“Lease…What?”
Understanding “Leasehold” Properties in Hawaii
My phone rings with a buyer eager and ready to add a second home in Waikiki to their investment portfolio. They all have a similar question… “$80,000 for a condo in Hawaii!! Why not?!” Unfortunately- the age-old saying might apply here - If it seems too good to be true, well… it probably is.
To understand leasehold properties in Hawaii we should start with a brief history lesson. In the 1800s when King Kamehameha III owned all of the lands in Hawaii. In 1848 the Great Mahele divided this land up between Land Divisions (Ahupua’as), and The Royal Government. The great Mahele made possession of the land possible for the first time ever but it was often difficult to prove. For this reason, most of the land was sold, and governed by trusts we still know and recognize today as Queen Emma Foundation, Liliuokalani Trust, Bishop Estates, and more. Famous Trusts then turned around and leased the lands to local people per agreed-upon terms and fees. These terms often included similarities to ownership such as long periods of use, utilizing the property to your liking during the term of the lease, and responsibility for utilities and property taxes. Thankfully for property owners, since the 1800s the majority of single-family homes on Oahu have been converted to “Fee-Simple Ownership” due to regulations and rising property values. Condominiums on Oahu however, were not subject to mandatory conversion laws. For this reason, about 10% of Condos in Waikiki, you can still find leasehold ownership status.
So What’s the Catch?
There are THREE IMPORTANT CONSIDERATIONS when deciding if you should buy a Leasehold versus a Fee simple property on Oahu.
First, and most importantly HOW MUCH TIME IS LEFT ON THE LEASE? Typically leasehold ownership was written with long lease periods (50+ years). Unfortunately, most of these leases started in the late 1900s and are now halfway or more through their agreed upon timelines. The length of the lease effects a potential buyer for three reasons.
- Leasehold properties have an inherent risk that at the end of the lease. “The Lessor” or Land owner can ultimately decide to take back control and ownership from “The Lessee.” For this reason, leasehold properties typically depreciate as they near the end of the lease instead of appreciate which most people have come to expect when purchasing real estate as an investment. Additionally, the quintessential benefits of homeownership might not apply. For example, leases with less than 30 years remaining; the IRS does not consider the property as “real estate” there for you won’t be able to 1031 exchange or defer capital gains.
- The second most important reason to pay attention to the time left on the Lease is that Leases with less than 30 years remaining will not qualify for a conventional 30-year mortgage. Most lenders require an additional 5 years to be left on the lease on top of the length of the loan. I.e: If you are applying for a 15-year Adjustable Rate Mortgage there will need to be 20 years or more left on the lease length.
- Lastly, “The lessor” can and will renegotiate the lease fees on predetermined dates throughout the lease, roughly every 20 years. For this reason, it is important to examine the lease rent history. Have there been recent increases or are there any renegotiations upcoming? This is important because unforeseen renegotiations can potentially cut into an investors cashflow in the future.
The second important consideration when looking at leasehold is WHAT ARE THE FEES? The lease rent is often not listed on popular websites such as Zillow and Realtor.com. Call your realtor to ask how much the lease rent is if you are looking at a leasehold property and it is not listed. Lease rent can often be a costly addition paid to the lessor on top of the purchase price, HOA, property taxes, and utilities.
The last and final most important consideration is WHAT IS YOUR EXIT STRATEGY? This includes asking questions such as “Who owns the fee?” & “Has the fee ever been available for purchase?” OR “Is the fee available at the time of purchase?” If the fee is available, It is almost always in your best interest to purchase the fee. Once converted, you can start enjoying typical homeowner benefits such as equity, appreciation, hedging against inflation, and tax benefits. If purchasing the fee is not within your wherewithal at the time ask; “will the Lessor offer the Fee availability in the future?” Sometimes, when dealing with large trusts this can be difficult to find out and there are no promises it will become available again. As an exit strategy, when the inevitable time comes for you to relinquish the property will you be okay selling at a decreased value? For most buyers, the answer to this critical question lies in if it is worth it in the meantime? After all of these precautionary questions, it is important to note, Leasehold is not all bad. It can be great for a certain buyer profile.
The Upside
So, who can benefit from these unique opportunities? In my experience, there are a few types of buyers who have been more than pleased with leasehold purchases. The one commonality between all the leasehold buyers is that they are buying for immediate use and are not attached to the long-term investment.
The Cashflow Investors - Investors are always looking for one thing, a positive return on their money. For example: In a leasehold building that also allows short-term rentals; an investor can take advantage of a low purchase price, use little of their own money, and generate positive monthly cash flow. Investors always act according to the numbers, If the numbers are right they will take the risk of depreciation over the course of their investment.
The College student - A typical college student is not ready to buy their first home so these lower purchase prices provide a unique opportunity for them. College students are already prepared to rent therefore the lease rent does not come as a shock to them but over the course of 4 years, they may be able to save some money by purchasing low and renting out additional rooms to roommates to offset the cost of what would have been spent over the years regardless. College students usually have a predetermined plan and exit strategy come graduation.
Seniors and Business Owners - Seniors and business owners invariably will occur cost to live and rent. Leasehold provides a more affordable option to enjoy for a period of time. For both parties beyond the term of the lease, the use is typically no longer needed. For seniors in Hawaii as long as they do not intend to pass down the asset to their kin, Leasehold condos provide an affordable living option in which they can find peace being in tropical weather and a place to call their own that they otherwise may not have been able to afford. An important note is to make sure such buyers have a plan in the event they outlive the life of the lease.
Business owners looking for office space to rent are in a similar position. Knowing that they may not need this office space after 20+ years but will need to a space now, either way, provides them the opportunity to calculate costs ahead of time and even save money over time on future rent expenses.
With diligent planning, research, and understanding, Leasehold may be the right choice and has the potential to provide excellent opportunities that otherwise may not have been feasible. The most important point when searching for real estate on Oahu is to understand the land tenure status before purchasing. Specifically, how will “fee simple” or “leasehold” ownership affect your unique wealth-building goals?