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What Is a Ground Lease?
A ground lease is an agreement that permits a tenant to develop a piece of property during the period of the lease. After the lease period, the land and all improvements the tenant makes return to the property owner. Ground leases may also be referred to as land leases since the landlord is leasing out only the land.
Ground leases should include the following essential aspects:
- Default conditions
- Financing conditions
- Rights of the landlord
- Rights of the tenant
- Terms of the lease
- Title insurance
- Use provisions
How a Ground Lease Works
Ground leases involve leasing land for a long-term period to a tenant who then constructs a structure on that property. A typical ground lease covers a period from 50 to 99 years.
- Who owns the building
- Who owns the land
- Improvements to the property
A ground lease stipulates that the property owner will own any improvements unless the parties create an exception. This type of contract also stipulates that the tenant will pay relevant taxes during the period of the lease. Landlords may be able to sell the property on the land at a higher rate once the term of the lease expires because they can assume all improvements at that point.
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A landlord may choose to use a ground lease in order to:
- Avoid capital gains
- Generate revenue and income
- Retain property ownership for planning reasons
Ground leases are primarily used in commercial agreements. However, these types of leases are very different from other leases that you might find for office buildings and shopping complexes. Other commercial leases do not usually assign the lessee to take responsibility for the unit, charging tenants rent so they can operate their business instead.
When using a ground lease, however, a tenant will usually assume responsibility for any kind of expenses. Expenses that would be the responsibility of the tenant on a ground lease include:
- Financing costs
Types of Ground Leases: Subordinated vs. Unsubordinated
You'll find two main kinds of ground leases: subordinated and unsubordinated. The difference between these two types deals with what happens if a tenant has financial difficulties during the term of the lease. Many times, tenants will take on debt to finance projects on the land they lease.
Subordinated Ground Lease
A landlord will agree to be a lower priority in terms of any other financing obtained on the property when signing a subordinated ground lease. If the tenant signs a subordinated ground lease on a plot of land, borrows money to build on that land, then defaults on the loan, the lender can go after the property (including the land itself) as collateral.
In other words, the landlord in a subordinated ground lease allows the property deed to act as collateral should the tenant default on a loan used to make improvements. The landlord can negotiate higher rent payments since they are taking on additional risk with subordinated leases. A landlord may also choose to create a subordinated ground lease since constructing the building on their land can increase the property's value.
Unsubordinated Ground Lease
A landlord who signs an unsubordinated ground lease retains top priority if there are claims on the property. This means that tenant's lenders cannot foreclose on the land if the tenant defaults on the loan. If the tenant defaults, the lender could go after the tenant's business assets . However, the lenders cannot gain full control of the property as they could do with a subordinated ground lease.
Because the lender cannot take ownership of the land in an unsubordinated ground lease should a tenant not pay their loan, prospective lenders may hesitate to extend a mortgage so a tenant can make improvements. As a result, landlords usually have to charge lower rent to the tenant.
Advantages of a Ground Lease
Ground leases can offer benefits to both landlords and tenants.
Landlords can look forward to certain advantages when signing a ground lease, including:
- Steady income: While still retaining ownership of their property, a landlord can access a steady income stream. Ground leases usually also have an escalation clause. This clause guarantees rent increases as well as eviction rights, which offers protection if a tenant should default on rent or other types of expenses.
- Tax savings: If a landlord sells property outright to a tenant, they realize a gain on that sale. On the other hand, when they execute a ground lease, they don't need to report any gains. However, there still may be tax implications in regard to the rent they receive.
- Retain control: Some ground leases may include provisions that allow a landlord to keep a certain degree of control over their property. This can include how the property is developed and how it is used. In these cases, the landlord will be able to deny or approve changes to their land.
Tenants enjoy a few advantages when signing a ground lease as well:
- Building in a prime location: Tenants gain the ability to build property in a prime location they might not otherwise be able to purchase. That's why you'll often find large chain stores utilizing ground leases in corporate expansion plans.
- No required down payment: As the tenant does not need to have a down payment to secure land (they would if they were purchasing the property), less equity is involved. This, in turn, frees cash for other uses. It also improves the yield on utilizing that land.
- Reduction to tax burden: As rents that are paid on a ground lease can be deductible for income taxes (both federal and state), the overall tax burden of the tenant is reduced.
Disadvantages of a Ground Lease
Certain disadvantages also exist for both landlords and tenants when choosing to use a ground lease.
Landlords looking to execute a ground lease should be wary of potential drawbacks:
- Loss of control: If a landlord doesn't include the proper clauses and provisions in their lease, they can end up losing control of the property.
- Higher tax implications: This varies based on the location of the property, but a ground lease can come with higher tax implications for the landlord. Though landlords don't realize a gain from selling the property, the rent they charge is considered income. That means rent will be taxed at the ordinary rate, and this can increase the landlord's tax burden.
Tenants also should be aware of drawbacks to a ground lease, including:
- Reduced flexibility: Tenants may encounter obstacles in using or developing the property if the landlord requires approval before they make any changes. A tenant may therefore experience more restrictions than they would if they had purchased the property.
- Higher costs: Costs that come along with the ground lease process may end up higher than the costs of just purchasing a property outright. A tenant should be prepared for various costs adding up, which can get expensive, especially when waiting for approval for certain projects. Costs can include improvements, permits, and taxes.
It's very important that both the landlord and tenant review the lease with expert support before they sign it. Working with an expert contract lawyer when creating a ground lease can ensure both parties are protected.
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