Most real estate transactions come down between two types of property interests: fee simple vs. leasehold. Let's take a look at each one and how it will affect your bottom line as an investor.
Fee simple is a type of freehold estate ownership. It's often called fee simple absolute because the term defines the complete and absolute ownership of a property.
In a real estate transaction, a buyer will put a down payment on the property (usually 20%) and be granted the fee simple title of the property, which indicates ownership of the land and any future improvements made to it. The buyer thus becomes the fee simple owner and maintains the rights to occupy the land as well as sell, lease, trade, or gift it as a fee simple estate to another party.
If this explanation has you thinking, "Isn't this the way real estate sales are normally conducted?" you'd be right for the most part. But in commercial real estate transactions -- and in some states, residential real estate as well -- there's an option for a different type of property ownership interest known as leasehold.
A leasehold interest is formed when a lessor signs a contract (called a ground lease in commercial real estate) with a lessee. The lessee then pays rent to the lessor for the rights to the land much like a fee simple owner would, but with a few key differences:
- The lessor does not own the land. Rather, the party is permitted land usage for a defined period of time. In commercial real estate, leases are often signed for decades or more at a time.
- Should a new leasehold owner take on the property, the land use is restricted to the time that was stipulated in the original lease.
- When the lease ends, the land goes back to the lessor in what is known as reversion. The reversion may also include any buildings or land improvements.
- The use, maintenance, and improvement of the land may be restricted as indicated in the lease.
You can think of leasehold ownership in terms of long-term renting, which is why it works well for commercial real estate. However, it's also used for condo transactions; fee simple, on the other hand, is usually reserved for single-family homes and townhomes.
There are a few states -- notably New York, Florida, and Hawaii -- that use leasehold ownership more regularly for certain property transactions. This is because leasehold ownership typically makes sense for islands or coastal communities where there's limited land for property use. It's especially common in Hawaii, where many beachfront condos were developed over the decades; however, fee simple properties do exist in Hawaii.
Pros and cons of leasehold ownership
There are several advantages and disadvantages to investing in leasehold real estate:
- To obtain a leasehold property, a lessee usually pays far less than the customary 20% down payment preferred for fee simple ownership.
- The lessee can sell the lease to another party without the lessor's permission. This is a common practice in commercial real estate.
- Leasehold ownership costs landlords a fraction of what it would normally cost to get into real estate, and yet they still reap the same cash flow month after month.
- Unlike other situations where there will be lease rent increases over time, long-term leases can lock in steady rental rates that can be renewed for years, even decades to come. This is a good option for a tenant on a fixed income.
- There is the possibility that the lessor could sell their remaining interest in the land. The price would be based on the value of the land and the remaining lease term. Depending on how far into the lease this happens, it could represent an excellent opportunity for the lessee.
- You can't build equity with a leasehold estate. While rental property investors might be drawn to the good monthly cash flow for little buy-in, that all ceases once the lease term expires, leaving them with no property ownership in the end.
- The value of the land depreciates with every year of the lease.
- If the lease has fewer than 10 years remaining, the lessee needs to find a cash buyer, as financing will not be available.
- A 1031 exchange is only a possibility if there are more than 30 years left on the lease term.
- HOA fees are charged separately from the lease payment.
The bottom line
While fee simple represents the most complete ownership allowed in real estate, it's not the only way to do business. And while leasehold ownership does have its disadvantages, it also has its advantages in commercial real estate leasing and condo ownership.