If you own property in an up-and-coming location or own residential or commercial property that could be redeveloped into a "higher and much better use", then you have actually come to the best location! This article will assist you summarize and hopefully demystify these two approaches of enhancing a piece of property while getting involved handsomely in the upside.

The Development Ground Lease

The Development Ground Lease is a contract, generally varying from 49 years to 150 years, where the owner transfers all the advantages and problems of ownership (expensive legalese for future revenues and costs!) to a developer in exchange for a month-to-month or quarterly ground lease payment that will range from 5%-6% of the fair market value of the residential or commercial property. It allows the owner to take pleasure in a good return on the value of its residential or commercial property without needing to sell it and doesn't need the owner itself to take on the tremendous threat and problem of building a brand-new structure and finding renters to inhabit the new structure, skills which lots of genuine estate owners just don't have or desire to learn. You might have likewise heard that ground lease rents are "triple web" which means that the owner sustains no expenses of operating of the residential or commercial property (besides income tax on the received lease) and gets to keep the full "net" return of the negotiated rent payments. All real! Put another way, throughout the regard to the ground lease, the developer/ground lease tenant, handles all obligation genuine estate taxes, building and construction costs, borrowing expenses, repair work and maintenance, and all operating expenses of the dirt and the new building to be developed on it. Sounds respectable right. There's more!

This ground lease structure likewise permits the owner to take pleasure in a reasonable return on the existing worth of its residential or commercial property WITHOUT needing to offer it, WITHOUT paying capital gains tax and, under current law, WITH a tax basis step-up (which decreases the amount of gain the owner would eventually pay tax on) when the owner dies and ownership of the residential or commercial property is transferred to its beneficiaries. All you give up is control of the residential or commercial property for the regard to the lease and a greater participation in the revenues originated from the new building, however without the majority of the threat that goes with structure and operating a brand-new structure. More on risks later on.

To make the offer sweeter, a lot of ground leases are structured with regular increases in the ground rent to secure versus inflation and likewise have reasonable market price ground lease "resets" every 20 or so years, so that the owner gets to enjoy that 5%-6% return on the future, hopefully increased value of the residential or commercial property.

Another positive characteristic of an advancement ground lease is that when the brand-new building has been constructed and rented up, the property manager's ownership of the residential or commercial property including the rental stream from the ground lease is a sellable and financeable interest in realty. At the exact same time, the developer's rental stream from operating the residential or commercial property is likewise sellable and financeable, and if the lease is prepared appropriately, either can be sold or funded without threat to the other celebration's interest in their residential or commercial property. That is, the owner can obtain cash versus the value of the ground leas paid by the developer without impacting the developer's ability to fund the building, and vice versa.

So, what are the disadvantages, you might ask. Well initially, the owner gives up all control and all possible revenues to be stemmed from structure and running a brand-new structure 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 transfer your residential or commercial property to the designer and the old building gets destroyed, the residential or commercial property no longer is leasable and will not be producing any earnings. That will last for 2-3 years until the brand-new structure is constructed and totally tenanted. If the designer stops working to develop the structure or stops halfway, the owner can get the residential or commercial property back by cancelling the lease, however with a partly developed structure on it that creates no earnings and even worse, will cost millions to complete and rent up. That's why you should make definitely sure that whoever you lease the residential or commercial property to is a proficient and knowledgeable contractor who has the monetary wherewithal to both pay the ground lease and complete the building of the building. Complicated legal and service options to offer protection against these threats are beyond the scope of this post, but they exist and require that you discover the best business consultants and legal counsel.

The Development Joint Venture

Not pleased with a boring, coupon-clipping, long-term ground lease with minimal participation and limited upside? Do you desire to take advantage of your ownership of an undeveloped or underdeveloped piece of residential or commercial property into an interesting, brand-new, bigger and much better financial investment? Then possibly an advancement joint venture is for you. In a development joint endeavor, the owner contributes ownership of the residential or commercial property to a limited 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 endeavor, which percentage is identified by dividing the reasonable market value of the land by the overall task expense of the brand-new structure. So, for instance, if the worth of the land is $ 3million and it will cost $21 million to build the brand-new building and lease it up, the owner will be credited with a 12.5% ($3mm divided by $24mm) interest in the entity that owns the new building and will get involved in 12.5% of the operating earnings, any refinancing earnings, and the earnings on sale.

There is no earnings tax or state and local transfer tax on the contribution of the residential or commercial property to the joint endeavor and for now, a basis step up to reasonable market price is still available to the owner of the 12.5% joint endeavor interest upon death. Putting the joint endeavor together raises various questions that need to be negotiated and solved. For example: 1) if more money is required to complete the structure than was initially budgeted, who is accountable to come up with the extra funds? 2) does the owner get its $3mm dollars returned first (a priority distribution) or do all dollars come out 12.5%:87.5% (pro rata)? 3) does the owner get a guaranteed return on its $3mm financial investment (a choice payment)? 4) who gets to manage the daily service choices? or significant decisions like when to re-finance or sell the new structure? 5) can either of the members transfer their interests when desired? or 6) if we build condos, can the members take their earnings out by getting ownership of certain houses or retail areas instead of money? There is a lot to unload in putting a strong and reasonable joint endeavor agreement together.

And after that there is a threat analysis to be done here too. In the development joint venture, the now-former residential or commercial property owner no longer owns or manages the dirt. The owner has actually acquired a 12.5% MINORITY interest in the operation, albeit a bigger project than in the past. The threat of a failure of the project doesn't just result in the termination of the ground lease, it could result in a foreclosure and maybe overall loss of the residential or commercial property. And after that there is the possibility that the market for the brand-new building isn't as strong as initially forecasted and the new structure does not generate the level of rental income that was expected. Conversely, the building gets developed on time, on or under budget, into a robust leasing market and it's a crowning achievement where the value of the 12.5% joint venture interest far exceeds 100% of the value of the undeveloped parcel. The taking of these dangers can be significantly decreased by picking the same competent, experience and economically strong developer partner and if the anticipated benefits are large enough, a well-prepared residential or commercial property owner would be more than justified to handle those risks.

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 experienced professionals. Brokers who understand advancement, accounting professionals and other monetary advisors, development consultants who will deal with behalf of an owner and of course, good experienced legal counsel. My 2nd piece of recommendations is to utilize those specialists to identify the financial, market and legal dynamics of the possible deal. The dollars and the offer potential will drive the choice to establish or not, and the structure. My 3rd piece of advice to my clients is to be real to themselves and try to come to a sincere realization about the level of threat they will want to take, their ability to discover the ideal designer partner and after that trust that designer to manage this process for both party's mutual financial advantage. More quickly stated than done, I can assure you.

Final Thought

Both of these structures work and have for years. They are particularly popular now since the expense of land and the cost of building and construction products are so pricey. The magic is that these development ground leases, and joint ventures supply a less costly way for a developer to manage and redevelop a piece of residential or commercial property. Less expensive in that the ground rent a designer pays the owner, or the revenue the designer shares with a joint venture partner is either less, less risky or both, than if the designer had actually purchased the land outright, and that's a good idea. These are advanced transactions that demand sophisticated experts working on your behalf to keep you safe from the threats inherent in any redevelopment of property and guide you to the increased value in your residential or commercial property that you look for.