Ground Leases - How to Value and What am I missing?
I am looking at a potential acquisition (retail value add) that has a for sale price that doesn't make sense , but the broker mentioned the seller would be open to a ground lease, and wanted a proposal. I have done some digging through the forum and online and I have a general grasp of what to look for, but had some questions:
- How are the annual or monthly payments normally valued?
- Is it just based on what my project can afford to pay or is there a normal rule of thumb here that I am missing?
- Also is there normally some sort of key money or payment up front along with the lease payments?
- How financeable are these things if they are 50-100 years and how tricky are exits?
- Any pitfalls I should think about when structuring this?
Thanks!
Ah, ground leases! They can be a bit tricky, but let's break it down:
The annual or monthly payments are typically valued based on a percentage of the land's fair market value. This can vary, but it's often in the range of 6-10%.
It's not just about what your project can afford to pay. You also need to consider the market value of the land, the length of the lease, and the terms of any rent resets.
Key money or upfront payments can be part of a ground lease, but it's not a given. It really depends on the specifics of the deal and the negotiation between the parties.
Financing a ground lease can be more complex than a traditional mortgage. Lenders may be wary of the long-term nature of the lease and the fact that the land can revert to the owner at the end of the lease. However, it's not impossible. You'll just need to work with a lender who understands ground leases.
As for pitfalls, there are a few to watch out for. One is the potential for rent resets to fair market value, which can lead to significant increases in your lease payments. Another is the fact that you don't own the land, which can limit your control over the property and its future use.
Remember, every ground lease is unique, so it's crucial to read the terms carefully and consider getting advice from a real estate professional or attorney. Good luck!
Sources: Modeling ground lease payments into a pro forma, Calculating Ground Lease: Rule of Thumb?
I work on a lot of these in NYC for class A and trophy assets, so not all of this may be applicable
- How are the annual or monthly payments normally valued?
Valued off of a cap rate or NPV using a certain discount rate (typically very low as the ground position has low risk)
- Is it just based on what my project can afford to pay or is there a normal rule of thumb here that I am missing?
If you're asking how ground payments are typically calculated, its generally based off a % of gross NOI. Generally want to be 20% or lower, but I've seen as high as 30% on newly cut ground leases.
- Also is there normally some sort of key money or payment up front along with the lease payments?
Yes, if the option is 1. buy the fee simple position, or 2. buy the leasehold position, the 2nd option will result in a much lower up front payment, but annual ground rent payments on a 99 - XXX year term, handing the keys back at the end
- How financeable are these things if they are 50-100 years and how tricky are exits?
Financing for retail has recovered much better than office, but "leasehold" is still a scary word for lenders. If the ground rent isn't too high of a % of gross NOI, and you have >50 years left on the term, there shouldn't be too much of a difference compared to if you were trying to raise financing for it fee simple
- Any pitfalls I should think about when structuring this?
Avoid FMV resets at all costs, especially if the "Fair market value" is of any use, and not just existing use. try to avoid and CPI or inflation catch-up mechanics unless its capped at a few % per year.
Sigh, when will people finally learn with ground leases...
Above are all great points, but the most important is the last one. NO FMV AND CAPPED ANNUAL INCREASES OR BUST. Seriously. Both of those are non starters unless you hate your money. I've seen it go wrong sooooo many times, but this time will be different right?
And 20% of NOI was always my MAX threshold. You want to be as far inside that as possible.
Value the ground lease on an NPV (use like 6% as a starting point) and it should be around or below the fee simple land value that's your gut check to know it makes sense. Cuz remember your basis is the value of the lease + your actual basis.
I would also add 50bps to your exit cap to account for ground lease risk on the property. Ground lease assets shouldn't be trading par with fee simple caps.
A good rule of thumb is - if the ground lease isn't straightforward to value, its dogshit.
I think something to consider the 6% should be higher since it's a spread over treasuries. Maybe like a 7% discount rate although it is land, but you are the one making the payments.
I would also make the broker give a number, if the owner is open to a ground lease what number does he have in mind. A waste of time to have him tell you to shoot a random number out there in my mind, you could say $500k a year and he says the owner wants $750k for no reason other than they aren't accepting your first offer. Get a hard number first before putting yours out there.
20% of noi or gross income? 20% of noi seems low no? Why is the 20% rule in effect? It is just an overall leverage issue?
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Seller is asking you to buy the land and lease it back to them, or for you to buy the leasehold?
For me to buy the leasehold. Sorry I should have clarified. Got the numbers back and mentioned above, let me know your thoughts.
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