The use of ground leases for affordable housing has drawn increased attention lately.
At a time when soft money is difficult to acquire and construction costs are high, ground leases may be able to help generate additional upfront proceeds to fill funding gaps and push a transaction forward.
In recent years, a few companies have begun offering ground leases on affordable housing properties, including Safehold, a publicly traded real estate investment trust. The firm’s ground lease structure is well established outside of the affordable housing sector with nearly $7 billion of transactions closed to date, but the application on affordable housing, specifically low-income housing tax credit (LIHTC) transactions, is a new innovation, according to Steve Wylder, executive vice president and head of investments at Safehold.
The company closed its first LIHTC transaction in 2023 and has since closed more than 19 ground leases on housing credit developments.
Safehold, the lessor, acquires the fee interest with proceeds at a premium to the underlying land value, funding both the land cost and a tenant improvement allowance, which serves as an additional funding source for the project. According to Wylder, the lease rate—Safehold’s cost of capital—is “well inside of conventional permanent debt, which typically helps to drive a 10% to 20% increase in permanent proceeds after including ground rent as an ‘above the line’ operating expense and resizing the debt accordingly.”
It’s a 99-year lease with fixed-rate bumps and no fair market resets. The lease itself is intended to be highly financeable and saleable and has continued to evolve with input from various investors and lenders in the LIHTC space. In effect, the ground lease capital functions as a noncompetitive, low-cost gap filler, Wylder says.
While this strategy is still unfolding, here are several points to think about:
Learning Curve: Private ground leases are still a relatively new concept. While a number of these transactions have closed, it can still take some time to socialize the structure with housing authorities, bond issuers, investors, and other capital sources, Wylder says, adding that it is critical to align with a team experienced in LIHTC ground leases.
Impact: A ground lease structure is often most impactful on larger transactions in higher area median income and higher land cost markets, according to Wylder.
Questions to Ask: Many lenders and finance partners are still studying this new strategy and what it means for them and their development partners, says Paul Weissman, senior managing director and head of affordable housing production at Lument, a leading commercial real estate finance company. As a result, it is important for developers to understand how a project’s debt and equity providers feel about ground leases.
Weissman adds that developers should be sure to analyze how much they will be paying over the course of the transaction both on an on-going basis and at sale by applying an estimated cap rate to ground lease payments. It’s important to understand payment escalation clauses and Consumer Price Index look-back adjustments in order to fully evaluate any additional risk and cost associated with them.
Deal Terms: When it comes to underwriting and costs, ground rent is typically sized to roughly one-third of untrended net operating income, growing at 2% per year. Ground rent is treated as an “above the line” operating expense. Lease rates are variable but today are generally in the low- to mid-5% range, says Wylder.
- End Game: Developers should focus on how flexible a ground lease will be over the life of the investment, not just at closing, says Devin Peterson, managing partner at Haven Capital, a real estate finance firm specializing in ground leases. He points to Haven’s structure as an example of how that flexibility could look: “a fully amortizing ground lease with defined early repurchase options and a $1 buyout at maturity, giving developers a straightforward and predictable path to fee simple ownership.” That structure preserves value at the leasehold level and allows sponsors to refinance, sell, or recapitalize with certainty, without fair market value resets or interference with property operations, according to Peterson.