Written by Victor McConnell, MAI, ASA, CRE and Grace McWatters
This Featured Article is contributed by the Real Estate Affinity Group of AHLA's Hospitals and Health Systems Practice Group.
There is an old adage in real estate which states that “under all is the land” [i]. This statement is quite literally true when dealing with ground leases upon which buildings are constructed. Within the healthcare real estate sector, it is common for hospitals to utilize a ground lease to facilitate the development of a new building. Most often, these arrangements are pursued on hospital campuses, where hospitals may prefer to retain a greater degree of control over a new development than would exist if they sold the land. The ground lessee entity may be a real estate investment trust (“REIT”), a physician group, a developer, or another third-party. A ground lease allows a hospital to retain long-term control of the site, along with the ability to have certain controls over the development and leasing of the building. A hospital’s motivations for pursuing a ground lease structure may also stem from a variety of other strategic or economic objectives, such as freeing up capital for other uses. [ii] A developer may prefer to acquire the land, though a ground lease structure does provide the developer with the advantage of slightly lower total capital requirements (as they do not need to purchase the land).
The focus of this article will be to: a) provide an overview of valuation considerations associated with ground leases; b) understand key attributes of on-campus ground leases; c) evaluate ground-lease related compliance risks; and d) discuss key issues such as ROFRs, options, use restrictions, and more.
What is a ground lease?
A ground lease is defined by Black’s Law Dictionary as “a lease of vacant land, or land exclusive of any buildings on it, or unimproved real property. Usually a net lease.”[i]
The Dictionary of Real Estate Appraisal defines a ground lease as “a lease that grants the right to use and occupy land. Improvements made by the ground lessee typically revert to the ground lessor at the end of the lease term
When an entity owns real estate without any leases (or other ownership interests) in place, the entity generally owns the “fee simple estate” in the real estate. Fee simple estate is defined as "absolute ownership unencumbered by any other interest or estate, subject only to the limitation imposed by the governmental powers of taxation, eminent domain, police power, and escheat
.”[iii] Ownership of the fee simple estate could encompass solely vacant land or could encompass land and improvements. When a ground lease is executed, separation of ownership between building and improvements occurs, and both a “leased fee estate” (for the lessor) and a “leasehold estate” (for the lessee) are created. Leased fee estate is defined as “the ownership interest held by the lessor, which includes the right to receive the contract rent specified in the lease plus the reversionary right when the lease expires.”
[iv] Leasehold estate is defined as "the right held by the lessee to use and occupy real estate for a stated term and under the conditions specified in the lease.”
[v] When a developer is in the lessee position on the ground lease and the lessor position on the building lease, their position is sometimes referred to as a “sandwich interest,” or “sandwich lease.”[vi]