[Originally published in The Wendel Report, Spring 2007 issue.]
[This article is Part I of a three-part series on ground leases.]
Parties that are considering entering into an agreement for the sale and purchase of real property may want to consider entering into a long-term ground lease as a possible alternative to sale and purchase. This article discusses the advantages and disadvantages to landlords and tenants in commercial ground lease transactions.
A commercial ground lease is usually defined as a lease of land (typically the land is not improved), for a relatively long term (e.g., 50 to 99 years), where all expenses of the property are the obligation of the tenant (e.g., taxes, repair and maintenance expenses, insurance costs, and financing costs), and which allows for tenant financing for the construction of the project to be constructed on the land either by leasehold financing, and/or so called "fee subordination" financing. Ground leases, therefore, are not only leases in the traditional sense of the word but are also financing instruments.
Ground leases differ substantially from other types of commercial leases such as, leases for space in shopping centers and office buildings because of the long-term nature of ground leases and the financing provisions and requirements.
The Landlord Perspective
There are three basic advantages for a landowner to enter into a ground lease instead of selling the property outright:
- A ground lease avoids recognition of gain the landlord would otherwise realize if the property was sold to the tenant. There is no income tax consequence to the landlord upon execution of a ground lease, provided there are income tax consequences upon receipt of rent.
- The landlord retains fee ownership to the property. This is an important consideration to many family trusts and institutional owners who desire to maintain long term-ownership in order to put the property to economically productive use.
- Through various provisions in the ground lease documents, a landlord may retain some element of control over the development and permitted uses of the land that is leased under the ground lease. Many ground leases require a tenant to develop, construct and operate a specific type of commercial project and not change the nature of the project without the landlord's prior approval.
There are, however, potential disadvantages for a landlord in a ground lease transaction. For example:
- If a landlord permits its fee interest in the land to be security for the tenant's financing, the landlord runs the risk of losing its property through foreclosure if the tenant defaults under its financing.
- Rent paid to a landlord is income to the landlord and taxed at ordinary rates, as opposed to capital gain rates. Depending upon a landlord's particular tax situation, this may be a significant disadvantage to a landlord.
- If a landlord does not include sufficient controls in the ground lease document, a landlord may have little or no control over the development and use of the land.
- Many ground leases contain provisions either restricting or prohibiting the landlord from borrowing against its equity interest in the land during the term of the ground lease
The Tenant Perspective
There are two major advantages for a tenant entering into a ground lease, as opposed to purchasing the land.
- A ground lease substantially reduces the tenant's front-end development costs because it eliminates land acquisition costs.
- All rent payments made under a ground lease are deductible by the tenant for federal and state income tax purposes.
The major disadvantages for a tenant in a ground lease transaction are:
- The cost of ground leasing property is usually higher in the long term than if the tenant purchases the property initially; whether or not this is a significant disadvantage is dependent upon how long the tenant intends to own the project in question.
- Typically, a tenant will have somewhat less flexibility over the development, use, and operation of the property because of restrictions that may be contained in the ground lease.
- The tenant may not be able to pull all or part of its equity from the project through refinancing because of limitations in the ground lease.
- A tenant's leasehold interest under the ground lease is essentially a "diminishing asset" in that the value and marketability of the project will diminish as the end of the term nears.
The negotiation and preparation of a commercial ground lease is often difficult and time consuming. There is no such thing as a "standard form" ground lease, similar to other types of form leases that are often used in shopping centers and office buildings, for example. It is imperative that clients and their attorneys have a thorough understanding of present and anticipated future issues, requirements and concerns, as well as an understanding and anticipation of the requirements of the participating lenders as the ground lease should clearly and adequately address these matters.