The Modern Ground Lease: White Knight in a Time of Market Volatility?
Modernizing ground leases has become a cause celebre among lenders and lawyers
The commercial real estate industry is always looking for more efficient ways to access capital, and the hunt becomes especially important in times of market choppiness when there’s often a distinct dearth of capital providers. Like now.
Which is why ground leases are being seen in an attractive new light.
“If there’s a recession, liquidity will be even more constrained, which will mean real estate investors will have to be that much more efficient in order to navigate the market,” said Jay Sugarman, chairman and CEO of Safehold, a ground lease-focused real estate investment trust. “That only strengthens the value proposition for modern, well-structured ground leases.”
Indeed, in an inflationary environment with rising interest rates and skittish financiers, investors are already having to find more creative ways to structure deals, as a CRE lending field that was packed only a year ago has now been reduced to tumbleweeds blowing in the fall breeze.
Tim Doherty, head of investments at Safehold, describes the modern ground lease as a “means to inject stability into the capital stack. Already the lowest-cost capital in the market, modern ground leases provide low-cost, long-term, predictable capital that can give investors and developers peace of mind by reducing the amount of debt they need to take on in a volatile market, mitigating refinancing risk in the process,” he said. “This was true when rates were low and the market was stable, and it is still true in the market today.”
As an example, take the math on a $100 million acquisition at a 6.5 percent cap rate.
“If a buyer adds a ground lease to the capital stack, they’re immediately reducing their transaction cost by about $35 million, assuming the ground lease proceeds account for 35 percent of the acquisition cost at a 4.35 percent initial yield,” Doherty said. “This allows the buyer to significantly reduce their own leverage, limiting their maturity risk and helping generate enhanced returns.”
The new new
Ground leases, once a document executed then buried deep below ground for 100 years — complete with the terrifying chance it would someday rise from the earth in the style of a marauding zombie and reset — have evolved into something quite different today.
Wary of issues that have arisen with antiquated ground leases, investors in more recent transactions have been busy constructing the so-called modern ground lease that serves in a more efficient way.
“The modern ground lease is one that is more creative, a capital tool to be collaborative, highly fixed, and not variable in nature,” said Max Nipon, senior vice president of Montgomery Street Partners, a private equity fund manager that has a roughly $1.5 billion ground lease real estate investment trust.
Indeed, a variable, resetting ground lease is the stuff of nightmares. Remember the kerfuffle around the Chrysler Building? So does half the industry — and the Abu Dhabi Investment Council. An iconic piece of New York’s history sold for a mere $150 million in 2018, thanks to its ground lease with Cooper Union, which reset from $7.5 million to $32.5 million.
“With old ground leases, it was very difficult to predict what your rent would be in the future,” Sugarman pointed out. “It was very difficult to understand what your rights and responsibilities were.”
Safehold is one firm striving to eliminate elements of variable rent today, whereas old ground leases had the ability to “revalue the rental stream,” often for the gain of the fee owner, Doug Heitner, chief legal officer of Safehold and iStar, said in a 2020 interview on Safehold’s blog.
“These fair market value resets were the death knell of all the busted ground leases you’ve ever heard about,” Heitner said in the interview.
Heitner added that “in traditional ground leases there were limitations on the type of financing that a leaseholder could get. There were hoops to jump through. … So, we eliminated pretty much every covenant related to the leaseholder’s ability to finance their position.”
Today’s ground leases, then, aren’t the same animal to be feared. Rather, they can work firmly in the sponsor’s favor, a welcomed nugget of knowledge in a volatile market that all too often feels like a losing game.
Montgomery Street Partners — via its private Ground Lease REIT — recently put a ground lease to good use when it acquired the iconic Hudson Hotel in Midtown Manhattan from Cain International for $207 million. It simultaneously executed a 99-year ground lease with an undisclosed party who has big plans to convert the hotel into a multifamily building.
“We contributed $170 million of the $207 million through a ground lease, which allowed us to buy the lease fee position,” Nipon said. “So we acquired the property and immediately leased it to the sponsor, leaving us with a 99-year lease fee interest and the sponsor with a 99-year leasehold interest.” Parkview Financial provided the rest as sponsor equity and ultimately leasehold lender capital.
“The ground lease structure and then the leasehold loan structure allowed for this deal to work,” added Nipon. “It becomes a blended cost of capital that’s less than the traditional alternative. So you get more leverage that costs you less and ultimately equates to an overall better economic solution for the sponsor.”
Low-cost leverage is as rare as hen’s teeth in the current environment, with rising interest rates coupled with nervous lenders making dollars harder and harder to come by. For Montgomery’s deal, the one-two punch of the ground lease on top of the acquisition was critical.
“This particular sponsor was not going to be able to get a big construction loan, and it would have been way more expensive for them,” said Danielle Ash, legal adviser on the deal from Duval & Stachenfeld. “It’s a great example of how a ground lease fits in a very difficult market where interest rates are increasing and there are a lot of risks that lenders are not willing to take on.”
“Currently we are in a market with tight liquidity,” Nipon said. “The fact that ground leasing presents pretty certain liquidity from very high-caliber providers at the cost of capital that is slightly less than what their alternatives are is compelling right now.”
And the Hudson Hotel is just one of many transactions in which Montgomery is putting the modern ground lease to good use.
In fact, over the last year, it has closed nine ground lease transactions around the country totaling roughly $600 million.
“That is $600 million of ground lease proceeds,” Nipon said. “I would say the percentage of real estate value today aggregates to roughly $2.5 billion dollars of real estate.”
Welcome to the upside down
The modern ground lease appears to be going from strength to strength today.
Sugarman’s Safehold went public in 2017 with a portfolio of around 75 ground leases nationally, and has grown from $300 million to $6 billion over five years.
“We have looked at the top 30 cities and there’s about $7 trillion of commercial real estate — the market is massive,” Sugarman said.
Nipon added that the geographic landscape of recent ground lease deals unfolds way outside the major gateway cities.
“Ten years ago, we were financing South Florida, New York, Boston, Chicago, D.C., Los Angeles, San Francisco,” he said, “These are highly sophisticated markets where ground leasing has been prevalent for quite some time, but you’re certainly now seeing it in secondary and tertiary markets.”
Update: This story originally misattributed source material. This has been corrected. We apologize for the error.
Emily Fu can be reached at email@example.com.