Ground lease for $140,000/year or build my own 14,000 sq ft at $3.5-4.5m? Need advice.
I own a commercial plot of land (**edit**: Bought in 2006 for $400,000) in a popular city and a real estate group wants to put in a franchise in there.

I could build about 14,000 sq ft of real estate space for about $3.5m-4.5m. The area goes for about $20-30 sq ft + NNN.

The franchise wants to cover all construction costs and such and I would just be leasing them the land.

They would take up the entire plot and pay me $140,000/year over 5 years flat, then increase by 10% every 5 years on a renewal.

I’m unsure on which path to take, or if doing a ground lease is inherently more risky.
[{"id": "iflwbeu", "text": "Would you be willing to sell the land?", "replies": [{"id": "iflwr33", "text": "I could sell the land for $2.1m; but I would prefer not to.", "replies": [{"id": "iflzov3", "text": "I\u2019m going to take the mid point of those numbers for argument sake ($4M build out and $25/SF NNN).\n\nAt $2.1M market value for land you\u2019re at a 6.7% return which is solid on the ground lease scenario. You\u2019re basically spending $4M to increase your NOI by $210,000/year, which is giving you a 5.25% return, so you\u2019re diluting your returns in the buildout scenario. \n\nIf you\u2019re confident you can build it at $3.5M and get $30/SF that bumps you up to an 8% overall return, making it more attractive. I would narrow down the terms with this franchise group. Making it a build to suit on an open book basis where you are striving to hit a certain yield on cost (I would say a minimum of 7% return so you\u2019re beating your ground lease return based on the market value of the land). \n\nThe downside to the ground lease scenario is you\u2019d be locked in to sub-2% annual bumps for a long time. If you have a good location and can get 3% annual bumps on a building lease and push rents even higher on a renewal, I would go to the build to suit route. But make sure the franchise group would agree to those terms or similar to lock in your return.\n\nIf you picked up the land for cheap, say sub $1M, I would say the ground lease would be the more favorable option as you can lock in mid-teen\u2019s annual returns without doing the work, and then you can refinance and use those proceeds in another investment.", "replies": [{"id": "ifm1na8", "text": "u/rexocity13 thanks for the advice! I purchased the ~0.8acre  plot for about $400,000 in 2006.\n\nI\u2019ve been meaning to build on it but never quite got there until recently!", "replies": [{"id": "ifm415u", "text": "Gotcha this is helpful. I\u2019m going to assume around $10K/year in carry costs for 15 years so you\u2019re total basis is $550K, feel free to adjust. \n\nLet\u2019s say the value of a ground lease is an 8% cap conservatively here. Meaning if you were to sell it you would receive $140,000/.08= $1,750,000. You\u2019d be getting $1.2M net, which is 218% of profit margin. Or if you\u2019re a long term holder you\u2019d be getting a 25% return.\n\nLet\u2019s take a very aggressive scenario, where you build it for $3.5M, lease it for $30/SF and sell for a 6% cap. You\u2019d sell it for $7M and you\u2019d net $3M ($500K basis plus $3.5M build), which is a 75% profit margin, which is much less percentage wise but you make an additional $1.8M in profit. Still, there\u2019s a time value component since you\u2019d probably build and lease it 12-18 months from now, risk cost overruns, approval delays, etc. \n\nAt more conservative $25/SF, $4M build and a 7% cap valuation, your profit gets swallowed up. Stabilized value would be $5M and you\u2019d be getting only a $500K profit for all that work (when you were making $1.2M on just the ground lease).\n\nI\u2019d say you\u2019ve made the most of your profit already by buying the land cheap and can get nice return and profit by just signing a ground lease. Seems like a lot of risk in a very uncertain time in the market to build and start earning income over a year from now. I\u2019d weigh other factors as to how much effort you\u2019d have to put into building it, signing a GC contract, going through city approvals, additional legal fees with a more complicated contract with the franchise group. Seems like for a deal of this size I personally would take the bird in hand and lock in a killer deal while doing all the work/risk to MAYBE get some more profit (but also maybe eat into your profit).", "replies": [{"id": "ifmko4f", "text": "u/Rexocity13 what happens if say the franchise chain closes the location and/or goes bankrupt (I don't imagine it will, but it feels in the market that chains come and go quickly)?", "replies": [{"id": "ifmlva4", "text": "Part of the ground lease should be that all of the improvements are yours, so if they default you have possession of the building that you didn\u2019t even pay to build", "replies": [{"id": "ifrzryo", "text": "u/Rexocity13 you are one savvy person; I had a question about this net operating income that I will receive.