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Owners and developers unearth opportunities through creative land leases
By Philip “Fred” Himovitz, CCIM
Reprinted from From CIRE Magazine, Mar-Apr 2012

Editor’s note: Originally published in 2006, “Ground Control” is one of the most popular articles in CIRE’s archive. Author Philip “Fred” Himovitz updated the article for republication.

Commercial real estate developers and investors often favor total fee ownership of income property. The propensity to own — and the emotions attached to it — sometimes can result in misguided decisions and strategies and lost opportunities. Relinquishing ownership of income property is really a question of when, not if.

Once developers move beyond the notion of ownership as an investment goal, new opportunities that may not have been visible before, such as ground leases, become apparent. In its most basic form, a ground lease, or land lease, separates the ownership of land from the ownership of the improvements on the land, such as an office building or a shopping center. The landowner leases the land to the developer of the improvements, who pays rent for use of the land.

Typically ground leases are long-term and include set rent escalations, eviction rights should the lessee default, and a reversionary right, which means improvements on the property revert to the landowner at the end of the lease term. While such lease terms do not particularly favor developers, ground leases offer some distinct advantages to them.

The two most prevalent types of ground leases are subordinated and unsubordinated. Each provides benefits that can enhance the developer’s yield and turn dismal or modest returns into more attractive and risk-mitigated ventures. They also give developers the opportunity to involve multiple partners without negotiating formal partnership agreements.

Ground leases transfer control — not ownership — of a property and, for the landowners, they are considered one of the most secure forms of real estate investment. But landowners may be considered preferred investors and may be open to developers who offer them a stake in the improvements erected on their land, in exchange for other considerations such as rent abatement for vacancy. Such a quid pro quo can substantially reduce risk to a lender.

Lease Structures

In a subordinated ground lease, the landowner offers the land as collateral for the developer’s mortgage, giving the landowner a significant stake in the development risk. The subordinated ground lessor is considered a secondary lender with junior rights behind the primary lender, usually a bank or other financial institution.

Normally the ground lessor has a future claim on the improvements, as most ground leases require improvements to the land to revert to la

ndowners at the end of the lease. As such, ground lessors usually consider the downstream value of the improvements in establishing a rental rate. On the other hand, a ground lease that provides for the removal of any improvements at the end of the lease, such as relocatable metal buildings, modulars, portable plants, or parking lot appurtenances, would factor that eventuality into the rate as well.

The subordinated ground lease rental rate is usually a few percentage points above long-term permanent loan rates applied to the land value, which would correctly calibrate the risk-reward equation, including the risk of foreclosure, for the ground lessor.

The unsubordinated ground lease offers the landowner a more desirable role, comparable to that of the primary lender. This makes long-term permanent conventional financing more challenging for the developer, since the lender must assume the risk of lease termination and default. However, due to the senior position of the unsubordinated ground lessor, the ground lease rate can be lower and therefore much more attractive for the developer. The permanent lender recognizes the ground lease payments as an annual expense that will be factored into its loan underwriting. In total, the cash required in the deal by the developer is reduced while his yield is increased.

In both cases, the developer’s requirement for cash in the deal is reduced because of the value that the landowner brings to the deal. The reduction in cash usually required causes the investment yield to increase when the income stream is extended into the future. The value of the future cash stream will be determined by a threshold discount rate, resource availability, and underlying assumptions — the same general market and economic model assumptions that apply to fee-simple land ownership deals.

Other considerations include the length of the remaining lease term, reversion covenants, and extension and renewal rights and options. Occasionally the ground lessor will participate in the cash flows by applying a lease rate as a percentage of the income that the rental property produces. This strategy can have the positive effect of averting a monetary default in the event of a “dark” project. It also has the positive effect of mitigating the risk that a first mortgage lender perceives if the lease is unsubordinated. For example, if prevailing long-term interest rates are 6 percent, a comparable subordinated ground rental rate might be 8 percent, whereas an unsubordinated lease might be priced at par or 6 percent.

Ground Lease Benefits

The potential to form a joint venture with a building developer can be attractive to the primary ground lessor. The yield values are enhanced by the security of the future improvements. Provisions against wasting the property, requirements to maintain the improvements, cure and notice rights, certain reasonable approval conditions, and the ubiquitous hazardous materials covenants are standard.

