Ground Lease Explained: Pros and Cons of Ground Leases

A typical ground lease is a land lease agreement wherein the lessee or tenant pays rent on a parcel of land and can build and modify the property there. After the lease term is up, the leased land, all new property built on it, and any additions to that current property transfer in ownership to the landlord or lessor.

Real estate investors looking to construct office buildings often find this type of commercial real estate lease particularly useful. The rent payments are generally much cheaper long term than buying a piece of land outright. Additionally, the lease terms are usually long enough and allow so much freedom to develop the land that lessees can act almost as de facto owners in their own right.

There are two main types of ground lease agreements: subordinated ground leases and unsubordinated ground leases. If a ground lease is subject to subordination, the landlord will risk foreclosure if the tenant defaults on their payments. In other words, the lender is the top priority here, even above the lessor. In contrast, the terms of unsubordinated ground leases will not hand the lessor’s real estate investments off to the lender if the lessee defaults.

Lessees are entitled to many benefits with ground leases, which are a type of commercial lease. Consider these four pro arguments for signing a ground lease agreement:

1. 1. Long-term leases: Ground lease terms are usually very long. The lease structure generally lasts from twenty-five to ninety-nine years—for many lessees, the lease won’t even end within their lifetimes. The lower upfront cost for a longer period of time might justify taking on potential rent increases in the future.
2. 2. Ownership of the improvements: A ground lease should free up a lessee to operate as if they own the property itself. They possess total ownership over any improvements they make to the land, subject only to landlord approval.
3. 3. Prime locations: The less expensive cost of ground leases overall allows lessees to rent in far more desirable locations than they would otherwise be able to afford, such as if they outright bought the same land or leased it under different terms.
4. 4. Tax-deductible lease payments: While lessees might be on the hook for property taxes, their ground rent payments are deductible. The unique terms of each lease contract will determine whether the two cancel each other out.

Lessees should have a realistic and nuanced approach to ground leases. Here are four cons to consider:

1. 1. Answering to others: This type of real estate lease still leaves the lessee answering to their landlords. Even if they’re on the hook for all the expenses, they still need to seek approval from the real property owner to do whatever they want.
2. 2. Escalation clause: Most ground lease contracts will come with an escalation clause allowing the lessor to increase rent as the market allows. This means the initial payments a lessee makes on the property will almost certainly be far lower than the payments they make on the property decades into the lease.
3. 3. More responsibility: The freedom of a ground lease for lessees also comes with more responsibilities. Any taxes, costs, construction loans, and so on accrued in developing the leased property will be theirs to bear in addition to the rent they owe to their landlords each month.
4. 4. Potential eviction: Each ground lease contract will extrapolate on the specific eviction rights a tenant can expect, but the reality is the risk of eviction will always be there in even the most generous of lease terms. Lessees might feel like de facto owners, but they’re still technically on another person’s property.

Lessors stand to gain a decent amount from ground leases. Here are just four of the key benefits:

1. 1. Capital gains tax avoidance: Selling real estate is usually subject to capital gains taxes, while the profits yielded through renting property are not. Lessors can measure what they will pay in increased income taxes against what they will avoid in potential capital gains taxes.
2. 2. Landlord approval: The property owner still has the ability to veto or approve changes made on their land as stipulated in the terms of the lease.
3. 3. Ownership of the land: While ground leases give the lessee plenty of freedom, lessors still own the most important piece of the property: the land itself.
4. 4. Steady income stream: A regular tenant ensures a steady cash flow for lessors. If a lessee proves to be reliable, they could help support the landowner’s income for years or even decades upon decades.

Ground leases pose certain risks for the landlords, also known as the lessors. Here are four of the most common:

1. 1. Higher income taxes: Since rent payments count as income, ground lease lessors will likely see an increase in the amount they must pay in income taxes. This can be offset by various other tax breaks implicit in a deal like this.
2. 2. Less control: Ground leases give landowners far less power over their financial destinies, particularly in the case of subordinated leases. Much of the endeavor’s success relies on the implicit assumption that the tenant will not default at any given time. If they do, the lessor will inevitably take a hit—although a landlord might mitigate the extent of such a financial hit with the type of ground lease they use.
3. 3. Lower priority than lenders: For subordinated ground leases, the lessor is at a much lower priority level than their lenders. Should the lessee default, they might lose their land to the leasehold mortgage lender through no fault of their own.
4. 4. Potential for failure: As with any financial endeavor, ground leases pose a risk for failure to lessors. Especially given the long duration of the contracts, it’s possible the tenant will not yield enough returns to pay off the lessor at some point.

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