Leasehold Ownership
in
A Guide to
Authorized
by the
This article
will help you understand some of the issues involved in buying and owning
residential leasehold condominium and cooperative apartments, as well as
dwelling units within Planned Developments (PUD). This article uses the term
apartment unit to refer to all three forms of ownership. Anyone buying a
leasehold residential apartment should be aware of all of the consequences of
leasehold ownership.
AFFECTS YOUR DECISION TO BUY. If you are contemplating the purchase of a
residential leasehold apartment unit, their are
additional considerations than their are in the event that you were
contemplating the purchase of a comparable fee simple apartment unit. For
example, you will be concerned with the length of the remaining lease term,
what happens to your unit at the end of the lease term, and how increases in
the rent payments are determined. Answers to these questions will enforce your
decision to buy.
AFFECTS YOUR ABILITY TO OBTAIN A LOAN. As an owner of a
leasehold apartment unit, you some day may want to refinance your leasehold
apartment unit. A short time remaining on the fixed period or term of the lease
could create obstacles to obtain the needed financing. This could be a problem
if you wear seeking to refinance either an agreement of sale or a mortgage that
is soon to become due and payable in full.
AFFECTS YOUR ABILITY TO RESELL. If you want to sell your leasehold
apartment unit, you could find the apartment unit becomes more difficult to
sell as the lease term approaches its rent renegotiation and explicit
expiration dates. Naturally, a buyer would be more attracted if the lease had a
longer period until rent renegotiation or expiration.
Also, lease
provisions regarding such matters as the increase of rent and the expiration
date of the lease term may seriously affects the willingness of some lenders to
finance the proposed purchase of the apartment unit. If, due to the length of
the lease term, buyers have difficulty obtained financing, a seller may need to
make concessions in order to sell the apartment unit. The value of a unit could
decrease as the lease term nears the expiration date.
In order to
understand leasehold issues, it is helpful to review some of the basic
terminology.
As the purchaser
of leasehold property, you acquire the right to occupy and use the leased
property for the time period stated in the lease agreement. In return for this
right, you agree to make rent payments to the lessor
and abide by the other terms of the lease.
This article is
concerned with the ground lease and with those leases related to the ground
lease, such as an apartment lease. The ground lease is a lease of land only,
usually for a long term (55 years or more, from the original date of the
lease). It is a means used to separate the ownership of the land from ownership
of the buildings and other improvements constructed on the land. In many cases,
a developer enters into a master ground lease with the fee simple owner,
agreeing in the lease to construct a residential project within a certain
period of time. The developer or cooperative Corporation, or in some cases the
ground lessor, then enters into a sublease or a new
lease of the land with the apartment owner. The developer may lease the
improvements to the apartment owner by way of an apartment lease or sublease,
or sells the improvements to the apartment owners by way of a condominium
conveyance or apartment deed.
The long-term
lease should be distinguished from the short-term rental of an apartment where,
for example, a tenant rents and apartment from a landlord for six months to a
year and makes monthly rent payments. In the latter case, the tenant receives
no ownership in the land or the unit. The tenant only enjoys the right to use
the apartment during the period of the short-term rental. In contrast, the
lessee of the long-term lease enjoys the right to sell the leasehold interest
to a new buyer.
FEE SIMPLE: Fee simple ownership is
probably the most familiar form of ownership to buyers of residential property,
especially on the Mainland. Fee simple is sometimes called fee simple absolute
because it is the most complete form of ownership. A fee simple buyer acquires
ownership of the entire property, including both the land and buildings. The
fee simple owner does not pay ground rents, but does pay maintenance fees and
real property taxes. 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: The leasehold interest
is created when a fee simple land-owner enters into an agreement or contract
called a ground lease with a lessee. A lessee buys leasehold rights 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 residential
leasehold property does not own the land and must pay ground rent. Second, his
use of the land is limited to the remaining years covered by the lease.
Therefore, the land returns to the lessor, and is
called reversion. 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.
LEASED FEE
INTEREST:
After a lessor leases his land to a lessee, the lessor
retains an interest called the leased fee. Once, the fee owner leases the land to the lessee, the lessor's rights
to the land are subject to the rights of the lessee under the lease. The
lessor's rights include the right to receive rent
payments, the right to enforce the lease conditions such as maintenance, and
the right to recover complete possession and control of the property when the
lease term expires.
