In a classic ground lease situation, the lessor leases vacant land to the lessee on a long-term basis, and the lessee is responsible for construction of a building or other improvements. In another variation, the land may already be improved, and the lessee agrees to make extensive renovations to the existing improvements. In a third variation, the land is fully improved and the lessee, concurrent with the consummation of the lease transaction, buys the improvements from the fee owner of the land. In all three scenarios, the rent the lessee pays is based on land value alone.

Typically, the term of a ground lease is very long term (20 or 30 years to perpetuity; although in California, by statute, the term of a lease may not exceed 99 years.) The rent is usually fixed, or at least determinable at any time, and is "net," with the lessee responsible for all property taxes, insurance, utilities, and all costs of maintaining the property.

The lessee is generally given a broad set of rights with respect to the property-broader than one would normally see in a commercial lease transaction. This wide latitude allows the lessee to generate a return sufficient to justify its investment, and to attract the financing necessary for the construction of the improvements. It also highlights a basic difference between the ground lease and commercial lease transactions. In the typical commercial lease, the lessor is principally looking to his tenant's credit standing to assure that the rent will be paid and the lease terms fulfilled. In most cases, the typical commercial lessor expects to regain his property eventually. Unless there is a rise in rental rates, early termination of the lease is to the lessor's disadvantage.

The lessor of the ground lease, on the other hand, has parted with control of his real estate for a period usually beyond his and his children's lives and beyond the economic life of the improvements to be erected by the lessee. Rather than looking to the strength of the lessee's credit, he has created an annuity which is secured by the land and the improvements that the lessee has constructed on his land, or, in case of their destruction, by the insurance on these improvements. While the improvements typically pass to the lessor on expiration of the lease, the reasonable assumption is that they will then be obsolete and of relatively little value. Their present worth, however, is assurance that the lessee and his assigns will pay the rent at least until the improvements become obsolete. The difference between a commercial lease and a ground lease is further highlighted by the fact that a ground lease is sometimes used as a substitute for a sale. A ground lease becomes a particularly attractive alternative where a lessor has a low basis in his property, and would pay a heavy capital gains tax were he to sell. Instead, execution of a lease is not a taxable transaction. A lessee may also prefer a ground lease to a sale, since it avoids his having to tie up his capital in a purchase. Moreover, under a ground lease, the lessee is likewise benefitted by his ability to deduct the rent and depreciate the improvements.Given the lessee's obligation to construct, materially renovate or purchase the property's improvements, it is essential that the lessee have the ability to "finance" the improvements by mortgaging the leasehold. To create a "mortgageable ground lease," it is thus imperative that the ground lease contain certain provisions required by lenders to meet its legal, regulatory and underwriting requirements. Several of the most important components are as follows:

Right to Encumber/Subordination.

The unfettered right to encumber the leasehold is central to the lessee's ability to finance a ground lease. Even with that right, in many circumstances, a lender will also require that the lessor subordinate it fee to the lender's mortgage. In other words, the lender will require that the landowner grant the lender a lien against the underlying fee. This obligation obviously imperils the lessor's position, subjecting him to loss of his land by the lessee's default. Moreover, it weakens the lessor's financial position by reducing the value of the lessor's estate, and effectively preventing the lessor from obtaining a first mortgage on the fee for his own use. On the other hand, yielding to this demand may be the only way the lessor can improve its otherwise vacant land, converting it into an income producing asset, and at a minimum, should certainly yield the lessor a higher rent. In the event that the lessor yields to a subordination, he should still be careful to place limits on the type and amount of financing he permits.