Are Apartment Buildings on Ground Leased Land Bad Investments?

Around the Palm Springs area, there are a number of multifamily properties sitting on land that is owned by someone else.  In my conversations with investors, many of them immediately lose interest when they find out about the ground lease.

Are they jumping to conclusions? Maybe.

The worst-case scenario, a real possibility, is that the owner of the ground lease refuses to extend the lease and takes the property away from the investor. And, to be fair, they could.

However, I've never heard of it. (If you have, I'd like to hear about it.) Really, not once have I ever met, or heard a story about, a hostile acquisition..

Instead, the ground leasor usually wants cash-flow, not the management. There's a formula (in the cases I've seen) based on a percentage of the assessed value, a number which is calculated into the net operating income and cash flow of the property. At the end of the lease, or well before the end, the lease is extended.

So, when the property is sold, there's actually an opportunity for the buyer, the new investor, to get a deal by playing the hostile acquisition card.

Every investment, whether it's an apartment property or baseball cards, can be represented by a simple cash flow estimate. Every investment requires an investment (a negative, or an arrow pointing down). Then, hopefully, each year afterward, there's positive return (an arrow pointing up). At the end, when the investor sells the property for more money (that's how it's supposed to work), there's a big arrow pointing up.

In a ground lease, there may not be a big arrow pointing up at the end, if the ground leasor assumes the ownership of the property.

However, the investment may still have been a good deal for the investor; it depends on the acquisition price.

The buyer can justify a low offer by, properly, claiming that the ground leasor may not extend the ground lease, and the future value will be zero. The seller cannot promise, on behalf of the ground leasor, that all future leases will be extended. He doesn't have that authority. In any case, the value of the property is only that of the improvements, not the land, so the price should be less than comparable fee-simple properties.

A smart buyer can make low bids, and get excellent properties, with some faith that ground leases are generally extended by ground leasors. It's a gamble; but so is all of investment. It's a good bet.