What is a Ground Lease
Ground leases for commercial real estate development can be a viable option for both land owners and tenants for many purposes. A commercial ground lease is usually defined as a lease of land (typically the land is not improved), for a relatively long term (e.g. 50 to 99 years), where all expenses of the property are the obligation of the tenant (e.g. taxes, repair and maintenance expenses, insurance costs, and financing costs). Typically, the tenant is a developer or entity attempting to construct new buildings or improvement or to renovate existing structures. A properly structured ground lease will allow a tenant’s equity in the project to be financed, sold or otherwise dealt with independently of the ownership of the land. Ground leases, therefore, are not only leases in the traditional sense of the word but are also financing instruments.
Often, a ground lease is the only viable option when a landowner refuses to sell their land or in situations where the owner of real property cannot sell ground the developer is interested in developing due to a lack of legal authority or for tax considerations in which there would be a substantial taxable gain.
While ground leases offer control and not ownership of property, this arrangement is often preferred by land owners who desire developers to provide them improvements erected on their land in exchange for various considerations such as rent abatement.
However in certain situations, the landlord may desire to maintain ownership due to investment considerations, tax consequences and avoids recognition of capital gain. Additionally, land owners may find it difficult to establish a reasonable price for their property due to market uncertainties, changes in real estate value, government policies, land use codes and tax legislation. Therefore, the ground lease may present distinct advantages to a land owner who is disinclined or uncertain about selling. With the right project and the right developer, a well-structured ground lease can serve to provide the land owner with a minimum reasonable return, the participation in improvement to the property, providing increased value and further value in the long term and ownership of the land which of course reverts to the land owner upon expiration of the lease.
From the developers perspective, in ground lease is often attractive for economic purposes and provides a relatively inexpensive means of financing acquisition of land especially when the value of the land is in excess of what the developer can comfortably afford to pay. If the land owner agrees to “subordinate” to the developers leverage and to use any equity requirement, a ground lease may prove to be an excellent option.
Another consideration is whether the ground lease will be subordinated. In a subordinated ground lease, the land owner offers the land as collateral for the developer’s loans which creates a significant exposure in the risk of development. Often, when the land owner will agree to subordinate, their fee interest to the developers financing, this usually will result in substantial cost to the tenant in terms of base and/or percentage rent. Subordinating a lease is generally understood to mean that the land owner subjects their fee interest to the tenant’s lender, so if the mortgage is foreclosed, the lender can acquire the land free of the ground lease and obligation to pay rent.
Generally, in most circumstances, a landowner would be reluctant to subordinate their fee interest because the subordinated ground lessor is considered a secondary lender with junior rights behind the primary lenders. Normally the lessor has a future claim on improvements and inasmuch as most ground leases usually are predicated upon improvement to the land which will revert to the land owner at the termination of the lease. Therefore ground lessors are usually considered the downstream value of the improvement in establishing a rental rate. However, in certain circumstances a ground lease may provide for the removal of any improvements at the end of the lease which, of course, would factor into the lease rate as well. In most situations, the developer will negotiate a ground lease before financing is arranged and will need tremendous flexibility regarding future financial terms. Therefore, the land owner who subordinates should require some restraint such as: loan amount, interest rate, balloon payments and the like.
A significant advantage in ground leases is that the developer’s requirement for cash is significantly reduced because the ground lease is a substitute for the cost of land acquisition. The ground lease provides a ‘closed stream of income’ who retains ownership of the property and will receive surrender of the real property with improvements at the expiration of the lease term. Of course, the return of real property with improvements at the end of the ground can either be benefit or detriments depending upon the nature and quality of the improvements and the costs for demolition or renovation.
Since ground leases are a form of financing which provides an income stream to the land owner, this interest is typically not subordinated to subsequent financing. Commercial lenders will generally accept the priority of the ground lease, however, they will often require an agreement which permits the lender to cure any ground lease defaults and enter into a substitute ground lease with the ground lessor.
Various factors to be considered in ground leases include the length of the lease term, renewal rights, extensions, lease rates, participation by land owner in cash flows by receiving a percentage of income generated and rights of lenders.
Another consideration which parties have as an alternative to a developer leasing land, is the formation of a joint venture between the developer and land owner. The conveyance of land to a joint venture is usually tax free. Returns to the land owner in the partnership can be negotiated so that there is substantially the equivalent to the return under a ground lease. For economic purposes, the terms of a joint venture can be structured to mirror a ground lease. While ground leases can have significant advantages to the both the commercial developer and the land owner, it is imperative that both parties achieve a fair and balanced lease that is not calculated to take advantage of the other participant. A successful ground lease will benefit both the developer and the land owner. An unsuccessful ground lease will often have detrimental effects upon both parties.
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