One of the primary questions seasoned investors ask when they meet with an investment property broker is:
How do I enhance my Internal Rate of Return (IRR) on the cash I invest, including tax benefits, to create a long-term strategy for wealth appreciation without sacrificing current ownership advantages?
By acquiring a commercial real estate property that has a long-term ground lease using a 1031 transaction, investors not only achieve their goals of increasing their cash position, receive tax benefits, and acquire a catalyst for long-term wealth growth; they also gain the ability to purchase additional income properties without sacrificing ownership advantages in current properties.
CASE IN POINT
- A $100 million real estate investment property is projected to yield a capitalization rate of 7%, producing $7 million of net income for the tenant;
- The purchaser of the ground lease will offer the property owner 35% of the total value of both building and land.
- The ground lease is constructed with a 99-year lease term that has a 5.25% to 5.75% interest only rate, with annual 2% bumps in the lease rate that are paid by the gross income from the property.
Often there would be a buy back option in year 15 for the original fee owner to buy back the land from the ground lease purchaser for a 15% premium.
To help the investor acquire the ground portion, a loan of up to 70% of the lease-hold value can be financed at low rates and offered as would a fee deal with 10-year terms and non-recourse financing. Based on today‘s mortgage rates, there will be a generous cash flow above the ground lease payment. The lease payment from the tenant with future increased rent is a bonus.
Between the lease payment to the property owner and the funds of the new loan arrangement, the balance on the past loan, if any debt still exists, will be easily satisfied; and the extra funds can be used to buy out partners that are no longer needed in the deal or execute new 1031 transactions to purchase additional income property that yields extra cash flow.
OWNING THE INVESTMENT
There will likely be less equity required to hold the investment property going forward, and the cash flow of the asset will not only support the ground lease payment and the loan payment, but returns on cash flow to the lease-hold owner will raise his IRR. The property owner now owns the building without the ground ends up with a 100% depreciable asset, and utilized it in a much more beneficial way for building investment capital.
In addition, the risk in the deal has lessened for the ground lease owner, because he captured 35% of the total value of the property at optimum prices, and did not gamble on the value of the entire entity (i.e. the value of the property plus the value of the lease). As an investor, a combination of cash in your pocket today is often more valuable than keeping full equity in a deal based on its possible increase in value in the future.