What is a ground lease? Examples and pros & cons

What is a ground lease?

A ground lease is a long-term lease agreement where a tenant rents land from a property owner and typically has the right to build or improve structures on it. The tenant is usually also responsible for paying property expenses, including taxes, insurance, and maintenance costs.

Once the lease term ends, the land and any improvements revert to the landowner. Most ground leases last for 50 to 99 years.

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

Types of ground leases: Subordinated vs. unsubordinated

A lessee who signs a ground lease will often seek financing to develop the property. Whether the lender has recourse to the land in the event of a loan default depends on the type of ground lease in place. Here’s a breakdown of the two main types:

Subordinated ground lease

• Land is used as collateral. The lender has a higher claim than the landowner if the tenant defaults.
• The landowner has a lower repayment priority. In a default, the lender is repaid before the property owner. 
• Why would a landlord agree? The lessee may not be able to secure financing without using the land as collateral. Furthermore, subordinated leases typically come with higher rent payments to compensate the landowner for the added risk. 

Unsubordinated ground lease

• Land is not used as collateral. The landowner’s interest is not subordinated to the lender.
• The landowner has a higher repayment priority. In a default, the landowner is repaid before the lender. 
• What’s the trade-off for the landlord? Because the risk is lower, rent payments are usually lower than in a subordinated lease (all else equal).
  

Ground lease vs. other lease types

Here are a few other related lease types and how they differ from ground leases:

Ground lease vs. land lease

A land lease is another term for a ground lease. They are synonymous.

Ground lease vs. net lease

A net lease is a lease where the tenant is responsible for some or all of the property expenses:

• A single net lease requires the tenant to pay rent and property taxes.
• A double net lease requires the tenant to pay rent, property taxes, and insurance.
• A triple net lease requires the tenant to pay rent, property taxes, insurance, and maintenance costs.

Most ground leases are structured as triple net leases. 

Ground lease vs. traditional commercial lease

A traditional commercial lease involves a tenant renting space in an existing building. In contrast, a ground lease involves renting undeveloped land on which the tenant is usually responsible for constructing improvements, such as buildings.

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 of ground leases 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 of ground leases 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 the pros of ground leases for tenants and landowners

Cons of ground leases 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 of ground leases 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 the cons of ground leases for tenants and landowners

Disadvantages and risks 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, and the owner could lose their asset. 

Borrowing limitations

Tenants who have signed an unsubordinated ground lease can find raising money for a project difficult. 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.

Long-term commitment and loss of control

Ground leases can last anywhere from 50 to 99 years, during which the landowner has limited control over how the land is used. That’s a long time to lock up an asset. 

Rent renegotiation and inflation risk

Poorly structured escalation clauses may lead to rents that don’t keep pace with inflation or market rates, lowering your long-term income potential. If you’re not careful, you could get stuck with an underperforming asset for decades or be forced to sell.

Expert tip: Structure ground leases smartly

Ground leases are powerful tools, but only when structured right. Here are a few tips I always give when someone is considering investing or developing with a ground lease:

• Scrutinize the escalation clauses. If rent resets aren’t tied to CPI or clear market value benchmarks, your income stream could lag behind inflation, especially over a 99-year term.
• Include exit plans. Ground leases require long-term thinking. Build in options for the tenant to extend, renew, or exit early under agreed-upon terms.
• Don’t DIY the lease. Ground leases are not simple contracts. Hire legal and CRE pros with experience in land leases to structure favorable terms that align with your investment goals.

Miles Urban Hector

Miles Hector is a Solutions Engineer at Agora in New York. He began in ABS and derivatives at Bank of America Merrill Lynch before moving into real estate private equity, focusing on infill development financing in the Western U.S., particularly Los Angeles County.

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Key components of a ground lease agreement

Here are the key components of a ground lease agreement: 

• Rent structure and escalation clauses. The lease outlines the base rent amount and how it will increase over time, typically through fixed increases, percentage-based escalations, or adjustments tied to inflation benchmarks.
• Responsibilities of the tenant vs. landlord. The agreement clearly defines who is responsible for expenses such as property taxes, insurance, maintenance, and utilities. Most ground leases place these responsibilities on the tenant. 
• Reversion clauses and improvements. Typically, ground leases include a clause stating that any improvements made by the tenant, such as buildings or infrastructure, will revert to the landowner at the end of the lease term.
• Financing and subleasing rights. The lease specifies whether the tenant can use the property as collateral for a loan and under what conditions the tenant is permitted to sublease or assign their interest to another party.

Common ground lease disputes: Issues and practical solutions

Though rare, ground leases can be the source of disputes between landowners and tenants. Here are some common points of disagreement and how to resolve them:

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:

1. All taxes related to the property are the responsibility of the tenant.
2. 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.
3. A ground lease does not result in a capital gain for the property owner, as there is no land sale.
4. The landowner may have to pay income tax on the lease rent.
5. Before signing a ground lease, tenants should ensure the property owner has the legal authority to lease the land.
6. The ground lease should address local zoning regulations and land use regulations.
7. The options for renewal or extension form a vital component of the lease.
8. 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.