n most areas of the United States, land is owned in fee simple. A fee simple owner has ownership of the entire property, including both the land and buildings. Fee simple ownership is the most common and complete form of land ownership.
Leasehold ownership was a very common method of ownership on Oahu 30-40 years ago with most residential homes being owned in leasehold. It enables homebuyers to purchase a properties at far lower cost than if the properties were purchased as fee simple.
A leasehold interest is a rental agreement created between a land owner (the lessor) and a lessee, who is leasing the land from the fee simple owner.
This rental agreement is called a ground lease. It is usually written for a period of 55 years with 30 or 40 years at a fixed rent and then a slightly higher rent for an additional 25 or 15 years. The lease rent is usually renegotiated every 5 years. Lease extensions or renewals are common so leasehold homeowners or buyers could obtain long-term mortgages for refinancing or purchases.
A lessee acquires leasehold rights similarly as fee simple rights. However, the leasehold interest does differ from a fee simple interest in the following five aspects:
(1) The buyer of residential leasehold property does not own the land and in almost all cases, pays a ground rent to the lessor.
(2) The use of the land by the lessee is limited to the remaining years covered by the lease.
(3) When the ground lease ends, the land returns to the owner or lessor. If there is a surrender clause in the ground lease, the buildings and other improvements on the land may also revert to the lessor.
NOTE: Most of the ground leases on Oahu contain a surrender clause; i.e., the buildings and other improvements revert to the lessor at the end of the lease.
That’s why I prefer to purchase leasehold properties in buildings that have a mix of fee simple, leasehold or fee available. This way I know the building will continue to exist when the grand lease expires, and the fee is available for sale.
(4) The use, maintenance, and any alterations made to the leased land are subject to local ordinances as well as any restrictions contained in the lease.
(5) a lessee can sell or transfer the ground lease to another party, referred to as an assignment of lease; however, the sale or transfer is usually subject to the review and approval of the lessor.
So, what happens when the ground lease on a condo expires where the fee has never been offered?
Well, no one knows.
The ground leases on the first two leasehold complexes expired in 2007. It was hoped that a precedence would be set by these first two complexes, but that did not occur. Both complexes were quite small. The first lessor reluctantly caved-in to community pressure and agreed to sell the fee interest to the leasehold owners. The second lessor went to court where a judge ruled early in 2008 that the lessees would have to surrender their homes. Unusual circumstances existed with each of these complexes, but similar unusual circumstances are likely to exist with other complexes.
Leasehold ownership on Oahu has become increasingly unpopular in view of all the uncertainty. If the fee is available, many buyers will purchase it simultaneously with purchasing a unit in leasehold. Therefore, the leasehold value for a unit is usually the fee value for a comparable unit less the cost of the fee and fee closing costs. The cost to buy the fee is a combination of the unencumbered value of the land offset by the remaining years on the lease. As the lease gets progressively shorter, the fee price usually gets progressively higher, particularly near the end of the lease.
Mortgage financing also becomes an issue. As the lease gets progressively shorter, it becomes increasingly more difficult to find lenders that make loans on the property. When there are less than ten years remaining on the lease, the leasehold property is virtually unsellable except to a buyer that is willing to pay cash at a very discounted price.
There is also a 30-year requirement on the land lease for a leasehold property to qualify for a 1031 exchange, which means there must be at least 30 years remaining until the expiration of the lease (not renegotiation).
If you are the owner of a leasehold property, we advise you, in most cases, to buy the fee as soon as practicable, as the cost of the fee will continue to increase with time. If buying the fee is impracticable, in most cases, you should sell your property in leasehold as soon as practicable, as the leasehold value will likely continue to decline with time. If you decide to wait to sell for the next period of rising prices on Oahu, you may find that the cost of the fee has increased more than the increase in value of your leasehold home; i.e., you will net less from the sale. This general advice obviously varies with the leasehold property and the owner’s situation.
So are there good buys in leasehold?
Leasehold is considerably less expensive than fee simple, with the value decreasing toward the end of the lease. But some buyers are more concerned about what they’re able to do today than what may happen tomorrow.
The fact that a home is leasehold has no impact on the rent that it produces. So, some investors opt to buy in leasehold because leasehold properties can generates a pretty handsome cashflow.
The mortgage payment for some leasehold homeowners (offset by tax deductions) is less than the cost to rent a comparable home. So, some homeowners also opt to buy in leasehold. It may enable them to own in a complex that otherwise would be too expensive.
As long as you understand the implication of owning a leasehold property, there are many good buys in the leasehold to generate a good cash flow for investors.
Read more on Why Buy Leasehold Properties from Cash Flow