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If you own genuine estate in an up-and-coming area or own residential or commercial property that could be redeveloped into a "higher and better use", then you have actually concerned the best place! This post will help you summarize and ideally demystify these 2 methods of enhancing a piece of genuine estate while taking part handsomely in the advantage.

The Development Ground Lease
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The Development Ground Lease is a contract, typically ranging from 49 years to 150 years, where the owner transfers all the advantages and problems of ownership (fancy legalese for future revenues and expenses!) to a developer in exchange for a monthly or quarterly ground lease payment that will range from 5%-6% of the reasonable market worth of the residential or commercial property. It allows the owner to enjoy a great return on the value of its residential or commercial property without having to offer it and doesn't need the owner itself to handle the incredible danger and problem of building a new building and finding tenants to inhabit the new building, abilities which numerous real estate owners just do not have or wish to find out. You may have likewise heard that ground lease rents are "triple net" which implies that the owner incurs no charges of operating of the residential or commercial property (other than earnings tax on the gotten rent) and gets to keep the full "net" return of the worked out rent payments. All true! Put another way, during the term of the ground lease, the developer/ground lease tenant, handles all obligation genuine estate taxes, construction expenses, obtaining costs, repairs and upkeep, and all operating expenses of the dirt and the new building to be developed on it. Sounds quite excellent right. There's more!

This ground lease structure likewise enables the owner to enjoy a sensible return on the present worth of its residential or commercial property WITHOUT needing to offer it, WITHOUT paying capital gains tax and, under current law, WITH a tax basis step-up (which lowers 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 give up is control of the residential or commercial property for the term of the lease and a higher participation in the revenues originated from the new structure, however without many of the threat that opts for building and running a new building. More on dangers later on.

To make the offer sweeter, a lot of ground leases are structured with periodic boosts in the ground rent to secure against inflation and likewise have fair market price ground rent "resets" every 20 or two years, so that the owner gets to delight in that 5%-6% return on the future, hopefully increased worth of the residential or commercial property.

Another positive quality of an advancement ground lease is that as soon as the brand-new building has actually been developed and leased up, the property owner's ownership of the residential or commercial property including the rental stream from the ground lease is a sellable and financeable interest in property. 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 drafted correctly, either can be sold or financed without threat to the other party's interest in their residential or commercial property. That is, the owner can borrow cash against the worth of the ground leas paid by the designer without impacting the developer's ability to fund the structure, and vice versa.

So, what are the downsides, you might ask. Well first, the owner quits all control and all potential profits to be derived from building and operating a new building for between 49 and 150 years in exchange for the security of minimal ground lease. Second, there is danger. It is mainly front-loaded in the lease term, however the risk is real. The minute you move your residential or commercial property to the designer and the old structure gets demolished, the residential or commercial property no longer is leasable and won't be producing any earnings. That will last for 2-3 years up until the brand-new structure is built and completely tenanted. If the designer fails to build the structure or stops halfway, the owner can get the residential or commercial property back by cancelling the lease, but with a partially built building on it that produces no profits and worse, will cost millions to finish and rent up. That's why you need to make definitely sure that whoever you lease the residential or commercial property to is a competent and knowledgeable home builder who has the financial wherewithal to both pay the ground lease and finish the building of the structure. Complicated legal and company options to supply security against these threats are beyond the scope of this post, but they exist and need that you find the best business advisors and legal counsel.

The Development Joint Venture

Not pleased with a boring, coupon-clipping, long-term ground lease with limited involvement and restricted upside? Do you wish to utilize your ownership of an undeveloped or underdeveloped piece of residential or commercial property into an interesting, brand-new, bigger and better financial investment? Then perhaps an advancement joint endeavor is for you. In an advancement joint venture, the owner contributes ownership of the residential or commercial property to a restricted liability company 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 endeavor, which percentage is identified by dividing the fair market worth of the land by the total job cost of the new structure. So, for example, if the worth of the land is $ 3million and it will cost $21 million to develop the brand-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 brand-new structure and will take part in 12.5% of the operating earnings, any refinancing proceeds, and the profit on sale.

There is no income tax or state and regional transfer tax on the contribution of the residential or commercial property to the joint endeavor and in the meantime, a basis step up to reasonable market value is still available to the owner of the 12.5% joint endeavor interest upon death. Putting the joint venture together raises many questions that need to be worked out and fixed. For instance: 1) if more cash is needed to end up the structure than was originally budgeted, who is accountable to come up with the extra 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 day-to-day business decisions? or significant choices like when to refinance or sell the new building? 5) can either of the members transfer their interests when preferred? or 6) if we build condominiums, can the members take their profit out by getting ownership of specific homes or retail areas instead of cash? There is a lot to unpack in putting a strong and reasonable joint endeavor arrangement 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 gotten a 12.5% MINORITY interest in the operation, albeit a larger task than in the past. The threat of a failure of the task does not 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 structure isn't as strong as originally projected and the new building doesn't create the level of rental earnings that was anticipated. Conversely, the structure gets developed on time, on or under budget, 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 value of the undeveloped parcel. The taking of these dangers can be substantially minimized by picking the very same competent, experience and economically strong developer partner and if the anticipated benefits are large 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 advice to anybody considering the redevelopment of their residential or commercial property is to surround themselves with skilled experts. Brokers who comprehend advancement, accountants and other financial consultants, advancement consultants who will work on behalf of an owner and naturally, excellent skilled legal counsel. My 2nd piece of advice is to utilize those experts to figure out the financial, market and legal dynamics of the prospective deal. The dollars and the deal capacity will drive the decision to establish or not, and the structure. My 3rd piece of advice to my customers is to be true to themselves and try to come to a truthful realization about the level of threat they will be willing to take, their ability to find the best designer partner and then trust that developer to manage this process for both party's mutual financial advantage. More easily said than done, I can guarantee you.

Final Thought

Both of these structures work and have for years. They are especially popular now due to the fact that the cost of land and the expense of building and construction materials are so expensive. The magic is that these development ground leases, and joint ventures supply a less costly way for a developer to manage and redevelop a piece of residential or commercial property. More economical in that the ground rent a designer pays the owner, or the revenue the designer show a joint endeavor partner is either less, less dangerous or both, than if the designer had actually purchased the land outright, which's an advantage. These are sophisticated transactions that require working on your behalf to keep you safe from the dangers fundamental in any redevelopment of real estate and guide you to the increased value in your residential or commercial property that you look for.
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