If you own real estate in an up-and-coming location or own residential or commercial property that could be redeveloped into a “greater and better use”, then you have actually come to the ideal place! This article will help you summarize and ideally demystify these 2 approaches of improving a piece of real estate while getting involved handsomely in the benefit.
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The Development Ground Lease

The Development Ground Lease is a contract, typically ranging from 49 years to 150 years, where the owner transfers all the advantages and burdens of ownership (elegant legalese for future profits and costs!) to a designer in exchange for a regular monthly or quarterly ground rent payment that will vary from 5%-6% of the fair market price of the residential or commercial property. It permits the owner to enjoy a good return on the value of its residential or commercial property without having to offer it and does not require the owner itself to take on the remarkable danger and complication of constructing a new building and finding tenants to inhabit the brand-new structure, abilities which many property owners just do not have or desire to learn. You might have also heard that ground lease rents are “triple internet” which implies that the owner sustains no expenses of operating of the residential or commercial property (aside from income tax on the gotten rent) and gets to keep the complete “net” return of the worked out rent payments. All real! Put another method, throughout the term of the ground lease, the developer/ground lease occupant, handles all duty for genuine estate taxes, building and construction expenses, borrowing costs, repairs and upkeep, and all running costs of the dirt and the brand-new building to be developed on it. Sounds quite great right. There’s more!

This ground lease structure likewise permits the owner to enjoy an affordable return on the present value of its residential or commercial property WITHOUT needing to sell it, WITHOUT paying capital gains tax and, under existing law, WITH a tax basis step-up (which minimizes the amount of gain the owner would ultimately pay tax on) when the owner dies and ownership of the residential or commercial property is moved to its heirs. All you quit is control of the residential or commercial property for the term of the lease and a higher participation in the profits originated from the new building, however without the majority of the danger that goes with structure and operating a brand-new building. More on dangers later.

To make the deal sweeter, most ground leases are structured with routine boosts in the ground rent to safeguard against inflation and also have fair market price ground lease “resets” every 20 or two years, so that the owner gets to take pleasure in that 5%-6% return on the future, hopefully increased worth of the residential or commercial property.

Another positive attribute of a development ground lease is that when the brand-new building has been built and rented up, the landlord’s ownership of the residential or commercial property consisting of the rental stream from the ground lease is a sellable and financeable interest in property. At the same time, the designer’s rental stream from running the residential or commercial property is likewise sellable and financeable, and if the lease is prepared properly, either can be offered or funded without threat to the other party’s interest in their residential or commercial property. That is, the owner can borrow cash versus the worth of the ground rents paid by the developer without affecting the designer’s ability to finance the building, and vice versa.

So, what are the downsides, you may ask. Well first, the owner offers up all control and all prospective earnings to be derived from structure and running a new building for between 49 and 150 years in exchange for the security of limited ground lease. Second, there is threat. It is predominantly front-loaded in the lease term, however the danger is genuine. The minute you move your residential or commercial property to the developer and the old building gets demolished, the residential or commercial property no longer is leasable and won’t be producing any income. That will last for 2-3 years up until the new building is constructed and fully tenanted. If the developer fails to develop the building or stops halfway, the owner can get the residential or commercial property back by cancelling the lease, however with a partially built building on it that produces no profits and worse, will cost millions to finish and lease up. That’s why you must make absolutely sure that whoever you lease the residential or commercial property to is an experienced and experienced builder who has the monetary wherewithal to both pay the ground rent and finish the building and construction of the building. Complicated legal and organization services to provide protection against these threats are beyond the scope of this short article, however they exist and need that you discover the best company consultants and legal counsel.

The Development Joint Venture

Not satisfied with a boring, coupon-clipping, long-term ground lease with limited participation and restricted advantage? Do you wish to take advantage of your ownership of an undeveloped or underdeveloped piece of residential or commercial property into an amazing, new, bigger and better investment? Then maybe an advancement joint venture is for you. In a development joint venture, the owner contributes ownership of the residential or commercial property to a minimal liability business whose owners (members) are the owner and the designer. The owner trades its ownership of the land in exchange for a percentage ownership in the joint venture, which percentage is figured out by dividing the reasonable market worth of the land by the overall project expense of the new building. So, for example, if the worth of the land is $ 3million and it will cost $21 million to develop the new structure and lease it up, the owner will be credited with a 12.5% ($3mm divided by $24mm) interest in the entity that owns the brand-new building and will get involved in 12.5% of the operating profits, any refinancing profits, and the earnings on sale.

There is no income tax or state and regional transfer tax on the contribution of the residential or commercial property to the joint endeavor and in the meantime, a basis step up to fair market price is still readily available to the owner of the 12.5% joint endeavor interest upon death. Putting the joint venture together raises various concerns that must be worked out and solved. For example: 1) if more money is needed to complete the building than was initially budgeted, who is responsible to come up with the additional funds? 2) does the owner get its $3mm dollars returned initially (a top priority distribution) or do all dollars come out 12.5%:87.5% (professional rata)? 3) does the owner get a guaranteed return on its $3mm investment (a preference payment)? 4) who gets to manage the daily company decisions? or major choices like when to refinance or offer the new structure? 5) can either of the members move their interests when desired? or 6) if we construct condominiums, can the members take their revenue out by getting ownership of particular apartments or retail spaces instead of cash? There is a lot to unload in putting a strong and reasonable joint venture contract together.

And then there is a risk analysis to be done here too. In the development joint venture, the now-former residential or commercial property owner no longer owns or controls the dirt. The owner has obtained a 12.5% MINORITY interest in the operation, albeit a larger project than previously. The danger of a failure of the task does not simply lead to the termination of the ground lease, it could result in a foreclosure and perhaps total loss of the or commercial property. And then there is the possibility that the marketplace for the brand-new building isn’t as strong as initially predicted and the brand-new building doesn’t produce the level of rental income that was expected. Conversely, the structure gets built on time, on or under budget, into a robust leasing market and it’s a home run where the value of the 12.5% joint venture interest far surpasses 100% of the worth of the undeveloped parcel. The taking of these dangers can be considerably reduced by picking the same competent, experience and economically strong designer partner and if the anticipated advantages are large enough, a well-prepared residential or commercial property owner would be more than justified to handle those dangers.

What’s an Owner to Do?

My very first piece of advice to anybody considering the redevelopment of their residential or commercial property is to surround themselves with skilled specialists. Brokers who understand development, accountants and other monetary advisors, development specialists who will work on behalf of an owner and naturally, good knowledgeable legal counsel. My second piece of suggestions is to use those experts to identify the financial, market and legal characteristics of the possible deal. The dollars and the offer potential will drive the decision to establish or not, and the structure. My 3rd piece of advice to my clients is to be true to themselves and attempt to come to a sincere realization about the level of threat they will be ready to take, their capability to find the ideal designer partner and after that trust that designer to control this process for both party’s mutual financial advantage. More quickly stated than done, I can guarantee you.

Final Thought

Both of these structures work and have for years. They are particularly popular now due to the fact that the expense of land and the expense of building and construction materials are so expensive. The magic is that these development ground leases, and joint endeavors supply a less costly method for a designer to control and redevelop a piece of residential or commercial property. Cheaper because the ground lease a developer pays the owner, or the profit the developer shares with a joint venture partner is either less, less dangerous or both, than if the developer had actually bought the land outright, and that’s a great thing. These are advanced transactions that require sophisticated experts working on your behalf to keep you safe from the threats intrinsic in any redevelopment of real estate and guide you to the increased worth in your residential or commercial property that you look for.