How to Invest in Commercial Real Estate

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Episode #098 - The Advantages & Disadvantages of GROUND LEASES in Commercial Real Estate!

by Criterion, Braden Cheek, Brian Duck
March 6th 2023

Today hosts Braden Cheek, Brian Duck and Joel Thompson discuss the potential benefits & risks of ground leases in commercial real estate.

Time Stamps: 0:00 - Introduction 0:14 - Let’s ta... More

What's up and welcome back to how to invest in commercial real estate. And today we have a super exciting topic but before we get into that, we're gonna talk a little bit about, um, inflation. Right. Yeah. Unfortunately the latest report last week, uh inflation, uh, looks like it ticked back up. I think it was either December or January numbers that came out. And so it looks like the fed is going to continue to raise interest rates maybe slightly more aggressively than we thought. Uh, kind of at the very end of last year. So we're gonna have to deal with that and that also caused a 10 year to push up higher. So, you know, I think a couple of weeks ago 10 year was down near 3.5. Now it's back up over four. Yeah, I think people are doing anything to find the yield that they can. Right. I mean, the 4% 10 year treasury bill or, like you said, you know, some bank is offering 4.5% for a 13 month CD. That's, that's not bad if you've got any cash at all right now. I mean, there's not other many investment opportunities and, you know, the market still probably got some, some ways down to go. So, you, you're probably not buying into that right now. Real estate offerings are slim.

There's not a lot of deals happening right now. So, interesting time. Yeah. So deals might slow even more, huh? Yeah, I'm, I'm expecting overall deal flow to be pretty low this year. Well, I think we have some deal flow taken up that we're excited about. Can't talk about it too much yet. But there's some, we got some things in the works, things on the horizon. You're in the um construction of iconic. How's that going? It's good. We are doing uh porn foundations here in about 2 to 3 weeks and then the vertical construction will start going pretty quickly. So we're probably complete that in about 15, 16 months from now. Is that just wood? Yes, I think it's just three story total structure, but the parking garage is obviously concrete. So that's well, yeah, the parking garage got changed though. It's just on grade parking now because the foundation issues, I think I mentioned that to you. Uh Bigsby, I guess is just a whole bunch of sand like where you are. It's close to the Arkansas River and then there's no bedrock anywhere close to the surface.

Can, can we over overdub like the Sahara desert? Uh Bigsby, I guess is just a whole bunch of sand like where you are, it's close to the Arkansas River. Yeah. And then there's no bedrock anywhere close to the surface. Can, can we over overdub like the Sahara desert? Lots of sand? Uh So yeah, the development's going uh good though. Uh We're getting all of our equity together. The loan is in place and it's gonna really impact uh downtown Bigsby. So we're excited about that and then we may have a partner uh joining us for the Broken Arrow development. I was gonna ask you if there's any news on Broken Arrow that you can announce yet. Uh, not, not officially yet, but we're in talks with a potential development partner to get that project, uh, built in the next, uh, you know, starting in the next several months. So, and that one you guys have had for, for years. So it's nice to see a little too long, too long. It was the first development that we decided to try to do and I knew it would be a learning experience. Uh, but I didn't think it would take this long, a three-year learning experience. Hopefully at the end I get our money out and maybe make a little bit. That would be awesome.

That would, it's kind of what I say about crypto. You know, it's true. I don't care how long it takes if I can just get my money out and make a little bit, well, not crypto. But what you said before that was a perfect segue into what we were talking about today and, and sometimes in developments when or when we're launching offerings, there's a variety of different ways the tenant can lease from us, they can lease the ground from us. We could do a build a suit where we're maybe building the building and they're leasing back the building from us or they could buy the parcel and then they could build the building. There's so three different main ways, right? They, they could buy the land, they could lease the building that we build or we own or they can lease the dirt and build their building. And we're gonna get into some of the advantages and disadvantages and perspectives into looking at that and why some of these deals are structured that way. So where should we start? I, I think you start with exactly what is a ground lease? Ok. Um Yeah, ground lease. So typically when you're buying real estate, you are buying what's called a Fee Simple uh title, which means you're getting the land and everything on it.

Uh Basically uh the most complete ownership that you can have how ground lease differs is that you are uh leasing the ground and you can put any improvements you want on the ground. But at the end of the ground from the ground, from the landowner, right? Yeah, leasing the, you, you go and you, you basically like you would lease an apartment but you lease the, the ground, the dirt and then you can put improvements buildings on that. But at the end of that lease, the landlord does not have to lease the land to you. And so whatever's on that land, at the end of that, uh that lease term will revert back to the landowner. And so then I guess we need to talk about, well, why would someone do that? Yeah. Yeah. Why would you do that? I mean, why would somebody do that? Well, good. Uh now, now that you've asked that question, so I, I want to use an example because we've done a, a couple of ground leases and so I'll take the, the one we did out in Vegas because it's simple is we had a very small uh patch of parking lot that was on a signal right in front of our retail center.

