The Land Under A Business–The Most Valuable Asset

Anyone who owns a home that was located in a hot housing market a few years ago knows that the land can be worth more than the actual home. Now many companies are figuring out the same about their own real estate holdings. Many entrepreneurs spend their adult lives building a business up so that it can be sold at their retirement or passed down to their heirs. Now many of them are finding that the land under the business is worth far more than the business itself. Major retail firms are in this category. A lot of companies will be more attractive for their hard assets than their actual sales, particularly during a recession.
The Lessor’s Benefits
When land values soar, strategies must change. An example could be the developer of upscale homes who wants to keep the ownership of the valuable land as an investment. The use of the land lease can widen the market by reducing the purchase price of the house. In certain parts of the country, the value of the land equals the value of the house. Leasing the land can cut the purchase price nearly in half. With this type of land lease, there is usually a provision for a rent increase halfway through the lease term in accordance with the results of a reappraisal of the land.
The Lessee’s Benefits
The land lease results in the following benefits for a builder or developer:
1. She/he can acquire a valuable parcel of land with very little cash investment.
2. This leasehold that is acquired is an asset that can increase in value, and then could be used as security for a loan, or could be sold for a profit.
3. The rental payments are fully deductible by the lessee. If he/she had purchased the land instead of leasing it, only the interest portion of the payments would be deductible.
4. With a subordinated land lease, the lessee-developer gets the equivalent of a 100% loan on the land.
Land Rent and the Term of the Lease
Usually, a developer-lessee will attempt to get the longest possible term in the lease because the shorter-term land lease would have a smaller market for resale. A long-term land lease is generally a net lease under which the lessee pays the carrying costs, including real estate taxes.
When the land rental is a fixed amount, it is a percentage of the fair market value of the land when the lease is executed. This lease will often include a provision for reappraisal of the land at fixed intervals, with new adjustments in the rent. In some cases, for instance with a shopping center, the landowner might demand a share of the percentage rentals over and above the fixed land rent. (Much of the income in the shopping center will come from percentage overages from the sub-lessees.)
A Subordinated or Unsubordinated Lease
If the owner of the land will not subordinate the to a leasehold mortgage, the developer should get a reduction in rent because the unsubordination will cause his or her financing to be more expensive. Subordination could be the most important item in the terms of the lease. Even a short subordinated lease might be better than a longer unsubordinated lease, even though the longer lease is more salable.
The landowner may or may not allow the interest as owner-lessor to be subordinated to the interest of a leasehold mortgagee. When there is a subordination to the mortgage, the lender, in effect, gets a fee mortgage on the land rather than a leasehold mortgage.
When the lease is unsubordinated, the landowner-lessor has first rights over the lender in case the lessee-mortgagor should default. With these terms, the lessee could find that he/she cannot get a loan, or can get one only at a higher rate of interest. Without the subordination, the mortgage is, in effect, a second lien since the lessor’s claim on the rents takes precedence over payments on the mortgage.
The objections of an owner to subordination of the lease could be as follows:
1. He/she could lose the property if the lessee defaults on the leasehold mortgage.
2. Subordination reduces his or her possibility of mortgaging the fee interest in the land, which would be a logical move for the lessor.
If the subordination were part of the terms, the landowner would record the right to receive any notice of default from the leasehold mortgagee and the right to cure the default. The expense would be reimbursed to the owner by adding the amount to the lessee’s rent obligation.

Considerations In Ground Leasing

Landowners may choose the ground lease as a way to benefit an easy and risk-free investment vehicle and as a way to secure the long-term appreciation of the property. Sometimes a ground lease can put the lessor at risk. That is because the deal centers on the concept of sharing economic returns. The lessor becomes a partner of the lessee because the total rent is usually determined by the lessee’s net operating income or net cash flow. If the lessee does well, the lessor does too. However, if the lessee’s business is a loser, so is the lessor.
Therefore, the lessor must consider the financial feasibility of the project. Independent analysis should show that the project represents the correct improvement of the site and that the projected payments will actually be received by the lessor.
There are at least four things that a prospective land lessor should remember before entering into a transaction:
• In most land lease transactions, the economic return to the lessor ultimately reflects the underlying performance of the real estate operated by the lessee.
• The lessor’s evaluation of the deal must focus on the quantity of income projected pro forma but also must include a clear assessment of the likelihood of actual receipt of projected rent.
• Because the conditions and complexities of a land lease can mask the risk associated with achieving the projected rent levels, accurate assessments of the strengths and weaknesses of the real estate is essential.
• Land lease provisions must be tested against the current fee value of the land.