The ground lease is a common type of commercial land rental arrangement with several potential advantages for lessees and lessors. It is crucial for the contracting parties to understand this type of leasing agreement so they can make financially beneficial decisions. So, what is a ground lease in commercial real estate?
In commercial real estate, ground leases are long-term land rental contracts (20 to 99 years long) that grant a tenant the right to develop or build on the land. Tenants pay for the developments (including associated taxes and insurance), but property owners retain ownership of the additions.
Commercial real estate ground leases are complex, though their underlying principles are straightforward. Property owners and prospective tenants wishing to know the basics of ground leases should find the following information helpful.
What Is A Gound Lease In Commercial Real Estate?
Ground leases (also called land leases) are a form of long-term rental agreement in commercial real estate. The duration of this type of lease generally ranges from 20 to 40 years, up to 99 years or more (though this is less common).
During the lease period, the tenant rents a piece of land and has the right to construct buildings and other infrastructure at their own expense. The tenant is responsible for the costs of the developments and improvements to the land, including:
- Financing the construction
- Maintenance
- Insurance
- Taxes
In return, the land owner receives rental income while also retaining ownership of the developments made by the tenants.
Ground leases can be advantageous for tenants because they don’t have to purchase land to develop buildings and infrastructure to run their business operations. For lessors, the principal benefit is that the financial value of their property increases as a result of the tenants’ improvements.
Common examples of ground leases include:
- Enterprises that rent land to build and operate manufacturing facilities.
- Large retail chain companies that construct and operate stores on rented land.
The tenant’s degree of autonomy to build on the land varies depending on the lease provisions. In some cases, lessors might retain the right to determine how the tenant develops and uses the land, which can prevent tenants from making the kinds of improvements they prefer or need.
Typical Contents Of Ground Lease Agreements
Ground leases typically contain the following contractual terms and conditions.
Lease Duration
The period that the lease agreement is valid for. This period covers the date of initial occupancy to the date when the tenant is required to vacate the land.
Rights Of Contracting Parties
Ground leases set out the rights of the contracting parties. These rights pertain to the privileges and responsibilities legally assigned to the lessor and lessee, such as:
- The owner’s right to access the land.
- The conditions under which the tenant can exit the lease before it expires.
- The extent of the owner’s authority and control over the tenant’s improvements on the land.
Provisions For Use
Use provisions in ground leases prescribe the business and related activities occupants are legally allowed to undertake on the land.
The provisions also describe the nature and scope of the property developments tenants are entitled to implement.
Financial Obligations
Land leases contain provisions that indicate the rental payment amount and schedule. This part of the lease contract usually includes an escalation clause that prescribes the percentage and frequency of rent increases.
Crucially, the lease agreements also assign responsibilities for associated costs such as maintenance and taxes.
Deposit Fees
Land lease contracts usually contain clauses that stipulate the security deposit tenants must pay, including the fee amount and details about how and under what conditions the deposit is refunded.
Title Insurance
Title insurance provisions indicate the scope of the owner’s title insurance policy. This element of the lease agreement also sets out tenants’ rights regarding obtaining leaseholder title insurance.
Defaults
Land lease agreements stipulate the conditions and contingency measures that apply if tenants default on rental payments or loans taken to fund property improvements (see subordinate leases below).
Subordinated VS Unsubordinated Ground Leases
Lessees often take loans to finance developments on the land they’re renting. So, who is liable for the debt if the tenant defaults on these loans? This is where unsubordinated and subordinated ground leases agreements enter the picture.
If the lease is subordinated, this means the land serves as collateral for the loan, in which case the owner is liable if the tenants don’t service their debts. Unsubordinated leases protect the land owner from creditors’ claims if lessees default.
Subordinated leases make it easier for tenants to obtain loans for property developments but pose a risk to owners (as creditors can make claims on their land if the lessors default). For this reason, landowners usually increase the rental payment amounts to accommodate this additional risk exposure.
Tenants may find it more challenging to access financing if their lease is unsubordinated, while landlords are insulated from creditor’s grasp because the land is not used as collateral. The advantage for lessees is that the rental payments for unsubordinated leases are generally lower.
The Pros Of Ground Leases
The most significant benefit of ground leases for tenants is that they get to build and use infrastructure without needing to purchase land. By renting (rather than purchasing) commercial real estate, lessees can divert capital to develop buildings or facilities crucial to their business operations.
If the lease is subordinated it is also easier for tenants to obtain financing for improvements they wish to make on the property. Another fundamental advantage is that the long-term duration of land leases gives tenants security of tenure.
Ground leases are also beneficial for landowners. Firstly, owners receive rental income from the property on an ongoing basis while maintaining ownership of the land.
The second critical benefit is that lessors own the improvements to the property but do not have to pay for these additions. When lessees develop the property, for instance, by constructing new buildings, this increases the financial value of the real estate, which the owner can realize if they sell the land.
Ground leases also enable lessors to achieve considerable cost savings they would otherwise be liable for. If owners sell the property, they do not pay capital gains tax on the improvements to the land.
Depending on the lease terms, the landowners might have control over any improvements tenants wish to make to the land. This arrangement places a legal obligation on tenants to consult with owners and obtain their approval prior to implementing construction.
The Cons Of Ground Leases
Ground leases also have several cons or disadvantages for contracting parties.
The most obvious disadvantage for tenants is that they do not own the buildings or related infrastructure they construct, despite the time and capital they invested in these improvements.
If the rental contract contains provisions granting owners decision-making power over additions to the property, this could create difficulties for tenants. For example, a lessor could interfere with, delay, or object to the lessee’s building plans.
Another potentially negative feature of land leases for occupants is that these parties are liable for the overhead costs associated with the property improvements, such as:
- Tax
- Insurance
- Maintenance
A con for owners is that they might lose control of the building and other additions to their land. Without clauses that provide lessors with adequate control, tenants might pursue developments the owner does not want.
Owners also have to pay tax on the rental income they obtain from the lessees. The financial impact of this disadvantage might be more or less significant depending on the local tax rates.
Conclusion
Ground leases are an economically viable option for commercial tenants and landowners. Tenants gain long-term access to land they can develop to undertake their business operations. Lessors benefit by gaining regular rental income and legal ownership rights of the improvements that lessees make to the property.