This feature is unavailable at the moment.

We apologize, but the feature you are trying to access is currently unavailable. We are aware of this issue and our team is working hard to resolve the matter.

Please check back in a few minutes. We apologize for the inconvenience.

- LoopNet Team

You must register your contact information to view secure information on this listing.
You must register your contact information to view secure information on this listing.

The Basics of Investing in Ground Leases

Immediate Cash Flow Is King in This Asset Class

Retail facilities are sometimes built on long-term ground leases. (CoStar)
Retail facilities are sometimes built on long-term ground leases. (CoStar)

The notion of an investor leasing land for 50 years, with all improvements on that land reverting to the landowner upon expiration of the ground lease, can seem illogical to long-term holders of commercial real estate. But when carefully structured, these arrangements can generate much-needed cash flow, especially for newer CRE investors.

LoopNet spoke about ground leases, also called leaseholds, with John McNellis, co-founder of McNellis Partners, a Northern California-based shopping center development firm, that has held long-term ground leases — some going on 40 years, now — as part of its overall CRE portfolio.

McNellis is the author of “Making it in Real Estate: Starting Out as a Developer,” a compilation of essays that provide advice and guidance to nascent real estate developers. McNellis wrote the book to help others avoid the mistakes he made as he learned the craft, one transaction at a time. One essay in the book focuses on leaseholds; in it, he compares the overall return on a leasehold investment to a comparable fee simple investment.

With LoopNet, he discussed the following key elements of a ground lease or leasehold investment:

  • Two kinds of ground leases.
  • The basics of a ground lease.
  • Uses and zoning.
  • Focus on existing ground leases.
  • Similarities to an amortizing loan.
  • Lease expirations.
  • Stable cash flow.

Two Kinds of Ground Leases

McNellis set the stage by differentiating between two types of ground leases.

“To clarify, this is not a two-party ground lease where there's the rich ground owner and say, Walmart on the other side. We're talking about a three-party ground lease where you have the ground owner, the developer (or the investor in the middle) and then the tenants in occupancy.”

Two-party ground leases “happen a lot … if you have a particularly juicy piece of land,” and people are pestering you to sell, McNellis noted. However, the arrangement he encourages investors to consider is a three-party ground lease, in the role of developer/operator between the landowner and the tenant.

The Basics of a Ground Lease

For ease of understanding, McNellis started by providing what he called “a vastly oversimplified” scenario between a landowner and a developer, with the novice investor in the role of the developer. The situation he presented began with a landowner disinterested in developing the land themselves. A developer comes along and offers to buy the land, but the owner says no. “And then [the developer] goes back and stews for a while and says ‘okay, how about I lease it from you?’”

The landowner offers the land for lease at $1 million a year. The developer calculates they will need to spend $10 million to construct a building and secure tenants, so they request a 50-year term and the parties agree.

Uses and Zoning

Most CRE ground leases in the U.S. are completed for industrial, retail and office uses and less so for multifamily facilities, McNellis said. But the land being leased typically isn’t already zoned for its proposed use.

Often, a landowner is a farmer whose “grandparents picked their location well because now it sits next to a freeway interchange,” joked McNellis. But despite this choice location the land is still zoned agricultural. So, in circumstances where the developer is commencing a ground lease, they will often need to factor in several years to obtain zoning when setting the lease term with the landowner.

McNellis provided a different example, centering around an office building. “It could be that it's a perfectly good building, but it's empty and it just needs to be renovated, so there's no rezoning.”

Again, the investor pays $1 million a year to the building owner. They put $10 million into the building renovation and they lease the building for $2.5 million a year. Even with the cost of the ground lease, the developer stands to make a comfortable return.

Focus on Existing Ground Leases

Drawing on his hard-won experience, McNellis advises that novice investors avoid setting up new ground leases in the role of the developer. “Occasionally, they work out,” McNellis said, but generally if you are an eager developer courting a reluctant landowner that won't sell, but will agree to a ground lease, “almost by definition you’re going to pay too much ground rent,” he added.

