The answers are many, but perhaps the most obvious of them all is positive leverage. By selling the ground, the investor can reduce equity and greatly increase returns. In a purchase or recapitalization, often a ground lease, in concert with leasehold financing can result in leverage as high as 90%, while boosting cash-on-cash returns 2x or even more!
Let's go through an example to illustrate:
The Property: A $100 million asset, valued at a 7.5% cap rate, with a $7,500,000 NOI.
The Ground Lease: A $40 million dollar ground sale and the creation of a 99-year lease. Ground rent is fixed at 5.50%, with 3% annual escalations.
Leasehold Financing: 70% LTV, 10 year term, 30 year amortization at 4.5% interest.
Fee Simple Financing: 70% LTV, 10 year term, 30 year amortization at 4.5% interest
The results over a 10-year hold:
|Amount||Cap Rate||Amount||Cap Rate|
|Amount||C-on-C Yield||Amount||C-on-C Yield|
|NCF (LEVERAGED)||Year 1||$3,243,843||10.81%||$2,292,316||21.76%|
|Cash Flow (10 Years)||$43,417,529||$30,681,720|
|Equity (Year 10 at 7.5% Cap Rate)||$74,414,714||$52,586,398|
The merits of bifurcation in the given example are clear. In the Leasehold position, the investor will maximize leverage and simultaneously boost returns. Total proceeds between the ground lease and leasehold financing amount to $89,466,667 – $19,466,667 more than the fee simple financing alternative and almost 90% of the sale price is achieved comprising $19,466,667 more than fee simple financing will allow. The cap rate in the leasehold position has improved 133 basis points in the first year and 174 basis points by year 10. The leveraged cash-on-cash return has improved 1,095 basis points in the first year. Moreover, on the average over the 10-year period, the cash-on-cash return has improved by 1,466 basis points.
Most importantly, over the length of the 10-year hold, with leasehold debt in place the seller can achieve almost 90% leverage on the asset while continuing to enjoy an average of $3,068,172 in net cash flow annually for a total of $72,734,785 in additional receipts over 10 years assuming a sale at the end of the period.
Let's schedule a time to discuss!