Your Guide to the Ground Lease in Commercial Real Estate

Ground leases are gaining traction in the real estate market, with experts projecting a compound annual growth rate (CAGR) of 2.5% through 2029. For commercial property investors, this real estate niche offers a way to unlock the value of their land while maintaining ownership. For small businesses, ground leases present a way to secure a location to operate with lower up-front costs.

In this guide, we'll provide an overview of ground leases in commercial real estate, cover the key aspects of how ground leases work, the different types of leases available, and the potential advantages and disadvantages for both tenants and landowners. You'll gain a solid understanding of this segment of the real estate market and be able to determine whether a ground lease makes sense for your business. Let's get started!

Understanding the ground lease

A ground lease, also commonly referred to as a land lease, is an agreement between a land owner and a tenant wherein the tenant leases the land and then constructs buildings or makes improvements to it.

The key component of this structure is that the landlord retains ownership of the land, while the tenant has the right to use it for a specified period. Most ground leases range from 30 to 99 years.

Now, you might wonder: why would anyone opt for a ground lease instead of buying the land outright? For businesses, it offers a more affordable way to develop or operate without the high costs of land purchase. Landlords benefit as well, gaining a steady income stream without the responsibilities of development or management.

What's in a ground lease?

Agreements for ground leases commonly include:

• Rent amounts and payment schedules: Defines the precise amount of rent and the schedule for payments. It may include specifics about payment methods and any penalties for late payments.
• Escalation clauses: Describe the conditions under which the rent will increase, such as through a fixed percentage, linkage to an index like the Consumer Price Index, or predetermined amounts at specific intervals.
• Lease term: Specifies the start and end dates of the lease agreement, indicating the total duration of the tenant's right to occupy and use the land.
• Responsibilities for taxes, insurance, and maintenance: Identifies if the tenant or landlord pays for property taxes, insurance, and maintenance. Divides these financial and operational responsibilities clearly.
• Use provisions: Specifies what the tenant can do on the leased land. Lists allowed activities and banned ones to confirm compliance with zoning laws and the landlord's preferences.
• Improvement clauses: Detail how tenants can alter or improve the property. Includes the need for landlord approval, code compliance, and end-of-lease improvement terms.
• Default and termination conditions: Explains what constitutes a default, such as failure to pay rent or comply with lease terms. It outlines how to notify and remedy defaults, and under what circumstances either party can terminate the lease.
• Renewal options: Provide terms under which the tenant may extend the lease beyond the original term. Includes conditions to exercise the renewal option and allows renegotiation of lease terms for the renewal period.

Benefits of a commercial ground lease

Let's take a closer look at the advantages that a land lease has to offer for tenants and landlords.

For landlords

• Steady income: Ground leases provide property owners with a consistent stream of income over the course of the lease term. Since the tenant is responsible for making rent payments, it can be a reliable source of revenue without the uncertainties of market fluctuations.
• Minimal risk: With a ground lease, property owners transfer the responsibility of property development and management to the tenant. This reduces the owner's exposure to risks associated with construction costs, property maintenance, and market changes.
• Long-term value: A ground lease's long-term nature enhances the property's value and provides the owner with a predictable income stream for an extended period.
• Asset preservation: By leasing the land rather than selling it outright, property owners retain ownership of a valuable asset. This allows them to preserve the land's value and potentially benefit from any future appreciation.
• Flexibility: Ground leases offer property owners flexibility in how they use their land. They can tailor the lease agreement to suit their financial goals and investment strategy. Additionally, they have the option to renegotiate terms or sell the leasehold interest if desired.

For tenants

• Access to valuable land: Ground leases provide tenants with access to prime real estate locations without the need for a significant upfront investment. This allows businesses to establish themselves in desirable areas where purchasing land outright may be financially prohibitive.
• Conservation of capital: Instead of tying up capital in land acquisition, tenants can save their financial resources for other business needs, such as operations, marketing, or expansion. This flexibility is especially helpful for startups and small enterprises with limited capital.
• Long-term stability: The longer terms in ground leases provide tenants with the confidence to make substantial investments in property improvements, knowing they have access to the land for an extended period.
• Control over improvements: Tenants have the freedom to develop and customize the property to suit their specific business needs. This control allows businesses to design and construct buildings or infrastructure tailored to their operations, branding, and customer experience.
• Predictable costs: The rent paid under a ground lease is typically fixed or tied to predetermined formulas, providing tenants with predictable costs over the lease term. This predictability provides better financial planning and budgeting for the business.

Disadvantages of ground leases

Ground leases naturally come with some downsides. Here are the major ones to consider:

• Control limitations: Both landlords and tenants may have restricted authority over property decisions, which can impact their ability to manage or utilize the property effectively.
• Fixed costs: Ground leases often involve predetermined rental expenses, constraining potential profitability for landlords and limiting financial flexibility for tenants.
• Property constraints: Changes or improvements to the property may be restricted, affecting the property's value and usability for both the property owner and tenant.
• Financial risks: Tenant default can cause financial losses and legal issues for landlords. Tenants may face penalties and eviction for lease breaches.
• Long-term commitments: Lease terms restrict flexibility, affecting stability and profitability for landlords and tenants.
• Uncertainty: Factors like regulatory changes and market fluctuations can cause unknown future outlooks.

Types of ground leases

There are two common types of ground leases:

1. Subordinated ground lease

In a subordinated ground lease agreement, the tenant's rights come after other interests, like a lender's lien. If there's a default or foreclosure, the lender's claim is more important than the tenant's rights. This can mean a higher risk for tenants.

2. Unsubordinated ground lease

Unsubordinated ground leases prioritize the tenant's rights over any mortgage or liens on the property. Even if the property owner defaults or faces foreclosure, the tenant's rights stay protected. This type of lease offers tenants more security, as their occupancy isn't easily affected by the property owner's financial situation.

Completion of a ground lease

At the end of a lease, landlords retain ownership of the land along with any improvements made by the tenant during the lease term. The land owner may choose to renew the lease with the existing tenant, negotiate a new lease with different terms, or explore other options for the property.

Depending on lease terms, tenants may have to remove or compensate the landlord for improvements made to the property.

Ground lease leasehold

Ground leases have emerged as an increasingly popular and versatile option in the commercial real estate market. They offer an opportunity for landowners to generate a reliable income stream while retaining long-term control of their property. For tenants, this arrangement provides access to prime locations and the ability to develop the land according to their needs without the substantial upfront costs of purchasing the property.

As with any real estate transaction, consider the terms of the agreement and the options available before signing any papers. By understanding the potential risks and rewards, you can structure an agreement that aligns with your long-term goals and maximize the value of your property.

The growing interest in ground leases is likely to continue as market conditions evolve and more stakeholders recognize the benefits of this arrangement. With careful planning and due diligence, land leases can provide a foundation for successful partnerships and thriving businesses.

Ground lease real estate FAQs

Why are ground leases 99 years?

The 99-year term for ground leases is a common practice, not a legal requirement. It balances the landowner's interest in retaining long-term ownership with the lessee's need for stability and investment justification. While this duration has become customary, lease terms can vary based on mutual agreements between the parties involved.

What is the difference between NNN and a ground lease?

A NNN lease involves tenants paying all property expenses: property taxes, insurance, and maintenance. A ground lease is renting land to develop or improve. NNN is about operational costs of an existing property while ground leases focus on land use.

Important note: This post is for informational and educational purposes only. This post should not be taken as legal advice or used as a substitute for such. You should always speak to your own legal counsel before taking action.