I don't know if I would have priced selling that land just as is, but maybe I could have gotten a half a million dollars for it if I'm just guessing, you know, because it wasn't even, maybe a half an acre, maybe less than a half an acre. We've talked about this before and I'll, I'll probably pay Aaron to go back and find it and overdub it over this video. But I'm pretty sure I thought it was a quarter acre. You thought it was an acre? I was wrong. It is. In fact, one acre, it was 11 whole acre, the whole acre to you, it's questionable. But, uh, every time with this guy anyway. And so, uh, we looked at selling it, that's all we could get. And so what we wanted to do was say, ok, what, what can we build on it? And it, and would, would we make more money doing that? Well, traditional retail is gonna be, you know, a couple $100 a foot and, and just base construction costs, uh, couple $100 a foot, maybe like five years ago. Yeah. Well, in addition to the land and, uh, T I and everything like you're, you're over that, but just base hard construction cost maybe 200 for the shell.

And, uh, and so we started talking to companies about maybe doing a ground lease and these coffee companies, they'll come in and they'll put this kind of a manufactured building on it. So their costs are pretty low. It's a pretty small building, right. Uh, but you get yourself a ground lease. And so with that ground lease now they're paying, uh, ground rent to you and you don't have any cost to, to build a building. But now with that lease, it's not just a patch of dirt that's worth a half a million bucks. Now, it's worth a cap rate on that income. And these ground leases that are really clean and they're 15 years, they're brand new. Uh, people on 10, 31 exchanges will pay high prices or low cap rates for those. And so when we, uh when everything shook out, we were able to get a $65,000 a year ground lease from Dutch Brothers coffee. And so instead of selling the, the, the half acre or one acre lot for half a million, 700,000, we were able to sell the Dutch Brothers for a million and a half. And so we were able to maximize value for us by doing the ground lease. Now, uh in certain circumstances, you may be able to maximize value by building a retail center and leasing each one of those out.

But the cost is not guaranteed. You could have overruns, the leases aren't guaranteed. Uh And the, the cap rate on those are isn't guaranteed. And so there's just so many unknowns. And so I think you can get most of your value if you have a parcel like this and doing a ground lease with a, a tenant like a Dush Brothers or Starbucks or something and, and, and then getting you the maximum amount as quick as you can and waiting to do the whole development. Yeah, and you can get uh a study done. Uh I think you can get a study done the highest and best use study. Can't you get one of those done on a site like this to kind of evaluate some of these options as a developer? Yeah, kind of like a bov, but the CCIM guys know how to do this best in and highest use. And so they can look at a couple different options for you and, and look at net profit. So let's say in that same scenario, uh, a tenant is approaching us to lease a piece of ground to maybe put a Dutch brothers or we've done a salad and go. We're about to do a Black Rifle coffee company. There's a lot of these concepts out there. But why from a tenant's perspective, would they wanna just lease the dirt? Maybe have a little bit of open ended exposure at the end of their lease term?

15, 20 years down the road. Why would they want to do that? What are some of the advantages for the tenant? Well, the 1st, 1st thing I can think of is there's no initial cash outlay for all the land, right? So they don't have as much upfront expenses. Um, and then on top of that, like for the Dutch brothers, I mean, that's a, that's a small building and they, they make hundreds of them. Uh I'm sure their costs are, are, are pretty low. What, what I am curious about though? Give that as an example, what, uh, what term period was that lease for? Because it seems to me like, you know, a five or 10 year lease, it doesn't pay out quite yet. So, are they typically longer than that? Yeah, they're, they're definitely typically longer ground leases are going to be, uh, typically be the longest leases. You see, and you'll see some of them for up to 99 years. Uh, but, but generally they're at least 15, uh, at least 15 years. I, I think I've seen maybe a couple of 10 year but that would be the, the, the bare minimum that I've ever seen a new ground lease would be 10, but most of the time 15, 2025 year ground lease. That makes sense because it's got to make sense for them uh for it to be profitable during that, that lease period because there's a good chance afterwards that they may not be able to lease.

There's no guarantee. They, they, they know on, on some level if uh the landlord raises the rent and they're willing to pay it, they can stay there, but there's not a guarantee. Um But to go back to what you, you were saying, yeah, it's the cash, I think number one for a company that's trying to grow a cash outlay is a huge thing because they make money with locations. And so let's say they have a set amount of money. Uh let's call it $10 million. They're thinking how many locations can I get with that? $10 million? And if I have to buy the, the land for a million dollars a pop and then put my building on it and then maybe I can only do you know, let's call it 20. But if I don't buy any of the land and I just get a rent payment, well, then I can do 40 or 50 locations. And so, and they're, they're, they're cash flowing on each location. So I think that's probably some of the metrics they're using on why they would be open to it. Another massive benefit, right? Is depreciation. When you're buying a building, a commercial non-residential building, you depreciate over like 39 37.5 years, a super long time.

