It is a common assumption that a commercial real estate investment (CRE) always involves the fee simple purchase of an asset. While this is a very popular option, it isn’t always the case. In some instances, a property owner may elect to enter into a long term “ground lease” with a real estate investor instead of selling the property to them directly. When this happens, the transaction becomes slightly more complicated and there are a number of important items that should be carefully considered. Let’s start with the basics.
What is a Ground Lease?
Simply, a ground lease, sometimes called a land lease, is a long term lease arrangement whereby the owner of a vacant parcel of land leases the property to an investor rather than sell it to them outright. In return for their lease payments, the investor/lessee/tenant gains the right to construct a building on the vacant land and operate it for themselves or lease the space to other entities and businesses. Because the “tenant” is going to construct one or more buildings on the property, they need the security of a long term lease so ground lease terms typically range from 50-99 years.
Benefits of Ground Leases
There are benefits to ground lease agreements for both the landowner and the tenant.
Ground leases are most common for pieces of land that are extremely well located or have some other unique feature that would make it nearly impossible to replicate. For this reason, many landowners are reluctant to sell their property. So, rather than sit on it, they can enter into a ground lease with an investor, which produces a steady income stream from the property while retaining ownership of the land. In addition, the terms of a typical ground lease include rental escalation clauses, the ability to take the property back in the event of a default (eviction rights), and a clause that allows ownership of the building and all improvements to revert back to the property owner at the end of the lease term (reversionary clause).
From the “tenant’s” perspective, the major benefit of a ground lease is that it allows them to get into the deal without the upfront equity typically required of a purchase. So, it is a low cost alternative that can provide them with access to an A+ property that they can then improve and operate for themselves or lease to other businesses, which would provide them with their own stream of rental income.
The primary downside to a ground lease has to do with the added difficulty of obtaining financing for the property.
Risks of a Ground Lease
In return for financing the cost of improvements upon a vacant piece of land, a lender will typically require a first position lien on the property and all improvements thereto. However, a ground lease tenant does not own the property so this is not something that they have the ability to provide. To rectify this situation, the lender may require the property owner to “subordinate” their interest, which is the primary risk of a ground lease transaction. When the property owner subordinates their interest to the lender, it means that their claim on income comes second to the lender. Tactically, this means that the rent payments from the ultimate tenant must be used first to make the loan payments and second to make the ground lease payments, which essentially becomes part of the property’s operating costs. If the ground lease tenant defaults on their loan payments, the lender has the ability to begin foreclosure proceedings in the property, which could potentially leave the landowner with nothing. In short, subordinating their interest to a lender represents a risk for the property owner.
So, why would they do it? Well, everyone’s motivation is different, but there are a few reasons this could make sense. First, the landowner may just want the income from the ground lease payments, which includes periodic rent increases. But, they may also own other property around the one being leased, meaning the valuation of their other property could benefit from improvements to the ground leased property. Or, they may obtain some other indirect benefit in the transaction.
But, lenders do not always require the property owner to subordinate their interest. If they don’t, these are known as unsubordinated ground leases, where the landowner retains their first position in the hierarchy of payments, which is a less risky position for them. However, this puts the lender in a more risky position because they now have a lower priority in the payment hierarchy.
When Are Ground Leases Used?
As mentioned above, ground leases are typically used when the land has a prime location and/or some other unique feature that would drive the owner’s desire to retain ownership of it. For example, ground leases are particularly common in states like New York where vacant commercial property land is scarce or with large national tenants like McDonalds or Starbucks who need those prime locations for their business and want to minimize the upfront investment required to obtain them.
Ground Lease Considerations
From an investor’s standpoint, there are several key items that should be considered carefully before entering into a ground lease with a landowner:
- Term: Is the ground lease term sufficient to construct the property and make an adequate return on investment? Typically, most ground lease terms are in the range of 50-99 years.
- Escalations: When and by how much do the lease payments increase over the term?
- Eviction Rights: If there is a default on the lease, what are the landowner’s rights to cure it?
- Willingness to Subordinate: Although it may not be expressly written into the lease, it should be determined whether or not the landowner is willing to subordinate their interest to a lender. If so, it can certainly make the transaction easier to finance.
- Limitations on Use: On occasion, a lease may specifically prohibit certain uses. For example if the landowner owns a nearby coffee shop, they may exclude a coffee shop from the list of permissible uses.
When in doubt, it is always a good idea to work with a qualified real estate attorney to review the specific provisions of the lease.
Interested In Learning More?
First National Realty Partners is one of the country’s leading private equity commercial real estate investment firms. We leverage our decades of expertise and our available liquidity to find world-class, multi-tenanted assets below intrinsic value. In doing so, we seek to create superior long-term, risk-adjusted returns for our investors while creating strong economic assets for the communities we invest in.
In our own deals, we typically prefer a fee simple purchase of a property, but there are unique cases where a ground lease may make sense. When these come up, we evaluate the deal just like any other and make an ultimate decision as to whether we should proceed with the transaction.
If you are an Accredited Investor and would like to learn more about our investment opportunities, contact us at (800) 605-4966 or info@fnrpusa.com for more information.
