A ground lease grants a tenant the right to use and occupy land. These have become increasingly common. If appropriately constructed, they create a win-win scenario providing the fee owner with a predictable cash flow and unencumbered reversionary rights, and provides a tenant with a secured location, reduced capital expenses and improved after tax cash flow.
Ground rents are being employed across the risk spectrum and the prices and investment objectives associated with them will vary dramatically.
In a ground lease, the fee owner is acquiring the cash flow (ground rent) and the value of the reversion (reversionary rights) at the termination of the leasehold. Ground leases and other triple net leases have grown in appeal as 1031 exchanges have become a primary tool in the commercial real estate market. Owners of management intensive properties have opted – through an exchange – to acquire triple net lease fee interests, where the headaches associated with ownership rest almost exclusively with the tenant. The growth of ground leases has also been perpetuated by property owners, recognizing the scarcity of quality commercial sites and opting to maintain ownership while deriving some monetary benefit from the land.
Several primary factors that influence the value of a ground lease are the (1) the investor’s motivation; (2) general long-term appeal of the location and site; (3) the designated use: (4) credit quality of the tenant: (5) strength of industry: and (6) strength of business model: and, (7) the scope of the proposed improvements and their conformance to industry standards. Once these factors have been incorporated into a risk analysis, the ground lease is reviewed and therein lies a number of additional elements that can materially influence value and the associated capitalization (cap) rate.
Some terms of a ground lease which influence the value of the fee interest include the (1) lease terms – most are triple net; (2) amount of the rent, (3) the length of the lease with options, (4) the timing of rent increases, (5) whether a subordination clause is in force, (6) the language if present – pertaining to a reappraisal clause, and (7) whether any language in the lease adversely affects the reversionary interests of the fee owner. This list is not intended to be all inclusive or to minimize the potential complexity of a ground lease, but it serves to point out the major elements that have to be considered in either valuing a ground lease or extracting reliable units of comparison from a sale of a ground lease.
A quick look at a sale or listing of a ground lease will indicate a going in land rate and investors and analysts often focus on these land rates in their initial discussions. The length of the lease often advantages the leasehold and disadvantages the leased fee interest: a longer lease allows the leasehold interest to amortize their capital investment over a longer period and places them in a better position to secure financing. To what may be the detriment of the fee owner, a longer lease also defers the receipt of the property reversion. The length of the lease coupled with the timing of the rent increases may significantly alter the IRR to the investment: a ground rent with a going in cap rate of 7.5% could produce a significantly different return – dependent upon the variability of the cash flow over the term of the lease.
The contribution of the improvements to the value of the reversion is dependent upon the length of the lease, the physical life of the improvements and the functionality of the improvements for alternative use . Where leasehold interests involve “branded” buildings the adaptability of these buildings to other appropriate uses for the site may be limited or, or in fact, may pose a liability at the termination of the lease.
A subordination clause may effectively transform the fee owner into a junior lien holder of the leasehold interest and dramatically advantage the leasehold interest. If a land lease is subordinated to the leasehold interest, a creditor of the leasehold interest, under certain conditions, could effectively wipe out the equity to the ground lease in the event of a default on the part of the leasehold. Clearly under these conditions (subordinated) the required return to the ground lease position will be higher than under conditions where this risk exposure does not exist.
A reappraisal provision could create a condition where the amount of the ground rent could change during the term of the lease and has the potential to adversely affect either the fee owner or the leasehold. A reappraisal clause can be significantly alter the risk relationship between the fee owner and the leasehold interest.
The generally accepted method of comparing investments and extracting their implied going- in cap rates – where the comparables have divergent and variable escalation clauses is to convert the variable income into a “level-equivalent income” and impute cap rates based on the sale price of the asset and the revised (level-equivalent) NOI. This same methodology is appropriate for any triple net lease (ground, leased fee or leasehold) or any variable cash flow.
Residual techniques and rate relationships are also helpful. Where the fee owner has unencumbered reversionary rights, a cap rate applicable to the land (land rate) will typically b e lower than a cap rate applicable to the leasehold interest (building rate): and where this relationship exists, the land rate will implicitly be lower than the rate applicable to the leased fee interest (overall cap rate). Overall cap rates applicable to leased fee estates are usually more transparent and more readily available in the course of market research.
However, contractual elements may alter this relationship. As indicated a subordination clause makes the claims of one party subordinate to another. Where a fee owner subordinates its interest to a leasehold interest, it may create a situation where – based on the allocation of risk – the building rate is lower than the land rate.