There are many ways to underwrite real estate construction. One of the less used is ground leases, even though they offer several attractive features, including flexibility, according to Terri Adler, managing partner of Duval & Stachenfeld.
What’s the situation with capital market financing for construction?
At the start of the pandemic, the market for construction financing was in a bit of freefall. Lenders were faced with enormous risk on lagging deals that were forced to halt construction work — not to mention the inability to foreclose due to court closures and moratoria around the country. As a result, we saw many lenders walk away or re-trade terms at the last minute. Although optimism has returned and 2021 was an incredibly busy year for the industry, traditional construction financing remains tight, with lenders often turning away good deals that have too much hair or asset classes (such as hospitality and spec office) that are rebounding more slowly.
What role do ground leases play?
The modern ground lease provides an alternative structure. The transaction is typically executed as a sale-leaseback, where the ground lessor acquires the land for a lump-sum purchase price and leases the asset back to the developer for 99 years. The proceeds from the sale, together with any improvement allowance from the ground lessor, are then available to the developer for project costs, reducing the amount of construction debt needed to complete the capital stack. This additional capital source, in turn, (1) reduces the risk to the construction lender, and (2) reduces the developer’s equity requirement.
Walk me through a theoretical ground lease deal structure.
The typical ground lease transaction is executed as a sale-leaseback, where the ground lessor acquires the land for a lump-sum purchase price and leases the asset back to the sponsor (or its affiliate) for 99 years. A modern ground lease will usually charge the tenant a base rent that escalates by a set percentage every few years, with moderate rent resets based on CPI or another, predictable marker of inflation on specified years throughout the term (usually every five, 10 or 20 years). That rent is due regardless of the asset’s performance and without regard to fluctuating expenses, as all taxes, insurance, maintenance and other operating costs are paid directly by the tenant. The ground lessor will have limited controls with respect to approving debt encumbering the tenant’s leasehold interest, project plans and budgets, certain major renovations, and assignments of the lease (similar to what a lender might expect), but without restrictive performance hurdles or coverage ratios. Otherwise, the tenant maintains day-to-day control of the development, leasing and management for the life of the asset.
In a development deal, the ground lessor might also have additional proceeds available to the sponsor as a tenant improvement allowance, to be advanced subject to draw procedures similar to that of a construction lender.
Is the purpose typically to finance new construction or to exit an investment?
One of the most attractive things about a ground lease is how flexible it is. The model works for nearly all types of assets (other than condos for direct sale) and all stages and scales of development — whether ground up, substantial renovation or fully stabilized. It can take out debt and co-exist with subordinate leasehold or mezzanine debt, as the lease will provide standard ways for a lender to step in and perform should the tenant default. More recently, we have seen a larger proportion of ground lease deals used to finance construction or substantial renovations, but we have closed a fair number of ground leases for stabilized assets, as well.
Ground leases were reputed to be wealth destroyers. What about that?
The modern ground lease is a totally different animal from its predecessor. Traditional ground leases often had catastrophic rent resets determined based on a fixed percent of the fair market value of the asset, measured at the time of the reset. This kind of reset could essentially wipe out all the value that the lease created. A modern ground lease will usually charge the tenant a base rent that escalates by a set percentage every few years, with moderate rent resets based on CPI or another, predictable marker of inflation on specified years throughout the term (usually every five, 10 or 20 years). This method of escalation prevents the same level of volatility and, as we have seen over the past few years, allowed the modern ground lease to survive and even thrive in challenging times. Further, the old ground lease was primarily drafted to protect the landlord’s investment by giving the landlord wide leeway to dictate the use, operation and capital structure of the asset. The modern ground lease is much more flexible, giving its tenants more autonomy and ability to create value, not just maintain it. In the right structure, a ground lease can even result in higher returns to the sponsor, while the landlord gets a stable, long-term investment that it can leverage like a bond.