Cash Flow Crunch Prompts Renewed Interest In Land Leases

Property owners and developers of some relatively high-profile assets – like the Hard Rock Casino in Rockford, Illinois – have been turning to sale-leaseback deals of the land their buildings sit on in an attempt to mitigate interest rate shocks and ratcheting loan terms. 

The growing popularity of these “ground lease” deals comes as commercial real estate lending hits historically low levels as lenders face their own regulatory capital crunches. The ground lease deals, in which the owner sells the land beneath a building while keeping the building itself, typically span 50 years or more and in some cases are a lifeline that keeps the ownership group from having to “hand over the keys” to their lenders. 

Land leases historically enjoyed popularity primarily in Manhattan, where landowners leased “air rights” to high-rise developers, creating income streams that extended across generations. About 11% of securitized office properties in New York operate under ground leases, but beyond New York City, the practice was typically restricted to fast-food establishments, bank branches and pharmacies. (If you saw the McDonald’s origin story in The Founder, you know that founding CEO Ray Kroc was a big believer in ground leases.)

The sparse use of ground leases had some justification, as they had traditionally been escalations. Given that uncertainty, most developers shunned the arrangement for more assured forms of financing. 

But land leases have evolved over time, prompted by circumstances like those surrounding New considered fraught territory. Market rate adjustments written into land leases often were figurative land mines when unchecked land inflation led to unpredictable lease expense York’s famed Chrysler Building, where the owners were forced to sell for less than one-fifth of what they paid because of significant land lease increases. 

Where past ground lease agreements often lacked smoothed cost adjustment mechanisms, modern land leases commonly feature pre-arranged fixed annual rent increases (normally about 2%, with capped inflation adjustments every ten years) that offer building owners and their lenders greater predictability and lowered risk. 

In the current capital-starved climate, ground leases are being embraced across a range of sectors including industrial, hotels, retail, and even multi-family residences. And on the other side of the transaction, specialized real estate investment trusts, insurance companies, and private equity have all eagerly entered the ground lease arena.

Those capital providers are drawn to ground leases for multiple reasons: It’s one of the few segments in commercial real estate capital markets that is currently growing, which means opportunity for new investors. 

And risk is reduced by having very steady collateral – the land – that’s not subject to natural disasters such as tornadoes, hurricanes, or wildfires. Even in a worst-case natural disaster scenario, land typically returns to its original state, giving further risk mitigation to the ground owners.

For developers facing cash flow challenges, there are two main avenues to explore land lease deals. They can either directly engage with specialized ground lease finance funds or companies, or they can enlist the services of commercial real estate brokers to market the land to prospective buyers and investors on their behalf.

The proceeds of sale/leaseback deals can be used for various purposes: Some building owners plow the funds back into their properties to make the buildings more marketable in the current tough office leasing environment. Another prevalent strategy is to pay down debt on the buildings, lowering payments and easing the pressure that soaring interest rates have caused. 

Proceeds can also be dividends to investors, boosting returns and allowing the developers to live to fight another day. The proceeds from a land sale are generally subject to long-term capital gains tax rates, giving further advantage to the building owner. 

Though there isn’t a good comprehensive index of ground lease deals happening globally, anecdotally, there appears to be a significant increase in these deals active in the market right now. 

What is known is that ground leases now make up a $2.5 trillion dollar asset class, and that the deals are moving into new sectors and new ownership structures, including healthcare, higher education, energy infrastructure, and more.

Even not-for-profits are getting into the ground lease game: Last year, Lowe announced a 99-year ground lease deal with Howard University in Washington, DC to develop a 10-story mixed use space on a former parking lot on the university’s campus. University officials were looking for a way to better develop their community, taking advantage of a burgeoning real-estate market in the area to better attract students. 

This new breed of ground lease deals isn’t without risk, as both sides may have something to gain in further negotiations in the later years of an agreement. Ground lease deals, as in other tenant-landlord situations, can suffer from non-cooperative parties.

But challenging times for some commercial real estate segments are once again meeting innovative financial structures to ease pressures and create market liquidity. Leasebacks can provide effective real estate benefits for willing companies, and more and more capital providers seem ready to pony up the capital to do it.