Ground Leases, Once Distrusted, Are Getting A New Lease On Life With Investors

The Federal Reserve’s unusually sharp interest rate hikes since early last year have cast a cloud over most real estate markets and left investors struggling to find opportunities that beat inflation without incurring substantially more risk. The looming prospect of recession this year and uncertainty over the pace of further rate increases are complicating the picture.

But there’s one underappreciated corner of the real estate market that is relatively unaffected by tighter monetary policy and is even benefiting from the change — ground leases.

The ground lease, in which landowners allow building owners to operate a property over a period of up to 99 years, is still struggling to shake off a historic reputation as an unfair practice that leaves building owners vulnerable to greedy landlords. Dating back to the Middle Ages and introduced to the U.S. from Britain, ground leases are now a sophisticated $17.4 billion industry used by a variety of commercial properties from retail to banks to fast-food outlets. Jay Sugarman, the CEO of Safehold, estimates the market could grow to $100-$500 billion. 

A Hedge Amid Economic Uncertainty

The financial mechanics of ground leases make them particularly attractive at times of rising interest rates and economic uncertainty. A modern ground lease gives investors long-term income with built-in inflation protection and minimal risk in the same way as a bond. But unlike a bond, it also gives landowners the benefit of asset appreciation because ground rents paid by the building owners adjust in line with inflation. Property taxes and maintenance expenses are all shouldered by building owners as well.

The returns from a ground lease investment today are significantly higher than a year ago with no increase in the risk profile.

Some types of ground lease are actively benefiting from higher interest rates. Under one model, ground lease operators buy the building and land together before selling the building to a commercial tenant. The rising interest rate environment means that these buyers are getting bigger discounts on buildings, enabling landowners to give their building owners better cap rates while still getting a higher overall return. The Fed rate hikes mean this ground lease model can generate returns of nearly 6% today compared to around just 4.5% a year ago. 

Ground leases got a bad rep in the past, often justifiably, because leases were structured in a way that gave landlords the right to reset the rent to a “fair value” rate. This resulted in sharp, unpredictable rises in rent that destroyed value for tenants who owned the buildings and disincentivized them from keeping a property maintained in good condition.

A high-profile example of this is New York’s iconic Chrysler Building, which sold in 2019 for less than a fifth of its 2008 purchase price, partly due to being locked into an old-style ground lease that saw its rent balloon to over $32 million from $7.5 million.

A Cleaned Up Reputation

Modern ground lease structures are far more equitable, giving tenants and landlords much more certainty in getting the outcomes they want. Clearly defined rent bumps are built into the contract, providing predictability for building owners while still ensuring that landowners’ returns keep pace with inflation. This has made it easier to get mortgages on properties, helping to encourage more investment in the sector and fueling innovation.

Ground leases worth under $1 million that used to be considered too small for bigger players can now be bundled up with other properties and offered to investors. 

Invesco’s Real Estate’s $5 billion move to fund the purchase of 20,000 single family homes as rentals shows how institutional capital is moving into spaces that were once seen as limited to individuals or local firms. Mobile home parks are attracting growing interest from ground lease investors, though admittedly not without some controversy. 

Invesco also took part last year in a $500 million raise for Montgomery Street Partners’ ground lease REIT. Ares Capital-backed Haven is another vehicle betting big on ground leases, launching in 2020 with an initial $1 billion.

Of course, no investment is risk-free, but proper due diligence in the following areas can reduce the risk of investing in ground leases to a very minimal level.

What To Watch For

First, investors need to understand the profile of building tenants who are providing the revenue to the building owner who then rents the land, avoiding becoming too reliant on a single tenant or a declining business. Any investor leasing to a big retailer like Macy’s, which is rapidly shuttering its stores, risks being left with a lot of dark, empty buildings.    

Second, they need to be confident that the location of the land is somewhere that will continue to attract businesses over the long term. You don’t want to be stuck with a 99-year lease in a dying town. 

Third, keep things simple by ensuring the investment yields a positive return above debt costs from day one. Some investors today are using debt to buy properties with a negative initial return with the intention of turning their return positive over time by increasing rents. This approach could easily backfire if the rental market doesn’t continue inflating as it has in the past.

Lastly, it’s always wise to ensure that building owners have a contractual obligation to maintain the property to specific standards during their leasehold period to avoid the risk of the landlord eventually getting back a building that needs expensive renovations or even needs to be demolished.

With these boxes ticked, investing in ground leases is as close to a rock-solid inflation-beating investment as you’ll get right now.