative use.
In the context of a deed, a recapture agreement is used by a grantor to protect or "recapture" its investment in the purchased parcel in whole or in part, through a recapture payment based on all or a portion of the purchase price. The recapture payment may be calculated based on many business strategies, including a sliding scale of a percentage of the purchase price applicable to various heighted improvements on the purchased parcel (i.e., regional or national distribution warehouses).
Key Elements of Recapture Agreements
Recapture agreements are generally straightforward documents that include the following essential elements:
Parties. The parties to a recapture agreement are generally the borrower and the beneficiary. Sometimes, a third-party is a party as well. For example, a recapture agreement will name a foundation or other organization that effectively runs the program for benefit of the Government.
Terms of Recapture. The recapture terms describe the obligation to return funds to the Government, including the condition and timing of payment. Generally, these terms are either a set payment schedule or an amount tied to appreciation of the property. Set payment schedules are most common in a loan program ran by an organization other than the agency responsible for the financing payment.
Tying the amount owed to the appreciation of the property is often done in the case of a project completed by a developer for the benefit of the Government as part of a specific incentive program. Specifically, the agreements will often state that if the property is sold before or on a date certain, the amount to be returned is X% of the appreciation of the property. This type of agreement is generally best suited for a community that has undertaken multiple projects. Tying the return to appreciation allows for the investor to recapture, in a small way, some of their funds. In addition, since the return is proportional to appreciation, it makes the project still more attractive to the property owner to invest in.
Conditions. Conditions are tied to the terms of the recapture agreement. Performance of the project is a common type of condition, such as a min-time of ownership. Other conditions often include anything related to the preservation of any conditions of the program being implemented, such as the requirement to lease space at a reduced-cost (such as workforce housing). Further, the agreement can also have a condition tied to a similar type of project being completed nearby. It can be a similar project either such as a second building by the same developer or a similar project in the same area. Any time a project has a performance goal, that goal should also be incorporated into the recapture agreement.
Incentives. Finally, the recapture agreement should also detail any incentive being offered by the Government below a quantity threshold (usually 100%). Sometimes this will simply state that the recapture will be reduced by X% for every year beyond the minimum term a program has been met. Additionally, some incentives will tie recapture to a job creation goal. This will generally state that a set amount of funds will be forgiven for every job created.
How Recapture Agreements Function
The process of implementing recapture agreements typically involves the following steps:
- The property owner notifies the city or municipality and/or their authorized agent of their intent to redevelop or repair the property.
- The city and/or its authorized agent review the proposed plans.
- The city sends the property owner an offer letter outlining the specific steps the property owner must take to avail themselves of the recapture agreement.
- If multi-year and tiered financing is employed with respect to recapture agreements, a table will also be established setting forth the percentage owed over multiple years and a tiered breakdown to correspond with those years (e.g., 10%, 20% etc. as discussed above).
- The agreement would be executed by the parties involved with all the detailed terms culminating in an understanding of the process with the applicable zoning laws and local ordinance.
Recapture agreements may be utilized in the following manners:
- One-time fee for certain improvements – some municipalities may determine that only certain improvements affect the district and provide a one-time fee. For example, two properties within a district may be redeveloped and the redevelopment can be broken down into stages. In this case, and if there are other property owners in the district doing the same, the city can evaluate and charge individual property owners based on facilities being created and/or utilized in the district rather than a flat rate or a large fee. The one-time charge could be based on the difference between the calculation of the new assessment based on the new rate and the current rate.
- Recapture agreement on change in zoning – in this scenario the zoning change governing the district may change the tax rate applicable to that district. Accordingly, the municipality could implement a recapture agreement assessing a fee to property owners whose properties are being newly assessed, but would be only based on the difference in assessed valuation in accordance with the new tax rate.
- Master plan – sometimes a municipality may have an overall master plan, which could call for one or various facilities within the district to be funded by the property owners. In this scenario, the implementation of the master plan could be in the above-mentioned categories based on a timeline that could fall within a one-year timeframe.
Legal Considerations of Recapture Agreements
The legal enforceability of recapture agreements can be a complex matter, affecting all parties involved in a development project. Ensuring that the language of these agreements is precise and that the recapture funds are duly accounted for, is critical in steering any likely legal challenges. Furthermore, the party responsible for making improvements or otherwise incurring capital costs has a vested interest in knowing just how long they can claim reimbursement for these costs. In terms of planning and strategy, the timing and the means of obtaining recapture funds should be assessed in advance of any development agreement being finalized.
