A ground lease is an agreement in which a business or investor is permitted to develop a vacant parcel of land in the form of a lease agreement over a defined lease period. Once the lease period expires, the land and all improvements constructed by the ground lease tenant are turned over to the land owner. Ground lease terms could last as long as 10-99 years.
The property owner holds title to the land during the lease period while the tenant is responsible for all financial aspect of development and improvements in the property. Typically, tenants are obligated to cover maintenance expenses, taxes, insurance, repairs, and utilities. It’s important to note that tenants are not permitted to depreciate the land portion of the improved property. The IRS does not for the depreciation of land because land does not lose value over time through deterioration like a building would.
Ground leases often house very strong and long lasting tenants such as popular food-chain restaurants, retail stores, and bank branches.
Location of the land could also be a factor in determining if a lease may be a viable consideration. The location may incline favorable and profitable amenities such as being located on a popular high traffic signalized street corner in a populated downtown.
Ground leases may either be subordinated or unsubordinated. A subordinated ground leases is when the property owner pledges the land as collateral for the developer’s mortgage while taking a lower priority in the hierarchy of claims on the ownership of the land. While most landowners who follow through with subordinated ground leases do so to negotiate favorable terms, this could be counterintuitive due to the fact the land owner could be subject to lose their property to the lenders of the tenants.
On the other hand, an unsubordinated ground lease, is when the property owner maintains its first position in the hierarchy of claims on the asset. This means that the lender of the tenants cannot take ownership of the land in the event of a default by the tenant. As result, the lender may require substantial equity into planned improvements on the part of the borrower and cause a lender to become hesitant to extend loans since the lender cannot claim the property as collateral in the case of default.
There are both advantages and disadvantages for both the landowner and the tenant. Some advantages to the land owner include retaining ownership of the land while producing a steady stream of income. Also the landowner is not burdened with making improvements to the land as well. Landowner disadvantages may come when considering the landowner’s tax situation as the rent received is taxed at ordinary rates instead of capital gains rates. In addition some leases restricts a landowner’s ability to borrow the equity ownership of the land of the terms agreed upon.
Pros for tenants includes a useful way to gain access to what is often prime and market savvy locations which would be more expensive if purchased outright. Tenants also can take advantage of their tax implications as well by claiming deduction on rent payments under a ground lease from a federal or state agency. Some disadvantages that tenants face is sometimes the use of the land and intended development can become restrictive which may not be the case if the land was brought outright. Also taking into account the terms of leasing the land, tenants may overall pay more through rents due to escalation clauses which allows rent increases over the term of an agreement compared to an outright purchase.