Key Takeaways

  • A land lease (or ground lease) is an arrangement where a tenant leases land but owns any structures on it.
  • Land leases allow access to prime real estate without the upfront cost of purchasing land.
  • They are commonly used in commercial developments, agriculture, and mobile home parks.
  • Land leases can be either subordinated (riskier for the landlord but beneficial for the tenant) or unsubordinated (safer for the landlord).
  • Ground lease valuation considers risk, lease terms, tenant creditworthiness, and location.
  • The lease reversion clause means improvements often revert to the landowner at lease end.
  • Common lease lengths range from 50–99 years, and agreements include rent escalations and maintenance responsibilities.
  • Seeking legal guidance for drafting or reviewing a commercial land lease agreement is recommended.

What Is a Ground Lease?

A ground lease or land lease is a lease of the land. Generally, land leases can range from 50-99 years and allow the tenant to build on the land. In a ground lease, the landowner is different from the owner of improvements or buildings on the land.

Types of Properties That Use Land Leases

Land leases are commonly found across several property types, especially where long-term development or specialized use makes purchasing land impractical or cost-prohibitive. Some common applications include:

  • Commercial Developments: Shopping centers, office buildings, hotels, and industrial parks often sit on leased land.
  • Agricultural Uses: Farmers may lease land to grow crops or raise livestock without owning the acreage.
  • Mobile Home Parks: Residents typically own the mobile home but lease the land it sits on.
  • Renewable Energy Projects: Solar or wind farms often operate on leased land due to large land requirements.
  • Public Infrastructure: Airports, transportation hubs, and government buildings may lease land from private entities or other government bodies.

These leases often span decades to ensure a return on investment, especially when tenants invest heavily in infrastructure or buildings.

Why Ground Leases Make Sense

While it can seem strange for an individual or tenant to build on another person's land, a ground lease provides numerous benefits to the contracting parties. Here are some of the benefits of ground leases:

  • The most important advantage of a ground lease is that it allows tenants to access lands in prime locations where it may be impossible to buy land.
  • Ground leases save the tenant the initial cost of buying the land, reducing the upfront equity requirements for the investment, increasing yield, and providing liquidity for other projects.
  • A ground lease provides the landowner with a steady source of income from a reliable tenant without losing ownership of the land.
  • Ground leases include provisions that allow the landowner to increase the rent over the term of the lease and protect against defaults.
  • Land leases usually carry a reversionary clause that makes the landowner the new owner of improvements to the land when the lease expires.

Key Elements of a Land Lease Agreement

A well-drafted land lease agreement outlines the responsibilities and rights of each party. Key elements typically include:

  • Lease Term: Often 50 to 99 years to align with the lifecycle of the tenant’s development.
  • Rent and Escalation Clauses: Initial rent plus periodic increases tied to inflation or market rates.
  • Use Restrictions: Provisions detailing permissible use of the land (e.g., commercial, agricultural).
  • Maintenance Obligations: Usually assigned to the tenant, including upkeep of any structures.
  • Improvements and Ownership: Tenants often own buildings and improvements during the lease term.
  • Reversion Clause: Specifies that ownership of improvements may transfer to the landowner upon lease expiration.
  • Early Termination and Default Terms: Conditions under which the lease can be ended early and remedies for breaches.

These terms help protect both the landowner’s interest and the tenant’s investment over time.

Subordinated vs. Unsubordinated Ground Leases

Subordination is the priority of ownership interest or claims in an asset. If a construction loan or permanent loan was obtained to execute improvements on a land, the senior lender is given top priority to claims on the asset as collateral for the funds. The implication is that every other lender or claims must be subordinated. Their claims will come after the claims of the senior lender.

A subordinated ground lease is a land lease where the landowner has a lower priority in the hierarchy of ownership claims on the land. This implies that the landowner is using the land as collateral in a transaction to finance improvements..

While it can seem odd for a landowner to subordinate his interest in a land lease, it may be advantageous for the concerned party.

