Is leasehold property a good idea?

Question

Has anyone ever purchased a deal where a municipality owns the land and the improvements and rents it to the tenant to sublease? This example is an apartment complex in an industrial area owned by an airport. The "rent" is 3% of the gross revenues generated by the property. The airport had the buildings (from when federal gov turned the land over to the Airport Authority after WW2.) and allowed the current "owner" to spend a few $M improving the buildings. They signed a lease for 99 years and it's assumable. The price to the "owner" is the same as a normally valued apartment complex. So... can I:

1. Take depreciation on the structures if I don't own them? Are there any IRS exclusions for long term land leases?

2. Get financing from a lender?

3. Deed the property to me FROM a federal entity (now subject to property taxes)?

There is currently nothing in the lease that talks about what happens at the end of the lease. The airport is willing to make a new lease with us down the road. Is it unreasonable to pay a normally valued apartment price for something that is actually just the rights to a lease?

Dennis Bragg · Answer

Ryan, this kind of deal reminds me of a situation a friend of mine, Carla, encountered a few years back in a suburb near San Diego. She had a client who picked up a leasehold interest in a shopping complex on land owned by the city. But in their case, the lease was long enough and well-structured enough that the income and stability felt almost like a normal acquisition.

In your scenario, the airport authority charging a rent based on a percentage of gross revenue isn’t unheard of, and from what I’ve read in The Economist, these ground lease structures can pop up in different forms. You need to make sure you understand every detail: how the lease terms adapt over time, what kind of negotiating room you’ll have when it’s time to renew, and whether lenders in your area are open-minded about financing these kinds of ground leases. Some lenders do see a 99-year lease..especially one that’s asumable..as pretty close to ownership, just with an asterisk. But you’ll want to do a little digging and maybe talk to a local lender who’s dealt with ground leases before, from what I’ve heard.

On the tax front, if you have the benefits and burdens of ownership for the structures, depreciation might still be on the table. That’s not guarenteed..talk to a CPA who’s handled something similar, as these nuances can get tricky. If the improvements were recognized as taxable property before, you might be able to keep the property taxes and depreciation setup. It’s a good idea to confirm you have a path to record title in a way that’s financeable, even though this isn’t a standard fee-simple sale.

The big question is whether it’s reasonable to pay a market-rate price when you’re not actually scooping up the land. Sometimes, yes. If you have a stable asset, predictable returns, and a lease structure that’s well-known and well-documented, a regular market valuation might make sense. But if the lease terms are murky, if renewal conditions aren’t guarenteed, or if the airport authority could dramatically shift the deal down the line, then you should be asking for a discount..or at least some protective clauses in the contract.

I’m curious... if you were to step into this kind of leasehold now, how do you think you’d explain the upside to your future buyers or partners when you eventually decide to exit?

Ryan Sajdera · Answer

@Dennis Bragg I keep getting hung up on the depreciation end as if its allowed or not. What I've found so far is that I can 1031 into it as long as the lease is longer than 30 years. I also talked to the city. If the airport authority would deed the buildings to me, it would cause them to be entered on the tax roll. My 21k per year rent payment to the airport would now be 80k in taxes. The benefit here is that I cannot get behind on taxes and if I fall on hard times and my buildings are empty, my rent payment is based on my income, so I guess that is attractive. Lower income = lower rent. The property also comes with 7 acres that the airport told me i could improve with their permission. I can build a mini storage or whatever as long as the zoning is compliant. Or I can make it a gravel lot, put up a fence, and call it boat and rv storage. The ability to generate more income for simply the cost of a building is another huge cost saving over buying an expensive commercial lot and developing it. I also think that if I can make all of my money back in 4 years with a cash out refinance, what is the danger? After cash out refi in 4 or 5 years, it's all pretend money from there on out. Another thing that my brain keeps milling on is the fact that if in a normally purchased deal, I work hard and pay off a 3 million dollar building in 20 years, and then don't pay my 80k annual property tax, I'm going to lose my 3M building that I "own" but somehow don't really actually own. So who cares if I own or not? I'll be dead by the time the lease ends, so I just need to be able to depreciate it and leverage it and I think it should be pretty close to owning.  As a side note the airport is interested in making a new lease. The current 99 year lease started in 1987, not 1945. And it doesn't even talk about what happens at the end because I guess they all just assumed we'd accidentally fly our cars into the sun in 99 years. 🫠  but there has been some legislation passed that prevents them from going more than 50 year leases. So we would go from a 60 something year lease (it has been extended when she purchased 10 years ago), to a 49 year lease. I would push for a clause that states the buildings and land deed to the leasee after the termination of the lease. That gives an investor a real asset to collateralize and it gives them incentive to not let the buildings dilapidate at the end of the lease. They are very win win oriented and they say each lease is unique and creative it different ways because each of the 130 businesses there are in buildings, factories, hangars, and shops all located on federal ground. So I'm confident I could find a solution, but would probably be forced to walk away if there was no favorable outcome for lease termination for the investor.

Bill B. · Answer

So in less than 20 years you have to give the building back to the government? (99 years from 1945). Seems like they be worth nearly zero in 10-15 years.

The only good use I can see of the fees are based on rent charged would be for a tenant to purchase it and charge themselves $0 or near $0 rent to avoid the rent based charges.