Building Your Commercial Empire from the Ground up: Ground Leases, a creative alternative in the Current Economy

In today’s economic climate, managing losses is as important as ever. The economic downturn has bludgeoned most securities portfolios and property holdings. If you happen to be one of the unfortunate many who mistimed the real estate market, those holdings can feel like an anchor on your bottom-line. Many feel their only options are to unload these properties at significant losses or continue to hold them for the foreseeable future while waiting for property values to rebound. However, holding these properties is normally very cost prohibitive. A third option one should consider when weighing the alternatives, is the ground lease.

Ground leases are an oft-overlooked solution for individuals or business owners trying to manage property holdings decimated by the downturn. Ground leases are typically leases of unimproved land that requires the tenant to construct new improvements. Ground lease terms range anywhere from 10 to 99 years in length. A ground lease differs in significant ways from a short-term commercial space lease. It represents a complex transaction and, oftentimes, involves three-way negotiations between the landlord, the tenant, and the leasehold lender.

LANDOWNER ADVANTAGES

The current economic climate has stalled many commercial property transactions. Not only are landowners reluctant to unload their real estate holdings at their current depressed values, viable purchasers are fewer and farther between. Lenders are only willing to extend financing to the most credit worthy individual or business, making financing the purchase AND development of real estate impossible to obtain for many would-be buyers. Ground leasing side steps the need for financing the purchase of property, requiring only the capital needed to develop it, opening landowners to a much larger group of potential developers.
Ground leases allow the landowner to avoid costs normally associated with holding property, as ground leases typically require the tenant to pay all real estate taxes, insurance and maintenance on the property in addition to their rent obligation. Additionally, ground leases avoid taxable capital gains the landowner would otherwise realize if the property was sold to the tenant.
It is not uncommon for landowners to use ground leases as a means of providing a reliable source of income. This income can supplement current earnings or even provide a dependable source of monthly retirement income. As retirement becomes a not so distant reality many property owners assign leased property to a trust to provide steady income for the landowner and his or her heirs.
Typically the landowner retains a reversion at the expiration of the ground lease, meaning all improvements to the property and the value added to it revert back to the landowner. However, depending on the projected value of the improvements to the property, the landowner may wish to incorporate into the lease a provision permitting, at his election, for the removal of any improvements to the land at the tenant’s cost and liability.

LANDOWNER DISADVANTAGES

There are several potential disadvantages for a landowner in a ground lease transaction. Ground lease transactions are almost universally more complex than a sale would have been. The nature of the ground lease makes defining the terms of the lease and any loan difficult. Additionally, financing is often difficult for a lessee to obtain without the landowner permitting the property to be used as security for financing development of the property which exposes the landowner to the risk of losing the property through foreclosure should the tenant default. However, the landowner may be able to negotiate more favorable lease terms or even for a share of the lessee’s profits in exchange for subordinating his fee title.
As with most leases, a ground lease transfers with any sale of the property. Landowners will likely encounter many would-be buyers that are scared away by the length of the lease attached to the property. Upon finding a willing buyer, property encumbered by a long-term ground lease typically sells for 15-20% less than it would without that encumbrance.

CONCLUSION

The negotiation and preparation of a commercial ground lease is often complex and time consuming. Filling in the blanks may be appropriate for standard commercial leases but there is no “standard form” when it comes to ground leases. It is essential that landowners and their attorneys have a comprehensive understanding of present and possible future issues, requirements and concerns, as well as an understanding of the requirements of any lender as the ground lease should clearly define and adequately address these matters.