Commercial Land Lease Agreement: Everything You Need to Know
A commercial land lease agreement is a contract signed between parties over a ground lease transaction.3 min read
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.
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.
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.
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:
- 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.
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