In the simplest form, a ground lease is a long-term net lease (usually 49 years or 99 years) of land including any improvements on the said land. Assets that can be subject to a ground lease include but are not limited to, vacant land, office buildings, and large residential buildings.
Advantages for Owners/Ground Lessor:
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The owner retains ownership to the property and therefore:
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is not responsible for any capital gains or transfer tax payments they would incur if they were to sell (although there are instances where transfer taxes might be incurred);
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keep the property in the family and thus will generate a hassle-free income stream for generations;
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they can mortgage the leased property; and
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can sell the property.
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The ground lessee (the tenant) under the ground lease would be responsible for all of the management, costs, and expenses of the leased property.
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The ground lessee will maximize the potential and improve the property by:
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making capital improvements to the existing structure; or
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in the case of a development site, they will be constructing a new building.
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Many ground leases contain a clause (reversionary clause) which transfers any improvements made by the tenant to the landlord at the end of the lease.
Advantages for Tenants/Ground Lessee:
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The tenant’s basis would be significantly reduced because the tenant would not need to provide the upfront capital that is needed to purchase the property.
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If an owner is unwilling to sell his property, this gives the tenant/investor a way to utilize this asset in a way that can benefit both parties.
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The tenant can mortgage the lease, however, any financing obtained will not be against the leased asset.
Ground leases are an effective tool that property owners can use to maximize the upside potential of their asset without the expenses associated with transferring ownership of the property through a conventional sale. In general, a ground lease (master lease) is a long-term net lease (usually 49 years or 99 years) of land including any improvements (if any) on the said land. Once a landlord decides to ground lease their property they must pick the right ground tenant to partner with. Unfortunately, often times owners choose a ground tenant based solely on receiving the highest offer for their property. However, this should not be the only factor to take into consideration. Landlords must properly vet any prospective ground tenant and should take into consideration asking the ground tenant my “Top 5” questions as outlined below.
What is the ground tenant’s transaction history; have they done a ground lease in the past?
Ground leases are known to be very complex transactions and are in many ways like a partnership. It is crucial to choose a sophisticated and experienced ground tenant to successfully negotiate the terms of the lease. Working with a ground tenant that has past experiences with ground leases can provide the owner with comfort and guidance through the sometimes grueling lease negotiations. Furthermore, experienced ground tenants can provide tax efficient structures to help save the landlord money. An example of this is compounding/deferring the taxes associated with an upfront payment made by the tenant.
What type of work is the ground tenant guaranteeing?
Unlike a standard office or retail lease, obtaining a personal guaranty and/or security deposit from a ground tenant are not common practice on ground leases. However, a personal guaranty from the ground tenant guaranteeing to complete certain capital improvements on the property within a specific timeframe provides the landlord with security. All such work should be outlined in an itemized “Scope of Work” that should be attached as an exhibit to the lease. Furthermore, the more money a tenant spends the more “skin in the game” they have. It is important to note, however, that the amount of money that the ground tenant should spend depends on the condition of the property and the type of property.
Has the ground tenant ever defaulted on a ground lease?
A prior default on a ground lease does not necessarily mean that you should not pick that ground tenant. It is more important to find out the reasons for defaulting and how many times they have defaulted. Multiple defaults or defaulting due to overleveraging or inexperience should be considered red flags.
How many years has the ground tenant been in business?
Due to the cyclical nature of the real estate market, it is important to pick a ground tenant who has been through it all, and survived! However, this should not rule out new companies whose principals have ground leasing experience in their repertoire.
Has the ground tenant completed similar projects that you can tour/visit?
Ground leases can be made on all different property types including but not limited to: vacant land, industrial properties, office buildings, residential buildings, and hotels. Therefore, it is important to pick a ground lessee who specializes in the same asset class as your property. It is also helpful to visit and tour the prospective ground lessee’s projects in an effort to get a better idea of their craftsmanship and expertise in their execution.
Are most owners familiar with ground leases? How do they respond when you explain how they work?
Most owners either don’t know anything about ground leasing or they’ve only heard part of the story, so we created an informational website (groundlease.nyc) to help educate them. The way ground leases are structured opens opportunities for owners who don’t want to sell but are still open to doing a deal. Ultimately, owners should understand that a ground lease is just like any other type of real estate transaction in that both sides of the table need to feel like they’re making a deal that works for them economically.
On the other side of the equation, an investor who’s looking to purchase an office property south of 96th street in Manhattan should understand that there are only roughly 1,571 office buildings that are over 20,000 square feet, which means there’s a finite amount of inventory. This knowledge helps tenants approach deals creatively as well.
Who should consider a ground lease?
