April 2, 2021

Grassland Landscape

The concept of a lease is generally universal: a contractual agreement by which one party pays the other for certain services or for the use of a certain property over a period of time. However, understanding the distinctions between different kinds of leases and their applications is crucial.

Unlike residential leases, for example, which tend to be highly regulated agreements for the tenant’s personal use, commercial leases are typically long-term agreements for business purposes. These leases are attached to profit-generating assets, such as land, buildings, and vehicles. 

Although ground or land leases are not exclusive to the commercial sector, they are, more often than not, crucial to commercial property developments. So, what is a ground lease? Read on to find out all you need to know.

Ground Leases Explained

It is an undeniable fact that land is one of the most commercially viable assets.  It forms the foundation of both farming and construction industries, and thus, by implication, is the backbone of the commercial world. 

When it comes to immovable property, most people tend to assume that anything attached to the land, such as a building, is the property of the landowner. While this is a false assumption, it isn’t an unreasonable one. The predominant understanding of land ownership is shaped by homeownership, which is often tied to ownership of the land.

So, what is a ground lease? Exactly what it sounds like: a rental agreement for the lease of land. Let’s dive into more detail. 

Ground Rent

In a nutshell, ground leases separate ownership of the land from ownership of the buildings or improvements on the land. The lessee contracts with the landowner or lessor for the right to develop the land during the lease period, typically for commercial purposes.

The lease period is long-term and usually runs for up to 99 years to facilitate property development. During this time, and depending on the specific terms of the lease agreement, the lessee may construct a building or structure or otherwise improve the land. Any improvements made to the land are made at the lessee’s own expense.

In exchange for the enjoyment of these rights, the lessor receives a regular payment or ground rent. The rental amount is payable on a monthly, quarterly, or annual basis – as per the agreement between the lessee and the lessor. 

However, because the lease period can span several decades, the rental amount is often made subject to an escalation clause. An escalation clause or escalator clause guarantees a change in the price initially agreed upon, subject to certain conditions being met. For example, the rental price may be adjusted for inflation annually. The clause helps protect the interest of the lessor for the duration of the lease period.

Commercial property developments that are built on leased land, for example, apartment buildings and shopping malls, may, in turn, rent out their premises to tenants. Alternatively, the lessee may be permitted to sub-let a portion of the land to another property developer and collect regular rental payments. It is important to differentiate these payments from the underlying ground rental payment.

Construction

While agreements may vary, the tenant is usually held responsible for expenses throughout the lease period in addition to the rental amount. These expenses may include taxes, insurance, maintenance, repairs, and utilities. This makes land leases a type of triple-net (NNN) lease.

Although the lessee takes on a number of expenses that the landowner would otherwise incur, some of these expenses, for example, rental payments and repairs, may be tax-deductible. However, it is important to bear in mind that it is only the party responsible for the expense in question that may write it off as a tax deduction. The lessor may therefore be entitled to certain tax deductions.

At the end of the lease period, the lessor inherits the improvements made to the land at the lessee’s expense. However, there are no hard and fast rules. For example, the parties may renew the lease, the landowner may elect to sell the property to the lessee, or the lessee may be required to demolish any structures erected on the land.

A real-world example of a ground lease agreement is the Lotte New York Palace Hotel in Midtown Manhattan. The hotel’s development was proposed in the early 1970s on land leased from the Archdiocese of New York. In the early 2000s, a review of the lease contemplated an increase in the rental in line with increased property values, inflation, and standards of living.

Subordinated vs. Unsubordinated Ground Leases

Property developers often need to finance improvements on leased land. As with any loan, the risk of default is borne by the lender. To lower this risk, the lender may require collateral – an asset pledged as security for a loan. In the event of default, collateral may be sold or foreclosed by the lender as a means to recoup funds.

Real property is the most commonly used form of collateral security. In a subordinated ground lease, the landowner allows the land to be used as collateral security for the improvement loans taken out by the lessee. Should the developer default on the loan repayments, the land may be vulnerable to sell for the benefit of the lender.

This means that the lender has a stronger claim to the land than the lessor. Conversely, the lessor has a weaker claim to the land than the lender. For example, if the lessee borrows $1,000,000 to finance the construction of an office building but defaults on the loan repayments, the lender may sell the land along with its improvements to recover the investment.

