Fee under a ground-leased MOB at 5% or the leasehold building at 7.4%

Question

Two things crossed my desk in the same submarket and they're basically opposite ends of the same building type, so I want to hear where the room lands.

Option one is the fee interest under a 38,000 sf on-campus medical outpatient building. 48 years left on the ground lease, ground rent $310k a year with CPI bumps capped at 2%, priced around $6.2m. Call it 5% going in. I own dirt next to a hospital, the improvements revert to me at expiration, and I do essentially nothing for five decades. The building operator carries the roof, the chillers, the tenant improvement money, all of it.

Option two is a leasehold interest in a comparable off-campus building, 51 years remaining under the ground lease, 7.4% on in-place NOI after ground rent is paid. That's a 240 basis point pickup for taking on the operating risk, the capital plan, and a diminishing asset.

What I keep going back and forth on is the 2% CPI cap on the fee position. Over 48 years a 2% ceiling on a fixed obligation is a slow erosion if inflation runs anywhere above it, and my reversion is so far out it doesn't discount to much. The leasehold at least has rents that reset with the market every five to seven years as leases roll.

Ground lease terms vary enormously and how the documents treat leasehold financing, casualty, and default cure rights is state and contract specific, so read the actual lease rather than the summary.

paulgrant17 · Answer

So on option one you own the land and someone else owns the actual building on it, and in 48 years the building becomes yours without you paying for it? What stops them from letting the building fall apart for the last ten years since they know they're handing it over?

priya_n21 · Answer

@wren the lease usually has maintenance and surrender standards, but enforcing them in year 44 against an operator who's already mentally moved on sounds like exactly the kind of second job I'm trying to avoid.

@orchard the 5% with a 2% cap reads to me like a bond with a bad coupon. I want income without a second job, and I'd still take the leasehold, because at least the 7.4% is paying me now and rents on the medical suites reset. Fifty years of watching my ground rent lose to inflation is a slow way to be wrong.

kevin_lombard · Answer

I went through this twice and I still don't understand why anyone sells the fee under a building next to a hospital. If the land is that safe, why not keep it?

brandonlee36 · Answer

@juniper because 5% money is worth something to a seller who wants capital today, and health systems in particular sometimes want the campus land off their balance sheet. Nobody sells because the asset is bad, they sell because they want the cash.

@orchard the number I'd want is the leasehold's remaining amortization schedule against its capital plan. A 51 year leasehold sounds long until you find out the building is 1998 vintage with original rooftop units and the tenant improvement obligations on two renewals in the next four years. My portfolio taught me that the capex you can't see is the whole difference between a 7.4 and a 5.9.

ehernandez74 · Answer

Questions before I could vote. Who has the right to mortgage the leasehold, and does the fee owner have to sign anything for the leasehold owner to refinance? Is there a rent reset or is 2% CPI-capped the whole escalation for 48 years? And what happens on casualty, does insurance proceeds go to rebuild or can the leasehold owner walk? Those three answers move the fee position from a bond to something with real risk in it, and I wouldn't guess at any of them from a marketing package.

tylerbrooks9 · Answer

I want the boring one and I think the fee is the boring one. 5% that arrives whether or not the chiller dies, and I never approve a tenant improvement allowance in my life. @marlow calls it a bad coupon and maybe, but the leasehold at 7.4% has a capital plan attached and someone has to run it. That someone is me.

nicole_adeyemi · Answer

@verity the fee looks boring right up until the leasehold owner defaults and you inherit a half-empty specialized building with a mortgage you didn't sign, depending entirely on what the cure and mortgagee protection language says. That's why @anchor's questions are the whole deal.

The thing I'd add on the land side: check the zoning and the parking ratio on that parcel independently of the current use. On-campus medical often sits on land entitled for one thing with shared parking agreements that expire on a different schedule than the ground lease. In 48 years the reversion is worth whatever the entitlements allow then, and parking ratios for medical run high. I've seen a reversion get much less interesting once someone read the shared access agreement.

Fee under a ground-leased MOB at 5% or the leasehold building at 7.4%

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