The Client's Story
This particular client was referred to us by their CPA. A multi-generational Montana ranch family, they were selling a second ranch and wanted to exchange into other ranch property – but they hadn’t found one that met their parameters. After talking it over with her CPA, they gave us a call to explore a 1031 exchange into commercial real estate instead. The goal was to find an appropriate investment property to supplement their income from their main ranch. The one requirement they had was that the property be of very high quality and require no management by them. They were most interested in security as opposed to a high investment return.
Rolling Up Our Sleeves
When we began, this client was unfamiliar with commercial real estate, but proved to be a quick study. We started the process by educating and informing her and her family about the different types of commercial real estate most likely to meet their parameters of price, desire for high security and no management. We provided them with an overview of the current market, highlighting the strengths and weaknesses of several available properties – none of which we recommended purchasing. This was simply an exercise to get them fluent in commercial real estate, so that they would be ready to act when we did find a suitable property.
After presenting, evaluating and discussing many properties, they decided on a brand new Chick-fil-A ground lease property in New Mexico. Chick-fil-A is one of the most successful fast-casual restaurant companies in the country. The company has no debt, and their average store sales lead the entire industry.
This was an off-market property that we sourced directly from a New Mexico developer with whom we had previously done business. The developer was constructing the building for Chick-fil-A as a ground lease, where Chick-fil-A pays to construct (and therefore owns) the building. Our client would purchase and own the land only, and Chick-fil-A would pay them monthly rent to lease the land. The lease holds Chick-fil-A responsible for all expenses and duties related to the building and property -- our client would have no management responsibilities.
Further, as is expected with ground leases, at the end of the lease term -- or earlier if the lease were to be terminated -- ownership of the building would transfer to our client at no cost. Thus, the lease is backed by the value of the building, which was about $1 million in this case -- offering significant security to our client.
Income from a ground lease is generally lower than income from a land and building lease for two reasons:
1) The tenant is only leasing the land, not the building. This also means that the purchase price is lower.
2) The cap rate is lower for ground leases than for land and building leases, because a ground lease is secured by the value of the building. As with any investment, lower risk means lower returns.
Our client preferred a ground lease because they were most interested in security, rather than a higher return.
The land itself is a one-acre lot located just off one of the busiest intersections in Albuquerque. This location makes it more likely that the tenant will succeed here and be able to fulfill the lease obligations, while also making it more likely that our client could quickly find a new tenant should the need ever arise.
We conducted extensive due diligence, examining the lease documents, covenants, conditions and restrictions (CCRs) governing the property, property survey, title commitment, market demographics and more. We vetted the tenant, examining its ability to fulfill its lease obligations. Throughout the entire process, we reviewed our findings with our client and their attorney. We effectively managed our client’s 1031 exchange to ensure all time limits were complied with, and had suitable back-up properties identified in case the Chick-fil-A deal fell through. As the final step in our due diligence, we conducted a site visit, viewing the property and touring the surrounding area.
Our client utilized a 1031 exchange to transition from their ranch into a high-quality triple-net ground lease property. In so doing, they were able to avoid paying a substantial amount of income taxes and they now receive an additional $75,000 per year in income from the property to supplement their ranching income. They have no property management responsibilities – they simply receive a rent check from their tenant each month. Their lease is guaranteed by Chick-fil-A corporate, and someday our client will own the building when the lease expires or is terminated.
When this occurs, our client will be free to lease both the land and building to a new tenant. At that point, they should expect to make some changes to the building in order to tailor it to a new tenant’s needs, but can also expect to earn a much higher lease rate since they will now be leasing out the building as well as the land. This may significantly increase their income and investment return.
We've provided this information 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.
© 2016 Jack Sauther & Diana Sauther