“This has happened to me, in my early days, at least half a dozen times where I did an entire deal and it turned out fine, except I didn't make any money,” he offered with laughter. “I paid too much — either too much for the land or too much in ground rent.”

“You can only do that every so often. So, my caution is don't start ground leases if you're going to do this [as a nascent developer], try to find old ones that you can buy at a discount.”

McNellis cautioned that investors should carefully assess ground leases where the ground rent adjusts upward without consideration for what's happened with the tenants in occupancy. He gave the example of a shopping center — where the retail rents have been flatlining for a dozen years — that is subject to a ground lease that's bumping up 10% every five years.

Initially, that might appear to be a stable cash flow. But if you are too optimistic, you may fool yourself into thinking that retail rents are going to rise, McNellis said. “That's why you have to be very leery of deals with big, fixed ground rent increases. It’s not the least bit certain that you can pass on those rent increases to the actual tenants. They don't care what your ground rent is. They just care about current market rents.”

Similarities to an Amortizing Loan

“When you're underwriting it or figuring out whether you should do the deal in the first place, you have to assume that A: you're not going to be able to buy the land; and B: you're not going to be able to extend the lease,” McNellis said.

“Properly viewed, a leasehold is an amortizing loan. It's just that there's no lender involved. The lessee is, in effect, making a loan to themselves [because] they have to get all of their capital back, just as a lender would with an amortizing loan. So, over a 30-year period, a lender gets interest plus principal back. In a ground lease, you've got to get your interest rate and your capital back,” he added.

At the end of the term, the investor has to walk away. Their grandchildren do not get the building, said McNellis, but if the investor has been smart, they’ve received their full capital back over that 30-year period, and chances are they’ve taken that money and reinvested it elsewhere.

Lease Expirations

Office tenants often face the inability to renew in place for a myriad of reasons, ranging from rising rents to another tenant’s expansion rights. Given these conditions, engaging an office tenant toward the end of a ground lease, and conveying that there is a hard stop at the end of say five years, is not a deal-breaker, according to McNellis.

“But in my world, which is more retail-oriented, the big tenants — like Safeway, Walmart and Home Depot — they would want more term,” McNellis said. So, if the landowner is set on terminating the ground lease, those retailers can negotiate directly with the landowner to continue renting or to buy the land. Alternatively, the developer in the middle may go back to the ground owner, extend the ground lease and continue collecting rent from the retailers.

Stable Cash Flow

Asked why he advocates for purchasing leaseholds toward the end of their term, McNellis said: “simply because there’s less competition,” making prices better for buyers.

He noted that “generally, larger institutions are unwilling to consider ground lease purchases because of their finite nature, meaning that as you approach the latter years of a leasehold, it becomes unsellable except at a very steep discount.” This is why McNellis counsels budding CRE investors to purchase leaseholds then.

Concerning lenders, McNellis added that “banks are often unwilling to loan against leasehold interests because their loan would be in a second position behind the interests of the underlying ground owner,” effectively making the bank’s loan a second mortgage.

“If you're starting out [as a real estate investor] the really tricky part is getting cash flow going, because on a fee simple, ground-up deal, it might be five or seven years before you, as a developer, actually start seeing cash flow. And the question is, how do I eat?”

Using a stock and bond analogy, McNellis continued, “you buy gross stocks, let's say Amazon, that never pay dividends, but hopefully [will] go up over the long term. And then you balance that by buying bonds that pay yields immediately.”

“Take that advice and apply it to real estate,” McNellis said. “So, yes, you can work on your ground-up Xanadu, but it's going to take five years and you'll make $10 million. But in the meantime, maybe buy a leasehold that has immediate cash flow and that's the bond yield. You're not going to make a huge capital gain off of it, but it’s great cash.”

Was this article helpful?