What is Leased-Fee?
Leased-Fee 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 lease 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 property owner decides to sell the legal right to use the land, the owner retains a leased-fee interest in the land. The leasehold interest allows the tenant/lessee to occupy and use the land and/or any improvements and does not convey ownership of the land itself.
How does Leased-Fee Interest 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 tenant/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. Many leases are fixed for an initial period of the lease and then readjust periodically, such as every 10 or 20 years, for the remainder of the lease.
So why would you buy a leased-fee interest?
There are several reasons to purchase leased-fee interest – lower acquisition cost compared to fee simple, consistent income throughout the term of the lease, appreciation potential, and lower maintenance cost and effort. As an investor, you definitely want to be on the leased-fee interest side of the lease!
Similar to the leasehold interest, the leased-fee interest acquisition cost is lower than the fee simple interest because you are only buying one aspect of the property. Because the land is the most valuable component of the property, the acquisition cost for the leased-fee interest will be higher than a leasehold interest, but still lower than if purchasing the fee simple interest in the property.
As with many other types of investments, the value is determined by the income generated by the asset. The leased-fee owner receives monthly lease rent as determined by the terms of the lease. The lease rent is either fixed for the term of the lease or fixed for the beginning period and then increases at pre-determined increments based on a pre-determined calculation.
The other variable that drives the leased-fee interest acquisition cost higher than the leasehold interest is the potential appreciation in value. Generally, the land values appreciate and once you own the leased-fee interest, you own that land forever. The leasehold interest is only for the length of the lease and at some point in the life of the lease, the value generally begins to depreciate. At the end of the lease, the land and any improvements revert back to the leased-fee owner and it becomes fee simple ownership interest in the property.
Not only does the leased-fee owner receive income in the form of lease payments, they also save on the expenses for the property. Most leases shift the responsibility of all expenses, such as property tax, maintenance fees, etc. to the leasehold owner. In addition to the significant reduction in expenses, the leased-fee owner doesn’t have to maintain the improvements or manage tenants in the case of a sublease.
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. The leased-fee owner can offer to extend an existing lease, renew the lease, or even offer 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. This is where the patient investor can realize a significant gain in the property value as they become the fee simple owner of the property.
An example of one of my clients really helps to understand how this works. My clients own several fee simple units in a building, have solid rental income, and the properties have appreciated nicely. Unfortunately, they were recently notified of a $30,000 assessment on each unit for necessary capital improvements of the building. As my clients are getting older, they are also getting tired of managing the units and finding new tenants almost every year.
My clients recently purchased the leased-fee interest in another building because of the low acquisition cost, stable income, potential appreciation, and ease of ownership. They were looking for something in the $300,000 price range and nothing in that fee-simple price range in the metro Honolulu market appealed to them. They could, however, buy the leased-fee interest in a 2-bedroom condominium for $310,000. The current fee simple price for 2-bedroom units in the same building is around $600,000.
The terms of the lease provide for current annual lease rent of $10,000 and an increase in lease rent for the last 10 years of the lease, which expires in 2032. The annual lease rent is not quite at the cap rate they were looking for, but when we explored the potential overall yield of the property after reversion in 2032 and considered the ease of owning the property, they decided to move forward.
Between now and 2032, the lease rent will increase one more time and their return on investment will improve. When the property reverts, they will have the fee simple interest in a property that should be worth almost double the initial investment of $310,000. As I mentioned earlier, the current market value of similar fee simple properties is around $600,000. In the unlikely event values remain stagnant over the next 12 years, they will still gain $290,000 in addition to the lease rent they have collected over the 12 years of the remaining lease term. If property values continue to rise, as they often do in Hawaii, then the value gained at reversion will be even greater.
The terms of the lease also assign who pays for the various expenses and carrying costs of the property. The leasehold owner is responsible for property taxes, maintenance fees, and any assessments during the lease. If there is a $30,000 assessment on this unit, my clients don’t have to worry about it. They also don’t have to worry about the work to find tenants during the term of the lease. The leasehold owner is responsible for the monthly lease rent whether they are an occupant, or they are renting the property to a tenant.
During our due diligence the question of missed lease payments did come up. There is always the possibility that a leasehold owner either decides not to pay the lease rent or can not pay the lease rent. That can cause some extra legal expense and hassle for the leased-fee owner, but it can also create a situation where the reversion is accelerated and the leased-fee owner becomes the fee simple owner much sooner than the lease expiration.
Fee-interest ownership is great for investors looking for a stable long-term investment as it can potentially take a few decades until the lease ends and the reversion provides the big return. This is ideal for younger investors who don’t have as much to invest and have the luxury of time on their side. This can be a great asset for retirement planning, especially if the leased-fee interest is purchased in a self-directed Roth IRA. It can also be a great asset for long term estate planning. A leased-fee property purchased for the benefit of young children now can help to fund their college tuition or even become a future home after reversion.
It is important to know that financing can be difficult for the purchase of leased-fee interest and most of these types of purchases are cash. There are some lenders and financial institutions that will provide financing, but still require a substantial down payment. Local lenders and financial institutions understand this type of ownership and are more comfortable with it.
How does an investor find available leased-fee properties?
Many of the large leased-fee offerings have been through the larger brokerages and not listed in the MLS. There are also some brokers that are known to represent large institutional landowners when they decide to sell off large quantities of leased-fee interests. From time to time there will be leased-fee interests listed in the MLS.
Contact me if you have questions or if you would like assistance finding a leased-fee interest opportunity.