As an initial matter, there are issues inherent to the development and definition of a recapture agreement that do not arise with a more common form of municipal agreement like a payment in lieu of taxes. As discussed above, recapture agreements are not a tool used widely by municipalities as a whole. Accordingly most municipalities would require some level of support for why a recapture agreement was drafted. If the document is ever challenged, a court will want to know why this mechanism was used instead of a payment in lieu of taxes or even just amending the zoning by-law to contemplate these improvements under the sole responsibility of the developer. Most importantly, should a challenged be levied, the court is going to want to know what basis the municipality has for any constraints placed onto the developer.
One such strategy that could be used to shield a municipality from a challenge is to ensure that the recapture agreement has contingent provisions that fallback on a different kind of municipal agreement. In this case, the recapture agreement can be justified as being premised on a balance of interests between municipal use and private benefit. For example, a recapture agreement could explicitly provide that should a court declare any part of it invalid or unenforceable, then the agreement would operate as a payment in lieu of taxes agreement.
The community benefits to be provided as a result of either a payment in lieu of taxes or recapture agreement are supposed to be of a nature that would have otherwise not been possible, had no other agreement been entered into. Within this context, the agreement must be drafted in a manner to reflect the benefit being given, so that no issues arise further down the road about what the recapture payment is meant to compensate for. It is also imperative to ensure that the recapture payment be calculated on a reasonable basis, so that there is no confusion or controversy about the amount. Parties can book unto themselves obligations and benefits that are not strictly compliant with the requirement that benefits must be proportional and foreseeable.
In terms of remedies, should a developer not make the agreed upon improvements, the city is always at liberty to assess a fine under its power to regulate building and construction. In terms of recovering recapture funds that are overdue, the municipality may wish to pursue smaller claims through the Small Claims Court. In this case, the municipality will be forced to produce the recapture agreement in order to recover on the claim. In the event of difficulty in enforcing the agreement, court intervention may be necessary.
Pros and Cons of Recapture Agreements
The insertion of a recapture agreement in the real estate context can have both benefits and risks. The primary benefit is that it serves to financially protect developers before, during and after development to ensure that the property remains in the intended use. There are a multitude of examples of rents potentially becoming available, but it is helpful first to understand how these agreements function. Those familiar with the commercial leasing world will be familiar with the real estate example of a tenant of a multi-storey condominium asking for the additional amendment of a recapture agreement to be inserted into the lease of its premises. For example, the tenant made a $200,000 spend commitment on the tenant improvements in its premises. The tenant recognizes and appreciates the value of the premises it occupies and, in a move that reflects appropriate due diligence, understands what alternate spaces are available and for what price. The tenant is in a situation where its usefulness is recognized and therefore, when the tenant has spent $200,000 in improvements and a short time later the landlord approaches the tenant with a notice of default while the tenant is still paying rent, the tenant is able to convince the landlord to amend its lease to reflect its true value in the marketplace and its rental rate is reduced to the usual marketplace rate. For example, instead of the previous $50.00/sf rental rate, the tenant is now paying $25.00/sf. Where does the developer fit in? During the development of the premises by the tenant before its move, the developer is required to make concessions to the tenant, such as parking credits, rent free periods, tenant inducements, free parking allowances and the like. The cash flow, the profit, the outcome is that much less than would otherwise be the case if the tenant does not exercise its new rate under the new amendment. As well, for the developer (landlord), the principal of fairness suggests that the landlord should recapture some of the land value that the landlord has lost at the close of the tenant improvements. A recapture agreement will come to the aid of both the developer and the landlord. By amending the leases to contain a recapture agreement in favour of the developer, the developer is well protected. For a period of five years after the commencement of any lease, or some period that is agreed, the developer will be able to recapture some of the costs incurred to the developer on a number of fronts. First, the developer will be able to recapture the difference between the $25.00/sf and the $50.00/sf rates for the premises. An important component of the recapture agreement is the ability to determine the value of a particular space and the appropriate lease rental rates as they pertain to that area and that space and make those adjustments to the lease agreement where necessary. The $25.00/sf rate has to change to fair value. The developer will also be able to recapture lost revenues because the vacating tenant never fulfilled all of the tenant’s improvements in the rentable area. As a result, the new lessee goes into the same space and requires that the developer fulfill the tenant improvements. The inexpensive 36" square tiles need to be replaced with the cheaper 12" square tiles. Once again, the developer needs to do so. The developer/tenant will also have an opportunity to recapture common area costs plus a profit or other costs that are associated with the installation of and construction of the tenant improvements and the space that has been vacated by the former tenant and is now being leased to the new tenant. While recapture agreements provide a great deal of value to landlords and developers, they can also provide a great deal of risk to the tenants and post tenants. Tenants and post tenants will be able to recap their lost investment in the unamortized cost of the tenant improvements that were installed during the development of the building. For example, if the tenant improvements were amortized over a period of 5 years and halfway through the five-year period the tenant moves out, then there is the remaining unamortized balance of two and a half years that will need to be covered. The tenant may not look favorably upon the additional lump sum payment to a deposit fund that will be kept in trust by the landlord. It is also likely that the tenants will want to implement a "leaving date" clause. In the circumstances described, the tenant may wish to move out without penalty on the last day of the month instead of the first day of the month.