Whereas tenant improvement, furnitures, fixtures and equipment, a lot of the stuff they're, they're building right after they lease the ground, they can appreciate that over their lease term. So that's 15 years, that's 20 years, that's way shorter than huge and they can write off the entire amount of the rent. Uh And, and so from a tax perspective, it's more efficient for sure. Ok. And so it sounds like the deals most likely will work out in the term that they want. And if they can't get a, a new lease out of the landowner, they can just move down the block and probably find someone else who's got a small patch of land that'll, that'll take the lease that they want to pay. Right. And then they just pluck another building down. Right. I mean, and I'm sure there are some ground leases where the, let's say this manufactured, you know, building I've I've seen them now, they're doing shipping containers as a, as a coffee store, pick it up. Like, I wonder if it's negotiated in the lease where they, they obviously they can't take any of the improvements that are on the land or attached to the land, but they can pick up that, that, you know, shipping container or whatever manufactured building that they have and then just take it to another location pretty easy.

Another thing if you're local at Tulsa, um the new retail center over by Saint Francis and the double tree that was uh built on a 99 year ground lease. And my kind of thesis on that is somebody, I mean, that's such a valuable piece of land, right? So you don't want to ever sell it. It's only gonna go up in value. I mean, that's a mega location with the biggest, one of the biggest office buildings in town and the biggest hospital in town. So you don't necessarily want to sell that hard corner and it generates a taxable event, right where it's just receiving income for the next 99 years. It's way less taxable than a massive sale. Well, so we've talked from a tenant perspective and, and we don't want to have this episode go too long, but from a buyer's perspective, like why would I want to buy a ground lease or what's called a leasehold? So, so as a landowner, I I ground lease to a developer or to a retail and they build something and they get the tenants. Now, if someone wants to sell those buildings, they don't own the land, they're selling a leasehold uh title, uh a leasehold title to whoever wants to purchase it.

And so if you're looking at buying a deal and it, they say, hey, this is a leasehold, these old Walgreens, let's say or something, you've got to understand what the risks are there because you're buying a building that, that as soon as that, that lease is over, you may not have. And so when you buy a typical Walgreens, you may put, let's say you put a million dollars down, the, you're gonna pay off that note. Uh, $4 million note, you have $5 million Walgreens, let's say. And in 10 years, that may be worth 8 million. Well, now after all these years, you've paid it off that you get that 8 million, you can sell that 8 million. But in a leasehold, you don't, uh, you may put that same money down and you may get a loan and you may pay off that loan. But at the end of that ground lease, if that landowner doesn't want to extend it, then then all of that money you don't get back, you could lose 100% of your, your capital and the amount of the loan that you've paid off. So where would you see that? That's probably like the best location ever. Right. The best tenant ever because they're double dipping on the exit, right? As a developer, they're selling the land lease, they're selling the building lease.

I mean, they're, they're maximizing as high as possible. The only way you could possibly do that is if people felt like this had to have been a sure thing, it needs to be a good location, but here's the things you want when you're buying a leasehold is you're gonna look for as long of a, a lease uh ground lease as possible, like the 99 year uh like a 99 year or something that's got uh 55, 10 year options. You know, you have 50 years and, and you have the option as the leasehold owner to extend or not extend. So you have flexibility there and it's already uh you already built in increases, you know exactly what your rent's gonna be and you can build your model that, that's number one, number two is you need to have uh you need to be getting paid uh uh a high, you need to be buying at a higher cap or a lower price for comparable real estate if one's a fee simple and one's a leasehold. Um because once again, you are, are gonna not, you're not getting your equity out potentially whenever that land lease is done. And you could say, well, I'll sell it before the lease is up, ok?

But you're still gonna, with less time on that land lease, you're gonna have to reduce the price even further. Well, it's got an inverse relationship because of the leasehold interest, it becomes more risky. Whereas traditional real estate, the value traditionally always goes up because it's valuable. Yours is going and it's working its way to zero. Correct. That's important to know. So you say, well, how could that ever make sense? How could I ever lose 100% of my invested capital and still be money ahead? Well, uh if you get AAA good enough spread, let's say you're gonna buy a six cap and then the leasehold is at a nine cap right now, your, your returns are so much higher every year compounding and the longer you, you go out, uh the the pur initial purchase price becomes negligible or it can under the right circumstances. So it's a little bit of a complex uh way to go about uh calculating that. So I would say for beginning investors that buying a leasehold, uh you may want to get some expert opinion, definitely get an expert opinion. If you are considering a leasehold, very riskier compared to traditional real estate, you don't wanna look like an idiot because you didn't realize it was leasehold versus fee simple, right?

