Leasing the ground. Sounds a little strange, right?
As it turns out, ground leases are becoming an increasingly popular option for commercial real estate (CRE) developers. For CRE lenders, that means it’s important to understand how ground leases work, and how they can impact a project’s financing.
In this article, we cover the information and tips CRE lenders need to know about ground leases, including:
A ground lease, also known as a land lease, is basically what its name suggests. Rather than purchasing the land outright, a ground lease allows a developer or other interested party (also known as the lessee or tenant) to lease the rights to a piece of land, while the land’s owner (also known as the lessor or landlord) retains the ownership interest. Similar to any other lease, the lessee is obligated to pay a recurring fee for the right to use the land, and is restricted by certain guidelines outlined in the lease.
Since most ground leases are created with the intention of pursuing a new development, they are typically long-term leases that can range anywhere from 10 to 20 years to upwards of 99 years. Once the lease term is over, the lessor regains control over the land and will own anything constructed on it.
Typically the lessor of a ground lease is an institution or group that plans to be around long enough to see the end of the lease, such as state institutions, government entities and religious organizations. However, there is nothing restricting an individual from leasing their land if they choose.
One way to think of a ground lease is that it’s a form of interest-only debt. The lessee is typically not obligated to make a down payment like they would if they purchased the land outright, and since no principal payments are being made the lessee will not own the property at the end of the term.
Lending on a project involving a ground lease is a potentially profitable endeavor for CRE lenders, but there are a few differences and potential risks compared to traditional lending that lenders should keep in mind. We’ve outlined four tips for navigating those differences and risks below.
Unlike a typical development loan that would use the borrower’s ownership in the land as collateral, a loan involving a ground lease uses the ground lease itself as collateral. Because of this, lenders need to understand the difference between an unsubordinated and subordinated ground lease.
In an unsubordinated ground lease, the lender is not allowed to foreclose on the land itself in the event of default by the borrower because the landowner maintains a superior position. This means the only recourse available to the lender is to attempt to take ownership of any improvements performed by the borrower. If the borrower has not performed any improvements or the improvements are not completed, the lender could be stuck with an asset of little to no value. As you might guess, an unsubordinated ground lease is not an ideal situation from the lender’s perspective.
On the other hand, a subordinated ground lease puts the lender in a superior position to the landowner and allows the lender to foreclose on both the improvements and the land itself in the event of the borrower’s default. This puts the lender in an ideal position, giving them a higher level of recourse and lessening the reliance on the borrower’s improvements. Although the landowner would prefer an unsubordinated lease, a subordinated lease is the best option for the lender.
If a lender wishes to make a loan on a project involving a ground lease, they should ask that it be subordinated, if possible. While loans could still be made with an unsubordinated ground lease in place, it puts the lender at a disadvantage and creates a higher level of risk.
As with any lending decision, lenders should thoroughly review the provisions outlined in the ground lease prior to lending any money to the borrower.
Are there any restrictions on the type of property that can be constructed? Are there size limitations? Does the borrower have to meet certain construction timelines? Once the property is built, who has the final say on setting the rental rate and selecting tenants?
The answers to these questions and others like them will all be outlined in the ground lease documents. It is vital that the lender understand the answers to these questions and their impact on the overall risk of the project.
As mentioned earlier, the primary form of collateral available in a transaction involving a ground lease is the lease itself. Because of this, lenders should make every effort to limit the potential for the ground lease to be changed or terminated.
One of the biggest risks when lending on a project secured by a ground lease is the borrower defaulting on the lease. If a ground lease is written heavily in favor of the lessor, this situation could lead to the lessor terminating the ground lease and leaving the lender with no recourse.
Luckily, there are ways for the lender to avoid this worst-case scenario.
Prior to executing the loan, the lender should require that the lessor provide them with written notice if the borrower defaults on their lease payments. In addition, the lease should give the lender the ability to correct the default themselves. By doing this, the lender will have the advanced notice and power necessary to keep the ground lease from being terminated, even if the borrower defaults.
Aside from being protected against a complete default, lenders should also require that the ground list limits or completely restricts the potential for future changes to the lease terms. If changes are to be made, the lender should be the party to approve those changes. Doing so will decrease the risk of a future change negatively impacting the lender.
Lastly, it’s not enough for lenders to understand ground leases solely from their own perspective. To truly become proficient at closing deals with ground leases involved, lenders also need to see them through the eyes of the borrower.
For example, say a developer is planning to pursue a $100 million office project and wants to construct the building on prime parcel of land in a downtown area. The developer can either purchase the land for $10 million, or sign a ground lease with the landowner with a payment of $100,000 per year.
If the developer opts to purchase the land outright without using financing, they will need to pay $10 million in equity. This will reduce the amount of equity they have available to pursue the actual development, which is the ultimate goal of the investment. This scenario also assumes the land is available for purchase to begin with, which isn’t always the case.
Alternatively, the developer could sign a ground lease for the land, which would likely require no down payment and allow the developer to retain $10 million of equity to contribute towards the development of the office building. Not only does this scenario reduce the amount of equity the developer needs to raise, but it could also increase the percentage return on investment for the project since there will be less equity involved. In some situations, the developer could even receive additional financial benefit by deducting the ground lease payments from their tax obligations.
While this scenario is oversimplified, it’s a good example of how and why a ground lease makes sense to developers in some situations. Lenders who are able to understand the financial implications of a ground lease from the borrower’s perspective will be better equipped to make lending decisions when a ground lease is involved.
We hope this article gave you a good understanding of what a ground lease is and how CRE lenders should navigate ground leases in their lending decisions. Though they may add an additional level of complexity, ground leases are becoming increasingly popular and could present lenders with additional lending opportunities.
If you’d like to learn more about the CRE lending industry, check out our blog for great articles that cover a number of lending topics.