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Recession-Proof Ground Leases Are an Overlooked $2.5 Trillion Asset Class

The headline-making transactions in commercial real estate usually involve big high-rise buildings, major portfolio trades with gargantuan price tags, or company mergers with even more zeros attached to the transaction. It’s a rare occasion, however, that the industry gets excited over ownership of something that is an inseparable part of every real estate transaction: land. Most owners of multifamily properties, office towers, and other property types own the whole “kit and caboodle,” the land as well as the building on which it sits. Yet, there are plenty of instances in which the land and the building are owned separately, with the building owner occupying the property under a ground lease agreement with the landowner. Ground lease, or land lease, transactions don’t account for a large percentage of commercial real estate transactions, but they have significant value. The addressable market for ground leases in the United States totals $2.5 trillion. There may not be as many bragging rights to owning a ground lease or leasing land compared to owning or leasing a trophy asset, but such an arrangement has its advantages on both sides of the ownership table.

In the development arena, traditional ground leases involve a long-term lease agreement, typically 50 to 99 years, during which time a developer constructs a building on the leased site and is landlord of everything but the land itself, taking responsibility for any building improvements and applicable taxes. With transactions involving existing buildings on ground leases, the same ownership obligations apply. For the lessee, land leases open the door to developing on prime land without having to carry the burden of financing the acquisition of the site, and for either the developer or the purchaser of a building on a ground lease, the lease payments are tax deductible.

As for owners of coveted land, there are a few good reasons for leasing out a site on a ground lease as opposed to selling it. Ground leases typically involve fixed payments over the term of the lease, which provides a steady income stream. On the face of it, ground leases can be win-win for the landowner and the building owner, that is until the lease expires. Barring special agreement terms or lease renewal, at the end of the traditional ground lease, the building sitting on the land becomes the property of the landowner. At this point, the landowner can choose to negotiate a new lease with the property owner with the advantage of being able to demand higher lease payments. The landowner, now the property owner as well, can also opt to sell the building to the highest bidder.

Given the terms of leasehold agreements, the ground lease sector is essentially a “safe” investment and is counter-cyclical. “Generally, ground rent payments represent less than one-third of the overall net operating income generated from the building, and rank senior to leasehold interest payments. As such, it is usually in the tenant’s best interest to keep making ground rent payments,” Harsh Hemnani, an analyst with Green Street Advisors, told Propmodo. And with the option for a landowner to take possession of the building in the event of a default on lease payments, there’s no long-term loss of funds. “These factors make ground lease recession-proof,” he said.

Investors are taking note of the fact that many lease leasehold agreements are due to expire within the coming years, especially in Manhattan. Land lease agreements in New York City became popular more than a century ago, meaning many of the city’s historic buildings are on borrowed land and borrowed time. However, expiration dates are not the only game changer in the ground lease arena. Some leasehold agreements contain clauses providing market value-based resets in rents, and for properties that are not performing well enough to accommodate the increased payments, the building owner may be forced to sell, which is precisely what happened with the renowned Chrysler Building in Manhattan.

Cooper Union has long owned the land beneath the 1930s-era Chrysler building and in 2018, per terms of the market-based rent clause, the educational institution increased the annual ground lease rent from $7.5 million to $32.5 million. The Chrysler Building was struggling with a diminished occupancy level that was no match for the new rental obligations. The owner, a partnership of Tishman Speyer and Abu Dhabi Investment Council, ultimately sold the Chrysler building in 2019 to RFR Realty LLC for only $150 million, a drastic discount to the $800 million that Abu Dhabi had paid Tishman for a 90 percent stake in the building in 2008. In such situations, the landowner could be left holding a poorly performing, devalued property providing no income stream if a new buyer willing to pay the increased rent doesn’t come to the fore. Still, a premier parcel, particularly in New York City, won’t go without offers for long, leaving the landowner with great potential to regain any loss of income from the previous lessee’s default.

Vornado Realty Trust found itself in a similar situation in 2020, when tenant Topshop filed for bankruptcy and shuttered its retail space in their building 608 5th Ave. in Manhattan. With a big vacancy and no backfilling option at the mixed-use retail building, Vornado chose to surrender the property to the landowner, the Korein family, effectively ending the land lease that would have expired in 2033.

Given the low-risk nature of land leases for landowners, these investments are becoming more popular in the midst of today’s precarious economic environment. “The ground lease industry is growing quickly as investors increasingly allocate capital to the sector, looking to capitalize on the high risk-adjusted returns available in the market,” said Hemnani. Safehold Inc., a ground lease REIT, is the largest public ground lease portfolio today with assets valued at more than $6.2 billion across 30 U.S. markets from coast to coast. 

Another prominent company in the ground lease industry is Ground Lease REIT, which focuses on the origination and acquisition of long-term ground leases on developments and existing properties spanning the property type spectrum. Established in 2020, Ground Lease REIT markets its 99-year financing product as a return-enhancing alternative to conventional financing. Ares Management Corp. and real estate private equity firm Regis Group are also in the land-lease business, having created Haven Capital, a real estate finance platform offering ground leases as a funding solution for everything from developments to recapitalizations to lease-ups.

While ground leases are growing in popularity among commercial real estate investors, currently, the ground lease market is not expanding at as fast a pace as it would in a different climate. The overall decrease in real estate transaction volumes has dampened ground-lease origination activity. Furthermore, on many new land lease transactions, tenants are pushing back on the traditional terms. “On deals that do occur, tenants appear to be unwilling to lock in high ground lease costs for a near-perpetual time period of 99 years, which has resulted in a decline in ground lease transactions,” Hemnani said.

Given that land is a finite product in this world, it makes great sense to invest in it and a ground lease offers the owner a certain protection in uncertain economic times. Even if the lessee becomes unable to continue to meet rent obligations, the landowner has protections in the form of the ability to sell the property. Newer land-lease agreements are evolving, with many eliminating the value reset clause, but this niche investment type remains a popular option for risk-averse investors.

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