Ground leases make the most sense for long-term property owners who aren’t prepared to make the necessary capital improvements required to maximize their property’s upside potential. Someone who owns a plot of land, a property with significant air rights, doesn’t want or need to build, or someone who wants to ensure that their property remains in the family to produce generational income would also benefit from considering a ground lease.
How do owners benefit from ground leases?
The property title never transfers to the tenant; therefore, the owner stays the owner of the property while generating income on the property. The owner is not responsible for capital gains tax, unless there is an upfront payment, and in some cases the owner is eligible to avoid transfer tax payments. The property also remains in the family, which means the asset will generate a hassle-free income stream for generations to come.
The ground lessee (the tenant) is responsible for all the management, costs, and expenses of the leased property. By making capital improvements to the existing structure or in the case of a development site, constructing a new building the ground lessee will maximize the potential and improve the property. Many ground leases contain a reversionary clause, which transfers any improvements made by the tenant to the landlord at the end of the lease.
How do tenants benefit from a ground lease?
Many developers and commercial tenants have long been faced with property owners who ask for a price that isn’t supported by comparable deals. The owners are emotionally attached to the asset, and they’d rather sit on it than do a deal that makes sense for both parties. The tenant’s basis is significantly reduced because they don’t need to invest upfront capital for a purchase. If an owner is unwilling to sell, a ground lease can still get a deal done that will give them long-term access to prime locations.
Are ground leases complicated?
The more knowledge each party brings to the transaction, the smoother it will go. To that end, our real edge at Skyline is our personal relationships with the most active real estate players in today’s market. For owners, this translates into not wasting time and getting a deal done correctly. Ground leases are considered sophisticated and complex transactions. If structured correctly, ground leases can be tax efficient and protect both the ground lessee and lessor.
What asset classes can be ground leased?
Technically, you can ground lease any asset class, but most commonly vacant land, industrial properties, office buildings, residential buildings, and hotels are ground leased. An example of recent ground lease transactions in New York City include: SL Green leased 885 Third Avenue, “The Lipstick Building,” to Ceruzzi Holdings; Extell Development signed a 99-year lease for Goldman-owned properties at 516 East 14th Street, 530 East 14th Street and 222 Avenue A; and Skyline Properties’ most recent ground lease at 236 Fifth Avenue with The Kaufman Organization.
Is the owner stuck once the ground lease is in place?
Since the title to the property never transfers to the tenant, the owner retains the right to mortgage the leased property or sell it. In fact, the owner can borrow more money from the bank once the ground lease is in place because often their net income has increased substantially.
Once the tenant has committed to a ground lease, are they trapped?
The ground lease tenant retains the option to mortgage their lease or assign the lease to a new tenant. It’s also worth mentioning that since the tenant is not on the title, the owner is not responsible for any debt they incur, so if the tenant default on the debt, the landlord isn’t held accountable.
What makes an appropriate ground lease tenant?
Ground leases can be thought of as long-term partnerships. Therefore, it’s vital that landlords have partners who are knowledgeable about ground leases to provide the owner with tax efficient structures. The tenant also needs the financial ability to perform the renovations or development in the timeframe outlined in the lease. When picking a ground tenant, owners should look for tenants who are willing to provide personal guarantees for the work they are saying they are going to do, and they should obtain a comprehensive understanding of the tenant’s financial history including defaults.
One of the biggest “deal killers” during ground lease negotiations circles around the issue of whether or not to include a rent reset in the ground lease. In general, rent resets are used to protect the landlord (lessor) from inflation which in turn can increase future ground rent paid by the ground tenant (lessee). As a consequence, the lessee is reluctant to accept a rent reset whereby “killing the deal.” However, crafting language to protect both the landlord and tenant can help keep the deal “alive.” Most of the time, unfortunately, the discussion surrounding rent resets is not properly handled because the parties do not have a proper understanding of the specifics and reasons for these resets. In order for a ground lease to make sense, the rent reset clause must take into consideration the needs of both the lessor and lessee.
Today, ground leases are being utilized more and more to creatively maximize value for both the lessors and the lessees. A ground lease, in essence, is a long-term net lease of land between the lessor and lessee. Depending on the terms in the lease, a ground lease can provide the lessor with substantial benefits while simultaneously allowing the lessee to maximize the assets upside potential.
For example, ground-leased properties have a host of tax advantages for lessors. Lessors will not be responsible for paying the capital gains taxes they may incur if they were to sell the property (although there are instances where capital gain taxes might be incurred). Leasing rather than selling their property via a ground lease allows owners to establish generational streams of income from the property without the responsibility of managing the property.
