Developers Are Leveraging Ground Lease Structures to Fund Construction

We may be nearing the third year of the pandemic, but lenders remain hesitant to fund new developments, particularly in de-stabilized assets like hotels, retail and office. To secure construction financing, developers are leveraging ground leases, which serves as an alternative way to secure early capital and de-risk the deal to get lenders more comfortable.

“Construction lenders are typically taking the highest level of risk in a deal, other than the sponsor,” Danielle Ash, a partner at Duval & Stachenfeld, tells GlobeSt.com. “The construction lender has to be convinced that the risk is worth it. Ground leases really provide the ability for the ground lessor to take the initial risk that a construction lender doesn’t want to take.”

Under a ground lease on a new development, the lessor provides and initial infusion of equity into the project. This both allows the sponsor to reduce its equity stake in the project and helps to mitigate risk for the lender. “The construction lender is happy an willing to make the loan because the risk is smaller and there is a second party betting on the fact that the project will be completed,” says Ash. “If all else fails, the lender may not have put in much money yet because the first money in is the ground lessor. The initial risk is really taken off the table.”

These deals are also a win for the ground lessor “Traditionally a ground lessor has a coupon clipping position. They simply own the lease and get rental income, and they get a pretty consistent rental stream,” says Ash.

Utilizing a ground lease as part of the capital stack on a new development isn’t a new concept, but it did become popularized during the pandemic. “Investing in that rental stream was always available, but it wasn’t as attractive as it is now. A lot of investors didn’t have deals to invest in because so much of the market was under water. These were really good deals that were still working,” says Ash.

However, Ash says the structure was rising in popularity even before the pandemic. “The market was changing about what real estate is going to be and what is it going to sever,” she explains. “The kinds of assets that were attractive to construction financers was changing. They don’t necessarily want to take a risk to the pre-development side or be in the capital stack when the developer is securing permits or when there is zoning risk.”