By Craig D. Timmins
What does a business do when it has its eye on a piece of prime property, but the owner isn't willing to sell? Most would simply walk away and look for another piece of land to purchase. However, another option should be considered. A ground lease may prove to be the perfect structure to satisfy the needs of both the property owner and the end-user. Simply stated, in a ground lease, the property owner agrees to allow a third party to use the property for an agreed upon rental amount and term.
Local examples include the north Naples McDonald's; Longhorn Steakhouse, Hops and First South Bank in Naples; Eckerd at Pelican Landing in Bonita; Pagefield Commons and the Publix on the corner of College and U.S. 41 in Fort Myers.
Pros & Cons
Depending on who you talk to, ground leases are a great deal, an unacceptable risk, or something in between. The primary advantage lies in the ability to develop on prime property without buying the property, which substantially reduces the initial investment. Tenants can also write off rent for tax purposes and maintain greater liquidity to enable more rapid expansion.
Ground leases also offer an alternative to property owners who are hesitant to take a development risk. Without the appropriate development experience, understanding the complexities of the process as well as hiring engineers and architects can be intimidating. With a ground lease, property owners avoid this unfamiliar, expensive and potentially risky territory. At the same time, owners transform their vacant parcel into an income producing property.
There are also disadvantages. From the tenant's perspective, one of the downfalls is that at the end of the lease the building usually reverts to the owner of the property. That is to say, the structure built on the site (such as a restaurant or drugstore) becomes the property owner's at the end of the lease, not the tenant's. Additionally, traditional bank financing of improvements located on leased land can be difficult. Since most property owners will not subordinate their interest to the tenant's lender, tenants often must rely upon their business' financial strength and access to public capital markets in order to procure loans or equity. Subordination requires the property owner to allow the lender to take back the property in the event the tenant defaulted on its loan, a situation obviously unacceptable to many owners.
The Fine Print
Generally, ground leases have a primary term of 10 to 20 years and include provisions for lease extensions. Under a typical agreement, tenants pay rent equal to a percentage of the property's value with increases every five years. Depending on a variety of circumstances, tenants may also agree to pay additional rent if their sales volume exceeds certain levels. This "percentage rent" is sometimes negotiated as part of the economics offered by tenants to property owners. Most commonly seen in restaurant leases, paying percentage rent often affords a reduction in fixed rent and provides the property owner with upside if the tenant is very successful.
Ground leases are generally structured on a "net" basis, whereby the tenant pays all operating costs, including maintenance, taxes and insurance. This provides the property owner with a predictable, dependable income stream. Some owners will then borrow money against this income stream and enjoy the immediate use of a substantial sum of money.
Property owners may be reluctant to sell their land for many reasons. Some simply are in no rush to sell, and are looking to enjoy a very long appreciation. Most commonly, the property owner wants to avoid a hefty capital gains tax that would be payable at the time of sale. While some owners elect to defer the tax burden by entering into a 1031 tax deferred exchange, others feel more comfortable keeping their property.
Ground leases can provide an excellent opportunity for both property owners and tenants. The right combination is a well capitalized national or regional tenant that wants to locate on that coveted, prime site.
Craig D. Timmins, CCIM is a principal with Grubb & Ellis|IPC, a full-service commercial real estate company serving Southwest Florida.