As the commercial real estate market has experienced large swings in value in recent years, many clients have contemplated investing in long-term commercial real estate ground leases as an alternative strategy for their 1031 exchanges or for their portfolio currently sitting in cash. As a response to some of the questions I’ve received, I have decided to discuss at length some of the talking points related to this type of investment.
First, let me define what I mean when I discuss investment in commercial real estate ground leases. I am referring to purchasing “land” which is leased long-term to a tenant who has then constructed a building for their operations on the property. The types of tenants most often seen doing ground leases are banks, restaurants, and some single-tenant retail operations. Some of the criteria to consider are as follows:
- Remaining Term Left on Lease: When considering investing in a ground lease, the remaining lease term is a key factor. Ground leases typically range from 10 to 99 years depending on the tenant and the use. Provided there are decent rental increases, a longer-term lease translates into greater security for the investor. There are those occasions when a tenant is nearing the end of their current land lease and their lease rate is below market where a shorter term lease may be an advantage to a investor assuming that at the end of the lease the rate can be renegotiated increasing the overall yield. This is a riskier strategy and does not fit for all investors.
- Credit of the Tenant: This is the age old question when buying all types of commercial real estate. Is the tenant going to be able to pay the rent? There is a much lower default rate on ground leases than traditional leases. This is primarily because tenants are investing a lot of capital into their own building and they understand that if they default their building reverts to the landowner. Defaults are rare except in the cases of overall bankruptcy and insolvency of the tenant. Also, the ground lease market is dominated by larger companies with less credit risk.
- Purchase Price as Compared to the Replacement Cost of the Building and the Underlying Land: As I evaluate these deals, this is probably the most pertinent factor. An investor is essentially buying land and needs to understand what the value of the land (without the lease) is and what the value of the building, if vacant, would be. I’m not suggesting that it is not appropriate to pay higher than these values, especially when the credit of the tenant, and the length of the lease warrant it. It is just important to evaluate this to know what your downside risk is especially when there is some concern about the tenant or the uniqueness of the improvements.
- Is the Building an Asset or a Liability: Most often times, the building is an asset to an investor. When the lease term ends, the investor ends up with the building that they can hopefully re-lease to another tenant at higher rents. However, the type of building may limit that potential. For example, several years ago many investors were buying properties leased to Sonic Drive-Inn restaurants. The challenge with these were that the buildings were very small and unusable to other tenants. Therefore, in the case of a default, the cost of demolition of the building became a liability to the investor.
- Ease of Ownership: One of the best advantages for most investors is the fact that there is little to no management responsibilities. The tenants are typically responsible for all maintenance and expenses from fixing the toilets to paying the property taxes. An investor’s work is typically limited to taking the rent check to the bank to be deposited.
- Lack of Depreciation: Since you are only acquiring the land, there is no tax advantage through depreciation.
- Rental Increases and Related Risks: Rental increases are important to consider for any commercial real estate investment but even more so for ground leases since the lease terms are typically longer. This is even more of a concern in an inflationary market. I have seen ground leases that have no increases for as long as 20 to 25 years. Although the credit of the tenant is good, the purchasing power of those dollars becomes less and less every year and many investors are not happy with the investment towards the end. When comparing potential investments with similar cap rates, the rental increases in the lease often become the determining factor.
- Financing: Financing can be very challenging for purchasing land leases. They are most often cash deals.
- Expected Returns in Today’s Market: As with all commercial real estate investments, returns are all across the board. Most often we see ground leases in the 4% to 7% range depending on the factors discussed above. These seem low as compared to investment in buildings. However, the risk is typically much less and the credit stronger. Many investors compare buying ground leases to buying corporate bonds of the tenants. For example, there are banks and retailers whose bonds are only paying 2% whereas you can buy a property ground leased to the same company for 25 to 50 years for a cap rate of 5%.
Hopefully this gives you some of the talking points to consider when buying ground leases. Whether you are in a 1031 exchange or just looking for a place to put that cash sitting in your savings account, ground leases are an interesting alternative to consider.