Ground Leases-Friend or Foe?

On the surface, a ground lease seems like a simple concept: a landowner grants permission for a tenant to use their land in exchange for rent. This agreement seems easy to grasp, but if you look beneath the surface you will uncover some hidden details that often go unnoticed.

For starters, a ground lease allows the tenant the right to make improvements (e.g. build a hotel, retail shopping center, apartment complex, or even dig/drill) on land they do not own in exchange for annual rent. A typical lease term of a ground lease is between 50 to 99 years, with the tenant not only paying an escalating annual rent, but in most cases all the other expenses tied to the property. Ground leases have to be long term in nature to justify the tenant making improvements to land they will ultimately concede to the landlord upon the lease expiring.

Although it seems like there is not a lot of upside for the tenant, burdened by rent and other expenses to use land, there are a few benefits. For one, buying land can be expensive, especially when talking about development/acquisition deals in urban/populated environments. The ground lease agreement will enable the tenant to save upfront costs on land, which will free up capital for other expenses such as construction costs. Alternatively, maybe it is not a cost saving tactic, but simply the landlord is unwilling to sell a highly desirable parcel of land. Under this scenario, the tenant might be willing to engage because the project economics are too enticing to pass up.

The tenant will be saving costs upfront; however, over the long term, all these expenses attributed to a ground lease will most likely be higher than purchasing the land outright. Another disadvantage for the tenant is obtaining financing with an unsubordinated ground lease, because the landowner will have hierarchy of claims over the lender. The lender will not be able take control of the land upon default of the tenant, and therefore might lend less or not at all. Moreover, properties constrained with ground leases will continually lose value to reflect the landlord taking ownership of the improvements, as the lease gets closer to expiration. Lastly, the ground lease might be restrictive to how they develop the land or use it in the future, preventing the flexibility granted when the tenant owns the land free and clear.

Flipping the coin to the other party of the agreement, the landlord, also has upside and downside in entering a ground lease agreement. The first and most obvious advantage is the landlord still owns the land, making it a stable long-term investment, especially for family-owned land that needs to be put to economic use. Not only is the landlord collecting rent and most other expenses tied to the property, but the landlord is also benefiting from the appreciation in the land value as improvements are constructed on their land. Depending on how the lease is structured, the landlord might also retain control on how the land is developed in the future, requiring the tenant to seek approval before making dramatic changes to the property. Furthermore, renting out the land does not trigger a capital gains tax like it would during a sale; upon execution of the ground lease, no income tax event occurs until the landlord starts collecting rent.

While it might seem like the landlord is in the driver’s seat collecting rent with little to no downside, this isn’t entirely the case.  One big financial risk facing the landlord is the risk the borrower defaults on the loan. causing the landlord to lose the land, if the landlord is in a subordinate position to the lender.  Another down side for the landlord is that rent collected on a ground lease is taxed as ordinary income, which is taxed at a higher rate compared to the capital gains rate.  Lastly, borrowing against the equity built up in land under a ground lease can either be restricted or prohibited depending on the terms of the ground lease.

A ground lease agreement is more complex than initially meets the eye; therefore, obtaining financing for acquisition/development deals with ground leases can be difficult. Please contact any Senior Director at Metropolitan Capital Advisors to help you navigate the complex capital markets.

The Author, Andrew Hanzl, can be easily reached at Ahanzl@metcapital.com

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