What is a ground lease?

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.

Capital efficiency

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.

Rent steps

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.

Lease term

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.

Purchase options

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).

Sizing

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.