Ground Lease

What Is a Ground Lease?

A ground lease is an agreement in which a tenant is permitted to develop a piece of property during the lease period, after which the land and all improvements are turned over to the property owner.

How a Ground Lease Works

A ground lease indicates that improvements will be owned by the property owner unless an exception is created and stipulates that all relevant taxes incurred during the lease period will be paid by the tenant. Because a ground lease allows the landlord to assume all improvements once the lease term expires, the landlord may sell the property at a higher rate. Ground leases are also often called land leases, as landlords lease out the land only.

Although they are used primarily in the commercial space, ground leases differ greatly from other types of commercial leases like those found in shopping complexes and office buildings. These other leases typically don't assign the lessee to take on responsibility for the unit. Instead, these tenants are charged rent in order to operate their businesses. A ground lease involves leasing land for a long-term period — typically for 50 to 99 years — to a tenant who constructs a building on the property. 

A 99-year lease is generally the longest possible lease term for a piece of real estate property. It used to be the longest possible under common law. However, 99-year leases continue to be common but are no longer the longest possible under the law. 

The ground lease defines who owns the land, and who owns the building, and improvements on the property. Many landlords use ground leases as a way to retain ownership of their property for planning reasons, to avoid any capital gains, and to generate income and revenue. Tenants generally assume responsibility for any and all expenses. This includes construction, repairs, renovations, improvements, taxes, insurance, and any financing costs associated with the property.

Tenants generally assume responsibility for all financial aspects in a ground lease including rent, taxes, construction, insurance, and financing.

Example of a Ground Lease

Ground leases are often used by franchises and big box stores, as well as other commercial entities. The corporate headquarters will normally purchase the land, and allow the tenant/developer to construct and use the facility. There's a good chance that a McDonald's, Starbucks, or Dunkin Donuts near you are bound by a ground lease.

In July 2016, New York-based investment firm AllianceBernstein purchased a 99-year ground lease from BLDG Management for New York City's George Washington Hotel in a deal worth $100.4 million. BLDG originally purchased the hotel when it was in foreclosure in 1994. Although the building was used by the Manhattan-based School of Visual Arts as a student dormitory, BLDG filed plans in April 2016 to restore the property to a hotel with a restaurant, bar, and ground-level stores. The property currently operates as the Freehand Hotel, a boutique hotel, in New York City's Flatiron District.

Some of the fundamentals of any ground lease should include:

Subordinated vs. Unsubordinated Ground Leases

Ground lease tenants often finance improvements by taking on debt. In a subordinated ground lease, the landlord agrees to a lower priority of claims on the property in case the tenant defaults on the loan for improvements. In other words, a subordinated ground lease-landlord essentially allows for the property deed to act as collateral in the case of tenant default on any improvement-related loan. For this type of ground lease, the landlord may negotiate higher rent payments in return for the risk taken on in case of tenant default. This may also benefit the landlord because constructing a building on his land increases the value of his property.

In contrast, an unsubordinated ground lease lets the landlord retain the top priority of claims on the property in case the tenant defaults on the loan for improvements. Because the lender may not take ownership of the land if the loan goes unpaid, loan professionals may be hesitant to extend a mortgage for improvements. Although the landlord retains ownership of the property, they typically have to charge the tenant a lower amount of rent.

Advantages and Disadvantages of a Ground Lease

A ground lease can benefit both the tenant and the landlord.

Tenant Benefits

The ground lease lets a tenant build on property in a prime location they could not themselves purchase. For this reason, large chain stores such as Whole Foods and Starbucks often utilize ground leases in their corporate expansion plans.

A ground lease also does not require the tenant to have a down payment for securing the land, as purchasing the property would require. Therefore, less equity is involved in acquiring a ground lease, which frees up cash for other purposes and improves the yield on utilizing the land.

Any rents paid on a ground lease may be deductible for state and federal income taxes, meaning a reduction in the tenant's overall tax burden.

Landlord Benefits

The landowner gains a steady stream of income from the tenant while retaining ownership of the property. A ground lease typically contains an escalation clause that guarantees increases in rent and eviction rights that provide protection in case of default on rent or other expenses.

There are also tax savings to a landlord who uses ground leases. If they sell a property to a tenant outright, they will realize a gain on the sale. By executing this type of lease, they avoid having to report any gains. But there may be some tax implications on the rent they receive.

Depending on the provisions put into the ground lease, a landlord may also be able to retain some control over the property including its use and how it is developed. This means the landlord can approve or deny any changes to the land.

Tenant Disadvantages

Because landlords may require approval before any changes are made, the tenant may encounter roadblocks in the use or development of the property. As a result, there may be more restrictions and less flexibility for the tenant.

Costs associated with the ground lease process may be higher than if the tenant were to purchase a property outright. Rents, taxes, improvements, permitting, as well as any wait times for landlord approval, can all be costly.

Landlord Disadvantages

Landlords who don't put in the proper provisions and clauses in their leases stand to lose control to tenants whose properties undergo development. This is why it's always important for both parties to have their leases reviewed before signing.

Depending on where the property is located, using a ground lease may have higher tax implications for a landlord. Although they may not realize a gain from a sale, rent is considered income. So rent is taxed at the ordinary rate, which may increase the tax burden.