Chapter 17 | Ground Leases as a Source of Finance

Overview

A ground lease is a special case when the owner of a building does not have a fee simple interest in the land. Rather, the building owner leases the land from a third party landowner. A ground lease is similar to a mortgage, as both have fixed payment streams that have priority over equity claimants, and failure to pay causes a contractual default that triggers specific remedies.

Summary

Ground leases generally specify that the landowner (the lessor) receives any structures remaining on the land at the end of the lease. That is why ground leases typically have very long terms (e.g., 99 years). Ground leases tend to be renegotiated every 10-20 years, because as the expiration date approaches, the landowner may have little incentive to extend the lease.

An advantage of the ground lease structure to the building owner is the ground rent payment is tax-deductible, while owning the land provides no tax shelter via depreciation.

It is somewhat complicated to value a building that is subject to a ground lease. When doing so, the discount rate used on the ground lease payments should be lower than the discount rate for the fee simple ownership structure, as the landowner owns a priority portion of the property’s cash stream. Therefore, the landowner’s expected rental stream has much less risk than the property under a fee simple structure. Remember that you have to pay your ground lease or lose your building!

Lenders may demand that the landowner agrees to subordinate their ground lease claim to the mortgage holder. This subordination means that the landowner accepts a lower position in terms of rights to the collateral and the cash flows throughout the life of the loan. Subordinating their land means that if you default on your mortgage, the lender not only has recourse to your building but also to the landowner’s land to satisfy their mortgage claim. Such a mortgage proposal might be acceptable to both the borrower and the lender, but landowners typically have a difficult time agreeing to such provisions.

In the end, when ownership of the land and the building are split, it is hard to make everyone happy. That is why the ground lease structure is relatively rare and usually inefficient.

Questions

These are the types of questions you’ll be able to answer after studying the full chapter.

1. What is a ground lease?

2. What is one distinct advantage of a ground lease in the U.S.?

3. If properties trade at an 8% cap rate in the market and forward year NOI is $10M, what is the property worth? If the property is on a 99-year ground lease requiring payments of $2M per year, what is the building worth?

Audio Interview

Why some investors won’t touch a property with a ground lease (7:03)

Excel Figures

Download Excel

Key Terms

To view the definition, click or press on the term. Repeat to hide the definition.

The outright purchase of both a building and the land on which it sits.

An agreement in which one is permitted to own a building on a separate landowner’s parcel for a finite lease period, at the end of which all improvements on the land become the property of the landowner.

Chapter Headings

  • Valuation of an Operating Asset Subject to Ground Lease
  • Method #1: Ground Lease Payment DCF
  • Method #2: Ground Lease Payment Capitalization
  • Method #3: Building Net Operating Income DCF
  • Method #4: Building NOI Capitalization
  • Financing of a Property Subject to a Ground Lease

More on this subject

The Top Quarterly Publication for Commercial Real Estate Investors

 

 

Excel for Real Estate Certification

 

 

Bisnow / Linneman Education Videos

 

 

Investment Strategy Specialists

 

Looking for investment analysis software?

valuate app logo