Why Ground Lease When You Can Sell? Why Ground Lease When You Can Buy?

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A lease is a lease is a lease – or so you may think. Yes, real property leases grant an estate in land to a tenant for a period of time. And yes, the tenant pays for that right of possession. But the action in a lease isn’t in the conveyance provisions; it’s in the contract provisions. That’s right, a lease is a contract. Multiply out the rent and other annual monetary obligations by the length of the lease term (in years), and you’ll see that it might be (and often is) a big dollar contract. Even more important, unlike the vast majority of contracts whose obligations are satisfied in days or weeks, a lease contract goes unfulfilled for a long, long time. And that’s why drafting one requires a special talent and special experience. What’s special? — The ability to see long into the future.

If this special talent is needed for a common, space lease, it is more than doubly needed when preparing a ground lease. That’s because a typical ground lease has a life of 50, 75, “99,” and even 500 years. That takes it beyond the life of the parties involved in its creation, and the future brings surprises. Neither Nostradamus nor Jules Verne got everything right.

We have a great deal of interest in ground leasing but, today, we’ll be limiting our Ruminations to the following question: “Why a ground lease?”

If a tenant has to build its own building (as is often the case), and has all of the burdens of ownership, why would it lease a property knowing that at the end of the lease term it has nothing left to show for its money and efforts? There are a number of common reasons, principal among them being that the owner won’t sell the land and the tenant has no alternative. It may be just a stubborn love of the land or it might be shrewd estate planning.

Owning and actually operating a piece of real estate works well when done by a limited number of owners or decision makers. In the family context, that’s the first generation. As members of that generation die, their interests are divided, time and again, resulting in a lot of owners – and, a lot of different ideas about how the property should be developed. Contrast that with owning just the landlord’s interest in a ground lease. There are limited or no duties. All the ground landlord receives are periodic payments. Consequently, it doesn’t matter how many fractional owners there are; all that is needed is to make distributions of the income from the lease. There is no (or extremely limited) need to manage the asset.

Real property often carries a long-term unrealized gain, waiting to be taxed upon its sale. Not every landowner is interested in making further active real property investments, making a like kind exchange unappealing. So, selling undeveloped or underdeveloped land can result in a “tax discount.”

Ground leasing the same land keeps ownership in the family. At the owner’s death, because of the current estate tax “stepped up basis” arrangement, the built-in gain may never be taxed. At the same time, formerly inutile land, though appreciating in value, now brings income to its owner and, after death, to the next generations.

Sometimes, it is almost purely psychological – the owner wants to retain a sense of control.

Somewhat related, ground leasing may be seen by an owner as a way to develop a property without any further investment. Such an owner may treasure the “reversion,” the time when the originally vacant land “returns” to it, fully developed. Call it a form of delayed gratification. While there may be many a “slip ‘twixt the cup and the lip,” in a perfect or near-perfect world, someone else has developed the property while paying rent for the given number of years, and then you get it back.

It may also be that the tenant needs only part of a tract, and the government won’t allow a subdivision. That’s a common scenario. A bank wants to own the corner of a shopping center to house a branch location. The owner would sell, but absent unavailable governmental approvals, there is no separating the corner from the rest of the property. So, a ground lease is executed with a very, very long term. It could be 500 years (but not in every jurisdiction – pay attention to local law). All of the rent is paid up front, amounting to the equivalent of what would have been the purchase price. The bank is responsible for everything about the leased land and improvements thereon. And, the lease gives the bank the right to try to get a subdivision whenever it wants and, if successful, to buy the leased land for a nominal sum.

Governmental land is ripe for ground leasing. For one, approval of the sale of public land can make an official uncomfortable. Leasing is easier to explain. Also, when a public entity owns land, it can design financial incentives to motivate developers to undertake projects that might otherwise be unattractive. Ad valorem taxes can be replaced with PILOT (Payment in Lieu of Taxes) agreements, effectively granting a tax incentive to the ground tenant developer. By contract (i.e., the ground lease), the governmental landowner can control the developer’s project in ways that go beyond restrictions in land use laws without being guilty of spot zoning. And, unlike land use laws whose scope is limited by enabling legislation and a public adoption process, the provisions of a ground lease can be far more flexibly reached.

Very often, even if economically wise for a governmental entity to sell some land outright, it is either politically undoable or extremely cumbersome to do so. In some cases, it may take approval from a legislative body whose outlook differs from that of the proposed seller – a local governmental entity.

Non-profit, land owning entities, houses of worship for example, may also face legal barriers to an outright sale of even clearly surplus land or could face difficulty obtaining hierarchical approvals, if not from constituents. Some entities might need approval from the state’s attorney general. In some cases, the land was donated to the entity with a restriction on selling it. Ground leasing may not be similarly challenged.

Another reason for ground leasing is to facilitate government incentive financing. This is often done through the use of bonds such as “Industrial Development Bonds.” Such financing usually calls for the real property to be owned by the borrowing governmental or quasi-governmental agency, such as an “Industrial Development Corporation.” The agency has no interest in operating any project on that land, but, by reason of the financing structure, has to “own” the land. So, it is typical for the agency to then ground lease what it owns and to give the ground tenant a bargain-right to acquire the land (and its improvements) when the bonds have been fully paid (from the rent received by the land-owning governmental entity).

Even though most developers would like to own their project’s land to remove another party from the equation, there can be financial incentives to lease, rather than own, land. One way or another, there will always be a financing cost, whether in the form of interest or ground rent. The ground lease can be the most senior obligation in a development scheme, and the rent paid may be lower than the interest payable on an acquisition loan. At the same time, the ground tenant has no need to put its cash into land, a non-depreciable asset. On the flip side, because of the secure nature of the landlord’s interest in a ground lease (especially after construction has been completed), the rent can be thought of as bond-like income, an attractive holding for institutional investors. Ground rent can be structured to hedge against inflation and, ultimately, the ground landlord will own the improvements.

Craftspeople who construct real estate deals have tool boxes. Some boxes may contain only a few tools; some are overflowing. The good deal-builder knows that a hammer, a.k.a., a “sale,” may not be the right tool for a particular project. So, they, the good deal-builders, also have the “ground lease” tool in that box. They don’t need to use it all that often, but when the right project comes along, it is like using the perfect size spanner.

Readers are invited to supplement today’s posting with their own examples of when a ground lease is the perfect size spanner. Just “Leave a Reply” below (at the bottom of this page).

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Comments

  1. Thanks. This is excellent.

    I’ve posted a link to your article on my blog.

    http://legaltowns.wordpress.com

  2. Financing a ground lease, in which the lender’s mortgage (or deed of trust) is not secured by the typical fee interest in the real property but rather by the borrower’s leasehold interest therein, is a notoriously difficult challenge. In your scenario, the same bank which finances its own construction of improvements would not be so kind to third party borrowers.

    • Dan Hertz says:

      I’ve been involved in a few transactions where the landlord agreed to subordinate its income stream (never it’s fee interest in the land!) to the lessee’s financing. This has proven helpful in securing financing. On another point, if the lessee’s income doesn’t live up to pro-forma expectations, both parties may find it advantageous to renegotiate the terms of the ground lease.

  3. Excellent thought out article. I too will be posting a link in my next Cirex News & Views email blast! Thank you for posting…got the wheels turning on a whole new venue of revenue stream.

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