Take in the skyline of any major U.S. city and you’ll be looking at a fair number of hidden time bombs.
These are the thousands of buildings with ground leases that are getting close to the end of their term, leaving unprepared building owners vulnerable to big financial losses.
Ground leases are a proven and effective tool for owners of buildings to free up capital, get access to desirable locations, and take advantage of tax benefits.
However, buildings on ground leases come with a risk that looms larger over time. At the end of the multi-decade ground lease term, the building normally reverts to the owner of the ground, giving them the upper hand in negotiations over rent prices and the possibility for an extension of the lease.
New York, where ground leases have long been part of the fabric of real estate, provides plentiful case studies of resulting disputes and financial disasters.
The owners of the landmark Chrysler building were forced to sell it in 2019 for less than a fifth of what they paid a decade earlier because of huge rent increases imposed by the landlord going into the final 20 years of the lease. Legal battles and complex maneuverings–like those over the 625 Madison Ave. building–are common, as tenants seek to avoid 10-fold rent increases or the loss of their investment.
Ground lease tenants who own the buildings that sit atop of these ticking time bombs lose billions every year by giving the keys back to landlords. These painful outcomes are sometimes unavoidable–but there’s a lot that the building owners can do to make the most of a difficult situation and even turn it to their advantage.
Most importantly, building owners need to avoid sleepwalking into a scenario where there’s only a decade or two left on the ground lease. Whenever I see disputes over ground leases that are entering their last few years of the lease term, I shake my head and wonder how the tenants could have let things go unaddressed so long, allowing the power to shift strongly in favor of the landlord. With ground leases typically lasting 50 to 99 years, building owner tenants should be getting clear on their goals and negotiating with landlords no later than 20 or 30 years before the expiration date.
The key is to try to create a win-win scenario, where both parties would benefit from an extension to the ground lease. Most landlords are reasonable actors who will be open to discussing an extension of the arrangement that meets their cashflow goals.
A landlord that sees their land occupied by a building that is well maintained, attractive, and with low vacancy rates has a big incentive to extend the lease without demanding terms that are too onerous. So, leaseholders should ensure they’re maintaining the building well and keeping it up to date in order to attract strong sub-tenants and keep the building cash flowing. One way to be proactive about planning for building maintenance is to channel regular payments into a reserve fund dedicated to capital improvements and building renovations, thereby avoiding large one-off expenses while enabling the building owners to charge higher rents and add long-term value for the landlord. For example, it’s common these days to see outdated strip mall centers being converted into modern complexes with new elevations and beautiful facades that attract more consumer spending and better-paying subtenants.
Building owners looking to extend a ground lease will nearly always need to accept rent increases but having a building in good condition with vibrant businesses will give them valuable leverage in negotiations. Ground rent can be structured to rise in increments over years, which building owners can more easily recover by slowly increasing the rent they charge sub-tenants. A second option is to offer the landlord an initial large bump in rent of around 20% as a lease-extension incentive followed by smaller annual increases to smooth out the impact over time.
When ground lease extensions are agreed to, the building owners must ensure they are at least several decades long. It’s also crucial not to fall into a lease that includes “fair-market” rent increases–a common feature of old-style ground leases that has led to extortionate rent demands by landlords.
Sometimes landlords just don’t want to extend their ground lease, perhaps because they want to redevelop the property themselves or they are planning to execute a change in use for the land. In this case, building owner tenants usually have the possibility of negotiating to buy the land or putting themselves forward to the landlord as a partner for the redevelopment project. This may not always be the most ideal outcome for the building owner who was wanting to simply extend their ground lease–but at least it avoids the nightmare scenario of walking away empty-handed.
The worst-case scenario for a building owner with an expiring ground lease is to find themselves dealing with a landlord who is uncooperative and determined to use their negotiating leverage to extract the maximum short-term gain. Some landlords buy expiring ground leases with the express intention of gouging tenants with big rent hikes soon after they acquire ownership of the land.
Even then, tenants have options to fight for their interests. If everything else fails, one option is to become a deliberately bad tenant by neglecting to perform maintenance and updates. This can bring landlords into conflict with city authorities over code violations, even raising the threat of eminent domain property seizures. The prospect of this type of headache can make even the most profit-hungry landlord rethink their strategy and engage with a tenant for a mutually beneficial agreement.
There’s no getting away from the fact that ground leases have the potential to land building owner tenants in an awkward predicament. But early planning and communication can go a long way toward defusing the time bomb–and even turning it into an opportunity.
Jim Small is the CEO of SANTÉ Real Estate Investments.
The opinions expressed in Fortune.com commentary pieces are solely the views of their authors and do not necessarily reflect the opinions and beliefs of Fortune.
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