By Terry Painter, Mortgage Banker
Member of the Forbes Real Estate Council
What is a master lease? What are the benefits and how is it used?
A Master Lease as it pertains to commercial real estate is a financial instrument that allows a buyer/lessee to lease the property with an option to purchase it at a later date. The lessee has equitable title, not legal title which allows the lessee complete authority to run the property and benefit from the properties income and appreciation. The seller/Lessor benefits from receiving monthly payments and no longer being responsible for maintaining the property.
A master lease is most often used in a situation where a seller/lessor, wants to lock in a higher price today than the property is worth based on it’s occupancy, net income and/or condition. In most cases, the seller does not have the financial means or motivation to improve the property. In exchange, the buyer who does have the money and motivation to enhance the property gets the advantage of putting very little money down. They can then start repositioning the property – remodeling it, re-tenanting it, and raising rents. The lessee makes monthly payments to the lessor. At some specified future date the lessee has the right to purchase the property for the agreed upon amount. At that time, the property will usually qualify for quality permanent financing and be worth a lot more. The buyer/lessor gets the benefit of appreciation. The seller/lessor has the benefit of getting more for the property than it was worth when the master lease agreement was signed.
Example of How a Master Lease is Used
A client of mine came across a large 140,000 square foot empty manufacturing plant located just off a busy freeway interchange in Iowa. The property had been for sale for close to two years. The owner had died and his wife did not have much interest in re-tenanting the property. My client called major clothing chains and got interest from four to locate stores at this location. He still needed another twelve. His idea was to repurpose the property into a factory outlet mall. With 10% down he was able to sign a master lease on the property with the widow. She was pleased to be getting monthly payments and he was excited about his new venture. My client was able to negotiate ten leases with him putting in the separating walls and utilities, and the tenants putting in the leasehold improvements. 28 months later when the property was 65% occupied, my client was able to obtain a bridge loan to purchase it at the agreed upon price in the master leases. In most cases, master leases are only attractive to sellers who just do not want the headache of having to improve their commercial property.
Most often, the master lease is favorable for both the buyer and the seller. The buyer/lessor gets equitable title for the property which gives them the right of total control of the property with the exception that they cannot sell it. The lessee will obtain legal title in the future if the purchase option goes through. The seller/lessor retains legal title. This results in the buyer getting all of the profit as well as tax benefits. For a master lease agreement, the buyer has all the responsibility for the property. This includes repairs, maintenance, utilities, taxes, and management. Once the property is fully leased or just prior to the master lease expiration, which ever comes first, the buyer/lessee, has the right to either purchase the property for the agreed upon price, or give the property back to the seller/lessor.
Another benefit for the buyer is that banks are not involved in the master lease agreement. This is advantageous for buyers who have poor credit, lack experience, and lack savings for a down payment. The buyer’s goal is usually to improve on these items so they can qualify for permanent financing in the future. It’s lower risk for the buyer also because any loan connected to the property as well as the title are in the name of the seller.
How does the Master Lease Option work?
- The buyer purchases the piece of commercial real estate with a relatively small deposit. For a million dollar purchase price it might be as little as $25,000 down.
- At the signing of the master lease, the buyer gets equitable title.
- The terms are set firmly to not be changed. This means that any rise in the property’s value is for the buyer to keep.
- The buyer is entitled to get the total amount of cash flow as well as the total amount of tax benefits.
- The buyer gives a monthly lease payment to the seller.
- Once the lease term is up, if the buyer is not able to purchase the property the equitable title becomes null and void and all rights go back to the seller.
Another example of a master lease for a multifamily property:
An apartment property was for sale which had a fire. One whole building of 12 units was uninhabitable and needed repair. The seller who was in ill health used the insurance money to pay medical bills. He did not have the money or inclination to do the repairs.
This seller being in a distressed financial state was a great candidate for a master lease option. The buyer got together with the seller and worked out a win/win master lease agreement with a three year term. The great news for the seller is that they got a got a down payment, and future monthly payments and was free from the distressed property.
Does a Master Lease Work in Today’s Real Estate Market?
At the time of the writing of this article in 2019, it has been a seller’s market for over four years in the US. A seller’s market is not the best time for a master lease to be favorable for the seller. This is because there is a shortage of properties for sale and buyers will pay more for distressed properties than they are worth. In a buyer’s market the opposite is the case.
Two requirements to be able to negotiate a master lease:
- Get the seller to feel strongly motivated about doing a deal.
- Write down details of what the seller is motivated by and form a real estate transaction with terms that is based on this motivation. This way the seller is best served, but also you as the buyer make sure you win in the transaction.
What the seller receives from the transaction:
- A sale that is simple
- Monthly payments that in most cases more than cover their mortgage payments
- Freedom from having to be involved with the property. This includes financial as well as personal matters.
What the buyer receives from the transaction:
- Because the loan continues to be in the name of the seller, the buyer has reduced risk.
- Buy the property with no credit, no banks, and a low amount of money down, or no money down.
- Once the lease is paid, the buyer can have any money that is left (which is cash flow for the buyer).
- Buyer gets to keep all profits and appreciation
- There is an option to buy once the period of time that was agreed upon for the master lease to expire has expired.