Because it is
so important that buyers understand the terms of the lease before purchasing a
leasehold residence,
COPY OF LEASE
DOCUMENTS: At a minimum, the buyer
must receive a copy of the lease document or documents, which contain the major
provisions of the lease. The lease documents could be any one of the following:
In addition to
the minimum legal requirement, buyers should review other relevant lease
Document. For example, the buyer of a cooperative apartment may want to review
the master lease in addition to the proprietary lease on the apartment.
RECEIPT OR
CONTRACT: The buyer must sign a
receipt or a copy of the sales contract to acknowledge receiving the lease
documents. The receipt or contract must also include a summary of the major
provisions of the lease in plain language, lease rent renegotiation dates, how
renegotiated lease rents will be calculated, and surrender clause provisions.
Normally this will be accomplished in a separate addendum attached to the
contract or receipt. Buyers also must be informed that current law does not
give condominium and cooperative leases the right to require that the lessors sells them the leased fee interest in the land
under their apartments. Finally, the buyer needs to acknowledge that he or she
has read and understands the terms of the lease documents.
It is the
responsibility of the seller to furnish the buyer with a copy of the lease
documents and other information about the lease. The seller may provide the
information directly or through an agent, most likely the seller's real estate
agent. Copies of the recorded lease and amendments are available at the Bureau
of Conveyances public record office in
The seller or
seller's agent must provide the required information to the buyer within 10
days from acceptance of the sales contract (that is, no later than 10 days from
the date the buyer and seller reached a final agreement for sale of the
property).
As a buyer, you
should read the lease carefully and be sure you understand its terms and
conditions and how they affect you and relate to your plans and goals. The best
time to do this is before you make an offer to purchase your leasehold apartment
unit. To obtain a copy of the lease, ask the seller, the seller's agent, or
your own adviser. In reviewing a lease, it is especially important to find out
the following information:
LEASE TERM: Find out the length of
the lease, how many years are remaining until the lease ends, and whether their is any right to extent.
LEASE RENT: Be sure you understand
how much lease rent you will have to pay (which often includes general excise
tax), when it is payable and to whom, what penalties are prescribed for late
payment. Lease rents typically adjust periodically every 10 or 15 years. Find
out when the rent adjusts, and to what amount. Also find out whether or not
your maintenance fee payments include the lease rent.
LEASE RENT
RENEGOTIATION DATES:
At some point the rent may adjust, but to an amount, which will be renegotiated
at that time. Know when the rent payments are scheduled to be renegotiated. The
lease likely contains more than one renegotiation date, such as every 10 or 15
years.
CALCULATION
OF NEW LEASE RENT: Understand how the new rent payments will be determined upon
renegotiation, including any procedures involving the use of arbitration. The
lease often contains a formula for calculated the new lease rent. This formal
is generally based on a percentage of the market value of the unencumbered fee
simple land existing at the time of renegotiation. If market value increases
significantly, so will your future lease rent.
SURRENDER
CLAUSE: Read the surrender
clause carefully. It tells you what will happen to your apartment unit when the
lease comes to an end. Most leases provide that the buildings on the land
including your apartment, become the property of the lessor upon the expiration of the term of the
lease--automatically and without any payment.
AMENDMENT TO
LEASE: Leases are sometimes
amended to reflect a change in the lease terms or an extension of the term of
the lease. The best way to tell if there have been amendments is to examine a
recent title report on the property prepared by a licensed title company.
The law also
provides that, within five days of acknowledging receipt of the lease
documents, the buyer has the right to cancel the contract and recover all
deposit money. The seller and buyer may agree in writing to reduce or extent
the time period required for the seller to provide the lease documents and the
buyer to review them.
Your Standard
Sales Contract (also called the Deposit Receipt, Offer and Acceptance or DROA)
may contain a detailed addendum that informs you about leases in general and
specifically about your own lease. Ask the sales agent for a copy of any
standard leasehold addendum so that you can review it in advance of your making
an offer. Be sure to ask questions if you do not understand any part of the
addendum.
If, after
reading the lease Document and the summary of its major provisions provided by
the seller, and discussing this with your real estate agent, you still have
questions about the lease, you should see an attorney familiar with real estate
leases. The attorney can help you understand how the lease and its consequences
affects you and your use of the property.
LEASE TERM: The length of the term
of an apartment unit ground lease may be for whatever the original lessor and lessee agreed upon; however, the typical length
is at least 50 years, and usually is within a range of between 55 and 75 years.
LEASE RENT: Typically, the rent
will be fixed for the early years of the lease term and afterward will be
renegotiated periodically.
