If you own real estate in an up-and-coming area or own residential or commercial property that could be redeveloped into a "greater and much better usage", then you have actually come to the ideal location! This post will help you summarize and ideally debunk these two techniques of enhancing a piece of real estate while getting involved handsomely in the advantage.

The Development Ground Lease

The Development Ground Lease is an agreement, normally ranging from 49 years to 150 years, where the owner transfers all the benefits and burdens of ownership (expensive legalese for future incomes and expenses!) to a designer in exchange for a month-to-month or quarterly ground rent payment that will range from 5%-6% of the reasonable market value of the residential or commercial property. It allows the owner to take pleasure in an excellent return on the value of its residential or commercial property without having to offer it and does not need the owner itself to take on the significant danger and complication of building a new building and finding tenants to occupy the new building, skills which numerous genuine estate owners just do not have or want to discover. You may have also heard that ground lease rents are "triple internet" which means that the owner sustains no expenses of operating of the residential or commercial property (other than earnings tax on the gotten rent) and gets to keep the complete "net" return of the negotiated lease payments. All real! Put another way, during the regard to the ground lease, the developer/ground lease renter, handles all obligation for genuine estate taxes, construction costs, borrowing costs, repair work and maintenance, and all running expenses of the dirt and the new structure to be constructed on it. Sounds pretty great right. There's more!

This ground lease structure also permits the owner to enjoy a reasonable return on the present worth of its residential or commercial property WITHOUT having to sell it, WITHOUT paying capital gains tax and, under present law, WITH a tax basis step-up (which reduces the quantity of gain the owner would ultimately pay tax on) when the owner dies and ownership of the residential or commercial property is moved to its heirs. All you quit is control of the residential or commercial property for the regard to the lease and a higher involvement in the earnings obtained from the new structure, but without many of the risk that goes with building and operating a brand-new building. More on dangers later.

To make the offer sweeter, a lot of ground leases are structured with routine increases in the ground lease to protect against inflation and also have fair market worth ground lease "resets" every 20 or so years, so that the owner gets to enjoy that 5%-6% return on the future, hopefully increased value of the residential or commercial property.

Another positive characteristic of an advancement ground lease is that as soon as the new structure has been built and rented 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 property. At the same time, the designer's rental stream from running the residential or commercial property is likewise sellable and financeable, and if the lease is prepared appropriately, 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 rents paid by the developer without affecting the designer's ability to finance the building, and vice versa.

So, what are the downsides, you may ask. Well initially, the owner offers up all control and all possible revenues to be derived from building and running a brand-new structure for between 49 and 150 years in exchange for the security of restricted ground lease. Second, there is risk. It is primarily front-loaded in the lease term, but the danger is real. The minute you move your residential or commercial property to the developer and the old building gets demolished, the residential or commercial property no longer is leasable and won't be creating any income. That will last for 2-3 years up until the new structure is built and totally 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 constructed structure on it that creates no profits and worse, will cost millions to end up and rent up. That's why you should make absolutely sure that whoever you rent the residential or commercial property to is an experienced and skilled builder who has the financial wherewithal to both pay the ground rent and finish the building and construction of the structure. Complicated legal and service solutions to offer protection versus these dangers are beyond the scope of this post, but they exist and need that you discover the ideal service consultants and legal counsel.

The Development Joint Venture

Not satisfied with a boring, coupon-clipping, long-lasting ground lease with restricted involvement and limited benefit? Do you wish to leverage your ownership of an undeveloped or underdeveloped piece of residential or commercial property into an interesting, brand-new, bigger and much better investment? Then maybe an advancement joint venture is for you. In an advancement joint endeavor, the owner contributes ownership of the residential or commercial property to a minimal liability company whose owners (members) are the owner and the developer. The owner trades its ownership of the land in exchange for a portion ownership in the joint venture, which portion is determined by dividing the reasonable market price of the land by the overall task expense of the new building. 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 building and will take part in 12.5% of the operating profits, any refinancing earnings, and the earnings on sale.

There is no earnings tax or state and local transfer tax on the contribution of the residential or commercial property to the joint endeavor and in the meantime, a basis step up to fair market value is still available to the owner of the 12.5% joint endeavor interest upon death. Putting the joint venture together raises various questions that must be worked out and resolved. For example: 1) if more money is required to finish 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 top priority circulation) 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 manage the day-to-day company decisions? or significant decisions like when to re-finance or offer the brand-new structure? 5) can either of the members move their interests when preferred? or 6) if we develop condominiums, can the members take their profit out by getting ownership of specific homes or retail areas rather of cash? There is a lot to unpack in putting a strong and reasonable joint endeavor contract together.

And then there is a risk analysis to be done here too. In the advancement joint venture, the now-former residential or commercial property owner no longer owns or controls the dirt. The owner has actually acquired a 12.5% MINORITY interest in the operation, albeit a larger task than in the past. The threat of a failure of the job doesn't simply lead to the termination of the ground lease, it could lead to a foreclosure and possibly total loss of the residential or commercial property. And then there is the possibility that the market for the new structure isn't as strong as originally projected and the brand-new building does not create the level of rental income that was expected. Conversely, the building gets constructed on time, on or under budget, into a robust leasing market and it's a crowning achievement where the value of the 12.5% joint venture interest far surpasses 100% of the value of the undeveloped parcel. The taking of these threats can be considerably lowered by choosing the same skilled, experience and economically strong designer partner and if the anticipated benefits are big enough, a well-prepared residential or commercial property owner would be more than justified to handle those dangers.

What's an Owner to Do?

My first piece of suggestions to anybody thinking about the redevelopment of their residential or commercial property is to surround themselves with experienced experts. Brokers who comprehend advancement, accounting professionals and other financial consultants, advancement experts who will deal with behalf of an owner and obviously, good skilled legal counsel. My second piece of recommendations is to use those experts to figure out the economic, market and legal characteristics of the prospective deal. The dollars and the offer capacity will drive the choice to develop or not, and the structure. My third piece of recommendations to my customers is to be real to themselves and try to come to a truthful awareness about the level of risk they will be prepared to take, their capability to find the right designer partner and after that trust that designer to manage this process for both party's mutual financial advantage. More quickly 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 expense of land and the cost of construction materials are so costly. The magic is that these development ground leases, and joint endeavors offer a less costly method for a developer to control and redevelop a piece of residential or commercial property. Cheaper because the ground lease a designer pays the owner, or the revenue the developer show a joint venture partner is either less, less dangerous or both, than if the developer had actually purchased the land outright, and that's a good idea. These are sophisticated transactions that demand sophisticated experts dealing with your behalf to keep you safe from the risks inherent in any redevelopment of property and guide you to the increased value in your residential or commercial property that you look for.