Fee Simple vs Leasehold Homeownership

Fee Simple vs Leasehold

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

Buy Leasehold Properties for Cash Flow

Leasehold Properties for Cash Flow

Hawaii real estate is unique in that many land on which building stands are owned by separate owner. The Bishop Estate owns many land in Hawaii, and so are many private owners.

What is leasehold properties?

Leasehold properties are buildings or structure that stand on a leased land. The owner of the building or structure own all of the structure on the land, but pays lease rent for the land on which is the building or structure sits.

Most home buyers shy away from leasehold properties because they are afraid of the lease rent and lack of control. Most home owners wants to own their home AND the land under it free and clear. Besides, lease are renegotiated every so many year, so there is chance that the new negotiated fees may be more than what the owner wants to pay, and this makes many people uncomfortable with purchasing leasehold.

Besides, it is generally more difficulty to get financing from banks, especially if you don’t have the cash, and needs financing. Most banks require the leasehold properties to have at least another 50 years remaining on the lease.

Some banks may be able to finance your leasehold properties purchase with portfolio lending.

At lease expiration, it is up to the lease fee owner to either extend the lease for or take the land back. In the case, where the lease fee owner decides to take the land back, that means the building on the land has to go “poof” or demolished or the lease fee owner may take the building and do whatever they want.

This is the biggest fear of leasehold properties purchase.

But Why You Still Want to Buy Leasehold Properties for Cash Flow?

For a savvy real estate investor, purchasing leasehold properties make sense. If you ask 10 people, 9 of those would tell you Honolulu is a horrible place for real estate investors because real property price is too high to provide good cash flow.

These people are missing out on a big lucrative market.

The purchase price of a leasehold property is usually a lot cheaper than fee simple. Of course, you’re not buying the land. You’re only paying for the structure. You pay the lease rent, or should I say your tenant pays the lease rent for you. But YOU write off the lease rent as tax deduction as operating expense.

This is how you can get properties with CAP rate of 6% or more. If you manage your property well and put it into good use, you can get even up to 30% CAP rate.

I can show you how.

If you get yourself a good deal, and you recooperate most of your initial investment before the lease expiration date, you’ll not have to worry about the lease fee owner taking the land back because you would have made your money back many times. If the lease fee owner extends the lease, that’s even better for you, your property continues to generate cash flow for you.

Here's another trick, I generally look for condo buildings where the lease fee is available to purchase. This gives me more control, and I know it will be my choice to give up the condo when the lease expires.

The other benefit is that when I'm ready to refinance, I can purchase the fee and own the condo free and clear.

The best time to buy a leasehold condo is when the condo AOAO just purchased the lease fee for the building and selling to the owners. This usually put pressure on the condo and many would choose to give up and sell their condo as leasehold. This makes them motivated to sell as many does not have the mean to purchase the lease fee or to get financing to purchase the fee.

Leasehold Property and Sandwich Lease

The concept of using leasehold property for investment is sort of similar to a sandwich lease.

In sandwich, you, the investor rent (lease) a condo from the owner, and you turn around to sub-lease the unit to a renter.

Say, you found a really nice rental property in a nice, highly desirable neighborhood with good school. The owner is asking for $2,000 a month rental income. You know you can rent this for $2,200. You rent the unit from the owner for $2,000, then you find a renter who is willing to pay you $2,2000 per month for this same unit. In this case, you cash flow with none of your own money $200 per month. No maintenance on your part either, because you’re not the owner.

Before you to start doing this, you need to be sure that the owner is okay with you sub-leasing. Just common courtesy.