Ariel Property Advisors
In a challenging economic environment, equity can be the most expensive form of capital. As a result, developers and investors often look for alternative ways to control their assets that give high returns. In commercial real estate, ground leases are a great solution that allows owners to maintain that control, while offering flexibility for all parties involved.
A ground lease (also referred to as a land lease) is an agreement between a tenant and an owner for the right to use land for a prolonged period, typically 49 to 99 years. This strategy allows, for instance, a developer to minimize upfront land costs and generate revenue while allowing the landowner the opportunity to maintain ownership of the property while collecting on the lease.
The arrangement is more common than you might think, with some famous examples being the Chrysler Building, which leases land that has been owned by Cooper Union since 1859, and Lotte New York Palace, which leases the land from the Archdiocese of New York.
Ground Lease Versus Sale
The Owner’s Perspective
Long-term landowners have benefitted over the past few decades from rising prices, either due to rezoning or market appreciation, but they may not be active real estate players themselves. All the same, they find themselves sitting on a significant amount of valuable land. Many of these owners want to avoid the risks and challenges of developing from the ground up or may be averse to becoming a more active real estate investor.
Inactive landowners may find it difficult to raise financing for projects, even with a valuable piece of land, because of a lack of experience in navigating the complexities of a development project. If they can overcome that hurdle, there are further impediments to building, such as not having the relationships to find the right general contractor, rising building costs and uncertain future income.
However, negotiated properly, a ground lease allows an owner to control the asset, maintain ownership, dictate the type of asset to be developed, increase cash flow from the property, minimize development risk and provide future generations with a fully developed asset.
“Ground leasing is a strategy often employed by families transitioning control of commercial real estate to the next generation,” says Brian M. Cohen, a commercial real estate partner at law firm Goulston & Storrs. “Even an active owner of commercial real estate without a clear successor, for example, may employ a ground lease to create a passive cash-flowing vehicle for future generations where there is no clear successor to develop or actively operate a property.”
The ground lease is also treated like any other commercial real estate asset. The lease is financeable and even sellable, albeit usually at a discount to the value of actual ownership. The owner can borrow against the rent payments they are receiving throughout the lease, typically on favorable terms once the land is developed or a new structure established, allowing the owner to pull out tax-free capital.
Taxes offer one of the biggest advantages of a ground lease, as opposed to a sale. If the land was purchased at a low price compared to the current value, a sale would net a large profit, but would also incur high capital gains taxes for the seller. In a ground lease, the payments to the owner are considered ordinary business income and are taxed as such—and the owner gets to keep their land.
Risks for Owners
There are some drawbacks, though. A landowner might not get the optimal price for the land. For instance, if the real estate is in a high-income area, developing a condominium building improves the value of the property and might net a high return on a sale. However, developers cannot sell condos on a building they only control temporarily. A residential building on a ground lease would thus result in lower land value and thus less income from the property.
There are also risks if the owner pivots the type of property, such as from a retail space to a warehouse space or from a hotel to a residential building.
“Property once used for an owner-occupied business such as a grocery store or manufacturing facility may be more valuable if redeveloped as market rate or affordable housing,” says Cohen. “In this scenario, the first few years of the ground lease term, when there’s development risk and no cash flow, have the most risk for the property owner. The property owner can require the developer to provide guarantees, letters of credit and rights for the property owner to terminate the ground lease and take back the property if development milestones are not met.”
Once the development is complete, with tenants in place and paying rent, a ground lease structure can be a strong alternative to an outright sale.
The Developer’s Perspective
The development (or redevelopment) of real estate requires large amounts of capital and is highly time-sensitive. Depending on the location, asset type and property condition, land could be a major budgetary strain. When a developer acts on a ground lease opportunity, the upfront capital needed for the project is considerably less, because they are not purchasing the land, allowing the developer to leverage their equity into other projects.
Similar to a ground lease being financeable and sellable for the owner, the lease can also be capitalized by the developer. Banks and investors will look at the difference between the net income and the annual lease payments to determine the value, which determines how it can be leveraged.
The main drawback for the developer is that they cannot always develop the highest and best use of the property, such as in the example of the residential building. They can build for rentals but not for condo sales, though that is often reflected in the land price, which would be below the sales market value. However, unless the developer eventually purchases the land, the control of the asset will revert back to the landowner at the end of the lease term. For fee-based developers, this is less important, since they usually plan to exit the asset in five to 10 years.
The Value of Ground Leases in a Post-Covid-19 Landscape
The real estate landscape is adjusting rapidly to shifts in demand as people are changing how they interact with built spaces. Many owners are seeing the need to convert their properties to alternative uses to keep up with seismic shifts in product demands. Hotels are suddenly seeing an oversupply in the market, and so owners may want to convert their assets to residential buildings. Similarly, an office or retail owner might want to reposition a property, for instance, to an industrial or warehouse facility.
These conversions are risks that land owners might not want to take on. Ground leases offer a potential solution. While there will likely be a discount on the leasing price based on today’s market value, the future upside could still be there as the market resets. In down markets, there is less capital supply available, and the ground lease can act as a financing vehicle for the owner when other financing is either unavailable or cost prohibitive.
The takeaway for owners and developers alike is that they can create an arrangement that has the flexibility to meet the challenges of a changing market. Owners can retain their assets and developers can minimize costly land expenses and reduce expensive debt.