The continuous decline in interest rates in the recent years has created a big issue for income investors and especially retired people that now have to increase their risk profile in order to achieve higher yields than what is available in the investment grade or government bond markets today. Bonds are today trading at some of the lowest yields ever and generally considered as being very overvalued. With this article, I want to offer bond investors a solution that can help them achieve higher and more sustainable income without taking additional risk. The asset class that I am referring to is the Ground Lease.
Ground lease overview
Ground leases are the least risky form of real estate investment available. It is a rarely encountered asset class that is highly misunderstood by many, including even real estate professionals.
So what is exactly a ground lease and more importantly what makes it so attractive relative to a bond?
A ground lease is usually defined as the lease of a piece of land for a relatively long period of time (e.g. 50-99 years) to a tenant that is then allowed to construct a building on the property. So as the ground lease investor, you are the owner of the land and earn rents paid by a tenant that is given the right to use the land for a pre-determined period of time. This structure is often used when a tenant, for example McDonald's, desires to build a new restaurant in a specific location, but the landowner refuses to sell his property. In this case, the ground lease can offer great advantages to both parties: The tenant, McDonald's, gets to build its new restaurant on a well-located piece of land and does not have to come up with the upfront cash necessary to acquire the site. And the land owner receives stable income paid by the tenant while still keeping the ownership of the land.
It is a win-win situation for both parties and an important component of many commercial real estate deals today.
Example of a McDonald's ground lease:
Why is a Ground lease so attractive for an income investor?
- Just like a bond, the cash flow is secured and agreed upon when signing the lease agreement. There is no cash flow risk as it is contractually agreed between the tenant and the land owner.
- Unlike bonds, the cash flow increases over time automatically. It is very usual for a ground lease to have built in rent escalations in the lease agreement to protect the land owner from inflation and to account for the land becoming more valuable over time. A 2% increase in cash flow per year is common.
- The initial yield of ground leases is typically higher than the yield of bonds with the same credit and duration. Often the initial yield of a ground lease might be 4.5% while the corporate bonds of the same company might sell at a 4% yield.
- Since land prices increase over time, you will achieve much higher returns than with bonds on average over time. You enjoy the benefits of the equity as well as the fixed income worlds. Your cash flow is guaranteed and increased automatically and additionally the value of your investment can appreciate over time. A well located piece of land in an infill location can well appreciate 2-3% a year which provides an extra component of return to the ground lease owner.
- A ground lease is less sensitive to interest rate risk than bonds. When increase rates increase, bonds immediately lose value. On the other hand, when interest rates are increased, it is sign that the economy is doing well which is a positive for a ground lease owner who will often in a healthy economy enjoy higher rental growth and higher land value appreciation. Cap rates of ground leases can however also increase with interest rates, but this risk is at least partially mitigated by the benefits that a real estate investor receives from a stronger economy.
- Unlike bonds, the cash flow and principal are protected by inflation. Land prices have generally a positive correlation with inflation. Bond investors are at large risk of losses when inflation unexpectedly increases.
- When the ground lease expires, the land owner receives all the improvements of the tenant free of any charge. This means that whenever the lease is over, the tenant will have to give his building to the land owner for free. This can add lots of value in many cases and provide a 3rd component of return to the land owner.
- Unlike other forms of real estate investments, the ground lease investor does not have to pay any operating expenses such as utilities, repairs, property taxes, etc. These are all the responsibility of the tenant who must pay all the expenses.
- Ground leases provide a great passive and hands free investment for the long term investor. Once the lease agreement is signed, the land owner just receives check after check and the tenant takes care of the rest.
- In case the tenant would default, in many cases the land owner would gain ownership of the improvements for free and release the building to another tenant. In the case of a default in the bond market, you risk to lose everything. The ground lease investor might in many cases actually hope that the tenant would default, so he could receive the building for free which increases his return.
- It is even more unlikely that a tenant defaults on a ground lease than a borrower to default on a bond because he would have to give up the improvements for free. Ground leases with good credit tenants are very safe investments.
- Just like bonds, ground leases provide returns uncorrelated with the stock market and secure cash flow even during occasional bear markets.
Corporate Bonds versus Ground Leases
In both cases, there is an agreement between two parties to lend something in return of a cash return. In the case of bonds, the lender lends money and receives interest in return. In the case of a ground lease, the land owner "lends" the land and receives rent in return. The terminology is different but the general concept is identical. There is a contractual agreement that obligates the borrower/tenant to pay interest/rent to the investor.
So both have no cash flow risk, but it could be argued that the ground lease is much safer because it is "backed" by real estate which will always be there even if the tenant would default. The real estate can then be released to another tenant in the worst-case scenario. The principal is not lost. This is very different if a borrower defaults on your bonds. Ground leases also protect against inflation and interest rate increases to a larger extent than bonds. It is for these reasons that certain people even argue that ground leases are the safest assets of all asset classes as long as the site is in a good location and leased to an investment grade tenant.
Despite all these risk mitigating factors, ground leases still achieve typically much higher total returns than bonds.
Ground leases have 4 different return components: the cash rent, the land value appreciation, the gain in ownership of the improvements when the lease expires and additional value appreciation if cap rates would go down. It is not uncommon for the ground lease investor to achieve a total return between 7% and 10% even if the risk profile of the asset class is very low. Bonds only have 2 return components: interest and value appreciation if interest rates go down. In today's market, interest is minimal and appreciation is unlikely for bonds.
The reason why ground leases achieve higher returns despite the lower risk profile is because they are less liquid assets than bonds and they require larger amounts of capital to be purchased. If you have multiple millions to invest, you could buy a ground lease directly yourself. However, if you are not part of the high net worth individuals, you will have to follow another route to gain exposure to this asset class.
To my knowledge, unfortunately there is not today any REIT that only specializes in ground lease investments, but there are a couple that have ground leases as part of their portfolio, including the large retail REIT Kimco (NYSE:KIM) and National Retail Properties (NYSE:NNN).
Alternatively, you could also invest in Net Lease REIT which own triple net properties. This is a little different from ground leases as Net Lease REITs also own the building itself in addition to the land, but it has also many similarities such as: stable cash flow from contractual long term agreements, operating expenses are the responsibility of the tenant, have typically higher occupancies, and the expected cash return and total return are higher than bonds. There are many Net lease REITs and examples include Realty Income (NYSE:O), W.P. Carey (NYSE:WPC), American Realty Capital Properties (ARCP) and National Retail Properties which also owns some ground leases.
Again, triple net leases are not the same asset class as ground leases and can be a little riskier. However, they are what come the closest to a ground lease and you can invest in them by buying shares of REITs. These Net Lease REITs will most of the time have the majority of their portfolio allocated to triple net leases and a smaller portion into ground leases. Triple net leases could be compared to bonds in a similar way as we did above with ground leases, and the results would not be materially different.
Bonds are today in many cases so overvalued that they do not provide any real return after inflation and taxes to their investors. They do not provide any protection in case of severe unexpected inflation either and are at risk of large losses if eventually the interest rates would go back to historic levels. If today, you need the income and are unwilling to take additional risk, I would recommend you to study further the ground lease market which is a great alternative in my view.
A ground lease can offer the stability of a bond investment with the return benefits of an equity investment.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.