The Commercial Classroom: The land lease alternative - by Edward Smith, Jr.

This column is offered to help educate agents new to commercial and investment brokerage and serve as a review of basics for existing practitioners.

Your client has been leasing space for their business. Now they are asking you, should they buy a building or land lease property and build.

There is another underlining question here. Should your client be buying or building at this time? Should they perhaps continue to lease space?

Timing is everything! Where is the market? Real estate values go up and down in cycles. You do not want to buy at the height of the market. Someone who purchased real estate in 2007-2008, bought it at the wrong time. We saw values crash 25%-30% or more shortly thereafter. Now is a good time to buy as we are at the beginning of the next cycle.

Typically when rents go up so does the value of the building. Real estate tends to appreciate in value over time, meanwhile ones mortgage is being paid down increasing equity. Eventually the property could be sold at a profit. But market trends need to be projected into the future, where will prices be five or ten years from now?

Your client’s business plan needs to be considered, will their space requirements increase in the future? Are they looking to buy a building now, but sell it in the future when the business grows, in order to buy an even bigger building? Is there a financial constraint as to how large a building they can purchase now? What is their financial capability?

The Land Lease Alternative

Some facts about land leases, they are written for a long term, typically 49-99 years. It is the tenant’s responsibility to pay for the construction of any improvements – to construct a building. At the end of the lease any improvements to the property revert to the land owner. Land leases are typically Triple Net (NNN), meaning all expenses are paid by the tenant.

Sometimes tenants have no choice; an owner of very desirable, well located property will not sell it, it is only available as a land lease.

Advantages of the land lease include less upfront acquisition costs; land can be very expensive; the rent for the land is tax deductible. It affords more latitude in the design of the building and may offer the ability to construct more space than is needed for one’s business, creating rental cash flow from other tenants. A new building can take advantage of the latest technology, energy and environmental efficiencies. 

The building on a land lease could be sold in the future, but would always have the land lease ending date encumbering it.

In buying an existing building you are paying for the value of the land and building. If financed today you would need 30%-40% down based on the package price. The age and condition of the building are critical, what will need to be done to maintain the property in the next one to five years?

Whether your client buys an existing building or builds new, they will have the same tax deductions for operating costs, real estate taxes and depreciation. Land is not depreciable.

Another major consideration, will this be your client’s only location or do they see multiple locations in their future? Plans for expansion can be expedited by removing the cost of buying land; using their funds only for building construction. If property cost $500,000 and construction costs $500,000, by land leasing they could open two facilities for the same $1 million. For this reason national retailers and franchises, which open many stores each year, prefer to land lease.

Client’s considering a land lease and building their own building generally are committing to have their business at this location for a very long time.

Edward Smith, Jr., CREI, ITI, CIC, GREEN, MICP, CNE, is a commercial real estate consultant, instructor and broker at Smith Commercial Real Estate, Sandy Hook, CT.