When the main investment objective is to generate highly consistent and safe income, investors have generally turned themselves to bonds (LQD; VCLT; IEF). While this may have worked well in the past and allowed investors to earn a satisfying yield, today's environment is much less favorable to bond investors.
After a multi-decade-long decline in interest rates, the yields are today at historically low levels:
This creates two major issues to bonds investors:
- Not enough income is earned to meet their needs - this is particularly dangerous to large institutions and retirees.
- The value of their bond holdings may erode as interest rates return to normal and inflation accelerates.
As bonds appear to be historically overvalued and unable to fulfill the current income needs of investors, we want to present an alternative that can help certain investors achieve higher and more sustainable income without taking additional risk. The asset class that we are referring to is Ground Leases.
Ground Leases: An Alternative to Income Investors
Ground leases represent the ownership of a piece of land and the lease of it to a tenant who then builds and operates a property on it. The lease terms are exceptionally long at up to 99 years, and upon expiration of the lease, the ownership of all the improvements reverses back to the land owner. 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.
Ground leases are commonly considered to be the safest part of a commercial real estate capital structure because:
- Ground rent payments are senior to everything, even loan payments on the improvements.
- The lease terms are exceptionally long and commonly protected against inflation.
- The land owner has zero responsibilities, all expenses are borne by the tenant, and finally, in case of an unlikely default, the land owner receives all the improvements for free.
Example: McDonald's (MCD) 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.
Why Invest in Ground Leases Rather Than Bonds?
The fundamental difference between a bond and a ground lease is small, but ground leases earn higher returns in the long run. In both cases, there is an agreement between two parties to lend something in return of a cash payment. In the case of bonds, the lender lends money and receives interest in return. In the case of a ground lease, the landowner "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.
Yet, there are many reasons why long-term driven income investors may favor ground leases today:
- Growing Cash flow: Just like a bond, the cash flow is secured and agreed upon when signing the lease agreement. However, unlike the bond, it is common for ground leases to have built-in rent increases in the lease agreement to protect the landowner from inflation and to account for the land becoming more valuable over time. A 2% increase in cash flow per year is usual.
- Greater Default Protection: The rent payments of the ground lease are in most cases senior to interest payments on loans. Moreover, even in the very unlikely case of a default, the downside is limited as the landowner gains ownership of the improvements that the tenant has made "for free" and can re-lease the building to another tenant. In comparison, if an investor buys a bond which later defaults, the investor risks 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 in turn might increase the total return. It makes defaults very unlikely as the tenant has a lot to lose.
- Greater Inflation Protection: Unlike most bonds, the cash flow and principal are hedged against inflation. Land prices have generally a positive correlation with inflation, and since landlords have no responsibilities over property expenses, they are very well protected. In comparison, bond investors are in most cases subject to inflation and interest rate risk. In this sense, ground leases are more comparable to "Treasury Inflation Protected Securities" ("TIPS") (TIP) from a risk profile perspective.
- Higher Total Returns: The initial yield of ground leases is typically a bit 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. In addition to a higher initial yield, the income grows over time and well-located properties tend to appreciate, causing even greater outperformance in comparison to bond investors.
- Lower Interest Rate Sensitivity: Ground leases tend to be less sensitive to interest rate risk than bonds because cash flow growth and asset value appreciation mitigate some of the downside risk.
- Additional Upside at Lease Expiration: When the ground lease expires, the landowner 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 landowner for free. This can add lots of value and provide a third component of return to the landowner.
Put simply, ground leases are able to better fulfill the income needs from bond investors, and often provide additional upside in the long run along with better protection against defaults, inflation and even rising interest rates.
How to Invest in Ground Leases?
Ground leases are illiquid assets and generally require millions in capital to build a diversified portfolio on your own. As such, direct ground lease investments are only suited to high net worth individuals and institutions with long investment time frames and no need for immediate liquidity.
For all the other investors, there exists a new alternative to gain exposure to ground leases with the added benefits of liquidity, diversification and professional management.
Meet the First Ground Lease REIT
Safety, Income and Growth (SAFE) is a freshly IPOed REIT and the very first one to exclusively focus on ground lease investments. Given the higher safety of ground lease investments, it is no wonder that the company's ticker is "SAFE." Even its logo is a picture of a large safe:
Following a successful IPO at $19.50 per share about one year ago, the company has put together a diversified portfolio of 28 ground leases located in most major markets of the nation:
Most sites have been improved with valuable multi-family, office, hotels or industrial buildings with an average remaining lease term of 59 years until expiration and rent increases in 93% of leases.
It makes for a very safe and predictable income stream for decades to come with consistent growth, inflation protection, and zero landlord responsibilities.
Priced at an 8% discount to the book value of $20 per share, we believe that the shares are slightly undervalued, and the 3.2% dividend yield makes a safe income investment for conservative investors looking for a bond alternative that enjoys additional growth and inflation protection.
Alternatively: there exist a few other REITs that own ground leases as part of their portfolio strategy. The net lease REITs Realty Income (O), National Retail (NNN) and W.P. Carey (WPC) are some examples here, but for pure-play ground lease exposure, SAFE is the only REIT today.
Put simply, ground leases combine the benefits of equity investments with many advantages of fixed-income world all in one. Your cash flow is guaranteed and increased automatically, and additionally, the value of your investment can appreciate over time.
Ground leases are certainly not suitable for every investor and every situation, but if you are long-term driven, need safe income, can ignore short-term fluctuation, and accept illiquidity risk, then ground leases may make a solid portfolio replacement to bonds.
They fulfill the same income need, but provide additional upside and protection in the long run, especially in the case of accelerating inflation.
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Disclosure: I am/we are long WPC (MAY INITIATE A POSITION IN SAFE OVER 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.