Leased Fee and Leasehold Arrangements: Proceed With Caution

Cracks are beginning to show in CMBS loans that have leased fee and leasehold structures, according to a new DBRS Morningstar report—and perhaps unsurprisingly, those tensions are beginning to show in unsecuritized deals too.

Ground lease arrangements are a tale as old as time in CRE, and in the good old days it was rare to see a ground lessee default on rent obligations.  But as land values skyrocketed in markets like New York City and San Francisco, owners seized the opportunity to split off fee and leasehold interests, and investors sought to sell the ground fee interest to up their cash-on-cash returns. The catch, Morningstar notes, is that property revenue has to keep up with rent and revenue increases. And since a leasehold interest is by its very terms a finite arrangement, it’s essentially a “wasting asset” that’s worth zero when occupancy rights revert back to the leased fee holder. 

While historically it’s been unusual to see CMBS ground-leased fee loans under stress from a ground lessee’s failure to pay rent, that’s no longer necessarily the case. The Morningstar report notes that increasingly the economics of ground-lease agreements impair the value of the leasehold interest, and vice versa—and in some cases, the ground leases terminate, leaving the leasehold lender with no collateral and no methods to recoup its investment.  And while “the CMBS market seems to have caught on to this”—leading to fewer leasehold loans in conduit pools over the past several years—leased fee loans secured by the fee, or ground underneath commercial properties, are still common in CMBS, “but we believe they deserve closer scrutiny,” the report says. 

Among the other risks: leasehold owners may have to spend serious cash to keep existing tenants or attract new ones, while rental income may also drop—and all the while, tax and ground rent obligations remain. Leasehold owners may also suffer cash flow problems to release or maintain properties or to cover debt service payments. And if value is impacted for a lengthy period, the leasehold owner may also just walk away if they can’t restructure the ground lease—leaving the ground lessor with a devalued asset that would require a cash infusion to stay afloat. 

Morningstar urges striking a balance between the economics of owning and financing fee and leasehold interests where properties are subject to ground leases. Bifurcating ownership by creating a ground lease and selling the ground interest to a long-term investor can optimize owners’ investment return, and as long as debt leverage for each interest considers the risks inherent in that arrangement, both sides can benefit.