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Investing from the ground up

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Ground rents on commercial property constitute an investment with characteristics different to that of traditional property.
This article depicts the processes by which they are created and provides insight into the attractions for investors...

Commercial ground rents are normally created when a
landowner, the freeholder, grants a leasehold interest to
a developer, who constructs a building on the land. Normally
the developer is granted a long leasehold interest for a
fixed period, say 125 years. The return to the freeholder is
through a combination of an upfront premium on the grant
of the lease, and an annual ground rental payment. This can
be as little as a peppercorn, but is normally a percentage
of the open market rental value of the land or the buildings
constructed on it. The arrangement can be beneficial to
both parties, the developer is able to defer some of their
upfront costs by minimising the expenditure on land. The
freeholder is able to take advantage of the specialist skills of
the developer in devising and letting a suitable scheme, and
receives a secure income stream.

Freeholders will often sell on their interests to long term
investors. The attractions of the ground rent investments are
myriad. The ground rental income is secure, as it is normally
a small percentage of the open market rental of the buildings
on the land. As such should the leaseholder default a large
reversionary interest would be realised. The income stream
from commercial ground rents is more similar to that of a bond
than a traditional property rental income, with the income being
fixed or rising for the residue of the leasehold term.

The rental review system for commercial ground rents
allows their investment performance to mirror a wide variety
of income streams. Increases can be fixed in line with the
Retail Price Index, the underlying rental value of the site or
fixed amounts based on an annual compound increase of
two to three percent. The frequency of rental increases have
a large bearing on the value of the ground rent, assuming
the income is reviewed on an upward only basis the more
frequent the reviews the higher the Net Present Value of
future rental payments. This has a strong affect on values.
Traditional commercial ground rent vendors include
councils and large landowners, who often have large
industrial holdings on which ground rental leases were
granted in the 1960s-1980s. These are normally sold at
public auction to ensure there is a clear demonstration
of seeking best value for the taxpayer. Purchasers
vary depending on lot size and initial yield, but normally
come from a cast including institutional investors, family
trusts, private investors and specialised ground rent
investment companies.

Many of the traditional irritants of property investment
are absent. There is little risk of void periods, few
management responsibilities and little reason to interact
with the occupants, whose contractual relationship is
normally with the head leaseholder.

Initial yields are low, with much of the value stored
in the deferred reversion of the underlying property. As
such ground rents tend to be unable to support high
loan to value loans, and most investors rely on equity
funding in lieu of bank finance.

To conclude commercial ground rents reflect an opportunity
for the cautious investor to gain exposure to property with
few of the hazards associated with traditional property
investment. This is negated to an extent by the scarcity of
high quality investment stock and specialised knowledge
required to ‘cherry pick’ attractive opportunities.

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