Ground rent sale and leaseback transactions have been prevalent in the UK holiday parks market in recent years and are now starting to be used more widely in the hospitality and leisure sector and beyond. In this article, we will look at the key features of a ground rent sale and leaseback and how these transactions can be used to drive value for owners.
Ground Rents Today
In a basic sale and leaseback structure, a real estate owner/operator (e.g., hotel or serviced apartment operator) will sell the freehold interest in its property to a third party – typically an investment fund – and take a lease-back allowing the operator to continue operating from the site. This is nothing new; sale and leasebacks have been used to release capital in property-rich companies for some time. There are two key features that differentiate a ground rent sale and leaseback from the traditional model: term and rent.
Term: Ground rent leases are typically for terms of between 100 and 250 years without any early exit rights. The long duration has a number of benefits:
- The operator knows it has long term rights to continue running its business. A typical sale and leaseback might involve a lease of 20 to 30 years, a long enough duration for an office or warehouse operator but not long enough to justify the investment that many hospitality and leisure businesses will make in a site. We also typically see operators benefitting from an option to reacquire the freehold interest for nominal value at the expiry of the lease. The purchaser is therefore viewing the transaction more like a financing than a purchase – at the end of the term, the purchaser has been repaid its initial capital investment plus interest and walks away.
- The long term nature of the lease makes it more attractive as security to third-party lenders allowing the operator to obtain more favourable terms for debt finance secured against the leasehold interest.
- The investment purchaser is acquiring a long term income stream. Typical ground rent purchasers are pension funds and insurance companies who need to secure long-term returns on investments to service their underlying products. More recently, however, specialist ground rent funds and traditional real estate investors have been trying to break into this market.
Rent: Rather than reflecting a market rent for the real estate, the initial rent payable under a ground lease will be calculated as a percentage of the earnings before interest, taxes, depreciation and amortization (EBITDA) of the operating business. This ensures that the on-going rental payments are affordable for the business. Rent will then be increased on an annual basis by reference to inflation (in the UK typically linked to the Retail Price Index or the Consumer Price Index) with a collar and cap to provide certainty for both operator and purchaser. Rates somewhere between 1% and 5% are most common. The price paid for the freehold interest by the purchasing fund will, in turn, be calculated by applying a yield to the agreed rent rather than paying the open market value of the unencumbered freehold property.
The Future of Ground Rents
The ground rent structures outlined above have become an established source of capital raising in the UK holiday parks market in recent years. Going forward we see three key areas for their growth.
Diversification of Asset Class: Ground rent structures can be applied to any property-rich operating business, making the hospitality and leisure industry a key target area. Hotels, serviced apartments, student accommodation and senior care facilities can all benefit from ground rent opportunities. Whether the asset is owner-operated or there is a third-party management agreement in place, a ground rent structure can be used to release capital for the owner which can either be reinvested in the asset or extracted to release funds to shareholders/investors. It is even possible to use a ground rent structure where a property is leased to a third party, though this invites added complications. The ground rent sale and leaseback structure is by no means UK-specific and can be implemented in most jurisdictions, subject to statutory constraints on lease terms.
Diversification of Investors/Purchasers: Traditionally ground rents have been a specialist market predominantly attracting purchasers looking for long-term income, such as pension funds. However, the UK market in particular has seen significant expansion recently with institutional real estate funds vying for a slice of the market. As the number of purchasers increases, so terms for the owners and operators become more attractive.
Deal Timing: With rents being geared off EBITDA, ground rent structures have historically favoured well-established, stabilised real estate operating businesses. Increasing flexibility in available transaction terms creates new opportunities. Deals can be structured based on predicted EBITDA (with appropriate protections in the legal documents). Where sites have potential for redevelopment or expansion that would lead to an increase in EBITDA (e.g. scope to add additional units on a holiday park), ground rent purchasers will now often commit to providing additional capital (in return for increased rent) when the expansion is complete, thus effectively providing a guaranteed route to refinancing development finance. A ground rent structure can also be used as a source of acquisition financing, either on the purchase of an additional site as a bolt-on to an existing business or to finance the acquisition of a target operating business. There are a number of challenges in successfully utilising a ground rent structure in this way.
To date, ground rents have held a relatively niche place in the real estate market with a limited number of purchaser funds, restricted asset class application and tight constraints on the available terms. The increasing popularity of operational real estate as an asset class coupled with the need for both property owner/operators and institutional investors to become more creative in order to drive returns will see a broader use of ground rent structures in the UK and beyond.
The Goodwin Real Estate Industry team blends deep knowledge of institutional sale and purchase transactions and leasing terms with an unmatched understanding of the hospitality and leisure sector to deliver ever more complex ground rent structures on behalf of investors and owner/operators in a range of jurisdictions.