Ground Leases in Commercial RE

The mechanics, advantages, and risks of a commercial property ground lease

The commercial ground lease, sometimes called a land lease, has been a common real estate development strategy for decades. Unlike traditional lease agreements where the tenant leases both the land and the improvements or buildings on the land, a ground lease involves the leasing of land only, which can be improved or developed by the tenant. This type of investment can be helpful to any number of investors, developers, and businesses, and is not restricted to any specific asset class.

What is a Ground Lease?

A ground lease is a contractual arrangement where the landowner (often referred to as the “ground lessor”) leases land to a tenant (the “ground lessee”) for a specified period. The ground lessee is given the right to develop the land during the lease term, whereas a typical commercial lease requires specific approval from the landlord/lessor to modify or improve the leased property.

Key Features of a Ground Lease

There are two key features to a ground lease:

First, the lease term, or the duration of the contractual arrangement, is often much longer than the typical residential or commercial lease – with terms commonly ranging anywhere from 30 to 99 years. This allows the tenant to be certain that they will be able to benefit from the use of any buildings or improvements that the tenant constructs on the leased ground, without needing to rely on the landlord to extend the lease term.

Second, any improvements that the tenant makes to the leased ground will become the property of the landlord when the lease expires. This allows the landlord to be confident that their land will grow in value throughout the long lease term without the landlord having to expend the funds to build buildings or other structures on their property.

Ground leases come in various forms and are highly customizable, each tailored to suit the specific needs and objectives of the parties involved. Additionally, ground leases may incorporate provisions for rent escalation, renewal options, and restrictions on land use, among other stipulations.

Challenges for Lessors and Lessees

While ground leases offer compelling benefits, they also present certain challenges and considerations that all parties should carefully assess.

1. Ownership Structure: One of the primary considerations in ground lease agreements is the ownership structure of improvements erected on the leased land. Unlike traditional commercial lease arrangements where the landlord typically retains ownership of improvements, ground leases may involve various ownership scenarios, including fee simple ownership by the tenant or a leasehold interest held by the landlord. Property owners (landlords/lessors) should strongly consider owning the commercial property in the name of a limited liability company (LLC) or land trust.
2. Rent Determination: Establishing an appropriate rent structure in ground lease agreements can be complex, particularly given the long-term nature of these arrangements. Factors such as market conditions, lease term, and the value of the underlying land must be carefully evaluated to ensure a fair and equitable rent. As with all leases, rent in a ground lease will often increase throughout the lease term at predetermined intervals.
3. Maintenance and Obligations: Ground lease agreements should include clearly defined maintenance responsibilities of the landlord and tenant. Clear provisions regarding maintenance obligations, repairs, insurance requirements, and compliance with zoning regulations are essential to avoid disputes and ensure the proper upkeep of the leased property.
4. Risk Allocation: Ground leases involve the allocation of various risks between the landlord and tenant, including risks related to property damage, liability, environmental hazards, and changes in land use regulations. Effective risk allocation mechanisms, such as indemnification provisions and insurance requirements, are crucial to protect the interests of both parties.
5. Exit Strategies: Planning for the termination or transfer of a ground lease is essential to avoid potential complications and disputes down the road. Ground lease agreements may include provisions addressing lease termination, assignment and subleasing rights, options to purchase the fee interest in the land, and procedures for dispute resolution.

Key Provisions to Include in Your Ground Lease

1. Title and Ownership Rights: Good and marketable title to the leased land is very important to the validity and enforceability of a ground lease. Landowners must possess the legal authority to lease the land, free from any encumbrances or title defects that could impede the tenant’s use and enjoyment of the property.
2. Zoning and Land Use Restrictions: Ground lease agreements should address compliance with local zoning ordinances, land use regulations, and other legal restrictions governing the use and development of the leased property.
3. Environmental Considerations: Environmental due diligence is essential in ground lease transactions to identify potential contamination risks, hazardous materials, and other environmental liabilities associated with the leased property. Ground lease agreements should include provisions addressing environmental indemnification, liability allocation, and compliance with environmental laws and regulations. Environmental surveys and various professionals may be necessary.
4. Default and Remedies: Ground lease agreements should delineate the rights and remedies available to parties in the event of a default, including non-payment of rent, breach of lease covenants, insolvency, and multiple other scenarios. Provisions regarding notice requirements, cure periods, and remedies such as lease termination, eviction, or specific performance should be carefully drafted to protect the interests of both parties. These are commercial lease agreements, even if their structure is unique.
5. Tax Allocation: Ground lease transactions may have significant tax implications for both parties, including issues related to income taxation, property taxation, and capital gains treatment. Tax considerations should be thoroughly evaluated and addressed to optimize tax efficiency and minimize potential liabilities.

Commercial Ground Lease Template

The Oklahoma Real Estate Commission (OREC) publishes standard real estate transaction forms, but does not have a standard ground lease template. Accordingly, ground lease landlords and tenants should work with real estate attorneys that practice commercial real estate law, such as the attorneys at Avenue Legal Group.

Commercial Property Attorneys

Ground leases are a versatile and valuable tool in the toolkit of commercial real estate professionals, offering a flexible framework for land development and asset management. Parties considering or entering a ground lease arrangement should engage experienced commercial real estate legal counsel.