What’s a Ground Lease?

[NOTE:  this post originally appeared on The Vanilla Shell on November 20, 2010]

Ground leases might be one of the most overlooked aspects of commercial real estate.  In a ground lease, a landowner leases the land to a party who then constructs improvements upon the land.  The landowner retains ownership of the land while at the same time transferring control of the land (i.e., the development of the land) to another party. 

The duration of a ground lease is longer than a traditional commercial lease; 30 years is considered a short term by ground lease standards and oftentimes these leases run for 99 years.  At the end of the lease term, ownership of the improvements reverts to the landowner. 

Ground leases can be subordinated or unsubordinated.  A “subordinated” ground lease refers to the fact that the landowner subordinates their interest in the property to the mortgage of the lessee’s lender.  An “unsubordinated” ground lease is just the opposite:  the landowner essentially plays the role of the primary lender.

The advantages to the landowner is that the land appreciates in value by virtue of the improvements for which the landowner does not have to finance.  A ground lessee has the advantages of (a) gaining the use of a piece of property which the landowner does not want to sell; and (b) not having to finance the acquisition of the land. 

A ground lease works best with a landowner who owns a prime piece of property (such as a corner commercial lot) leasing to a creditworthy corporate retail business (such as a national retail chain) that does not want to own real estate.  The lessee gets the use of the prime piece of property and the landowner gets the income stream from a “safe” tenant for many years.

There are disadvantages to a ground lease.  Obviously, tying up the property on a long-term lease could affect the landowner’s ability to sell the property.  Furthermore, if the ground lease is not drafted properly and there are no provisions for rent increases over the term, the landowner may not see the expected appreciation in the property’s value (given that the income stream would stay the same throughout the lease term).

For the lessee, the ground lease – especially an unsubordinated ground lease – can present a disadvantage in terms of securing financing for the intended improvements.  Unless the lessee can provide adequate security to the lender, the lender is not likely to want to finance the lessee’s improvements. 

A ground lease is not the proper structure for every commercial lease transaction.  Nonetheless, for the right landowner, the right property and right tenant – and if properly drafted — a ground lease could be a very lucrative structure for all parties involved.