What is Commercial Ground Rent and How Does it Work?
Commercial ground rent is an important concept for property owners. When it comes to ownership ground rent situations vary somewhat, but their ultimate premise remains the same.
In these situations, the property owner owns the land but not necessarily the building on that land. The owner charges a fee for the use of the land. Here is what you need to know about these rents, sometimes referred to as a commercial ground lease.
What Are Ground Rents in Commercial Real Estate?
Ground rents are rental agreements in which one party owns the building but does not own the land on it. The arrangement allows the land owner to charge the building owner a fee, or rent, for the use of that land. These are typically monthly land rental payments.
Ground leases like this can occur in many situations. They are somewhat common in hotel and office buildings. However, they may also be applicable to residential properties.
Types of Ground Leases
There are two types of ground leases commonly available – subordinated and unsubordinated leases.
Most often, the building tenant secures financing to build or improve the real estate in some way. They do not own it, though. As a result, if that tenant defaults on the loan they’ve secured, that can make it harder for the lender to collect. It is typically easier for a tenant to obtain a loan with a subordinated lease, then.
In this situation, the landlord, or property owner, agrees to the building being used as collateral, encouraging lenders to provide the loan. This typically allows the landlord to charge a higher rate for the lease because of the risk associated with it.
Unsubordinated leaves are different. In these situations, the lender for the tenant’s building is restricted from taking possession of the building should the tenant default on the loan payments. In this situation, there is less risk to the lender, which is why it is likely the landlord will charge lower monthly payments.
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Importance of Understanding Ground Rents
Understanding the ground lease agreement is critical for all parties involved. In this lease agreement, the contract is between the landlord, or the party that owns the land, and the tenant. The tenant typically pays a fixed fee on a monthly basis to utilize that land. This gives the tenant the right to use the property.
Often, the tenant owns the building on the land, but the tenant does not own the land the building sits on. This type of arrangement typically requests less upfront capital for the tenant compared to purchasing the land and then building the structure on it.
How Commercial Ground Rent Works
Commercial ground rents are a different alternative from traditional real estate financing. They enable property owners to see their property improved upon while retaining control over the asset. The tenant is able to secure the space they need, but they do so at less cost upfront than purchasing the land itself outright.
Landlords and tenants must fully understand the terms and conditions associated with the lease agreement. This can differ from one project to the next. The lease agreement will ultimately determine how the property can be used, the length of the lease, and the long-term outcome of that agreement.
Benefits of Commercial Ground Rents
Commercial ground rents create benefits to all parties involved, in most cases, as long as the property owner and tenant agree to the terms.
Benefits for Property Owners – Tenants
For the tenant or the property owner, there are benefits to using a ground lease agreement. Some of those include:
- Lower capital investment upfront when working to build a new structure since there is no purchase of the land itself
- In residential properties, such as mobile home parks, the use of ground leases makes it possible for more people to afford to buy a home because their loan only includes the cost of the building, not the actual land, lowering their monthly payment.
- In some situations, the IRS allows for a ground-rent payment deduction, which is much like that of mortgage interest, reducing the cost of ownership.
Benefits for Investors – Landholders
For the investor, or landholder, commercial ground lease agreements like this can offer several benefits:
- Most ground leases are held for 50 to 99 years. This provides a long-term secure financial return for the investor.
- After the lease term, most property and improvements made to it will revert to the property owner.
- The tenant will pay for all insurance, maintenance, building construction and improvement costs, property taxes, and other fees. This includes most related to operating the property.
Potential Drawbacks of Commercial Ground Rents
All parties should consider the benefits and drawbacks of commercial ground leases. Here are some careful considerations.
Disadvantages for Property Owners – Tenants
They are somewhat limited and can be a disadvantage to property owners – tenants in several ways.
- These leases tend not to be ideal for startups or small businesses, even if they look attractive initially. That is because, in the long term, they can be hard to maintain should the company falter.
- The land owner may have the right, depending on the terms of the agreement, to raise the land rental fee over time. This could make it increasingly more expensive to maintain the property.
Disadvantages for Investors – Landowners
There are some less-than-desirable outcomes for some of these properties.
- For landowners who want to purchase and flip the property, this type of investment is not ideal because it can be hard to do so within a reasonable amount of time and with financial security.
- Should the business or tenant fail to meet payments, the landowner may not have much recourse to seek out payment and may have to manage the building as well.
What Happens After the End of Ground Lease?
Most commercial ground lease agreement terms are very low. That helps to lower the risk associated with the investment of the property. After the lease is up, most allow for the land owner to take back the property – which would include any improvements made to the property during the lease period, even the building itself.
It is possible that the two parties can come together to create a new agreement for an extended amount of time. That is only possible if both agree to the terms and conditions of it at the time of the lease renewal.
Wrapping Things Up
For commercial investors, ground rents can prove to be a lucrative investment strategy. They allow for long-term investment, which means ongoing, often decades-long contracts with reliable income for the landowner. This also is a way to protect against inflation.
For the leaseholder or tenant of the property, there are benefits as well, including more flexibility in obtaining loans due to lower costs. It can also mean more affordable rent. The terms and conditions of the lease agreement can differ in all areas, which also provides flexibility to both the property owner and the tenant in most situations.
All parties should consider the pros and cons of this arrangement before making the decision to enter into it. Yet, many will find it offers a number of excellent benefits, especially in the long term.