COVER STORY, NOVEMBER 2008

1031/TIC UPDATE
Ground ownership income and upside for 1031 investors.
Will Obeid

Obeid

If the old saying for real estate is “location, location, location,” then the mantra of the day is certainly “financing, financing, financing.” While the financial markets remain severely dislocated and somewhat disconnected from today’s commercial real estate fundamentals, real estate investors around the world are looking at how to best position themselves to achieve their investment objectives. The 1031 investment market is no different from any other part of the real estate sector right now; the gears just seem to be stuck and it needs the financing engine to be lubricated with enough grease so that it can get the wheels moving forward again. 

As real estate investors continue to navigate these turbulent times, investors who would like to take advantage of 1031 exchange opportunities need to stay aware of the various investment structures that are available. Tenant in Common (TICs) and Delaware Statutory Trusts (DSTs) are two popular investment vehicles that cater to the co-ownership model. Typically, TICs and DSTs are structured around an income-producing piece of real estate such as an office building or shopping mall. The problem with these types of structures is that, even when the property is master leased to the investors, the cash flow is based on the economics of the property. If the property fails to meet its debt service obligations, it is likely that the investors could lose their capital. 

An attractive alternative for real estate investors that is becoming increasingly popular with 1031 buyers is to purchase only the fee (the ground) interest appurtenant to an income-producing leasehold estate that is subject to a long-term ground lease. Other than the fee interest mortgagee’s position, the fee interest in the equity (fee mortgagor) is the most passive and secure portion of the “real estate stack” in this type of transaction. Properly structured, a fee (ground) interest purchase is advantageous for 1031 investors seeking a passive source of income that will grow over time. The bonus for 1031 investors is that, at the end of the ground lease, ownership of the valuable improvements on the leasehold estate reverts to the fee owner. 

Recent examples of transactions of this type abound, including deals where investors purchased only the leasehold interest in the improvements on a property that is subject to a long term ground lease. Typically the ground lease will last for 99 years, with annual ground rent bumps of 2.0 percent to 2.5 percent. The lender on the leasehold (the leasehold mortgagee) usually receives a mortgage with only the leasehold interest as collateral, and not the improvements. The fee (ground) owner will typically give a separate mortgage to its own lender (fee interest mortgagee). 

In these circumstances, both the fee interest mortgagor and mortgagee will feel adequately secure. The fee interest mortgagee holds the most secure and first position in the “real estate stack” of the two, now bifurcated, pieces of real estate (the fee and the leasehold). The fee mortgagor is in a very secure position with a lot of collateral protecting its position. This is because, in three ways, the fee mortgagor is receiving something akin to bank credit. First, the fee mortgagor receives assurances through the credit of the property’s tenants, who typically provide some form of security or guaranty (subject to the conditions of their lease) that there will be sufficient cash flow to pay expenses at the property, including the ground rent (which is the fee owner’s main source of income).

Second, the leasehold mortgagor will typically act rationally to protect its equity by backstopping any shortfalls from its own contractual rental income, which shortfalls could cause the property to fail or be lost to the leasehold mortgagee or the fee mortgagor. Third, even if the leasehold mortgagor failed to backstop the project and chose instead to mail the keys to its lender, the leasehold mortgagee would step in and act to prevent the imminent loss of its collateral.  

So in essence, the fee mortgagor (ground owner) is getting bank credit for its position at a 6.0 percent return with rent bumps every year. Typically, in a properly structured ground lease, the fee position constitutes approximately 30 percent to 35 percent of the total real estate stack, which means 65 percent to 70 percent of the real estate stack needs to collapse or fail before its income is affected. So for the fee owner, the bifurcated structure described above provides a valuable risk-adjusted return.    

Other interesting aspects of a properly-structured long-term ground lease of this nature include:

• The ground lease is absolutely triple net, meaning the tenant (leasehold mortgagor) pays taxes and any expenses associated with the property or tenant default.  

• Title is deeded to landlord (ground owner) at expiration of the 99-year period. In the event that the leasehold mortgagee takes over the lease, the leasehold mortgagee gains title to the improvements.  

• Neither a casualty nor a condemnation terminates the lease. In the event of damage to the property, the tenant must restore the building. In the case of condemnation, the ground rent is reduced in proportion to the percent of condemnation.  

• The leasehold mortgagor may sell or assign the lease at any time.  

The biggest issue surrounding these ground leases is typically centered on the subordination language contained therein. This is important because lenders need to be certain that they have a secure position that is not adversely affected by another lender’s ability to foreclose. However, if the foreclosure, condemnation and casualty provisions are properly thought out and structured, the subordination issues largely go away. Essentially, the mortgagees for both the leasehold interest and the fee interest need to be adequately assured that they will be able to foreclose on their respective equity interests, without disrupting the structure of the ground lease for the other parties thereto. In other words, the potential foreclosure of the mortgagor for either the leasehold or fee position cannot negatively affect the other mortgagee. To the extent the parties address these issues when drafting and negotiating the ground lease, these subordination concerns will be addressed and the lenders will both be satisfied. 

A properly-structured ground lease offers 1031 investors an excellent risk-adjusted return alternative with passive income and growth potential. The improvements are maintained by the leasehold mortgagor in the real estate stack, and the fee position is financeable; thereby, creating the potential of increasing cash returns and satisfying the leverage requirements for a 1031 exchange. In these turbulent times, the 1031 investor should consider co-ownership structures as well as fee interest ground lease alternatives based upon their tolerance for risk.  

Will Obeid, Gemini Real Estate Advisors, Tenant-In-Common Association.

©2008 France Publications, Inc. Duplication or reproduction of this article not permitted without authorization from France Publications, Inc. For information on reprints of this article contact Barbara Sherer at (630) 554-6054.