Considering setting up a ground lease for your real estate? We have summarized a few details about it for you.
In this article:
Know More About Ground Lease
Ground Lease Definition
A ground lease or a ground rent is a type of commercial real estate lease where a lessee develops the real estate property he or she is renting.
Like an ordinary lease, there are two parties involved – the lender or the landlord/real property owner, and the lessee or the tenant.
The lessee is required to pay rent to the landlord on a periodic basis. The landlord can also evict the lessee in case of non-payment.
Ground lease has been a staple in commercial real estate investment financing.
It enables a lender to build a business on a well-located land that cannot be purchased. Different huge businesses like McDonalds and Starbucks take advantage of a ground lease to be able to expand in strategic locations.
This type of leasehold agreement also helps both the lender and the tenant save on real estate taxes. Land purchase requires higher real estate taxes and other expenses compared to a lease agreement.
Unlike a usual land purchase, upfront cash payments are not needed. This may lower the required upfront equity in financing the investment.
As a result, the tenant could free more cash that they can then use for another investment. Also, the landlord would receive a steady income stream from rent payments while retaining the ownership of the real property.
A land lease agreement has premises for escalation and eviction rights, as well.
These premises may legally allow the lender the following:
a. Ownership of the improvements on the leased land once the lease term is done
b. Increases in the rent fee over time
c. Additional protection in case the lessee defaults
Types of Ground Lease
There are two main types of a ground lease agreement – subordinated and unsubordinated ground lease. The main differences between the two are in relation to the tenant’s loan financing on real estate property improvements.
One example of such real estate property improvement is land development.
Typically, a tenant would also borrow money to finance the construction for the improvements on the leased land. As a result, the tenant may partner up with a land developer for a construction loan.
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Subordinated Ground Lease
In a subordinated ground lease, the landlord agrees that the title of the property will be used as a leasehold mortgage for the tenant’s loan on property improvements.
For the tenant, this may be beneficial. Having the property as a leasehold mortgage increases the tenant’s chances in obtaining a construction loan. And, this may give the tenant better terms on the loan, as well.
For the landlord, this may be risky. In case the lessee defaults on the construction loan, the land improvement loan may result to foreclosure and the landowner may lose the title to the commercial real estate property itself.
Since this type of leasehold is risky, the landlord may demand for rent fee increases for the land lease. Also, the landlord may impose stricter control on lease transactions with the tenant.
Unsubordinated Ground Lease
On the other hand, in an unsubordinated ground lease, the landowner does not allow the property to be used as a leasehold mortgage. This puts the landowner in a safer position since there is no risk to any foreclosure.
In case the tenant defaults on the construction loan, the ownership to the land improvement may go to the landowner. This may be beneficial to the landowner, since such land improvement may increase the leasehold’s fair market value.
Also, since this type of leasehold is less risky, the landowner may grant a lower rental fee.
Setting Ground Lease Payments
One challenge the real property lender may face is setting the most optimal rent fees. The lender, as the property owner, may face a huge probability of default if the price is too high.
The lender may peg the rental fees on the fair market value of the rent of similar properties. And then, he or she may give annual rent increases due to inflation.
The lender may also opt to have a fixed percentage increase periodically. Another common option the lender may do is to reset the rent costs every 10 to 20 years.
The lender may grant rent payment deferral to the lessee as leasehold mortgage financing aid during the initial stage of the property development.
Setting up a ground lease contract may seem too complicated. Both the property owner and the lessee may need to involve different professionals, but given the numerous benefits of a ground lease, it may be the best solution for your real estate needs.
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