The Beauty of The Ground Lease - Shopping Center Today - October 2012 Issue - By Ben Johnson

When Milton Cooper speaks, people tend to pay attention. As executive chairman of Kimco Realty Corp., the largest owner of neighborhood and community shopping centers in North America, Cooper made the firm one of the first REITs to trade on the New York Stock Exchange some two decades ago. So when early this year Cooper cited ground leases as an example of the firm’s focus on quality on an earnings conference call, he managed to turn a few heads. He pointed to Kimco’s ownership of some 750 retail land parcels. “These ground leases for the most part have escalations in rent,” Cooper said. “It’s a wonderful, safe, quality investment, despite rents being low when compared to store leases.”

Cooper also put forth a particularly profitable example. “For years we have had a net effective annual rent of less than $100,000 per annum on a 100,000-square-foot store in Staten Island [New York],” he said. “A new ground lease has become effective for the same facility to a large national retailer at an annual rental of $2 million a year. I think you get our point,” he said.

Ground leases are anything but groundbreaking. In fact, they almost seem to have been around since the creation of dirt. Essentially, a commercial ground lease is a lease of land for a relatively long term of up to 99 years. They are typically triple-net in nature, meaning all the expenses of the property are the obligation of the tenant.

It is not possible to quantify just how large the ground-lease market may be, but sources say it is huge. Lance Marine, first vice president of retail services at CBRE, points out that the typical shopping center has two or three outparcels, and the vast majority of outparcels are ground-leased. Marine, who specializes in brokering ground leases in the District of Columbia area, says he has completed about 100 of those over the past few years. “It’s a substantial income stream to developers,” said Marine.

Ground leases provide tenants with several major advantages, Marine says. First, many retailers favor ground leases over traditional-space leases, because the former can free up capital that can be spent on the buildings rather than stay tied up in land. “Retailers across the board are very focused on having their brand and their identity in their unit, and having four sides to personalize benefits them much more than if they had taken an end cap or in-line space,” said Marine. And further, all rent payments made under a ground lease are deductible by the tenant for income-tax purposes, he says.

For owners, ground leases carry three basic advantages over selling the property outright: A ground lease is a way for the landlord to avoid realizing a gain from a sale to the tenant, the landlord retains long-term ownership, and the landlord may retain certain controls over the development and permitted uses of the land. Many ground leases require a tenant to develop, construct and operate a specific type of commercial project and not to change the nature of that project without the landlord’s approval.

There are some disadvantages too. Rent paid is income and is taxed at ordinary rates rather than capital-gains rates. If ground leases are not written correctly, the landlord may have little or no control over land use and development. And many ground leases contain provisions that either are restrictive or prohibit the landlord from borrowing against the land.
Tenants also have disadvantages in doing ground leases. The cost of ground-leasing property is usually higher in the long term than if the tenant purchases the property up front. 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. Also, the tenant may not be able to pull all or part of its equity from the project through refinancing. A tenant’s leasehold interest is essentially a “diminishing asset” in that the value and marketability of the project will diminish as the end of the term nears.

Ultimately, ground-lease transactions are give-and-take on the part of both landlord and tenant, but supply and demand also dictates the balance of the negotiations. “In a market like D.C., where land is limited and demand from retailers is strong, the developer will drive and dictate that decision to a ground lease,” said Marine. “It is not just a retailer’s decision. It is also a developer’s decision. They are both in control of that process.”

The process of writing ground leases can be easier than space leases, says John J. Schupp, senior vice president of development and project management at Jones Lang LaSalle. “We have a number of ground leases that are in process right now,” Schupp said. “It literally can be an easier document to see through the legal process. Everything you can do with a standard space lease you can do with a ground lease.”

Robert James runs one of the leading firms specializing in brokering ground leases. He founded Kimco Exchange Place with Milton Cooper in 1998 and ran it for 10 years before acquiring it from Kimco four years ago. Today the firm is called EXP Realty Advisors and has offices in New York City and Dallas. James estimates that the company transacted some 300 ground leases as a division of Kimco and has closed over 100 deals as an independent company.

“It was Milton’s idea,” said James. “He didn’t know exactly what the business would look like, but I was hired to create a business around 1031 exchanges. It ended up making money as a brokerage business, where we would be able to sell the ground-leased McDonald’s at a lower cap rate than we could the balance of the shopping center.”

