Why do people buy on leased land?

Question

I came across what looked like a great property on Loopnet.  It's a Starbucks, yogurt shop, and Subway on a parcel in a large shopping center in a great area at 8.26% cap.  After dropping everything to go look at it, I decided to make an offer (my first non-residential deal!)  As I was researching the deed, I realized that it's on leased land and that the land was not being offered for sale.  There are about 20 years left on the lease.  Am I correct that after the lease ends, the land owner would own the building?  Since you make money in real estate 4 ways (appreciation, cash flow, amortization, tax shelter), why would any investor in their right mind buy something like this, where you don't get the benefits of appreciation and amortization?  I was unhappy with the realtor for not making this clear in his listing and wasting my time, but he brushed it off like it's normal.  Am I missing something?

Bill Gulley · Answer

Can't run a business from a bond. The building residual may go back to the land owner as well and in return the lease may be discounted. You can figure your return on a property like this (or any other) but you can't figure the return that a tenant or owner may realize. It's also irrelevant what their return has been.

A corporation doesn't look at a business location as an individual RE investor might, there is no  passive income or "retirement income". You may consider your home as an investment, but it's not an earning asset, no income but you have an economic benefit from owning. :)

Bill Gulley · Answer

Short answer; it's cheaper.

The lease is 100% expensed along with depreciation of improvements, increased cash flow, building costs are depreciated, residual is written off, tax liability impact is less, if not, they don't go there. Leases often will be renewable at some set basis so the option of staying may be there. May have an option to buy as well. They will consider their cost of capital and take the most beneficial route. Not all businesses even plan on being in a location for 20 years, economic and growth trends may tell them they will be there for 12 years, they can lease out for eight years and be on the green side. Lots of factors, but it is common, very common. Consider too, great locations may not be for sale, it's the only way you'll get into that location. It's all about the money! :)

Bill Gulley · Answer

Only thing riskier would be selling ice cream to Eskimos in Alaska I'd think, but I'm sure they have it, I just wouldn't count on annual sales projections too much.

Know the business that goes into a commercial space, if you don't understand the business you can't really determine their ability to pay the lease. :)

Joel Owens · Answer

This is where who is guaranteeing the lease matters. If Cold Stone was a corp guarantee then it wouldn't matter if the store was losing money every year. They would be obligated to pay the lease until primary term ends unless the whole parent corp. went under . This versus an individual or small franchisee where the personal guarantee doesn't mean much because they can go under quick.

When looking at these types of buildings lenders look for credit grade to investment grade tenants backing the lease and how much of a percentage do they make up of the total building?

Example if you have 5 units and breakeven occupancy on a loan for this property would be 60% and corp tenants only makeup 20% of the building then the loan is being carried by mom and pop and poses more risk. If on the other hand 3 to 4 units are corp it pretty much covers the breakeven occupancy level of the loan.

Amy A. · Answer

Thank you both for the insight!  I'm glad to see he added that it's a ground lease, I'm quite sure that wasn't stated a few weeks ago when I received notice of the listing.  When I asked him about it after figuring it out myself, he said something about it being confidential.  I've been sitting on this question for a while now as I've been busy with other things.

I know, an ice-cream or yogurt store in Maine is pretty risky!  Most of them shut down for the winter.  Our local frozen custard shop just opened on Mothers' Day.

Joel Owens · Answer

Hi Amy,

It's sounds like you are talking about a ground lease. At the end of the ground lease usually listed in the lease terms the building reverts back to the owner.

Now in rare cases it's not a ground lease but a leasehold interest where you are just buying the income stream for whatever set time is left before the options kick in. You are  ago between for the tenant and the land owner. The payouts are usually higher but you have a ton of risk and financing on those deals is very tough to get. I see leaseholds maybe 2% of the time. Ground leases maybe 10 to 12% of the time. The rest are usually NN or NNN absolute lease structures.

A buyer might purchase this for just the income stream. They might not care about the tax component of it and may already have multiple of those in their portfolio.

I have some clients that own zero cash flow deals on properties for advanced tax strategies, regular NNN, and some ground leases for a mix.

I just found your property you were looking at. Originally listed on 5/1/2014

It says right in description:

----------------------------------------------------------------------------------------

Description

( kept company listed private) Real Estate is pleased to offer for sale this prime retail investment located in the heart of Cooks Corner in Brunswick, Maine.  The property consists of a three unit, 5,744 +/- square foot retail building that is 100% leased to Starbucks, Subway, and Orange Leaf.  Situated on 0.68 +/- acres (under LONG TERM GROUND LEASE), the premises offers a drive thru for Starbucks, outdoor seating, and 44 onsite parking spaces.

--------------------------------------------------------------------------------------------

It is a nice property. The problem will be that Cold Stone Creamery went out there and a yogurt shop came in for 2013. The Subway ( have to know if it's a franchisee or corp guarantee) and the Starbucks only show to have 4 years left on recently renewed options.

The fact that it's a ground lease, 4 years left on primary renewed lease, and a low price in the 800's you are looking at a local bank with likely a 5 year term and the amort. might be 20. The low loan price the fixed interest rate is likely higher and you will have recourse on it.

I have these conversations everyday with new clients. If you want commercial you need someone who does this day in and day out to know what Is being looked at. The financing on a deal makes or breaks a return and that it tied to lease terms, quality of the tenants, location, and loan size being sought.

In these situations I would try to negotiate the renewal of the lease another 5 years before closing to extend to 9 years primary. You have to sweeten the pot to the tenants to get them to consider this otherwise they will stick to the original layout of the lease and renewals. Another key is the sales. The cold stone creamery went out. I would imagine because cold items are not a year round draw like a Starbucks and a Subway would be in that area serving hot foods and drinks as a selection. I look sales for the national average for  a Subway and a Starbucks and then see if they are below average, at par, or above average top performer for the company. Also the trending of the last few years for sales and the percentage of sales to lease payment.

Hope it helps.

Amy A. · Answer

Thanks!  So are you saying that it makes sense for a business that wants that location, but not as much for a passive investor looking for retirement income?  If one were paying all cash, they would have an 8% return plus tax benefits with some inflation protection via rent increases, but at the end of 20 years they would not get the principal back, so it's not truly an 8% return.  Am I correct on this?  Unless you want to pick up the building and move it, the owner of the land under the building would own the building at the end of the land lease.  I don't have time to calculate the actual return now, but it seems it would be very low and would make more sense to invest in bonds.

Why do people buy on leased land?

Most Popular Reply