On Tuesday, September 13, 2023, the U.S. Treasury sold $35B worth of re-opened 10-year notes, at a yield of nearly 4.30%, which was the highest in any 10-year note auction in over 15 years. The 6-month bill has hovered around 5.50%, which marks one of its highest points since the 6-month has been regularly offered. These record-breaking treasury rates have many real estate investors asking themselves why they would consider investing in single-tenant assets, especially ground leased opportunities when they can achieve potentially higher yields from T-Bills. However, these investors are missing several key factors when comparing the two.
T-Bills, T-Notes, and T-Bonds are U.S. Government debt instruments offered to the public to help fund government spending. An investor purchases any of the three treasury securities, essentially loaning the U.S. Government your investment. The investor is then compensated by receiving their full principal investment back, plus interest, at maturity. In a market like we are in today, this is an enticing opportunity for investors to achieve a high yield (relative to U.S. securities yield history) with minimal risk. Unfortunately, these U.S. securities lack any type of residual value.
Often, real estate professionals talk about ground leases as if they were securities, and the reason for this is simple: they essentially are. When purchasing a ground lease, the buyer is acquiring the land underneath the building, typically occupied by a tenant with strong credit, signed to a long-term lease (10-25 years), and pays a reasonable ground rent. Additionally, since the owner owns the land underneath the building, and not the building itself, they are unable to take advantage of depreciation. The landowner has zero responsibilities – all the landlord does is collect rent every month. And, ground leases are advantageous, again, assuming depreciation isn’t considered because the tenant will pay to build their own building. The rent will typically be much cheaper as opposed to buying a building that someone constructed and hence, having to get a return for the increased costs of ‘going vertical.’
Due to the similarities of securities and net-leased investments, investors often compare which of the two investment strategies will give them a higher initial yield, and don’t think about the long-term benefits that these lease structures may provide. There are several key differentiators that make real estate a superior investment:
Rental Increases & Blended Yield
For an investor deciding between securities or a ground lease, one facet you must consider is the rental increases typically seen in lease rental schedules. These contractual rental increases boost the investors’ annual cash flow versus 10-year treasuries investors must calculate their potential blended yield, and ROI (return on investment), on a leased investment, when deciding which investment opportunity is right for them.
Excellent Underlying Real Estate & Market Rent Growth
Regularly, investors under-appreciate the underlying real estate that they acquire in ground-leased assets. Often, the parcel situated underneath the ground lease is one of the most well-situated parcels within the market, giving the landowner an extremely desirable piece of real estate if the tenant were to vacate. Now, because the tenant vacated, the landowner inherits the improvements at a significantly reduced basis or below the replacement price of the constructed asset. This provides them with an opportunity to re-tenant the building, which often warrants a significantly higher rent than they were previously collecting on the land lease only.
As available land diminishes, especially in markets benefiting from population growth, land value typically increases, providing landowners with land appreciation. Once the ground lease expires, and the landowner becomes the building owner, their parcel becomes even more valuable. With T-Bills, the government can simply print more and change the Fed Funds Rate which will affect value. Additionally, over long periods of time, real estate values have maintained an upward trend.
As shown in the graphs above, historically, the 10-year note’s yield (left) has fluctuated depending on several market factors, while retail market rents (right) have continuously increased, regardless of market conditions.
Long-Term & Minimal-Risk Investment
Potentially the most important reason to consider investing in ground leases is the long-term security and stability that ground leases provide. This simply can’t be mimicked by other investments. An investor is acquiring the land underneath the building, and there is only a finite amount of land, albeit well-located land. Additionally, the tenant is investing significant amounts of money into their building, further tying them to the site. Combine that with the below-market rent that is normally seen in ground leases, and the probability is high that the tenant will be at that site for a long period of time.
The four benefits of investing in ground lease opportunities above are just a couple of examples of the many benefits of investing in ground leases. So, next time an investor asks why they would consider a ground lease at an initial yield lower than the 6-month, but still higher than the 10-year, I would advise them to not invest solely based on which opportunity has a higher initial yield and to think about the long-term benefits that a ground lease may provide them, as well.