Determining ground-lease rental rates.
As a result, an appraiser often has to incorporate both historical and proxy formation to form an opinion as to an appropriate land-lease rate. It helps to know what land-lease rates have been in the past and how these rates were influenced by economic trends, such as an expansionary economy versus a recessionary economy or inflationary prices versus more stable price movements. Finally, the terms of a ground lease and the relative risks to a lessee or a lessor definitely influence the appropriate ground-lease rental rate.
Much of the discussion in this article centers around northern California. Examples of ground leases are found downtown San Francisco, where periodically sites have been leased for high-rise office building construction; metropolitan San Jose, widely referred to as Silicon Valley, where ground leases are sometimes used to facilitate research and development (R&D) building construction for the electronics industry; and high-volume commercial arterials throughout the Bay area, where smaller prime parcels are sometimes ground leased for retail outlets. Nonetheless, the factors outlined in this article should be considered anywhere in the country in establishing appropriate ground-lease rates. Obviously, specific items such as market demand and location are unique to an individual property and should be assessed accordingly by an appraiser.
LAND LEASES--HISTORICAL BACKGROUND
Land leases, also commonly referred to as ground leases, serve as a mechanism for a property owner to retain long-term ownership of a particular parcel while at the same time allowing a user to control the property for a length of time sufficient to make him or her willing to invest in site and building improvements. A basic land-lease transaction involves an owner, referred to as the lessor, who agrees to give up control of the property for an extended period, referred to as the term of the land lease. The control of the property passes to the lessee, who in return agrees to pay the lessor a periodic rental rate for the right to use the property. At the end of the land-lease term, the control of the property returns to the lessor. This process is referred to as reversion. Most often the reversion includes all building improvements put on the property by the lessee. In other words, building improvements paid for by the lessee ultimately become the property of the lessor at the conclusion of the land lease.
The motivation for the lessor to enter into a land lease is to retain ownership of the property while at the same time generating income. The motivations of the lessee are somewhat more complex in light of the fact that a ground lease is almost always more complicated than a straight fee purchase. The motivations of a lessee include:
* To obtain long-term control and use of property that would not otherwise be available (i.e., property not available for sale)
* To avoid the upfront capital cost of purchasing property
Land-lease transactions are relatively infrequent compared to outright fee purchase and ownership. Ground leases are relatively more frequent where property is limited, and for this reason landlords have relatively greater control in the negotiating process. In fact, the majority of land leases occur in four areas.
Far more than any other location in the United States, the state of Hawaii experiences widespread use of land leases. The state is geographically limited relative to supply and experiences strong demand. This situation is further compounded by the fact that historically much of Hawaii was owned by five families and used for agricultural purposes. As Hawaii developed, these families and later their estates used land leases as mechanisms to retain long-term ownership of property while generating income. More recently there has been pressure from the state of Hawaii to extend the rights of lessees beyond the original terms of the leases, and also to convert land leases to fee ownership in favor of the tenants. This government regulation of the real estate market in Hawaii is the direct result of the fact that many of the land leases are for individual residential properties. Similar government regulations in California would be highly unlikely because most ground leases are for commercial purposes.
Densely urbanized downtown areas
In the continental United States, the relatively infrequent land leases that do exist are found most often in downtown commercial areas such as Manhattan and San Francisco. Land-lease activity surges when office market conditions are strong and is virtually absent when demand is weak. In San Francisco from approximately 1979 to 1984, a time that corresponds with the strongest office demand in history in that city, a number of land leases were transacted. Property owners had strong leverage in the negotiation process as a result of the demand, and developers were willing to enter into the land leases because of the perceived profits to be earned based on the strength of the market. Many of these land leases turned out to be disastrous for lessees as rental rates for office space dropped during the second half of the 1980s, but the ground-lease rates continued to rise because of the contract terms negotiated between lessors and lessees. This experience has made the market cautious and few, if any, ground leases for major building construction have occurred in downtown San Francisco in the past five years.
