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If you own realty in an up-and-coming area or own residential or commercial property that might be redeveloped into a "greater and much better use", then you have actually come to the ideal place! This post will help you sum up and ideally demystify these 2 methods of improving a piece of property while getting involved handsomely in the benefit.

The Development Ground Lease

The Development Ground Lease is a contract, usually varying from 49 years to 150 years, where the owner transfers all the benefits and problems of ownership (elegant legalese for future profits and costs!) to a developer 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 take pleasure in an excellent return on the worth of its residential or commercial property without having to sell it and doesn't need the owner itself to take on the significant risk and issue of building a new structure and finding occupants to inhabit the new structure, skills which numerous property owners just don't have or want to find out. You may have also heard that ground lease rents are "triple internet" which implies that the owner incurs no costs of operating of the residential or commercial property (aside from income tax on the received rent) and gets to keep the full "net" return of the negotiated rent payments. All true! Put another way, throughout the regard to the ground lease, the developer/ground lease occupant, handles all responsibility for genuine estate taxes, building and construction costs, obtaining expenses, repair work and upkeep, and all running expenses of the dirt and the new structure to be constructed on it. Sounds quite great right. There's more!

This ground lease structure likewise allows the owner to enjoy an affordable return on the existing value 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 lowers the quantity of gain the owner would ultimately pay tax on) when the owner passes away and ownership of the residential or commercial property is transferred to its heirs. All you quit is control of the residential or commercial property for the regard to the lease and a higher participation in the earnings derived from the brand-new building, but without the majority of the risk that opts for structure and running a new building. More on risks later on.
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To make the deal sweeter, the majority of ground leases are structured with periodic boosts in the ground rent to safeguard against inflation and likewise have fair market worth ground rent "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 quality of a development ground lease is that as soon as the new structure has been constructed and rented up, the proprietor's ownership of the residential or commercial property including the rental stream from the ground lease is a sellable and financeable interest in genuine estate. At the very same time, the designer's rental stream from running the residential or commercial property is also sellable and financeable, and if the lease is prepared appropriately, either can be sold or funded without danger to the other party's interest in their residential or commercial property. That is, the owner can obtain money against the value of the ground rents paid by the designer without impacting the developer's ability to finance the building, and vice versa.
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So, what are the disadvantages, you may ask. Well first, the owner quits all control and all potential profits to be originated from building and operating a brand-new building for between 49 and 150 years in exchange for the security of limited ground lease. Second, there is danger. It is predominantly front-loaded in the lease term, however the threat is genuine. The minute you move your residential or commercial property to the developer and the old structure 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 up until the brand-new structure is developed and fully tenanted. If the developer fails to construct the structure or stops halfway, the owner can get the residential or commercial property back by cancelling the lease, however with a partially constructed building on it that creates no revenue and even worse, will cost millions to finish and lease up. That's why you must make absolutely sure that whoever you rent the residential or commercial property to is a proficient and skilled home builder who has the financial wherewithal to both pay the ground lease and complete the building of the structure. Complicated legal and business solutions to offer protection against these are beyond the scope of this post, but they exist and require that you find the right company consultants and legal counsel.

The Development Joint Venture

Not satisfied with a boring, coupon-clipping, long-term ground lease with restricted involvement and minimal advantage? Do you want to leverage your ownership of an undeveloped or underdeveloped piece of residential or commercial property into an exciting, new, larger and better financial investment? Then maybe an advancement joint endeavor is for you. In an advancement joint venture, the owner contributes ownership of the residential or commercial property to a restricted liability company whose owners (members) are the owner and the developer. The owner trades its ownership of the land in exchange for a portion ownership in the joint venture, which portion is determined by dividing the reasonable market value of the land by the overall job expense of the new structure. So, for example, if the worth of the land is $ 3million and it will cost $21 million to construct 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 structure and will take part in 12.5% of the operating revenues, any refinancing earnings, and the profit 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 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 need to be negotiated and solved. For example: 1) if more money is needed to finish the building than was originally allocated, who is accountable to come up with the extra funds? 2) does the owner get its $3mm dollars returned initially (a concern circulation) or do all dollars come out 12.5%:87.5% (pro rata)? 3) does the owner get an ensured return on its $3mm financial investment (a choice payment)? 4) who gets to manage the day-to-day service decisions? or significant decisions like when to re-finance or sell the brand-new structure? 5) can either of the members transfer their interests when preferred? or 6) if we develop condos, can the members take their revenue out by getting ownership of certain homes or retail areas instead of money? There is a lot to unpack in putting a strong and fair joint endeavor contract together.

And then there is a threat analysis to be done here too. In the advancement joint endeavor, 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 in the past. The threat of a failure of the task doesn't just lead to the termination of the ground lease, it could lead to a foreclosure and perhaps total loss of the residential or commercial property. And after that there is the possibility that the market for the new structure isn't as strong as initially projected and the brand-new structure doesn't create the level of rental income that was anticipated. Conversely, the structure gets developed on time, on or under budget plan, into a robust leasing market and it's a crowning achievement where the value of the 12.5% joint endeavor interest far exceeds 100% of the worth of the undeveloped parcel. The taking of these risks can be considerably reduced by selecting the same skilled, experience and financially strong developer partner and if the anticipated advantages are big 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 first piece of recommendations to anyone thinking about the redevelopment of their residential or commercial property is to surround themselves with knowledgeable professionals. Brokers who comprehend advancement, accountants and other financial advisors, development specialists who will work on behalf of an owner and obviously, excellent experienced legal counsel. My second piece of advice is to use those professionals to determine the financial, market and legal characteristics of the possible transaction. The dollars and the offer capacity will drive the choice to develop or not, and the structure. My third piece of guidance to my clients is to be real to themselves and attempt to come to a sincere awareness about the level of risk they will be willing to take, their ability to find the ideal developer partner and then trust that designer to manage this procedure for both celebration's mutual economic advantage. More easily said than done, I can ensure you.

Final Thought

Both of these structures work and have for years. They are especially popular now since the expense of land and the expense of building materials are so costly. The magic is that these advancement ground leases, and joint endeavors provide a less costly way for a designer to manage and redevelop a piece of residential or commercial property. Less costly in that the ground rent a designer pays the owner, or the profit the developer show a joint endeavor partner is either less, less dangerous or both, than if the developer had purchased the land outright, and that's a good thing. These are advanced deals that require advanced specialists working on your behalf to keep you safe from the risks intrinsic in any redevelopment of realty and guide you to the increased value in your residential or commercial property that you seek.