Industries Commonly Utilizing Recapture Agreements
Any company that leases real estate may find themselves in a position to enter into a recapture agreement. However, industries that make intensive modifications to their leased space, own large portfolios of leased space, or require specialized components to their business that are more easily moved into a new facility tend to use them more than others. Examples of those industries include: telecommunications, industrial, and banking/financial institutions.
Telecommunications
Telecom companies are most commonly known for purchasing property on their lease term expiration with the expectation that the leased space will be immediately subleased in the marketplace. Telecom needs have changed drastically since the 1990s and early 2000’s when telecom was booming, and leasing was an excellent way to acquire space. Now , many companies in this industry are repositioning and selecting to enter into purchase and sale agreements in terms of leasing. When selecting this option they most often are required to enter into recapture agreements as well.
Industrial
Industrial companies are required to obtain county and city approval before demolishing existing structures on their property. A recapture agreement is a perfect way to ensure that the existing improvements are removed relatively quickly after closing. It also allows the buyer to secure funds from the seller up front to demolish structures that may later be difficult to remove, or in the case that the existing improvements may contain environmental contamination that the buyer needs cleared for future development.
Banking/Financial Institutions
Some banks prefer to obtain their owned property before the foreclosure process may occur. For example, it is in the interest of certain banks to acquire property in which the bank is the beneficiary and bank has the ability to control the timeline of the foreclosure process. In this sense it provides the bank with an added level of security during times of default.
Negotiating a Recapture Agreement
Whether the issue arises in the context of a recent municipal tax assessment or the need to maintain a lease following an expansion, recapture agreements are most commonly implicated in real estate transactions. The negotiations related to recapture agreements are different from any other aspect of a real estate transaction because they relate to an intangible asset. It is often not practical for the seller or landlord to provide the purchaser or tenant with as much credit as may be desired. In addition, many times it would be unfair to provide the potential purchaser or tenant with as much credit as may be desired because it is likely only to be enjoyed by the purchaser or tenant until the time of repurchase.
Communication of objectives is key to effective negotiation of recapture agreements. A seller, be it a municipality or a private seller of real property, should contact their attorney before responding to a request for recapture consideration. There are things that can be done to limit the liability of a seller to provide recapture consideration. At the same time, without proper negotiation, recapture consideration may be lost altogether. For the buyer, effective negotiation is equally important. A buyer is often understandably concerned over a potential lack of amortization credits, but does have the opportunity to identify and remediate issues early on, if they are aware of the potential exposure early in the transaction.
The proper approach to negotiations will vary with each scenario, but generally speaking, it is advisable to keep the number of parties involved to a minimum so that the negotiations are not prolonged. Efforts to maximize power dynamics, while creating unreasonable expectations, may be less than productive.
Recapture Agreements vs. Other Commercial Real Estate Contracts
In the landscape of real estate transactions, recapture agreements are often overlooked in favor of more familiar agreements like purchase and sale contracts, leases, and easements. While these agreements each have important roles, recapture agreements carve out a distinct niche.
Where a purchase and sale agreement is a forward-looking agreement between a buyer and a seller that provides for the purchase of a parcel of real property, recapture agreements are much narrower. Recapture agreements typically come into play when an owner of land wants to take advantage of a favorable economic or tax benefit from the local government, but obtains the benefit by agreeing to perform, allow, or refrain from performing certain obligations. It is not uncommon in Georgia that state and local governments will incentivize development with grants, reduced property tax assessments, or licenses to use governmental property for a certain period of time with the recapture of the incentive if the developer violates the terms of the incentive. The recapture agreement will memorialize the incentives given, the developer’s obligations to perform or not perform, and what actions will trigger recapture.
This is quite different than a lease, which contemplates a smaller, discrete slice of time for the use and occupancy of property for consideration. In addition, recapture agreements, while often long-term with respect to what is required of the property owner, are usually brief and limited with respect to the duration for which the recapture obligation applies. Those obligations are typically tied to the term of the incentive. Otherwise, the recapture agreement will become largely irrelevant, as the property use will have ceased to be incentivized, and the governmental entity will have long benefitted from the incentive. Thus, recapture agreements are short in terms of time and long in terms of what they require.
