A ground lease is the appropriate type of lease for the parties interested in transacting on land. Also known as a land lease, a ground lease is an agreement between a landowner and a tenant for land which has not been improved. The piece of land being leased can either have a rudimentary infrastructure in place or could even be bare. This lease is a long-term arrangement typically lasting between 50 to 99 years.
Once the terms are agreed upon, the tenant makes improvements to the land by undertaking construction on the property. The tenant is also responsible for paying expenses for insurance, taxes, and repair and maintenance. The ground lease outlines the ownership of the land and the construction and improvements made on it.
There can be two types of ground lease: subordinated and unsubordinated.
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Subordinated Ground Lease
In a subordinated ground lease, the landowner gets a lower priority on claims on the land in question by agreeing to such terms.
While the fact that the owner itself would agree to take on a lower priority on the land that he owns may seem counterintuitive, the owner benefits from the improvement of his property. Further, giving up the first claim on the land also allows him to negotiate favorable terms, including a higher rent.
Unsubordinated Ground Lease
In an unsubordinated ground lease, the landowner retains top priority on the property in case the tenant defaults on loans taken for undertaking improvements on the land. This means that lenders to the tenant cannot take ownership of the land in the case of a default by the tenant. This top priority usually means that the landowner charges lower rent to the tenant. And even though it makes his position safer than it would be in a subordinated lease, lender become hesitant to extend loans to the tenant as they cannot claim the property in case of a default.
Advantages and Disadvantages of a Ground Lease
Pros to the Tenant
For a tenant, a ground lease is a useful method to gain access to prime locations which would otherwise be very expensive to purchase outright. A ground lease also helps a tenant to focus on taking out loans to make improvements on the land and begin doing business instead of being bogged down by the cost of land acquisition.
There is a tax implication as well. The tenant can claim the deduction on rent payments under a ground lease from federal and state governments.
Pros to the Landowner
For a landowner, a ground lease provides a means to retain the ownership of a land and a steady stream of revenue in the form of lease payments, which would not be the case in an outright sale. Further, he does not have to worry about the hassle of making improvements on the land, which a tenant does. Given the terms of the lease, all improvements made on the land can become the property of the landowner, thus providing another benefit. The terms of the agreement may also help the landowner have some control over the kind of construction made on the land and its stated use.
Cons to the Tenant
Given the terms of an agreement, a tenant may find the intended development and use of the land in question restrictive, which would not be the case if an outright purchase was undertaken.
Also, the cost of leasing land, taking into account escalation clauses which outline rent increases over the term of the agreement, may turn out to be higher for the tenant in the long-term, as compared to an outright purchase. This, however, depends on the viability and success of the project or business undertaken on the property.
Cons to the Landowner
Given a landowner’s tax situation, a ground lease may be disadvantageous as the rent received is taxed at ordinary rates instead of capital gain rates. Further, some leases prohibit or severely restrict a landowner’s ability to borrow against the equity ownership of the land for the terms of the lease.
He also needs to be very careful about the terms of the lease agreement, failing which he may lose control over the improvements on his land and their end use.1–3