Outside Counsel

Development on a Ground Lease

, New York Law Journal

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Dennis M. Sughrue

As the New York real estate market continues its recovery, land prices have attained record heights. While the price of development may vary from neighborhood to neighborhood, and even from block to block, land prices in Manhattan's most gilded precincts approach $1,000 per square foot. Even outside Midtown's "Billionaire's Row," land prices in established Manhattan and Brooklyn neighborhoods routinely surpass $500 per square foot.

These eye-watering numbers have dramatically altered the development landscape. While New York's rents are the highest in the nation, they aren't high enough, taking account of land prices, to justify rental development. Even condominium sale prices of $1,500 a foot—only recently considered more than respectable—fail to make the grade, as escalating land costs erode profit margins. Predictably, developers have stampeded into the luxury market, while rental housing and modestly priced for-sale construction have languished.

The trend is ominous. A real estate industry tied solely to the wealthy is at risk of alienating its natural constituents. For most New Yorkers, the upper echelons of the industry inhabit a different planet, where concerns about rent and mortgage payments are considered quaint. The industry is also dangerously reliant on a small class of the global rich, whose appetite for New York real estate may not always be so voracious. In short, it may be time to reevaluate the current development paradigm. Properly structured ground leases may be part of the answer.

The Ground Lease

A ground lease has several defining traits, many of which are more typical of outright, fee ownership than ordinary leasehold tenure. A ground lease term is typically long, ranging from 25 to 150 years (if not longer). A ground lease customarily affords the lessee wide latitude in demolishing, redeveloping and subleasing any improvements located on the land. A ground lessee is further "triple-net," allocating responsibility for all real estate taxes, insurance premiums, legal compliance costs and other expenses associated with the land to the ground lessee. Finally, a ground lessee may mortgage its leasehold interest, and its mortgagee may avail itself of mortgagee protections set forth in the ground lease, such as notice and cure rights in the event of a lessee default, and the right to a new lease upon the then-executory terms of the ground lease, upon any termination of the ground lease by reason of the tenant's default.

Ground Lessor's Perspective

Before discussing the attractiveness of a ground lease for a developer, it is important to understand its appeal to a landowner. At today's high prices, why not sell? For many owners, this logic is compelling. But, for three classes of landowners—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 intensely local. Some of the most desirable parcels in the city remain in the hands of families whose title may date back generations. These families, however, usually lack the capacity to redevelop their land on their own.

While the temptation to take the money and run may be great, there are countervailing forces at play. First, after accounting for transaction costs (including transfer taxes and brokerage commissions), which may exceed 7 percent of gross sales proceeds, and income tax, which soaks up another 30 percent of these proceeds (assuming a zero basis), a sale may lose some of its appeal. Second, some families have sentimental attachments to New York City real estate. After all, who can put a price on owning a piece of the capital of the world, especially if it's been owned by the family for generations?

A ground lease, in addition to offering lessors the psychic benefit of continued ownership of the land, reduces transaction costs and income tax. First, the big ticket transfer tax item—city transfer tax of 2.625 percent—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 (if the term exceeds 49 years or the lease contains an option to purchase), but state transfer tax is a manageable .04 percent of the present value of the rents payable during the term. And while rents under the ground lease would be taxed at the ordinary income tax rate, the gains-tax levy payable upon a sale would be entirely avoided.

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 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.1 The 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 demonstrates that the lease would generate rent that would contribute to its viability.

A savvy institution could also leverage a ground lease into additional facilities. A synagogue could ground lease its land for redevelopment, provided that, upon completion, the ground lessor sublease a portion of the new building, at a preferential rent, to the synagogue for use as a sanctuary.

Even if a not-for-profit could freely dispose of its land, its principals may not wish to do so. They may prefer the long-term annuity provided by a ground lease to a one-shot cash infusion that could one day be squandered by an improvident board.

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