Slaying the Land Cost Dragon

DEVELOPMENT ON A GROUND LEASE

GUY

By Dennis M. Sughrue

Developers in New York now confront a stark, new reality. In established Manhattan and Brooklyn neighborhoods, for the first time in memory, land prices exceed construction costs. This calculus shapes the development landscape in profound ways. In this market, only luxury condominium development “pencils out”, accelerating a shift away from rental development, toward construction targeted at the rich.

The trend is ominous. An industry tied to the wealthy is an industry at risk of alienating its constituents. For most New Yorkers, the upper echelons of the real estate industry inhabit a different planet, where mundane concerns about rent and mortgage payments are considered quaint. The backlash has already begun, with the election of a mayor openly hostile to luxury development. The real estate industry has also become dangerously dependent on a small class of the global elite, whose appetite for New York real estate may not always be so voracious. In short, it’s time to think of innovative ways around skyrocketing land costs. A properly structured ground lease is one of these ways.

The Ground Lessor’s Perspective

Before discussing the attractiveness of a ground lease for a developer, it is important to understand its potential appeal to a land owner. After all, with development rights fetching record prices, why not sell? For many owners, this logic is indeed compelling. But not for all owners. Indeed, for three classes of land owners—families, not-for-profits and the City itself—the benefits of a ground lease may outweigh those of a sale.

The Family Owner

While New York has become a magnet for international real estate investment, the industry is still, in many respects, intensely local. Some of the most desirable parcels in the City remain in the hands of families whose title dates back generations. These families, however, often lack the capacity to redevelop their land on their own.

While the temptation for these owners to take the money and run may be great, there are countervailing forces at play. The first is economic. New York City’s transaction costs are in a league of their own. Transfer tax, brokerage commissions and other transaction costs can easily exceed 7% of gross sales proceeds. These costs, however, pale in comparison to the tax man’s take. The combined federal, state and local gains tax is approximately 30%. Given the extremely low basis of most family-owned real estate, this rate usually kicks in at or near the first dollar of proceeds. After accounting for these expenses and taxes, an outright sale may lose its appeal.

Less tangible factors may also weigh against a sale. New Yorkers are obsessed with real estate, and are often extremely reluctant to part with it. After all, who can put a price on owning real estate in the country’s, if not the world’s, most desirable city. And some New Yorkers are tied to real estate for reasons which, while sentimental, are understandable. Who could tell the owner of a loft building, which originally housed a business founded by his immigrant forbearers, that cold economic calculations dictate a sale?

For these small-scale owners, a ground lease may be the answer. Ground lease transaction costs are lower than those of an outright sale. First, the big ticket transfer tax item—City transfer tax of 2.625% does not apply, as the City does not deem the transfer of a leasehold estate, regardless of the term, a transfer of real estate. The State does, however, if the term exceeds 49 years or the lease contains an option to purchase. But State transfer tax is a manageable .04%, with the tax calculated on the present value of the ground rents for the term. And while rents under the ground lease would be taxed at the ordinary income tax rate, the gains-tax hit payable upon a sale would be entirely avoided.

A ground lease also offers small-scale holders the psychological benefit of retaining title to their land. It also offers them or their descendants the opportunity to participate in the appreciation of the value of the land, by, for example, providing for “bonus rent” upon the redevelopment of the premises with floor area development rights in excess of the floor area development rights available on the commencement date. Thus, the almost mystic bond between family and land is not broken. In a world where sentiment can weigh as heavily as cash, this fact can make all the difference.

Not-for-Profit Institutions

Not-for-profit institutions—educational, religious, charitable and philanthropic—comprise another class of likely ground lessors. These institutions, while usually cash-strapped, own some of the City’s most coveted real estate. But they can’t easily sell it. They must often contend with charter documents and deed restrictions that rigidly circumscribe the disposition of real estate. They must also obtain the approval of the New York State Supreme Court to any land disposition. This approval is granted, or denied, based upon the recommendation of the Charities Bureau of the New York State Attorney General’s Office. The AG’s Office, in evaluating a proposed sale, scrutinizes the charter documents and the economic terms of the deal to ensure that the transaction does not contravene the institution’s mission.

