Ground lease agreements are popular, especially in the commercial arena where chain stores or franchises acquire land to develop or improve to their specific requirements. Before a landowner or tenant leases ground, they must consider all the factors, including what to expect when the lease concludes.
A ground lease is when a landowner provides property to a tenant to develop within the parameters of the agreed specifications of the lease agreement. Unless specified otherwise, when the lease ends, the land, including all developments and improvements, becomes the owner’s property.
Not all ground leases are the same, and various factors influence the lease period and the contract specifications, including what happens when it ends. In this article, I will provide a short explanation of the most common land leases and what to expect when it concludes.
What Happens At The End Of A Ground Lease
Leasing an open piece of land, known as a ground lease, is where the tenant has full use of the land to develop or use. The land development and what happens when the lease expires is stipulated within the agreement. Generally, all improvements and developments made during the land lease become the landowner’s property once the lease term concludes or is terminated.
Because the tenant only has the use of the property and loses the value of any development and improvements after the lease concludes, the term generally spans over a long and profitable period. The lease conclusion terms vary depending on the contract signed by both parties.
The owner benefits from generating an income from the freehold property and the development value. At the same time, the tenant can develop it to produce revenue or some form of benefit. Contract stipulations are written that underline all the requirements, including the lease period and conclusion.
To provide a better understanding of what happens when a ground lease ends, I must break down the two main types:
- Subordinated Ground Lease
- Unsubordinated Ground Lease
The Main Types of Ground Leases
With every land lease, some contractual requirements and stipulations vary depending on the lease agreement between the owner and the tenant. Land lease requirements also include what happens at the end of the lease, and it depends on whether it is a Subordinated or Unsubordinated lease.
The difference between a Subordinated or Unsubordinated ground lease:
- Subordinated Ground Lease – A Subordinated land lease is when the landowner advances the land title as security for the developer to obtain a construction loan. The landowner has a large share in the project but risks losing the land title if the loan defaults. A higher rental rate is agreed to compared to unsubordinated leases to counter the risk.
- Unsubordinated Ground Lease – An Unsubordinated land lease gives the landowner maximum claiming control. The power to claim by the landowner includes the improvements made to the property by the tenant during the lease period and a refund if the tenant defaults.
Early Termination Of A Ground Lease
When a tenant and landowner enter into a lease agreement, both parties must consider all the factors, requirements, and stipulations, including the penalty for early termination. There are several reasons why a tenant may terminate the lease prematurely:
- Real estate market slump
- Recession
- Profitability
- Environmental liabilities
- Financial strain (development and improvements)
When the tenant prematurely terminates a ground lease, the landowner is compensated according to the termination penalty clause in the contract. Various land lease agreements do not have this clause and generally end up in court to determine the damages.
Benefits And Drawbacks Of A Ground Lease
A successful ground lease is when the owner and the tenant benefit from the agreement, which means that both parties are left satisfied once the lease agreement is concluded. A ground lease agreement also has some drawbacks, which the landowner and tenant must consider.
Tenant Benefits
Prime land, especially for commercial use, is scarce, and the ones available are extremely expensive, which makes it hard for tenants to develop and purchase the land. Tenants acquire land to develop via a lease agreement without the financial strain, freeing up money for construction.
Typical examples are chain stores like Starbucks and Whole Foods, which lease and utilize ground for their corporate expansion plans. Not only do tenants avoid a large property down payment to secure the land, but they can also deduct the rent from their federal income tax.
Landowner Benefits
Without the finances to develop an empty piece of land, it remains a financial burden for the landowner. Most owners approached by tenants for a lease agreement jump at the opportunity to get a steady income while benefitting from the improvements made to the property. Not only does the landowner get a monthly income, but the rent is subject to a yearly increase, generally 3% in the U.S.
Some ground lease agreements give the owner some property control, which often includes its development and use. The landowner does not have to report any gains, although there are some rent payment tax implications.
Tenant Drawbacks
How the ground lease starts, proceeds, and concludes is subject to the stipulations in the lease agreement. Lease agreements that require landowner approval before any changes can cause roadblocks during the development or use of the property.
The lack of flexibility and control of the development often cost more than purchasing the property from the landowner. Other financial drawbacks include high rent, taxes, permits, and improvement approvals.
Landowner Drawbacks
A ground lease agreement requires due diligence, and the owner must consider every aspect, including taxes, development control, etc. Proper provisions in the contract are needed to ensure that the landowner does not lose control of the property.
Rent paid by the tenant is considered income, and it is taxable. Sometimes, the property’s location causes it to fall into a higher tax bracket, which increases the financial burden of the landowner.
Conclusion
Generally, a ground lease ends after the full lease period with the landowner’s property returned, including all the development and improvements. Some land leases have stipulations in the contract agreed upon by the tenant and owner that may vary, including its conclusion. Early termination of a ground lease agreement may also affect the outcome.