Episode 5 Notes (Ground Leases)

I uploaded episode 5 of the podcast yesterday, which covered how to use a ground lease as a financing tool. In case it's helpful to refer back to this intel in the future, here are my notes from the interview:

Background on Montgomery Street Partners

- Private equity firm based in Dallas

- Program designed around co-GP investment with existing operators.

- $7.5B of RE allocation through a series of discretionary equity funds invested in GP interests

- Seek to identify thematic investments and source a single operator with a strong track record and actionable pipeline that can be scaled through co-GP investments. Examples include manufactured housing and RV storage ($4B AUM), BTR (5K units under management), student housing, cold storage, industrial development platform, life science vehicle to create new life science nodes in secondary and tertiary markets, small car wash business.

- Recently launched 2 new verticals: NNN and construction pref.

- Ground Lease REIT where Montgomery Street is the external manager

Background on Ground Lease REIT

- Launched in 2020

- Structured as private REIT with mostly institutional capital

- Montgomery Street is external manager

- Goal is to deliver to investors a well risk-adjusted, long-term, highly durable series of cash flows with inflation protection.

- Have originated ~$1B in ground leases

- Have ~$600M of dry powder

- Lever only at the corporate level (no asset level debt)

How ground leases are used as a financing tool

- Alternative form of financing

- Three primary benefits:

1) Lower blended cost of capital

2) Incremental leverage through GL + leasehold loan

3) Delay deployment of equity and create incremental IRR to the investor

- Any asset class in infill locations around the country

- Anything from ground up development through existing stabilized cash flowing assets.

How is the size of the ground lease is determined?

- Want ground rent to be 25-30% of NOI (3.5x - 4x coverage)

- Once you determine appropriate ground rent, then divide by their pricing (cap rate) to calculate gross proceeds

What's current pricing?

- Depends on asset class and business plan

- Priced over 30-year treasury

- Cheapest cost for existing cash flowing multifamily is 30-year UST+0.65%.

- Development opportunities are 30-year UST + 0.85%-1.00%

- More challenging office executions are wide of that, e.g. 30-year UST + 1.25% - Ground leases include 2% annual escalator, periodic CPI resets (typically every 5 years capped at 3-4%)

- No Fair Market Value resets

- 99 year lease term

What are common scenarios where sponsors are using the GL structure?

- Existing MF paired with an agency loan. Freddie in particular has a good program for this.? You'll get more leverage with the ground lease + agency than you would with just agency. Can get up to 75-80% look through leverage.

- The blended cost of capital of GL + agency can be 200-400 bps cheaper than the blended cost of capital of agency+pref

- Seeing a lot of traction for distressed office.

- Getting more calls from lenders than expected because they want to take some chips off the table and reduce their exposure.

- Construction loans in process with interest reserves that are out of balance and the take out loan doesn't look as viable and the senior lender won't fund until the loan is brought back in balance.

- Bridge loans from 2021 that are now over-levered, the GL program can pay down the existing debt to buy some runway to when the market improves.

What scenarios don't work well?

- Don't want a location that could be obsolete in 20+ years. Focused on infill locations.

- GL program doesn't work well with cap rate asset class that's comparable to their pricing, e.g. industrial

- Don't want chunky capex that's not capitalized in the future

Does it work with MF deals closing at TCO?

- Yes. They financed a MF asset in New Jersey that was coming off a construction loan with a debt fund. 10% leased. Provided a GL sized to 3.5x coverage, 35% of stabilized value.? Paired it with a bridge loan provided by Arbor that's now going to be taken out by an agency loan.

What senior lenders are comfortable with ground leases?

- Most debt funds are open to it. They look at the GL similar to an A-note.

- Many banks

- CMBS

- Freddie (HUD and Fannie find it more challenging)

- Not common with life companies

How will the GL industry evolve going forward?

- Continue to deliver strong value proposition to the market.

- Prolific in both low and high interest rate environment because they're always the lowest cost of capital

- Offer an escape route for lenders and sponsors for distressed and impaired assets

- Biggest hurdle is there needs to be more leasehold trades to demonstrate there's a buyer pool that's not scared away by the GL.

- Over next 2-5 years, you'll see properties start to sell that have modern ground leases included, which will clear the runway for a new wave of originations.

What's minimum check size?

- $10M, which equates to ~$35M total project or acquisition cost - No maximum, have done $200M ground leases