By definition, a ground lease is a long term agreement, typically between 50 to 99 years, for a land-only rental. The landlord holds the title on the property, and the tenant is responsible for the financial burden of development and improvement of the property, all of which revert back to the landlord at the end of the lease. While the more common type of commercial lease is for space within a retail or office building, ground leases present a unique opportunity to both parties and one that can be mutually beneficial.
The obligations of the tenant in a ground lease agreement are much greater than that of the landlord. Ground leases hold the tenant responsible for all expenses relating to the property, including the initial maintenance, insurance, financing, taxes and repair. This type of lease also allows for financing of the construction project through either:
- Fee Subordination Financing – This can only occur if the landlord agrees to have their fee interest in the land in question to become encumbered through a deed of trust which would provide security for the tenant’s loan.
- Leasehold Financing – The more common form of financing, this is a type of loan procured by the tenant and secured by a deed of trust among other forms of security, which encumbers the leasehold interest of the tenant.
From a tenant’s perspective, there are advantages and disadvantages of employing a ground lease.
- Tax benefits. Rent payments made by the tenant are tax deductible.
- Reduced cost up front. Land acquisition costs are eliminated, freeing up the tenant’s capital for other areas of the project such as improvements or development.
- Immunity to market fluctuations. There is no risk to the tenant in terms of market value of the land on which their property sits.
- Reduced flexibility. The tenant may be subject to limitations and conditions over how they may develop or use the property in accordance with the lease.
- Increased long term cost. Depending on the duration of the lease, the tenant may pay more in rent over the long term than if they had purchased the land initially.
- Limited access to equity. The lease agreement may contain restrictions, limiting the ability of the tenant to draw on their equity for refinancing purposes.
The obligations of the landlord all but end once a ground lease agreement is in place. They are responsible only for any mortgage payments relevant to their fee interest as well as property taxes on the land.
The advantages and disadvantages of ground leases, from the standpoint of the landlord, include:
- Fee ownership. This constitutes absolute ownership of the land, and is particularly beneficial to those desiring long term investment opportunities or in a case such as family owned land.
- Limited control over land use. Depending on the terms of the agreement, the landlord may maintain some control over how the land is used.
- Land appreciation. If the improvements on the land are desirable, the landlord may benefit from its appreciated value.
- Financial risk. Should the landlord agree to fee subordination financing, they run the risk of foreclosure in the event that the tenant defaults on their financing.
- Taxable income. Any income generated through rent is subject to taxation.
- Undesirable development. The land may be developed in such a way that the landlord finds objectionable or results in a depreciation in land value.
Ground leases may present an attractive alternative for both land owners and developers in today’s market. It is imperative however, that both parties enter the agreement with a clear understanding of present and future concerns and requirements, to ensure a beneficial outcome for each.
For more information on ground leases, contact Douglas Commercial.