What is a Ground Lease?
A ground lease is a contractual agreement where a tenant is permitted to develop a piece of property during the lease period. Upon the lease’s expiration, the land along with any improvements is returned to the property owner.
Key Insights
- Development Opportunities: Tenants are allowed to develop land during the lease term.
- Long-term Leases: Typically spans 50 to 99 years, most commonly in commercial contexts.
- Financial Flexibility: Allows tenants who cannot afford to purchase land to construct property while providing landlords with a steady income.
How It Works: A Deeper Dive
A ground lease ensures that improvements on the property will transfer to the property owner unless exceptions exist. During the lease period, the tenant usually covers all related taxes. These agreements help landlords enhance property value at lease end, making such leases more lucrative than typical commercial rentals.
Leases Lilke No Other
While most commercial leases focus on providing a space for tenants’ businesses, ground leases enable tenants to take full development responsibility. These leases, which can extend up to a maximum of 99 years, diverge from standard lease practices concerning duration, developmental rights, and financial obligations.
Real-World Example: Giants in Ground Leasing
Ground leases are extensively used by notable franchises and large commercial entities. For instance, companies like McDonald’s, Starbucks, and Dunkin’ Donuts often operate on leased land where they build and use facilities. Macy’s, too, leases ground for its stores despite owning the buildings, accruing long-term lease liabilities amounting to billions.
Key components often included in these leases encompass:
- Terms and conditions
- Rights and responsibilities of landlords and tenants
- Financing provisions
- Use clauses
- Fee structures
- Title insurance
- Default clauses
Types of Ground Leases: Subordinated vs. Unsubordinated
Subordinated Ground Leases
In a subordinated ground lease, landlords take on a lower priority of claims on the property in case tenants default on improvement loans. This facilitates higher rent but comes with increased risk for landlords, who may negotiate higher rents.
Unsubordinated Ground Leases
Conversely, an unsubordinated ground lease means landlords retain top claim priority. While aiming to minimize risk, this scenario necessitates lower rent charges, potentially making loan professionals wary of extending mortgages for improvements.
Pros and Cons: Who Benefits and Who Doesn’t?
Tenant Benefits
- Prime Location Access: Tenants can establish a presence in key locations they couldn’t afford to buy.
- Capital Flexibility: No hefty down payment required, freeing up funds for other investments.
- Tax Deductions: Rent may be state and federally tax-deductible.
Landlord Benefits
- Consistent Income: Secure a recurring income while retaining ownership.
- Control: Ability to dictate land use and approve or deny development changes.
- Tax Efficiency: Avoid capital gains taxes, albeit rental income is taxed at ordinary rates.
Tenant Disadvantages
- Development Restrictions: Tenant requires landlord approval, leading to potential delays and additional costs.
- Higher Costs: Rents, taxes, crisis financing, as well as cumbersome legal fees may outweigh advantages of outright property ownership.
Landlord Disadvantages
- Loss of Control: Without stringent provisions, landlords may lose control over developmental modifications by tenants.
Key Concerns and Is a Ground Lease Worth It?
Drawbacks
Ground leases might result in property loss, lower income if no rent increases are pre-envisioned, and tax pitfalls like non-offset of income through depreciation.
Investment Worthiness
Ground leases may offer strategic advantages in location and investment alternatives but come with the caveat of developmental limitations imposed by landlords.
When a Ground Lease Expires
Upon expiration, a ground lease typically continues under the existing terms unless specified actions are undertaken to alter or terminate the agreement.
Summary
A ground lease empowers tenants to develop valuable properties during their lease, ultimately benefiting both parties via secure income and property development, thus rendering it a beneficial arrangement under the right circumstances.
Related Terms: Land Lease, Capital Gains, Landlord, Tenant.
References
- Contracts Counsel. “Ground Lease”.
- SeekingAlpha. “Macy’s: Evaluating The $3.25 Billion of Lease Liabilities”.
- U.S. Securities and Exchange Commission. “Macy’s, Inc. Reports Fourth Quarter and Full-Year 2022 Results”.