FIXED RENT: Most leases have a fixed
rent period of between 25 and 35 years. During this period the rent is fixed or
predetermined. There may be one or more step up increments during the fixed
rent. You know exactly how much your lease rent payments will be.
RENEGOTIATED
RENT: At the end of the fixed
rent period, the lease rent is renegotiated, or adjusted. This is sometimes
referred to as reopening. When you purchase your leasehold apartment unit, it
is very important to realize that you don't usually know the exact amount of
rent you will have to pay over the entire life of the lease. As you can
imagine, this is important factor for both you and your lender to consider as
your ability to pay monthly mortgage payments may be directly affected by
changes to the lease rent payments. This is because the renegotiated rent is
generally based on a certain rate of return on the value of the unencumbered
fee simple land in the future (at the time of renegotiation).
ASSIGNMENTS
OF THE LEASE: The transfer of a leasehold interest is accomplished by a document
called an assignment. When you sell your leasehold apartment unit to a new
buyer, you assign the lease to the buyer, (also called the assignee). Your
lease may require the consent of the lessor prior to
any assignment of the lease. Courts have held, however, that the lessor may not unreasonably withhold consent. Even after an
assignment, you may remain responsible under the lease unless the lessor releases you and agrees to allow the buyer to assume
all the responsibilities of the lessee.
PUBLIC
CONDEMNATION: Occasionally all or a portion of the leased property is taken by a
government authority for a public purpose such as road widening or sewer
installation. When condemnation occurs, the lease specifics what happens to
your apartment unit and how you are compensated for loss of your leasehold
interest. Read your lease carefully.
SURRENDER: The surrender clause
provides what happens to the apartment unit and other improvements when the
lease expires. At the end of the lease term the lessee must surrender or
deliver to the lessor possession of the land. What
happens to the apartment units and other improvements on the land depends on
the language of the surrender clause. Be sure to read the surrender clause
carefully. Most surrender clauses can be divided into three types:
APARTMENT
UNIT TO LESSOR:
The first type of surrender clause gives the apartment units and common
elements to the lessor upon expiration of the lease.
If the lessor desires to remove the apartment unit,
the lessor is responsible for any costs involved in
demolition and removal.
APARTMENT
UNIT TO LESSEE:
The second type of surrender clause gives the apartment unit to the lessee.
However, because the lessee must return the land to the lessor
in its original condition when the lease ends, the lessee is responsible for
the proportionate costs of the demolition and removal of the apartment unit.
This could be a disadvantage to lessees if they must pay for the demolition and
removal. If the building is still in good condition or can be refurbished, the lessor may be willing to purchase the apartment units and
improvements from the lessees.
LESSOR
PURCHASES APARTMENT UNIT: The third, and least common, type of surrender clause is one
where the lessor and lessee have agreed on a price
the lessor will pay for the apartment unit and its
share of the common elements upon expiration of the lease.
EVENTS OF DEFAULT: The lessee incurs many
obligations under the lease such as maintaining the building, paying real
property taxes and lease rent, and maintaining insurance. Failure to abide by
the terms of the lease, including failing to pay real property tax and lease
rent and maintenance fees could result in money damages or even termination of
your lease.
MAINTENANCE
AND INSURANCE: The lessee is usually held responsible for the maintenance and
upkeep of the property, including paying all real property taxes and assessments,
insuring the apartment against loss or damages by fire, and for maintaining
public liability insurance.
TERMINATION: The lease terminates on
the expiration date specified in the lease agreement. A lease may also be
terminated by mutual agreement of the lessee and lessor,
or by eviction because of a breach of a lease provision.
Unless you have
the cash to pay the full price to buy your apartment unit, you will need to
obtain a loan to finance the difference between the cash down payment and the
sales price. The terms of the lease can affect your ability to obtain a loan,
especially if the lease is due to expire in less than 30 years, or if there are
only a few years remaining on the fixed rent period.
Most banks and
other lending institutions have policies for approving loans on leasehold
property that can affect a buyer's ability to finance, or refinance, and an
owner's subsequent ability to resell. Certain lenders require that their be at
least 10 years remaining on the fixed rental portion of the lease, or that the
term of the lender's loan be no longer than the remaining number of years on
the lease, less five years.
In addition,
the Veterans Administration will not guarantee a mortgage beyond the actual
time remaining on the fixed rent period of the lease, and the Federal Housing
Administration insurers mortgages only up to 5 years
beyond the fixed rent period of the lease.
