Upping Your Ground Lease Game, Part I
- Feb 17, 2016
Ground leases are common, particularly in the retail sector, and CRE professionals who aren’t up to speed on the ins and outs of ground leases need to up their game.
A landowner may opt for a ground lease in order to retain control of a property while reaping the economic benefits of development, and without construction risk and the headaches of managing the property. The ground-lease owner can avoid capital gains taxes and create a low-risk, long-term income stream.
Developers prefer to own the property outright, but may only be able to acquire a highly desirable development site by entering into a ground lease with the landowner. While complex and difficult to finance, a leasehold structure can result in more cost-efficient financing over the long term. The developer can achieve higher leverage than with a conventional fee simple structure, since rather than purchasing the underlying land, they lease it over a very long term.
Many lenders will not finance ground leasehold interests, and those that do have very specific underwriting and structuring requirements. From an underwriting perspective, the lender is primarily concerned that the remaining term of the ground lease will be sufficient to protect its security interest, and will carefully evaluate the ability for the debt to be refinanced at the maturity date. Financeable ground leases typically have a term of 50 to 99 years because the remaining lease term must extend well beyond the mortgage term, enabling the lender to recover the loan amount before the ground lease term expires.
Lenders treat ground rent several different ways when underwriting project cash flows: Some will underwrite the ground rent as an “above the line” operating cost, and others will consider it a financing cost incorporated into the denominator when calculating the debt service coverage ratio. The difference in these underwriting approaches can have a significant impact on mortgage loan proceeds.
Another often overlooked consideration is that lenders are also concerned about ground rent escalations that are tied to CPI or fair-market-value adjustments, which make future rent increases uncertain unless they’re capped. Fixed-ground rent payment schedules in which future payments are known are much easier for lenders to underwrite. Leases with CPI or FMV adjustments and no caps on future rent increases will often be conservatively underwritten, resulting in low mortgage proceeds. In some cases, lenders won’t consider financing leases that have uncapped CPI or FMV adjustments at all.
In addition to underwriting, valuation and structuring issues, there are several important legal rights and remedies that must be considered. Given the complexity and risk associated with structuring and financing ground-lease positions, owners, investors, lenders and developers often rely on third-party experts and professionals, not only for legal and valuation advice but to source capital, as well.
For more insights from Jay Maddox on ground lease financing, stay tuned for Part II of this series.