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Ground Leases: A Commercial Real Estate Financing Alternative
As the commercial real estate market continues to weather higher financing thresholds and rapidly evolving retail modalities, developers and investors are increasingly turning to alternative financing structures to move projects forward. In recent years, ground leases have gained popularity as an alternative for developers, offering more flexibility and leaner launch costs than traditional fee ownership of vacant land, pad sites, storefronts, or other standalone structures.
Barriers to Financing
The past two years have yielded the highest rates of commercial real estate loan delinquencies since 2015, with 1.6% of total outstanding commercial real estate debt in default as of Q4 of 2024, compared to a rate of just 0.6% in 2023. This sharp increase in delinquencies can be attributed to a confluence of economic pressures, including persistently high interest rates, bloated construction costs, lower demand for brick-and-mortar shops and office space, and ongoing labor shortages across the industry.
Many traditional lenders have responded to this rise in defaults by implementing more stringent loan requirements, making financing increasingly difficult to secure. This can result in less predictable investment calculations, causing otherwise promising development deals to stall before breaking ground.
The Ground Lease Structure
Under a ground lease, a developer can lease unimproved land from a landowner, rather than purchasing the property outright. Typically, the developer will then construct its improvements on the land at its own expense, and assume responsibility for most, if not all, of the obligations associated with property ownership, including alterations, ongoing maintenance, repairs, and the payment of utilities and property taxes. When the ground lease term concludes, ownership of the developer’s improvements most often reverts to the landowner.
Why would a developer want to improve land it does not own, take on the responsibilities and costs of an owner, and in the end, be left without any interest in the land or buildings? This article will provide a basic overview of how a ground lease structure can free up capital, improve site selection, and, when properly negotiated, give developers added flexibility and predictability.
Overcoming Early Deal Killers
Upfront Capital
By trading a lump sum purchase price for monthly installments of rent, ground leases allow developers to minimize the substantial upfront capital outlay required to purchase land so that they can allocate existing resources toward construction and development costs and reduce new debt. With respect to free-standing retail projects in particular, a ground lease enables retailers to expand into new markets and devote funds to the construction of multiple stores or buildings without also simultaneously committing capital to the purchase of multiple parcels. By reducing initial investment, otherwise infeasible projects may become viable.
Reluctance to Sell
Some landowners are increasingly unwilling to part with land in up-and-coming and growth-limited locales. This could be because owners who have seen real estate prices skyrocket in their lifetimes are more likely to consider land a long-term investment that will continue to exponentially appreciate. Ground leases offer developers, and retailers in particular, a way to strategically establish themselves in the most desirable locations without having to convince reluctant owners to sell their prime real estate.
The potential for expansion to highly visible locations has made the ground lease model popular not only with retailers, but increasingly attractive to regional banks, financial institutions, and even multifamily developers. In order for a deal to be worthwhile for a developer, however, the ground lease must be drafted with certain tenant protections.
Tenant-Favorable Terms
Long Lease Terms; Broad Rights of Use and Assignment
The long lease terms featured in ground leases (typically ranging from 20 to 99 years), when coupled with broad tenant rights of use and assignment, provide ground lessees with another significant advantage: flexibility.
If the location is profitable, a tenant may operate in its thriving location for decades and establish a long-standing presence in the community. However, if the site proves to be a miscalculation for the business or consumer demands shift over the lifespan of the lease term, broad rights to use the land for another purpose, and/or to assign or sublet the premises to a third-party user, allows the tenant to pivot if necessary and sublease the space to an operator willing to assume tenant’s obligations under the ground lease.
Also, ceding all improvements to the landlord at the end of a long lease term relieves the ground lessee of the responsibility to demolish or restore a building that is likely decades old by the time the ground lease expires.
Lower Rental Rates and Fixed Escalations
Where a developer leases unimproved land from the landowner, rental rates typically reflect the value of the undeveloped property. This can result in a deal with lower rates subject to fixed rent escalations that occur infrequently throughout the lease term and any extensions. This contrasts with rental calculations in standard commercial leases for improved properties, which often include annual or biennial rent increases and higher initial and renewal base rates tied to market value. For instance, a ground lease might include 10% increases every five years across a 60-year term, whereas a shopping center lease might escalate annually at 3% compounding for three years and then be subject to a floor-capped fair market rent adjustment in order to renew. The former provides developers with long-term cost certainty similar to a fixed-rate mortgage.
Rights of First Refusal
While the above provisions are intended to engineer long-term solutions for tenants, we recommend that developers negotiate for a right of first refusal or purchase option in their ground leases. The idea here is for tenants to have priority in purchasing the land should the landowner decide to sell during the lease term. These rights can put tenants in a better position to secure a profitable location before the lease expires or even prevent competitors from acquiring the underlying land.
Tenant’s Ability to Finance
A critical issue in any commercial ground lease is the tenant’s right to encumber the leasehold, and a ground lessee’s financing will often be conditioned on the landowner’s grant of certain rights to tenant’s lender under the lease, including in the event of a tenant default. This issue is too complex to address in this alert, but the tenant will want to make sure it has the flexibility it needs (as required by its lender and otherwise) to obtain both construction and permanent financing.
Looking Forward
By reducing initial capital requirements, providing cost predictability, and offering long-term flexibility, ground leases can enable development activity that might otherwise be sidelined. However, because parties can be bound by these agreements for up to a century, the ground lease represents one of the most complex deal structures in commercial real estate. Comprehensive legal guidance throughout the process – from identifying opportunities and securing entitlements to establishing financing structures and negotiating construction contracts – is necessary to ensure ground leases protect all parties’ interests over their extended durations.
If you would like to learn more about ground leases or determine if a ground lease structure is right for your next project, please contact a commercial real estate attorney at Otten Johnson for guidance. We have negotiated hundreds of ground leases, and we can help ensure your interests are well protected before you enter into a long-term agreement.
