In for the long haul: Commercial ground leases

What are commercial ground leases?

Hugo James: Traditionally ground leases have been used by businesses with a large real estate component to their operations such as health and elderly care operators, hotels, supermarkets, garden centres or holiday parks as an efficient long term financing option. Commercial ground leases work by enabling such real estate owners to sell their freehold land to an investor whilst entering a long-term lease to enable continued use of the property and the ability to raise finance against the long lease interest.

In the commercial real estate sector, these leases are often structured with terms lasting more than 99 years, with leaseholders making regular ground lease repayments to the freeholder throughout this period. At the end of the lease, the freeholder may regain the property or, in many cases, allow the leaseholder to buy it back from them for a nominal sum.

Tom Benham: Ground leases are not new, in fact, they have been around in various forms for centuries. But they have been growing in use for commercial real estate owners as more businesses have recognised how they can be used to support their activities. In recent years we have also seen more private equity investors using ground leases as a way to optimise the capital structure of their investments and enhance returns. 

How are investors approaching this strategy from an allocation perspective?

HJ: People who are unfamiliar with the asset class often think of commercial ground leases as a real estate play, which is not quite right.

It is the leaseholder who is responsible for the day-to-day management of the property and is directly exposed to the commercial property market. In fact, given the extent of the over collateralisation, ground lease yields may not change if market rental levels for the use of the buildings or operating income fall during the lease term.

Investors in commercial ground leases are therefore really acquiring a secure stream of future rental cash flows that are more bond-like in nature. For this reason, most investors tend to approach commercial ground leases through their fixed income portfolio allocation, replacing investment grade corporate and government credit investments.  

What opportunities do you see in the asset class going forward?

TB: Commercial ground leases have become a particularly relevant financing solution in the current landscape as COVID-19 has made its impact felt on the economy.

We have seen a number of businesses looking more closely at ground leases in the wake of the pandemic as a means of increasing their liquidity in the short term, unlocking value in their real estate investments to fund their operations. Many have also seen the benefits commercial ground leases offer relative to other lease structures available in the market which, in some cases, have caused considerable consternation during this challenging trading period.

From an investor perspective, commercial ground leases have also demonstrated their resilience during the pandemic, performing well in both absolute and relative terms. Due to the volatility and the tightening we have seen in broader credit markets, COVID-19 may also help investors in commercial ground leases to secure enhanced returns and terms. So, the pandemic is supporting supply levels and is likely to accelerate the growth of the asset class.

HJ: Looking beyond COVID-19, there is a significant opportunity to grow the use of ground leases in the real estate market.

Ground leases are a particularly efficient financing solution for owners of commercial real estate, however, they are only utilised by a relatively small section of the market today. This is changing and we have seen a significant uptick in the number of players utilising ground leases as familiarity with them and the benefits they bring from a long-term capital management perspective has grown.

There is also a real opportunity to grow their use outside of markets where they have traditionally been prevalent. Commercial ground leases are now common in the UK and have gained a strong foothold in the United States. In continental Europe, commercial ground leases are an emerging asset class. But substantial opportunities exist across all markets to grow their use across different sectors of the commercial property market.