Jim Luchars, Stonebridge Companies

Ground leases have existed in commercial real estate for years and the ground lease structure is in fact much more common in Europe than in the United States. Overseas, it is viewed as financing mechanism that is typically back-stopped by some form of real credit. From my experience, the ground lease structure in the U.S. is much less uniform, particularly when it involves hotels. This is a function of the diversity in non-institutional landlords and the difficulty in fairly capturing rent from a business and income stream that changes daily. There are very few markets in the US where hotel leasehold interests are common with New York City being the exception. However, as we enter into the later stage of the hotel cycle, owners and investors push for more creative ways to finance and deploy capital and rationalizing away the risks of a ground lease structure has become more common, even in the Boston hotel market. Many leases are based on quirky terms that have been in place for decades, while some are negotiated as a new form.

There are some key, basic terms that every hotel owner should have an understanding of prior to entering a ground lease negotiation:

• Lease Term: a rule of thumb on ground lease terms is anything below seventy-five years is more difficult to finance and sell at a future date. It is hard to generalize, but lenders often get nervous financing shorter term ground leases as they are simply less liquid than a fee interest and are already leveraged by the ground rent payment and subordination to the fee position.

• Rent: developing a formula for determining rent for a hotel on a ground lease is complicated and it has to encompass what the landlord perceives as fair rent, allowing for enough coverage for tenant income to comfortably cover rent payments, and to be acceptable to a leasehold lender that is assessing debt service coverage on income net of rent. Typically, landlords set a fixed base rent and a percentage rent that is driven off of hotel top line revenue performance. However, some leases have just a percentage rent formula that is tied to revenues. The challenge with setting a high fixed base rent is that the fluctuating income stream of a hotel may not always meet its coverage, particularly if it is also subject to a leasehold mortgage payment. This issue is more prominent in major urban markets like Boston and New York where land values are extremely high and landlords push base rents in excess of 30% of the hotel Net Operating Income (NOI). In these cases, the leasehold position is more difficult to finance as it is already highly leveraged through the lease itself. A common rule of thumb is to negotiate a rent formula that delivers rent in the range of 5-6% of total revenue or 20% of hotel NOI.

• Rent growth and fair market value (FMV) resets: The negotiation of the escalation of rent is equally as important as the actual rent formula. Often, annual or five/ten year cumulative increases are used based on CPI. These numbers are sometimes capped to limit exposure for the tenant during hyper inflationary periods. A key term that can impact leasehold value is whether a lease contains one or more Fair Market Value (FMV) rent resets which can be calculated in a number of different ways. If this provision is not carefully negotiated, a FMV reset can result in rent doubling, tripling or worse depending on the economic conditions at the time of the calculation and the method for dispute and arbitration. Usually, FMV resets are not implemented in a lease until later in the term such as year 50 in a 75-year lease.

• Superiority of the lease: If as a tenant, you intend to finance a leasehold position, it is important that your lease contains specific language that sets the lease superior to any fee position. For example, if there is a fee lender who forecloses on the fee property, the language in the lease should outline that the lender has to assume the leasehold position “as is” and cannot amend the lease or remove the tenant. Many lenders will not consider financing a leasehold position without this protection.

• Condemnation/casualty: another key negotiation point in a ground lease is how the proceeds are divided under a condemnation or major casualty among the landlord, the fee lender, tenant and the leasehold lender. While the probability of a taking or a major casualty is very low, a lender (whether fee or leasehold) needs to be comfortable that their position is senior to the borrower in the waterfall of insurance proceeds from this type of event.

• Capital improvements: Typically, in ground leases on commercial real estate, land lord rights with respect to tenant capital improvements are limited. This can differ for hotels as they are more capital intensive and the tenant’s re-investment in the property often has a direct impact on performance and maximizing any percentage rent. It is not uncommon for landlords to have rights to approve any hotel brand change in a property or to default a tenant if a hotel franchise agreement is not maintained or replaced with a comparable hotel brand.

Real estate capital markets appear close to their peak and the emergence of more leasehold transactions is a sign of this frothiness. As deals are pushed to new levels, investors will take more risk which is inherent in any ground lease. An example of owners pushing financial structure to maximize returns is converting a property to a fee and leasehold interests and selling or financing the two pieces separately for a profit. This is more common in New York than Boston or other markets but, in one writer’s opinion, it is a sign of caution to hotel investors. In any ground lease negotiation, ensure that you have solid legal counsel in the review of terms and fully understand exposure relative to rent coverage. 

Jim Luchars is chief investment officer for Stonebridge Companies, a hotel development and operating company. Prior to joining Stonebridge, Luchars was a principal at AEW Capital Management overseeing all hotel investments. Luchars has over 25 years of experience in the hotel business and commercial real estate.