Ground Lease in Commercial Real Estate

What is a Ground Lease?

A ground lease is a type of long-term lease agreement that allows the tenant to build on and make significant improvements to the leased property. Ground leases usually last between 50-99 years, and generally stipulate that the property and all improvements made during the lease will revert to the landlord after the termination of the lease.

In general, ground leases are the most similar to triple net leases, or bond leases, as they require a tenant to pay for property taxes, insurance, maintenance, building repairs, and all other associated costs with operating the property.

Who Benefits From Ground Leases?

Ground leases aren’t for everyone; they’re especially ill-suited for small businesses, start-ups, and commercial property investors who wish to flip their property within in a reasonable time-frame. However, they do provide significant financial flexibility for larger organizations. For example, if a large-chain supermarket or retail chain (think Trader Joe’s or an Apple Store) wants to purchase a location in a prime area, but no suitable location is available for sale, they may be able to find a firm willing to offer them a ground lease. In addition to getting their hands on prime real estate, the tenant does not have to provide a down payment, which can help free up more capital for further expansion plans.

On the landlord side, large investment funds, including family office funds, as well as government and quasi-government organizations, may not want to give up the rights to their most valuable land, but may wish to generate a certain degree of income/profit. A ground lease lets them do this, by keeping the rights to the land, and knowing that, if they wish, they will likely be able to sell the property for a profit when the tenant’s ground lease is up.

Types of Ground Leases

In general, there are two major types of ground leases; subordinated and unsubordinated ground leases. In most cases, a tenant will get financing in order to build or improve the property, but they do not technically own it, which can complicate things if they default on their loan. It’s significantly easier for a tenant to get a loan with a subordinated lease, since the landlord has agreed to put the building us as collateral for the loan. Landlords can usually charge higher rates for subordinated leases, due to the additional risk they’re taking on. In an unsubordinated lease, the lender cannot repossess the building if the borrower/tenant defaults on their loan. Landlords usually must charge significantly less for unsubordinated ground leases, as it’s somewhat more difficult to get financing for the construction/improvement of properties with this kind of lease.

Lease Assignment and Ground Leases

Most traditional lease agreements provide some ability for a tenant to assign— or transfer, their lease obligation to another tenant. This is also the case in most ground lease agreements, but, since these leases are much longer term and usually involve significantly larger amounts of money, stipulations may be complex. Unlike subleasing, in which the original tenant typically still collects rent from the new tenant, in a lease assignment, a direct relationship is created between the new tenant and the landlord. However, original tenant may still carry some liability should the new tenant default on their lease.

Leasehold Financing for Ground Lease Tenants

Leasehold financing provides ground lease tenants the funds they need to build or make improvements on a property. Unlike a traditional commercial real estate loan, which uses the property itself as collateral, leasehold financing uses the tenant’s ground lease as collateral. Before approving a borrower for leasehold financing, however, a lender will typically want to make sure that the tenant/borrower’s ground lease agreement is flexible enough to prevent a loan default (i.e. permitting lease assignment and allowing the property to be used for a different purpose should the first purpose fail). Conversely, a landlord (and the landlord’s lender, should they have one) will want to make sure that the tenant/borrower’s collateral is limited to the ground lease, (i.e. an unsubordinated lease) and that the leasehold lender cannot pursue the property itself in the case of default.

Ground Leases and Escalation Clauses

Since ground leases last for such long periods of time, it only stands to reason that the landlord would need to increase rents on a periodic basis. For this reason, most ground leases contain an escalation clause, which allows a landlord to increase rent, as well as evicting tenants that default on their leases. Escalation clauses can come in several varieties; for instance, they can have fixed annual increases, such as 2.5% increase every year, or a certain rent increase per square foot (PSF), or, they can have variable increases, often tied to inflation as measured by the Consumer Price Index (CPI). Since they are long-term leases, ground leases may also have increases staggered over a greater time period, such as a 20-25% rent increase every 10 years. Landlords generally prefer increases tied to price indexes, as it will most closely track their expenses, while tenants prefer fixed increases, as it will allow them to plan more effectively. Some leases combine the best of both worlds, by tying rent increases to the CPI (or another index), while limiting the maximum amount rent can increase in a year.

See: Lease Renewal

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