Easements are also commonly encountered in the real estate context. On the surface, recapture agreements may be seen as similar in some respects. Yet a key distinction is that easements may constrain the use of property in an affirmative manner, whereas recapture agreements typically do not. Like recapture agreements, easements are commonly granted for a set term. However, unlike recapture agreements which typically provide for the return of money, easements can only ever revert the property to the owner. Another difference is that easements run with land, whereas recapture agreements are personal to the parties and do not run with the land.
Although recapture agreements may be used more narrowly than other real estate agreements with respect to the usages, timeliness, and length of time, recapture agreements are nonetheless meaningful agreements for real estate parties as they provide for flexibility of opportunity and obligations for real property owners.
Recapture Agreement Case Studies
Tenants often face recapture agreements in the context of a lease, purchase and sale agreement or another commercial real estate transaction. The following case studies highlight when a recapture agreement has been successfully implemented or when it has not, and the lessons learned.
Example #1 – Tenant Challenges Recapture Contributions Post-Closing
In 1992, Bank of the West purchased land in Santa Clara County, California. At closing, the seller signed a warranty deed, a recordable Grant Deed conveying the property to the purchaser. The deed provided that the grantor intended to reserve certain rights of access and utility installation over the property conveyed to the grantee. The grantor only recorded the first page of the deed. Due to the seller’s failure to include the recorded second page of the deed, the referenced reservation was not recorded. Therefore, when a third-party purchaser took title to the property, it took title without any notice of the seller’s reservation.
Years later, in connection with re-development, the purchaser discovered the existence of the second page of the deed. The seller prepared and executed an amendment to the deed on October 31, 2008, which was recorded eleven years after the date of the grant deed. The King’s Court decision of 2014, concluded that the City failed to provide notice of its right to make improvements to the property. Because the purchasers were not put on notice by recordation, the grantor was barred from attempting to enforce the aforementioned reservation. (City of Santa Clara v. King’s Court Mobilehome Park, 224 Cal.App.4th 630, 650-651 (2014)) (Sec. 1005 provides notice of a recorded document that "relates to the title of real property.") The conclusion of King’s Court provides some torture for record title proponents: ". . . the grantor must prove that the instrument is authentic and exactly reflects what occurred at the time of the conveyance . . ."
Practical Tip: Read the Grant Deed carefully to ensure all clauses are included. Check the grant deed against the county recorder’s website to ensure it has been recorded in its entirety and notify the grantor if the deed has not been recorded.
Example #2 – Tenant Accepts Recapture Contribution but Later Challenges Recapture Contribution
Recapture agreements are found in purchase and sale transactions. A seller agrees to make recapture contributions if the purchase is made subject to existing covenants and/or easements, or the presence of certain physical improvements that are subject to negotiation between the parties. For example, the City of Los Gatos earlier this year had a recapture agreement with British Columbia Investments who purchased 73.6 acres of land commonly known as Vasona Park. The Recapture Agreement stated that the purchaser shall pay four recapture contributions to the City of Los Gatos upon the occurrence of the first of five specific development events, including the issuance of a building permit, or if the purchaser transfers title to any part of the property. In 2015, British Columbia Investments sold the property to Santa Clara Valley Water District and withheld the recapture contribution due under the agreement. Subsequently, the City of Los Gatos patently failed to pass a resolution that is a precondition to the validity of the recapture agreement. The City of Los Gatos relied on an exemption that provided: "When future development and/or the possibility of future development is being protected by a restriction or covenant on the property deed, the person or entity obtaining title to the property or any portion thereof shall be allowed to defer the payment of recapture until such time as future development is undertaken." The lawsuit filed by the City of Los Gatos against Santa Clara Valley Water District concluded the recapture contributions cannot be avoided. The court stated, "[t]he City was under no obligation to notify future purchasers or transferees of the deed restrictions." The court went on to state that the recapture agreement was a private agreement not an exaction and therefore the City of Los Gatos was entitled to the recapture contributions.
Practical Tip: If you are a tenant taking a transfer of title, contractually speaking, understanding the meaning and implications of recapture agreements may be beneficial. Be prepared to pay the recapture payment in the event of future development.
Future Developments in Recapture Agreements
Looking ahead, recapture agreements are likely to become more commonplace as governments and agencies attempt to fund municipal improvements through alternative financing methods. This increased use of recapture agreements could also lead to heightened regulatory oversight intended to increase transparency in any recapture agreement process. It is also possible that in the absence of any legislative or regulatory direction , municipalities and other entities will adopt by-laws, policies or practices that require recapture agreements over certain thresholds. Increased municipal and stakeholder support for recapture agreement arrangements may also influence future developments in this area. Thus, as we look to the future, there continues to be significant opportunity for the use of recapture agreements.