James notes that ground leases have long-term upside for good reason. “They are very safe,” James said. “I did retail bankruptcy restructuring for three years before I joined Kimco, and I never closed a ground lease. If the store didn’t work I would sell the ground lease.” Ground leases typically trade at cap rates 75 to 125 basis points below comparable building-and-land deals, James says. “The reason is, that’s a safer income stream, so it should trade at a lower cap rate,” he said. “Generally, the tenants renew every time, but if they go bankrupt, they will sell it to somebody else.”

Though drugstores have driven much of the demand for ground leases over the past few years, other retailers and restaurants are driving more deals these days, says Jeremy Cohen, a partner in the commercial real estate practice of Hartman Simons & Wood, an Atlanta-based law firm. “They all want their one-acre outparcel somewhere out in front of the shopping center, so they can build and control their improvements without worrying about a landlord screwing up their plans,” said Cohen. “I don’t see anything in the future that will prevent them from continuing to happen.”

Robert James to Attend the 3rd Annual Net Lease InterFace

Robert James is President of EXP Realty Advisors, Inc. which is a boutique investment sales business specializing in 1031 exchanges and the exclusive listing of single tenant net leased properties nationally. EXP Realty Advisors has offices in New York City, Dallas Texas and will soon add a California office. Rob has sold over 1.3 billion dollars of real estate in 39 states.

The 3rd annual InterFace Net Lease conference will bring together 250 leading players in the NNN, sale leaseback and 1031 markets to New York City for a day-long information and networking conference on Tuesday, September 11th (Opening cocktail reception on Monday night, September 10th).

Hear from 35+ speakers on seven panel sessions addressing topics such as:

• State of the Net Lease Market: The Outlook for the 4th Quarter and 2013
• Will the Investment Market Continue to See Record Demand, Limited Supply and Cap Rate Compression?
• Where is Pricing and Underwriting, What Debt Instruments are In (and Out of) Demand, How are Conduits Impacting the Marketplace and Will New Capital Sources Emerge in the Coming Year?
• The Retailer Perspective: Tenants Share Their Expansion and New Development Plans and How the Real Estate Industry Can Best Work With Them
• What’s in the Pipeline, Will New NNN & BTS Supply Come Close to Meeting Investor Demand, and What Structures are Being Used to Finance New Development?
• 1031 Market Update: The Potential Impact of Tax Law Change on Private Buyers and a Still Recovering Market
• The Outlook for the Sale-Leaseback Market in 2013
• Keynote Address: Now is the Time for Investing in Net Lease Real Estate Nicholas S. Schorsch, Chairman of American Realty Capital Trust and Co-Founder of American Realty Capital

New 3.8 Percent Tax and the Impact on Real Estate

With potential tax increases looming on the horizon, the value of tax deferral mechanisms, such as Section 1031 exchanges, have never been greater. One example of a potential tax increase which appears likely to take effect is the new Medicare tax, which Congress passed as part of the Health Care and Education Affordability Reconciliation Act of 2010, and was recently upheld by the Supreme Court. The Medicare tax, which goes into effect on January 1, 2013, will impose a 3.8% tax on the net investment income of joint filers with adjusted gross income over $250,000, and single filers with adjusted gross income over $200,000.

The new Medicare tax applies to adjusted gross income (the figure on the bottom of the front page of IRS Form 1040), which includes interest, dividends, capital gains, wages, retirement income and income from partnerships and small businesses. It appears the tax will also apply to dividends, rents, royalties, interest (except municipal bond interest), short and long-term capital gains, the taxable portion of annuity payments, income from the sale of a principal residence above the $250,000/$500,000 exclusion, gain from the sale of an investment property or a second home, and passive income from real estate and investments in which the taxpayer does not materially participate.

JUST SOLD: NNN LA Fitness

Blackstone Planting Its Flag Even More Firmly in CRE

In the current lackluster environment for huge private-equity deals and leveraged M&A buyouts that marked the previous boom cycle, Blackstone Group LP has increasingly shifted its focus tocommercial real estate investments. The firm, credited with timing the market perfectly in the previous cycle with its acquisition and subsequent sell-off of the former Equity Office Properties portfolio, is hoping to again capture lightning in a bottle as investor demand heightens for core property assets in leading U.S. and European markets.