\n\n$140,000; should I setup an LLC as an S Corp and pay myself a salary of $30,000 and then pay myself in distributions on the other $110,000? Or should I do something entirely different?\n\nThanks for your wise words of wisdom. I'm going with the ground lease option.", "replies": [{"id": "ifs2q3y", "text": "Now I\u2019m punching above my weight - I\u2019d leave that for a tax professional to answer!", "replies": [], "depth": 9}], "depth": 8}], "depth": 7}], "depth": 6}], "depth": 5}], "depth": 4}, {"id": "ifnq280", "text": "Sorry to jump in here, but where can I learn what you just did here with the valuation and analyzing the deal? Any books I can read about this?", "replies": [{"id": "ifnra7i", "text": "I\u2019d recommend The Real Estate Game by William poorvu for this \u201cback of the napkin\u201d type analyses. For more advanced, excel modeling I recommend Justin Kivels courses on Udemy (they have sales every few weeks where the courses are like $10 each).", "replies": [{"id": "ifpsnky", "text": "Thanks for this. The way you broke down this deal is amazing and makes a lot of sense!", "replies": [], "depth": 6}], "depth": 5}], "depth": 4}, {"id": "ifoclrb", "text": "You\u2019re missing the assessment of risk in your 8% vs 6.7% yield comparison.\n\nIs it worth the construction, leasing, financial, and market risk you take on for an incremental 1.3% yield? Plus additional managerial responsibilities, future capex, etc?\n\nIf you could negotiate absolute NNN build to suit leases before you stick a shovel in the ground, sure it\u2019s as simple as looking at the yields. But in reality I think a major question is whether OP has the managerial chops to take care of the completed property if he builds.", "replies": [{"id": "ifoeiy1", "text": "For sure, I later commented that I would lean the ground lease rather than take all that work and risk for an uncertain (and possible lower) amount of profit", "replies": [], "depth": 5}], "depth": 4}], "depth": 3}], "depth": 2}], "depth": 1}, {"id": "iflxfp3", "text": "If the credit of the tenant is strong this NOI is worth about 2,500,090\n\nAs long as you bought the land for less than this , what\u2019s the downside??", "replies": [{"id": "ifm15md", "text": "There is little to no risk to them if the valuation and rent meets their expectations", "replies": [], "depth": 2}], "depth": 1}, {"id": "iflxomi", "text": "$140,000 per year at a 6cap is only a ~$2.3M valuation of the property with the franchise and lease in place. If you can build a 14,000SF leasable building and charge $25/sf/yr then do that, get an absolute NNN lease signed and sell it with that NOI at a 6cap for $5.5M+", "replies": [{"id": "ifm1mum", "text": "But if it costs him $4.5M to build and he spent $1M on the land theyre not creating any value. I haven\u2019t been involved with NNN retail deals but 6% cap seems aggressive in this inflationary environment. Seems like credit would have to be pretty strong to get a 6% cap, if that. \n\nIf he spent more than $1M on the land, gets closer to $20/SF in rent and/or exit valuation is worse than 6%, then he\u2019d be destroying value by building it himself, making the ground lease much more attractive. If he/she spent $1M or less on the land they\u2019d be creating more value with the ground lease rather than building on it if the ground lease is worth $2M+", "replies": [], "depth": 2}], "depth": 1}, {"id": "ifm4dgl", "text": "Unless this tenant is one of the \u201cbig boys\u201d and are aren\u2019t worried about financing, I wonder how the tenant is going to finance construction with a 5 year GL?", "replies": [], "depth": 1}, {"id": "ifm5mpp", "text": "I would lean towards the ground lease. It\u2019s reliable money. And a bird in the hand. \n\nBuilding something new is an issue because\n1. How sure are you that you can build it for that amount, and avoid overruns? Construction is expensive right now. \n2. You\u2019re banking on rent rates 2 years from now when construction finishes. The market might get worse. \n3. You\u2019re not making any money until the construction finishes in 1-2 years (or longer).