Triple-Net (NNN) Ground Leases
When most people think of a commercial property lease, they probably think of a lease that includes the land, building and improvements. But there is another type of commercial lease: a ground lease.
A ground lease encompasses the land only. Generally, the tenant will construct its own building on the leased ground. Throughout the term of the lease, the tenant will own the building and will pay the landowner monthly rent to lease the land. At the end of the lease -- or earlier, should the tenant default on the lease -- ownership of the building conveys to the landowner at no cost. Thus, the lease is backed by the value of the building constructed upon the land, offering the landowner significant security.
Let’s look in depth at some of the unique aspects of this type of investment.
Why would a business owner build on land they don’t own? There are a number of reasons why this structure benefits the tenant, including:
- It may enable a business to set up shop in a premier location, on land that may rarely, if ever, come up for sale.
- It allows the business to use available cash for construction or other business needs, rather than tying up capital in land purchase costs.
- It offers an income tax advantage, as rent payments are fully deductible against their income. Conversely, land is not a depreciable asset so any cost allocated to land offers no depreciation deduction against the company’s income.
For many of our clients, the first and foremost thing on their mind is financial security. They want a conservative investment that may offer them long-term, stable income, and not subject them to unnecessary risks. Ground leases can be a good fit for these folks for a number of reasons.
Nearly all ground leases will have a “reversionary clause” in them. This reversionary clause dictates that upon expiration of the lease, or earlier if the tenant were to terminate the lease prematurely, ownership of the building conveys to the landowner -- generally at no cost. Because of this reversionary structure, the tenant has a strong vested interest to do everything in their power to fulfill the terms of the ground lease, because they lose their building if they don’t.
Ultimately, when this conveyance occurs, the landlord now owns both the land and the building. If the building is in good shape and a new tenant is found, the landlord will typically incur some tenant improvement costs to renovate the building to meet the new tenant’s needs. But, because the landlord is now leasing out both the land and building, the landlord may be able to charge significantly higher rent and thus increase the net operating income from the property. And because the value of commercial real estate is based upon the value of cash flow it delivers, this also increases the property’s value.
When considering a ground lease, it’s important to ensure that the transfer of the building will occur without any cost to the landowner. This is typical -- but in rare circumstances, the reversionary clause can require the landowner to pay some consideration for the building. For example, the tenant may have negotiated a right to be compensated for the undepreciated cost of the improvements. We would not recommend purchasing a ground lease property that requires any such consideration.
Another benefit to the landowner is that a commercial ground lease is typically a passive investment, requiring no active management. A ground lease is generally a type of triple-net lease, and holds the tenant responsible for all management duties and costs associated with the property, such as real estate taxes, snow-plowing, parking lot maintenance, new roof, etc. A ground lease should provide “mailbox money” -- it’s an investment that should require no, or very little, work on your part.
These are typically long-term leases. Most single-tenant triple-net ground leases to retail tenants will have primary lease terms between 15 and 25 years, with multiple renewal options thereafter. If all renewal options are exercised, the full term may be 40 years or more.
The lease should provide for regular rent increases throughout the lease. This provides the landowner with a hedge against inflation. Rent increases, which typically occur every 5 years throughout the primary lease term and any renewal options, will range from 5% to 12%, with most at 10%.
In terms of the tenants and guarantors behind a ground lease, they tend to be parent companies operating hundreds or even thousands of stores (as opposed to small franchisees who may operate many fewer units). Many types of corporate tenants enter into ground leases, including Walgreens, McDonald’s and other restaurant companies, various banks, automotive retailers such as O'Reilly Auto Parts, and many more.
Because of the reduced risk and solid income streams that commercial ground leases offer, their cap rates generally will be lower than land and building leases with comparable tenants.
Often, ground leases require less capital to purchase than a comparable land and building lease, as you are paying only for the land -- not the building. Having a smaller price point means that this type of investment may be more accessible for some investors, or may allow investors to more easily diversify their investment into multiple properties.
Details to Consider
One of the drawbacks to ground leases is that the landowner does not receive an annual depreciation deduction on their income tax return, as land is not depreciable. However, whether this is a significant disadvantage or not depends on the investor's specific situation. For example, for the agricultural family who is selling a ranch or farm and completing a 1031 exchange into a ground leased property, there may be little, if any, downside from a depreciation standpoint. The reason is that most ag properties that have been in the family for many years have very low depreciable basis, and 1031 rules dictate that the basis from the property sold must be carried over and become the basis of the property purchased -- there is no step-up in basis on the purchase. So in this situation, future depreciation deductions will be limited regardless -- thus, this may not be a significant drawback for an ag family. On the other hand, if a cash buyer (not completing a 1031 exchange) purchases a ground lease, the purchase price will become the property’s basis. Thus, having no depreciation deduction may be a significant disadvantage to the cash buyer.
Subordinated vs. Unsubordinated
When it comes to funding the construction of the building and improvements in a ground lease structure, the tenant may use lender financing. Such financing will likely be secured by the building and improvements, so if the tenant were to default on the loan the lender could lay claim to the building and improvements -- but not the land. The lender would then be responsible for making the ground lease payments to the landowner while the lender found a replacement tenant. This is called an “unsubordinated” ground lease; it is much preferred for the landowner and is common practice.
However, in rare cases, a ground lease can be “subordinated.” In such a case, the lender holds first lien position for collateral purposes and has priority over all other claims on the property if the tenant defaults on the loan. Thus, the landowner is subordinated to the lender, and is essentially offering title to his land as collateral for the tenant’s construction loan. This can directly benefit the tenant, as it may be easier to obtain financing -- but it can be risky for the landowner, who stands to lose his land if the tenant defaults on the loan. This type of subordinated ground lease is rare -- no mindful landowner would subordinate his interest to the lender.
Our clients have purchased many ground lease properties, and we have never seen a subordinated ground lease -- but it is certainly an important item to confirm in the lease documents.
Ground leases are a unique real estate investment option that appeals to many conservative investors. For the investor whose primary goal is to maximize income with higher returns (which also comes with associated higher risk), ground leases may not be a good fit. But for the investor seeking a long-term stream of stable, predictable income while minimizing their investment risk, ground leases are an excellent option to consider.
We’ve provided the information in this Straight Talk guide for general educational purposes. It is not intended as specific tax or legal advice. Please consult a professional for specific advice regarding your particular situation.
© 2018 Jack Sauther & Diana Sauther