Commentary FEBRUARY 10, 2021 Ground Leases and Leasehold Interests in CMBS: When the Value of the Parts Doesn't Equal the Whole Kurt Pollem The Chrysler Building has been an iconic pres- the way. The investment seemed to be a great Managing Director ence in the New York skyline since the 1930s success, and it was for a while. However, the North American CMBS when its distinctive Art Deco dome and spire ground-lease agreement contained a rent +1 212 548-6394 rose up into the sky. But the story of this Mid- clause prevalent in New York City that allows [email protected] town office tower ownership highlights certain for a market-based reset over a longer period important risks regarding the economics of the to account for possible appreciation catch-ups. Steve Jellinek ground lease contract between ground lessor There was a big problem, though. The older Vice President – Head of Research and ground lessee. It also raises the question of floorplates and infrastructure of the building North American CMBS what happens if, for any number of reasons, a were becoming less desirable to tenants. The + 1 312 244-7908 property’s leasehold improvements cannot bear increasing ground rent payment began to [email protected] the burden of ground lease rent payments that overwhelm the property’s revenue as the aging only increase over the typically very long period building’s occupancy and rental rates continued Erin Stafford stipulated in such agreements. to lag much newer properties. Managing Director Global Structured Finance The Chrysler Building was constructed on land In 2008, Tishman sold a 90% interest in the +1 312 332-3291 owned by the Cooper Union school, which building to the Abu Dhabi Investment Council [email protected] entered into a long-term ground lease with the for $800 million, or $667 per square foot (psf). developer and as ground lessor, has enjoyed a Then in 2018, the market-value-based ground steadily increasing income stream of ground- rent reset provision triggered a more than 300% lease payments ever since. By 1998, however, increase in the annual lease payment, as it occupancy had stagnated under previous shot up to $32.5 million from $7.5 million the ownership. The once majestic office tower was prior year at a time when the property’s rental in need of repair and the Japanese lenders income was dropping. Per Reis, the Chrys- wanted to sell the defaulted leasehold mort- ler Building’s 2019 average asking rent and gage they had made on the famous property. vacancy were $66.31 psf and 18.5%, respec- Tishman Speyer (Tishman) and Travelers were tively, compared with the 2019 New York Metro the winning bidders, in part because Jerry average asking rent and vacancy of $75.26 psf Speyer himself reportedly negotiated a more and 8.2%. When Tishman and Abu Dhabi sold economical 150-year ground lease with Cooper the building in 2019 to RFR Realty LLC (RFR) for Union beforehand and took over the leasehold a mere $150 million, it stunned the commercial interest. The new owners believed that after real estate world. The price equated to just $100 million in capital improvements, leasing $125 psf, indicating that the leasehold and the would improve and tenant lease revenue would existing improvements were of very little value, easily cover the future ground-lease payments. even for an iconic landmark. Now the question remains: Will RFR be able to negotiate a new Under Tishman Speyer’s leadership, the repairs ground-lease agreement like Jerry Speyer did were made and the Chrysler Building once in 1998? If not, the investment in the leasehold again leased up and increased in value along interest could be destined for failure once again. 1 DBRS Morningstar Ground Leases and Leasehold Interests in CMBS: When the Value of the Parts Doesn't Equal the Whole Commentary $35 million Bifurcating the Fee and Leasehold Interests So what has changed? Land value in New equity Ground lease arrangements have existed York City, for example, continued its steep rise. contribution for centuries in real estate. The typical Property owners and financing agents saw more $100 million purchase ground lease results in two distinct legal opportunities to unlock that increased value by price estates: the ground lessor’s fee interest in bifurcating the fee and leasehold interests and 6% going -in the underlying land and the ground lessee’s financing both interests. Real estate investors cap rate $65.0 million leasehold interest in the improvements. seeking acquisitions sought to split off and sell loan $14.5 million equity These two estates, subject to the terms of the ground fee interest to lower their equity con- 65% LTV fee $49.2 million simple value; the ground lease, can then be separately tribution and increase their cash-on-cash returns 9.2% debt $32.0 million owned and financed. In the normal course, retaining