Why Invest In Dirt?
Investors Discover The Advantages of NNN Ground Leases
The concept of buying a home is fairly straightforward. The purchase includes the house and also the lot or acreage it sits on. That same package deal is not always the case in commercial real estate. A landowner can arrange a ground lease, which effectively allows the land and building to be owned by two or more parties.
So, how does it work? A ground lease is an agreement between a landowner and a tenant who wants the rights to occupy or use the land for business purposes. In the triple net lease (NNN) marketplace, ground leases are commonly used for restaurants and retail locations operated by major brands such as McDonald’s, Home Depot and Whole Foods among others. The ground lease allows the tenant to “make improvements” to the land for business purpose – aka develop a building.
Ground leases are very long term in nature due to its strategic importance and the capital investment involved in the development. The typical ground lease is between 20-99 years. Tenants assume responsibility for all site improvements (building development costs), as well as all expenses, maintenance and ongoing management associated with the building. They pay rent on the ground lease for the use of the land. At the end of the lease, control of the land – and all improvements – revert back to the landowner.
Why do commercial tenants agree to a ground lease?
For a tenant, walking away from a building they have paid for at the end of the ground-lease sounds like they are getting the short end of the stick. However, a ground lease gives a business a desired real estate presence in key, strategic locations that they otherwise would not have the opportunity to obtain. Ground leases serve as the means to an end goal for many retailers and restaurant operators.
In some cases, a retailer or restaurant can’t buy the land, because the landowner doesn’t want to sell or the cost of the land is exorbitant. So, a ground lease is a very viable option. Leasing versus owning the land also provides additional advantages to the retailer, such as freeing up capital that the retailer can invest in operating the business. Tenants can recoup some added tax benefits with rents that are deductible as expenses. A ground lease also allows a retailer to focus on their core competency, which is operating their business – not investing in real estate.
On the opposite side, ground leases can be an excellent option for investors who may not want to sell the land for a variety of reasons. The land might be very valuable. So, rather than selling the land and facing the consequences of a capital gains tax bill, an investor can opt to generate steady income from the long-term lease of the land. Ground leases also are common in situations where an investor wants to maintain control of a prime piece of real estate, such as a development site in Midtown Manhattan or Downtown Los Angeles.
Why are ground leases attractive to NNN investors?
Given the long term nature of ground leases, they are inevitably bought and sold as NNN investment properties. Some of the attractive features of ground leases are:
Low risk: At the top of the list is that ground leases are extremely low risk. In fact, ground leases are one of safest investments in commercial real estate. No matter what happens to the tenant, or the building, the investor would always own the land. Anything else added to the land is like a cherry on top.
Appreciation: The investor inherits improvements if the tenant leaves, or when the ground lease eventually expires. The landowner also greatly benefits from the economic developments in the area over time and any improvements to the land. This can greatly boost the overall value of the parcel by more than 10 times.
Long-term passive rental income: Ground leases are ideal for targeted NNN tenants. The NNN ground leases generate bond-like returns with steady, predictable rental income and the tenants take care of all costs associated with the property such as maintenance, property taxes and insurance. Ground leases are usually structured with rent increases over the term of the lease. In the current low-interest rate market, the rates on ground leases stack up very favorably compared to the yields bonds are generating. For example, ground leases might generate a 4.5 - 5.5% return versus 2 - 3.5% for corporate bonds.
Strategic estate planning: A ground lease is a great generational asset, because when it passes to heirs there is a step up in basis that recalibrates the value and minimizes the potential capital gains tax if heirs do decide to sell. For example, the late New York real estate mogul Sol Goldman accumulated over 240 properties in Manhattan over decades that included a number of long-term ground leases. He left his heirs a portfolio that is now valued at more than $6 billion, yet the heirs will benefit from the step-up in value.
Be mindful of potential drawbacks
It also is important to note that ground leases also have some unique characteristics that may not make them a good fit for every investor. One difference to note is that ground leases do not qualify for depreciation. Depreciation only applies to the building. So, it is not applicable to a NNN investor who holds a ground lease on the land. The counter point to that is while depreciation recognizes the potential deterioration in value over time due to aging, land generally does not lose its value over time.
The cap rates for NNN ground lease also reflect the relative safety of this asset type as low risk often correlates in a lower yield. Cap rates for NNN ground lease investments are typically lower than similar fee simple NNNs (in which you own both the land the building outright). This can be expected as the tenant is taking on the development risk associated with constructing the building. Typical cap rates for ground leases range between 4-5.5%, whereas cap rates for direct comparable NNN properties are 75 to 100 basis points higher.
As with any lease, there is a risk of tenant default. The ground lease holder may not be legally affected by a tenant that is struggling financially. For example, if a national restaurant franchisee financed the development of the building and the operator is unable to pay the mortgage, the lender may foreclose on the building. However, that would not affect the landowner as long as the owner has an unsubordinated ground lease or first position ahead of the lender in the hierarchy of claims on the ownership of the land.
As with an NNN investment, it is important to consider the attributes of a particular investment and how it fits with your investment goals and objectives. However, ground lease ownership can be a wise strategic investment, especially for those investors who are attracted to the long-term benefits of building generational wealth. To learn more about whether a NNN investment property is the right fit for your financial freedom and lifestyle goals contact Andrew Vu at 415-539-1120 for a complimentary NNN strategy consultation.