If you own real estate in an up-and-coming area or own property that could be redeveloped into a “higher and better use”, then you’ve come to the right place! This article will help you summarize and hopefully demystify these two methods of improving a piece of real estate while participating handsomely in the upside.
The Development Ground Lease
The Development Ground Lease is a contract, typically ranging from 49 years to 150 years, where the owner transfers all the benefits and burdens of ownership (fancy legalese for future revenues and costs!) to a developer in exchange for a monthly or quarterly ground rent payment that will range from 5%-6% of the fair market value of the property. It allows the owner to enjoy a good return on the value of its property without having to sell it and doesn’t require the owner itself to take on the tremendous risk and complication of constructing a new building and finding tenants to occupy the new building, skills which many real estate owners simply don’t have or want to learn. You may have also heard that ground lease rents are “triple net” which means that the owner incurs no costs of operating of the property (other than income tax on the received rent) and gets to keep the full “net” return of the negotiated rent payments. All true! Put another way, during the term of the ground lease, the developer/ground lease tenant, takes on all responsibility for real estate taxes, construction costs, borrowing costs, repairs and maintenance, and all operating costs of the dirt and the new building to be built on it. Sounds pretty good right. There’s more!
This ground lease structure also allows the owner to enjoy a reasonable return on the current value of its property WITHOUT having to sell it, WITHOUT paying capital gains tax and, under current law, WITH a tax basis step-up (which reduces the amount of gain the owner would ultimately pay tax on) when the owner passes away and ownership of the property is transferred to its heirs. All you give up is control of the property for the term of the lease and a greater participation in the profits derived from the new building, but without most of the risk that goes with building and operating a new building. More on risks later.
To make the deal sweeter, most ground leases are structured with periodic increases in the ground rent to protect against inflation and also have fair market value ground rent “resets” every 20 or so years, so that the owner gets to enjoy that 5%-6% return on the future, hopefully increased value of the property.
Another positive attribute of a development ground lease is that once the new building has been built and leased up, the landlord’s ownership of the property including the rental stream from the ground lease is a sellable and financeable interest in real estate. At the same time, the developer’s rental stream from operating the property is also sellable and financeable, and if the lease is drafted properly, either can be sold or financed without risk to the other party’s interest in their property. That is, the owner can borrow money against the value of the ground rents paid by the developer without impacting the developer’s ability to finance the building, and vice versa.
So, what are the downsides, you may ask. Well first, the owner gives up all control and all potential profits to be derived from building and operating a new building for between 49 and 150 years in exchange for the security of limited ground rent. Second, there is risk. It is predominantly front-loaded in the lease term, but the risk is real. The minute you transfer your property to the developer and the old building gets demolished, the property no longer is leasable and won’t be generating any revenue. That will last for 2-3 years until the new building is built and fully tenanted. If the developer fails to build the building or stops halfway, the owner can get the property back by cancelling the lease, but with a partially built building on it that generates no revenue and worse, will cost millions to finish and lease up. That’s why you must make absolutely sure that whoever you lease the property to is a skilled and experienced builder who has the financial wherewithal to both pay the ground rent and complete the construction of the building. Complicated legal and business solutions to provide protection against these risks are beyond the scope of this article, but they exist and require that you find the right business advisors and legal counsel.
The Development Joint Venture
Not satisfied with a boring, coupon-clipping, long-term ground lease with limited involvement and limited upside? Do you want to leverage your ownership of an undeveloped or underdeveloped piece of property into an exciting, new, bigger and better investment? Then perhaps a development joint venture is for you. In a development joint venture, the owner contributes ownership of the property to a limited liability company whose owners (members) are the owner and the developer. The owner trades its ownership of the land in exchange for a percentage ownership in the joint venture, which percentage is determined by dividing the fair market value of the land by the total project cost of the new building. So, for example, if the value of the land is $ 3million and it will cost $21 million to build the new building and lease it up, the owner will be credited with a 12.5% ($3mm divided by $24mm) interest in the entity that owns the new building and will participate in 12.5% of the operating profits, any refinancing proceeds, and the profit on sale.
There is no income tax or state and local transfer tax on the contribution of the property to the joint venture and for now, a basis step up to fair market value is still available to the owner of the 12.5% joint venture interest upon death. Putting the joint venture together raises numerous questions that must be negotiated and resolved. For example: 1) if more cash is needed to finish the building than was originally budgeted, who is responsible to come up with the extra funds? 2) does the owner get its $3mm dollars returned first (a priority distribution) or do all dollars come out 12.5%:87.5% (pro rata)? 3) does the owner get a guaranteed return on its $3mm investment (a preference payment)? 4) who gets to control the day-to-day business decisions? or major decisions like when to refinance or sell the new building? 5) can either of the members transfer their interests when desired? or 6) if we build condominiums, can the members take their profit out by getting ownership of certain apartments or retail spaces instead of cash? There is a lot to unpack in putting a strong and fair joint venture agreement together.
And then there is a risk analysis to be done here too. In the development joint venture, the now-former property owner no longer owns or controls the dirt. The owner has acquired a 12.5% MINORITY interest in the operation, albeit a bigger project than before. The risk of a failure of the project doesn’t just result in the termination of the ground lease, it could result in a foreclosure and perhaps total loss of the property. And then there is the possibility that the market for the new building isn’t as strong as originally projected and the new building doesn’t generate the level of rental income that was expected. Conversely, the building gets built on time, on or under budget, into a robust leasing market and it’s a home run where the value of the 12.5% joint venture interest far exceeds 100% of the value of the undeveloped parcel. The taking of these risks can be significantly reduced by selecting the same competent, experience and financially strong developer partner and if the expected benefits are large enough, a well-prepared property owner would be more than justified to take on those risks.
What’s an Owner to Do?
My first piece of advice to anyone considering the redevelopment of their property is to surround themselves with experienced professionals. Brokers who understand development, accountants and other financial advisors, development consultants who will work on behalf of an owner and of course, good experienced legal counsel. My second piece of advice is to utilize those experts to determine the economic, market and legal dynamics of the potential transaction. The dollars and the deal potential will drive the decision to develop or not, and the structure. My third piece of advice to my clients is to be true to themselves and try to come to an honest realization about the level of risk they will be willing to take, their ability to find the right developer partner and then trust that developer to control this process for both party’s mutual economic benefit. More easily said than done, I can assure you.
Both of these structures work and have for years. They are particularly popular now because the cost of land and the cost of construction materials are so expensive. The magic is that these development ground leases, and joint ventures provide a less expensive way for a developer to control and redevelop a piece of property. Less expensive in that the ground rent a developer pays the owner, or the profit the developer shares with a joint venture partner is either less, less risky or both, than if the developer had bought the land outright, and that’s a good thing. These are sophisticated transactions that demand sophisticated experts working on your behalf to keep you safe from the risks inherent in any redevelopment of real estate and guide you to the increased value in your property that you seek.