land lease technique for hot markets? - Posted by Mary Nichols (CA)

Real Estate Investing Office
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Posted by Mary in CA on September 09, 2005 at 10:35:10:

As always, you are full of enlightenment. I didn’t consider all these people paying way over any hope of cash flow for the foreseeable future as land banking, but considering the location of this one (near brand new university), I’d guess you’re right. Though I don’t see much hope for a rent increase in the area for at least 5 years. (about when construction at the university site will be completed), so I guess they must have deep enough pockets to carry it (or so they think now).

Thank you for your explanation and your recommendation.

Mary Nichols

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land lease technique for hot markets? - Posted by Mary Nichols (CA)

Posted by Mary Nichols (CA) on September 07, 2005 at 13:52:13:

I posted similar message on main forum only to be told it isn’t done anymore. Not overly helpful nor entirely accurate, since Trump’s books are full of investors owning buildings while others own the land underneath.

So I’ll try again here. I’m looking for reasons why this would or would not work . . . .

I’m in one of those hot markets where

  • appreciation is predicted at 30% or more for next year;

  • nothing cash flows unless you can buy way below market (rumored as possible, but I haven’t seen it); rents rarely cover mortgages let alone taxes (but needless to say, owners won’t sell for way below market and other investors are snapping up properties at high prices (are they losing money or do they know something I don’t?))

  • foreclosures almost non-existent (properties sell before auction for enough to pay off properties and return balance to owners).

  • no HUD or other government owned properties available

  • few if any bank REOs

Either property owners are greedy (who isn’t?) or their realtors don’t understand commercial (maybe quite likely) but income properties are showing the same irrational exuberance in pricing.

Case in point

Office building (3 units: 900, 1200 & 1200 sf I think; realtor said 2500 and didn’t have info from owner but I walked it and think my numbers are close)
Asking price $500,000 (“that’s what other office buildings are selling for”)
Current mortgage $100,000 from 2001 I think
Vacant (!!!)
Last rents all 3 units as single unit to tenant (Church) for $1600 per month (annual $19,200) NNN
Expenses: water/sewer, common area electric, rest room hot water/gas; probably less than $300/mo; janitorial and landscape maintenance a bit more
Property taxes 1.1% of purchase price (not sure what taxes would be if building only)

Only comp on market (within 2 blocks - not sold as of yet) $695,000; 6300 sf, offices, rents at $0.70/sf (below market of $0.75/sf) plus CAM; 4 plexes (not commercial - apartments) more common in area; averaging $410,000 rents at 4x +/- $800 depending on building amenities.

Assuming a generous NOI of $19,200, at a

10% cap rate the price should be $192,000 (vs $500,000)
9% cap rate the price should be $213,333 (vs $500,000)
8% cap rate the price should be $240,000 (vs $500,000)
7% cap rate the price should be $274,286 (vs $500,000)
national average 6.6% cap rate (not sure if this is for office buildings, though) the price should be $290,909 (vs $500,000)
6% cap rate the price should be $320,000 (vs $500,000)
5% cap rate the price should be $384,000 (vs $500,000)

Assessors’ numbers 30% land value; 70% improvements if relevant to anything

So my question is this . . . is there a way to make property cash flow by buying only the building and giving a ground lease on the land?

Is there a formula for determining what the land alone is worth? For determining a ground rent?

I tried this

a. at asking price of $500,000 but no reserves

building purchase at $178,000 (rents at $0.75/sf = $3200/mo = $27,360 agi after 5% vacancy
(at asking $500,000-$178,000) land at $322,000
land lease @ 8% $ 2,147 = $25,764 (this is more than they were getting in rent!)
negative cash flow

b. at a lower price but no reserves

building purchase at $178,000 (rents at $0.75/sf = $3200/mo if sf correct = $27,360 agi after 5% vacancy
(at $350,000 price - 178,000) land at $172,000
land lease @ 8% $ 1,147/mo = $13,760/yr
yields a positive cash flow of $1,100 per month if I can rent at $0.75/sf NNN

Is my scenario valid? Are my numbers right (assuming my assumptions correct)? Or am I missing something?
Has anyone done this? How low is reasonable for land rents? 5%? 6%? The 8-10% came from older examples when interest rates were higher.

Thanks for your thoughts.

Mary Nichols
Stockton, CA

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Re: land lease technique for hot markets? - Posted by ray@lcorn

Posted by ray@lcorn on September 08, 2005 at 12:43:46:

Mary,

The ground lease structure is still around, though used sparingly, and mainly for single-user credit tenants.

In the past, ground leases were commonly used under all sorts of projects, office buildings, banks, gas stations, etc. It is also known as “yank the land”, and can be a valid structure in the right circumstances.

However, there are some thorny issues that make the structure difficult to deal with under present loan underwriting standards.

Chief among them is the issue of subordination. Most lenders require the ground lease to be subordinated to their mortgage. Most land owners want the ground lease to be superior to protect their interests in the event of a loan default. Hence the structure is rarely feasible without a credit tenant for the ground lease.

The next most difficult issues are the length of the lease and the reversion clause. Unless the lease is longer than any proposed mortgage, financing is a non-starter. When the ground lease expires, most provide that the building ownership transfers to the lessor, eliminating tenant leasehold interests. That gets sticky unless the ground lease is always of sufficient length to allow leases to be honored.

And last but not least, the scenario you’ve described does not change the fact the property is way overvalued to anyone loking for cash flow. No, those paying these prices don’t know something you don’t. They’re just willing to accept less for returns, usually betting on market appreciation. This is essentially a land-banking exercise that depends on an ever-rising market to succeed.

Unfortunately, a multi-tenant property at the price and lease rates you’ve quoted carries what in my view is an uncompensated risk premium. I’d pass.

ray