What is a ground lease?
A ground lease is a contractual arrangement between a landowner and a tenant for the use of a piece of property. Ground leases, also known as land leases, are standard in the commercial real estate industry. They are usually for long periods and can last 50 to 99 years.
As the name suggests, a ground lease involves an agreement for the use of land. The tenant has the right to develop the property and erect buildings or other structures on it. The lease agreement typically states that at the end of the lease term, the land and all the improvements made on it will become the landowner’s property.
Another critical feature of a ground lease is that during the lease period, the tenant is responsible for making all property-related payments, including property taxes, insurance, and the cost of repairs and improvements.
Subordinated vs unsubordinated ground lease
A lessee who has signed a ground lease would likely raise a loan to pay for the development of the property. If there is a default in repayment, does the lender have recourse to the land? The answer to this question lies in the type of ground lease executed between the landlord and the lessee.
The property is used to secure the loan in a subordinated ground lease. If the tenant fails to repay, the landlord will have a lower priority for repayments than the lender.
This may not seem a good idea from the property owner’s viewpoint. However, a property owner would agree to enter into a subordinated ground lease primarily for two reasons. The first is that the lessee may be unable to raise funds to develop the property unless the land is offered as collateral. The other incentive for the landlord is that a subordinated ground lease usually commands higher rent payments.
Unsubordinated ground leases do not allow the tenant to use the land as collateral. Landowners do not subordinate their interest to the lender, which is to the landowner’s advantage. However, the flip side is that the landlord typically receives a lower rent in an unsubordinated ground lease.
How do ground leases work?
Ground leases give tenants the right to develop the leased property at their own expense. The tenant would be responsible for making improvements to the buildings located on the property as well as constructing new buildings. Additionally, the tenant would bear the ongoing property-related costs, including taxes, insurance, and maintenance.
An essential feature of a ground lease is that the land and improvements made on it revert to the landowner after the lease expires.
Why should lessees spend large sums on building new structures and improving the buildings on the site when they know that the property will go back to the landlord? Firstly, the lease terms in land leases run into decades. Most commercial leases in this category last 50 to 99 years; leases under 25 years are uncommon.
Another reason lessees are willing to invest in buildings and other structures is that the ground lease could include an extension option. The lease may also have a purchase option, which allows the tenant to purchase a fee interest in the land. In both these scenarios, the lessee would continue to have access to the property. In the first scenario, by the extension of the lease, and in the second as the owner of the land.
Note: Fee interest or fee simple interest refers to complete ownership of the property.
While discussing how a ground lease works, it is crucial to remember that the lease agreement entered into by the landlord and tenant defines the rights and obligations of each party. A ground lease would usually include the following clauses:
- Term of the agreement
- Extension option and purchase option
- Title insurance
- Lease rent and rent resets
- Use and sublet clauses
- Financing clauses
- Default conditions
- Rights of the landlord
- Rights of the tenant
Ground lease examples
Large retail chains typically use ground leases to acquire land. Subsequently, they develop the property. This can be an excellent strategy as it enables these companies to avoid investing large sums in buying land.
Yum Brands, Inc., which operates KFC, Pizza Hut, Taco Bell, and The Habit Burger Grill, uses ground leases to establish new outlets. Other companies, such as Chick-fil-A, Starbucks, and McDonald’s, follow the same approach.
Most ground leases entered into by retail chains include a clause allowing lessees to extend the lease or buy the land at the end of the lease term.
Developers also use ground leases to acquire properties, which they then lease to tenants. Recently, Brookfield Properties and Waterman Clark took over Lever House, a property at 390 Park Avenue, New York, under a new ground lease. After redeveloping the property, they started signing on new tenants. The list of occupants at this premium property includes financial services company Northern Trust, Houston-based Quantum Energy Group, and One Investment Management, a company based in London.
Pros and cons of ground leases
A ground lease offers several distinct advantages for both tenants and landlords. However, it also has some downsides. Here is a quick summary of the pros and cons of a ground lease:
Pros for tenants
Building in a prime location: Often, the best locations are owned by landowners unwilling or unable to sell their land. A family trust may not want to part with ownership of a prime location. Similarly, a church or other religious institution may not be permitted to sell land received as a gift. A ground lease may be the only way for a commercial real estate developer or a business organization to build on this property.
No down payment required: Acquiring prime land can be expensive. Even if you plan to make the purchase with borrowed funds, you will need to raise money for the down payment. A ground lease can provide a solution, as there is no down payment involved in this type of commercial lease.
Even if an organization has the funds to purchase a property, it may want to conserve its cash and opt to lease premises instead of buying.
Renew the lease or buy property at the end of the lease: However long the lease period is, it will end at some point. When it does, the property, with all the improvements made, will revert to the landlord. That could be a severe setback for the tenant.
Fortunately, there is a way out.
Most modern ground leases have a renewal option or a purchase option. This provides tenants with the ability to continue to retain the property.
