Ground leasing – options for reform to get the buyers back

Investor confidence in leasehold property, particularly in the Auckland residential market, is at an all time low after a series of very large and hotly contested rent reviews over the past 12 months. 

But although the ground lease is down, it would be premature to call it out. It has some valuable features to offer landowners, developers and tenants.

Ground leases have a strong track record of facilitating the development of large sites where no single developer has the resources to both acquire the land and carry out the development.  This will be especially relevant with the tighter lending criteria which will be the legacy of the global credit crunch.

We may also see an increase in ground leasing by public authorities as a tool to increase housing affordability and to control the built environment of our inner cities as it becomes increasingly apparent that the Resource Management Act does not necessarily guarantee good quality urban design. 

So what is a ground lease?  In its simplest form, it is a legal device where the landowner retains ownership of the land but leases to a tenant the right to develop and own buildings on that land. 

Most ground leases link the rent to a fixed percentage of the value of the land as a bare site, with regular rent reviews occurring every 5 to 7 years.  The net result is that the landlord retains the benefit of any increases in land value and also receives a long term income stream.

An added benefit is that once the site has been developed, the landlord’s rental income is secured by the value of the tenant’s improvements.  If the tenant defaults in payment, the landlord’s ultimate recourse is cancellation of the lease following which the landlord obtains the windfall of owning both the land and the buildings. 

Not surprisingly, ground lease property remains an attractive investment for landlords, especially where the site is fully developed.

For the tenant the picture is mixed. Although ground leasing creates an opportunity to buy a higher quality property for a lower up front cost the price paid by tenant investors has often failed to take into account future ground rent increases on review. 

This is not surprising as ground rents have increased at a faster rate than most people could have anticipated.  As a result of the global financial crisis, it may be many years before we see these increases again.  But at some future point, land values will start rebounding and the process will start all over again with tenants having to contend once more with increasing uncertainty and volatility. 

Tenant investors also need to be aware that most ground rents are set with reference to the unimproved value of the land based on its “highest and best use”.  A subsequent change to the district plan to allow a more intensive development of the site will drive a significant increase in land value which will in turn drive a significant increase in ground rent at the next review. 

Unless ground leasing evolves to recognise these issues, it may take many years to attract buyers back to the market.  Options include:

  • Linking the ground rent to CPI or to a fixed percentage increase.  This would, at the very least, promote greater transparency and avoid nasty surprises on review.  
  • The developer pre-paying the ground rent for a significant period of time (in excess of 25 years).
  • Retaining the link to increases in land value but halving  the percentage used to calculate ground rent.  The tenant would have to pay a higher lease premium up front but the reward would be reduced exposure to changes in land value over time. 
  • Fixing the ground rent as a percentage of the rental income received by the tenant, which would better align the interests of landlord, developer and tenant (although such a structure is more appropriate to commercial property).  

Landowners and developers drafting new ground leases would be well advised to consider these options if they are to win back the confidence of tenant investors.  If this does not happen then the damage done by recent media commentary may prove to be more lasting.  

This article first appeared in the New Zealand Herald on Wednesday 10th December 2008. Mark Nicholson is a Principal at Chapman Tripp.  These views are his own rather than the firm’s or its clients.

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