Ground Leases: Dangerous Territory Apr 27, 2016

Over the past 12+ months, IRR’s DC office has been involved with the valuation and analysis of more than 50 ground leased properties.

It is our view that, at present, these assets appear to be widely misunderstood, not to mention incorrectly analyzed. It must be clearly understood that a ground lease creates two separate and distinct assets and each require independent analysis: The ground owner position (leased fee) and tenant position (leasehold). Why? Investors in either position may have very different goals and/or requirements, not to mention price points.

Overview

In the overview, The Appraisal Institute generally recognizes two recommended methodologies in estimating the value of the leased fee:

A) Capitalization of the “income stream to the ground position (leased fee) or the tenant (leaseholder) owner” at a market derived leased fee or leasehold cap rate;

B) A subtraction of the leased fee position (as a standalone asset) from the entirety to derive a leasehold valuation. A corollary to item B is that “the sum of the parts” cannot exceed the value of the whole. More on this follows.

Recent analyses conducted by our office indicate that some of these basic concepts are being incorrectly considered in some transactions.

Major Issues

The major issues in this regard are:

1. Basic business terms are very poorly defined in the lease document. Primarily attached to dated ground leases, these items do not provide for adequate inflation protection, or do NOT provide the land owner with any material upside potential.
2. Ground rent re-set provisions are either vague or impossible to decipher in terms of how to derive future ground rent changes during the full term. Here, the issues are not specifying how the re-set point is to be valued (“As improved” at the re-set point? Under highest and best-use at the re-set point?), or not specifying how rates (i.e., required returns to be applied to the underlying land value) are to be defined and/or estimated.
3. Underwriting is also an issue. Some investors simply cap the present ground rent to estimate a current leased fee value. Others simply apply plug land value or land ratio analysis to estimate land (leased fee) value. In other cases, analysts do not consider future ground rent spikes that are significantly different from current ground rent, for example at stabilization. This omission of future ground rent increases significantly overvalues the leasehold position and jeopardizes lender asset security.
4. Valuation issues are also at play here. Several reports reviewed indicate appraisers are applying leased fee cap rates to leaseholds, and vice versa. A recent case also illustrated that appraisers are splitting the property taxes to each position, i.e., the land owner is assumed to pay the property taxes apportioned to the land, despite specific lease terms where the tenant is required to pay 100 percent of all property taxes (under the normal NNN lease provisions). Lenders in several of these cases have not corrected these glaring errors, to their regret…or peril. Alternatively, appraisers do not step back and test for the “sum of the parts” requirement.

All of these various scenarios reflect actual cases reviewed.

Solutions

IRR would recommend the following as to correct analysis of these ground leases:

1. All ground leases should be run-out to their full 99-year term, and all re-sets are to be fully considered, including “as is” provisions and “H&BU.” This is necessary so as to not understate the future ground rent. Tenants who do not do this run the risk of losing their entire investment. A corollary is that by doing this, all aspects of the deal are visible, including rent stream, timing, re-sets, etc. It requires some level of spread analysis, versus a simple cap rate estimate that may be abstracted from a radically different ground rent comparison. Wise investors do this, if for no other reason than to see potential risks such as lease duration; CPI changes; understanding land value at a distant future point; and fixed point pricing requirements; among others.
2. In terms of the “sum of the parts” quandary, current market conditions are such that buyers of either assets of land or the improvements are aggressively pursuing almost any deal out there, especially if it appears to be at an above-market yield. Said differently, in several cases reviewed, if the independent value of either position were viewed, it would be apparent that the total exceeds the value of the unified property, assuming there is no ground lease. This is financial engineering that may be mathematically correct, and may be supported by present market conditions from a valuation viewpoint. But such market conditions are also likely to be temporary, and are driven primarily by capital market conditions, not by ordinary valuation procedures. At the same time, the reverse is then also must be true–the “sum of the parts” may be less than the value of the property as a whole. Market participants rarely accept this lower value premise from a valuation viewpoint. Appraisers are required to reflect, not underwrite, what market activity indicates, e.g. a premium to the par value, if it is evident in the current market. This creates scenarios where unsupported projections must be applied in some cases.
3. Future ground lease documents must be written so that all terms are clear and that they are “bankable.” Creation of ground lease documents that are so draconian as to prevent construction financing for future improvements is counter-productive.

Conclusion

IRR is of the view that ground leases are returning in popularity as a financing vehicle. If true, this means that market players must very clearly understand their interests, as any misunderstanding of the business and legal terms renders any potential land lease a land mine.