WHAT IS LEASEHOLD?
Leasehold is a form of ownership that is fairly unique to Hawaii and may not be familiar to mainland and international investors. Due to the history of land ownership and the value of land in Hawaii, some land owners convey the legal right to use the land in return for rental payments and the right to repossess the land when the lease ends. This allows the land owner to retain ownership of the land while also earning income from the property.
It’s important to understand the terminology used in these types of arrangements. Fee-simple interest/ownership is the owner’s interest in the land and any improvements, unencumbered by any leases. This is what most people consider to be property ownership wherever they are from. When the land owner decides to sell the legal right to use the land, the owner maintains a leased-fee interest in the property. The leasehold interest allows the lessee to occupy and use the land and/or any improvements, but does not convey ownership of the land itself.
HOW DOES LEASEHOLD WORK?
As mentioned above, in return for permitting the tenant/lessee to use the property, the owner receives lease payments and the right to repossess the land at the end of the lease term, which is called reversion. These leases are typically very long, often 50 to 100 years, which allows the lessee the time needed to develop the land for their use and profitability. Lease rents can be fixed for the term of the lease or can readjust periodically. I’ve seen many leases fixed for the first quarter or half of the lease and then readjust every 10 or 20 years. There are still a few residential condo buildings on Oahu with fixed lease rents and a good amount of time left on the lease.
SO WHY WOULD YOU BUY A LEASEHOLD PROPERTY?
The main reason is the lower acquisition cost. The value of land in Hawaii is very high. Buying the leasehold interest in a property, instead of the fee-simple interest, allows for much lower acquisition cost and/or monthly expense, which significantly impacts the return on the investment.
Residential investors can buy a leasehold property at a substantial discount compared to a fee-simple property and rent the property at the same rate as a fee-simple property, assuming similar condition, views, etc. For example, a leasehold condominium in a building may cost $250,000 and the fee-simple unit right next door may be $400,000, but the rental income can be the same at $2,000 a month. The significantly lower acquisition cost has a major impact on the yield of the investment. At the end of the lease term, the property reverts back to the leased-fee interest owner, and the leasehold owner has met their investment requirements for the time period they owned the property.
The situation is similar for commercial investors, depending on the property and their investment goals. There is a lot of major retail, office, and industrial development on leasehold land in Hawaii. The leasehold owners develop properties to their highest and best use with monthly tenant rents exceeding the monthly lease payments to the leased-fee owner at a level that meets the leasehold owners’ yield requirements.
WHAT HAPPENS AT THE END OF THE LEASE?
It depends on the terms of the lease. As mentioned earlier, most leases dictate the property reverts back to the leased-fee owner at the end of the lease. There are cases where the leased-fee owner offers to extend an existing lease, renew the lease, or even offers to sell the leased-fee interest. If the leased-fee owner decides not to extend or renew the lease, or sell the leased-fee interest, the leasehold owner is obligated to walk away from the property with no compensation. Investment analysis should be based on the current terms of the lease and not optimism that the lease will be extended or the leased-fee interest can be purchased.
WHAT HAPPENS TO THE PROPERTY VALUE DURING A LEASE?
It is important to understand the history of leasehold property values when entering into a lease. At the beginning of a long-term lease (50 to 100 years) the leasehold value will more than likely remain constant or may even appreciate for several years into the lease, depending on a lot of variables. However, towards the end of the lease term, leasehold values typically begin to depreciate significantly. That’s why you’ll often see leasehold property listed at prices that are “too good to be true”.
In some cases the really low priced leasehold properties will work with very specific situations. I’ve had clients who know they are only going to be in Hawaii for a short period of time and there is a lot of time left on the lease. They have been able to get into the property at a much lower acquisition cost than a similar fee simple property and then exit before the property starts to depreciate.
I’ve had other clients who bought leasehold properties with extremely low acquisition cost at the very end of the lease and were able to meet their return requirements with the rental income during the 5 to 10 years remaining on the lease. Some have decided that the short time remaining on the lease is longer than they will be on island and the low acquisition cost ends up being less than they would pay in rent during the same amount of time.
In general, I would recommend Fee Simple because it is “complete” ownership of the land and improvements. It allows an owner to do what they want to do with the property, within existing legal requirements, and allows the owner to reap the full benefits of Hawaii’s historical property value appreciation. Fee simple ownership also allows the owner to pass along property to heirs.
In conclusion, leasehold ownership is unique and may or may not work with your investment strategy. It is very important to be clear on your investment objectives and have a really good understanding of the terms of the lease to see if they are a match. If you have questions or would like to discuss your investment strategy, I’ll be happy to take the time to understand your needs and find a property that works with your investment objectives. Please feel free to contact me to schedule an appointment.