\n\nPlus once you have the building done now you have to find a tenant and do TI which is even more money. \n\nGranted these days I\u2019ve soured on commercial construction.", "replies": [{"id": "ifmb2ja", "text": "I've soured on hassles.", "replies": [{"id": "ifqgpwh", "text": "Me too! ;)", "replies": [], "depth": 3}], "depth": 2}], "depth": 1}, {"id": "ifmcxtz", "text": "For me this would be a no question take the ground lease. You\u2019ve managed to make 140k yearly off a 400k investment (even if you bumped it up to 550k) that is great.", "replies": [{"id": "ifmzi0q", "text": "It\u2019s not really a 400k investment. What we\u2019re the carrying costs from 2006 to now\u2026. Assuming nothing was being done with it.", "replies": [{"id": "ifn2291", "text": "Obviously it is not just 400k. As someone mentioned even with carrying costs it\u2019s still a great return.", "replies": [], "depth": 3}], "depth": 2}, {"id": "ifnhm2f", "text": "Shoooot\u2026if they can do 140k then they can do 150k. Make a counter offer", "replies": [{"id": "ifnrc05", "text": "Also, don't forget countering on the yearly increases. I'd aim for 3% yearly instead of 10% every 5.", "replies": [{"id": "ifobrsh", "text": "10/5 is pretty common. Id more likely ask for a % rent over a threshhold depending on thr franchise.", "replies": [], "depth": 4}], "depth": 3}], "depth": 2}], "depth": 1}, {"id": "ifmk0lf", "text": "Does the rent on the ground lease reset every 5 years or is the initial term only 5 years? If the term is only 5 years, that doesn't make a ton of sense from the lessor's perspective. What if you choose not to renew the lease? Then you get a \"free\" $4 million building.\n\nEdit: also, worth mentioning if the ground lease is unsubordinated or subordinated.", "replies": [], "depth": 1}, {"id": "ifmmzum", "text": "Would the seller be able to drop the ground lease after 5 years?  I\u2019m still learning on deals like this.. why would a franchise just want 5 years and then optional renewals, seems like only 5years couldn\u2019t make a full BTS worth it", "replies": [{"id": "ifmtxmt", "text": "Typically the franchise has the option to renew and the landowner cannot end the option unilaterally. The franchise is locking in the property at a known rate for 15+ years, but they can back out every 5 years. Also the rent bumps are already known to the franchise.", "replies": [{"id": "ifn721k", "text": "At the end of the ground lease, does the landowner retain ownership of any structures or improvements, or do they have to \"buy then out\" like an auto lease?", "replies": [{"id": "ifo80u1", "text": "Typically they retain it, no buyout", "replies": [], "depth": 4}], "depth": 3}], "depth": 2}], "depth": 1}, {"id": "ifmozw2", "text": "Ground lease. Ground lease. Ground lease. \n\nYou don\u2019t want to deal with the hassle of construction, rising material cost, rising labor costs and general delays in supplies. It will also take a while for the building to be completed. \n\nWith the not so positive projections people have for the economy I wouldn\u2019t risk the $3-4 million in construction costs to build something that might not be fully leased. \n\nThe ground lease guarantees money in your pocket. It would be ill advised to walk away from that offer. Good luck!", "replies": [], "depth": 1}, {"id": "ifmq22e", "text": "If you\u2019d like to dm me info of who the tenant (franchisee) is, general market, and proposed ground lease terms (rental increase amounts and length of lease), I can give you a rough idea of exit value. \n\nWith the info you\u2019ve provided, it would seem the ground lease option would be the least amount of headache and decent return relative to your cost basis.", "replies": [{"id": "ifn4in6", "text": "Agree with this poster. A few comments:\n- the credit of the lessee matters\n- who is the lessee and what are they planning to build\n- if they blow out, can you feasibly release the property and for what potential use\n- 14,000 sf is quite large so assume this is a restaurant. What are the potential alternative uses And would this be congruent with the highest and best use", "replies": [], "depth": 2}], "depth": 1}, {"id": "ifn6m6i", "text": "If OP does a ground lease and in 5-10 years the company decides to not renew does OP just get a free building?  How does ownership of the building work out?\n\nEdit: Quick google search answered my question: A ground lease is an agreement in which a tenant is permitted to develop a piece of property during the lease period, after which the land and all improvements are turned over to the property owner.", "replies": [{"id": "ifobtum", "text": "Yes, he keeps all improvements.", "replies": [], "depth": 2}, {"id": "ifq62ed", "text": "In general yes, but not always.  I worked at Waffle House and we had a policy to sell the building at the end of the lease to the owner or we would demolish it.  We actually had to demo on once and the LL called me crying.  I had sent her the demo permit, and everything, all we wanted was like $30k.  She still refused so we took it to the foundation.  