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Commercial Ground Rents offer a compelling alternative to conventional real estate finance with benefits for investors and leaseholders/operators alike.
In brief
- Commercial Ground Rents offer an alternative to other types of finance, allowing property owners the opportunity to release value from their real estate while still controlling the asset.
- CGRs offer benefits to the investor, including longer investment terms and protection against inflation.
- Benefits for the leaseholder/operator include lower cost of capital, increased flexibility and affordable rent.
In this article David Martin & Michael Armstrong from EY Ireland’s Debt Advisory Team address the use of Commercial Ground Rents as an alternative to traditional debt finance for commercial property owners. Whilst not yet prevalent in the Irish market the structure has grown rapidly in the UK over the past five years and is now well-established in that jurisdiction. The product offers an alternative source for raising capital for Irish commercial property owners in the coming years. This article addresses the key fundamentals of commercial ground rents and structural differences to more common sale & leaseback transactions.
What are Commercial Ground Rents?
Commercial Ground Rents (CGRs) offer an alternative to conventional real estate finance and provide property owners a way to improve their capital structure by releasing value from their real estate while retaining control of the asset. This is done by selling the freehold and taking back an ultra-long dated lease at a rent much lower than traditional sale and leaseback levels, with minimal operating restrictions and potentially an option to reacquire the real estate for a nominal sum at the end of the agreed lease term. The capital, which is released to the operator of the building, can then be reinvested in the asset or extracted for the release of funds to shareholders/investors.
From an asset owner occupier’s perspective, CGRs are similar to secured amortising loans. The company gets a capital advance which is then serviced by rental payments akin to principal and interest repayments. From an investor’s perspective, CGRs could be likened to long-term inflation-linked bonds, albeit more illiquid, given the regular income stream.
Key differentiators between sale and leaseback and Commercial Ground Rents
Whilst legally similar to the more common sale and leaseback arrangement there are key differentiators from that structure that make CGRs unique.
Term
The term is generally long-dated and can range between 100 and 250 years, compared to 20-30 years for sale and leaseback arrangements. While CGRs do not generally incorporate early exit rights, increasingly arrangements include a buyback option where an operator can reacquire the freehold for its nominal value at the expiry of the lease (at 100 years, etc.).
Rent paid
Initial rent payable is calculated as a percentage (typically 8-15%) of the operator’s earnings before interest, tax, depreciation and amortisation (EBITDA) or expected EBITDA, rather than reflecting current market rent for the real estate. This compares to 50-60% usually seen in sale and leasebacks. Rent reviews thereafter are usually tied to inflation with a floor and cap to provide certainty for the parties.
Price paid for the Freehold
This is calculated by applying a typically much higher multiple to the agreed rent rather than the open market value of the unencumbered asset. Unlike sale and leasebacks, the ‘over-collateralisation’ of income and capital value means the transactions can be done with smaller asset owners or those without a material financial ‘covenant’ backing the income stream.
The retained leasehold interest
In CGR transactions the majority of the income and value is retained by the leaseholder, which represents an asset that can be leveraged or sold in its own right; unlike a sale and leaseback opco where there are much lower levels of income and value retained in the leasehold interest.
No cross collateralisation
Each property is assessed on its own merits and has a separate ground lease and usually no parent company guarantee is required.
Bank right to cure defaults
Unlike traditional bank finance, insolvency is not a default trigger. Further, if there is a default under the ground lease, the bank has the right to step in and cure the default. CGR transactions are suited to sub-investment-grade property rich operating businesses. With rents being geared off EBITDA, ground rent structures have historically favoured well-established, stabilised real estate operating businesses.
Who are the primary investors?
For pension schemes and insurers, the appeal of CGR is getting a long term, inflation-linked income stream, facilitating diversification of portfolios and the ability to match cashflow against their longest dated liabilities with an attractive return.
One of a number of investors is Alpha Real Capital (Alpha), a fund manager that specialises in secure income investing and has invested c.€2bn of commercial ground rents across a wide range of both traditional and operational real estate assets in the UK over recent years.
Commercial ground rents offer an alternative to traditional debt structures. The Irish commercial ground rent market is at a nascent stage, however the same was true of the UK market only a few years ago, where ground rents are now increasingly seen as a staple capital raising option for operational businesses that own quality real estate. Ireland’s legal and banking framework closely resembles that of the UK, making the investment opportunity readily transferable. One of the critical elements for us is to set a sustainable ground rent on day-one that should remain sustainable for the operational business over the long term, having regard to the trading potential of each individual property. The long-term nature of our investments and the flexibility that the ground lease provides make us a complementary partner for both real estate owners and financing banks.
Advantages of the structure
Benefits for leaseholder/operator
1. Lower cost of capital
CGRs involve a lower cost of capital when compared to other forms of finance. It can be used as an alternative to more expensive mezzanine debt or complementary to traditional senior debt.
2. Affordable rent
Rather than reflecting a market rent for the real estate, the initial rent paid for the use of the asset is based on a low percentage of EBITDA. Rent increases thereafter are linked to inflation. CGRs can also be structured based on predicted EBITDA. Where sites have the potential to expand, which would lead to an increase in EBITDA, investors are often prepared to commit to providing additional capital, in return for increased rents. This provides the operator with the opportunity for development/acquisition finance built into the arrangement.
3. Compatible with senior debt finance
The long-term duration of these arrangements makes it more attractive as security to third-party lenders, allowing the operator to secure more favourable terms for debt finance secured against the leasehold property.
4. Access to released capital
Capital released to the operator in the sale of the freehold may be used more productively being reinvested in the asset, reducing cash input and reducing external debt funding needs. These funds may also be extracted to release funds to shareholders/investors.
5. Flexibility
The operator maintains the freedom to operate the real estate asset without any onerous restrictions.
6. No refinance risk
The proceeds from the sale of the freehold is permanent capital that does not carry refinance risk or cost every few years.
Benefits for investor
1. Investment term
Advantageous for many investors whom require long term earnings as an alternative to long term expensive government bonds.
2. Inflation protection
Rent reviews are linked to inflation. Long term secure inflation linked cashflows to service long-dated pension liabilities.
3. Illiquidity premiums
CGRs benefit from an attractive illiquidity premium relative to listed alternatives.
4. Diversification
The unique structure of the asset provides an attractive diversification.
5. Not exposed to commercial property cycles in the same way
Value over-collateralisation is akin to debt loan to value rather than equity risk.
There will be specific tax considerations to be assessed which will vary from transaction to transaction depending upon the profile of the property owner and investor, and the tax attributes associated with the property.
Summary
Commercial Ground Rents offer an alternative to other types of finance, allowing property owners the opportunity to release value from their real estate while still controlling the asset. These arrangements are mutually advantageous for both investor and leaseholder/operator alike.