Do you own some land, perhaps with some dilapidated property on it? One way to extract value from the land is to sign a ground lease. This will allow you to earn income and possibly capital gains. In this article, we’ll explore what is a ground lease and how to structure one. Then, we’ll give an example of how one works and assess the pro’s and cons. Finally, we’ll answer some frequently asked questions about the ground lease.
What is a Ground Lease?
In a ground lease, a tenant develops a piece of land during the lease period. Once the lease expires, the tenant turns over the property improvements to the owner, unless there is an exception. Importantly, the tenant is responsible for paying all property taxes during the lease period. The inherited improvements allow the owner to sell the property for more money, if so desired.
Typically, a ground lease lasts from 35 to 99 years. Normally, the lessee takes a lease on some raw or prepared land and constructs a building on it. Sometimes, the land has a structure already on it that the lessee must demolish. The ground lease specifies who owns the land and the improvements, i.e., property that the lessee constructs. Typically, the lessee controls and depreciates the improvements during the lease period. That control reverts to the owner/lessor upon lease expiration.
Ground Lease Subordination
One important aspect of a ground lease is how the lessee will finance improvements to the land. A key arrangement is whether the landlord will agree to subordinating his priority on claims if the lessee defaults on its debt. That’s precisely what happens in a subordinated ground lease. Thus, the property deed becomes collateral for the lender if the lessee defaults. In return, the landlord asks for a higher rent on the property.
Alternatively, an unsubordinated ground lease maintains the landlord’s top priority claims if the leaseholder defaults on his payments. However, this might discourage lenders, who wouldn’t be able to take possession in case of default. Accordingly, the landlord will usually charge a lower rent on unsubordinated ground leases.
How to Structure a Ground Lease
A ground lease is more complicated than regular commercial leases. Here are some components that go into structuring a ground lease:
- Term: The lease must be sufficiently long to allow the lessee to amortize the cost of the improvements it makes. That is, the lessee must make enough profits during the lease to pay for the lease and the improvements. Furthermore, the lessee must make a reasonable return on its investment after paying all costs.
The biggest driver of the lease term is the financing that the lessee arranges. Normally, the lessee will want a term that is 5 to 10 years longer than the loan amortization schedule. On a 30-year mortgage, that means a lease term of at least 35 to 40 years. However, fast food ground leases with shorter amortization periods might have a 20-year lease term.
- Rights and Responsibilities: Beyond the arrangements for paying rent, a ground lease has several unique features. For example, when the lease expires, what will happen to the improvements? The lease will specify whether they revert to the lessor or the lessee must remove them. Another feature is for the lessor to assist the lessee in obtaining necessary licenses, permits and zoning variances.
- Financeability: The lender must have recourse to protect its loan if the lessee defaults. This is difficult in an unsubordinated ground lease because the lessor has first priority in the case of default. The lender only has the right to claim the leasehold. However, one remedy is a clause that requires the successor lessee to use the lender to finance the new ground lease. The topic of financeability is complex and your legal experts will need to wade through the various intricacies.
- Title Insurance: The lessee must arrange title insurance for its leasehold. This requires special endorsements to the regular owner’s policy.
- Use Provision: Lenders want the broadest use provision in the lease. Basically, the provision would allow any legal purpose for the property. In this way, the lender can more easily sell the leasehold in case of default. The lessor might have the right to consent in any new purpose for the property. However, the lender will seek to restrict this right. If the lessor feels strongly about prohibiting certain uses for the property, it should specify them in the lease.
- Casualty and Condemnation: The lender controls insurance proceeds stemming from casualty and condemnation. However, this may conflict with the standard wording of a ground lease, which gives some control to the lessor. Unsurprisingly, lenders want the insurance proceeds to go toward the loan, not property restoration. Additionally, lenders require that neither lessors nor lessees can terminate ground leases due to a casualty without their permission.
Regarding condemnation, lenders insist upon participating in the proceedings. The lender’s requirements for applying the condemnation proceeds and controlling termination rights mirror those for casualty events.
