Finance Ground Lease - Financial Freedom

A finance ground lease, also known as a capital ground lease, is a lease agreement where the lessee (tenant) essentially owns the improvements made on the leased land for the duration of the lease term. Unlike operating ground leases that treat the land as a simple rental expense, finance ground leases function much like a mortgage, impacting the lessee’s balance sheet significantly.

The defining characteristic is that the lease meets specific criteria, leading it to be capitalized on the lessee’s balance sheet as both an asset (the right to use the land and improvements) and a corresponding liability (the obligation to make lease payments). These criteria are often guided by accounting standards like GAAP (Generally Accepted Accounting Principles) or IFRS (International Financial Reporting Standards). Generally, a lease is considered a finance lease if one or more of the following conditions are met:

Transfer of Ownership: The lease transfers ownership of the asset (improvements) to the lessee by the end of the lease term.
Bargain Purchase Option: The lessee has an option to purchase the asset (improvements) at a price significantly below its fair market value at the end of the lease term, making it reasonably certain that the lessee will exercise the option.
Major Part of Economic Life: The lease term covers a major part (often 75% or more) of the asset’s economic life.
Present Value of Payments: The present value of the minimum lease payments equals or exceeds substantially all (often 90% or more) of the asset’s fair value.
Specialized Asset: The asset is so specialized that it is expected to have no alternative use to the lessor at the end of the lease term.

The benefits of using a finance ground lease include off-balance-sheet financing in certain situations (though increasingly less common due to evolving accounting rules), potential tax advantages (lease payments may be tax-deductible), and the ability to control and develop a property without incurring the full upfront cost of purchasing the land. This can be particularly attractive for businesses that need to conserve capital or prefer to allocate funds to other areas of their operations.

However, there are also drawbacks. Because the lease is capitalized, it increases the lessee’s debt levels, which can affect credit ratings and borrowing capacity. The lessee is also responsible for all property taxes, insurance, and maintenance related to the improvements. Further, at the end of the lease term, the ownership of the improvements typically reverts to the lessor unless there is a predetermined agreement for the lessee to retain ownership or purchase the land.

Due to the complexities involved and the significant accounting implications, finance ground leases require careful analysis and professional advice from both legal and financial experts to ensure the structure is beneficial and compliant with relevant regulations.