Ground leases are a unique and complex form of real estate transaction that offer distinct advantages and challenges for both landlords and tenants. Unlike traditional leases that involve the short-term leasing of land and improvements requiring initial upfront investment from the landlord – and unlike purchases requiring a complete divestment of the property and a high upfront purchase price from a buyer – a ground lease blends these two legal structures to form a unique relationship that provides long-term income and certainty for landlords, as well as long-term flexibility and stability for tenants. A ground lease is the long-term leasing of land only, with the tenant typically constructing and owning the improvements on the property, such as multifamily apartment buildings, office buildings, retail developments, college campuses, power plants, data centers, hospitals, museums, restaurant franchises and industrial warehouse and distribution projects.
This Holland & Knight blog post delves into the fundamental concepts, benefits and considerations of ground leases and aims to provide a comprehensive overview of this unique legal structure.
What Is a Ground Lease?
Generally, a ground lease is a highly negotiated lease agreement where the tenant leases the land from the landlord and constructs a new building or improvements on the land at the tenant's sole cost and expense. An essential aspect of ground leases for financing, liability and tax purposes is that the ownership of the improvements by the tenant is legally separate from the ownership of the land by the landlord. Ground leases usually have long terms, often ranging from 50 years to 99 years, allowing the tenant to recoup the cost of the improvements. Ground leases are generally structured as a true triple net lease (NNN), meaning the tenant is responsible for all expenses related to the property and its improvements, including maintenance, taxes and insurance, and the obligations of the landlord are minimal.
Parties Involved in Ground Leases
Ground leases are typically entered into by sophisticated parties willing to engage in a long-term relationship for a specific purpose for the development of the property. These parties may include investors, trusts, governmental entities, educational institutions, nonprofits and other organizations with long-term missions that prefer (or are legally required) to retain land ownership. Ground leases are particularly attractive to family trusts and real estate investment trusts (REITs) due to their lower risk and stability, along with lower landlord costs and obligations.
Advantages for Landlords and Tenants
For landlords, ground leases offer several financial, tax and legal benefits. Landlords retain ownership of the land, avoid recognition of gain from a sale, receive long-term income and transfer construction costs and risks to the tenant. At the end of the lease term, landlords usually receive a functioning building, which can increase the property's value. (However, with ground leases that have a particularly long term – such as 99-year leases – landlords may require tenants to demolish buildings prior to the expiration of the term.)
Tenants benefit from ground leases by paying lower upfront acquisition costs compared to purchasing the property and generally have the flexibility to build and operate their own facilities with limited ongoing landlord control. The tenant can also depreciate the cost of its improvements for tax purposes. Given the sizeable investment by the tenant in constructing and developing the property, leasehold title insurance is a necessity for tenants to confirm that construction and development are not impeded by any title matters of record and ensure that tenants' lenders receive proper security in connection with any development or operations financing.
Key Considerations in Ground Leases
Ground leases involve several important considerations, including the legal distinction between a fee interest and a leasehold interest. The landlord retains the fee interest in the land, while the tenant holds the leasehold interest in the improvements. This separation of interests plays a crucial role in financing, as both parties can obtain different types of loans secured by their respective interests (as discussed in more detail below).
Permitted uses of the property are another critical aspect of ground leases. While tenants often have liberal rights to use the premises for any legal purpose, landlords may impose restrictions to protect their reversionary interest in the improvements and protect any comprehensive architectural standards, reciprocal easements and access rights if the landlord owns adjacent tracts, such as for shopping malls, industrial parks, college campuses or multipurpose complexes. Any preexisting hazardous materials and ongoing environmental condition considerations should also be addressed in the lease agreement.
Financial Aspects of Ground Leases
Ground leases come with several financial considerations that can significantly impact both landlords and tenants. Two key financial aspects are depreciation and leasehold mortgages.
Depreciation
One of the primary financial benefits for tenants in a ground lease is the ability to depreciate the cost of the improvements they construct on the leased land. Since the tenant owns the improvements, they can take a deduction for the depreciated value of these improvements over their useful life, as determined by the IRS. For most commercial buildings, the IRS has set this useful life at 39 years. This means that the tenant can spread the value of the building over 39 years and deduct that value from their taxable income each year. This depreciation can provide significant tax savings for the tenant.
On the other hand, the landlord does not have the right to depreciate the land, as land cannot be depreciated for tax purposes. This distinction underscores the importance of understanding the separate interests in a ground lease: the tenant's leasehold interest in the improvements and the landlord's fee interest in the land.
Leasehold Mortgages
The "financeability" of a ground lease is one of its most important features. Most ground leases are structured to allow the tenant to obtain a leasehold mortgage, which is a loan secured by the tenant's leasehold interest under the lease. This type of financing enables the tenant to leverage their interest in the improvements to obtain funds for construction, renovation or other purposes.
The landlord can also obtain a loan secured by its fee interest in the land, known as a fee mortgage. The tenant's leasehold mortgage typically cannot encumber the landlord's fee interest in the property. In some cases, however, a "subordinated ground lease" may be arranged, where the landlord agrees to allow the tenant to obtain a mortgage that encumbers the landlord's fee interest in addition to the tenant's leasehold interest if the tenant cannot secure regular leasehold financing. This arrangement presents greater risks for the landlord, but the landlord can charge higher rent to compensate for this increased risk.
To ensure the lease is financeable, ground leases typically contain several provisions, including 1) the express right of the tenant to obtain a leasehold mortgage, 2) the landlord's obligation to notify the leasehold lender of tenant defaults and the opportunity for the lender to cure these defaults and 3) an agreement by the landlord and tenant not to terminate the ground lease voluntarily before the maturity of the leasehold mortgage. If the ground lease is terminated due to tenant bankruptcy, the landlord typically agrees to enter into a new lease with the leasehold lender on substantially the same terms as the initial lease. The leasehold lender should also be added as an insured party under the tenant's insurance policies and have the right to control the distribution of insurance proceeds in the event of a fire or other casualty. If the leasehold mortgage is foreclosed, the landlord typically agrees to recognize the purchaser at the foreclosure sale as the tenant under the ground lease. Another key provision that leasehold lenders will look for is an agreement by the landlord that following a foreclosure of the leasehold mortgage, the purchaser at the foreclosure sale will have a one-time right to assign the lease to a new tenant without the landlord's consent.
Conclusion
Ground leases provide a valuable real estate structure for both landlords and tenants, offering long-term stability and flexibility. Understanding the intricacies of ground leases is essential for parties who are considering this type of transaction. By carefully negotiating the terms and addressing potential risks, both landlords and tenants can benefit from the unique opportunities presented by ground leases.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.