Whenever someone said we were bluffing after that we just referenced that LL.", "replies": [], "depth": 2}], "depth": 1}, {"id": "ifnbacf", "text": "You'd have to be crazy to build a building with those expected costs and rental rates if you can do a ground lease at 140k.", "replies": [], "depth": 1}, {"id": "ifnlqcq", "text": "No brainer.  Do the ground lease.", "replies": [], "depth": 1}, {"id": "ifnn330", "text": "It\u2019s a tough one. A lot of good advice here. The real question is what is your risk tolerance for this specific asset and your overall portfolio? What is your level of experience in development? What\u2019s your threshold for the inevitable development brain damage for this site?", "replies": [], "depth": 1}, {"id": "ifnu5or", "text": "Do ground leases block the tenant from having any liens on the structure itself?  I'm imagining a scenario where the tenant goes bankrupt after 5 years but still has construction loans?", "replies": [], "depth": 1}, {"id": "ifo21zd", "text": "Tough to exit a ground lease with less than 50 years of term as banks won't finance it.", "replies": [], "depth": 1}, {"id": "ifo3sp4", "text": "If it was me I would do a ground lease for sure.", "replies": [], "depth": 1}, {"id": "ifo4fjw", "text": "The bottom line here is what is being proposed to be built on the site. If it\u2019s highly special purpose, there\u2019s always the possibility that that there would not be an end user and the building would need to be raised. However, if there are a lot of adaptive re-uses for the property, then the best thing that could happen is if they default and you end up owning the building.", "replies": [], "depth": 1}, {"id": "ifoau54", "text": "Go for it!!!!!! If not I\u2019ll buy the land from you for 800k \ud83d\ude0e", "replies": [], "depth": 1}, {"id": "ifobse3", "text": "Ground lease, absolutely no question here.\n\nYou\u2019re getting $140k/year on a $400k investment with essentially zero risk to you. Best case they stay long term, worst case they terminate after 5 years and you then get to assume control of the new building they paid for and rent it at whatever rents are then.\n\nFlip side is you put in probably $1M in additional equity to get at best $420k income assuming you lease the space absolute net (realistically you\u2019ll probably get quite a bit less). You assume all construction risk, management responsibilities, etc, have higher debt service and carrying costs.\n\nLong and short of it is building is WAY more risk than the potential incremental yield and level of effort you\u2019d need to put into management is worth.  Bird in the hand is the way to go here.", "replies": [], "depth": 1}, {"id": "ifoddaf", "text": "Ground lease.", "replies": [], "depth": 1}, {"id": "ifoj5eq", "text": "If you ground lease, at the end of the term, any improvements return to the landlord. The other part of your question is really more mathematical.", "replies": [], "depth": 1}, {"id": "ifpcec7", "text": "First good on you mate! 100% jelly!!! I would say pull the trigger on the $140,000 per year. If you have owned the property since 2006 why didn\u2019t you build already is my reasoning. If you get to keep the building after the lease you have added value!", "replies": [], "depth": 1}, {"id": "ifpw807", "text": "Wow 5 years is a very short term for a ground lease. Go for it", "replies": [], "depth": 1}, {"id": "ifqc3kp", "text": "That deal is in line with National Ground leases. 10% every 5 years despite current inflation is a market deal for ground lease. Hard to say if 140k is without knowing the market. I would push for 15 or 20 years of primary term and as soon as that lease is signed and the contingencies from the city are removed. Try and get the first option to be fair market value. Likely they wont, but its worth a shot.  Sell it as a NNN investment and roll your money into your next play. This is a win, I wouldn't over think it.", "replies": [], "depth": 1}, {"id": "igzzgjs", "text": "You need to talk to leasing and NNN sales broker asap.", "replies": [], "depth": 1}, {"id": "ihgnip7", "text": "With all due respect to the original poster, if you don\u2019t have the knowledge or experience to run a basic financial model comparing these to alternatives, I recommend you consult an experienced CRE broker in your market before moving forward with either scenario. The CRE market and terms are fluid especially right now. With inflation rising, that is now a term on the table that was once glossed over with 10/5. Subordination is a deal breaker. Again - find a good CRE broker and attorney experienced in ground leases. Their fees will be well worth what they charge you (assuming if is market based fee).", "replies": [], "depth": 1}, {"id": "ihne1oj", "text": "Ground lease", "replies": [], "depth": 1}]