Ground Lease Basics for Commercial Real Estate Investors

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Ground Lease

Imagine this.  You are a commercial real estate (CRE) investor and you discover the perfect parcel of land in New York.  It is located at the corner of “main and main” with excellent visibility from the road. It gets a significant amount of traffic and it is located in a high growth city with strong median income.  You are confident the parcel would be perfect for your client, a major drug store.  You have to have it.

But, after a bit of research and several phone calls, you run into a dead end.  The owner of the parcel isn’t interested in selling.  Is this a dead end?  It doesn’t have to be.  If an owner is open to creating a stream of income from vacant land, consider a “Ground Lease.”

What is a Ground Lease?

A Ground Lease / Land Lease, is a long term lease whereby a property owner leases their land to an investor.  In return for their rent, the investor gets the right to construct a building on the property. Once complete, they can use it for their own account or sublease it to other tenants.  

There are two key differences between a ground lease and a traditional commercial real estate lease. They are the leased premises and the term. 

As described above, the leased premises in a ground lease is usually a piece of vacant land. The leased premises in a traditional commercial lease is an existing building or space within a building. 

A traditional commercial lease term usually ranges from 5-20 years. However, it can take a long time to complete construction so a ground lease term is much longer.  In some cases, it can reach 99 years.

Given the unconventional nature of a ground lease agreement, it is only logical to ask, “why would anyone do this?”

Benefits of a Ground Lease   

There are benefits to a ground lease for both the landowner and the investor/developer.

For the landowner, they have an opportunity to create an income stream while retaining ownership of the land. Often times, the land is a prime location that can’t be replicated.  For many, this is preferable to sitting on a vacant piece of land while continuing to pay carry costs. Also, if the landowner owns multiple nearby parcels, the development of one can positively impact the value of their surrounding assets.

For an investor, the ground lease benefit that they can get into the deal without a significant upfront investment.  In addition, they typically get access to a commercial property in a prime location.

As with any type of investment, it is important to measure the benefits of a ground lease against the risks.

Risks of a Ground Lease

While there are several smaller risks in a ground lease, there are three big ones. They are: financing, default, and expiration.

Financing

When an investor enters into a ground lease, they intend to construct a building for which they will need financing.  But, a construction loan that involves a ground lease can be complicated.  

In a traditional construction loan, the lender requires a first position lien on the property and all improvements thereto.  If the borrower defaults, they will take the property/building back and sell it. Once sold, they will use the proceeds to pay down the loan balance.  But, in a ground lease, the borrower (investor) doesn’t own the land so they can’t grant a lien against it.  

To work around this issue, the lender will ask the landowner for a subordination agreement. This document gives them top priority in the hierarchy of claims in the event of a default.  This is called a “subordinated ground lease” and it represents some level of risk for the landowner.  In a worst case scenario, the ground lease tenant (the investor) defaults on the loan. When this happens, the lender will initiate foreclosure proceedings to take back the property and sell it.  If the sales proceeds are less than the loan balance, the property owner could lose their land.  The other option is an “unsubordinated ground lease.” This means that the property owner does not have to subordinate their interest. However, this is the exception, not the norm.

Default

Like any lease agreement, there is a risk that the tenant defaults. This means that they can’t or won’t make their lease payments.  Given the length of a typical ground lease, it is important that the landowner understand the investor/developer’s plan for the property and their capacity for executing it to make an assessment of the potential default risk.  To illustrate this point, consider two different scenarios.

In the first scenario, assume that the investor is well known and has a good reputation. In addition, they have significant lender and tenant relationships and a strong track record for performing on their contractual obligations.  Their plan is sign a ground lease and quickly develop a quick service store like Starbucks or McDonalds.  They have a letter of intent and the lease amount is sufficient to cover the construction loan and ground lease payments.  Given the financial strength of the end tenant and the investor’s experience, this is a relatively low risk situation.

In the other scenario, the investor has some experience and they plan to build a retail center on spec.   Construction is purely speculative and their hope is that they will be able to fill the space quickly once it is complete.  Given the lack of certainty, this is a far riskier situation that should give the land owner pause before signing the ground lease agreement.

Because the land owner is likely going to be required to subordinate their interest in the property, a default on the construction loan likely also means a default on the ground lease and a real possibility that they could lose the land with little or no compensation for it.

Expiration

Because the term of the lease is lengthy, up to 99 years, what happens at the end is often an afterthought because the parties to it may not be around to see it happen.  This is a mistake and both property owners and investors/developers must pay particular attention to the clause(s) in the agreement that handle what happens at the end of the lease.  Many ground leases contain a so-called “reversionary clause,” which means that ownership of the improvements (the building(s)) reverts back to the property owner upon lease expiration.  This may seem beneficial for the landowner, but it isn’t always because they could end up inheriting a 99 year old property that is in desperate need of renovation or demolition, both costly endeavors.

So, for both parties to the lease, it is critically important to understand what happens when it expires.

Other Ground Lease Considerations

The specifics of a ground lease can vary greatly from one agreement to another.  Outside of the benefits and risks mentioned above, there area number of other considerations for both the property owner and developer/investor”

  • Rent Increases / Escalation Clause:  Do the terms of the lease call for periodic increases in the rent paid to the property owner?  Given the term of a typical ground lease, they should be sufficient to keep up with inflation.
  • Eviction Rights / Lessee Default:  What rights does the property owner have to cure a default in the ground lease?  Whether or not a subordination agreement is in place is a major factor here.
  • Valuation:  From a property owner perspective, it is important to understand both how the lease itself is valued and how the improvements are valued in the open market.  In both cases, the value of the actual land is of a secondary concern because it isn’t part of the transaction.  Instead, a traditional discounted cash flow analysis on the stream of income can be performed and a market cap rate can be applied to determine value. 

Ground leases can be incredibly complicated documents so Investors, developers, and/or property owners interested in working with one should always consult a qualified real estate attorney with any questions.

Summary & Conclusion

Ground leases are long term lease agreements between a vacant land owner and a developer/investor who wishes to construct a building upon it.  They are most often found in dense, urban areas or for properties who have a prime location that is difficult or impossible to replicate.

A ground lease can be beneficial for a property owner because it allows them to produce income from an idle asset. In addition, they can be beneficial for investors because it allows them to get access to a prime piece of property without the upfront cost needed to acquire it outright.  But, they aren’t risk free.  Evaluating the strength of the lessee and the plan for the property is critical to minimizing risk in the transaction.

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