How ground leases work

On Behalf of | Jul 20, 2022 | Firm News

A ground lease is a long-term (typically 50 to 99 years) lease between a tenant and the property owner. During the lease period, the tenant develops the property by putting a building on it or making other improvements. At the end of the ground lease, also known as a land lease, the property and all the upgrades are turned back over to the property owner unless the contract indicates a different arrangement. The owner is free to sell or lease the improved property at the end of the lease or allow the lessee to renew the agreement.

Along with the lengthy duration, the other unique characteristic is that the renter holding the lease is responsible for all relevant taxes, and tenants assume all expenses related to the land, including the cost of construction, renovations, improvements, repairs, insurance, and financing related to the land.

Who uses them?

Ground leases are typically used for commercial spaces. Still, they differ from the typical commercial leases used in shopping malls or office buildings, which are more like a rental (leases are monthly or yearly) and still have an active landlord to maintain, update and alter the property for the tenant.

Who are the owners?

Big box stores, franchises and corporate entities often use ground leases. Rather than renting a space, the land for MacDonald’s or Starbucks land may be purchased by the corporate entity selling the lease to the franchisee. Then they will lease the land to a developer or tenant to construct a building and use it. These pieces of land could be adjacent to an Interstate 5 exit or in the heart of downtown Portland. The owner could also be a municipality renting public lands or the U.S. Forest Service allowing a ski area to be built.

99-year leases are better

This is generally the most extended lease term for real estate because that was the longest possible period under common law, but that is no longer true. Nevertheless, 99 years remains the norm for developers and property owners negotiating ground leases. Generally, there is no good reason not to make it any shorter than 99 years, and leases even longer than 99 years are considered better.

Regardless of the length of the lease, the tenant will likely want to renew the lease, but renewals are complicated — the issue is that the tenant doesn’t just have a new contract drafted. The amount of money involved generally dictates that they need to finance the lease purchase. Then an appraiser determines the value of the ground lease. A lender then may finance the purchase. This process should start up to 20 years before the end of the lease just to ensure that the deal gets done.

As the term nears its end, the value of the lease goes down. This is because the increasingly limited period left makes the ground decreasingly valuable. However, this may be counter-balanced by the increased value of the building sitting on the property, although that is not a given. If the tenant fails to renew the agreement or botches the renewal, the landowner may enjoy an unexpected windfall.

Why lease the land to someone else?

The landowner typically sees the ground lease as a way to retain ownership of the land and generate income or revenue while avoiding capital gains.

What goes in a lease?

The right lease will reflect the unique elements of the property, but some general fundamentals include:

  • Terms of the lease, 99 years or otherwise
  • Fees
  • Usage provisions
  • Rights of the landlord
  • Rights of the tenant
  • Title insurance requirements
  • ·     What happens if someone defaults

Subordinated vs. unsubordinated ground leases

Ground lease tenants typically take on debt to pay the lease. In a subordinated lease, the landlord agrees that they have a lower priority of claims than the bank that loaned the tenant money to build the property. The subordinate lease allows the tenant to use the lease to act as collateral if the tenant defaults. In assuming this risk and relinquishing their right, the landlord may negotiate a more lucrative lease amount. This still benefits the landlord because improvements to the property will likely increase its value.

Conversely, an unsubordinated ground lease makes the landowner the top priority if the tenant defaults on a loan for improvements. While this benefits the landlord in one way, the tenant may have difficulty securing a loan from a lender. The landlord would likely need to charge lower fees for the lease because it is less advantageous.

A fruitful relationship

The right ground lease benefits the tenant and the landowner. The benefits for the tenant include:

  • The renter can build on prime real estate that may not otherwise be available.
  • Those high-profile properties can be flagships for the retailer or business’s brand.
  • Unlike a mortgage loan, a ground lease does not require a down payment, which means the tenant needs less equity upfront.
  • Fees or rents may be tax deductible for the state and IRS, so the tenant pays lower taxes.

The benefits for the landlord include:

  • They received a steady income while maintaining ownership of the property.
  • Some clauses include guaranteed raises in rates.
  • There may be eviction rights, which can protect them if the tenant defaults on rent.
  •  A landlord approval clause in the lease enables the owner to approve or veto changes to the property.

There are disadvantages

There are certain risks for each side as well. For the lessors, it can involve:

  • Rental income can mean more taxes unless tax breaks offset these in the agreement.
  • These leases involve considerably less control over the property.
  • The lower priority of a subordinated lease could lead to the owner losing the land through no fault of their own.
  • Most businesses fail after a certain period, so the long contract increases the likelihood of default.

Potential problems for lessees to consider

Renters need to weigh the cons before signing a ground lease. Concerns typically include:

  • The lessee must still answer on some level to the landlord even when they are paying for all the property improvements.
  • That escalation clause may not accurately predict trends in the real estate market, and the fees may get prohibitively high as time passes.
  •  Lessees are responsible for managing the property, which can be a large and expensive proposition.
  • It depends upon the contract, but there is a risk of eviction from what the tenant considers their property.

Experienced guidance is essential

The unique nature and lengthy terms mean that landowners and lessees must be very careful before signing the agreement. An attorney with experience handling these issues will be vitally important in ensuring that the deal is fair and equitable for their client while also setting up the other party for success – ground leases only work well when it works for both sides.

Legal guidance from a professional also better ensures that the agreements are legally binding. If there is a dispute over the terms later, the lawyer can also help find a solution or handle litigation in court.