What is a Ground Lease?
A ground lease, sometimes called a land lease, is a contractual agreement between a landowner and an investor/developer whereby the developer agrees to pay the landowner a specified amount of rent each month in return for the right to develop one or more buildings on the property.
A typical ground lease is a land lease agreement wherein the lessee or tenant pays rent on a parcel of land and can build and modify the property there. After the lease term is up, the leased land, all new property built on it, and any additions to that current property transfer into ownership to the landlord or lessor.
Real estate investors looking to construct office buildings often find this type of commercial real estate lease particularly useful. The rent payments are generally much cheaper long term than buying a piece of land outright. Additionally, the lease terms are usually long enough and allow so much freedom to develop the land that lessees can act almost as de facto owners in their own right.
During the term of a ground lease, the tenant owns any improvements made to the property, including any buildings it constructs. For example, many Macy’s (NYSE: M) department stores are ground-leased. This means that Macy’s owns the building itself and any other improvements made to the land, say, parking structures but the company still pays rent on the land beneath the store.
Just like most other real estate leases, ground leases require tenants to make regular (usually monthly) rent payments. And ground leases are generally net leases, meaning tenants are responsible for paying property taxes, insurance, and maintenance expenses for the duration of the lease.
Ground leases tend to have very long terms, 20 to 40 years is common for an initial term, but ground leases up to 99 years aren’t uncommon. Improvements made to land that is ground-leased become the property of the landlord after the lease expires, or the tenant might be required to demolish them.
Unlike triple net investments, which consist of both land and buildings, ground leases consist of land only. Landlords can lease undeveloped commercial land to tenants, who are granted full rights to construct and operate on the property.
Types of Ground Leases
Ground lease agreements are classified into two types: subordinated and unsubordinated. The primary difference between these two deals depends on what happens if a tenant faces financial difficulties during the lease tenure.
- Subordinated Ground Lease
In a subordinated ground lease agreement, the land owner agrees to take a lower position in the claim hierarchy. If the developer were to default on their construction loan with the bank, this means that the lender has the right to foreclose on the property, sell it, and use the proceeds to repay the loan. Any funds left after the sale would be paid to the landowner.
If the tenant defaults on a loan used to finance upgrades, the landlord in a subordinated ground lease, permits the property deed to serve as collateral. Since the landlord is taking on more risk in a subordinated lease, they generally demand higher rent. Due to the potential gain in property value from having the building constructed on their land, a landlord may be willing to sign a subordinated ground lease.
- Unsubordinated Ground Lease
An unsubordinated ground lease is one in which there is no subordination agreement. This is a less risky position for the landowner, but an unsubordinated ground lease can make it more difficult for the lessee to obtain financing. As a result, the rent payments for unsubordinated ground leases tend to be lower than those for a subordinated ground lease.
The landlord who contracts via an unsubordinated ground lease retains top priority if there are any claims against the property. This means that even if the tenant defaults on the loan, the lender cannot foreclose on the property. The lender in these cases generally requires a personal guarantee that gives them the right to pursue the tenant’s personal assets if they default. Prospective lenders can be hesitant to extend a mortgage in the case of an unsubordinated ground lease. As a result, landlords typically have to accept a lower rent.
Pros of Ground Lease
The ground lease structure has benefits for both parties and they are;
- Term/Security
Due to the fact that it can take a significant amount of time to get a development project designed, entitled, and constructed, the typical ground lease term is quite lengthy. In some cases, a ground lease term can go up to 99 years. As such, the length of the lease term provides both the commercial property owner and the developer with the security of knowing that they will have an ample amount of time to get the project developed and to earn a return on their investment.
- Financial Advantages
For the property owner, the major financial advantage of a ground lease is that it allows them to generate a passive income stream from a vacant piece of commercial property without having to do much work. For a property owner, the major financial advantage is that they are able to gain access to a prime parcel of land without the upfront cost associated with a down payment on a land acquisition. The economics of leasing land instead of buying it can make for a very profitable investment.
- Market Advantages and Location
Often, ground-leased land is in a strong market with a prime location that would be incredibly difficult, if not impossible, to replicate. The strength of the location can make it easier to attract stronger tenants who are willing to pay higher rent to be in a strategic location. These higher monthly rents can be a major contributor to the success of the project. For the developer/investor, the major benefit of a land lease is that they get access to a prime piece of real estate without the high upfront costs associated with having to purchase the property outright.
Cons of Ground Lease
There are potential downsides to making an investment in a deal with a ground lease arrangement.
- Land Restrictions
Local rules and ordinances may restrict the type and/or size of the commercial property that can be constructed on the land. The allowable project may or may not be what the market demands, which can be a major determinant of the project’s success. Prior to making an investment in a ground-leased project, real estate investors should be certain that the proposed project is allowable under local rules.
- Long Term Costs
Given that ground leases can have terms of up to 99 years, the long-term costs of making monthly lease payments to the land owner can actually make the payments more expensive in the long run versus buying the land outright at the start of the project.
- Reversion
Investors should pay particular attention to the language that governs what happens to the land improvements at the end of the lease. In some cases, the terms of the lease call for all improvements to be returned to the landowner.
CONCLUSION
Ground leases aren’t perfect arrangements in all cases. For example, since they are building on land they don’t own, tenants may need to get the approval of the landlord before construction can begin. And tenants can lose control of their building after the term of the lease expires.
However, a ground lease can be a mutually beneficial arrangement for many landowners and commercial tenants, which is why they are quite common in practice. They allow landlords to retain ownership and receive a steady income, and they allow commercial tenants to build places to conduct their business without the added upfront cost of buying land.
As informed investors we should understand the risks associated with real estate investing and that there is no guarantee. Please do your due diligence.