Strip commercial sites
Prime commercial corners on arterials with a high volume of traffic represent a variation from the downtown ground leases. The substantive difference is that market conditions typically do not vary as dramatically and, even more important, the cost of the improvements relative to the land value is significantly less than a major downtown high-rise building. Commercial arterial ground leases are relatively common in comparison with other types of ground leases but are still rare relative to outright purchases. The fact that the building improvements are often of one-story, light-weight construction, such as for a gas station or a fast-food restaurant, mitigates the risk to a lessee relative to the potential profit. This is because the ground that is the subject of the lease represents a much larger portion of the total fee value of the property after building construction, so the lessee gets a proportionately larger benefit from the ground lease. This can be illustrated with a simple example. At the height of the downtown San Francisco office market boom in the 1980s, prime office land had a value of $50 to $75 per square foot of potential building area. A new class A office building was usually felt to have a value in the range of $300 per square foot. The land represented only 20% to 25% of the total likely value of the project. Nonetheless, all of the impediments and risks of having a land lease remain the same. For a gas station at a prime corner of a high-volume commercial arterial, the land value in the inner urban Bay area could easily be $25 per square foot of land area. For a one-acre site, this is approximately $1,000,000, which is far more than the improvements would cost. Similar economic rationales would apply to a fast-food restaurant. Relative to the difficulties and risks involved with a land lease, a lessee therefore has considerably less invested in the improvements. At the same time, a landlord's security position is enhanced based on a greater cost of improvements on the ground-leased site because any default under the lease will result in the improvements reverting to the lessor's ownership. These points are important considerations in establishing a ground-lease rate.
Silicon Valley boom in the 1980s
During the period from approximately 1981 to 1984, Silicon Valley (metropolitan San Jose, California) experienced a strong surge in demand for R&D-type industrial space. The circumstances that led to greater land-lease activity were similar those in downtown San Francisco during the same period. Silicon Valley was a fined geographic area with what at that time was perceived to be a limited amount of industrial land, experiencing strong demand that caused developers to make extraordinary profits. As a result, several developers ground leased parcels and subsequently developed them with R&D or large commercial facilities. Most often the lessor was an institution that desired to retain ownership of the property over the long term while generating income. Examples include the City of Santa Clara and Santa Clara University. At least two ground leases between private parties, however, resulted in industrial building construction. After the R&D boom ended in Silicon Valley in 1985, ground-lease activity for large-scale development came to a virtual halt. It should be noted that Silicon Valley does have a history of ground-lease activity starting from the 1950s, when Stanford University began ground leasing parcels in what is now Stanford Industrial Park.
GROUND-LEASE RATE INFLUENCES
In the previous decade, ground-lease rates in the San Francisco Bay area have typically ranged from 8% to 11%. There are a large number of variables that influence the ground-lease rate, which can be segmented into market and contract items.
Market influences on a land-lease rate are fundamentally supply and demand issues. Again, the reason there are many land leases in Hawaii is because of the limited supply and strong demand. While virtually all landlords might like to enter into ground leases with the idea of retaining ownership and at the same time generating income from their property, few prospective users of a property willingly enter into land leases because of a multitude of problems land leases create, including:
* The required negotiating and drafting of a ground lease make a transaction more expensive than a purchase. These costs should not be underestimated, as a complex ground lease on a major downtown property can cost $1,000,000 in legal fees.
* Leasehold financing is more difficult to obtain than fee financing. Even during the 1980s when financing was readily available, lenders usually required more documentation and greater security for leasehold financing. In the 1990s, when real estate financing is difficult, leasehold financing for new projects is virtually unavailable. To the extent that such financing could be obtained, it would carry a higher interest rate than more conventional fee financing.
* A greater risk is involved. With fee ownership there is ultimately some floor on the value of the property that gives the lender and equity owner security. With a leasehold interest, this floor does not necessarily exist. In Silicon Valley in the 1980s, one of the most disastrous ground leases was entered into by a developer and Southern Pacific Transportation Company for a site in northern San Jose. A local savings and loan institution then provided the developer with a construction loan, which he used to build several R&D buildings. The ground-lease rent increased annually based on a Consumer Price index (CPI) formula. At the same time, the overbuilding that occurred in 1985 depressed R&D building rents. The lender ultimately received the property back in foreclosure and determined that, because of the onerous terms of the ground lease, there was no leasehold value in spite of the millions of dollars spent on building construction. Ownership reverted to the lessor, who received a windfall in the form of the building improvements. These risks are now widely understood by both lenders and developers in Silicon Valley.
The predominant market influence on a land-lease rate is demand. At the current time, overall demand for R&D space in Silicon Valley is fairly weak. There has actually been negative absorption of industrial space in the central Silicon Valley over the past two years. These factors suggest that the weak market conditions that currently exist would influence the land-lease rate downward relative to historical levels.
