The Modern Ground Lease Is a Compelling Option for Construction Financing

While the financing landscape for stabilized property is somewhat commoditized, construction financing can be an adventure. In the past decade or so, regulatory and other concerns have driven down the leverage senior lenders can provide for development projects, which in turn has sent many a developer scrambling to fill the gap in their capital stack. This reality has only worsened in the current interest rate environment. As a result, a growing number of projects are being built with supplementary financing, including mezzanine loans, preferred equity and even C-PACE. But perhaps the most interesting development has been the recent popularity of a modern form of ground leases which, although not entirely new, have become increasingly flexible value-creators in the market.

Historically, ground leases were largely landlord-driven. A property owner in a land-constrained market like New York City might have a valuable parcel of land that was ripe for construction. If the ownership group wasn’t skilled at development and wanted to retain the property for the long term (e.g. as a generational family asset), it would often find a developer to take out a long-term ground lease. The tenant would acquire development rights — and, effectively, ownership rights — to the property for a century. The landlord, in turn, would retain ownership of the underlying land while getting an annuity-like consistent revenue stream.

The modern form of ground lease is a different animal. Driven by developers in search of capital, the transactions are initiated by existing property owners (or even buyers, in some cases) looking to develop or redevelop a property.

 After finding the appropriate deal party, the developer executes a sale-leaseback, selling the land to the buyer/landlord, and simultaneously executing a ground lease for the property, typically for a 99-year term. As with any ground lease, the tenant pays ground rent to the landlord on an annual basis, with rent escalating in a predictable manner tied to CPI or another stable index every five, 10 or 20 years to keep up with inflation.

 With the proceeds of the sale, the tenant shores up the capital stack, enabling the project to move forward with a lower-leverage leasehold mortgage. (In some cases, the developer can also invest less equity in the property as a result of the cash infusion from the sale.)

 For developers looking to get their projects onto better financial footing, the ground lease is a powerful tool. Though first utilized as a means of refinancing stable assets just a few years ago, it has already gained significant steam for construction projects in New York City and all over the country. With the developer’s equity and the ground lease equity, these projects immediately look more stable to construction lenders, which makes securing a senior leasehold loan that much easier.

As a growing number of developer-tenants have begun pursuing these deals, investor-landlords have jumped at the opportunity to transact with them. For these landlords, who effectively serve as capital investors, modern ground leases are attractive for several reasons. The risk level is unusually low. When making a typical debt or equity investment, the capital provider gives a slug of cash upfront and immediately assumes substantial risk; while there is collateral, if the project goes sideways, it takes a long and arduous process to make the investor whole. For example, foreclosure procedures in some states can take two or more years and, since the COVID-19 pandemic moratorium on foreclosures, that process has gotten even slower. But in a ground lease transaction, the capital outlay also entitles the buyer/landlord to the property deed. If the deal goes awry or the tenant stops paying ground rent, it is relatively easy for the lessor to gain control of the property through termination of the lease. Additionally, because the transaction is a sale-leaseback and not a loan, the investor/landlord doesn’t need to comply with banking regulations.

 One final unique feature of the modern ground lease – it creates value on both sides, for both the landlord and the tenant, ultimately increasing the value of the project as a whole.  While the traditional ground lease was, almost by definition, a long-term deal for the landlord, intended to protect its interest in the property in perpetuity — modern landlords approach the deals from the perspective of an equity investor, and will often look to sell or monetize their position after a few years, e.g. when the building is constructed and the lease default risk is further minimized.  

 For the majority of developers, assembling a full capital stack with reasonably priced financing options is one of the most challenging aspects of getting a project built, especially in the current interest rate and inflation environment. With construction lending getting tighter, developers are looking exhaustively at every option, and it’s telling that the modern ground lease is a tool that more and more of them are pursuing. Over the past 3 years, my colleagues and I have worked on upwards of 20 of these modern ground leases, and with the benefits they provide to landlords/buyers and tenants/developers alike, there’s every reason to expect their continued growth in the years ahead.

Danielle Ash is a partner at Duval & Stachenfeld LLP, one of the largest real estate law firms in New York City.