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Hawaii Property Ownership Explained | Fee Simple vs Leasehold

Fee Simple vs Leasehold

Most people only know of one type of real estate ownership; fee simple, also known as freehold. Hawaii and a few other states have another form of ownership known as leasehold. The difference in these two types of land tenure is very different and affects the value of the real estate. It is important to know the difference, especially if you’re buying real estate in a leasehold state.

Fee Simple

Fee simple ownership is probably the most familiar form of ownership to buyers of residential real estate. A fee simple buyer is given title to the property, which includes the land and any improvements to the land in perpetuity. In the case of a condominium, the purchaser would own a pro-rata share of the land. Aside from a few exceptions, no one can legally take that real estate from an owner with fee simple title. 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.

Leasehold

A leasehold interest is created when a fee simple land-owner (Lessor) enters into an agreement or contract called a ground lease with a person or entity (Lessee). A Lessee rents the land from the Lessor for the rights of use and enjoyment of the land much as one buys fee simple rights; however, the leasehold interest differs from the fee simple interest in several important respects. First, the buyer of leasehold real estate does not own the land; they only have a right to use the land for a pre-determined amount of time. Second, if leasehold real estate is transferred to a new owner, the use of the land is limited to the remaining years covered by the original lease. At the end of the predetermined period, the land may legally revert back to the Lessor, and is called reversion. At the end of the lease term, many lessors and lessees have agreed on either a new lease or the Lessor may agree to sell the land to the Lessee. In the case of a condominium 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. Finally, the use, maintenance, and alteration of the leased premises are subject to any restrictions contained in the lease.

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Dolores Lapalio

June 16, 2019

Is it possible to buy out the lease on a condominium and sell that unit as fee simple? What happens if all or a portion of the other condos in the building are still lease hold when the lease expires? is there a downside to the fee simple unit/s? It seems quite complicated and I notice that many apartments or condos are unable to qualify for 30 year financing. How does this affect the real estate market in general?

Paul Goodman

June 17, 2019

Purchasing Leasehold property has risks associated with it as outlined below:

1. Leasehold Properties May Decline in Value
Leasehold properties may potentially decline in value, even during a market rise. There is no hard rule on when leasehold property values will fall. However, they appear to drop when there are between 25-35 years remaining on the lease. There are a few reasons for this decline. The first reason is that a leasehold property is perceived as a higher risk since the time remaining on the lease is lower, and therefore it will take longer to recoup your money back. For example, you purchase a property at a great price with ten years remaining on the lease. Seven years later you decide to sell the property, but now you only have three years remaining on the lease. The new buyer will need to get an even a better deal since the lease is close to expiring. In Hawaii, most leases that expire have a surrender clause, meaning the land reverts back to the landowner. Although most leases have a surrender clause, most leases do get re-negotiated for a longer period.

The second reason leasehold properties can drop in value is due to financing. A bank will not give you a 30-year amortized loan on a property with 20 years remaining on the lease. If there are 20 years remaining on the lease, they may give you a 15-year loan, which means that your monthly payments will be substantially higher than if you had a 30-year amortized loan.

2. You May Not be Allowed to do a 1031 Exchange
If you are an investor, the IRS will not allow a 1031 exchange on a leasehold property with less than 30 years remaining on the lease. A 1031 exchange allows you to sell your property and exchange it for a “like-kind” exchange, which defers capital gains tax. A leasehold property with less than 30 years remaining on the lease is considered personal property, so it does not qualify for a 1031 exchange. If the lease is over 30 years, it will be eligible for a 1031 exchange.

3. Your Lease Rent May Drastically Increase
Your monthly lease rent may drastically increase at the renegotiation date as outlined in your lease. Various reasons could arise during a lease renegotiation that could trigger a substantially higher lease rent. One likely scenario in which this could occur is if the monthly lease rent was determined over 30 years ago, and therefore the monthly lease rent could be substantially below market. For example, there have been some leasehold properties on the island of Oahu with lease rent below $100 per month, which was set 30 years ago. When these below-market lease rents renegotiate to market rent, the lease rent could raise $300 to $400 per month.

4. You Could Surrender Your Property to the Land Owner
Leasehold properties have an expiration date and depending on the terms of the lease; you can lose your property at the end of the lease. Landowners have taken back property from leasehold owners on the island of Oahu, Hawaii in the past so it can happen. A lot of it depends on the landowner, the lease agreement, and the laws at the time your lease expires.

5. You May be Financially Pressured to Purchase the Fee
Sometimes the landowner decides to sell the fee to the homeowners. Although this seems like great news for the homeowner, sometimes it may not be as good as it may seem. In many cases, the landowner wants to sell all of the fee, not just a portion of it. This would be the case for properties in an association, where the landowner works with the association to purchase the fee. During this scenario, the association typically gets the majority of leasehold units to buy the fee, and the association acquires the remaining units. The association would usually finance the remaining units. If you do not have the funds or capability to get a bank loan and finance the fee, you may opt to keep your unit as a leasehold unit. In some cases, the building or your unit may not be financeable, so you would need to pay cash for the fee. If you are one of the units that did not purchase the fee, the new landowner is now the association. The association will charge you lease rent as outlined by the lease agreement, so nothing changes with that respect, but if later down the road you decide to purchase the fee, the new association can charge you whatever they wish for it.

Ultimately there is risk associated with the unknown in regards to what price you will have to purchase the fee for in the future. In many cases, the association will charge you the finance charges, as well as some additional fees if later you decide to purchase the fee. In this case, the fee price will most likely be increasing each month, whether or not the market is going up. Because of this, you may feel pressure to buy the fee since the price will continue to rise each month you keep your unit leasehold.

Paul Goodman

June 17, 2019

Aloha Delores
If you would contact me @ paulgoodman@hawaiilife.com or 808-217-6714, I would love to help address any of your questions or concerns.
Mahalo, Paul

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