Ground Rent

Definition of Ground Rent

In the context of commercial mortgages, ground rent is a periodic fee paid by a leaseholder to a freeholder (the landowner) for the right to occupy the land upon which a commercial building sits. While the borrower may own the physical structure and have the right to operate their business or collect rent from sub-tenants, the underlying land remains the property of the freeholder. Ground rent is a legal requirement established within the terms of a long-term lease.

The Relationship Between Ground Rent and Commercial Mortgages

Lenders view ground rent as a primary consideration when underwriting a commercial mortgage because it represents a prior charge on the property's income. If a leaseholder fails to pay the ground rent, the freeholder may have the right to commence forfeiture proceedings, which could result in the lease being terminated and the lender losing its security.

When assessing a mortgage application, lenders will specifically analyze the following aspects of the ground rent agreement:

• Rent Reviews: Lenders examine how often the ground rent increases. Frequent reviews or "stepped" increases can impact the long-term affordability of the mortgage.
• Escalation Clauses: Clauses that cause ground rent to double every 10 or 15 years are often flagged as "onerous." Such clauses can make a property difficult to sell or refinance, often leading lenders to decline the mortgage application.
• Lease Length: The lease must generally extend well beyond the term of the mortgage (often by 30 to 50 years) to ensure the security maintains its value.
• Marketability: If the ground rent is too high relative to the property's value, it reduces the Yield for investors, which in turn lowers the maximum loan amount a bank is willing to provide.

Impact on Property Valuation

Ground rent has a direct impact on the Net Operating Income (NOI) of a commercial asset. Since ground rent is an expense that must be paid before mortgage debt service, a high ground rent reduces the amount of cash flow available to cover mortgage payments. Consequently, properties with high ground rent are typically valued lower than those with nominal or "Peppercorn" rents.

A Peppercorn Rent refers to a ground rent that is of a nominal or symbolic amount (such as $1 per year). From a commercial lending perspective, a peppercorn rent is the most favorable structure because it carries negligible financial risk to the borrower’s cash flow and the lender's security interest.

Onerous Ground Rent Risks

In recent years, commercial mortgage providers have become increasingly cautious regarding onerous ground rent. If the ground rent exceeds a certain percentage of the property’s total value or its annual rental income, the property may be deemed unmortgageable by mainstream banks. Borrowers seeking a commercial mortgage on leasehold property should ensure that the ground rent terms are transparent, capped, and predictable to ensure the asset remains a viable security for a loan.