Much of the discussion around commercial real estate (CRE) investment tends to focus on purchase and sale transactions. While this transaction type accounts for much of the CRE investment activity, it isn’t the only type. Another common, but frequently misunderstood type involves a “ground lease.”
What is a Ground Lease?
A ground lease, sometimes called a land lease, is a contractual agreement between a landowner and a developer. In it, the developer agrees to pay the landowner a specified amount of rent in return for the right to develop one or more buildings on the property. Because it takes a long time to design, permit, and construct a building, the typical term of a land lease is long, up to 99 years.
Like other leases, if the ground lessee (the developer) defaults on their lease payment, the property owner has the ability to recover damages or evict the tenant.
Why Would Anyone Pursue a Ground Lease?
There are benefits to the ground lease structure for both the property owner and the developer.
For the property owner, they get a stable stream of income from the lease and they get to retain ownership of the land. This second point is particularly important because ground leases often involve parcels of land that have A+ locations and/or are otherwise impossible to replicate.
For the developer, the major benefit of a ground lease is that they get to enter into a transaction without the high upfront cost associated with a purchase. This frees up cash flow for other uses and increases the potential yield. Also, because the land often has an excellent location, the likelihood of attracting quality tenants is increased. For example, companies like Starbucks and McDonalds often use ground leases to gain access to strategic locations.
Ground Lease Risks
There are also risks to the ground lease structure for both the tenant (the developer) and the lessor (the property owner).
The primary risk for the tenant is the ability to get financing for their project. The details can get a bit complicated, but most lenders require a first position lien as collateral on a construction loan. However, the tenant (the developer) is not in a position to grant this right because they don’t actually own the land. Instead, they have to work with both the lender and the landowner to execute a subordination agreement. This means that, in the event of a default, the lender has top priority for repayment. If the property owner is unwilling to subordinate their interest, it can be difficult to obtain construction financing.
The primary risk for the property owner also has to do with the subordination agreement. In a worst case scenario, they could lose their property without any compensation for it. This could happen if the developer defaults on their construction loan and the bank forecloses on the property. If the foreclosure sale price is not enough to pay off the loan, there are no funds left to be distributed to the land owner.
Types of Ground Leases
There are two types of ground leases, subordinated and unsubordinated. The difference has to do with the existence of the aforementioned subordination agreement.
In a subordinated ground lease agreement, the land owner agrees to take a lower position in the claim hierarchy. In doing so, they are essentially pledging the land as collateral for a construction loan. Although this is a risk, it may prove to be beneficial in the long run if they own additional property surrounding the ground lease that could benefit from the new development.
In an unsubordinated ground lease, there is no such subordination agreement and the land owner remains in first position in the hierarchy of claims. This is considered to be a safer position for the landowner, but it comes with a downside. Because it can be more difficult to obtain financing on an unsubordinated ground lease, the rent payments and corresponding income stream are usually lower.
Key Ground Lease Terms To Look For
A ground lease is similar to a “regular” commercial lease in many ways. But, there are a several lease terms that are unique and should be considered very carefully before entering into one:
- Rent Increases: Do the ground lease terms include an escalation clause that mandates higher rents over time?
- Eviction Rights: Does the ground lease adequately protect the landowner in the event the tenant defaults on their lease payments?
- Reversionary Clause: Does the ground lease contain a reversionary clause that allows ownership of the improvements to revert to the landowner at the end of the lease term?
- Term: Is the length of the lease term adequate for the developer to construct their project (e.g. a shopping center) and make an adequate return on their investment? Often, the term of the lease can reach 50 – 99 years.
Ground leases are commonly used, but frequently misunderstood. They aren’t appropriate for every situation, but for landowners with property in prime locations, they can be a good way to generate a recurring income stream while retaining ownership of their asset. For developers, they can be a low cost way to get into a deal with a great location. However, the existence of a ground lease can complicate the construction financing process and may require a subordination agreement before it is finalized.
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