If you own property in an up-and-coming location or own residential or commercial property that could be redeveloped into a "greater and better use", then you've pertained to the ideal place! This post will help you summarize and hopefully debunk these two approaches of improving a piece of realty while taking part handsomely in the upside.

The Development Ground Lease

The Development Ground Lease is an agreement, normally ranging from 49 years to 150 years, where the owner transfers all the benefits and problems of ownership (fancy legalese for future earnings and costs!) to a designer in exchange for a monthly or quarterly ground rent payment that will vary from 5%-6% of the reasonable market worth of the residential or commercial property. It allows the owner to enjoy an excellent return on the worth of its residential or commercial property without needing to offer it and does not need the owner itself to take on the remarkable threat and problem of constructing a brand-new structure and finding occupants to inhabit the new building, skills which many property owners merely do not have or want to learn. You may have likewise heard that ground lease rents are "triple internet" which indicates that the owner incurs no charges of operating of the residential or commercial property (other than income tax on the gotten lease) and gets to keep the full "net" return of the negotiated lease payments. All true! Put another method, during the regard to the ground lease, the developer/ground lease tenant, takes on all obligation genuine estate taxes, building and construction costs, obtaining costs, repairs and upkeep, and all operating expenses of the dirt and the new structure to be constructed on it. Sounds respectable right. There's more!

This ground lease structure also permits the owner to delight in a sensible return on the present value of its residential or commercial property WITHOUT having to offer it, WITHOUT paying capital gains tax and, under current law, WITH a tax basis step-up (which decreases the quantity of gain the owner would eventually pay tax on) when the owner dies and ownership of the residential or commercial property is transferred to its successors. All you offer up is control of the residential or commercial property for the term of the lease and a greater involvement in the profits stemmed from the brand-new structure, however without the majority of the risk that goes with building and operating a new structure. More on dangers later.

To make the offer sweeter, a lot of ground leases are structured with regular boosts in the ground lease to protect versus inflation and likewise have fair market price ground rent "resets" every 20 or so years, so that the owner gets to enjoy that 5%-6% return on the future, ideally increased value of the residential or commercial property.

Another positive attribute of an advancement ground lease is that when the brand-new building has been developed 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 developer's rental stream from operating the residential or commercial property is likewise sellable and financeable, and if the lease is prepared properly, either can be sold or funded without threat to the other party's interest in their residential or commercial property. That is, the owner can obtain cash against the worth of the ground leas paid by the designer without impacting the developer's capability to finance the building, and vice versa.

So, what are the downsides, you may ask. Well initially, the owner quits all control and all prospective profits to be derived from building and operating a brand-new structure 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 threat is genuine. The minute you transfer your residential or commercial property to the developer and the old building gets demolished, the residential or commercial property no longer is leasable and will not be producing any revenue. That will last for 2-3 years until the brand-new building is developed and completely tenanted. If the designer stops working to develop the structure or stops midway, the owner can get the residential or commercial property back by cancelling the lease, however with a partly built building on it that produces no income and worse, will cost millions to complete and rent up. That's why you should make absolutely sure that whoever you rent the residential or commercial property to is a proficient and knowledgeable builder who has the financial wherewithal to both pay the ground lease and finish the building and construction of the structure. Complicated legal and business options to provide defense against these dangers are beyond the scope of this article, however they exist and require that you find the right business consultants and legal counsel.

The Development Joint Venture

Not pleased with a boring, coupon-clipping, long-lasting ground lease with limited involvement and restricted advantage? Do you want to take advantage of your ownership of an undeveloped or underdeveloped piece of residential or commercial property into an amazing, new, bigger and 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 limited liability business 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 identified by dividing the reasonable market price of the land by the overall job expense of the brand-new structure. So, for example, if the value 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 new building and will take part in 12.5% of the operating profits, any refinancing earnings, and the earnings on sale.

There is no earnings tax or state and regional 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 price is still offered to the owner of the 12.5% joint endeavor interest upon death. Putting the joint venture together raises various concerns that need to be worked out and solved. For instance: 1) if more cash is needed to finish the building than was initially budgeted, who is responsible to come up with the extra funds? 2) does the owner get its $3mm dollars returned initially (a top 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 choice payment)? 4) who gets to manage the day-to-day business decisions? or major choices like when to refinance or sell the new building? 5) can either of the members transfer their interests when desired? or 6) if we construct condos, can the members take their profit out by getting ownership of specific houses or retail spaces rather of money? There is a lot to unload 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 venture, the now-former residential or commercial property owner no longer owns or manages the dirt. The owner has actually acquired a 12.5% MINORITY interest in the operation, albeit a larger task than in the past. The risk of a failure of the project doesn't just lead to the termination of the ground lease, it could lead to a foreclosure and maybe overall loss of the residential or commercial property. And then there is the possibility that the marketplace for the brand-new building isn't as strong as initially projected and the brand-new building does not produce the level of rental income that was expected. Conversely, the structure gets constructed on time, on or under budget, into a robust leasing market and it's a home run where the value of the 12.5% joint venture interest far exceeds 100% of the value of the undeveloped parcel. The taking of these risks can be considerably reduced by choosing the very same skilled, experience and financially strong designer partner and if the expected advantages are big enough, a well-prepared residential or commercial property owner would be more than warranted to handle those threats.

What's an Owner to Do?

My very first piece of guidance to anybody considering the redevelopment of their residential or commercial property is to surround themselves with skilled specialists. Brokers who understand development, accounting professionals and other financial consultants, advancement specialists who will work on behalf of an owner and naturally, excellent skilled legal counsel. My 2nd piece of advice is to use those professionals to identify the economic, market and legal dynamics of the prospective deal. The dollars and the deal potential will drive the decision to establish or not, and the structure. My third piece of recommendations to my clients is to be true to themselves and try to come to an honest awareness about the level of threat they will want to take, their capability to find the ideal developer partner and after that trust that developer to manage this process for both party's mutual economic benefit. More easily stated than done, I can ensure you.

Final Thought

Both of these structures work and have for years. They are especially popular now because the cost of land and the expense of building products are so pricey. The magic is that these advancement ground leases, and joint endeavors offer a cheaper way for a developer to manage and redevelop a piece of residential or commercial property. Less costly because the ground rent a developer pays the owner, or the revenue the designer shares with a joint venture partner is either less, less risky or both, than if the developer had actually bought the land outright, which's an advantage. These are sophisticated deals that demand advanced specialists working on your behalf to keep you safe from the dangers intrinsic in any redevelopment of realty and guide you to the increased value in your residential or commercial property that you seek.