Despite the improving economic landscape, Blackstone's net income for its four main business segments fell 24% in the first quarter as the growth in the values of its asset slowed, including a 23% drop in Blackstone's real estate business from first-quarter 2011.

There appears to be a strong foundation behind the volatile quarterly numbers, however. Blackstone reported $190 billion in assets under management as of the end of the first quarter -- up almost 27% from a year earlier -- including $48.3 billion in real estate, which was up 38% from a year ago.

CRE generated the firm's highest revenue volume during the quarter at $427.2 million. Steadily improving fundamentals drove a 4% increase, or $1 billion, in the value of Blackstone’s carried portfolio, with the majority of value appreciation in the firm’s office and retail properties.

Blackstone’s credit business posted $50.8 billion under management, up 61% from last year, followed by smaller growth in private equity and hedge funds.

Tony James, president and chief operating officer, and Stephen A. Schwarzman, CEO and co-founder of the private-equity and alternative investment titan, attributed the decline in profits to continuing global uncertainty. But in calls with reporters and investors, they both expect business conditions will improve in the second half of 2012 and into 2013, and also noted that Blackstone has accumulated nearly $38 billion in dry powder for acquisitions.

"[CRE] deal flow is robust as the investing environment has remained favorable given the amount of distressed assets that need to deleverage around the globe," said Schwarzman, the legendary private equity financier and investment banker. "With little new supply and slowly increasing demand for commercial space, fundamentals continue to improve from the lows of the cycle. This has resulted in occupancy improvement and rent growth in most of our core markets."

"For key office assets in the United States, occupancy is up 300 basis points versus the prior year. In Northern California, our strongest office market, site of the tech boom in the United States, office rents are up more than 15% from the prior year. This gives you some sense of what happens when the law of supply and demand reasserts itself."

To take advantage of the upswing, Blackstone's James noted that the company could divert more of its capital raising efforts into core commercial properties, as well as funds in Asia and other emerging markets. The firm already tops all private-equity fundraisers in CRE, with its Blackstone Real Estate Partners VII accumulating $6.6 billion in the first quarter.

"Investors are hungry for yield, they’re hungry for inflation hedge, and we have, of course, tremendous market knowledge and ownership of assets throughout all the major regions," James said, noting Blackstone's successful closing of its global flagship fund in February.

In an asset class where fundraising has proven extremely difficult of late, Blackstone has raised over $10 billion of total capital, with a couple of billion more in commitments over the course of the year, "which will make it the largest real estate opportunity fund ever raised and multiples in terms of size of our nearest competitors, where that multiple of size gives us the ability for competitive purposes to do larger and more complex deals," Schwarzman said.

Blackstone is seeing similar trends in hospitality as in office and retail, with virtually no new supply and modest increases in demand leading to U.S. RevPAR gains.

"Positive absorption and declining vacancy is also evident in our industrial, retail, and senior living assets," Schwarzman said.

He also noted that Blackstone acquired a large portfolio of grocery-anchored shopping centers last year from Brixmor, formerly Centro Properties, in the largest deal in the world of any leverage type since the collapse of Lehman Bros. nearly five years ago, where occupancy is at its highest level since 2009 due to accelerating leasing activity.

Schwarzman said although improving, real estate debt markets are still constrained and competition for large complex transactions remains limited -- which is a good thing for Blackstone, one of the world’s largest providers of debt and equity capital. The firm deployed or committed $2.3 billion in capital in the first quarter, with 40% of this in Europe.

In addition to the retail power center portfolio acquired in an off-market transaction from highly leveraged Brixmor, Blackstone has acquired high-quality distressed industrial portfolios in the U.S. and the U.K., and most recently agreed to buy 65 U.S. warehouse properties from Australia-based Dexus Property Group, for $770 million. Blackstone also recapitalized Parc 55, a 1,000 room hotel in San Francisco, one of the nation’s strongest hotel markets.

"This is the distressed wave that people have been talking about. All are being purchased at a significant discount to replacement cost."

In terms of dispositions, Blackstone has sold or has under contract to sell nearly $800 million in assets so far in 2012, includes the sale of Pearlridge, a mall in Hawaii which closed in the second quarter. Schwarzman noted Blackstone's sale of $1 billion in assets in the last 12 months, completed largely at significant premiums to carrying value.

