Introduction to Ground Leases

ground leasesThe types of land that are most frequently ground leased include retail pads in commercial centers, land within high-density urban centers, land along ports and harbors, and other areas where land availability is low and land prices are high and expected to escalate. Are you interested in tackling ground lease appraisal assignments for commercial clients? Read this post for a breakdown of the typical tenants, reasons for use, motivations of the lessor, and potential disadvantages of ground leases.

Plus, check out our upcoming Pro-Series webinar, Commercial Case Study: Theme Park or Developed Site Value, on Wednesday, October 5 at 1:00pm EST. And take our Appraisal of Land Subject to Ground Leases course to gain a thorough understanding of the multiple components of ground leases. This information will give you a helpful edge when it comes to valuing commercial real estate, as well as prepare you to work with a wide variety of clients.

Typical ground lease retail tenants

The typical retail ground lease tenant is:

  1. A single tenant who requires a specialized build-to-suit structure
  2. A developer who sub-leases the ground lease to a single tenant retail user. The ground lease premises may be a finished retail pad within a shopping center or simply in raw condition.

Normally, the tenants require a stand-alone site rather than being able to conform to an in-line space in a retail center. Examples of typical ground lease retail tenants include the following:

  • Fast food restaurants
  • Full-service restaurants
  • Drug stores
  • Grocery stores
  • Convenience stores and gas stations
  • Banks
  • Big box retailers (i.e. Walmart, Target, Kohl’s, Staples, Office Depot, Best Buy)

Reasons for the use of ground leases

A ground lease allows the lessee to have long-term control over a retail site without paying out a lump sum for land acquisition. This is true whether the initial lessee is a developer or the actual retail tenant. By using a ground lease, either a developer or the retail tenant can have access to a site that an owner may not be willing to sell. Improvements owned by the lessee can be depreciated and generate a tax benefit while owned land cannot be depreciated. A ground rent payment is tax deductible.

Motivations of the lessor

The lessor receives a number of benefits when executing a ground lease:

  • No capital gains tax – Receiving cash flow from the land without triggering capital gains tax. This can be a major consideration for land, which has experienced a significant appreciation in value and yet receives no income.
  • No development risk or investment – All the risk of developing the land to its use is transferred to the lessee.
  • Long-term predictable cash flow – A defined rental income stream with specified rent increases over a long term.
  • Improvements revert to the lessor – Improvements typically become the lessor’s at the end of the lease (right of reversion). If the remaining lease period is short enough, improvements may have remaining utility and value.
  • Minimal management responsibility – The lessor is essentially a coupon clipper with no responsibility except for confirming periodic rent increases. All property tax and liability insurance are the responsibility of the lessee. All building maintenance is the responsibility of the lessee.
  • Strong incentive for lease renewals – Because the improvements revert to the lessor, there is a strong incentive for the lessees to exercise their option to continue the lease to retain control over the improvements. This incentive exists as long as the location remains viable and the improvements have significant remaining economic life and utility.
  • No construction risk for lessor – The lessee is responsible for construction of any improvements and controlling the construction budget. Many single tenant retail buildings have substantial specialty features. Banks and restaurants have specific designs that are intended to reinforce a particular brand identity, layout, and quality of construction. They can be constructed more efficiently and on a more reliable budget by contractors specializing in constructing that brand or property type for the lessee. A ground lease eliminates the budget and timing risks associated with construction for the lessor.
  • The lessor does not obtain construction financing – Obtaining construction financing or equity capital for the facility construction is entirely the lessee’s (or the sub-lessee’s) responsibility. A lessor who owns an adjacent shopping center may not want to use their financing sources.

Potential disadvantages of ground leases

Rent adjustments may not provide for future market rent

The ground lease initial term can run from 20 to 99 years and renewal options can add another 20 to 25 years to an initial term. Older ground leases were structured as flat leases with no provision for rent adjustments. Contemporary ground leases typically adjust rent every three to five years based on CPI, fixed adjustments, periodic appraisal or arbitration. Over a ten to forty year period a fixed percentage or a CPI adjustment can fall badly out of step with market rent for the land. This is particularly true for areas with rapidly increasing land value.

Difficulty in selling or financing the property

The leasehold interest is the lessee’s interest in the ground lease. There are a variety of reasons why a leasehold interest in a ground leased property can be more difficult to sell or for a buyer of the leasehold interest to finance. They include the following:

  • Leasehold interests in ground leased properties sell infrequently – Most properties sold are either leased fee or subject to leases of land and building combined.
  • Fewer lenders are familiar with ground leases – This uncertainty and unfamiliarity can increase the difficulty involved in the underwriting process.
  • Complexity of sorting out lessor and lessee responsibilities
  • The more complex nature increases the cost and effort in the due diligence effort
  • Lenders require several key clauses in the lease – For example, for a lease to be financeable, the lease must have a subordination clause, have adequate notice of default and other lease clauses, which then create a “financeable lease.”

These types of challenges generally do not apply in unsubordinated leases with national credit tenants. National credit tenants typically build improvements with equity funds rather than obtaining financing. Consequently, their leases do not need to meet the criteria for being financeable.

To gain a more thorough understanding of the multiple components of ground leases, sign up for our continuing education course: Appraisal of Land Subject to Ground Leases.

 

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