- Leasehold Mortgages: These are mortgages financing the lessee’s improvements to the ground lease property. Typically, lenders balk at lessor’s maintaining an unsubordinated position with respect to default. If there is a preexisting mortgage, the mortgagee must agree to an SNDA agreement. Usually, the ground lease lender wants first priority regarding subtenant defaults. Moreover, lenders require that the ground lease remain in force if the lessee defaults. If the lessor sends a notice of default to the lessee, the lender must receive a copy.
Lessees want the right to obtain a leasehold mortgage without the lender’s consent. Lenders want the ground lease to serve as collateral should the lessee default. That is, upon foreclosure of the property, the lender receives the lessee’s leasehold interest in the property. Lessors might want to restrict the type of entity that can hold a leasehold mortgage.
- Rent Escalation: Lessors want the right to increase rents after specified periods so that it maintains market-level rents. A “ratchet” increase offers the lessee no protection in the face of an economic downturn.
Ground Lease Example
As an example of a ground lease, consider one signed for a Starbucks drive-through shipping container store in Portland. Starbucks’ concept is to sell decommissioned shipping containers as an environmentally friendly alternative to conventional construction. The first store opened in Seattle, followed by Kansas City, Denver, Chicago, and this one in Portland, OR.
It was a rather unusual ground lease, in that it was a 10-year triple-net ground lease with four 5-year options to extend. This gives the ground lease a maximum term of 30 years. The rent escalation clause provided for a 10% rent increase every five years. The lease value was just under $1 million with a cap rate of 5.21%.
The lease terms, on an annual basis, were:
- Initial Lease Terms:
09/01/2014 – 08/31/2019 @ $52,000
09/01/2019 – 08/31/2024 @ $57,200
- Option 1: 09/01/2024 – 08/31/2029 @ $62,920
- Option 2: 09/01/2029 – 08/31/2034 @ $69,212
- Option 3: 09/01/2034 – 08/31/2039 @ $76,133
- Option 4: 09/01/2039 – 08/31/2044 @ $83,747
Ground Lease Pros & Cons
Ground leases have their advantages and disadvantages.
Ground Lease Advantages
The advantages of a ground lease include:
- Affordability: Ground leases allow tenants to build on property that they can’t afford to buy. Large chain stores like Starbucks and Whole Foods use ground leases to expand their empires. This allows them to grow without saddling the companies with too much debt.
- No Down Payment: Lessees do not have to put any money down to take a lease. This stands in stark contrast to property purchasing, which might require as much as 40% down. The lessee gets to conserve cash it can deploy elsewhere. It also improves its return on the leasehold investment.
- Income: The lessor receives a steady stream of income while retaining ownership of the land. The lessor maintains the value of the income through the use of an escalation clause in the lease. This entitles the lessor to increase rents periodically. Failure to pay rent gives the lessor the right to evict the tenant.
Ground Lease Disadvantages
The disadvantages of a ground lease include:
- Foreclosure: In a subordinated ground lease, the owner runs the risk of losing its property if the lessee defaults.
- Taxes: Had the owner simply sold the land, it would have qualified for capital gains treatment. Instead, it will pay ordinary corporate rates on its lease income.
- Control: Without the necessary lease language, the owner might lose control over the land’s development and use.
- Borrowing: Typically, ground leases prohibit the lessor from borrowing against its equity in the land during the ground lease term.
The Omni Commercial Lease Calculator is a good example of the genre. You enter the area, rental rate, and agent’s fee, it does the rest.
Frequently Asked Questions – Ground Lease
They are gross leases, modified gross leases, single net leases, double net leases and triple net leases. The also include absolute leases, percentage leases, and the subject of this article, ground leases. All of these leases provide benefits and drawbacks to the lessor and lessee.
Typically, ground leases are triple net. That means that the lessee pays the property taxes during the lease term. Once the lease expires, the lessor becomes responsible for paying the property taxes.
The land always reverts to the lessor. Beyond that, there are two possibilities for the end of a ground lease. The first is that the lessor takes possession of all improvements that the lessee made during the lease. The second is that the lessee must demolish the improvements it made.
Typically, a ground lease term extends to at lease 5 to 10 years beyond the leasehold mortgage. For example, if the lessee takes a 30-year mortgage on its improvements, the lease term will run for at least 35 to 40 years. Some ground leases extend as far as 99 years.