A ground lease is a layer of capital: price it, compare it with the equity it replaces, and find the rent, exit cap and leverage at which it stops paying.
A ground lease raises the sponsor's equity IRR when the ground rent, and the land value given up at exit, cost less than the return on the equity they replace. On an illustrative 100 million property, 20 million of it land, ground leasing the land at 4.5 per cent instead of buying it lifts the levered IRR from 13.53 to 14.13 per cent, 60 basis points. The edge disappears if the ground rent is above 5.13 per cent, if the leasehold sells at an exit cap more than 80 basis points wide of the freehold, or if lenders cut leverage on the leasehold to 50 per cent.
Worked in full in Private Equity Real Estate by Julian R. Sterling, with every figure reproduced in a free workbook.See the book on Amazon →
Ground leasing the land is a form of financing. The sponsor does not pay 20 million for the land today; it pays a rent for it every year instead, and at the end it sells a leasehold interest, which is worth less than the freehold because the buyer inherits the ground rent. So the question is the one asked of any layer in a capital stack: what does this money cost, and is that more or less than the money it replaces? Here the ground lease replaces part of the equity and part of the mortgage.
| Input | Buy the land | Ground lease |
|---|---|---|
| Purchase price | 100.0 | 80.0 |
| Net operating income, year 1, before ground rent | 6.50 | 6.50 |
| Ground rent, year 1 (4.5% of land value) | 0 | 0.90 |
| Growth in NOI and ground rent | 2.5% | 2.5% |
| Loan to value, interest only | 55% | 55% |
| Interest rate | 6.00% | 6.25% |
| Exit cap rate on year-11 NOI | 5.75% | 6.25% |
| Sale costs | 1.0% | 1.0% |
The leasehold carries a 25 basis point higher loan margin and a 50 basis point wider exit cap rate, both illustrative: lenders and buyers price the ground rent ahead of them and the shortening lease term.
NOI to the sponsor = property NOI − ground rent
Annual equity cash flow = NOI to the sponsor − loan × interest rate
Exit proceeds = year-11 NOI to the sponsor ÷ exit cap × (1 − sale costs) − loan
In Excel: =IRR(B20:L20) on the equity row, one column per year from year 0 to year 10
Step 1: buy the land. The loan is 55.0 and the equity 45.0. Year-1 cash flow is 6.50 − 55.0 × 6.00% = 6.50 − 3.30 = 3.20, a cash-on-cash return of 7.11 per cent. Year-11 NOI is 8.32, worth 144.7 at 5.75 per cent; after costs and the loan the equity receives 88.3. The IRR is 13.53 per cent and the equity multiple 2.85x.
Step 2: ground lease the land. The price falls to 80.0, the loan to 44.0 and the equity to 36.0. NOI after the 0.90 ground rent is 5.60, a 7.00 per cent yield on the 80.0. Interest is 2.75, so year-1 cash flow is 2.85 and cash-on-cash 7.92 per cent. In year 11 the property earns 8.32 and the ground rent has grown to 1.15, leaving 7.17, which sells for 114.7 at 6.25 per cent. Equity receives 69.5. The IRR is 14.13 per cent and the multiple 2.91x.
Step 3: price the ground lease as capital. Against owning, the ground lease gives the sponsor 20.0 today, takes the ground rent every year and costs 29.7 of net exit proceeds, because the leasehold sells for 30.0 less. The rate that equates those flows is 8.27 per cent. That is dearer than the 6.00 per cent mortgage but much cheaper than the 13.53 per cent equity, which is why the levered IRR rises. It is also below the 9.88 per cent unlevered IRR of the freehold, so even an all-cash buyer gains: 10.28 per cent on the leasehold, 41 basis points more.
| Ground rent, % of land value | Same exit cap as freehold | +50 bp | +100 bp |
|---|---|---|---|
| 3.5% | 16.09% | 15.05% | 14.08% |
| 4.5% | 15.19% | 14.13% | 13.13% |
| 5.5% | 14.26% | 13.17% | 12.15% |
The two break-evens are a ground rent of 5.13 per cent of land value, 1.03 a year, at the base exit cap, and a leasehold exit cap of 6.55 per cent, 80 basis points wide of the freehold, at the base rent. Exit pricing moves the answer as much as the rent does: each 50 basis points of exit cap is worth about a point of IRR. The exit cap sensitivity shows the same mechanism on a freehold.
Treat the ground lease as a layer of capital and price it: here it costs 8.27 per cent, between the mortgage and the equity, so it lifts the levered IRR from 13.53 to 14.13 per cent. The gain is small and fragile, gone above a 5.13 per cent ground rent, a leasehold exit cap 80 basis points above the freehold's or a lower loan. The capital stacks and the leverage ladder of the book are built cell by cell in the free workbooks for the book.
Usually, if it is priced below the equity it replaces. On the illustrative case it lifts the levered IRR from 13.53 to 14.13 per cent, because the ground rent and the 29.7 of exit value given up cost 8.27 per cent a year, against 13.53 per cent on the equity. A higher rent, a wider leasehold exit cap or lower leverage can reverse it.
Treat the land price saved as money received, the ground rents as payments, and the lower leasehold sale price as a final payment, then solve for the rate. With 20.0 of land, a 4.5 per cent rent growing 2.5 per cent a year and 29.7 less at exit after ten years, the cost is 8.27 per cent: dearer than a 6.00 per cent mortgage, cheaper than equity.
The buyer inherits the ground rent and a lease that keeps shortening, and lenders are more cautious about it, so it pays less per unit of income. In the illustrative case a 50 basis point wider exit cap is assumed; valuing the leasehold at the freehold's 5.75 per cent would overstate the IRR at 15.19 per cent instead of 14.13.
This article is one calculation from Private Equity Real Estate. The book takes the same case from first principles to the decision, chapter by chapter, and every figure it prints is a live formula in the free companion workbooks.
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