A ground lease offers a way around these restrictions. Charter or deed restrictions may only prohibit transfer of fee title, leaving the door open to a ground lease. And even if the charter or deed restricts the land to the original, institutional use, the text may be expansive enough to encompass profit-making uses (including residential and retail use by a ground lessee) which support the institution’s mission. And while a ground lease would usually require court approval, the Attorney General would likely recommend such approval, if the institution reasonably demonstrates that the lease would generate rent that would contribute to the institution’s long-term viability.

A savvy institution could also leverage a ground lease into additional facilities. For example, a church or synagogue could ground lease land for redevelopment, upon the condition that, upon the building’s completion, the developer would sublease to the lessor certain space in the new building for a sanctuary or parish hall. Alternatively, the transaction could be structured as a “sale-condo back”, with a twist. As New York law does not accommodate the establishment of a condominium on a ground lease, the parties could agree that upon completion, the developer would subject the project to a cooperative regime, with a proprietary lease (technically, a sublease) of the institution’s facilities, upon favorable terms, granted to the institutional ground lessor.

Even if a not-for-profit could freely dispose of its land, its officers and directors or its trustees may not wish to do so. While intangible factors—such as an institution’s attachment to the City or a particular neighborhood—may weigh against a land sale, economic ones do as well. The directors or trustees of a not-for-profit are charged with ensuring its long-term viability, not its immediate enrichment. As such, a board may prefer the “annuity” provided by a ground lease, to be paid over many generations, over a one-shot cash injection, which could be squandered at a later date by an incompetent or unlucky board.

The City of New York

The City’s most important ground lessor is likely to be the City itself. To bolster the finances of the New York City Housing Authority, the Bloomberg administration has proposed ground leasing underutilized Housing Authority plots (such as parking lots) to developers. While this proposal has met with resistance from public housing tenants and the City Council, it is likely to receive a sympathetic hearing from the de Blasio administration, provided that any redevelopment incorporates a significant affordable component. Indeed, the balance to be struck by the incoming administration will concern the mix of market-rate and subsidized units within ground-leased City land, rather than the idea of ground leasing itself.

The Developer’s Perspective

While a prospective ground lessor has many reasons to consider a ground lease, a developer has only one: money. Simply put, a ground lease can take the sting out of today’s land prices and render feasible transactions that otherwise wouldn’t “pencil out”. Take, for example, a prospective rental development site consisting of 100,000 square feet of development rights. Assuming a development rights price of $500 per square foot, the land price would equal $50,000,000. Even if a developer can finance the acquisition and construction of the building upon advantageous terms, the hard and soft costs of construction, coupled with operating costs, might require rental assumptions which are not warranted by the market.

But if the transaction were structured as a ground lease, a rental project that might otherwise be unfeasible could begin to make sense. For example, the land value could be paid in two tranches, the first being a “key money” payment of $5,000,000, the second being annual payments of $1,500,000, subject to adjustment by some fixed percentage, or the consumer price index, every five years. The developer could seek financing to cover not just the hard and soft costs of construction, but also the initial “key money” payment and ground rent due prior to completion of the construction and initial lease-up of the building. Pursuant to the construction loan documents, an amount sufficient to pay this rent most likely would be deposited into a reserve and disbursed directly by the lender to the ground lessor as the rent became due. Ideally, the developer would complete the construction and initial lease-up of the building before this reserve is exhausted. Upon completion and stabilization, the developer could then refinance the construction loan with a “permanent” loan, presumably upon terms more favorable than construction loan terms, as the risk profile of the loan would be dramatically different. A portion of the proceeds of this loan could be used to establish another reserve (held by the bank, or in the developer’s own account) which, together with the building’s cash flow, would be sufficient to pay ground rent.