Clearly, an unsubordinated lease presents possibilities that offer an alternative investment vehicle that provides security to patient investors and can be traded, sold, or transferred in creative ways. For example, tax-deferred 1031 strategies are possible by trading into an income investment as a sandwich ground lessee-ground sublessor. The usual threshold is that the lease term be greater than 25 years. Since these instruments can take on the color of a security, real estate professionals who enter into these deals should carefully document all aspects of the transaction and seek advice from qualified securities professionals.

In addition, opportunities exist in some municipal ground lease situations wherein, under certain conditions, property taxes are completely or virtually eliminated. Likewise other tax benefits accrue to these sanctuaries because of the reversionary character of building improvements and the incentive-rewarding jobs creation. These areas of investment can offer a spectacular advantage over neighboring competing properties in pricing and yield.

Lease term and length influence the acceptability of ground lease deals. The current climate is cautionary because of the parochial need to own; however, institutional managers realize that it is all factored into the risk and yield and accept the challenge with appropriate lease drafting and terms that are favorable to the asset managers’ objectives. The environment is changing as the pressure for yield performance and risk mitigation goes begging. The challenge is pioneering in an area where heretofore only the creative and adventurous have explored.

LOCATION
The southwest corner of West Road and Easton Commons Drive one block east of Highway 6 North in Copperfield Houston, Harris County, Texas 77095

LAND SIZE
4.1 Acres (178,596 SF)

FRONTAGE
Over 594 feet of frontage on West Road and over 300 of frontage on Easton Commons Drive

COMMENTS
This property is a commercial reserve out of the Copperfield development at the lighted corner of West Road and Easton Commons Drive. West Road is a major four lane esplanade thoroughfare running from Barker Cypress to Sam Houston Tollway. A public park is being planned for the land directly behind the property and a Kroger-anchored retail center is across the street. Property is well-suited for townhomes, retail, assisted living, daycare or office. Seller financing available to qualified buyers.

More info

By Michael Reed from yourhoustonnews.com

With Houston’s third loop, the Grand Parkway, expected to become a reality in 2016 and a boon to the job market soon afterward, it’s easy to wonder just how far from the heart of the city is too far to be a viable urban alternative.

Well, it wasn’t that long ago concerns along those lines were voiced over another major roadway project.

“I remember when they were wearing snake boots to do surveys of where the toll booths would go,” said Janet Wagner, president of the Harris County Historical Commission, referring to southern sections of Beltway 8 in the mid-1990s. “That was all vacant or farmland then.”

While that region on either side of state Highway 288 may have been among the least developed along the Beltway’s route, it was not alone in gaining both population and new businesses. And, according to statistics from the Houston-Galveston Area Council, it’s still growing.

Within two miles of either side of the entirety of Beltway 8, the population was 646,130 in 1990, about the time the final segment opened. It now stands at 952,634, but is expected to increase to 1,175,262 in 2025 and 1,322,042 in 2035.

The H-GAC data also shows the number of people working in the same proximity has grown from 217,218 in 1990 to a current level of 482,831. It is expected to reach 587,911 in 2025 and 676,576 in 2035.

That would be a projected increase increase of about 40 percent in both population and employment over the next 25 years.

Growth inevitable

“It’s a really large area, so it’s difficult to say how much this (growth) can be attributed directly to it (the roadways),” said Chris Van Slyke, a traffic program manager at H-GAC.

In many ways, the growth was inevitable and to large extent had already occurred by the time Beltway 8 was conceived, let alone became a functioning roadway, according to Billy Burge, president of the Grand Parkway Association Board.

“I can remember years of delay to building the first one, and how Bellaire didn’t want it,” he said, referring to Houston’s original loop – Interstate 610. “That came well after everyone was all clustered up.”

Burge said the Grand Parkway, hopefully, will allow for a more orderly distribution of growth ahead of major population increases that are forecast.

“It’s not so much a shift (in population) as it is getting ahead of growth this time, so people can do things like drive straight to the airport,” he said. “It’s a more orderly way of life with less congestion.”

