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Ground leases are different things to different people and carry a varying set of pros and cons. Below, we look into the types of ground leases, what they are, and how they work. Depending on your view looking in- whether you are a landlord, property owner, or potential investor, a ground lease takes on a whole new meaning.
What Is a Ground Lease?
In a nutshell, a ground lease (also sometimes called a land lease) is an agreement between a person who owns the land and a person who wants to build a property. The investor or property developer pays the landowner a monthly rent for the right to build there.
Specific agreements vary in both value and time-frame, and the final outcome can go several ways depending on the interests of the parties involved.
How Do They Work?
The first step is for an investor to find a piece of land they wish to develop on and approach the owner with terms. A land lease agreement hands over the right to build on the ground over a set number of years, but all land improvements at the end of the lease and the property of the landlord.
They are usually long-term leases spread out over at least 50 years, meaning the owner of the leased land has a steady income from the rent the developer or tenant pays.
The ground lease defines exactly who owns the property and who owns the land during the lease term. It also dictates who is responsible for the tax burden and any legal issues that may arise during the construction. Usually, it is the property owner who takes on this responsibility.
Types of Ground Lease: Subordinated VS Unsubordinated
There are two types of ground leases: a subordinated ground lease and an unsubordinated ground lease. The primary difference is the terms of debt and what happens if a tenant defaults. Generally speaking, a landlord should push for an unsubordinated ground lease to better protect their land and property. However, it is easier for a developer to get financing with a subordinated ground lease.
Subordinated Ground Lease
It is far easier to get the planning permission and necessary financing for a development with a subordinated ground lease. Because they do not actually own the property, they cannot offer much collateral should things go wrong. With a subordinated lease, the landlord agrees that the bank can have the first claim, meaning they take a lower priority in the chain.
If everything goes wrong, the lender has the right to cease the real estate property and foreclose, selling it to pay off the debt. After the debt is repaid, anything left over is passed to the person leasing the land. Of course, this is risky, but sometimes it is the only option.
Unsubordinated Ground Lease
The obvious benefit of unsubordinated ground leases is the far less risky position the landowner finds themselves in. In the event of a tenant default, the land is protected, so the owner cannot lose their property. The person leasing land has first place in the claim hierarchy, meaning the lender cannot foreclose without landlord approval.
Because of the extra protection, banks are not so quick to offer finance deals to developers.
Ground Lease Fundamentals
A ground lease structure always follows the same fundamental inclusions:
- Lease terms and conditions should be clearly detailed with an in-depth account of the agreement.
- All rights of both the landlord and the tenant should be discussed and confirmed with legal backing.
- Financial conditions relating to both the landowner and property developer or tenant for the duration of the land lease are set in stone.
- All fees are laid out and agreed upon.
- The lease term (how many years) must be determined before anything is signed.
- What happens if the tenant defaults? There must be no doubts in this matter.
- Insurances for the title and outcome at the end of the lease period should be provided. Although this varies between each lease, ground leases must include a plan for the eventual end of the agreement.
Benefits of a Ground Lease Investment
There are many benefits of a ground lease for real estate investors, especially those interested in developing a commercial property.
The Luxury of Time
Confirming a construction loan and finalizing planning takes time and delays are not uncommon. The ground lease process allows developers some breathing room to get everything organized and finalized without rushing.
A typical ground lease lasts between 50 and 99 years, which is ample time to get a project on its feet. Both the property owner and the developer can take comfort in the knowledge that time is on their side.
Financial Benefits for Both Parties
The property developer benefits by gaining access to an excellent piece of land that they could otherwise not afford; swapping a hefty up-front payment for the manageable ground rent. As an investor, this is also beneficial, as it means there is not as much money required upfront, meaning less risk all around.
Many property owners and developers also come to mutually beneficial financial deals relating to the later phases of the lease, but these are on a case-by-case basis.
Access to Prime Real Estate Markets
Those who are building a commercial property can lease a ground area in a prime location without putting themselves into crippling eternal dept. Commercial real estate is highly lucrative, especially if you can negotiate higher rent payments from tenants due to the location and market.
Rent payments from the completed commercial real estate property can repay a construction loan and leasehold mortgage much faster if it is in the right place. Securing a ground lease with a cooperative property owner with land right on the bullseye is the golden ticket for many commercial real estate developers.
Risks of a Ground Lease Investment
Of course, land leases also come with risks- just like any investment opportunity. Several potential downsides come specifically with this type of lease.
Restrictions and Limitations
Different areas have their own building and real estate laws. Everything from the size of the building to the number of windows can be controlled by local councils and regulations. Anybody considering investing in a land-leased development should thoroughly investigate the local planning procedures and how likely they are to have an impact on the success of the project.
Total Costs Over a Long-Term Period
Bearing in mind that a ground lease can last up to almost a century, the total cost can add up to a lot more than it would have to buy a property outright. Although the lower rent paid every month is far more manageable than forking out a lump sum down payment, it eventually becomes a hefty sum in its own right.
Watch Out for Reversion
Never invest in a development on leased ground until absolutely sure of the exact terms. Some leasehold mortgage leases state that the developers do not retain ownership of the improvements to the land at the end of the contract.
If the company and investor put money into is going to lose control of a property rather than retaining ownership, that does not bode well for potential financial returns.
Pros and Cons of Ground Leases for Landlords
There are two sides to every coin: the landlords who lease the ground also have a central part to play. Entering into a land lease agreement also has its ups and downs for the owners.
Pros
- Leasing ground provides a steady income stream for a landlord for decades on an otherwise empty piece of land without having to do a lot of work- what's not to like?
- Most deals include escalation clauses that allow landowners to adjust rent and retain control of eviction rights if necessary.
- Owners can benefit from tax savings by leasing rather than selling. If sold outright, a landlord experiences higher tax implications relating to reported gains, which do not apply in long-term lease agreements.
- Sometimes the landowner retains a level of control in the development. In other words, they have a say in what changes do or do not happen.
Cons
- In some areas, the relevant taxes may be fairly high for landowners. Although they can experience tax benefits by not selling, having a tenant pay rent counts as income.
- If the lease agreement is not well-reviewed, the landlord can end up losing control of their property and find themselves with little power to do anything about it.
Ground Lease Frequently Asked Questions
What happens when a ground lease expires?
It depends on the agreement between the two parties.
Is a ground lease a good investment?
Yes, it can be, but only if the investor thoroughly investigates the ins and outs of the deals. Jumping into a commercial lease without reading the fine print can lead to trouble further down the line. Many large chain stores with corporate expansion plans choose to develop through commercial leases, so there is no doubt about the potential an investment could have.
What is the difference between a ground lease and a normal lease?
An ordinary lease often involves an already existing real property owned and built by someone else. In this case, you simply rent the space. Office buildings or shops inside a mall are prime examples of how other leases work.
With a land lease, the main difference is that you want to build your own space from the ground up. They are long-term and involve a property deed and a very different set of criteria.
How long does a ground lease usually last?
A ground lease can last anywhere between 50 and 99 years.
Who owns the house built on the leased land?
The ownership of the property at the end of the lease depends on the terms of the agreement. If the developer has paid the property taxes for the duration of the lease and the landowner agrees, then they retain ownership at the end of the lease term.
Sometimes the contract states that all improvements to the land are reverted to the landowner when the deal expires, although, over the course of almost 100 years, arrangements are often made between the two parties.
Final Thoughts
Ground leases have excellent potential benefits for both investors and landowners, as long as the agreements are well planned and thoroughly reviewed from both sides.
