By Belinda D. Schuster, CCIM, Northwest Indiana Commercial Real Estate
Ground lease agreements make up a sizable portion of commercial real estate transactions, especially in the retail sector. A ground lease is simply a long-term lease on land. The tenant is allowed to implement improvements on the land without holding ownership. While most associated the retail industry, ground lease agreements can apply to any type of property, including hotels, office, industrial, storage, healthcare facilities, and residential apartment buildings.
Ground leases came about due to the unwillingness of landowners to sell valuable parcels of land. Retailers and other potential lessees were interested in the potential of these sites, without wanting to become burdened with maintaining ownership.
However, despite the mutually beneficial framework, negotiation for ground leases can be complex, due to many possible variables involved. Ground leases are not for the faint of heart; however with the right team they can provide opportunity for great returns.
Whether or not a ground lease is subordinated can have a big impact on the outcome of the deal. Subordination refers to the hierarchy of claims on the asset and associated with the collateral for a construction loan or permanent financing of the improvements. Rent rates and their adjustments over time are also another major factor. Keep focused on balancing the competing interests between landowner, tenant and developer to gain steady momentum. A comprehensive ground lease can provide substantial benefits for all parties involved. Listed below are some but not all characteristics, advantages and disadvantage for each of the parties involved:
Key Influencing characteristics of a ground lease are:
- A long term between 25-100 years or more
- Lenders recognize the ground lease payments as an annual expense and will be factored into the underwriting
- Cost of construction, financing and development can be complex
- Ground leases are transfer of control not ownership of a property
- Subordinate or unsubordinated play an important part in financing the construction project
- Rental rates may be influenced by external market factors, property location, tenant characteristics, and historical rental rates.
- The ground lease rent structure is heavily tied to the project’s financing, the return on investment rate and future value.
- For the landowners they are considered one of the most secure forms of real estate investments
- Long term income stream that can be past onto heirs
- Avoids capital outlay for improvement costs
- Retain title to property and is an alternate to selling which avoids recognition of capital gains
- A means to developing property with professional development and management firms
- No operating responsibilities
- May have to permit subordination to secure tenant’s financing
- Risk losing its property through foreclosure
- Rent to landowner is income and taxed at ordinary tax rates
- Lender may require a broad use provision to use property for “any lawful purpose”
- Substantially reduces the front-end development costs by eliminating land acquisition cost
- Rent payments under ground lease are deductible by tenant for federal and state income tax purposes
- Avoids the need to finance the non depreciable land cost
- Both subordinated and unsubordinated provides benefits that can enhance the developer’s yield
- It my be possible to create multiple partners without negotiating formal partnership agreements
- Ground leases complicates almost every element of the project
- Expenses associated with ground leases are substantially greater than a transaction cost of the land
- Ground leases tend to be perceived as a land owner device
- Landowner may not agree to subordinate land to tenant making financing difficult
- Developers may perceive the complexity and challenges out weigh the advantages in a commercial development.