Unscrambling Property Interests

Properties involving Triple Net Leases (NNN) are among the most popular investments for both institutional and individual investors.[1]  Under a NNN lease all property expenses are paid  by the tenant, not by the landlord.  However, many leases that are advertised as NNN contain certain “carve outs,” or exceptions. The most common exceptions are the roof, structural walls (but not demising walls), and foundation. These selected expenses remain the responsibility of the landlord. At times, a property may be offered as a NN lease, indicating that one of the three expenses is to be paid by the landlord. Only a careful reading of the lease will reveal which category of expense will be the landlord’s responsibility.

Investors are attracted to NNN lease properties because they require less management time and money than a property which demands the landowners full attention. They are also heavily promoted to investors seeking a replacement to complete a S.1031 exchange. But all is not wine and roses. It is important that the tenant under a NNN lease have a strong financial statement capable of adequately maintaining the property in good condition.  With regard to a 1031 exchange, it is critical to differentiate a fee-simple property which is subject-to an occupancy lease from a leasehold interest subject to a ground lease.

When a property is leased, the interests in the property are separated: the tenant, or lessee, holds the leasehold interest, while the owner of the property (the lessor) retains the leased-fee interest. Because of frequent errors in describing what is being sold, it is essential that the buyer verify the interest offered for sale  prior to spending time, money and effort investigating its condition. A call to a title officer is the safest and quickest way to do this.

A property described as a fee-simple interest indicates that the seller possesses all the rights associated with ownership of the property. But if the lease is governed by a ground lease, then the buyer may be buying either the leased-fee interest or the leasehold interest.

A great deal of misinformation occurs when a property listed for sale is described as a “fee-simple (groundlease).”  This description is not only ambiguous but fails to specify whether the leasehold interest or the leased-fee interest is for sale. It suggests only that a ground lease is involved. It is the oxymoronic equivalent of “a spherical cube;”  It’s either a sphere or a cube; it’s either a fee-simple interest, or a leasehold interest or a leased-fee interest. It can’t be both.

An owner of a property may lease the property utilizing a NNN lease to a credit-worthy tenant such as Walgreens, Applebee’s, MacDonald’s, Rite Aid, Chase Bank or similar branded business These leases are typically written for long periods, 15-25 years, but no ground lease is involved. These leases may be described as “occupancy leases,” because the tenant secures only the rights to use and possess the property for the term of the lease but does not hold any  development or ownership rights in the property. In this instance, a buyer acquires the fee-interest subject-to the existing lease, which remains in place.

In contrast, a landowner may secure a location, build an improvement which is subsequently leased to a credit tenant and then sells a leasehold interest (only) in the property to a third party utilizing a ground lease. Under a ground lease the buyer of the leasehold interest obtains not only the rights to use and possess, but – in the case of  vacant land- the right to develop improvements on the land, and is subsequently responsible for all expenses of ownership including property taxes, insurance, and maintenance. The ground tenant as owner of the improvement also has the right to depreciate the value of the improvement without the need to allocate a portion of the entire property’s Basis between the land (non-depreciable) and the depreciable improvement. He may also sub-let, sell, or exchange his leasehold interest.

The distinction is vital since a buyer of the fee interest, even though it is encumbered by an occupancy lease, obtains ownership of the entire property. The rights to use and possess the improvement for a limited time are simply rented out.  But the buyer of the leasehold interest subject to ground lease has an ownership interest in the improvements for a determinable period. At the expiry of the ground lease ownership of the improvements reverts [2] to the owner of the land (owner of the leased-fee interest).

In arriving at the value of a fee-interest property it is customary to capitalize the first year’s NOI on the assumption that the owner can release the property indefinitely. But if the tenant holds a  leasehold interest under a ground lease then capitalizing the first year’s NOI to establish the value of the leasehold is inappropriate since the leasehold interest expires at term expunging the tenant’s rights to any future income. The Capitalization method of valuation assumes that the income continues in perpetuity

Many, many leasehold interests involving ground leases are priced as though they were fee-interests, and not leasehold interests, and are therefore significantly overpriced.


[1]   The three Ns stand for net of property taxes, insurance, and maintenance.
[2]     Almost all ground leases call for this reversion at expiry.

 

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