Choosing a real estate investment strategy can be challenging. There are risks no matter what avenue you choose, but understanding all options, including a ground lease, is important.
A ground lease can be a good option for landlords or property owners who want prime locations, but not understanding what a ground lease is and how it works can be detrimental.
We’ve broken down everything there is to know about the ground lease and what landlords and tenants must consider.
What Is a Ground Lease?
A ground lease is different from any other type of lease. With a ground lease, the tenant owns the building but not the land. The land is undeveloped, and when a tenant leases it, they have the right to develop it while the lease is in effect.
Ground leases typically have very long terms, sometimes as long as 99 years, because when the lease expires, the land and any improvements (including buildings) go back to the owner. Tenants make regular rental payments to the landlord like they would if they rented the building.
Ground Lease Terms and Title
Tenants need to pay attention to the ground lease terms, just as they would the terms to purchase land or property.
The term is essential because they want it at least as long as it takes to recoup the cost of construction or improvements made to the building.
Just as important, however, are the title terms. Even though tenants aren’t buying the land, the title agreement is essential. At a minimum, they should purchase a title insurance policy to protect their leasehold interest in the land.
When signing a ground lease, tenants should consider the following for title commitments:
- They should receive all appendices to the title.
- The grantee on the title’s name should exactly match the name of the landlord to prevent legal issues.
- Ensure the title premiums are paid and the leasehold title policy is executed.
- Determine if any existing loans must be subordinated to the ground lease.
The Benefits and Drawbacks of Ground Leases
Ground leases offer benefits for both the lessee and the lessor.
- Can build in a prime location: Tenants have a greater chance of building in a prime location because they don’t have to worry about purchasing the land. A ground lease is much more affordable than buying land, allowing them more options.
- Lower out-of-pocket expenses: Since tenants don’t need money to put down on the land, they may be able to utilize more land or have more money for construction and improvements.
- Lower tax burden: Ground lease rents may be tax deductible for business owners, lowering their tax liability.
- May be restricted: Without owning the land, tenants may need to ask permission or get approval for any improvements or changes. This can be burdensome and may limit what they can do.
- Losing the improvements: If the tenant doesn’t extend the lease upon expiration, they lose any improvements made to the land to the owner.
- Tax and insurance are the tenant’s responsibility: Tenants are responsible for all taxes, insurance, and maintenance costs.
- Retain control: Depending on how landlords write the lease, they may be able to keep control over the improvements on the land to avoid any unnecessary issues or undesirable improvements.
- Regular income: Landlords can benefit from the steady income of a ground lease without the hassle of making the improvements themselves. Landlords may also include an escalation clause so the rents increase with market rents.
- Retain ownership of the improvements: When the lease expires, landlords get ownership of all land improvements unless the tenant extends the lease.
- Strict wording is necessary in the lease: Without proper counsel, landlords could easily be taken advantage of if they don’t have control over the improvements made to the property.
- Rent is taxable income: The income received from ground rents can significantly increase the landlord’s tax burden.
Ground Lease Negotiation Considerations
When negotiating a ground lease, lessees should consider the following:
- Request Right of First Offer to give you options if the landlord wants to sell.
- Clearly state how the improvements will be handled at the end of the lease term, including if the tenant is responsible for destroying them.
- Determine how market rents will be determined, whether based on current use of the property or highest-and-best use (current use is more favorable).
Role of Ground Leases in an Investment Strategy
Investors who want to diversify their portfolio can invest in ground leases. As tenants build on the property, it will increase the property value, giving them even more profits when they sell the land or take possession of the improvements upon lease expiration.
Of course, like any investment, there aren’t any guarantees. Landlords should ensure they have an escalation clause to charge higher rents as the market dictates, and there’s always the risk of bad tenants defaulting on their leases.
A ground lease can be a good way to diversify your portfolio or to have land for your property without coming up with capital. Understanding the nuances of the lease and being properly protected with the support of an attorney is essential.
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Note By BiggerPockets: These are opinions written by the author and do not necessarily represent the opinions of BiggerPockets.