If you own property in an up-and-coming area or own residential or commercial property that could be redeveloped into a "greater and better use", then you have actually pertained to the ideal place! This article will assist you sum up and hopefully demystify these two techniques of improving a piece of realty while getting involved handsomely in the upside.

The Development Ground Lease

The Development Ground Lease is a contract, usually ranging from 49 years to 150 years, where the owner transfers all the advantages and problems of ownership (elegant legalese for future earnings and costs!) to a developer in exchange for a month-to-month or quarterly ground rent payment that will range from 5%-6% of the fair market worth of the residential or commercial property. It enables the owner to enjoy an excellent return on the worth of its residential or commercial property without needing to offer it and doesn't need the owner itself to handle the incredible risk and issue of building a new building and finding tenants to occupy the new structure, abilities which lots of property owners just don't have or desire to find out. You may have also heard that ground lease rents are "triple internet" which indicates that the owner sustains no costs of operating of the residential or commercial property (besides earnings tax on the received lease) and gets to keep the complete "net" return of the negotiated lease payments. All real! Put another method, throughout the term of the ground lease, the developer/ground lease renter, handles all responsibility for real estate taxes, building and construction expenses, borrowing costs, repair work and upkeep, and all operating costs of the dirt and the new building to be constructed on it. Sounds respectable right. There's more!

This ground lease structure also allows the owner to delight in a reasonable return on the present value of its residential or commercial property WITHOUT having to sell it, WITHOUT paying capital gains tax and, under present law, WITH a tax basis step-up (which reduces the amount of gain the owner would ultimately pay tax on) when the owner passes away and ownership of the residential or commercial property is moved to its heirs. All you provide up is control of the residential or commercial property for the regard to the lease and a greater participation in the earnings obtained from the new structure, but without the majority of the danger that chooses structure and running a brand-new structure. More on dangers later.

To make the deal sweeter, a lot of ground leases are structured with periodic increases in the ground rent to protect versus inflation and likewise have fair market worth ground rent "resets" every 20 or two years, so that the owner gets to take pleasure in that 5%-6% return on the future, ideally increased value of the residential or commercial property.

Another positive quality of a development ground lease is that when the brand-new structure has actually been built and leased up, the property manager's ownership of the residential or commercial property consisting of 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 also sellable and financeable, and if the lease is prepared effectively, either can be sold or financed without risk to the other party's interest in their residential or commercial property. That is, the owner can borrow money against the value of the ground rents paid by the developer without impacting the designer's capability to finance the building, and vice versa.

So, what are the disadvantages, you might ask. Well first, the owner provides up all control and all possible profits to be originated from building and running a new building for in 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 risk is genuine. The minute you move your residential or commercial property to the developer and the old structure gets demolished, 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 fully tenanted. If the developer stops working to build the building or stops midway, the owner can get the residential or commercial property back by cancelling the lease, however with a partly developed building on it that produces no revenue and worse, will cost millions to complete and lease up. That's why you should make absolutely sure that whoever you lease the residential or commercial property to is an experienced and experienced contractor who has the financial wherewithal to both pay the ground rent and finish the building and construction of the structure. Complicated legal and company options to offer defense against these risks are beyond the scope of this article, but they exist and require that you discover the right organization advisors and legal counsel.

The Development Joint Venture

Not satisfied with a boring, coupon-clipping, long-lasting ground lease with restricted involvement and minimal upside? Do you desire to leverage your ownership of an undeveloped or underdeveloped piece of residential or commercial property into an amazing, new, larger and much better investment? Then perhaps a development joint venture is for you. In an advancement joint endeavor, the owner contributes ownership of the residential or commercial property to a minimal liability business whose owners (members) are the owner and the developer. The owner trades its ownership of the land in exchange for a percentage ownership in the joint venture, which percentage is figured out by dividing the reasonable market price of the land by the total task cost of the brand-new structure. So, for example, if the value 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 structure and will take part in 12.5% of the operating profits, any refinancing proceeds, and the revenue 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 venture and for now, a basis step up to fair market value is still readily available to the owner of the 12.5% joint venture interest upon death. Putting the joint endeavor together raises numerous questions that need to be worked out and fixed. For example: 1) if more cash is required to end up the structure than was originally budgeted, who is accountable to come up with the additional 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 investment (a preference payment)? 4) who gets to control the daily company choices? or major decisions like when to refinance or sell the new building? 5) can either of the members move their interests when wanted? or 6) if we develop condominiums, can the members take their earnings out by getting ownership of particular homes or retail areas rather of money? There is a lot to unpack in putting a strong and reasonable joint venture contract together.

And after that there is a danger analysis to be done here too. In the advancement joint venture, the now-former residential or commercial property owner no longer owns or controls the dirt. The owner has actually gotten a 12.5% MINORITY interest in the operation, albeit a larger project than before. The danger of a failure of the job doesn't simply lead to the termination of the ground lease, it might lead to a foreclosure and possibly overall loss of the residential or commercial property. And after that there is the possibility that the marketplace for the new building isn't as strong as initially forecasted and the brand-new building doesn't produce the level of rental earnings that was expected. Conversely, the building gets constructed on time, on or under spending plan, into a robust leasing market and it's a home run where the worth of the 12.5% joint venture interest far surpasses 100% of the worth of the undeveloped parcel. The taking of these dangers can be significantly lowered by picking the same qualified, experience and financially strong designer partner and if the anticipated benefits are big enough, a well-prepared residential or commercial property owner would be more than warranted to take on those threats.

What's an Owner to Do?

My first piece of guidance to anyone thinking about the redevelopment of their residential or commercial property is to surround themselves with experienced professionals. Brokers who comprehend advancement, accountants and other monetary consultants, development consultants who will work on behalf of an owner and of course, good experienced legal counsel. My 2nd piece of recommendations is to utilize those professionals to identify the financial, market and legal characteristics of the possible deal. The dollars and the deal capacity will drive the choice to establish or not, and the structure. My third piece of guidance to my clients is to be true to themselves and try to come to a sincere awareness about the level of threat they will be ready to take, their capability to find the right developer partner and after that trust that developer to manage this process for both celebration's shared financial advantage. More easily stated than done, I can ensure you.

Final Thought

Both of these structures work and have for years. They are particularly popular now due to the fact that the expense of land and the expense of building and construction products are so pricey. The magic is that these advancement ground leases, and joint ventures provide a more economical way for a developer to control and redevelop a piece of residential or commercial property. More economical in that the ground rent a designer pays the owner, or the earnings the developer shares with a joint venture partner is either less, less dangerous or both, than if the developer had purchased the land outright, and that's an advantage. These are advanced transactions that require advanced experts working on your behalf to keep you safe from the risks inherent in any redevelopment of property and guide you to the increased value in your residential or commercial property that you look for.