Hospitality Ground Leases

The hospitality industry is facing a critical moment. As interest rates fluctuate, many hospitality groups find themselves squeezed by increasing debt service expenses, a consequence of the Federal Reserve’s efforts to combat inflation. Ground lease deals may offer these businesses a flexible solution to lowering expenses.

Regional banks, traditionally the major source of financing for the hospitality sector, have as of late significantly reduced their involvement in this once-booming market. Recent data reveals that nearly 60 hotel projects have been halted due to the banking crisis. Numerous ongoing developments are also grappling with the burdensome impact of rising debt service costs.

Confronted with a make-or-break situation, an expanding group of developers and operators are embracing long-term ground leases as a strategy to streamline operating expenses and decrease capital investments for new projects. In a tight capital market, a land lease is a method to unlock capital that would be otherwise tied up.

Selling land underneath an already-developed project or leasing land for a potential development is not an uncommon practice. This approach, widely embraced for decades across various sectors, including the hospitality industry, serves as a means to reduce development cost by up to a third. In dollar terms, saving one-third on a $30 to $40 million investment at the outset can pay huge dividends in the future by paying lower costs on the lease than the operator would pay on the debt. In the current high-interest rate environment, it also offers the opportunity to pay down costly debt, minimizing periodic debt service payments.

The market for ground leases, also known as land leases, has expanded to $18.7 billion in 2022, marking an increase from $15.3 billion in 2012. Although projections suggest a slight decline in 2023, the ground lease market is projected to return to its previous growth trajectory in the years ahead. Sale-leaseback arrangements are also making inroads into the gaming industry, auguring well for future growth.

In a focused and strategic approach, ground leases enable developers in accommodations and restaurant fields to concentrate on crucial elements of their business success while shedding the financial burden of land acquisition.Ground leases have long been a staple in the fast-food franchise end.

 In certain scenarios, ground leases also provide operators the chance to establish a presence in high-traffic locations that might be otherwise unattainable through outright acquisition. For example, Marriott recently entered into a land lease agreement for a project in downtown Nashville. Working with the property owners, the 0.78-acre property will be developed across all three included parcels. 

In the end, it doesn’t matter who owns the dirt underneath, the brand on top is what stands out. Using ground leases is a method of making the capital stack for a hospitality project far more efficient. In other words, operating a restaurant or hotel on leased land can generate higher returns over the long-term than on owned land.

Typically, when selling a ground lease for a parcel owned by an existing operator, the process involves seeking bids from various companies specializing in this practice. In cases where a specifically locally-owned property is sought, negotiating a long-term ground lease can be initiated with the current owners.

The hospitality industry exhibits a distinctive affinity for ground leases, setting it apart from sectors such as commercial office space developments. Those in the hospitality sector are more likely to absorb lease increases due to pricing flexibility not commonly found in other industries. In this sector, ground leases frequently incorporate periodic increases, typically ranging from one-and-a-half to two percent annually, as stipulated in the contract.

The initial agreement plays a crucial role in defining the terms of the ground lease. These contracts are typically 50-75 pages in length, and even longer with appendices. It is advisable to enlist the assistance of a lawyer with expertise in ground leases, as the intricacies of the contract will play a significant role if a dispute arises. Over the course of long-term contracts, property use could evolve, and the standard contract, in most instances, will allow for some alterations in the operation.

Ground leases contracts traditionally provide the business and the building owner with substantial autonomy to carry out improvements within the confines of local land use and zoning regulation, as well as any existing rights-of-ways on the parcel. With landlord permission, expansions within reason are usually acceptable.

Executing a ground lease still leaves the building owner, not the land owner, responsible for property taxes, liability insurance for the grounds, all building maintenance and improvements. However, anything subterranean, where the source is not traced to the building owner, remains the obligation of the land owner.

Given the continued interest of the landowner in the property’s utilization, it is typically mandatory to furnish annual audited financial statements to the lessor for examination. Transparency plays a crucial role in fostering a positive relationship between the ground lease owner and the lessee.

Ground lease deals will likely become the de facto standard for the hospitality industry, particularly if interest rates continue at current levels. The partnership between the owner and operator provides a win-win arrangement, allowing the owner/operator to significantly lower capital costs, or, in the case of sale, draw out capital for mortgage paydown or property improvements, while giving the lessor a steady income stream.