By: Andy Jonsson – June 24, 2021
In this article, we will cover:
- What is a Ground Lease?
- Who benefits from a Ground Lease and why would a Tenant agree to Ground Lease?
- What are the downsides of a Ground Lease?
- A commercial real estate brokers take and value to a retail real estate investor
What is a Ground Lease?
A ground lease is an agreement in which a tenant is permitted to develop a portion of a property during a lease period, after which the land and all improvements are turned over to the property owner.
This is a slightly nuanced approach to commercial real estate that, at face value, doesn’t make a whole lot of sense but when you dig in, could be very beneficial to a tenant. The reason why it may be confusing to someone that is new to commercial real estate is because the tenant will sign a ground lease with the landlord and then pay for the costs to develop the land and then at the end of the lease term will give this improved land back to the landlord and will have no future stake in the improved land.
Who benefits from a Ground Lease and why would a Tenant agree to Ground Lease?
The most obvious beneficiary would be the landlord as they get paid rent and NNN reimbursements throughout the Lease term and, on top of that, at the end of the Lease term the land is fully improved and significantly more valuable to either sell or lease to a new tenant.
Why would a tenant agree to a Ground Lease? The Tenant gets to build on a property in a prime location that they otherwise may not be able to purchase. This is the reason large national chains such as McDonalds or Chick-Fil-A will agree to a Ground Lease arrangement with a landlord – they want the A+ locations in any market. Additionally, the Tenant will not have to pay for a down payment to secure the land and the rents paid on a Ground Lease may be deductible for state and federal income taxes, which further benefits the tenant and reduces the cost of capital to open a new location.
What are the downsides of a Ground Lease?
There are not many downsides to a Ground Lease for the landlord but the biggest factor to consider would be similar to any Lease: the landlord loses control of the Land during the Ground Lease term and therefore no longer has the ability to utilize the land for other purposes. A landlord will want to ensure that the rent paid for the land is at Fair Market Value and any Options provided to the tenant to extend the Lease term are negotiated at Fair Market Value to ensure they are maximizing the value of the property.
The main downside for a Tenant is: the landlord gets to keep all of the tenant improvements at the end of the lease term or request that all the tenant improvements are removed from the land (if they desire). Therefore, the tenant would lose control of the property and the improvements on the property once the lease expired. The best way for a tenant to protect themselves against this issue is to ensure that they have multiple option periods to ensure control of the property if they desire. A tenant should also negotiate a Tenant Improvement Allowance to help offset their investment on the permanent, generic Tenant Improvements to be built and request that the landlord provide some written approval of the permanent improvements and that they will remain at the expiration of the Lease Term.
A commercial real estate brokers take and value to a retail real estate investor.
At ROME Real Estate Group, we are well-versed in ground leases and have seen first-hand the major impact a nice ground lease can have on a real estate investment.
Once a ground lease is signed with a Tenant, the value of the leased land becomes significantly more valuable as it is now a source of income for the landowner. In the current state of the commercial real estate market, the landlord could then sell this Land to a Single Tenant Triple-Net Lease (STNL) commercial real estate investor at a significant increase in value which would indirectly reduce the cost basis of the rest of the property.
As an example, a ½ acre pad parcel in a retail shopping center, in a prime location, fronting a major thoroughfare in Northern California might be worth anywhere from $500,000 to $1,000,000 for just the land-alone. If a landlord signs a ground lease on this parcel with a high-quality tenant such as Chick-fil-A or McDonald’s, with the tenant to pay $200,000 annually plus NNN reimbursements, the property would now be valued at a 4% to 5% annual return (“cap-rate”) equating to a valuation of $4,000,000 to $5,000,000 for this income producing real estate. This ground lease results in an increase in value of approximately $3-4 million.
Conclusion
In conclusion, a Ground Lease can be beneficial to both Landlord and Tenant and, when utilized correctly, will result in a net benefit to a shopping center.
For more information, please email me at: andy@romecre.com