Ground Lease
A ground lease separates ownership of land from the right to use it. The leaseholder pays rent to the landowner, assumes the operating costs of the site and usually owns or builds the improvements for the length of the term. Most ground leases run on a triple-net basis for a very long term, with contractual rent escalations, and the improvements generally pass to the landowner when the lease ends.
What the split between land and leasehold actually divides
The landowner keeps title to the dirt. The leaseholder holds a contractual right to use the site, pays rent for it and takes on the operating costs that an owner would normally carry.
The result is two interests in one property, each with its own cash flow. The landowner receives a rent stream that is contractual and long dated. The leaseholder receives whatever the building earns after paying that rent.
A building on leased land never carries permanent control of the site. How long the leaseholder keeps the right to use it depends on the term and on any extension rights written into the lease.
How a 99 year triple-net term, rent steps and reversion set the economics
Ground leases are typically triple net and run for 99 years. Rent usually steps up on a contractual schedule built to protect against inflation, so the payment in a late year is higher than the payment in the first.
At expiration the improvements usually transfer to the landowner. Unless the parties renew or specify another result, the building the leaseholder paid for reverts along with the land.
A long term postpones that reversion and leaves it in place. A leasehold with many years remaining behaves like an owned asset carrying a rising fixed charge, while a leasehold near the end behaves like a wasting asset.
Why ground rent is paid before the leasehold lender
In a typical capital stack, ground rent ranks ahead of the leasehold lender. Property cash flow has to cover the rent first, and only the remainder is available for debt service.
That ordering changes how coverage is measured. A leasehold lender’s coverage test starts from cash flow after rent, which is lower than the property income a fee-simple lender would see.
“In a typical real estate capital stack, ground lease rent payments have senior priority over the leasehold lender’s debt service payments.”
Duration makes ground lease values react to interest rates
Ground lease valuations are highly sensitive to interest rate changes because the rent stream is so long. Distant payments are discounted heavily, so a small move in the discount rate changes the present value of the whole stream by a large amount.
The same arithmetic applies to the landowner’s position. The longer the stream, the more of its value sits in the far end of the term.
How a short master lease sits on top of a long ground lease
Healthcare property owners often lease buildings to operators under triple-net master leases. Those leases can require the operator to pay costs under certain ground leases, and their terms generally run 10 to 20 years with renewal options.
A ground lease term of 99 years is several times longer than that. The master lease and the ground lease are separate contracts with different clocks.
End of term: what a shopping center owner stands to lose
A national shopping center owner reports 40 consolidated properties on long-term ground leases. Unless those leases are extended, the land and improvements revert to the landowner at lease end.
When a ground lease expires without a purchase or an extension, the leaseholder loses the right to operate the property. It generally shares in no value increase beyond the lease term.
Worked example: coverage on a hypothetical leasehold after ground rent
A hypothetical leasehold property earns net operating income of 2,400,000 before ground rent. Ground rent is 600,000 a year. The leasehold loan is 20,000,000, interest only at 6 percent, so annual debt service is 20,000,000 multiplied by 6 percent, or 1,200,000. These figures are illustrative.
Base case. Cash flow after ground rent is 2,400,000 minus 600,000, or 1,800,000. Coverage of debt service is 1,800,000 divided by 1,200,000, or 1.5. Cash left after debt service is 1,800,000 minus 1,200,000, or 600,000. A view that ignored rent would show 2,400,000 divided by 1,200,000, or 2.
Stressed case, same loan, same rent, same period. Net operating income falls 10 percent, to 2,400,000 multiplied by 90 percent, or 2,160,000. After ground rent the figure is 2,160,000 minus 600,000, or 1,560,000. Coverage is 1,560,000 divided by 1,200,000, or 1.3. Cash after debt service is 1,560,000 minus 1,200,000, or 360,000. The ignore-rent view would show 2,160,000 divided by 1,200,000, or 1.8.
Net operating income fell by 240,000. Cash after debt service fell by 600,000 minus 360,000, or 240,000, which is 40 percent of the base figure. A 10 percent decline in income took 40 percent out of residual cash because the rent and the debt service did not move.
Mistakes in ground lease analysis
Testing debt coverage on income before ground rent overstates the cushion. In the example above, the ignore-rent view shows 2 in the base case while the correct figure is 1.5, because rent is paid ahead of the lender.
Projecting building value past the end of the term credits the leaseholder with an asset that reverts to the landowner. A hold-period model has to stop at lease expiration unless a renewal or purchase is actually in the documents.
Holding ground rent flat across the model ignores the contractual escalations. Because they are built to protect against inflation, later-year rent is higher than year-one rent, and a flat assumption overstates later cash flow.
Reading the master lease term as the ground lease term mixes two clocks. A 10 to 20 year operator lease can sit on a 99 year ground lease, so the ground obligations run far longer than the operator commitment.
Valuing a ground lease as though it had short duration understates its rate sensitivity. A long rent stream moves more in value for a given change in rates than a short one.
Checklist questions for reading a ground lease
What is the remaining term? The remaining term, and not the original term, sets how long site control lasts.
Which costs sit with the leaseholder? Triple net is the usual structure, and the lease lists the specific expenses.
How does ground rent step up? Contractual escalations determine the rent in each later year.
What happens to the improvements at expiration? Reversion to the landowner is the usual result unless renewal or other terms say otherwise.
Are there extension rights or a purchase option? Either one changes what the leaseholder keeps beyond the term.
Where does rent rank against the leasehold debt? Rent sits ahead of debt service, so coverage is tested after rent.
Does a master lease sit on top, and for how long? Its term and renewal options may be much shorter than the ground term.
How sensitive is the value to rates? A long rent stream moves more with the discount rate.