When analyzing a typical commercial real estate investment/development opportunity, the assumption is that a property will be purchased, developed, held for a set amount of time, and then sold upon expiration of the planned holding period. While this is certainly the case for many transactions, it isn’t always the case.
In some cases, a landowner may be reluctant to sell their property for a variety of reasons, but this doesn’t mean a deal can’t happen. In cases where a landowner is reluctant to sell, an investor/developer may choose to enter into a “land lease,” also called a ground lease.
In this article, FNRP describes what a land lease is and the pros and cons of investing in a deal that involves a land lease. Let’s start with a simple definition.
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. The ground lease structure has benefits for both parties.
Benefits to Property Owner
A typical land lease involves a piece of land that is either in a highly desirable location or has some sort of distinguishing feature that would make it incredibly difficult to replicate. So, a land lease allows a commercial property owner to monetize their property while retaining ownership of the land. If the property owner has other land holdings in close proximity to the leased plot, those holdings may also benefit from rising values due to the development of the leased parcel.
Benefits to Investor
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.
Types of Ground Leases in Commercial Real Estate
There are two types of ground leases in commercial real estate, subordinated and unsubordinated.
Subordinated Ground Lease
In a deal that involves a ground lease, one of the challenges that a commercial real estate investor/developer typically faces is getting financing for the construction of their project. This is because a typical construction lender requires a first position lien on the commercial property as collateral for their loan. But, the developer does not own the property, so they are not in a position to provide this type of security. As a result, the investor must ask the commercial property owner to “subordinate” their interest in the property to the lender.
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 land owner.
A subordination agreement is often required to get the construction project moving, but a subordination agreement represents a real risk for the landowner. In an absolute worst case scenario, the land owner could lose their commercial property without any compensation for it. As such, they have to be very careful about whom they choose to partner with.
Unsubordinated Ground Lease
An unsubordinated ground lease is one in which there is no subordination agreement. This is certainly a less risky position for the landowner, but an unsubordinated ground lease can also 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.
Benefits of a Ground Lease
A ground lease has benefits for both the land owner and the investor/developer. They include the following:
1. Term/Security
Because 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.
2. 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.
3. 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.
Potential Downsides to a Ground Lease
There are three potential downsides to making an investment in a deal with a ground lease arrangement.
1. 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.
2. 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 versu buying the land outright at the start of the project.
3. 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 land owner.
Is a Ground Lease a Good Investment?
In short, yes, ground leases can be a very good investment. But, the structure, duration, and finances of the lease itself must be considered very carefully prior to committing to a deal that involves a ground lease.
As owners and operators of retail shopping centers, one of the things that we like to do at FNRP to add value to our assets is to enter into ground leases for the development of our property’s outparcels. This provides an additional stream of steady income for us and the parcel – once developed – can increase the market value of our existing commercial property.
Interested In Learning More?
First National Realty Partners is one of the country’s leading private equity commercial real estate investment firms. With an intentional focus on finding world-class, multi-tenanted assets well below intrinsic value, we seek to create superior long-term, risk-adjusted returns for our investors while creating strong economic assets for the communities we invest in.
To learn more about our investment opportunities, contact us at (800) 605-4966 or info@fnrpusa.com for more information.
