When leasing a commercial property, there are a number of different types of commercial leases one could encounter. In some cases tenants may be looking for a property they can build on and create improvements that fit their specific needs. If this is the case, then a ground lease might be the best option.
What Is a Ground Lease?
A ground lease is a type of lease agreement in which the tenant rents a piece of land and is permitted to develop that property during the period of the lease. During the lease term, the tenant owns any buildings, developments or improvements made on the land. Once the lease ends, the land and any construction or improvements on that land become the property owner’s.
Usually, ground leases are long-term, with a lease period between 20 to 99 years, said Scott Miller, Senior Director of Land Services, and Jeff Peden, Executive Managing Director of Land Services at Transwestern. Ground leases are typically net leases, they added, in which the tenant is responsible for paying property taxes, insurance and maintenance.
What’s the Difference Between a Subordinated vs Unsubordinated Ground Lease?
There are two types of ground leases: subordinated and unsubordinated. The difference between the two has to do with what happens if the tenant is dealing with financial trouble during the term of the lease.
Subordinated Ground Lease
With a subordinated ground lease, the landlord agrees to be a lower priority with regards to any other financing obtained on the property. If a tenant takes out a loan to build on the land and then defaults on the loan, the lender can go after the property, including the land, as collateral.
For instance, a tenant who signs a subordinated ground lease might take out a loan for $400,000 to build a retail property. However, if that tenant runs into financial trouble and is unable to make loan payments, the lender can go after the building and the land.
“Typically, this is done to facilitate debt financing to construct buildings on the property,” Miller and Peden said.
In many cases with a subordinated ground lease, the landlord might require higher rent payments because they’re taking on some amount of risk.
Unsubordinated Ground Lease
With an unsubordinated ground lease, the landlord retains higher priority than the lender. Lenders are not able to foreclose on the land or use it as collateral if a tenant is unable to make their loan payments. Rather, if the tenant defaults on the loan, the lender can only go after their business assets.
Some lenders may be unwilling to give out a mortgage to tenants who have signed an unsubordinated ground lease. Because of this added difficulty for the tenants, landlords will usually charge lower rent.
Pros and Cons of Ground Leases for Tenants
Like all leases, ground leases come with their advantages and disadvantages, for both tenants and landlords. For tenants, the pros and cons may vary depending on what you’re looking for in a commercial property.
- Location: With a ground lease, tenants can build a property in a location of their choosing, without being bound to pre-existing buildings in a location that might not be ideal for their specific business needs.
- Lower Taxes: For both federal and state taxes, the rent paid on a ground lease is tax deductible. The tenant is paying less taxes than they would be if they simply purchased the land.
- No Down Payment: With a land purchase, the tenant would be paying a large down payment to buy the land, after which they would still need to build on that land. However, with a ground lease, there is no downpayment, and more money can go toward building on the land instead.
- Reduced Lease Payments: If the tenant were renting both the land and the building, then lease payments would be much higher. With a ground lease, the tenant is making lower monthly payments.
- Building Customization: When leasing an already existing space, the tenant is not able to customize the building to fit their specific needs. However, with a ground lease, tenants are only leasing the land and can customize the property as they see fit.
- Some Higher Costs: Developing a property is costly, and although tenants are able to customize their building as they see fit, sometimes the financial costs might outweigh those benefits.
- Doesn’t Retain Ownership After the Lease Expires: After putting money and time into building a property and making improvements, the tenant will have to give up ownership of the property once the lease expires, if they choose not to renew the lease. At that point, the landowner stands to profit from the improvements the tenant made.
- Responsible for Fees: The tenant has to pay property taxes, insurance and maintenance expenses on the property for the term of the lease.
Pros and Cons of Ground Leases for Landlords
For landlords, a ground lease could be beneficial for a number of reasons, but of course it comes with both advantages and disadvantages.
- Lower Taxes: With a ground lease, landlords do not have to report any capital gains as they would with a land sale. On top of that, the tenant is responsible for property taxes.
- Steady Income: Landlords have the benefit of receiving monthly rent on the land, thereby granting them a steady income stream. In addition, many ground leases also include an escalation clause, which guarantees a rent increase and eviction rights in the case of a tenant defaulting on payments.
- Retains Ownership of Improvements: After the lease period ends, the landlord retains ownership of any improvements made on the land and can therefore sell the property at a profit.
- Lack of Control: In the situation where a landlord doesn’t include certain clauses in the lease, they might not have any say in what the tenant does with the land.
- Higher Income Tax: Although a landlord won’t have to pay capital gains taxes, the rent they receive from the tenant counts as income, and so they will have to pay higher income taxes.
Example of a Ground Lease
In Houston last June, Peden and Miller negotiated a 20-year, 2.64-acre ground lease for a new automotive dealership. The land was leased to Grubbs Automotive, with plans to convert the existing structures into a new Volvo automotive dealership.
In this example, Grubbs Automotive is leasing the land but has the freedom to build new properties and make improvements on the land and any existing buildings as they see fit. Once the lease term ends, if they do not renew, then all of those improvements become the property of the landlord.
What’s the Difference Between a Ground Lease vs Leasehold?
A leasehold estate is very similar to a ground lease, in that with a leasehold estate, the physical structures are owned by the tenant, and the land is owned by another party, from which the tenant is renting. The party that is leasing the land from the landowner has the right to use the land for the duration of the lease. When the lease ends, the building and any improvements become property of the landowner, similar to a ground lease. See also appurtenance.
However, according to Miller and Peden, “With a ground lease, you essentially have the rights as an owner of the land and the property or buildings that are on it for the period that has been agreed to. With a leasehold, there is an agreement between the owner of the property and the lessee with typically more restrictions on the lessee on what can be done with the property.”
Essentially, leasehold agreements come with more restrictions than ground leases but are otherwise fairly similar.
Is a Ground Lease Right for You?
While a ground lease comes with its advantages and disadvantages for both the tenant and the landlord, it’s important to know what you’re looking for in a rental agreement before deciding on a type of lease. Ground leases are beneficial because of their longevity and guaranteed income for landlords. And for tenants, ground leases allow you to build a property that fits your custom needs.
However, there are many different lease structures. Before deciding on what fits your needs, make sure to do your due diligence and learn about the different types of commercial leases in existence.