Ground Leases and Cooperative Housing Development

Moving across the economic spectrum, a ground lease may also permit developers to build and market for-sale units to New York’s beleaguered professional classes. While these people are wealthy by national standards, they are relegated to the margins by a New York housing market that caters to the super-rich. By enabling a developer to defer at least a portion of the land price to periods after unit sales, a ground lease takes considerable pressure off the “base case” pricing a developer needs to obtain, if it is to earn a modest profit after payment of land costs and the hard and soft costs of construction (including financing and carrying costs). A ground lease also offers flexibility to unit purchasers, permitting them to “amortize” land costs over the term of the ground lease (by incorporation of ground rent in monthly maintenance payments), rather than pay the entire land cost up front as part of the purchase price. This is an option that some cash-strapped buyers may find attractive.

For-sale housing on a ground lease, however, poses unique challenges. As noted above, New York law does not accommodate leasehold condominiums2. Thus, the preferred means of apartment ownership—a condominium—is not available. Rather, units must be marketed as cooperative apartments. However, the bylaws of the cooperative could afford purchasers rights typically afforded to owners of condominium units, such as the right freely to sell or sublease apartments (subject to a right of first refusal in favor of the cooperative board), and to finance their units without restriction. In addition, higher-than-average monthly maintenance fees necessitated by the payment of ground rent could depress unit prices. But pricing is an art, not a science, and none of these obstacles needs prove fatal. Furthermore, the offering plan should exhaustively disclose the terms of the ground lease, so no unit purchasers could later claim that they were not properly apprised of the structure of the development.

A developer must also give appropriate weight to the term of the ground lease. New York purchasers, unlike their London counterparts, are unaccustomed to leasehold tenure and likely will resist any term that falls short of the symbolic century mark. Rent should also be fixed during the entire term of the ground lease, so that purchasers can quantify the building’s rent obligation and be spared the prospect of facing impossible-to-ascertain “fair market rent” increases at a later date.

A developer must also ensure that, technically, the ground lease is adapted to a cooperative housing development. For example, the lease must afford the developer the right, upon the substantial completion of the building, to assign the lease to a cooperative housing corporation. Upon such assignment, the cooperative would assume all of the developer’s obligations under the lease, including the obligation to pay ground rent, maintain the building and pay real estate taxes, insurance premiums and other carrying costs. Further, if the ground lease imposes any guaranties or other personal obligations on the developer or its principals (such as a payment guaranty or a so-called “good-guy” guaranty”), these guaranties must be released at the time of assignment. The “assignment and subleasing” provisions of the ground lease must further permit (i) the issuance of proprietary subleases by the cooperative, (ii) the subsequent cancellation and reissuance of these subleases (or the assignment of these subleases) in connection with unit transfers and (iii) the issuance of stock in the corporation to unit purchasers and the subsequent assignment thereof to successor owners.

Making it Work

Any ground lease—whether for a rental or cooperative development—also affords the ground lessee wide latitude to demolish any existing improvements and redevelop the premises as a residential apartment building (with a garage and retail component, if appropriate). The ground lease should further obligate the ground lessor to cooperate with the ground lessee in connection with the redevelopment of the building. This obligation to cooperate should be as expansive as possible. It should include, for example, the obligation to execute any applications required to obtain a building permit or other permit. It should also obligate the ground lessor to cooperate in connection with any effort by the developer to obtain an “inclusionary housing” floor area bonus or real estate tax abatement that may become available through the incorporation of “affordable housing” within the project. For example, the ground lessor should agree that it will subordinate the ground lease to any agreement with the City to incorporate an affordable housing component in the building in exchange for additional floor area or a tax abatement. In addition, the ground lessor should agree to subordinate its fee title to any zoning lot development agreement entered into by the developer to transfer development rights to the leased parcel for incorporation in the new building. Finally, the ground lessor must agree that any fee mortgage would be subordinate both to the ground lease and any agreement with the City for tax or zoning benefits.

Conclusion

As demonstrated above, a properly structured ground lease offers benefits to both land owners and developers. It might even make it possible to develop homes for New Yorkers of modest means. In doing so, developers could do well by doing good. And the City would be the better for it.

Dennis M. Sughrue is a partner in the real estate group of Pryor Cashman LLP