These policies
may make it more difficult for an apartment unit owner to sell the unit as the
fixed rent period or the entire lease term shortens. Lenders are cautious about
lending money against leases with short fixed rent period because they are
concerned that the borrower may not be able to make the monthly mortgage
payment if the renegotiated lease rent increases substantially.
If you are
considering purchasing a leasehold apartment unit and only a few years remain
on the fixed rent period of the lease, it may be helpful to contacts an
appraiser to estimate approximately what the lease rent would be if
renegotiated at this time.
SHORTER LOAN
TERM: The buyer could apply
to a conventional lender for a loan with a shorter term.
OWNER
FINANCING: The lessee-seller may
be willing to finance the purchase through an agreement of sale or mortgage,
with the seller in essence acting as the lender.
EXTENDING THE LEASE: The lessee can inquire whether the lessor
is willing to extend the lease term.
PURCHASE THE
FEE: Finally, the lessee can
inquire whether it is possible to purchase the leased fee interest from the lessor. The lessor may decide to
make a voluntary sale of the leased fee interest to some or all of the
apartment unit owners in the project, but the lessor
is under no obligation to do so.
As we have
already seen, in most leases, the rent is not fixed, or predetermined, for the
full term of the lease. Rather, at certain dates (called renegotiation dates),
the lessor and lessee must agree on a new lease rent.
Lease rent renegotiations are usually scheduled in 10 to 15 years intervals
after the initial fixed rent period (usually 25 to 30 years). The majority of
leasehold apartment units in the State of
Most leases
contain a formula for determining the new lease rent. Because the formula is
frequently based on rent and market conditions existing on the renegotiation
dates, the rent could rise dramatically and is not known with certainty until
the actual time of renegotiation. As a buyer, it is important to read the lease
documents carefully so that you understand when and how the new lease rent
payments will be calculated upon renegotiation.
Most general
leases provide a formula for the renegotiated rents to be based on a stated
rate of return on the market value of the land under the project at the time of
rent renegotiation. For example, if at the time of renegotiation, the value of
the land under a 100-unit condominium is $5,000,000 and the stated rate of
return is 7%, then the formula would result in a renegotiated rent of $3,500
per year or $291 per month ($5,000,000 X 7% X 1%, assuming your unit
represented a 1% common interest in the land).
In other cases,
the rate of return is an amount to be renegotiated based on current land value
and current rates of return. Two other less common methods for determining
renegotiation rent are 1) Basing the new rent on current market rent for
similar buildings; and 2) Increasing the current rent by the change in the
consumer price index over the preceding fixed rent period.
Under all but
the last method, leases generally provide that if the lessee and lessor cannot agree on the new lease rent before the
beginning of the renegotiated rent period, the rent will be determined by an
arbitration procedure. For example, the lease may specify that the market value
of the land will be decided by three impartial real estate appraisers, one to
be chosen by the lessee, one by the lessor, and the
third selected by the first two. In deciding the market value, the land is
usually treated as though it had no structures on it.
After the
market value of the land is determined, it is multiplied by a percentage rate
of return specified in the lease (or, if not, then determined by the
appraisers) to compute the rent for the entire apartment unit project. Then
this figure is multiplied by the lessee's percentage share in the common
interest in the project to determine the amount of the lessee's individual
rent.
Many leases
have the rate of return set at a specific rate. Other leases may provide that
the rate be based on the prevailing rate of return for similar properties at
the time of renegotiation. The prevailing rate of return for similar properties
will depend on market conditions existing at the time of renegotiation.
As you can see,
this method of calculating renegotiated lease rent is tied closely to current
land value. Since there is no upper limit on land value other than current
market conditions, the new rent may increase greatly. This increase will
reflect the rise in land values since the beginning of the lease 25 to 35 years
ago.
If the lease does not provide for the arbitration of lease rent
and if the parties are unable to agree on the rent upon renegotiation, than the
law specifies the process to follow. The law does not, however, specify or limit the
amount or rate of rent to be paid. Here is the required procedure:
The law applies
to all cooperative proprietary leases, which call for rent renegotiation. It
provides that renegotiation of rent cannot take place more than once every 10
years and the first renegotiation can be no sooner than 15 years following the
commencement date of the lease. It also provides a formula for determining the
maximum amount of renegotiated lease rent to be paid by the cooperative housing
corporation.
