The Basics of Investing in Ground Leases

The notion of an investor leasing land for 50 years, with all improvements on that land reverting to the landowner upon expiration of the ground lease, can seem illogical to long-term holders of commercial real estate. But when carefully structured, these arrangements can generate much-needed cash flow, especially for newer CRE investors.

Two Kinds of Ground Leases

This is not a two-party ground lease where there’s the rich ground owner and say, Walmart on the other side. This is about a three-party ground lease where you have the ground owner, the developer (or the investor in the middle) and then the tenants in occupancy.

Two-party ground leases happen a lot if you have a particularly juicy piece of land and people are pestering you to sell. However, the arrangement he encourages investors to consider is a three-party ground lease, in the role of developer/operator between the landowner and the tenant.

The Basics of a Ground Lease

For ease of understanding here is “a vastly oversimplified” scenario between a landowner and a developer, with the novice investor in the role of the developer. The situation he presented began with a landowner disinterested in developing the land themselves. A developer comes along and offers to buy the land, but the owner says no. And then [the developer] goes back and stews for a while and says ‘okay, how about I lease it from you?

The landowner offers the land for lease at $1 million a year. The developer calculates they will need to spend $10 million to construct a building and secure tenants, so they request a 50-year term and the parties agree.

Uses and Zoning

Most CRE ground leases in the U.S. are completed for industrial, retail and office uses and less so for multifamily facilities. But the land being leased typically isn’t already zoned for its proposed use.

Often, a landowner is a farmer whose grandparents picked their location well because now it sits next to a freeway interchange. But despite this choice location the land is still zoned agricultural. So, in circumstances where the developer is commencing a ground lease, they will often need to factor in several years to obtain zoning when setting the lease term with the landowner.

A different example could be that it’s a perfectly good building, but it’s empty and it just needs to be renovated, so there’s no rezoning.

Again, the investor pays $1 million a year to the building owner. They put $10 million into the building renovation and they lease the building for $2.5 million a year. Even with the cost of the ground lease, the developer stands to make a comfortable return.

Focus on Existing Ground Leases

Novice investors avoid setting up new ground leases in the role of the developer. Occasionally, they work out, but generally if you are an eager developer courting a reluctant landowner that won’t sell, but will agree to a ground lease, almost by definition you’re going to pay too much ground rent.

At least half a dozen times where an entire deal and it turned out fine, except you won’t make any money. You’ll either too much for the land or too much in ground rent. You can only do that every so often. So, caution is don’t start ground leases if you’re going to do this [as a nascent developer], try to find old ones that you can buy at a discount.

Investors should carefully assess ground leases where the ground rent adjusts upward without consideration for what’s happened with the tenants in occupancy. Here’s an example of a shopping center — where the retail rents have been flatlining for a dozen years — that is subject to a ground lease that’s bumping up 10% every five years.

Initially, that might appear to be a stable cash flow. But if you are too optimistic, you may fool yourself into thinking that retail rents are going to rise. That’s why you have to be very leery of deals with big, fixed ground rent increases. It’s not the least bit certain that you can pass on those rent increases to the actual tenants. They don’t care what your ground rent is. They just care about current market rents.

Lease Expirations

Office tenants often face the inability to renew in place for a myriad of reasons, ranging from rising rents to another tenant’s expansion rights. Given these conditions, engaging an office tenant toward the end of a ground lease, and conveying that there is a hard stop at the end of say five years, is not a deal-breaker.

But in the world of more retail-oriented big tenants — like Safeway, Walmart and Home Depot — they would want more term. So, if the landowner is set on terminating the ground lease, those retailers can negotiate directly with the landowner to continue renting or to buy the land. Alternatively, the developer in the middle may go back to the ground owner, extend the ground lease and continue collecting rent from the retailers.