It may seem counterintuitive, but there are some reasons that a landowner may agree to include a subordination clause in a commercial land lease agreement. Remember that leased land is often undeveloped land and that any improvements made to the land by the developer will likely increase the value of the lessor’s land and the value of any adjacent property.

Construction

A subordinated lease will help the developer secure a loan on more favorable terms, sweetening the deal. To offset the increased risk of losing the land, a lessor will normally charge a higher rental price. Surrendering a stronger claim to the land will increase the lessor’s bargaining power in negotiations with the lessee. Due to the benefits that the lessee will reap from a subordination clause, they will be more inclined to agree to higher rental payments.

Unsubordinated ground leases are those in which the lessor retains the strength of their claim to the land. By virtue of being the title-holder, the landowner’s claim to the land ranks higher than those of any other debtors. In other words, the land can not be used as collateral security for the developer’s loan. Therefore, in the event of default, the lender cannot sell the land to recover the investment.

Because the land is not included as collateral security, the developer’s loan may be subject to less favorable terms to compensate for the higher risk. This is one of the downfalls of owning a building but not the land. In the extreme, the lender may be reluctant to finance the project entirely for fear of default. 

Due to the increased financial burden placed on the developer, and the reduced risk of losing the land, the lessor normally charges a lower rental to the lessee. A lower rental payment may be just the thing to coax the developer into persisting with the project on the landowner’s property.

Although unsubordinated leases offer significant protections to the landowner, they decrease the likelihood of the developer entering into the lease agreement. Faced with a potentially highly lucrative development, the landowner stands to benefit from a subordination clause. 

Reasons to Choose a Ground Lease

Lease agreements, like all contracts, will differ depending on the location of the parties, the property in question, and the outcome of negotiations. Therefore, it is difficult to give an in-depth analysis of the benefits and drawbacks of ground lease agreements without context-specific information.

In general, landowners and property developers alike may benefit from the agreement. For major developments, the initial capital injection for the investment may be restrictively high. In such a case, the landowner may be hindered by the cost of development while the developer’s efforts are similarly thwarted by the cost of buying a suitable parcel of land. A leasehold bridges the financial gap between development and land ownership.

Although it is the developer that typically proposes the project and seeks outland for construction or improvement, the landowner may have a say in the development. Clauses that make provision for the landowner’s input allow the lessor to retain some measure of control over the development. For example, the landowner may stipulate certain construction limitations.

However, retaining control of the property isn’t the only benefit to the landowner. The financial risks associated with developing the land are reduced as they are taken on by the developer. In addition to doing away with tax and other costs, the lessor enjoys a passive income in the form of regular rental payments and may negotiate a percentage of the profits from the project.

Shopping Mall

While tax may be charged on the rental profits, leasing the land as opposed to selling it is a means to avoid paying capital gains tax. Improvements made to the property that increases the value of the property are classified as capital gains. However, capital gains tax is only incurred upon the sale of the property and is not triggered by profits from rental income.

The question of subordination may be central to negotiations as it has wide-reaching implications for the apportionment of risk, the financing for the project, and the rental amount. While it may be impossible to strike a middle ground in terms of risk, should the landowner agree to a subordination clause, there is significant leeway to compensate for the risk through rental and profit-sharing agreements.

By opting for a land lease instead of a purchase, the developer saves on out-of-pocket expenses, such as a loan down payment. Remaining financially liquid may free up cash for other investment opportunities or for contributing toward the cost of a development loan.

Securing an ideal location for the development may be critical to its success. Even if the developer is in a position to buy land, chances are that prime real estate won’t be up for sale, and if it is, it may be set at an inhibitive price point. A leasehold allows the developer to choose from and to take advantage of the most desirable locations.

Initially, the benefits of a land lease may appear to overwhelmingly benefit the landowner, but that isn’t necessarily the case. Negotiating a mutually beneficial agreement is in the best interests of the lessor. After all, what is a ground lease good for if not to improve the viability of a project?

Conclusion

In the context of property development, a leasehold can provide a cost-efficient means to an end for both parties. On the one hand, the lessor benefits from a regular rental income and the increase in the value of his property. On the other hand, the lessee avoids the upfront costs associated with purchasing land for development.

If you’re in the market for an investment property, look no further than NNN Deal Finder to streamline your search. Browse through our NNN Property Listings or request a free custom list and guide book to help you make the best investment.

About the author 

Dwaine Clarke

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