If the lessee
corporation and the lessor cannot come to an
agreement on the new lease rent, the law requires that the rent be determined
by an impartial Third Party through arbitration proceedings conducted by the
State Housing Finance and Development Corp.
Several
possibilities exist at the expiration of the lease term, and most leases
contain a reversion and surrender clause.
REVERSION: The typical apartment
lease provides that the land reverts to the lessor at
the end of the lease term. In other words, when the lease expires, the lessor retakes possession of the land. When you buy an
apartment unit on leased land, it is important to consider what happens to the
unit after the lease expires.
SURRENDER
CLAUSE: Apartment unit leases
typically contain a surrender clause providing that, upon expiration of the
lease, the land, all apartment units, and other improvements become the
property of the lessor. The clause generally requires
that the lessee surrender to the lessor, upon
expiration of the lease term, all apartment units, garages, roads, landscaping,
and swimming pools, even if these improvements where built and maintained at
the lessee's expense.
ATTEMPT TO
NEGOTIATE AN EXTENSION OR NEW LEASE: The lessee could attempt to negotiate a new
ground lease or extend the ground lease even though the lessor
may not be legally obligated to do so. The lessor may
be unwilling to extend or enter into a new lease if the lessor
has plans to redevelop the property. On the other hand, a lessor
who plans to maintain the project as a residential property may be willing to
grant a new lease. In this situation, however, the new lease rent could be the
market rental price of the land and the apartment unit, as both became the
property of the lessor at expiration of the original
lease.
SURRENDER
IMPROVEMENTS TO LESSOR: If the lessee is unable to negotiate an extension of the existing
lease or a new lease, the lessee may be forced to surrender the apartment unit
to the lessor and move out.
REMOVAL OF
IMPROVEMENTS: The surrender clause may instead require the apartment lessees to
remove the structure and restore the leased land to its original condition at
the end of the lease term. In the case of a condominium or cooperative, the
initial apartment owner would be legally required to pay his or her
proportionate share of the expense of removal of the building that contains the
apartment unit when the lease expires.
The price at
which the fee may be offered is not subject to any legal restrictions. This
price may be determined by mutual agreement between the parties or set by an
impartial panel of one or more appraisers. In some cases, the lessor may want a certain price, leaving little room for
negotiation.
Appraisers
typically use the income approach to value the leased fee interest in the land
under a leased apartment unit. In addition to lease rent payable over the
period of the lease, the owner also will receive the return of the land at the
end of the lease (reversion).
The appraiser
calculates the amount of lease rent due over the fixed period of the lease and
estimates the projected rent over the renegotiated lease period. This amount is
then reduced (discounted) using present value tables. This reflects the fact
that lease rent dollars received in the future are worth less than dollars
received today. In essence, the appraiser asks how much would a person need to
invest today (as in an immunity) to receive a stream of income equal to the
amount of rent projected for the entire lease term.
Next, the
appraiser evaluate the worth of the revision of the land, by calculating the
projected value of the land at the end of the lease but then discounting that
amount to present value. An example follows:
Projected
ground rent over remaining lease term (discounted to present worth):
Present value
of fixed rent $600,000
Present value
of renegotiated rent $900,000
Plus
Present value
of reversionary interest in land (market value of raw land discounted to
present worth): $500,000
Equals
$2, 000,000
Times
Lessee's
percentage of common interest X 1%
Value of
leased fee interest $20,000
As you can see,
it is not easy to determine what price you may have to pay for the leased fee
interest, assuming the lessor is willing to sell, and
you are willing to buy. If the lessor does offer to
sell the leased fee interest, you may want to consult an expert to advice you
about the pros and cons of the offer. If the lessor
has not committed to sell the leased fee interest, you should carefully
consider the possible impact of this on present and futures value.
Sometimes
preliminary negotiations for the voluntary sale of the leased fee are underway
when the sellers list their apartment unit for sale. One of the questions you
as a buyer want to ask your seller is whether there is an ongoing or planned
leased/fee conversion. If so, the sales contract (DROA) should address such
issues as seller cooperation and transfer of any deposit money.
In 1988, the
Hawaii State Legislature enacted a law to give condominium owners associations
a right of first refusal to buy the leased fee interest if the lessor decides to sell to anyone other than the existing
individual apartment owners. At least 75% of the unit lessees must approve of
the purchase, or the lessor can complete his sale of
the fee to another party. The intent of this law is to encourage negotiation
for a leased fee sale between lessors and condominium
or cooperative owners or their associations or corporations.