An Analysis Of The Effect Of Ground Leases On Overall Property Values

Surveying the landscape of property development in the last half-decade reveals a notable turbulence within the sector. Numerous narratives in the mainstream business press highlight not not only stumbling projects on a domestic level but also on a global scale. Now, more than ever, efficient capital deployment is critical, and novel approaches are in order.

Traditionally considered a stable investment, the economic foundation of the industry has undergone a seismic shift due to the pandemic-induced shakeout and accompanying inflationary pressures. Factors such as escalating interest rates, elevated vacancy rates and lender reluctance to finance projects have collectively prompted a dramatic reevaluation of the entire category, with an associated impact on property values. This reassessment has left a profound impact on the industry’s collective mindset.

While all industries undergo transformation over time, the rapid pace with which market conditions have shifted in the real estate sector has astonished even the most discerning observers.

The repercussions have been extensive, with the most prominently highlighted being the aftermath in the office space market. The post-Covid shift to remote work has fundamentally transformed demand, resulting in historically high vacancy rates - estimated at 21% in the third quarter of 2023 - in previously sought-after business locations. However, the impact extends beyond office spaces, with rising interest rates playing a significant role in reshaping the industry’s dynamics.

The transformation is evident in the land lease market, also known as the ground lease market. While this market has experienced fluctuations, it has predominantly followed an upward trajectory in the past decade. This trend is attributed to the recognized benefits to the capital structure across various developments.

Long employed in major metropolitan regions facing limited access to high-traffic areas and prohibitive land acquisition costs, the land lease has gained increased acceptance across a diverse range of projects. While financing remains a primary consideration, operators are now discovering advantages that extend beyond traditional considerations.

Land leases are now commonplace in various sectors including retail (mall outparcels), the fast-food industry, fitness and health facilities, distribution centers, server farms, multi-family developments, and the hospitality space.

Illustrating the growing popularity of land leases is the recent agreement by Wynn Resorts to sell land and other real estate assets associated with its Massachusetts integrated resorts, Encore Boston Harbor. The transaction resulted in Wynn WYNN securing $1.7 billion in cash, enhancing its liquidity position. Importantly, Wynn maintains the rights to further develop the parcel.

Summing up the rationale for the deal, Wynn accurately noted, “the lease allows us to maintain a great deal of economic flexibility across economic cycles.” The cash infusion will fortify the company’s liquidity position, and the proceeds will be deployed in a manner that makes more economic sense while facilitating the retirement of other debts. 

For a gaming operator such as Wynn, offloading the property is a strategy that makes economic sense. Wynn now has the opportunity to use the cash to expand its operations, a move that will have greater returns than having the cash lie dormant in land. And, as an added incentive for the transaction, the annual land lease payment is a deductible business expense for resort developers. 

The Wynn deal, while among the largest of recent land lease transactions, is emblematic of a broader trend across the nation as operators strive for more efficient use of precious capital. Additionally, the sale/leaseback agreement allows Wynn to concentrate on its core business - gaming and hotel operations - while shifting the burden of property concerns to a third-party. It also allows Wynn to develop a long-term strategy for the property with the assurance of a lease that extends at least 60 years into the future.

Deal details typify the manner in which the modern land lease contracts are structured: 30-years, with a 30-year renewal, at a predictable cost through the term. It should be noted that some land leases have longer terms, some even extending to 99 years.

How does the agreement work for the leaseholder? On their end, Realty Income, in this case, can also count on a predictable income stream for their investors while allowing a degree of flexibility and adaptability - a 1.75% increase in lease payments over the first five years and an increase indexed to inflation, but capped at 2.5%, for the balance of the initial term.

Moreover, the addition of Encore Boston Harbor to its portfolio allows the publicly traded REIT to diversify its holdings both geographically and by industry. The Boston deal adds one more jewel to the more than 13,000 properties in Realty Income's portfolio of ground leases.

Prominent transactions such as Encore Boston Harbor provide a valuable case study on the strategic structuring of land leases that bring about mutually beneficial outcomes. Moving ahead such transactions are poised to be increasingly prevalent, expanding into secondary markets, as evidenced by developments in locations like South Bend, IN and Riverside, CA.

The Wynn Boston Harbor deal also underscores the significance of introducing financial efficiency to a project. These imperatives persist, remaining unaffected by stabilizing interest rates or even the prospect of a slight decline in the first half of 2024, thereby fostering the ongoing growth in land lease transactions.

This article is from an external contributor. It does not represent Benzinga's reporting and has not been edited for content or accuracy.