Ground Leases: What Are They Good For?February 24, 2021
A ground lease may be an attractive solution to problems confronting property owners who are struggling to hold onto their assets. Increasingly over the last year, I have seen some variation of the following situation: The infrastructure and systems of a commercial or mixed use building has degraded to the point that the building will not be in compliance with code without costly upgrades or repairs, but the income from the property is insufficient to pay for them. The property owner may not have the money (or does not want to risk the capital) to invest in the work.
The financial challenges facing property owners in this situation have been exacerbated by COVID-19, as many commercial tenants have closed up shop and large numbers of residential tenants have fled the City. In the meantime, offers to purchase are coming in at much lower prices than hoped for. Owners don’t want to sell at this depressed pricing, especially because the market may well pick up speed as soon as COVID-19 vaccinations become more widely available and life gets back to some semblance of normalcy.
What is a landowner to do in this situation? Enter, the ground lease.
In the classic ground lease, a developer leases property for a long term (usually 99 years) and constructs or substantially rehabilitates income-producing improvements, which allows the developer (the tenant under the ground lease) to realize income from its rental of that property to tenants of the improved property, while paying a ground rent to the landowner as an operating expense. In this way, the landowner may realize a bond-like income stream with a reversionary interest in the improvements at the end of the term. That income stream can be financed and allows the landowner to pull out equity tax free.
Advantages to the landowner are:
• The property will be developed by a real estate professional with the expertise and relationships to construct improvements efficiently and operate them profitably.
• The landowner’s interest in the property is not at risk since the developer can finance its leasehold independently.
• The lease is triple net and the tenant pays all costs of operating the property, including real estate taxes, repairs and capital improvements.
• The landlord has no management responsibility.
• Although the return to the owner is obviously lower than to the tenant-developer who is taking the development risk, a ground lease can be structured to permit the landowner to participate in some of the upside.
Why would a developer step into a property in a challenging market?
Successful developers have the resources to take a long view of a struggling asset. They also have access to wider sources of supply, capital and financing on better terms than might be available to a typical landowner. Many factors are involved in determining whether a particular property would be attractive or even feasible for ground leasing including lot size, available development rights, and zoning.
If any of this resonates, then ground leasing is worth investigating.
If you have questions about ground leasing, please reach out to Dena Cohen, partner in Herrick’s Real Estate Department.
For questions about the tax implications a property owner may consider before entering a ground lease, please reach out to Jacqueline Duval, partner in Herrick’s Tax Department and Chair of the Family Office Group.
© 2021 Herrick, Feinstein LLP. This alert is provided by Herrick, Feinstein LLP to keep its clients and other interested parties informed of current legal developments that may affect or otherwise be of interest to them. The information is not intended as legal advice or legal opinion and should not be construed as such.