Contract influences on the land-lease rate are the terms agreed to by the lessor and the lessee. These terms have become increasingly complex in the past 15 years in response to inflation. During the period from 1950 to 1970 when inflation was low, ground leases in which the contract terms relative to rent were based only on the value of the property multiplied by the land-lease rate, which would remain unchanged for the entire term of the lease, were not unusual. As inflation increased during the 1970s and early 1980s, lessors found they were disadvantaged, as the contract rental rate was far from the market rental rate. In response, ground leases evolved to include provisions that would allow the rent to keep pace with inflation or adjust to market. Other contract terms that influence the ground-lease rate include the issue of subordination, the potential sharing of profits, and the length of the term, including options.
There are two basic clauses used in ground leases by a lessor in an attempt to keep the rent current with market. The first and most common is a CPI clause. There are many variations on a CPI adjustment. The adjustment can be made annually or, more often in the current environment, can be made periodically; for example, every five years. The adjustment can be cumulative or simple interest. The adjustment can have a cap and a floor or be unlimited. The adjustment may also be only a portion of the CPI change, such as 50% or 75%.
The basic purpose of a reappraisal clause is to bring the ground rent back to market. A reappraisal can be done as often as the parties wish, but usually, because of the expense, it is done at a maximum of once every 10 years, and sometimes only once every 20 years. Variations on this clause include reappraising the land value but leaving the land-lease rate fixed; reappraising the land value and the land-lease rate to market; reappraising one or the other but not allowing the rent to be less than the most recent amount paid; and having the reappraisal clause only at the option of the lessor or the lessee.
The issue of a subordination clause has the potential to significantly influence the land-lease rate. A subordination clause means the lessor subordinates his or her interest to that of a lender. The existence of a subordination clause makes it considerably easier for a lessee to finance a project on the ground-leased parcel. This is because in the event of a default a lender's interest takes priority over that of the landowner, so the lender will view the property as substantially less risky than an unsubordinated ground lease. Given that increased yield is based on increased risk, an unsubordinated ground lease (with lower risk to the landlord) would carry a lower land-lease rate than a subordinated ground lease, all other factors being equal.
The term of a lease is also an important influence on the land-lease rate. The longer the term of a lease the more favorable it is for the lessee, in that there is a longer period of time to pay back the investment in the improvements. It is generally accepted that the longest possible term for a land lease, including options, is 99 years, although the exact legal basis for this is uncertain. Ground leases of less than 50 years are increasingly difficult to finance because there is not sufficient time to amortize building investment with a margin for changing market conditions. It stands to reason that because a longer land-lease term favors the lessee, a 99-year lease might carry a marginally higher rate than a 50-year land lease.
HISTORICAL LAND-LEASE RATES
During the relatively low-inflation 1950s and 1960s, land-lease rates (i.e., the percentage applied to the land value to establish rent) were typically in the range of 5%. These include old land leases, particularly those dome by the California State Transportation Department and other government agencies such as the Port of San Francisco, which had a large number of land leases that were renegotiated periodically.
Beginning in the late 1970s and extending into the 1980s, there was a relative upsurge in land-lease rates. This was in response to inflation as well as the greater demand for prime development sites as real estate development in general accelerated. Land-lease data throughout the 1980s tended to indicate rates in the range of 8% to 12%, with the most predominant range being 9% to 10%. The greatest influence on the rate was how often the land-lease rental adjusted to market, based on either a CPI or a reappraisal clause.
Leases with relatively longer periods of time between adjustments tended to be at the higher end of the range white leases that adjusted more frequently tended to be at the lower end of the range. In addition, the land-lease rate was influenced downward if the developer/lessee was willing to provide the owner/lessor with a participation in future potential profits. Usually, the participation was a relatively small percentage of the total projected profits. This could be a significant boost to the perceived overall yield to the lessor position, however, because the land represents a small amount of the total project costs. At the height of market activity around 1983, land-lease rates for major downtown office buildings might have been discussed at even as high as the 12% range, but this would have been the exception not the rule. It should be noted that because major high-rise office building construction takes a lengthy amount of time for both approval and actual completion, most of the ground leases had a period of one or several years at the start when only nominal rent was paid, with the provision that full ground rent would begin in the third or fourth year when the actual project was completed. This provision obviously influenced the total yield to the lessor below that of the stated land-lease rate, particularly in the early years of the lease.
Land-lease rates can also be identified for prime commercial sites along major arterials during the 1980s. As discussed previously, these were primarily for gas stations, fast-food restaurants, or other commercial operations that benefited from high traffic volume. In a number of appraisals done by the author's firm during the 1980s, land-lease rates for small commercial parcels most often fell in the range of 9% to 10%. The same factors pertinent to downtown high-rise commercial sites influence the land-lease rates for these commercial arterial parcels. Location is certainly a major influence on a rate, as is the issue of how much protection from inflation the land lease provides the landlord. This can erode the actual yield relative to the market value of the land. The creditworthiness of a tenant is a strong influence on a land-lease rate, with stronger credit warranting a lower rate. An appraisal completed by the author in the late 1980s for a fast-food restaurant on a corner parcel on El Camino Real in San Marco (a prime location in an upscale suburban community) leased by a highly creditworthy tenant concluded with a land-lease rate of 9.5%. The lease had a mechanism to allow the rate to adjust to market every five years.
