Unfortunately for multifamily buyers today, apartment properties in good locations remain difficult to find at yields that work. So, if you really want to own something in a top market, you may have to take a second look at something you wouldn't have considered before. Case in point: land leases.

"I think [leaseholds on apartments] will become more prevalent as we move into this corrective period," says David Casper, senior investment advisor with Hendricks and Partners, a broker based in Phoenix. "You will see buyers get more creative. One of the financing tools they have is the ground lease. In some cases, you can control five acres of dirt for $1,250 a month. You'd be a fool not to do it."

Forest City Residential owns interests in nearly 35,000 apartment units at 123 properties across the country. These holdings include 101 San Fernando, a 323-unit urban oasis in San Jose, Calif.
Credit: Forest City Forest City Residential owns interests in nearly 35,000 apartment units at 123 properties across the country. These holdings include 101 San Fernando, a 323-unit urban oasis in San Jose, Calif.

Yes, leaseholds have some benefits, including higher yields and tax advantages. But not actually owning the ground upon which a property sits certainly presents its own set of issues. There may be clauses that allow the cost of the lease to rise or fall based on things like the value of the land or the revenue of the property. So, you must make sure your numbers will work for a variety of situations.

Land leases are "perilous," agrees Craig Zimmerman, executive vice president of acquisitions for Essex Property Trust, an apartment REIT in Palo Alto, Calif., which owns three properties with land leases. "You need to understand them and the accelerators of the rent over the years."

Land Lease Basics

Land leases have been around forever, but they're usually more prevalent in the commercial and retail sectors than in the apartment industry. In multifamily, brokers and owners estimate land leases occur in fewer than 5 percent of transactions and frequently happen because a private group wants to retain ownership of the land. "They're often family-owned, and they want to pass the yield and residual value down," says Mark Hafner, director of investments for Greystar, a Charleston, S.C.-based multifamily firm that has two properties with land leases in its portfolio.

Why do people want to keep the spot of ground under an apartment building? That's simple: It's usually a valuable, irreplaceable piece of real estate. That was the case with Brentwood Gardens, a 50-unit apartment community in Malibu, Calif. Though the property was only on a 10-year land lease, a private investor spent $4.1 million to buy the complex. The reason: It was located on San Vicente Boulevard in the prime Brentwood area of Los Angeles. Buying a property with a land lease is "very common in New York and California," Hafner says. "In Charlotte [where Greystar bought a leasehold for 70 years], it's very uncommon."

In many places, multifamily buyers can expect to get a discount on land lease deals, depending on the terms and length of the land lease. "If it is outside 30 years, you will have a 50- to 100-basis point discount [0.5 percent to 1 percent]," says Bruce Furniss, senior investment advisor with Hendricks and Partners. "Inside 30 years, it could be 100 to 200 basis points or maybe even higher depending on the terms of the lease."

But that's no longer the case for many properties. "The discount rate on cap rates between a deal on a land lease and a deal without one has probably compressed over the last couple of years," Hafner says.

Work the Numbers

While many prospective property buyers just look at the discount rate on a land lease deal versus the price for a fee-simple property (where the land and the apartment building are purchased outright), others take a different approach.

When Essex underwrites a land lease transaction, the company basically views the deal as the opposite of a sinking fund, which is a fund where a company sets aside money over time, in order to retire its preferred stock, bonds, or debentures. "I need to get a high enough yield so that if I took the excess money and put it into an account and grew that account, at the end of the lease term, I would have enough money in that account to buy that asset," Zimmerman explains.

The ability to accrue that much money all depends on the length of the land lease and the property's net operating income. If a lease only has 10 more years before it expires, for instance, the property needs to generate more money because there's less time to generate the funds that could purchase the property. But, "if it's a 100-year lease, it's a very small amount," Zimmerman says.

That doesn't mean apartment properties on shorter land leases can't be profitable. Kitty Wallace, senior vice president for Sperry Van Ness, a broker based in Irvine, Calif., sold Brentwood Gardens based on its solid cash flow (thanks to its posh location) and the tax depreciation the property offered the buyer.

"We didn't market it to the real estate investor. It was just somebody buying the cash flow," Wallace says. "You have some risk, but if it can get you a 10 [percent] or 11 percent return, it's better than the return you get in real estate in California or the stock or bond markets."

