Ground-rent structures are increasing in popularity, attracting more and different investors who are carefully examining the strategy.

These types of structures involve freeholds being sold to specialist investors to free up capital for operations, and so far, this has been prevalent in the United Kingdom.

Examples of recent ground-rent deals in the U.K. include the Park Plaza London Waterloo; the Grange Hotel St. Paul’s, now the Leonardo Royal London St. Paul’s; and — following its 2017 acquisition of Q Hotels — Parkrose Real Estate's sale of some of that portfolio’s freeholds to PGIM Real Estate.

“Over the last few years particularly, we’ve seen a large growth in ground-rent structures being used in the hospitality and leisure sector, with property-rich businesses wishing to release capital,” said Martin Smith, a London-based partner at legal firm Goodwin. “From an operational perspective, there is a desire for full ownership and control, but typically for ground-rent structures what you will see is the businesses selling the freehold to ground-rent funds, in return for capital payments and taking back a long-leasehold interest. The key is ensuring that the leasehold interest provides sufficient operating control and flexibility for the business."

Matthew Pohlman, who is also a London-based partner at Goodwin, said ground-rent structures are specifically being deployed to deleverage bank debt and add working capital into the business at a low cost of capital.

Smith said a minimum leasehold term would be 100 years, but some cases have gone as high as 999 years. Ground-rent leases are structured differently than typical occupational leases in that they give the tenant more flexibility in what they can do to develop the site and run the business without landlord involvement.

Smith said COVID-19 has resulted in many businesses looking at alternative means of financing or releasing capital.

The lease will provide for the business to pay a rent, initially calculated by reference to the earnings before interest, depreciation, taxes and amortization rather than by reference to the open market value of the property, which it would be if it was a "normal lease,” he said.

Huw Holman, associate at real estate business advisory Knights Frank and who specializes in ground rents, income strips and development funding, said COVID-19 has affected banks’ current lack of appetite to lend in the hospitality sector, thus boosting such alternative financing structures.

“We are seeing it used to by hoteliers to refinance investment loans or pay off development loans," Holman said. "Ground rents provide a cheap source of capital and yields that are attractive for vendors."

Ground-rent structures initially started in the United Kingdom to permit developers to build hotels and other projects in return for a share of the income deriving from the development of that building, Smith said. The upshot of the structure is that land could be developed by a developer at no cost to its business but rather for it to receive a regular long-term income. The business would then have the land returned to it at the end of the lease term, which would typically be 100 or 125 years in length.

One risk of ground-rent deals is that operators are committing to rental payments for the duration of the lease, he said. If a business fails for any reason or even suffers a short-term drop in income, there is considerable exposure.

The type of investor looking to take on some of this deleveraged risk is changing, too, Smith said.

“Traditionally, these very long leases attracted long-income funds, pension funds and specialist funds looking for long-term, guaranteed income, but as the market has taken off and institutional investors have struggled to deploy capital through their more traditional investments, a number of other players have jumped into the space, many of those believing they could offer better terms,” he said.

Smith said so far none of the new entrants are regretting their moves. If the operating business fails, the fund can take control of the property and sell it, he added.

“It is like having super-senior security,” Smith said. “The only security, though, is on the property. An investor can take back the property, but that does not give them access to other business assets, such as the trading name, employees and goodwill."

The terms of ground-rent deals are improving and provide a good way of gaining immediate capital injections and calculating agreeable rental payments, he said.

“They are structures that can provide short-term capital relief but still allow directors to control a business’s direction,” Smith said.

One other thing to bear in mind is that such deals are long-term products, and within the current business climate the expectation is that COVID-19 is a short-term blip.

“The challenge is if you are new business," Smith said. "Rents need to be calculated on stabilized [earnings before interest, taxes, depreciation and amortization]. In other words, ignore the last 12 months of COVID-impacted trading."

Ground-rent structures, and changes to them, have also caught the attention of the authorities.

“The government definitely is keeping an eye on them," Smith said. "The challenge is that ‘ground rent’ is a fairly nebulous term, used in different ways in different sectors."

Structures used in the hospitality and leisure industry are different than those used in the residential market, but they are all lumped under the ground-rent heading, he said. How the government legislates to protect home owners could have wider impact, given recent government noise concerning leasehold residential mortgages.

Typically, the minimum lease is 100 years, but there is no real difference in pricing based on the length of a lease, just what the two sides agree. Rent is calculated on day one, along with a retail price indexed increase with a collar and cap.

For instance, 999-year leases have been around for a long time and are considered a virtual freehold as the term is so long and its expiry beyond the contemplation of those who signed up for it, Smith said.

There is vast difference in residential, where if the lease is below 75 years, mortgage companies start to get nervous and properties might not be able to be sold.

“From an operator’s perspective, concern is always about operational flexibility and whether the use of the property is fixed. That is, it is only able to be used as a hotel for 999 years, which would tie your hands,” Smith said.

Holman said he is starting to see an increase in ground-rent structures, not just in the U.K. but also in continental Europe.

“U.K. funds are looking at setting up European long-term funds, too," he said. "One question is, is this happening, as we saw on the back on the last financial crisis, because of the current situation? That is quite an interesting question. Are we at the same point now?"

There is still strong investor appetite given the income profile of ground rents, which provide secure long-term, inflation-linked cash flow that is an alternative to low-yielding bonds and gilts, Holman said.

“We have seen new entrants to the market alongside the traditional ground-rent investors, which has increased demand," he said. "However, the impact of COVID-19 on the hospitality sector has shown the importance of structuring ground rents correctly to ensure long-term sustainable income."

Tom Barrett, head of hotels and leisure at business advisory Savills Ireland, said ground rents have not spread much into Ireland.

The U.K. has more leverage and borrowing than Ireland, he said, so while he hasn't seen "exotic financing," there are certainly different structures, such as ground rent.

“Ireland was in such a bad way in 2008, '09, '10, that hotels after then were bought at more reasonable levels of debt,” he said.