Over the past couple of years, we have seen a dramatic increase in the number of requests to finance new construction of car wash facilities on leased land. These ground leases are generally long-term leases of property entered into between a property owner and tenant where the tenant leases land and subsequently constructs a building or other improvements on that land. Since ground tenants do not own title to ground leased property, financing to construct improvements is more complex than conventional mortgage financing.
There are several reasons why investors are seeking to build on leased land versus buying and building. Acquiring a leasehold interest can provide many benefits to the tenant, including the reduction of taxable income through the deduction of rent payments, the avoidance of high upfront acquisition costs of land, or simply because the desired property is not for sale.
Some opportunities don’t come with the option for purchase. In those cases, a ground lease is the only alternative. A typical example of this would be an outparcel to major retail development. In some instances, these sites can only be leased. Therefore, if you want that premium location in front of a major anchor retailer, you may have to agree to a ground lease.
Reduction of Injection
For those on a limited budget, a ground lease may be a way to reduce your upfront out-of-pocket costs. An example of this would be having to put 10 percent to 20 percent down for a loan compared to maybe just one payment for a lease. For example, on a $1 million dollar property, a land loan would require $100,000 to $200,000 or more down towards the purchase. That’s compared to the possibility of having to come out of pocket with as little as $10,000 or $15,000 for a ground lease. Therefore, a ground lease can reduce the amount of money you are required to inject.
From a tax standpoint, leasing allows you to write off the entire lease payment. In most cases, when you buy land, you cannot depreciate (deduct) the value of the land. You can only depreciate the building, equipment, and improvements. Therefore, leasing can give you more tax deductions. However, that being said, if you finance the purchase of property, the interest portion paid for the loan on the land is also deductable. Therefore, there are tax benefits to both financing and leasing property.
With a ground lease, a lender’s primary collateral is the building and improvements, as opposed to the underlying land. Therefore, from a lender’s perspective, financing improvements on leased land has elevated risk.
The perceived and real risk come in several forms. First, in the event of a default, the lender does not have the real property as collateral, which means there is less resale value. Second, the lender will have to continue to pay rent to protect the assets financed (building, equipment, and improvements), which means continuing to incur expenses. Third, the lender will potentially have to cure the borrowers default, which means paying the tenant’s past due rent. Again, throwing more good money into a bad situation.
Finally, the lender may have limited time to remarket the business, which can lead to “fire sale” offers from potential buyers. These factors all add up to increased risk. Therefore, borrowers can potentially see slightly higher interest rates and a limited pool of financial partners willing to finance construction on leased land.
STRUCTURING A GROUND LEASE
To help ease potential lender concerns, the terms of the lease and the protections for the financial institution must be spelled out up front. Some topics that need to be addressed to make the overall project financeable are: Leasehold Mortgage, Lease Term, Broad Permitted Use, Right to Assign, Right to Cure, Land Owner Default, and other items related to tenants rights.
The first and most important item is the lender’s ability to place a mortgage on the leasehold improvements. A leasehold mortgage is not a mortgage on the underlying land. It is just a mortgage on the building, equipment, and improvements that are being financed. If you are negotiating a ground lease, one of the first items that should be addressed with the land owner is your ability to place a leasehold mortgage on the improvements.
Because the lender’s collateral is dependent upon the existence of the ground lease, the collateral will have little or no value if the lease term expires. Therefore, a lender will most likely require that the term of the ground lease exceed the loan maturity date, including all loan extension rights. As a rule of thumb, the lease term with extension options should be at least 10 to 15 years beyond the full amortization of the loan. Therefore, if you were getting a 25-year loan to finance your project, the lease term with options should be at least 35 to 40 years.
Broad Permitted Use
Financing new construction on leased property is commonly done with both Small Business Administration and conventional loans. In general, SBA loans will finance a higher percentage of the project amount (offer higher LTVs). Conventional loans are more flexible, but are harder to get. Both conventional and SBA lenders will be concerned about the ability to remarket a site in the event of a default. Therefore, restrictions in the use of the property are closely evaluated. Any provisions of the lease that constrain how the property may be used can reduce the ability of the creditor to obtain maximum value for the collateral in the event of default and may limit your ability to borrow.