The depreciation potential offered by the land lease was just icing on the cake. "You get 100 percent depreciation because you can't depreciate the land" on the property, Wallace explains. "You can depreciate 100 percent of the purchase price in 10 years, which is greater than what cash flow was in 10 years." In the case of Brentwood Gardens, the property buyer got half a million dollars in cash flow annually while also enjoying an extra $650 million in depreciation for tax purposes that he could use on another building in his portfolio.

Smart Considerations

Projecting a property's financials down the road can be difficult under a land lease. In some respects, the owner of a building located on a land lease is stuck in no-man's-land. On one side is the apartment market, with its constantly changing rents. On the other side is the landowner, who may have put a lease in place that causes the apartment property owner's payments to readjust every five, 10, or 15 years. And when that happens, costs become volatile and unpredictable.

"These revaluations can be very dangerous," Zimmerman says. "You have to be very careful as to what revaluations are. I have seen people lose property. The land lease goes up so much that they [the building owner] can't afford the payments."

One way for buyers to avoid this scenario is to buy an apartment on a land lease where the terms change upon each transfer of the lease. Wallace has seen some buyers even go so far as to make bids for the ground under the asset. Sometimes, that works. But if it doesn't, the buyer must prepare to ride the lease out until the end. If time is running out, there's no guarantee a leasehold can be sold.

The only way to overcome this? Get a great deal or make sure the lease is long enough to recoup the money. "That's why taking on 30 years or more is important," Hendricks and Partners' Casper says.

KPR Investments bought the Fawndale Apartments in Houston with a permanent fixed rate loan for $2.3 million from LMI Capital. The Fawndale Apartments, a class B property built in 1973, has 108 units. The unit mix consists of 680-square-foot one-bedroom/one-bathroom units and 900-square-foot two-bedroom/ one-bathroom units.

StarPoint Properties in Los Angeles purchased The Village at Granada Hills in Northridge, Calif., for $28.6 million. Built in 1973, the 152-unit apartment building has two- and three-bedroom units averaging 983 square feet. StarPoint will begin renovations on a new community recreation room, billiard room, manager's office, and enclosed garage in October.

A Southern California-based private investor spent $3.75 million for the Nellis Arms Apartments in Las Vegas. The community, which was originally built in 1986, is on 1.7 acres and is currently vacant. Its 51 units each have two bedrooms and two bathrooms, and the community has a swimming pool. Sperry Van Ness represented the buyer.

The Hayman Co. in Troy, Mich., bought four garden-style apartment communities in Austin, Texas, from ITW Mortgage Investments III for $25 million. The four apartment complexes were Quail Run, Coppermill, Gateways, and Woodstone, and they have an average occupancy level of 95 percent. GMH Capital Partners represented the seller.

Royal Bay Orlando in Largo, Fla., bought Royal Bay Apartments in Orlando from MPI Orange Orlando in Atlanta for $9.24 million. The 165-unit apartment community consists of 13 buildings on 8.8 acres and was built in 1973. Its amenities include a swimming pool, lighted tennis court, fitness center, playground, and laundry facility. Cushman & Wakefield's Apartment Brokerage Services Group negotiated the sale.

–Listings compiled by Les Shaver

Action Items: What to Remember About Land Leases

1– Be skeptical of conversion opportunities. While apartment owners may be willing to buy properties with land leases, potential condo owners may be scared off. "You can still legally condo it out, but if you're not in New York, it's going to be very difficult to market that to homeowners," says Mark Hafner, director of investments for Greystar, a Charleston, S.C.-based multifamily firm that has two land leases in its portfolio.

2– Prepare to be persuasive with your lender. Banks are wary of approving land lease deals, and if they do agree to finance it, they generally will charge higher rates than for a traditional fee-simple deal. "You have to find a lender that will go subordinate to the ground lease," says Bruce Furniss, senior investment advisor with Hendricks and Partners, a broker based in Phoenix.

3– Watch your improvements. If the lease to the property you control is up soon, think carefully about making upgrades with long payback periods. "Every time you make a capital improvement, you have to be cautious about getting a return back in a timeframe that will be valuable to you," says Kitty Wallace, senior vice president for Sperry Van Ness, a broker located in Irvine, Calif. "Are you just creating value for guy with the land?"