If you're looking for real estate in an area where land is scarce, you may have to consider the possibility of taking a leasehold interest in a property. To that end, if you would like to know more about what it means to have a leasehold interest, read on below. We've taken a closer look at what a leasehold interest is and how it differs from a freehold interest as well as the benefits and disadvantages of choosing this form of ownership.
What is a leasehold interest?
In real estate parlance, having a leasehold interest means that, as a tenant, you have the right to enjoy exclusive use or possession of a particular asset for a definite period of time, as stated in a lease. This concept is similar to how you might rent an apartment from a landlord, but, typically, the lease lasts for much longer. It's much more common for leasehold interests to be discussed when talking about a ground lease, or leased plot of land, than a particular piece of real property.
A leasehold interest might work as described in the example below:
Lee owns a centrally-located piece of real estate in an urban area. Bob wants to build a hotel there, so he strikes up an agreement with Lee, the landowner. Per the agreement, Bob is entitled to build a hotel on Lee's land, but he has to pay rent to Lee for the privilege. In this case, Bob would own a leasehold interest in the land. However, since Bob covered the cost of building the hotel, he is considered to be the hotel's owner and is entitled to all the profits that came from it, minus the cost of renting the land.
While it's rare to see residential properties be subject to leasehold agreements, it is possible to find them if you look hard enough. As you might gather from the example above, leasehold agreements are more common in urban or resort areas, where the ground is very valuable.
Difference between leasehold and freehold interest
A leasehold interest is usually discussed in comparison to another type of property ownership, which is sometimes called freehold interest. To that end, we've taken the liberty of describing the difference between them below. Read them over so that you understand the difference between the two.
Having a freehold interest in a piece of land or a particular piece of real property is the most complete form of ownership. Also known as a fee simple interest, having this type of ownership means that you're given the title to the asset and no one can legally claim ownership of it other than you. As the fee simple owner, you have the right to possess, lease, improve upon, or sell the land or property in whatever way that you see fit.
In contrast, with a leasehold interest, you are the tenant, not the owner. In this case, your lease will outline exactly what you may do to the asset. Since these leases are much longer than what you might find with a traditional annual rental, tenants are usually allowed room for leasehold improvement, which means you'll probably be able to customize the space to fit your needs. That said, it's common to have to return the asset to its original state or to have ownership of these improvements revert to the landlord at the end of the lease.
What are the benefits of having a leasehold interest
Though leasehold interest situations may not be as common as fee simple ownership, there are some sizable benefits to choosing this method. We've laid them out for you below. Read them over to determine if this form of ownership is right for you.
The biggest benefit of leasehold real estate for landlords is that you retain ownership of a valuable asset: the land or property being leased. Additionally, depending on how leasehold improvement is determined in the lease, you may receive a developed piece of land at the end of the lease, without having to shoulder any of the construction costs.
Additionally, while you will have to pay property taxes on the piece of land you're leasing, there may be some tax benefit overall. For one, you still get the deduction. Since you aren't selling the property, you also don't have to worry about paying capital gains tax on the sale.
For tenants, the biggest benefit of choosing leasehold real estate is that the costs are inherently lower. On the one hand, simply renting the ground will cost much less than renting a ready-to-use building. On the other hand, your upfront construction costs will also be lower because you won't have to worry about accounting for land acquisition costs in your budget.
Additionally, since lease terms are longer than traditional leases, you won't have to worry about experiencing rent hikes as often. It's not uncommon for a leasehold lease term to last for 20, 50, or even 99 years, so it's possible for your lease rent to stay the same for decades.
What are the disadvantages of having a leasehold interest
That said, there are also some crucial disadvantages to choosing a leasehold interest over fee simple ownership. We've expanded on them below for your consideration. Make sure you understand how these disadvantages will affect you as you make your decision.
For landlords, the biggest downside of choosing a leasehold interest method of ownership is the rent that you can charge for a leasehold estate will be lower than what you might receive for a ready-to-use property. In addition, typically, you'll have limited control over the improvements that the lessee will end up making to the land. Plus, you won't have the ability to depreciate for any land improvements.
On the other hand, the principal disadvantage for tenants is that, since you don't own the land, you're not building equity with your monthly payments. Additionally, while you will be responsible for the building costs for any leasehold improvements, you may have to turn those improvements over to the landlord after your lease term is over, which can make it harder to secure financing to cover initial building costs.
The bottom line
Choosing to take on a leasehold interest in a property or piece of land may not be for everyone, but for some, this form of ownership can have big benefits. With that in mind, use this as a guide to the ins and outs of leasehold interest. Armed with this knowledge, you should be able to make an informed decision about whether or not this form of ownership is right for you.