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Understanding Real Estate Finance: Digging the Dirt on Ground Leases

by | Sep 1, 2021 | Commercial Real Estate

For many commercial real estate developers, the cost of acquiring land and then building out a project can be prohibitively expensive—particularly in high-priced urban markets and at a time when corporate tenants may be scaling back on space in the wake of COVID-19. 

Meanwhile, for real estate investors, developing and owning a building on a property can increase risk. A building’s owners may need to take on debt to finance construction or renovation, and they will be responsible for upkeep and ensuring the building is leased to tenants.

Enter the “ground lease,” also sometimes known as a “land lease.” Ground leases allow property owners to rent out their land on a long-term basis to a developer, who then is usually responsible for the construction, renovation, and future maintenance of the building for the life of the lease. 

REDUCING COSTS

From the standpoint of developers, a ground lease can substantially reduce the upfront cost of a project, while allowing them to construct buildings that meet their specific needs. 

The real estate investor may gain by reducing risks associated with a building, and by creating a revenue stream of lease payments that increase in value over time. The investment is also attractive to many investors because it is less directly correlated to the performance of the markets.

The concept of ground leases is an old one: Many iconic structures, such as the Chrysler Building in New York, are built on leased land. Most leases extend for decades, often up to 99 years. During this time, the lessee pays rent on the ground and, usually, all of the expenses associated with the building or buildings on it. At the end of the lease term, the property owner gains ownership of the buildings, though often, they negotiate a new long-term ground lease.

GAINING FAVOR

Until recently, ground leases had fallen out of favor. Lease terms routinely used formulas based upon the value of the land in calculating rent increases. In locales where land prices have ballooned, this practice has created issues for lessees who may face a sudden, unexpected spike in rent. 

Consider again the Chrysler Building. Constructed in 1931, the art deco skyscraper sits on land owned by the Cooper Union, a New York-based private college. According to a 2018 report in The Wall Street Journal, after a reassessment of the value of the land under the building, the annual ground lease rent increased from $7.75 million to $32.5 million and will increase to $41 million in 2028. 

Newer leases, however, are being negotiated without reset terms that link rent increases to property values. In most cases, a reset of the rent is tied to the rate of inflation and is subject to a cap.

The more favorable terms have led to increased interest in ground leases by developers and investors alike. Earlier this year, for instance, Dallas-based Montgomery Street Partners and an unnamed Fortune 500 company launched a new real estate investment trust (REIT) that aims to invest $1 billion in major-market ground leases. This came just a few months after two other large investment funds launched the Haven Group, another billion-dollar REIT targeting ground leases in the top 50 U.S. markets.

Negotiating and executing a ground lease requires a keen understanding of real estate finance, and leases should be carefully reviewed by a lawyer. Among other issues, legal counsel will consider the lease terms, any use provisions, insurance requirements, default provisions, casualty and condemnation language, other rights of the landlords and tenants, and conditions on financing. 

To learn more about the legal issues surrounding ground leases or for additional assistance in understanding real estate finance issues, contact us.