Therefore, having a ground lease with few or no restrictions in how it can be used will make the project more financeable.
Right to Assign
The financial institution will want the ground lease to be freely assign-able without the consent of the land owner. A lender-friendly lease should allow for the assignment of the lease to the lender or to the lender’s nominee. In addition, the lease should permit the current or new tenant the right to assign the lease to a subsequent tenant. Having a lease that is assignable will not only create a more financeable project, butit will increase the car wash operation’s value when it comes time to sell the business.
Notice of Default and Right to Cure
The lender will want the ground lease to contain provisions requiring the land owner to provide the lender with a copy of any notice of default sent to the lessee. In addition, the lender will need the right to cure any default by the lessee, which would entail making past due payments. This right to cure is generally for an extended period of time after the tenant’s rights to cure have expired. This gives the lender the ability to remarket the location.
Many people don’t consider the consequences of a land-owner default when leasing property. In the event the land owner has a mortgage on the property, there is always the possibility for the land owner to default. If there is an underlying mortgage on the property, a prudent lender will require a non-disturbance agreement. This agreement will recognize the ground lease and the leasehold mortgage, therefore protecting both the car wash operator and the leasehold lender in the event of a land-owner default. The last thing you would want is to be evicted by the property mortgage holder in the event of a land-owner default.
OTHER ITEMS TO CONSIDER
Having a good real estate attorney on your team should be a priority. There are many other items to consider when negotiating a ground lease. Some items that should be discussed related to tenant rights include:
The lease should specifically identify when the rent is to begin. Rent can start immediately, after due diligence is completed, after permits are issued, after the certificate of occupancy is granted, or after a period of operation. When rent starts can place a huge impact on both the lending decision and your pocket book.
Fire, storm, or some other event may happen to cause a loss or condemnation of the facility or equipment. The lender will insist that they have the right to receive the casualty proceeds and condemnation awards related to the assets financed. From a borrower’s standpoint, you may want to have the option open not to rebuild in the event of a catastrophic loss.
In the event of eminent domain closure, the proceeds of the eminent domain proceedings and the requirements of the tenant should be identified up front. While eminent domain is not common, addressing this issue in advance can eliminate arguments in the future. Items like which party receives the settlement for loss of ongoing business revenue and who is responsible for future rents in the event of an eminent domain closure are important.
Right to Alter or Demolish
In some cases, the tenant may want to alter, remodel, or demolish an improvement on leased land. The right to do so should be included in the initial ground-lease contract.
Right to Obtain Additional Financing
If a ground lease is 40 years, there is no doubt that the operator will want to replace equipment or complete upgrades to the facility at some point. The right to obtain financing for those events should be allowed along with the right to refinance and place specific UCC-1 filings — a notice of a security interest — on those assets financed.
Right of First Refusal
Tenants will generally want to have the right of first refusal to purchase the property if it is sold. The right of first refusal can come in many forms. The terms of this right should be negotiated as part of your initial ground-lease contract.
THE FINAL DECISION
As you can see, there are many items to consider when looking to lease versus buy. Having a good understanding of the impact of developing on leased ground from both a lending and operating standpoint is critical. While leasing may be a good option, it’s important to recognize the drawbacks. Ground leases will potentially limit your financing options, increase the interest rate, and reduce your potential resale value. On the positive side, ground leases can reduce your tax burden, have lower upfront costs, and give you access to premium locations not otherwise available.
The bottom line is: both the positive and the negative need to be factored into your decision to enter into a ground lease. If you do decide to lease, negotiating the right terms upfront will be essential to your ability to get the project financed.
Michael Ford is managing director for Coast Commercial Credit™. For additional information on financing new construction on leased land, you can contact him at (800) 400-0365 or e-mail MikeF@CoastCC.com.