Ground Leases and Building Leases

Establishing ground lease rates and / or commercial building lease rates in a lease that will continue to remain reasonable for both an owner and a tenant over the long-term is a difficult task.  As the Economist for the Arizona State Land Department’s Commercial Leasing Section back in the 1980’s I was part of a team that attempted to establish long-term rates on vacant properties for several State-owned properties, and while I did not remain to see it I am sure that every one of the leases that I helped to establish eventually required a renegotiation. 

Why did they fail?  Because establishing long-term lease rates is like developing any kind of speculative financial model, as the owner of the land you write the terms with rose colored glasses on anticipating that the market will continue to improve indefinitely into the future.  Then a year like 2008 comes along and destroys all of your assumptions and renders the leases useless since few if any of the tenants can pay the agreed upon rates.

So how do fast food, pharmacy and gas station tenants write their leases to make them last for 20, 30 or even 40 years?  It’s simple, they are providing a fixed and guaranteed triple-net return to the owner / landlord.   Some leases have terms that dictate that an appraisal will be completed on a property periodically so that the owner / landlord can benefit from the typical upward movement in real property value.  These terms are fair but they undermine the long-term expense stability that is sought by tenants.

I have analyzed many long-term leases and found that the longer their fixed term the farther from reality their rental rates become.  Lease terms established for 99 years on Downtown Las Vegas land were often tied to the Consumer Price Index (CPI). Those CPI adjustments however became excessive over time and the compensation to some owners grew to millions of dollars while the real estate market did not increased nearly as much. 

I have also seen long-term leases that did not include terms for reappraisal, fixed increases or automatic increases based on the CPI.  Tenants in cases of this type harvested a rental bonanza at the expense of the owner.  Appraisal analysts ask themselves “What was the owner thinking when he wrote this lease?”  A generation later the owner’s family has to supplement the rental income just to make the tax payments.

Most ground leases are established without regard for what improvement will be placed on a property.  If an owner is guaranteed a reasonable long-term return on a site that has hit its peak value from a national credit tenant does it really matter what will happen in 20 to 40 years?  For non-corporate owners the answer is usually no.  Let the tenant make whatever improvements that they desire, if guaranteed structurally sound they generally add value to the land.

Leasing becomes more complicated when tenants want to build improvements but don’t want to pay cash for or they need a loan.  Most land owners will not subordinate their first position to anyone.  Owners / landlords who become involved in the capital investments of tenants are relatively rare and leases that address capital contributions often become even more complex than a typical ground lease. 

For more appraisal information contact Glenn J. Rigdon MA, MRICS, ASA is a Las Vegas / Henderson Nevada based appraiser who can be contacted via email or via his business website known as Appraiser Las Vegas  (http://www.appraiserlasvegas.com), or you can also click on “Contact Us” on the home page of this website or visit my public profile at LinkedIn at http://www.linkedin.com/pub/glenn-rigdon-ma-mrics-asa/1a/30b/879/

Article source: http://www.appraisalarticles.com/Commercial-Leasing/4549-Ground-Leases-and-Building-Leases.html