The land lease is a type of real estate arrangement that is common in commercial real estate and in some types of residential real estate. Essentially, with a land lease – also known as a ground lease – the tenant owns any vertical construction while a landlord holds title to the dirt underneath.
Land leases are frequently found in retail real estate, including shopping malls, and for niche uses such as communications towers. In residential real estate, land leases are common for mobile homes and manufactured housing.
What Is a Land Lease?
With a ground lease, the tenant owns the building where it operates but not the dirt under that building. The land is owned by an investor. The landlord collects regular payments from the tenant, who owns the structure atop the parcel but pays for the privilege of using the property. The ground lease tenant has the right to develop on and occupy the property during the term of a ground lease. The tenant is the owner of any improvements made to the property, including any buildings.
JCPenney, Macy’s and other department store operators often operate on ground-leased parcels, even within shopping malls. So even though the merchant owns its physical building, it pays rent to use the land beneath the store.
Types of Land Lease Agreements
Land leases fall into two main categories – subordinated and unsubordinated. This distinction becomes important should the tenant use the property as collateral for a mortgage and then face financial hardship.
- Subordinated ground lease: This type of lease offers fewer protections to the landowner. If the tenant defaults on a loan while operating under a subordinated ground lease, the lender can pursue not just the vertical building but also the underlying dirt. The landlord essentially contributes collateral to a tenant – and can demand a higher lease payment as a result.
- Unsubordinated ground lease: This flavor of land lease offers more peace of mind to the landowner. The tenant’s lender doesn’t have the right foreclose on the land in the event of default. The lender can pursue the vertical assets of the tenant’s business to satisfy the default, but the mortgage holder can’t seize control of the land under the business.
How Does a Land Lease Work?
Once you get past the novelty of a commercial real estate user or mobile home owner being both an owner and a tenant at the same address, land leases aren’t all that complicated. The lease contracts call for lessors to pay rent regularly, typically once a month. Ground leases often are net leases, so the tenant pays for the costs of property taxes, insurance and maintenance.
One distinction is in the length of the lease. While a standard lease of a physical structure might last for only a few years, ground leases often come with extended terms – land leases can last as long as 99 years. So the commercial tenants that sign land leases tend to be financially stable, and have long operating histories. As with traditional leases, land leases allow for the landlord to evict a tenant for non-payment or other breach of contract. And the agreements often include an escalation clause that allows for annual rent increases.
Example of a Land Lease
Two operators of communications towers, SBA Communications and American Tower, are examples of commercial real estate users with voracious appetites for ground leases. In its most recent annual report, American Tower told investors that the land under fully 90% of its 218,353 communications towers is subject to long-term ground leases. The leases typically include initial terms of 5 to 10 years, along with one or more renewal periods. As a result, American Tower reports that it has more than 40 percent of its sites locked up through at least 2021.
What Happens When a Land Lease Expires?
The expiration of a land lease can be a non-event. The lessor and the lessee agree to new terms and continue their contractual arrangement. From an investor’s perspective, the expiration of a lease offers the opportunity to negotiate higher lease rates. However, a landowner may choose not to renew a ground lease agreement with the existing tenant.
In more dramatic cases – especially in instances where the land lease was signed decades earlier and the operator’s underlying business has changed significantly – the end of a land lease brings big changes. Improvements made atop the site that is land-leased become the property of the landlord upon the expiration of the lease, or the tenant might be required to demolish them.
Advantages and disadvantages of a Land Lease (from the landlord’s perspective)
There are pros and cons to landowners who rent their dirt to operators.
Among the advantages:
- Reliable income. Because land-lease tenants tend to be solid businesses, they regularly pay their bills.
- Less active management. Leasing out vertical space means dealing with constant maintenance and upkeep. With a land lease, the landowner has fewer responsibilities and fewer headaches.
- Appreciation. Land is rising in value nearly everywhere. A landlord who signs a tenant to a land lease still owns the underlying property when the land lease expires in 20 or 30 years.
- An inflation hedge. Hard assets such as real estate tend to perform well during periods of rising prices.
- A potential tax advantage. Depending on the landlord’s tax situation, selling a site to a user could trigger the capital gains tax. But keeping the land and leasing it to a tenant won’t trigger a taxable event (although you’ll still owe taxes on the rent you collect).
- Potential legal pitfalls. A poorly written lease can lead the landowner to lose control of the property.
- A tax break disappears. Owners of commercial buildings can claim depreciation, favorable tax treatment that reflects the declining value and constant wear and tear on vertical structures. But land isn’t eligible for depreciation.