But anyway, we've got two other buckets of how a tenant would approach us. So what about a build a suit? We, we've discussed ground leases, I think to death a build a suit. What are some of the advantages? What types of tenants do you see in there? What are some of the pros and cons? That's, that's a massive sector to build the suit? Yeah, we're already, we're already pretty, pretty long on time. So I didn't know we were gonna talk about build a suit. I, I'll say real quick, uh build a suit is, uh, let's say you want to do a, build a suit, you offer the land, uh, available to build a suit and, and let's say, uh, you know, Arby's comes along and they want, they want to take you up on that and they want you to front the cost for both the land and the building, but they want to build it their way, they want to build it exactly how they want Arby's built. Well, once you have their specs, you cost out exactly what it's gonna cost you to build the building that they want and then you back into the rent that you need, uh, on that build to suit. So that's kind of how, how that relationship works. Am I getting that right?

You get the back end of the rent that what you're fixated on the back end? You lost me there? Ok. So that even makes it easier for, uh, someone like you said, like an Arby's or a Dutch brothers to get into business because now their costs are even lower, right? They're not buying the land, they're not buying the building or they're transferring all of those costs into a monthly rental payment. And so, and that you agreed to get, and so let's say it costs you 2 million bucks. Well, you wanna, you want that to be on a, let's say a seven cab. And so you, you're gonna back into the rent that they need to pay you, uh, in order to cover all the expenses you're gonna have to build in that building and any profit that you want. Types of tenants you would see with this, I would, I would think, right. We're talking about how easy it is to get into a build to suit scenario. How little cash you need to have a build to suit scenario. So I would say that's a smaller, more regional, more local operator, maybe a newer operator. They don't have the, the, the Starbucks $10 million war chest to go up on 100 level locations. They're maybe working with like two or three. They're testing out a concept that's where I would see way more build the suits than just ground lease.

Ground lease I feel is institutional level. Build a suit is maybe a notch or two below that where it's kind of like these, these middle range, you know, we're not opening thousands but maybe 10 50 100. All right. Last bucket. Shortest topic. We're almost done. Pat sale. Why would somebody go in and and just say, sell me the dirt, I'll figure it out. And in most people's minds, they're probably thinking this is the most common thing when in reality it's, it's, it's not. So why are, why are so many people not just buying the land just off the top of my head? Why are they not buying the land? In that case? They are buying the land, right? And then they're going to, and then they're gonna build on it. Is that what you're saying? Yeah, they're gonna do whatever they want. Why would an owner though, choose to, to sell the pad? And more importantly, why would a tenant choose to do it? Why would a tenant just choose because from an owner if I'm making the same money versus a, build a suit and a pad sites, sale, pad site sale, I just sell you the land. No headaches at all. Yeah, it's super easy. So from my perspective, I'd almost prefer the pads site sale because it's easy. I think what I'm driving to here is that these tenants are in the business of selling coffee or selling tacos or selling salads to go or whatever it is.

They're not real estate developers. That's why they're leasing this. They can't hold hundreds of millions of dollars of real estate on their balance sheet. They don't know how to develop these buildings. They don't want to take the risk of engaging in architecture, engaging a general contractor, risking that it goes wrong being way over and then their taco concept was dead in the water before it even got out of the ground. You know what I mean? Yeah, I mean, I could be wrong but I would guess that the, the pad site sale will be for an owner that wants the quickest option. He doesn't want to wait around for a build, a suit negotiated or uh a ground r negotiated And that's gonna be the quickest way because it opens up to more buyers, uh developers, other investors and things could be that it, it could be a retailer that, that likes the location and wants to lock up the site. They're just not ready yet, but, but most likely it's going to be someone that's going to develop it uh and is gonna, you know, try to put a retailer in there. And so that, that's who I see. Uh buying pads and the only reason I would sell a pad is because it's the quickest and easiest way to get cash.

If you, if you can get a ground lease, I think you're gonna maximize the value more doing it that way, but you have to market it. You've got to wait for the right tenant. You have to negotiate that lease. So it just is gonna take more time to get to get your hands on the money. Well, a lot of different ways on how you can approach that. There's several different ways on how these tenants are, are getting these retail buildings. But it seems like a Dutch Brothers concept pops up overnight. You've never heard of it? And then there's one on every corner and these are some of the ways that they can do this at scale and open up so many locations so fast. You might think, how can they afford, you know, each of these locations? It's gonna cost millions. Well, I think we've debunked how you can go at speed, achieve scale with little cash out lay and, and just, you know, make your monthly payments. Anyway, we will catch you next time on how to invest in commercial real estate. Thanks guys.

Episode #098 - The Advantages & Disadvantages of GROUND LEASES in Commercial Real Estate!
Episode #098 - The Advantages & Disadvantages of GROUND LEASES in Commercial Real Estate!
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