Leasehold Interest
In real estate, a leasehold interest refers to a structure where an individual or entity (lessee) leases the land (i.e. ground lease) from the fee simple owner (lessor) of the land for an extended period of time. The lessee of a leasehold estate will generally own the improvements on the land and use the land and improvements as if the lessee were the owner of the land. During the term of the ground lease, the lessee will pay rent to the lessor for use of the land. At the end of the ground lease term, the lessee must return use of the land, and any improvements thereon, to the land owner.
Real estate investors are willing to lease the land when the cash flow from the improvements alone, after paying the ground lease payment, make the investment feasible. This is common with high-quality locations where the leasehold owner wants the location but the land owner is only willing to lease the land rather than sell.
Many office buildings in gateway cities (e.g. New York) are leasehold estates where the owner of the building leases the land underneath the building from a separate individual or entity for an extended period of time. One such example is the World Trade Center in New York City. The land is owned by the Port Authority of New York and New Jersey, but controlled by a separate group under a 99-year ground lease originally executed in July 2001.
Putting ‘Leasehold Interest’ in Context
Atlantic Property Group, a regional real estate investment firm, recently identified an opportunity to acquire a leasehold interest in Quincy Market Center, a 150,000-square-foot grocery-anchored retail center located in suburban Boston, Massachusetts. The center, constructed in 2005, is anchored by a high-performing national grocery chain and features a mix of 20 smaller tenants, including cafes, fitness studios, and boutique retail stores.
The Leasehold Structure
The property sits on 12 acres of land owned by the Quincy Development Trust, a family office that has held the land for over 50 years. Rather than sell the land outright, the Trust entered into a 75-year ground lease agreement with the original developer in 2004. Under this arrangement:
- Atlantic Property Group would acquire the existing leasehold interest, which includes ownership of the improvements (the retail center) and the right to operate and collect rents from tenants.
- The firm would be responsible for making an annual ground lease payment of $750,000 to Quincy Development Trust.
Investment Dynamics
Atlantic Property Group’s underwriting focused on the cash flow potential of the improvements after deducting the annual ground lease payment. The property generates gross annual rents of $5.25 million, with operating expenses of $1.5 million. This leaves a net operating income (NOI) of $3.75 million, out of which the ground lease payment must be subtracted, resulting in a net cash flow of $3 million.
Atlantic plans to pursue a value-add strategy by enhancing the tenant mix and renovating the façade of the property. With these improvements, the firm projects a 15% increase in total rents over the next five years, boosting NOI to $4.3 million and net cash flow to $3.55 million after the ground lease payment.
Exit Considerations
One unique aspect of the leasehold interest is that Atlantic does not own the underlying land, which limits the long-term residual value of the investment. However, the remaining 56 years on the lease term provides sufficient runway for their value-add plan and a profitable exit. Atlantic anticipates selling the leasehold interest to another investor at a 6% capitalization rate, achieving a significant return on equity.
Key Takeaways
- Leasehold interest enables Atlantic to control a prime suburban property without the capital outlay required to purchase the land outright.
- The ground lease payment significantly impacts net cash flow, making leasehold interest investments viable only in locations with strong cash flows from improvements.
- The limited ownership timeline of the leasehold interest must be carefully considered in underwriting and exit planning.
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