Leasehold versus fee simple ownership

Prior to the early 1960's, the island economy was based on agriculture, primarily pineapple and sugar cane, although taro farming and other agricultural activities were of great importance too. In 1962 the Kaanapali resort was established and helped fuel a new tourism based economy.  As tourism flourished, local land owners partnered with developers to build condominiums on their family owned properties. The condominiums were sold and leases were established for the land. This was a way that local families could retain ownership of the land and derive income from yearly lease rents. Alaeloa was set up as a residential condominium by the Fleming and van der Linden families who joined their parcels together to create a unique residential condominium.

What is Leasehold?

A leasehold interest is created when the owner of a property enters into an agreement to lease the property for a specified period of time. As the purchaser of a leasehold property, you are acquiring the right to occupy and use the leased property for a specified period of time stated in the lease agreement.

In the case of Alaeloa, the leasehold interest was created in 1965. An agreement has been reached between the land owners and the Alaeloa AOAO to extend the lease to December 31, 2059. Prior, the lease was set to expire December 31, 2024. Ground rents were established for the first 25 years, and lease rent renegotiation dates set for 1990, 2000, 2010, and 2020 and so on. Ground leases are determined by the appraised value of the property as if it were unencumbered and there were no improvements on the property. The Alaeloa lease stipulates that ground rents are determined by the appraised value times a specified interest rate or the then prevailing rate of similar properties similarly located.

All leases contain a surrender clause which states that the land and improvements revert back to the landowner at the expiration of the lease.  Many Lessors are negotiating with Lessees to extend the leases and in many cases we are seeing leasehold properties being converted to fee simple. The State of Hawaii is also making it easier for Lessors to sell the fee interest by reducing or eliminating capital gains charges on the sale.

What is Fee Simple?

Fee simple ownership is the most familiar form of ownership to buyers of residential properties.  Fee simple owners acquire both the land and building and do not pay lease rents. It is important to point out that fee simple ocean front properties can be very expensive and leasehold interests can serve to keep costs lower for apartment owners.

Here is an example outlining the difference in costs associated with a leased Alaeloa ocean front home versus fee simple:

In 2014, the county of Maui assessed valuation of the land for an ocean front property at Alaeloa is $1,990,200. Amortizing a loan on this value at 4.5% interest amounts to $10,084.05 per month. Lease rents on the same property are $5,967.35 quarterly, or $1,989.12 per month. The owner has full rights and use of the property as if owned in fee at a fraction of the cost.

Questions to ask when purchasing leasehold property

TERM OF THE LEASE: Determine the length of the lease and how many years there are remaining on the lease, and whether there are opportunities to extend your lease. This is particularly important when it comes to financing. Lenders generally require an additional five years.  For example, to obtain a 30 year loan, most lenders will want to see if you have at least 35 years remaining on your lease. In addition, leasehold property of at least 30 years is considered the same as fee simple for 1031 tax deferred exchange rules. It is advisable for you to consult with your accountant or legal advisor on any of these issues.

LEASE RENT: Be sure you have a complete understanding of the lease rent amount for your particular unit and when lease rent payments are due.  Depending on the property, some lease rents are due monthly, and some quarterly. Alaeloa lease rent payments are billed quarterly and due on the first day of each quarter in January, April, July, and October.

LEASE RENT RENEGOTIATION DATES: Lease rents are typically fixed for a set period of time, usually 10 years but may vary from property to property.  Familiarize yourself with these key dates in your lease and know how the new lease rent will be determined.

SURRENDER CLAUSE: The surrender clause will tell you what will happen to your apartment when your lease expires.

OTHER CONSIDERATIONS: Whether your property is fee simple or leasehold, condominium associations usually have monthly maintenance fees to cover the cost of operations for the property. Typical maintenance fees may include sewer, water, cable, garbage, landscape maintenance, building maintenance, management fees, pool service, etc. Apartment owners are also responsible for the payment of state taxes. It is good to know these costs prior to purchasing your property.

YOUR FAMILY LIFESTYLE: This might very well be your biggest consideration. While leasehold properties are not for everyone, you might find that owning leasehold is simply less costly than fee simple which may allow you to purchase a fantastic lifestyle property.

 It is good practice to obtain legal and financial advice prior to the purchase of any property