  • The landowner might agree to subordinate his claims if the funds are for improvements that will increase the value of adjacent assets of the landowner, effectively providing additional benefits for the ground lease owner.
  • Subordination can also allow the landowner to increase lease payments and secure more favorable lease terms.

Conversely, an unsubordinated ground lease is a land lease where the landowner retains the top priority for claims on the property. Should the tenant default, a lender has no legal right to assume ownership of the land. Unsubordinated ground leases usually have lower lease rates because they offer more protection for the landowner. Generally, lenders do not like to finance unsubordinated land leases, but they consider the lease payments when underwriting the loan to establish the maximum loan to release for the asset.

Pros and Cons of Land Leases for Tenants and Landowners

Understanding the advantages and drawbacks of land leases can help both parties determine if this structure is right for them.

For Tenants:

Pros:

  • Lower upfront costs than purchasing land.
  • Access to high-value locations that may be otherwise unaffordable.
  • Potential tax benefits through lease expense deductions.

Cons:

  • No land appreciation benefits.
  • Uncertainty upon lease expiration or renewal negotiations.
  • Potential difficulties securing financing (especially with unsubordinated leases).

For Landowners:

Pros:

  • Ongoing passive income from rent.
  • Retained land ownership with potential long-term value appreciation.
  • Repossession of valuable improvements after lease ends (if stated in contract).

Cons:

  • Limited control over property use (unless specified in lease terms).
  • Risk of tenant default, particularly in subordinated arrangements.
  • Long-term leases may restrict future redevelopment opportunities.

Both parties should weigh these pros and cons against their financial goals and risk tolerance.

Ground Lease Valuation

Ground lease valuation is similar to the valuation processes of other leases or income streams. To establish the present value of the land lease, valuators create projections of the lease rate, escalation schedule, and terminal value before applying a discount rate to it. The discount rate depends mainly on the risk profile of the projected cash flows. Likewise, the risk profile of a land lease depends on the following:

  • Subordination.
  • Creditworthiness of the tenant.
  • Potential of the location.
  • Value and quality of the improvements, and other relevant provisions of the lease.

It is crucial for the parties to have a clear understanding of the duties and obligations of the lease. Only then can the lease terms be applied to analyze a discounted cash flow for the project.

Ground leases play a critical role in many commercial real estate deals. Typically, the yield of a ground lease is meager because of the restricted cash flow. However, cash flows from a ground lease are relatively safe, particularly for unsubordinated land leases due to their superiority even to the mortgage. While land ownership can be a better option sometimes, land leases can offer several benefits to tenants, developers, and landowners without transferring ownership of the asset.

Financing and Insurance Considerations

Financing improvements on leased land can present unique challenges, particularly for tenants. Key considerations include:

  • Lender Reluctance: Some lenders hesitate to finance developments on leased land, especially if the lease is unsubordinated, due to limited collateral.
  • Lease Term Length: Lenders generally require a lease term that exceeds the duration of the loan, often with substantial time remaining after loan maturity.
  • Assignment Rights: Tenants may need the ability to assign the lease to another party as a condition of financing.
  • Insurance Requirements: Land leases often require tenants to carry liability, casualty, and property insurance for any improvements and to name the landlord as an additional insured party.

Frequently Asked Questions

1. What is a land lease in real estate? A land lease is a long-term agreement where a tenant leases land from a landowner and often builds on it, while the land remains under the owner's name.

2. How long is a typical land lease? Commercial land leases typically range from 50 to 99 years, allowing tenants to recoup their investment in improvements.

3. Who owns the building on leased land? The tenant usually owns any buildings or improvements during the lease term. Ownership may revert to the landowner upon lease expiration, depending on the lease terms.

4. Can you get a mortgage on a land lease property? Yes, but it’s more complex. Lenders evaluate the lease’s length, terms, and whether it’s subordinated. Unsubordinated leases may limit financing options.

5. Is a land lease a good investment? It can be for both tenants and landlords. Tenants avoid upfront land costs, while landlords earn steady income without giving up land ownership. However, lease terms must be carefully structured.

Legal guidance is highly recommended to draft financing provisions that are acceptable to all parties and protect the interests of both the tenant and the landlord.

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