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

Comments (23)

Feb 6, 2018

In my experience, the ground lease is considered an operating expense, and therefore goes above the NOI line.

    • 1
Feb 6, 2018

Yes, that's how we do it too - above the NOI line. Because when you sell the property most likely it will still have the ground lease on it, so it will still be a property expense.

    • 1
Feb 6, 2018

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.

    • 1
Feb 6, 2018

Why is that? Do you assume the buyer will buy the land once it expires?

Feb 6, 2018

We don't want to cap anything into perpetuity if the expiration is within a short term period since it won't be reflective of the returns in 10+ years, so we will take the PV of the remaining GL payments and deduct it.

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Feb 6, 2018

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Best Response
Feb 6, 2018

First piece of advice - don't do it. Just don't. But if you have to here are some pointers:

  1. 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.
  2. 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.
  3. 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.
  4. 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.
  5. Make sure to structure annual caps on the rent increases if pegged to CPI or better yet, just structure a fixed rent schedule.
    • 4
Feb 6, 2018

Agree with this. Ground lease payments during the construction period need to be capitalized into your development budget.

An approach to valuing the leasehold interest exit which hasn't been mentioned yet is as follows: (fee simple NOI / appropriate cap rate for property type and market) subtracted by (ground rent payment / ground lease cap rate, which should be lower than the fee-simple cap rate given it is typically the highest priority in the cash flow waterfall). This method only works if there are reasonable rent-steps and no market resets.

    • 2
Feb 6, 2018

Do you cap the 1st year ground rent? This is my second gut check usually, though I prefer to model out the entirety of the lease. I'm assuming you look at office deals based on your username and your knowledge of the topic.

Feb 6, 2018

Not for a trended analysis. I take the projected ground rent due during my stabilized/exit NOI period. For an untrended analysis, yes, I would use year 1 ground rent as ground leases typically have ground rents tracking CPI, or some other index meant to track inflation, so if you assume no opex growth, then ground rent should be static as well.

Feb 7, 2018

Also you need to be very cognizant of the remaining term on the lease. Lenders will generally want at a bare, bare minimum a longer remaining lease term than the proposed amortization period for the loan (i.e. > 30 years on a 30 year am), and often they'll want a 20-30 year cushion even on that. If you're modeling a deal with 60 years of term yet you may think you'll be fine, but if the life of the deal is 5-7 years and you go to sell the next buyer could have issues getting financing which will ding you on exitb

    • 2
Feb 7, 2018

All the insights above have been truly helpful. SB'ed you all and I hope that I can navigate this in the early stages a little better now. Thanks!

Feb 9, 2018
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