RateWatch #394 – Leaseholds

February 14, 2004 by Dick Lepre
dicklepre@rpm-mortgage.com

What's Happening

On Wednesday Greenspan testified before the House Banking & Financial Services Committee. From the text of his speech: "The U.S. economy may expand this year at the strongest pace since 1984, pushing the unemployment rate lower... At the same time, low inflation will allow the central bank to remain "patient" before raising interest rates... The picture has brightened... the prospects are good for sustained expansion of the U.S. economy."

Greenspan's words helped Treasuries (lower rates) and equities. With the short-term technicals
bullish we may see better rates this coming week.

Assuming that my assistant actually sent this on Friday the good news is that I am in Hawaii.
Hawaii is a special place when it comes to real estate and mortgages. Part of that is about
leaseholds.

Leaseholds

About 5 billion years from now, the sun will run out of hydrogen and no longer provide sufficient energy to maintain life on earth.

A similar but more immediate problem for some property owners are leaseholds. This is a form
of property ownership that most of us do not have to deal with. It is more common with
agricultural and commercial property than with residential property. The only area of the United States in which leaseholds are common is Hawaii.

Residential Leaseholds

Residential leaseholds may exist on properties which, to outward appearances, are condominiums
or planned unit developments. There also exist on single-family homes. Owning a leasehold,
in simplest terms, means that you own the house but not the land that it sits on. You lease the
land from its owner for a specified period of  time. Leases are commonly in the range of 55-99
years at inception.

In the case of a non-leasehold condo you own your unit and a partial ownership in the common areas. In a leasehold condo, you are leasing the three dimensional space occupied by your unit.

Term

Perhaps the most important thing about a lease is its remaining term. At the end of the term you generally surrender the property to the lessor. This includes all of the improvements, for example,
the house that you may have been living in.

Rent

The lease has a monthly rent. In the case of a condo, the maintenance fees may or may nor be
included in the rent.

Rent Renegotiation

Generally, the rent is renegotiated every few years. This may be any period from five to fifteen years. The amount of the new rent generally depends on the fair market value of the land as if it were unimproved and fee simple.

Problems

There are several obvious problems with leaseholds:

1) as the lease nears the end of its life the market value of the property may plummet.

2) financing can be difficult. My experience is that most lenders know almost nothing about leaseholds. When I have done these loans in the past, the folks at the lenders have acted like I was asking for them to donate an organ. As a rule the remaining term of the lease must exceed the term of the loan by two years. If you want a 30-year loan there must be 32 or more years remaining on the term.

You may have to deal with a local bank or S&L which is familiar with the property and the lease terms. It may be very difficult to get a conforming (FHLMC or FNMA) loan. The special nature of the laws and the nature of property ownership of condos in Hawaii may require a local lender. Some brokers specialize in loans on leaseholds.

3) Even if the term of the lease is sufficient, a lease which is subject to renegotiation in the near future will give a lender concern as to what the lease rent will be at that time. This must be
addressed by the appraiser who is asked to comment on the market and prognosticate the new lease rent at the next renegotiation date.

Why Bother?

On the surface, leaseholds seem to be a pain in the butt. Why would anyone bother with them? Leaseholds exist on some properties that are highly desirable. Oceanfront condos in Honolulu look mighty nice even if you do not really own the space occupied by your unit.

The history of leasehold condos in Hawaii parallels, to some extent, the relatively "feudal" nature of wealth and land ownership there. Between 1950 and 1990 the percentage of leaseholds in Hawaii grew dramatically. Some people who purchased property there did not fully understand the nature of a leasehold. In the early 1980's one of the large lessors increased rents dramatically and, to use
an expression relevant to the tropics, "the ship hit the sand." A law was passed mandating that fee
simple ownership be offered to all leaseholders. After challenge the law was upheld by the
U.S. Supreme court in 1984. But the law applied only to single-family homes. The result was that
the majority of leaseholds were then condos.

In 1999 the battle over leasehold condos came to a head when the City Council of Honolulu mandated conversion of leasehold condos there. One of the problems was that all of this bickering plus a downturn in tourism in Hawaii had a drastic effect of real estate prices. Some are faced with the prospect of buying or financing the conversion to fee simple on property that has lost a lot of value.

The battle in Hawaii that has resulted from all of this has left significant cultural scars on the population. The racial implications of the wealthy few, the native Hawaiians and the large
numbers of immigrant Asian workers have largely been ignored by the mainland press.

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