For lessees, they are not burdened by the upfront cost to purchase the property, therefore having more cash on hand to work on other projects. Depreciation from capital improvements they have made on the property and depending on the lease structure, the rent paid to the lessor can be deducted from their pre-tax income as expenses, whereby decreasing the overall cost-basis for the lessee. Still, despite the benefits, one of the biggest issues in ground leases that is often in contention are the clauses regarding the lease’s rent reset and how the reset will be calculated at pre-determined dates throughout the lease (generally every 25th, 33rd, or 49th year of a 100-year ground lease). The most common types of rent resets, include but are not limited to:
Fair Market Value (FMV) Reset
Appraisals are done to ensure that the rents being paid by the lessee are representative of the property’s current fair market value. The danger for the lessees is that in many cases the rent that is being paid is substantially less than the current FMV resulting in a dramatic rent increase. However, dramatic rent increases can be avoided if a rent floor and ceiling has been established during lease negotiations. Generally, the rent floor would be that the rent cannot be lower than the current rent and the ceiling would be that the rent cannot exceed a certain amount. The Lotte New York Palace hotel is set to have a rent-reset based on a fair market value reset in 2023. SL Green Realty Corp. is also set to have a rent-reset at 625 Madison Ave. based on the property’s fair market value in 2022.
Consumer Price Index (CPI) Reset
In many cases rent resets and structure are determined using the Consumer Price Index also known as a CPI. An increase in the CPI over a given period (usually in the 25th, 33rd, or 49th year of the lease term) and the loss in the property value is compensated by a proportionate percentage increase in rent that is calculated based on the change to the CPI, thereby protecting the lessor from inflationary pressures. Using the same rent floor and ceiling discussed above can alleviate the lessee’s risk.
Set Escalation
Set escalation clauses are very simple and easy to underwrite. Set escalation clauses usually calculate rent increases by (i) taking an agreed upon percentage and then multiplying it by the then current rent or (ii) agreeing that the rent will increase to a set number (e.x. from $1 million to $2 million). This method allows both parties to know the exact rent amount at any given point during the course of the lease.
RFR Realty struggled to refinance their mortgage on 390 Park Ave. due to a set escalation clause in which the ground lease rent was set to increase to $20 million in 2023 relative to the current $6 milllion. Another example, the Abu Dhabi Investment Council and Tishman Speyer were forced to put up the Chrysler Tower for sale this past January due to their rent-bill ballooning as a result of a rent reset. After paying $7.75 million in 2017, the rent in 2018 after the rent reset was $32.5million, an increase of more than 400%.
Highest and Best Use Reset
One method of calculating rent increase that has been causing issues for many iconic ground-leased properties is the method of increasing rent based on the property’s “highest and best use.” This is particularly true for areas where former business/office districts such as Park Ave. South and the Financial District have seen a huge rise in luxury residential development. Under this method of calculating rent resets, the rents are determined based on what is appraised to be the most profitable asset type for that parcel of land regardless of what currently exists on the plot of land. Tenants may find themselves stuck with an office building whose highest and best use is residential, but the tenant has neither the financial means nor the ability to convert the property type. If a lessor is stern on using this method, the lessee must request rent concessions in the form of free rent or reduced rent while they are repositioning the property.
Rent reset clauses should be collaboratively determined and meticulously reviewed before either party agrees to sign a lease. This is crucial to ensure that the terms are fair and also helps to avoid any potential problems that may arise. There is no reason why the rent reset should continue to be a “deal killer.” Ground leases are used to benefit both parties in a transaction; the rent reset clause should be no different.
There are two main types of ground leases: subordinated and unsubordinated. And the difference is what happens if a tenant runs into financial trouble during the lease term.
Subordinated Ground Lease:
In a subordinated ground lease, the tenant agrees to be a lower priority when it comes to any other financing the tenant obtains on the property. For example, let's say that you sign a ground lease on a parcel of land, and then borrow $500,000 to build a restaurant on it. If you default on the loan while under a subordinated ground lease, your lender can go after the property (including the land) as collateral.
Unsubordinated Ground Lease:
On the other hand, in an unsubordinated ground lease, the tenant has higher priority than any other lenders when it comes to claims on the property. In other words, the tenant's lenders may not foreclose on the land if they default. In the event of default, a lender on a property in an unsubordinated ground lease may be able to go after the assets of the business but cannot take full control of the property as they may be able to in a subordinated ground lease.
Obviously, with all things being equal, landlords would want to sign unsubordinated ground leases. After all, why would a landlord want to risk their property? In practice, landlords generally have to charge lower rent on unsubordinated ground leases in order to entice tenants to accept such an arrangement. Many lenders won't originate loans to build commercial buildings on ground leases unless they have the recourse to take control of the property in the event of the tenant's default. Unsubordinated ground leases are the more common arrangement. Even though they generate less rental income, landlords typically don't want to put their property at risk, essentially taking an active stake in the tenant's business.
By: Daniel Shirazi - March 20, 2018
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