Pros for landlords
Steady income: A ground lease can provide a property owner with steady cash inflows for decades. There are practically no expenses, as the tenant is responsible for property taxes, insurance, and maintenance.
Additionally, a ground lease usually includes a clause stipulating that the lease rent will increase periodically. These rent resets can ensure that inflation does not eat into the landlord’s income.
Tax savings: If landowners sell their property, the gain could be subject to tax, but a ground lease does not result in taxable gains. However, you should remember that the lease rent received by the landlord could have tax implications.
Retain control: Many investors consider land the best asset class and an indispensable part of a good investment diversification strategy. Consequently, many landowners are reluctant to sell their land. However, they need a method to generate income from it. A ground lease can provide the perfect solution. Landowners get an opportunity to earn a steady income stream without losing ownership of their land.
Table summarizing pros of ground leases for tenants and landowners
| Pros for tenants | Pros for landowners |
| Access to prime locations. | A steady stream of rental income. |
| Minimal investment required-no down payment. | No tax on capital gains. |
| Ability to renew the lease or buy the property at the end of the lease. | They can retain ownership of the land. |
Cons for tenants
Reduced flexibility: The ground lease may require the tenant to obtain the landowner’s permission to develop the property or to make changes to it. If the permission is not forthcoming it can prevent the tenant from taking advantage of a new business opportunity.
Higher costs: Tenants must bear the burden of property taxes, insurance, and maintenance in addition to the lease rent, which could also be subject to regular increases. Tenants must consider these factors when planning their budgets.
Cons for landlords
How the tenant uses the land: If the ground lease is loosely worded, the tenant may take advantage and use the land in a manner that is unacceptable to the landowner.
Higher tax implications: The lease rent received by the landlord could be subject to income tax, negatively affecting cash flows.
Table summarizing cons of ground leases for tenants and landowners
| Cons for tenants | Cons for landowners |
| The tenant may require the landowner’s permission to make changes to the property. | The tenant could use the land in a manner that is unacceptable to the landlord. |
| Tenants need to bear the burden of the costs associated with the property as well as escalating lease rents. | The landlord could have to pay income tax on the lease rent. |
Disadvantages of a ground lease
Foreclosure risks
A subordinated ground lease can expose landowners to foreclosure risks. Commercial leases in this category allow the land to be used as collateral against the loan taken by the tenant to develop the property. In the event of default, the lender has the right to foreclose on the property.
Borrowing limitations
Tenants who have signed an unsubordinated ground lease can find raising money for a project difficult. However, even a subordinated ground lease can impose borrowing limitations on the tenant.
While many lenders are willing to advance funds secured by a subordinated ground lease, others may not be as willing to do so. Some lenders are hesitant to accept ground leases as collateral because these leases can be terminated, which would disadvantage the lender.
Are ground leases a good investment?
Ground leases can make excellent investments. Let’s take a look at some of the advantages they provide:
- Investors receive regular lease rent for decades. The escalation clause in the lease ensures the rent increases over time.
- It is a form of hands-off, hassle-free investing.
- The ownership of the land remains with the investor.
- The investor can control how the land is used by inserting a suitable clause in the agreement.
- The tenant is responsible for property tax, insurance, and maintenance.
- It is an excellent way for investors to diversify their holdings and invest in real estate.
- The investor can benefit from the increase in the property’s value.
What happens when a ground lease expires?
Traditional ground leases stipulated that at the end of the lease, the property and all its improvements would revert to the landlord. However, modern ground leases often work differently. They can provide an option for the tenant to extend the lease or buy the property.
Ground leases can also be terminated early if both the landlord and the tenant agree. They can also be terminated if there is a breach of contract. However, such terminations will be governed by the termination clause in the agreement.
Legal and tax implications
Here are the primary legal and tax implications associated with ground leases:
- All taxes related to the property are the responsibility of the tenant.
- The lease rent paid by the tenant to the landlord may be treated as a business expense and help reduce the tenant’s taxable profit. As noted in point 4 below, the lease rent would be considered income in the landlord’s books of account.
- A ground lease does not result in a capital gain for the property owner as there is no land sale.
- The landowner could have to pay income tax on the lease rent.
- Before signing a ground lease, tenants should ensure the property owner has the legal authority to lease the land.
- The ground lease should address local zoning regulations and land use regulations.
- The options for renewal or extension form a vital component of the lease.
- The ground lease should clearly state whether it is subordinated or unsubordinated.
The bottom line
A ground lease can be an excellent investment vehicle for investors looking for a way to deploy funds in a manner that does not require a hands-on approach. It also provides a method for landowners to generate steady income from unused property.
From a tenant’s perspective, a ground lease offers a mechanism that allows near-permanent access to a property without the need to buy it. All in all, a ground lease can be a contractual arrangement beneficial to all the parties in the transaction.
