If you own property in an up-and-coming location or own residential or commercial property that might be redeveloped into a "higher and much better use", then you have actually pertained to the ideal place! This post will help you sum up and hopefully debunk these two approaches of improving a piece of realty while taking part handsomely in the benefit.

The Development Ground Lease

The Development Ground Lease is a contract, generally varying from 49 years to 150 years, where the owner transfers all the benefits and concerns of ownership (fancy legalese for future profits and costs!) to a developer in exchange for a monthly or quarterly ground rent payment that will vary from 5%-6% of the fair market price of the residential or commercial property. It enables the owner to delight in a good return on the worth of its residential or commercial property without having to offer it and does not require the owner itself to take on the significant risk and issue of constructing a brand-new building and finding renters to inhabit the new structure, abilities which lots of property owners merely don't have or wish to find out. You may have also heard that ground lease rents are "triple net" which means that the owner sustains no charges of operating of the residential or commercial property (besides earnings tax on the received rent) and gets to keep the complete "net" return of the negotiated lease payments. All real! Put another method, during the term of the ground lease, the developer/ground lease occupant, takes on all responsibility genuine estate taxes, building costs, borrowing expenses, repairs and maintenance, and all running costs of the dirt and the new structure to be constructed on it. Sounds respectable right. There's more!

This ground lease structure likewise permits the owner to delight in a reasonable return on the present value of its residential or commercial property WITHOUT needing to sell it, WITHOUT paying capital gains tax and, under present law, WITH a tax basis step-up (which reduces the amount 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 heirs. All you quit is control of the residential or commercial property for the regard to the lease and a greater involvement in the profits originated from the brand-new structure, however without many of the danger that goes with building and operating a brand-new building. More on risks later on.

To make the deal sweeter, many ground leases are structured with regular increases in the ground lease to safeguard against inflation and likewise have fair market price ground rent "resets" every 20 or so years, so that the owner gets to take pleasure in that 5%-6% return on the future, hopefully increased worth of the residential or commercial property.

Another favorable characteristic of a development ground lease is that as soon as the new structure has been developed and leased up, the property manager's ownership of the residential or commercial property consisting of the rental stream from the ground lease is a sellable and financeable interest in realty. At the same time, the designer'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 offered or funded without risk to the other party's interest in their residential or commercial property. That is, the owner can obtain cash versus the worth of the ground rents paid by the developer without affecting the designer's capability to fund the structure, and vice versa.

So, what are the downsides, you might ask. Well initially, the owner gives up all control and all prospective earnings to be derived from structure 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 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 destroyed, the residential or commercial property no longer is leasable and won't be creating any earnings. That will last for 2-3 years till the new building is built and completely tenanted. If the developer fails to develop the building or stops halfway, the owner can get the residential or commercial property back by cancelling the lease, but with a partially constructed structure on it that produces no income and worse, will cost millions to complete and rent up. That's why you must make definitely sure that whoever you rent the residential or commercial property to is a skilled and skilled home builder who has the financial wherewithal to both pay the ground lease and finish the building and construction of the building. Complicated legal and business services to provide defense versus these threats are beyond the scope of this article, but they exist and need that you find the ideal company advisors and legal counsel.

The Development Joint Venture

Not satisfied with a boring, coupon-clipping, long-term ground lease with limited participation and minimal upside? Do you wish to take advantage of your ownership of an undeveloped or underdeveloped piece of residential or commercial property into an interesting, brand-new, bigger and better financial investment? Then possibly 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 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 venture, which percentage is determined by dividing the fair market worth of the land by the overall job expense of the brand-new structure. So, for example, if the worth 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 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 for now, a basis step up to fair market value is still offered to the owner of the 12.5% joint venture interest upon death. Putting the joint endeavor together raises various questions that must be worked out and resolved. For instance: 1) if more cash is required to complete the building than was initially allocated, who is responsible to come up with the additional funds? 2) does the owner get its $3mm dollars returned initially (a concern circulation) or do all dollars come out 12.5%:87.5% (pro rata)? 3) does the owner get an ensured return on its $3mm financial investment (a choice payment)? 4) who gets to manage the everyday organization decisions? or major choices like when to refinance or offer the new building? 5) can either of the members move their interests when desired? or 6) if we construct condominiums, can the members take their earnings out by getting ownership of certain apartments or retail areas instead of cash? There is a lot to unload in putting a strong and reasonable joint venture agreement together.

And after that there is a danger analysis to be done here too. In the advancement joint endeavor, the now-former residential or commercial property owner no longer owns or controls the dirt. The owner has obtained a 12.5% MINORITY interest in the operation, albeit a larger project than previously. The risk of a failure of the project does not simply lead to the termination of the ground lease, it might result in a foreclosure and maybe overall loss of the residential or commercial property. And then there is the possibility that the market for the brand-new building isn't as strong as originally predicted and the new building does not create the level of rental earnings that was anticipated. Conversely, the structure gets constructed on time, on or under spending plan, into a robust leasing market and it's a crowning achievement where the worth of the 12.5% joint endeavor interest far goes beyond 100% of the value of the undeveloped parcel. The taking of these dangers can be considerably lowered by picking the same competent, experience and financially strong designer partner and if the anticipated benefits are big enough, a well-prepared residential or commercial property owner would be more than warranted to handle those risks.

What's an Owner to Do?

My very first piece of suggestions to anyone thinking about the redevelopment of their residential or commercial property is to surround themselves with experienced professionals. Brokers who understand development, accountants and other financial consultants, advancement consultants who will work on behalf of an owner and of course, good skilled legal counsel. My second piece of advice is to make use of those specialists to identify the economic, market and legal characteristics of the potential transaction. The dollars and the offer capacity will drive the decision to establish or not, and the structure. My third piece of suggestions to my customers is to be real to themselves and try to come to a truthful awareness about the level of danger they will be ready to take, their capability to discover the best developer partner and then trust that developer to control this procedure for both party's mutual financial advantage. More easily said 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 cost of building materials are so expensive. The magic is that these advancement ground leases, and joint endeavors offer a less expensive way for a developer to manage and redevelop a piece of residential or commercial property. Cheaper in that the ground rent a designer pays the owner, or the profit the developer shares with a joint endeavor partner is either less, less risky or both, than if the designer had actually bought the land outright, which's a great thing. These are advanced transactions that demand sophisticated experts working on your behalf to keep you safe from the risks intrinsic in any redevelopment of property and guide you to the increased value in your residential or commercial property that you seek.