Tzvi Rokeach is a partner at Kramer Levin Naftalis & Frankel LLP. Commercial Observer’s Partner Insights team spoke with him about the rising trend toward using ground leases.
Commercial Observer Partner Insights: What minimum size does a transaction need to be for a ground lease to make sense?
Tzvi Rokeach: There is no minimum size. It depends on the size of the investments by the developer relative to projected return and personal appetite for risk. It also depends on whether it’s a traditional or non-traditional ground lease. A traditional deal tends to require more upfront investment and a landowner who is looking to hold onto the land in the long run. These cases typically involve a sufficiently valuable piece of land. So, with the traditional ground lease, you might see something more sizable, but a non-traditional ground lease can be about any size. I’ve seen deals of anywhere between $5 million and $1 billion or more.
Is the increased interest in ground leases a function of low interest rates, cap rates, or stress in the lending market? Or is the ground lease market being completely reinvented?
It’s a combination of these things. We need to understand the rent, so when we get into the out years of the lease, the landlord will continue to realize value from the asset, and the tenant will still have a predictable rent expense. If the rent is unpredictable, or could potentially increase significantly, that makes the lease unfinanceable. Today’s low interest/cap rate environment enables parties to fix rent in a stable, long-term fashion. Also, because of COVID and the need to reposition assets, ground leases provide additional flexibility and financing options.
Why do lenders have an adverse reaction to ground leases around year 39?
I don’t think 39 is a magic number. Leasehold lenders are primarily concerned with limiting risk, so a very important consideration for the lender is ensuring that its borrower, the owner of leasehold, will be able to refinance the lender out of its position. It has to make sure that the rents in the out years of the lease are predictable. Also, they want to ensure there’s sufficient time remaining on the lease, so that for refinancing, it will be a worthwhile and valuable investment. So, it’s really the notion of ensuring that there’s sufficient term for that purpose.
In 10 years’ time, how prevalent will ground lease terms be for commercial real estate deals in the US?
There’s always going to be plenty of folks who want to take advantage of the ground lease structure. If somebody has land, and they’re looking for someone with investment or development capacity, then you’ve got a ground lease. But, in addition, coming out of COVID, for hotels and brick-and-mortar retailers who will be repositioning, we’re going to see a variety of ways people will look to reposition their assets. Being able to use ground lease financing will provide an additional, effective tool by which to do that.
