A ground lease is a long-term net lease of land including any improvements on the land, usually lasting 49 or 99 years. Development sites, office buildings and larger multifamily buildings are most often ground leased, however other assets can be subject to a ground lease as well.
Advantages for Property Owners:
Retain ownership of the property and benefit from passive income.
No responsibility for capital gains or transfer tax incurred if sold instead of ground leased (although there are instances where transfer taxes might be incurred).
Ground leased properties may be mortgaged.
Ground leased properties can be sold.
The ground lessee is responsible for all of the management, costs, and expenses of the property.
The ground lessee will improve the property by making capital improvements to the existing structure or in the case of a development site, they will be constructing a new building.
Many ground leases contain a clause (reversionary clause) which transfers any improvements made by the tenant to the landlord at the end of the lease.
Advantages for Ground lessees:
Tenant’s basis is significantly reduced as the tenant does not need to provide the upfront capital to purchase the property.
If an owner is unwilling to sell his property, this gives the tenant/investor a way to utilize this asset in a way that can benefit both parties.
The tenant can mortgage the lease, however, any financing obtained will not be against the leased asset.
Choosing the Right Tenant for Your Ground Lease
Ground leases are an effective tool that property owners can use to maximize the upside potential of their asset without the expenses associated with transferring ownership of the property through a conventional sale. In general, a ground lease (master lease) is a long-term net lease (usually 49 years or 99 years) of land including any improvements (if any) on the said land. Once a landlord decides to ground lease their property they must pick the right ground tenant to partner with. Unfortunately, often times owners choose a ground tenant based solely on receiving the highest offer for their property. This should not be the only factor to take into consideration, landlords must properly vet any prospective ground tenant and should take the following points into consideration.
What is the ground tenant’s transaction history, have they done a ground lease in the past?
Ground leases are known to be very complex transactions and are in many ways like a partnership. It is crucial to choose a sophisticated and experienced ground tenant to successfully negotiate the terms of the lease. Working with a ground tenant that has past experiences with ground leases can provide the owner with comfort and guidance through the complex lease negotiations. Furthermore, experienced ground tenants can provide tax efficient structures to help save the landlord money. An example of this is compounding/deferring the taxes associated with an upfront payment made by the tenant.
What type of work is the ground tenant guaranteeing?
Unlike a standard office or retail lease, obtaining a personal guaranty and/or security deposit from a ground tenant are not common practice on ground leases. However, a personal guaranty from the ground tenant to complete certain capital improvements on the property within a specific timeframe provides the landlord with security. All such work should be outlined in an itemized “Scope of Work” that should be attached as an exhibit to the lease. Furthermore, the more money a tenant spends the more “skin in the game” they have. It is important to note that the amount of money that the ground tenant should spend depends on the condition of the property and the type of property.
Has the ground tenant ever defaulted on a ground lease?
A prior default on a ground lease does not necessarily mean that you should not pick that ground tenant. It is more important to find out the reasons for defaulting and how many times they have defaulted. Multiple defaults or defaulting due to overleveraging or inexperience should be considered red flags.
How many years has the ground tenant been in business?
Due to the cyclical nature of the real estate market, it is important to pick a ground tenant who has proper experience. However, this should not rule out new companies whose principals have ground leasing experience in their repertoire.
Has the ground tenant completed similar projects that you can tour/visit?
Ground leases can be made on all different property types including but not limited to: vacant land, industrial properties, office buildings, residential buildings, and hotels. Therefore, it is important to pick a ground lessee who specializes in the same asset class as your property. It is also helpful to visit and tour the prospective ground lessee’s projects in an effort to get a better idea of their craftsmanship and expertise in their execution.