Owners and developers unearth opportunities through creative land leases.
Editor's note: Originally published in 2006, “Ground Control" is one
of the most popular articles in CIRE's archive. Author Philip “Fred”
Himovitz updated the article for republication.
real estate developers and investors often favor total fee ownership of income
property. The propensity to own — and the emotions attached to it — sometimes
can result in misguided decisions and strategies and lost opportunities.
Relinquishing ownership of income property is really a question of when, not
developers move beyond the notion of ownership as an investment goal, new
opportunities that may not have been visible before, such as ground leases,
become apparent. In its most basic form, a ground lease, or land lease,
separates the ownership of land from the ownership of the improvements on the
land, such as an office building or a shopping center. The landowner leases the
land to the developer of the improvements, who pays rent for use of the land.
ground leases are long-term and include set rent escalations, eviction rights
should the lessee default, and a reversionary right, which means improvements
on the property revert to the landowner at the end of the lease term. While
such lease terms do not particularly favor developers, ground leases offer some
distinct advantages to them.
most prevalent types of ground leases are subordinated and unsubordinated. Each
provides benefits that can enhance the developer’s yield and turn dismal or modest returns into
more attractive and risk-mitigated ventures. They also give developers the
opportunity to involve multiple partners without negotiating formal partnership
leases transfer control — not ownership — of a property and, for the
landowners, they are considered one of the most secure forms of real estate
investment. But landowners may be considered preferred investors and may be
open to developers who offer them a stake in the improvements erected on their
land, in exchange for other considerations such as rent abatement for vacancy.
Such a quid pro quo can substantially reduce risk to a lender.
subordinated ground lease, the landowner offers the land as collateral for the
mortgage, giving the landowner a significant stake in the development risk. The
subordinated ground lessor is considered a secondary lender with junior rights
behind the primary lender, usually a bank or other financial institution.
the ground lessor has a future claim on the improvements, as most ground leases
require improvements to the land to revert to landowners at the end of the
lease. As such, ground lessors usually consider the downstream value of the
improvements in establishing a rental rate. On the other hand, a ground lease
that provides for the removal of any improvements at the end of the lease, such
as relocatable metal buildings, modulars, portable plants, or parking lot
appurtenances, would factor that eventuality into the rate as well.
subordinated ground lease rental rate is usually a few percentage points above
long-term permanent loan rates applied to the land value, which would correctly
calibrate the risk-reward equation, including the risk of foreclosure, for the
unsubordinated ground lease offers the landowner a more desirable role,
comparable to that of the primary lender. This makes long-term permanent
conventional financing more challenging for the developer, since the lender
must assume the risk of lease termination and default. However, due to the
senior position of the unsubordinated ground lessor, the ground lease rate can
be lower and therefore much more attractive for the developer. The permanent lender
recognizes the ground lease payments as an annual expense that will be factored
into its loan underwriting. In total, the cash required in the deal by the
developer is reduced while his yield is increased.
cases, the developer’s
requirement for cash in the deal is reduced because of the value that the
landowner brings to the deal. The reduction in cash usually required causes the
investment yield to increase when the income stream is extended into the
future. The value of the future cash stream will be determined by a threshold
discount rate, resource availability, and underlying assumptions — the same
general market and economic model assumptions that apply to fee-simple land
considerations include the length of the remaining lease term, reversion
covenants, and extension and renewal rights and options. Occasionally the
ground lessor will participate in the cash flows by applying a lease rate as a
percentage of the income that the rental property produces. This strategy can
have the positive effect of averting a monetary default in the event of a “dark” project. It also has the positive effect of mitigating the risk
that a first mortgage lender perceives if the lease is unsubordinated. For
example, if prevailing long-term interest rates are 6 percent, a comparable
subordinated ground rental rate might be 8 percent, whereas an unsubordinated
lease might be priced at par or 6 percent.
potential to form a joint venture with a building developer can be attractive
to the primary ground lessor. The yield values are enhanced by the security of
the future improvements. Provisions against wasting the property, requirements
to maintain the improvements, cure and notice rights, certain reasonable
approval conditions, and the ubiquitous hazardous materials covenants are
an unsubordinated lease presents possibilities that offer an alternative
investment vehicle that provides security to patient investors and can be
traded, sold, or transferred in creative ways. For example, tax-deferred 1031
strategies are possible by trading into an income investment as a sandwich
ground lessee-ground sublessor. The usual threshold is that the lease term be
greater than 25 years. Since these instruments can take on the color of a
security, real estate professionals who enter into these deals should carefully
document all aspects of the transaction and seek advice from qualified
addition, opportunities exist in some municipal ground lease situations
wherein, under certain conditions, property taxes are completely or virtually
eliminated. Likewise other tax benefits accrue to these sanctuaries because of
the reversionary character of building improvements and the incentive-rewarding
jobs creation. These areas of investment can offer a spectacular advantage over
neighboring competing properties in pricing and yield.
term and length influence the acceptability of ground lease deals. The current
climate is cautionary because of the parochial need to own; however,
institutional managers realize that it is all factored into the risk and yield
and accept the challenge with appropriate lease drafting and terms that are
favorable to the asset managers’ objectives. The environment is changing as the pressure for yield
performance and risk mitigation goes begging. The challenge is pioneering in an
area where heretofore only the creative and adventurous have explored.
Philip “Fred” Himovitz, CCIM, is president of Himovitz Properties in Scottsdale,
Ariz. Contact him at email@example.com.
developers and investors believe that owning the land on which their investment
sits is the most ideal scenario. However, the following example illustrates the
yield advantages leasing land may have for some development projects.
fee-simple ownership scenario, the cash required to develop a
20,000-square-foot building might be $455,000. The same building developed
under a ground lease scenario requires only $245,000. While this represents a
$210,000 (54 percent) advantage for the ground lease deal, the overall yield
and challenge of a secondary sale still have to be investigated. With a
sufficiently long lease term remaining, the before-tax cash flow yield is 12.7
percent and 20.4 percent, respectively, and, after-tax, 9.3 percent and 16.0
yield differences are significant and, in this scenario, favor the lease deal.
Land and building costs, escalations such as U.S. Consumer Price Index hikes,
and debt underwriting criteria all influence the investment decision and
demonstrates another approach to development and a ground lease deal may be the
better option. It should encourage commercial real estate professionals to
explore the possibilities and opportunities ground leases present.
When tax consequences are considered, the
ability to deduct ground lease payments from the operations equation presents
the developer with a new dimension that favors or, at a minimum, gives parity
to the ground lease deal. The ability to deduct ground lease payments from
income in the tax computation makes that scenario more favorable. (See tables
on p. 34 for a cost analysis.)