Ground leases are not what they used to be. For the modern-day real estate financier, they are increasingly carrying more weight.
Managers like Haven Capital, Kawa Capital Management and Safehold are on the leading edge of what has become a modern ground lease movement. Proponents of the strategy tout the structure as the biggest innovation commercial real estate finance has seen since the first commercial mortgage-backed securities deal was printed in 1994.
There are a few practical reasons behind the evolution of these new model ground leases, which are markedly different from their older predecessors. Properly structured, modern ground leases can generate higher yields, more appropriately segment risk and ease estate planning.
“Today’s ground leases are very different than the ground leases of the past,” says Jacques Holzmann, director at Kawa Capital, which has executed more than $1 billion of ground lease transactions. “They are about trying to add value to a sponsor, rather than extracting value. And it’s also about the idea that the ground is a passive part of the capital stack and detracts value from sponsors who believe they shouldn’t be allocating a portion of their capital to something that passive.”
The nuts and bolts of it
The philosophy behind a ground lease transaction is quite simple and is driven by the idea that it is possible to enhance the risk-reward attributes of an asset’s components by splitting the land below a building from the building itself, David Eyzenberg, president of New York-based advisory Eyzenberg & Co, tells Real Estate Capital USA.
In one kind of structure, a sponsor can buy an asset for $100 million and split the property into a leasehold, or the building, and the leased fee, or the ground below. The sponsor could sell the leased fee to a fixed income-like investor that has lower return requirements than traditional real estate private equity funds and retain the leasehold, then obtain a first mortgage lien at a 65 percent or 70 percent loan-to-value ratio on that part of the property.
“It’s an innovation in the way that people structure real estate capital stacks and it’s at an early stage in its product life cycle”
There are also situations in which a sponsor that owns the fee simple – a piece of land and any building there – could sell the leasehold on a 99-year term. “In our niche on the advisory side, we are creating substantial value for land-owners by negotiating a financeable ground lease with leasehold developers,” Eyzenberg says. “The individual owner converts land into a safe, income-producing asset without having to contend with a sale or risky joint ventures.”
According to data from Safehold, a ground lease specialist headed by iStar chairman and CEO Jay Sugarman, the existing US ground lease market is about $100 billion, compared to a US institutional real estate market of around $7 trillion. The firm estimates that the potential US ground lease market is around $2.6 trillion, or about 37.5 percent of the total institutional market.
It’s difficult to size the potential opportunity in the US ground lease market because only a very small portion of properties are owned through this structure, notes Bruce Stachenfeld, chairman of New York law firm Duval & Stachenfeld. “When you think about it, it’s just pie in the sky. Any property that produces income could become a ground lease and that market is potentially huge.”
Historically, ground leases were concentrated in a handful of markets that included New York, Washington, DC and parts of Hawaii where the state retained land but sold the right to develop it to individual sponsors. Broadly speaking, these ground leases were structured with 99-year terms that allowed for regular, substantial rent increases tied to the estimated fair market value of properties.
Today’s ground lease specialists are taking a different tack. While the terms of ground leases still tend to be 99 years, rent increases are tied to the Consumer Price Index and may offer the leasehold owner the opportunity to buy back the leased fee and collapse the ground lease.
By comparison, Kawa offers a 99-year ground lease with fixed annual increases of 2 percent and can offer one buy-back option in the future. “Ground leases today have some kind of escalator, but no true reset, no new fair market value for the land,” Holzmann says.
“One of the challenges is really sizing the ground lease in a way that adds value to a sponsor. We are trying to get the sponsor to understand that it’s not always the highest proceeds that make the best ground lease.”
Potential future size of the US ground lease market
John Crump, a senior managing director at BH Properties, notes this use of the fair market value option for determining lease hikes was likely what gave the structure a black eye in the past by leading to uncertainty and often volatile changes in ground rents.
“When we work with sponsors on structuring ground leases, we try to make future rent increases as predictable as possible,” Crump says. “We set an initial yield with fixed periodic increases and the only major change will be based on a Consumer Price Index reset, which is often capped.”
Different sponsors benefit from different structures, including options that are closer to pure short-term debt or with lower proceeds or no repurchase options, Joseph Shanley, director of acquisitions at ground lease specialist Haven Capital, tells Real Estate Capital USA.
Size of the institutional
US real estate market
“We are in a position to provide more flexibility on a variety of terms to provide a financing option that is customized to our client and their specific transaction,” Shanley says.
Putting it all together
A ground lease works best for a sophisticated subset of borrowers who grasp its potential to generate ultra-efficient proceeds on what would otherwise be a traditional commercial real estate deal. An office REIT that wants to use leverage of about 60 percent on a typical deal might not be the right user, market participants tell REC USA.
Haven works with sponsors who want to use the structure to engineer returns and yields through innovative financing.
“It’s hard to generate yield and returns on a stable asset that trades at sub-4 percent cap rates. You need to structure that deal more creatively if you want to meet today’s yield requirements,” Shanley says. “This is a strategy for sponsors looking to generate higher cash-on-cash yields and higher returns than should be reasonably expected to achieve on that asset class.”
Haven typically looks at creating leaseholds of $20 million or more, with an average size of $50 million. That translates into approximately one-third of the capital stack of a deal, with the firm buying assets for 30 percent to 40 percent of their value and leasing them back on a 99-year term. This structure includes a CPI lookback every 10 years, as well as the opportunity for the sponsor to buy back the fee interest at years 40, 70 and 99 years, Shanley said.
“We are helping people to build high-leverage, efficient capital stacks,” Shanley says.
All of the market participants who spoke to REC USA believe this market is still at very early stages and they are all planning ways to expand their footprints.
Eyzenberg & Co has a robust advisory business in this segment of the market and is preaching the gospel of the structure to sponsors, lenders and even financial advisers that could use the structure as part of estate planning. The firm could also raise its own capital for investments. “In theory, there is an unlimited amount of capital for ground leases,” Eyzenberg adds. “The problem is the lack of opportunities and willing leasehold lenders.”
Estimated current size of the US ground lease market
Haven Capital’s Shanley also expects to see ground leases become more commoditized, like the way the CMBS market did more than 20 years ago. “I expect ground leases ultimately to be priced much more tightly, to have a uniform structure and look like CMBS,” he says. “It’s an innovation in the way that people structure real estate capital stacks and it’s at an early stage in its product life cycle.”
Kawa, which is investing nationally across sectors, sees room to expand its business with new developers that are trying to maximize value or other sponsors that are long-term holders of land. Eventually, REITs could also become more comfortable with holding the leasehold position.
“We continue to see ground leases becoming more prevalent in the industry and sponsors are realizing the value we can add to the structure,” Holzmann says. “The real estate market is already enormous, but ground leases are an important part of how it grows.”
For BH Properties, education is the factor that will allow more sponsors to use the structure.
“I think the proliferation of ground leases is one of education,” Crump says. “Most real estate investors have looked at traditional financing in which you get a loan and provide equity for the balance. But now, the idea of ground leases is starting to spread, and sponsors are realizing that they could have a better yield on every dollar of equity.
“A 99-year lease term is very predictable and it’s a tool that a lot of groups are starting to understand – it’s like a light bulb turning on when a sponsor realizes what it can do.”