As the outer loop, The Grand Parkway, obviously, will be bigger than the Beltway 8 – 177 miles vs. 88 miles in length. And, where the latter lies entirely in Harris County, the new roadway will also pass through Fort Bend, Montgomery, Chambers, Galveston and Brazoria counties.

H-GAC statistics show that within 2.5 miles of the Grand Parkway the population grew from 192,666 in 1990 to its current 455,116, and is expected reach 736,651 in 2025 and 972,473 in 2035. Jobs along the route – 50,184 in 1990 – doubled to 110,942 currently, and should climb to 164,041 in 2025 and 211,075 in 2035.

‘Unique and pretty’

Those increases of 114 percent in population and 91 percent in jobs are considerably larger than expected for the Beltway 8 corridor area between now and 2035.

Realtor Pattie Huey, who keeps close tabs on regional growth as HAR liaison to the Houston Builders Association, thinks she knows part of the reason.

“If you look at that land, it’s just waiting. People have been buying it up for years,” she said, specifically of areas to the north of Houston. “The population is always drawn to unique and pretty.”

She said increased access and better direct traffic routes will make the commutes much more manageable for many who will be working in Houston, but wouldn’t have considered living so far out with only the current roads to depend on.

“It’s not like we haven’t been living in outlying areas for very long time,” she said. “Do we refer to Cinco Ranch as being too far out now? I can remember when Memorial was too far out.”

Huey said she anticipates increased development around The Woodlands and predicted Magnolia’s population will grow considerably.

Well, if north of the Grand Parkway isn’t too far to be part of metropolitan area, what is? Could a fourth belt be in Houston’s future?

“From a loop standpoint, this is probably the last loop, and it is truly needed,” Burge said, adding that another loop would be built outside regional transportation authority, anyway.

See article here.

To jump-start their economies and create more jobs, states increasingly are trying to spur private sector business growth and investment. One way some political leaders are doing this is by reducing business taxes and government regulations.

According to the Tax Foundation, a nonpartisan public policy organization in Washington, D.C., “the most competitive tax systems create the fewest economic distortions by enforcing the most simple, pro-growth tax systems characterized by broad bases and low rates.”

Recently, the U.S. Chamber of Commerce published a report called “Enterprising States 2011” that ranked states in a variety of performance metrics, including their tax and regulatory environments. Those environments were compared in five ways: overall state and local tax burdens, corporate taxes, small-business costs, state government budget gaps, and cost-of-living indices.

With the exception of Texas, States that made the Chamber of Commerce’s top-ten list are not found on the East Coast or the West Coast because desirable coastal states don’t always need incentives to attract business investment and expansion. So states that offer lower taxes and regulations view those attributes not only as advantages but also as necessities in today’s competitive landscape for business expansion and job growth.

The importance of this relates both to corporate entities and to real estate development. Locating in or doing business in a low-tax state can help generate higher profit margins, while operating with fewer regulatory and bureaucratic hurdles can reduce red tape in the real estate development process, whether for environmental reviews or incentive programs.

Here is what they say about #6 Texas:

The Lone Star State is a low-tax state that offers a low cost of living and has an enterprise-friendly climate that’s paying off with high job growth rates. Recent state initiatives include a business tax reform that raises the revenue exemption.

Article excerpt from the Urban Land Institute by Jeffery Spivak

The future growth of the Greater West Houston trade area validates “Why rural land is a good investment”. The predictions from the West Houston Association of over 2,000,000 people in the 100 square miles outlined on the chart below in 2050 support the wisdom of investing in land in the west, south and north west. A&M’s Texas Real Estate Center reinforce this prediction that over 90% of the population in Texas will live in a triangle between Houston, Dallas, San Antonio and Austin by 2040. The I-10 corridors are the backbone for this predicted growth, with both residential and commercial development.

As an investor, the simplicity of buying land in rural counties offers lower taxes through an AG exemption and future lower development cost. The historical appreciation of this type of desirable land (rural, farm/ranch) can be measured in the major growth shown on the diagram west of HWY 6 which in the 1970s was rural farm and ranch land.

The cost of developing and owning land inside the West Houston Association diagram will be more complicated and expensive than it has been in the past with the future governmental controls from state and federal agencies.

From the February 2010 issue of REDNews by Sassy Stanton