In determining an appropriate land-lease rate for any particular property, site-specific considerations need to be weighed. Within the broader range of ground rental rates, it is the site-specific factors that should influence an appraiser's opinion of a land-lease rate for a particular property. Some factors that influence the land-lease rate are discussed in the following sections.
As a general principle, increasing size has an inverse effect on unit price and this extends to the land-rental rate. Typically, ground-leased parcels on high-traffic arterials are small, in a range of 0.5 to 1.0 acre, and demonstrate ground-lease rental rates at the high end of the range. Similarly, downtown high-rise commercial sites are generally less than two acres, although they are often dramatically higher in total value because of high downtown land prices. It is thus not only the physical size of a property but also the total value involved that must be considered by an appraiser concerned with the size criterion. The relatively fewer ground-leased R&D sites in Silicon Valley are typically larger, in the 5- to 10-acre range, which influences the land-lease rate downward compared with smaller strip commercial sites.
Creditworthiness of the lessee
This is the same consideration that appraisers deal with in establishing appropriate yields for income properties in general; that is, the greater the creditworthiness of the tenant, the lower the risk to the property income stream that influences the yield rate. Certainly the federal government's guarantee on a ground lease would involve considerably less risk than a local jurisdiction with poor financial strength. A McDonald's or Burger King guarantee on a ground lease would clearly warrant a lower ground-lease rental rate than a single-outlet franchisee just starting in business. A ground-leased site for a R&D building to be occupied and guaranteed by Apple Computer would be considerably more attractive to a lessor than a start-up electronics firm in its first phase of venture capital financing.
The influence of location on a land-lease rate is consistent with location adjustments in fee valuation. A superior location warrants a higher land-lease rate because of greater demand, while average or subpar locations modulate or depress the rate. In light of the complexities of a ground lease relative to simple purchase of the property, an average to poorly located property may not even be a candidate for a ground-lease transaction because of a dearth of potential lessees.
Again, the consideration of location and the land-lease rate is the same as in fee valuation. A superior location means the landlord has a more desirable site and therefore can logically command a higher than average land-lease rate.
Market demand is the most important single factor in an initial land-lease transaction. It is only in markets with strong demand that lessees are willing to enter into ground leases. The issue of market demand becomes somewhat more obscured during the rental adjustment process for an existing ground-lease contract. In these circumstances a lessee may argue that market demand has weakened since the initial start of the lease, thereby warranting a lower ground-lease rate, while a lessor may argue the site served the lessee's needs for the term of the lease and the issue of market demand is no longer relevant. Another aspect of market demand is the availability of substitute sites, which can also be viewed as barriers to entry in a given market. As noted earlier, ground leases are most commonly found where there is a shortage of alternative development sites.
Specific land-lease contract terms
The specific terms of a land-lease contract have a pronounced effect on the appropriate land-lease rate. If, as is most typical, an appraiser is charged with establishing a "market" land-lease rate but does not have the authority to change the contract terms of the lease, he or she sometimes needs to manipulate the market data to fit the contract. For example, an appraiser might find that the market indicates an 8% land-lease rate as appropriate with CPI adjustments every five years and a reappraisal clause in the 20th year. The land-lease contract, however, may call for the rent to be fixed for 20 years. Applying a market-based 8% land-lease rate thus would not provide a landlord with inflation protection consistent with market expectations. This may require an appraiser to adjust the 8% rate upward to account for the fixed nature of the rent over the extended 20-year period. Alternatively, the ground-lease contract might call for CPI adjustments on an annual basis and the rate would have to be moved down to account for this contract term, which could be inconsistent with current market thinking. A typical ground-lease contract may contain numerous specific clauses the appraiser would have to consider when establishing a market rate that actually reflects market expectations of the income stream.
There is no doubt that establishing an appropriate land-lease rate involves a higher than normal degree of subjectivity. Initial ground leases are fairly infrequent in most markets and this is particularly true during a recessionary economy with tight lending restrictions, which characterizes the economy of the past several years. Nonetheless, existing ground leases most often have clauses calling for periodic rental adjustments based on market data as interpreted by appraisers.
