Ground leases can be effective tools for property owners, tenants
As national chains increasingly focus on Michigan as a destination, ground leasing is gaining in popularity — but landowners and tenants both need to be cautious before entering into a deal.
The idea is relatively straightforward: A commercial ground lease allows a company to develop a parcel of property and operate its business for a lengthy period of time without having to buy the land outright. Unlike traditional commercial leases, a ground lease typically runs at least 10 years — and often upwards of 30 years — and is used as a financing instrument.
Ground leases can be great options for national retail and restaurant chains that want to lock in prime locations without investing in real estate. Family Dollar, O’Reilly Auto Parts, Tim Hortons, Olga’s Kitchen and Biggby Coffee have all made public commitments to grow their presence in the state, which means they and/or their franchisees may be looking for ground leases that will reduce their upfront development costs.
Landowners — often families who have been sitting on unimproved property for some time — stand to benefit from ground leases, too. They are able to secure a revenue stream from the lease while still retaining ownership of their property.
Sound ideal for both sides? Ground leases can be, but both sides need to do their due diligence to ensure they have the appropriate safeguards in place.
A ground lease transaction typically starts when a national chain approaches a landowner with a proposal. A letter of intent outlines the basic economic terms of the deal, such as the length of the lease, options to extend or purchase and lease price.
One of the primary considerations in any ground lease is which party will develop the land and build the building, the property owner or the franchisor/tenant? If the latter, it’s likely that the tenant will ask for concessions on rent or for the property owner to pay a portion of the construction costs. Such concessions may not be necessary and will depend on the rental terms and market rates of the development site.
The franchisor often holds the ground lease until the building is completed, then assigns it to one of its approved franchisees. The assignment provisions in the ground lease bear close scrutiny since a deal that goes sideways could leave the property owner on the hook for unpaid rent and other payments.
When establishing a ground lease, special consideration should be given to the following issues:
Most ground leases run for an initial term of 10 years and grant the tenant options to renew for three- to five-year terms that may result in a term of 30 years. It’s common for franchisees to want to limit the term so they will be able to get out of the lease early if things don’t go their way. But if you are the landlord, it’s advisable to seek a longer term upfront.
It’s important to know the going rate for ground leases in your community so that you’re not selling yourself too short — or paying too much. As the commercial real estate market improves, lease rates are rising accordingly.
Ground leases often contain contingencies for zoning approval, which can quickly turn into a nightmare for the landowner. If the franchisor doesn’t get approval for the project, can it terminate the ground lease? What if the franchisor decides the project is too costly after doing the site plan — can it back out? The wrong answer could tie up the property for months or even a year without delivering a deal in the end.
Franchisors will often ask for a collateral assignment document that will allow it to come in and assume the lease if the franchisee defaults. Some of these assignments can contain unfair or burdensome provisions, such as refusing to honor a default of the payments and making the property owner whole again. If the franchisor has to step back in, the property owner needs to have safeguards in place to make sure things are fair.
As mentioned above, a key issue is who is responsible for development of the land and construction of the building. Typically, the tenant is on the hook for these costs, although it might ask the property owner to assist with infrastructure — such as water, sewer and roads — if the land is vacant. It’s important to have a clear understanding of the basic land improvements required before the project can move forward.
David C.C. Eberhard is a partner at Warner Norcross & Judd LLP. He concentrates his practice in real estate, construction and corporate law. He can be reached at email@example.com.