Question

You and two business partners are considering the purchase of the following commercial investment property:

Commercial Property:

• Estimated purchase price: $600,000 (building only)
• Type of property: Mixed-use.
• Units: 3 residential second-floor Apts. - (A) 1,500 sq. ft., (B) 1,250 sq. ft., and (C) 850 sq. ft.
• 3 retail ground floor Units, with separate entrances, 1,200 sq. ft. each.     

Lease Information:

• Residential Apartments: All residential units are rented.
• Retail Units-annual rental revenues: Each Retail Unit is under a month-to-month gross lease.

Other Information:

• The property is subject to a 50 years ground lease (all property interests reverts to the seller at the end of the ground lease). The business partners with pay the ground lease landlord an annual ground lease payment of $20,000.
• Each business partner will purchase a 1/3 interest in the investment.

Provide your business partners with the following information:

1. What type of leasehold estate is a ground lease?
2. How does the ground lease impact their property ownership?
3. Besides the obligation to pay the annual ground lease rent, are there any other expenses the business partners would have to pay that pertain to the ground lease?
4. What happens to property/investment at the end of the ground lease term?
5. The business partners did not negotiate an option to renew the ground lease. What challenges may arise if they now want to renegotiate the renewal option into the ground lease?
6. For the retail tenants, identify the commercial lease types that may be used for the three retail tenants.
7. Based on your analysis in item 6 above, provide a recommendation of a lease type that should be used for the three retail tenants that will maximize retail rental revenues.
8. One of the retail tenants will eventually need more space and may need to move to a different property within the next 12-24 months. This tenant is expected to ask for a provision in the lease that will allow the sublet or assignment of the premises. Describe the differences between a sublet and an assignment lease provision. Provide a recommendation as to which provision is most beneficial to the business partners.
9. The business partners are concerned that some tenants may not like the change in ownership and attempt to get out of their lease obligations. Describe how leases may be terminated.
10. List the remedies available to the business partners if a tenant breached the lease terms.
11. List the different ways to hold title in the investment. Provide a recommendation that will be acceptable to the business partners.

Answer 1

1. What type of leasehold estate is a ground lease?

A ground lease is an agreement in which a tenant is permitted to develop a piece of property during the lease period, after which the land and all improvements are turned over to the property owner. A ground lease indicates that improvements will be owned by the property owner unless an exception is created and stipulates that all relevant taxes incurred during the lease period will be paid by the tenant. Because a ground lease allows the landlord to assume all improvements once the lease term expires, the landlord may sell the property at a higher rate. Ground leases are also often called land leases, as landlords lease out the land only.

2. How does the ground lease impact their property ownership?

The ground lease partner owns the land while the buildings would be owned by you and ur partners. After 50 years, the ground lease partner would take back his land and all the improvements in it (the buildings too). The three partners are expected to pay a ground lease amount every year and this cash outflow should be considered carefully in investment decision making.

3. Besides the obligation to pay the annual ground lease rent, are there any other expenses the business partners would have to pay that pertain to the ground lease?

The costs associated with a ground lease depends on the terms agreed upon by the ground lessor and the lessee at the time of lease. Thus the costs that the partners should be wary of are legal and due diligence costs involved in making the lease agreement, insurance expenses, increase in ground lease rent and frequency of increase as agreed in the lease, penalty in case of rent payment delaysetc.

4. What happens to property/investment at the end of the ground lease term?

The property (building, land) belongs to the ground lessor (ground owner) at the end of the ground lease term.