Throughout the 1980s, based on the market-comparable ground-lease data available, the multiplier for establishing ground rent in the San Francisco Bay area usually ranged from 8% to 10%. Factors that cause the range to descend are decreasing interest rates of all types, a low inflation rate, and poor real estate market conditions. Partially counterbalancing this is the fact that rates of return for real estate itself have typically risen over the past two years in response to perceived increased risk. A ground lease functions more like an interest rate instrument than like a real estate discount rate. The subject property comprises only land, which is the safest portion of a real estate investment. Most ground-leased property is to be improved with a building. A landlord thus typically has the security of building improvements. Unless a ground lease has a subordination clause, the landlord would receive a windfall if the tenant defaulted on the land lease. The windfall would be in the form of ownership of the building improvements for which the landlord did not pay, and would possibly constitute a much larger portion of the total property value than the land itself.
For most ground-leased property, landlords have no management responsibility, no maintenance costs, and no market risk, given a typical long-term, triple-net ground lease. Relative to a landlord's investment, there are no physical depreciation concerns as the landlord is not paying for any building improvements. For all of these reasons, a typical ground-leased property cannot be reasonably compared to an internal rate of return from an alternative real estate investment such as an office building or a shopping center. Rather, a ground lease is often much like a bank certificate of deposit or a corporate bond. As interest rates have decreased fairly substantially over the past two years, most ground-lease rates should also have decreased commensurately.
The issue of how the rent adjustment mechanism in a land lease will influence the land-lease rate can be clearly illustrated with a review of corporate bond yields. Currently, double A or better rated corporate bonds are yielding between 4.5% and 7.5%. Comparing corporate bonds of companies with the same credit rating, this spread of approximately 3 percentage points is accounted for by only one thing. That is the term of the bond itself. For example, a Mobil Oil bond maturing in July 1994 was yielding 4.34% on March 16, 1993. An Amoco oil company bond maturing in the year 2016 is yielding 7.5% on the same date. The difference is caused by the market's concern about future inflation. For the bond maturing in 1994, there is little inflation risk and the market is accepting a 4.34% yield for a safe corporate guarantee. For the bond maturing in the year 2016, 23 years in the future, the market wants an increased yield of 3 percentage points because recent economic history suggests inflation could certainly surge during that period.
This discussion is not meant to imply that an appropriate land-lease rate for a subject can be ascertained only by comparison with corporate bonds. Particularly in the current market, real estate risks are of concern and it is likely that a land-lease rate would be higher than a corporate bond with the same maturity schedule. Nonetheless, the spread of 3 percentage points does provide a basis for determining how the land-lease rate would be adjusted, depending on how often it has CPI or reappraisal clauses to keep it current with future inflation.
In determining an appropriate market-based land-lease rate, all of the factors discussed need to be weighed as to the influence on a particular subject property. During the 1980s, land-lease rates for small commercial parcels were typically in the range of 8% to 10%. Decreasing interest rates over the past two years outweigh increasing real estate yield rates in the typical ground-lease consideration, and the current range is 7% to 9%. Further, a particularly large parcel or a highly creditworthy lessee would influence this rate toward the low end of the range or possibly even below it. These considerations, however, need to be tempered with the fact that real estate is now a less favored investment than corporate bonds and bond yields, which range from 4% to 7% depending on the term. Other more site specific factors include local market demand; the landlord security positions relative to the improvement value or subordination clause; and the specific terms of the ground lease, particularly the rental adjustments. A subordination clause in favor of a lender would influence the land-lease rate upward, as would low value improvements nearing the end of their economic life, because a tenant would have less incentive to avoid default and a landlord would have less of a value buffer over the land value itself.
As with all appraisal problems, every land-leased parcel has its unique characteristics both in physical aspects and in lease language. The aforementioned 7% to 9% range is simply that: the low-to-high end of typical ground-lease rates appropriate for most situations in the current economic and market environment. It is certainly not all-encompassing. There will undoubtedly be unique properties or circumstances that dictate the selection of a land-lease rate conclusion outside of this range. The responsibility of an appraiser is to marshal sufficient data and analysis to convince a neutral third party that the rate selected conforms to likely market actions.
Chris Carneghi, MAI, is president of Carneghi-Bautovich & Partners, Inc., in San Francisco, and San Jose, California. He received a BS in urban economics at the University of California, Berkeley, and an MBA from San Jose State University. Mr. Carneghi has served as an expert witness and has published several articles on real estate appraisal and market research.
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|Date:||Apr 1, 1994|
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