"Although we were delayed in the second half of last year with some of our plans for realizations due to market turbulence, the market appears to be opening up more, particularly for properties that are stabilized. As such, we expect more asset sales in the second half of this year and into next year."

Schwarzman acknowledged that the limited partner investors that drove such deals as the EOP acquisition "have been basically traumatized by their experience in opportunity real estate," with many casualties in the private-equity space during the downturn due to loan maturities that couldn’t be refinanced.

"A large number of our competitors have gone out of business and they’ve gone out of business because they were buying leveraged real estate at very high prices," he said.

Company proposals to Blackstone for potential equity infusions and refinancing offer "almost the same deal with different names, where some piece of real estate was bought by somebody, it’s valuation is in some cases down 20%, it needs sometimes more, it needs way more equity to refinance it to the extent that they can live in a world of changed (lending) ratios."

"Who’s going to put that money up? There are very few people around who will actually do that and we are the dominant group left in the world that will do that, so people come to us all the time."

Capital providers and their consultants who funded those busted deals remain extremely cautious about exposing more money to this sector, passing on opportunistic deals in favor of reliable core real estate that don’t required much additional reinvestment or debt.

"What they’re worried about isn’t maximizing return; they want some exposure to the asset class. They just don’t want to live through these losses again."

"So I think this asset class is going to stay under invested in, even though the opportunities are actually terrific. There will be a few firms that raise funds, as they have, but those will be relatively small funds compared to what most of them have done previously."

Blackstone does not expect realized income from investments to peak until late this year and into 2013, mostly because its assets, especially real estate are appreciating rapidly, with robust underlying portfolio performance.

"Why give that away? We’ve got a wonderful compounding going on. We’ve got rents going up, we’ve got occupancies going up, we’ve got debt going down, and they’re leveraged. And I don’t understand, frankly, this focus on premature liquidations. We’re in the business of managing money."

James attributed that to a combination of factors, including shrinking stock, no new supply, the improving economy and the release of pent-up leasing demand from 2008-10.

"All of that is coming through now and I think it’s going to be good. I hope it will be even better, that the economy will at some point get a bit more robust growth. We want to wait for that to happen, if it’s going to."

In explaining the delayed realizations in real estate disposition, "we tend to actually realize significantly more than that mark," Schwarzman said. "And given the volatility of the market, it’s very hard to get this right."

As lending ratios improve from 60%-65% to 75%-80% of loan to value, the rising value of properties that Blackstone holds "will go almost dollar for dollar to us as the holder of the real estate," Schwarzman said. At disposition, the return on equity for the new owner will be about the same, but will push up the sale price beyond the simple fundamentals of increasing rents and increasing occupancies.

"Giving that up to satisfy some type of target for realizations is something we just wouldn’t do," he said.

Top 10 Most (and Least) Expensive U.S. Commercial Real Estate Markets

With economic challenges in the commercial real estate market, few U.S. markets experienced significant rent increases in 2010 from the previous year, according to new data released in December based on the Building Owners and Managers Association’s (BOMA) 2011 Exchange Report.

“Rents are still compressed from the 2007 highs, but it looks like in most markets, the bottom has hit and it’s stable now,” said Lorie Damon, BOMA’s vice president of education and research. “There has been modest rent growth in some of the better-performing markets, which tend to be on the coast.”

At $48.27 per square foot, New York tops the list of the most expensive commercial real estate markets, Shreveport, La. ranks is the least expensive at $10.47 per square foot.

Washington, D.C. followed in second place for most expensive at $42.63 per square foot. Five California cities ranked among the 10 most expensive markets. New York and San Francisco were the only markets in the group of most expensive cities to show an increase in rental income from the previous year.













BOMA noted the data suggest that prices remain favorable for tenants seeking to pursue new leases or renegotiate existing ones. Damon said building owners appear confident that rents will remain stable.

“They may not grow, but they will remain stable and at least won’t continue downward,” Damon said.









In terms of least expensive markets, Nashville, Tenn., followed behind Shreveport at $13.31 per square foot. Of the least expensive markets, both Dayton, Ohio, and Omaha, Neb., recorded 10 percent increases from the previous year.

The data are based on BOMA’s 2011 Experience Exchange Report. The annual report offers an analysis of BOMA’s data regarding operating income and expenses in more than 65,000 commercial buildings in close to 300 markets. The rental rates in each market reflect total income divided by total rentable square feet for that market.