Most people, particularly those from the Mainland US, are only familiar with one type of real estate ownership - fee simple. But there is another form of real estate ownership known - leasehold. It is important to know the difference between the two, especially if you're buying real estate in a leasehold state like Hawaii.
Fee simple is the type of ownership most buyers are probably familiar with when it comes to residential real estate. Fee simple gives the buyer ownership (title) of the entire property - the land and any improvements to the land in perpetuity (for an indefinite period of time). The fee simple owner has the right to possess, use the land and dispose of the land as he wishes--sell it, give it away, trade it for other things, lease it to others, or pass it to others upon death.
With a Leasehold property, one party owns the land while another party only has the right to use the land for a predetermined amount of time. A leasehold interest is created when a fee simple land-owner (Lessor) enters into an agreement or contract for a ground lease with another party (Lessee). A Lessee pays a lease payment to the Lessor for the rights of use of the land. The lessee may own the improvements on the land, but at the end of the pre-determined period, the land reverts back to the Lessor unless a new lease is negotiated and agreed to by all parties. Depending on the provisions of any surrender clause in the lease, the buildings and other improvements on the land may also revert to the lessor.
Some things to consider with leasehold property:
1) If leasehold real estate is transferred to a new owner, use of the land is limited to the remaining years covered by the original lease.
2) Leasehold properties are typically priced lower than fee simple units, but may also have stricter requirements when it comes to financing.
3) Lease Rent is in addition to any maintenance fees on the property and should be looked at in combination with the mortgage to understand the true cost of the property.
WHEN CONSIDERING A LEASEHOLD PROPERTY YOU WILL WANT TO KNOW:
THE LEASE RENT
The amount paid to the lessor for use of the land.
THE EXPIRATION DATE
The date that the lease is scheduled to end.
THE RENEGOTIATION DATE
The date when the lease rent amount will be renegotiated. Lease rents typically renegotiate periodically throughout a term (every 10-15 years).
THE FIXED PERIOD
The period in which the lease rent amount is fixed.
THE LEASE PROVISIONS
How are increases in the rent determined? The lease will often contain a formula for calculating the new lease rate, typically based on a percentage of the market value of the fee simple land at the time of renegotiation.
THE LEASED FEE INTEREST
The amount a Lessor will accept to convey fee simple ownership
THE LEASE TERM
The length of the lease period (in Hawaii this may be 25-99 years at a time). You will want to know whether there is a right to extend written into the terms.
THE REVERSION AND SURRENDER TERMS
Reversion is the return of the land to the Lessor at the end of the Lease Term. The Surrender Terms will tell you what will happen to your real property (building/unit) at the expiration date. In some cases the building become the property of the Lessor at the expiration of the term lease
YOUR ABILITY TO RESELL OR REFINANCE
Your ability to refinance or resell the leasehold property as the lease term approaches renegotiations or expiration dates is important to consider before you purchase. Financing for leasehold properties is difficult to get, and often unavailable for units with a short time left on the lease.
SO WITH SO MUCH RISK WHY WOULD SOMEONE PURCHASE LEASEHOLD PROPERTY?
Get the luxury lifestyle at a fraction of the cost of market value, pay a lease rent monthly fee that is typically less than a mortgage payment might be for the unit (and allow your assets to make money elsewhere).
NO HEIRS? RETIRE IN STYLE
Along the same line of thought, if you do not have heirs to leave your property to and want to live out your golden years in a better lifestyle and if the lease terms time out right, leasehold might be a good option. There is still the risk of you outliving the term the lease, so keep that in mind.
INVESTMENT RETURN VS RISK
Because the purchase price can be significantly lower than the same property in a fee simple ownership the return on the initial investment (if used as a vacation rental) might make sense. Especially if you can purchase with cash. You will want do your due diligence and get as much rental history as possible to determine if the numbers make sense for you, but when renting it out to vacationers, they don’t care if it’s a fee simple or leasehold property. They care about is the view, the amenities, the proximity to the beach. If you can get it at a fraction of the cost, you could start making a profit that much sooner. Again, there is always the risk of reversion at the end of the lease, but for the investor willing to take the risk, the payoff might be worth it. You should consult your lawyer and investment manager for guidance.