Ground Lease vs. NNN - Posted by Jim - IL

Real Estate Investing Triple Net Leases
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Posted by Penny on May 22, 2007 at 23:02:18:

Jim,

I don’t see a good exit strategy here. Maybe someone else who has done these can provide some additional insight, but here’s my run through of the numbers:

If you paid cash, it would take about 13 years to almost double your money via cashflow alone. If you finance, it will take longer because interest rates are higher than the returns and you would need to put down a lot just to break even with the debt service.

So the upside here is in the land appreciation.

Is the option to purchase in 2021 really $586k or is that a typo (maybe $856k?)?

If the option price is correct, then the following logic applies. The upside of the land appreciating + equity gains (if financed) is less likely to be realized since there is an option to purchase at a lower price 13 years from now than the $612,175 price today. Assume that the land will continue to appreciate. Even at a modest 3% annual inflation, the land would be worth about $875,000 in the year 2021. So there is considerable risk that the $586,000 option would, indeed, be exercised.

So your returns would be limited to the annual cash flow received over the 13 years minus the $26,175 loss against what you put down. And that’s before taxes.

If the option price is $856k (or whatever the correct number is), then things look a little different. Your main return comes with the land appreciation realized when the property is sold. So the property value trends in the local location are very important. They could be modest or substantial. Since no one knows, it is speculation. But there is an option cap on the price in 2021 and if appreciation is substantial, the same logic applies - the option is more likely to be exercised, thus limiting your eventual returns.

So it comes down to the acceptable return you seek for the funds you would invest in this property. If it doesn’t meet your goals, then move on to the next.

So there’s my $.02. If someone sees something I miscalculated or missed, please feel free to chime in.

Hope this helps.

Penny

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Ground Lease vs. NNN - Posted by Jim - IL

Posted by Jim - IL on May 21, 2007 at 22:58:38:

Hello…

I have been looking at sites which list NNN properties for sale. I found a property that was listed as a Ground Lease vs all others on the page that were listed as NNNs. Can someone help me understand the difference between the two? Both say “No Landlord responsibility” but who owns the building in the ground lease? The tenant?

Thanks for your help.

Jim

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Re: Ground Lease vs. NNN - Posted by ray@lcorn

Posted by ray@lcorn on May 22, 2007 at 10:19:56:

Jim,

Yes, under a ground lease the tenant owns the building for the term of the lease. Typical terms include a reversion clause in which ownership of permanent improvements, i.e. building(s), revert to the property owner at the end of the lease. In some cases (rarely) the lease may require the tenant to demolish and remove the improvements.

The question you didn’t ask is the difference between a NNN credit-tenant lease and a ground lease to the investor. Going rates on ground leases are 5%-6% caps for investment grade credit tenants, and NNNs are in the 6%-8% range, both pre-tax.

But the major difference is in the after-tax returns. Ground leases get no depreciation deduction, so all income is taxable. NNNs can shelter some to all of the income, the amount depending upon chosen depreciation schedules, value of the building vs. the dirt, and owner’s tax status.

ray

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Re: Ground Lease vs. NNN - Posted by AsifInNJ

Posted by AsifInNJ on May 28, 2007 at 12:01:03:

If the ground leases are not tax friendly and cap rate is low, why would somebody buy the ground lease instead of just buying the NNN property, which has higher cap rate and depreciation shelters lot of income from tax.

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Re: Ground Lease vs. NNN - Posted by Jim - IL

Posted by Jim - IL on May 22, 2007 at 18:30:00:

Ray,

Thanks for the information.

My follow up question is why (or under what circumstances) would someone invest in a ground lease instead of a NNN credit-tenant lease?

I have found the following opportunity and wondered if you could give me your thoughts…

Ground Lease on a McDonald’s
Sale Price $612,175
Cap Rate: 5.75%
Lease Term 20 years (Currently in Year 6)
Single Tenant Location
NOI: $35,200
Rent Adjustments: Years 6-10: $35,200
Years 11-15: $38,720
Years 16-20: $42,592
Lease renewal Options: Four 5-year options at
$46,851, $51,548, $56,690 and $62,360
Notes on Lease: Ground lease. No landlord responsibilities. *McDonald’s has right to purchase for $586,000 in year 20 (Oct. 2021).

Thanks for your time and knowledge.

Sincerely
Jim - IL

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Re: Ground Lease vs. NNN-Asif & Jim - Posted by ray@lcorn

Posted by ray@lcorn on May 28, 2007 at 13:24:22:

Asif (&Jim),

Quite often a ground lease is the preferred investment type for certain estate, trust, 1031 and institutional buyers.

If the tenant is a credit tenant (i.e. S&P rating of BBB or higher) then financing is available with a 1:1 debt coverage ratio.

These are known as “zero-flow” deals. This allows the investor to obtain the highest possible loan amount, thereby accessing the maximum amount of equity tax-free. Interest only loans coterminus with the lease are actually the preferred loan type, because 100% of the income is used to service the debt, resulting in zero taxable income.

With lending rates for credit tenant deals still relatively low this creates an extremely cheap source of capital for any use desired. For example, such a deal may be used to settle an estate among heirs while preserving legacy property ownership and/or avoiding capital gains taxes on property with significantly appreciated value and low tax basis where the step-up provision can’t be used.

Additional scenarios in which ground leases make sense include the use of captive entities to own corporate real estate with off-balance-sheet financing; development deals which exchange land interests for ownership in finished projects; and passive income streams offset by passive losses in other investments (subject to investor’s tax status).

ray

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Re: Ground Lease vs. NNN - Posted by johnmckee

Posted by johnmckee on June 07, 2007 at 14:19:30:

This is a bad deal even with the assumption of the %586,000 being a typo. Mcdonalds holds all the cards and decides on what the appreciation is worth based on their right to purchase for a set price. You need to own the land and not the lease upfront. Your glory will come when you decide who the next tenant or buyer is 20 years down the road by owning the land.