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.
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.”