the leasehold and financing it as well. yield Leasehold loan Value the ground lessor enjoys a highly predict- 65% LTV to able and generally well-secured payment But there is a catch, of course. The ground- 8% cap rate leasehold stream sometimes for as long as 100 or lease agreement is long, the ground rent value; 12.3% Hypothetical debt yield more years. The ground lessee owns a payment keeps going up, and property revenue Financing leasehold and is left to focus on operating also needs to keep pace with this increase. To better illustrate $53.5 million ground lease sale the real estate improvements, while often Thus, the transaction parties must be confident this, we’ll present benefiting from favorable tax and deprecia- that tenant rents will also grow over time and 5.75% yield on 99-year ground a hypothetical rent payment schedule; 3.9% tion treatment. For the most part, ground- that the property will remain attractive to financing: going-in cap rate lease payments were a modest portion of future tenants. Otherwise, the ground rent the leasehold owner’s operating expense burden on the leasehold interest begins to A real estate investor spots an opportunity to burden and a safe, reliable income stream creep up. Moreover, the leasehold interest, the purchase an office campus in a second-tier market. for the landowner. Up until recently, it was term of which is finite, is viewed as a wasting Based on the property’s current net cash flow (NCF) difficult to find examples of a ground lessee asset that becomes worthless when occupancy and assumed capitalization rate of 6%, the investor defaulting on a payment to the lessor. After rights revert to the leased fee holder at the will pay $100 million to purchase the property. And, all, the consequences are extreme. If the termination of the ground lease. As shown in based on prevailing lending conditions, we assume ground lessee defaults, ground lessors can the graph below, there is significant equity the purchaser qualifies for a mortgage loan at 65% of terminate the ground lease, extinguish the erosion in the leasehold interest compared the purchase price, leaving $35 million to be funded ground lease estate, evict the ground lessee, with a fee-simple interest over an assumed through cash equity. However, the investor believes and take back the property improvements. 50-year ground lease term. In this example, it can split off the ground fee interest and sell it to If the leasehold interest is financed, the we assumed a 2% annual growth rate in NCF a third party subject to a long-term ground-lease leasehold lender has similar risks in a to match the 2% annual ground-lease rent agreement where the property is leased back to the default situation. If the leasehold interest is increase. The leasehold interest value begins original investor. This enables the original investor terminated, the leasehold lender risks losing to deteriorate with 20 years remaining on the to continue to operate the property but also gain an its collateral entirely. Of course, leasehold lease. With only 10 years remaining, the value immediate return from the sale to the third-party loans and associated ground leases (to be begins to decline much more rapidly. As a investor, which can defray its equity requirements. financeable) are generally structured to give result, if a leasehold loan on a property subject Depending on the economics and property quality, the leasehold lender remedies in this situ- to a ground lease needs to be refinanced with the leasehold financing can be a superior alternative. ation, including rights to cure any defaults only 20 years remaining on the ground lease, In this example, assuming a 99-year ground-lease and effectively step into the shoes of the the expected valuation decline can make this term and beginning ground-lease payment of around leasehold borrower. exceptionally difficult. 20% of the property’s effective gross income (EGI), the purchaser is able to sell the ground-lease interest EXHIBIT 1 for $53.5 million at a 5.75% yield to the buyer (i.e., the Equity Erosion discount rate applied to the 99 years of ground-lease payment cash flow to arrive at the net present value purchase price). That leaves the original investor needing only to obtain the leasehold financing. Even at a greatly reduced loan amount on the leasehold Equit Erosion interest, the purchaser is contributing significantly less cash equity to buy the property while enjoying much higher returns over an assumed 10-year holding period. In this example, we assume a $32 million loan on the leasehold interest. When combined with the ground-lease sale, the borrower ends up contributing 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 27 28 29 30 31 32 33 34 35 36 37 38 39 40 41 42 43 44 45 46 47 48 49 50 less than half the equity of a fee-simple financing.