Real estate development projects frequently require substantial capital investments. Developers utilize various sources to fund the equity capital that drives their ventures, aiming to optimize their cost of capital. One crucial factor that can significantly influence the cost of capital is the utilization of a ground lease. This article will explore the concept of ground lease as a capital tool and will address how a ground lease can impact the cost of capital for real estate developers.

Understanding Ground Lease:

A ground lease is a long-term agreement between a landowner and a ground tenant (typically a real estate developer) that grants the tenant the right to possess, use and develop the land for a specified period of time. In exchange for those rights, the ground tenant pays rent to the landowner over the entire term of the lease. Frequently, ground leases are commonly used in situations where the landowner wishes to retain ownership of the land while allowing the ground tenant to construct improvements on the land such as commercial buildings or residential complexes.

Benefits of a Ground Lease to the Developer:

There are several reasons why the real estate developer would consider a ground lease for its development project as opposed to the fee simple acquisition of the land. These reasons include:

• The developer may be able to commit less equity capital to develop the property using the ground lease approach. When a developer acquires land through a ground lease, the initial investment is significantly lower compared to purchasing the land outright. By way of example, if the developer is building on a parcel of land valued at $3,000,000 and the lender will only lend 65% of the purchase, then developer’s equity contribution will be $1,050,000 plus the associated costs of acquisition of the land. If, however, the land is leased, then the initial annual ground lease payment may only be $150,000 (assuming that the ground lease is based upon a 5% return on the land value).
• The return on the invested capital is frequently greater if the developer leases vs. owns the land. The real estate developer’s expertise is in creating a real estate asset that can generate an unleveraged return of 10%-12% or greater. On the other hand, land generally has an unleveraged return of 4%-6%.
• The developer may be seeking less expensive and longer-term financing for the land component of the transaction. A ground lease is frequently for a period of 30 to 99 years. Most traditional developer “take-out” financing is for a period of up to 10 years unless some type of government sponsored entity financing is involved. After that point the debt must be refinanced. Therefore, the ground lease can be a source of very long term financing. Additionally, the ground lease rent will usually be a percentage of the land value. Frequently, that percentage is in the range of 4%-6% making the ground lease a relatively inexpensive source of capital.
• Frequently, large national chain retailers like CVS or Walgreens are only interested in a ground lease because they DO NOT want to own the land underneath their building. Their rationale is that their capital is better utilized in their business as opposed to in the property on which their building sits.
• There is a significant tax benefit to the real estate developer if the land is leased as opposed to being owned. This is because federal tax law does not permit the ground owner to annually depreciate or cost recover the land in determining their annual taxable income. However, a real estate developer who is leasing the ground may deduct the cost of the annual lease payments in determining their annual taxable income.

Conclusion:

The decision to enter into a ground lease agreement can have significant implications for a real estate developer's cost and amount of required equity capital. By (i) reducing the initial investment and equity requirement, (ii) increasing the return on equity capital, (iii) providing long-term, less expensive financing and (iv) providing a significant tax benefit, a ground lease can aid developers in optimizing their capital structure and securing financing on favorable terms. However, it is essential for developers to carefully evaluate the specific terms of the ground lease and assess its impact on the project's overall financial viability. By doing so, developers can leverage ground leases as a strategic tool to minimize the amount and the cost of equity capital and maximize the potential return on their real estate development investments.