Modeling ground lease payments into a pro forma
I'm currently modeling a development scenario where the developer would either sign a ground lease with the landlord or acquire the land for a specified price. While the legal and market value-related aspects require some further thought, I came up with an issue regarding how to model in the potential ground lease payments.
On one hand, ground lease payments (as an alternative to land acquisition) would be considered development costs and directly relate to other below-NOI items. On the other hand, ground lease payments reduce the cash flow to the property owner and thus should be taken into consideration when estimating a cap rate-based valuation for disposition. This would mean that ground lease payments might have to be considered a part of operating expenses.
So, my question to you - what would be the most optimal approach in terms of assigning ground lease payments and to deliver a "fair" valuation of this scenario? Thanks
Same answer as above, we keep it above the line for a long term ground lease. However, we do factor it below the line if the ground lease expires within a 10 year period.
Don't even consider developing a new building on anything aside from a fresh 99-year lease, that would be a travesty.
To answer your question, technically speaking, yes the lessor can take the property at expiration, however, this typically doesn't happen for a variety of reasons a few of which are listed below to give you an idea of how these things might play out:
All (prudent) investors will underwrite a scenario for a deal with a lease that doesn't have much term left with the assumption that they give it away at the end. They will then discount the cash flows to arrive at a purchase price for the leasehold that will give them the returns they need for the investment. For example the resulting PP gives you a 15% irr for the term and you are looking for value add returns, who cares if you give it away? If you are not looking at this scenario or worried about it, then you are confident or have already discussed a deal with the land owner about what happens in the end.
The value of the property and lease decrease as time goes on for obvious reasons. Imagine a scenario where there is ten years of term left and the sponsor tries to negotiate with the lessor to create a new lease. The owner says no. Lessee decides to cut all further investment in the property. Nobody wants to buy the leasehold. Building eventually shuts down and sits there deteriorating on the land. Now the owner has a derelict building that will sit there for a decade and no one will want to touch it with a ten foot pole. Meanwhile the land owner can be collecting rent on that land for literally doing nothing if he just creates a new lease and incentivizes the current or new lessee to keep the property operating, build a new one it, or anything that will continue to generate cash flow to pay the ground lease can be paid. Get the idea?
I have also seen incestuous situations where the fee owner is also an investor in the leasehold as well. Very weird but happens. Ultimately the lease gets collapsed in exchange for a portion of the fee interest in the asset.
Again, not an exhaustive list by any means, but just some color on what can happen at the end of these things. The point is that they are not really meant to be structured to fuck the leasehold owner. A lot of times the landowner is just a family that has or wants nothing to do with real estate and just wants (a ton) of passive income.
First piece of advice - don't do it. Just don't. But if you have to here are some pointers:
Yes, this is absolutely an above the line item, otherwise, you won't have a property. It is the most important operating expense when you don't own the fee really. For this reason, the ground lease payments during the construction period need to be capitalized, unless you structure a lease that has no ground payments during construction though I have never seen that.
If you don't have fair market resets in the lease (please don't for your own sake), then you just need to model out the ground lease payments to expiration, and discount it to arrive at a present value which, in theory, should be around what the land price would be for a fee acquisition. If it's significantly higher or not in-line with the market fee value, then the terms of the ground lease don't make sense.
Your return on cost on the NOI should yield a rate that has an additional premium to the normal spread that you would take for a development project. For example, if it's a 5.5% cap market and you would build a fee deal to a 7%, you would want to build to at least an 8% on a ground lease because there is a lot more risk in a leasehold and that also impacts the exit cap since a leasehold interest typically sells at a higher cap.
It is important to check the ratio of the ground lease payment to the NOI. Lender's for an example hate seeing anything above 20%, which you should too. Ideally you want this ratio to be as low as possible.
Make sure to structure annual caps on the rent increases if pegged to CPI or better yet, just structure a fixed rent schedule.