A month after New York-based real estate investment trust Safety, Income & Growth (SAFE) raised nearly $250 million in a late June IPO, it spent nearly half of that amount on Hollywood ground leases.
SAFE, the only publicly traded company focused solely on buying ground leases, made a $142 million deal for land under the mixed use Eastown development at 6201 Hollywood. A ground lease, which gives the lessee the right to build a property on a site or collect rents from the property on site, separates and defines who owns the land and who owns the building, as well as who is responsible for improvements on the property. A triple net ground lease, for example, requires tenants to pay the three “nets” — development, property operating and taxes/insurance.
Most ground leases range between 25 to 99 years. They are seen as a stable place for investors to park their money, earn steady returns and weather market fluctuations, said Michael Underhill, chief investment officer of Wisconsin-based Capital Innovations, who closely follows the L.A. commercial real estate market.
They offer insulation against “industry-specific downtowns or geography-specific events,” Underhill said.
But they’re also vulnerable to rent hikes from ground lessors and are trickier to finance than outright purchases, experts said.
Although SAFE is a new entity, its leadership is no stranger to big-ticket deals. A spinoff of ISTAR, SAFE is led by Jay Sugarman, the chair and majority owner of the Philadelphia Union, a professional soccer team in Chester, Pa. He previously managed private investment funds for a branch of the Vanderbilt family, the Burdens.
Officials at SAFE declined to comment on the company’s strategy. Brent Truscott, a partner at Detroit-based Bloomfield Capital who is not involved with SAFE, said that while returns on ground leases may be lower than some other real estate investments, the capital preservation and tax deferment benefits make them attractive.
Investors are struggling to find meaningful returns right now. “The Dow is at an all-time high, cap rates are very low in all classes, especially multifamily, and CDs [Certificates of Deposit] and Treasuries don’t return much more than money market rates,” said Sonny Ginsberg, co-founder of Chicago-based law firm Ginsberg Jacobs. “In this kind of a market, a stable-looking triple-net lease with a return between 5 and 7 percent is very attractive.
“The purpose is to have stable income despite a downturn,” Ginsburg added. “Tenants are generally less likely to walk away, since they often have significant sunk development costs and if they default they lose the value of the building, so I would say that most ground leases result in the owners receiving their projected income during a downturn.”
Although SAFE may be a lone wolf when it comes to public REIT companies, there are a number of private funds that specialize in bringing investors into ground lease deals, generally via 1031 structures, Ginsburg said.
But there are risks associated with ground leases that can put lessees in a tricky situation. In January, SL Green Realty—one of New York’s largest commercial landlords— got into a dispute at 625 Madison Avenue, where it is the ground lessee. The lessor at the property, Ashkenazy Acquisition Corp., is looking to hike the rent on the lease by tens of millions of dollars per year.
“Expectations of astronomical prices and rents in the future are pure speculation and not representative of the current market,” SL Green president Andrew Mathias said at the time.
“Usually ground leases have built-in escalation clauses and eviction rights, which give the landowner adequate rent increases over the term of the lease as well further protection in the event of a default,” Underhill said.
With the possibility of being held hostage on rents, why opt for a ground lease? It comes down to location. Ground leases are a good strategy for business owners who want prime locations but lower upfront costs and want to avoid the headache of dealing with land purchases.
“A ground lease does not eradicate risk,” Ginsburg said. “Ground leases do default, but I would say they default less often than other commercial leases.”
Underhill said that nowadays, “a developer might lease land for a term of 25 to 100 years or more, build a hotel, office building, strip mall or other project, and be confident that mortgage financing would be available from institutional sources.”
But that’s not always the case. One recent headline failure is at the landmarked Lever House office building in New York. The lessee, Aby Rosen’s RFR Realty, is staring down foreclosure at the property. Terms of the ground lease with the lessor, the Korein family, are said to have made it nearly impossible for him to refinance a $110 million CMBS loan on the property. When the ground lease resets in 2019, the anticipated annual rent would increase from $6.15 million to $20 million a year — and the property generates just $16 million to $18 million a year in net operating income, according to Trepp.
“There are many lenders that will not finance ground-leased property,” Truscott said. “Some lenders have an aversion to ground leases due to fears of leases being terminated for any myriad of reasons, including nonpayment of ground rent by the lessee or, in the case of a foreclosure, the assignment or assumption agreement to the lease was not properly drafted by the lender. And at the end of the day, some lenders just can’t get comfortable with the fact that they don’t ultimately control the underlying land in perpetuity that secures their mortgage.”