Pros and cons of a ground lease

The advantages and disadvantages of a ground lease.

This article was written by our asset management expert, Noah Shaffer. Please visit here to learn more about how NNN asset management services can help protect your investment.

Ground leases with national tenants.

Ground leases have become a common occurrence in the single-tenant net lease industry, with tenants such as 7-Eleven, Wawa, AutoZone, Chase Bank, and Burger King utilizing this structure on a significant portion of their newly constructed buildings. 

Tenants prefer the ground lease structure, because they are able to recognize the financial benefit from depreciating the cost of the building, without having to tie up a significant amount of capital in land. 

Cons of the ground lease structure for landlords.

Lower yield than NNN and NN properties when purchased in the market.

The most apparent detriment to landlords is a lower cap rate. Ground leases on new construction Wawas, for example, range from 4.5% to 4.85% in the open market. 

There is limited ability to improve the yield utilizing debt and tax incentives, so the purchase cap rate is close to the actual return.

Limited control over improvements.

Landlords have limited involvement with remodels and renovations which allows for passive ownership. However, the removal of the landlord from the construction process may leave them susceptible to the placement of liens on the property.

Landlords are required to grant Notice of Commencement approval, but are rarely given a Notice of Termination signaling the completion of construction and that the contractor has waived all liens. 

It is, therefore, important to check municipal records or request the Notice of Termination from the tenant within a reasonable timeframe following the completion of the project.

Landlords should request detailed renovation plans, contractor information, and budgets for the project prior to granting the requested Notice of Commencement. This information will be valuable when negotiating lease extensions at a later date.

No ability to depreciate building improvements.

The inability to depreciate improvements of the land limits the common real estate tax incentives to the interest expense deduction. 

Benefits of the ground lease structure for landlords.

Lower cost to develop, land improvement costs or land cost only, no construction costs.

Ground leases allow land owners to recognize significant income from their property without enormous capital expenditures and construction knowledge, both of which are required for build-to-suit projects. Some tenants may require the land owner to conduct site improvements, but this is a negotiable aspect of the lease and is easily managed.

Lower rent to market on new developments.

The ground rent paid by tenants is significantly lower than the rent paid on build-to-suit properties. This allows the landlord to purchase a property with a rent per square foot that is more in line with market rents. Lower rent levels significantly reduce the ability for tenants to request a rent reduction in exchange for the exercise of their options, or landlords having to reduce their rent to find a replacement tenant should the current tenant leave.

Receive building at end of the lease without paying to build.

As the fee simple owner in the land you are entitled to the possession of the building at the end of the lease, despite not paying for building improvements. Tenants may include a lease clause permitting them to demolish the building at the end of the lease term. This clause is rarely exercised.

Land is in limited supply, buildings can be rebuilt.

Ground leases are common in prime locations such as Manhattan, London, and Hawaii. While buildings often depreciate in value, land in strong locations often appreciates in value. 

Land value appreciation combined with rental growth allows for a higher return on investment than the cap rate of ground lease properties indicates. Special care and due diligence should be conducted to analyze land value appreciation in the local market over the past two decades, and when projecting land value appreciation over the ownership of the property.

Photo by Martin Sanchez on Unsplash

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