Imagine that you find the ideal land parcel to develop, but the owner does not want to sell – and desires to retain ownership in any future land appreciation. Or, you find the perfect development site that offers superior investment returns – but the land cost is prohibitively expensive, and makes your project infeasible.
In both scenarios, development is still possible by embracing a ground lease.
A ground lease is a lease for the land between a lessee, such as a developer, tenant, or asset manager, and the owner of the land. The owner, the lessor, provides rights to the lessee to develop his/her land while retaining ownership of the land. Meanwhile, the lessee retains ownership of the structures built upon the land. Both parties agree to the nature of development, land use, and the financial terms of the lease.
Ground leases are more common in densely developed areas, such as New York City, or in prime locations and intersections, such as small parcels on the corner of two major roadways ideal for a retail ‘pad’ site. However, ground leases do occur in many other instances, such as with land owned by a major institution.
Recently, Orangeburg, South Carolina entered into a ground lease with a private entity to construct and operate an aircraft hanger. And in December, the Durham Housing Authority signed a ground lease with the Miracle League of the Triangle, who will construct a baseball facility for special needs players in partnership with the Durham Bulls.
They are, though, more unusual outside of these circumstances due to the substantial legal costs and due diligence of preparing a ground lease and financing issues surrounding ground leases.
A ground lease can be structured in various ways, but among the most important terms of the ground lease include the rental rate, duration, and reset provisions, which will be explored in a future blog post (Part 2 of this series).
The rental rate is based upon the market value of the land. For example, if a parcel is valued at $5 million, and the rental rate is 5%, then the lessee would pay the property owner $250,000 per year. However, the precise rate is more difficult to determine, and requires market comparable data in order to determine a ‘fair market’ rate. This can be problematic in situations where contract terms need to be kept confidential, or a ground lease occurs in a market where such transactions are not common.
In order to give the property owner stable income over many years, the ground lease is usually structured for a long period of time. The result is that the property owner effectively possesses an annuity-like product: a series of recurring cash payments over a fixed number of years. For example, a ground lease between a REIT and private landowner for a 20-story commercial building in Manhattan may terminate after 50 years, while a ground lease between a city housing authority and multifamily developer may last 99 years.
Ultimately, the duration of the lease depends upon the financial goals of the property owner. The ground lease term may include various renewal options. For example, a 50-year ground lease may include an initial 20-year term, with two 15-year renewal options. However, the term of the ground lease should match the expected economic lifespan of the project, location, and product type. A 60-story commercial office building in a central business district will have a longer economic lifespan than a four-story suburban office building or stick-built Class A multifamily apartment building.
Having a long duration ground lease for a project that has a limited economic lifespan, or cannot be adapted for an additional use, does not provide economic value to neither the property owner or lessee. Furthermore, lenders would not be willing to finance a project that has relatively short ground lease terms since loan repayment would be at risk.
There’s more to know about ground leases; stayed tuned for Part 2 of this series.
John Raymond is a MBA candidate at the Kenan-Flagler Business School at UNC-Chapel Hill. He is also a Fellow with the Development Finance Initiative.