What is a ground lease?
USQ Ground Leases
New York, NY
A ground lease represents the contractual relationship between an owner of land and the entity entitled to the use of that land.
Typically, the land is leased on a long-term basis by the landlord to a tenant that operates the property. Ground leases are usually triple net (NNN), whereby the tenant is responsible for all expenses related to the premises (for example, property taxes, maintenance costs, and insurance premiums).
Bifurcation — the process of selling the underlying land, and leasing said land back under a ground lease — provides investors or developers access to low-cost capital, while reducing their reliance on other, more expensive financing sources. Whether investors are buying, selling, recapitalizing assets, or in need of liquidity, bifurcation can be an accretive capital solution.
Brief history of ground leases
The concept of a ground lease can be traced back to feudal times when land was held by the ruling class. During this period, nobles would grant land to villagers in exchange for various obligations such as military service or livestock. These arrangements established the basis for the tenant-landlord relationship and laid the foundation for the notion of a ground lease.
The Industrial Revolution brought about significant changes in property usage and ownership. As urban areas expanded, the demand for land grew exponentially. Ground leases gained further popularity in the 20th century in cities like New York where rapid growth coincided with limited land availability. Ground leases provided landowners a way to retain ownership of their land while granting developers access to prime markets at a reduced upfront cost, facilitating the development of key infrastructure and skyscrapers.
Like debt and equity, land and buildings are fundamentally different investments and should be capitalized accordingly. A bifurcated financing structure allows all parties to invest in assets that better match their preferred risk, maturity, and return targets, potentially resulting in lower funding costs and higher risk-adjusted returns.
Traditional ground lease vs. modern ground lease
At USQ, we believe that landlords under a ground lease should be focused on the stable, bond-like cashflow derived from ground rent — not in taking control of the leasehold interest.
Traditional ground leases often contain periodic resets every 10 to 30 years to bring ground rent up to fair market value and/or in line with other reference indices. These periodic resets can be highly disruptive to the tenant, as they often involve sudden and substantial ground rent increases. In the case of the Chrysler Building, ground rent increased by over 300%, from ~$7.5M a year in 2018 to ~$32.5M a year in 2019, contributing to a substantial loss to the building owner upon sale.
In the case of a modern ground lease, large, infrequent resets are discarded in favor of smaller, more predictable annual or bi-annual rent steps, allowing tenants to more accurately underwrite ground rent expense by eliminating the potential for an unexpected surge in ground rent.
In a traditional ground lease, the tenant is granted the right to the use of the property for a pre-defined period, typically 50 to 99 years. Upon expiry, the leasehold interest reverts to the landlord and the tenant loses all rights to use and/or operate the premises.
During early lease years, the fact that the improvements must one day be surrendered to a third party has limited impact on leasehold value. However, as lease expiry approaches, the impact on leasehold value becomes dramatic. This value degradation is compounded by the fact that obtaining market-rate financing becomes increasingly difficult as the remaining ground lease term decreases below 30-40 years, and leasehold owners become disincentivized to invest capital in maintaining the property, as they must turn over the keys to the landlord upon lease expiry.
Modern ground leases grant tenants the right to extend the lease term, substantially mitigating the value impairment caused by traditional ground leases.
Traditional ground leases do not typically contain purchase options that allow leasehold owners to repurchase the fee interest; once bifurcation is complete, the leasehold owner will never have the right to recombine the two estates and will be forced to face the erosion of leasehold value.
Modern ground leases contain purchase options that allow a leasehold owner to, on certain pre-determined dates, re-acquire the fee interest and recombine the two estates, giving the leasehold owner additional flexibility (for example, on an exit, the leasehold owner may offer both the fee simple interest and leasehold interest for sale, and elect the option that provides it with higher overall proceeds).
Traditional ground leases are sized inconsistently and inefficiently — sometimes resulting in a significant amount of untapped value (i.e., where ground rent is sized too conservatively), or the leasehold owner losing the asset prematurely (i.e., where ground rent is sized too aggressively).
Modern ground leases are sized with the intention of maximizing the benefit that property owners realize from selling the land today, while maintaining the long-term sustainability of the leasehold position. This helps to preserve the liquidity of the leasehold position long-term, and preserves leasehold owner’s ability to obtain additional financing on the leasehold position if so desired.
Advantages of a modern ground lease
A properly sized and structured modern ground lease can unlock previously dormant value, increase liquidity, and improve investment returns for property owners. A ground lease can be a highly accretive capital solution for investors buying assets, selling assets, recapitalizing assets, or in need of liquidity.
Choosing a ground lease partner
Most ground lease providers fail to resolve the fundamental conflict of interest that prevents many investors from considering bifurcation: a finite, 99-year lease term — after which the ground lessor takes over the improvements — is guaranteed to erode leasehold value over time.
The distinctive approach of the USQ Ground Lease addresses this and other historical flaws found in legacy contracts, providing our partners with a uniquely leasehold-friendly ground lease structure. The USQ Ground Lease includes predictable rent growth, as well as evergreen extension options that allow our partners to continuously reset the remaining lease term to 99 years.
An affiliate of Chatham Financial, USQ is a privately-owned firm focused on direct real estate acquisitions in leading markets. Our platform is the result of unique expertise and experience across fixed income and real estate.
Think a modern ground lease is right for your CRE property?
Schedule a meeting with one of our experts.
This material is not intended to be relied upon as a forecast or investment advice, and is not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy. It is being provided merely for illustrative and educational purposes and to provide a framework to assist in the implementation of an investor’s own analysis and an investor’s own view on the topic discussed herein.
The information and opinions expressed are as of the date indicated, and may change as subsequent conditions vary. The information and opinions contained in this material are derived from proprietary and nonproprietary sources deemed by USQ to be reliable, but are not all inclusive and are not guaranteed as to accuracy. As such, no warranty of accuracy or reliability is given and no responsibility arising in any other way for errors and omissions is accepted by USQ, its officers, employees, affiliates or agents. Reliance upon information in this material is at the sole discretion of the reader.
Investment involves risk including possible loss of principal. Diversification and asset allocation may not protect against market risk or loss of principal. Past performance is not a guarantee of future results.
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