Monday, June 20, 2011

Land Lease versus Fee Simple

Is owning land better than leasing it?

I get nasty comments from people (haters) who have nothing better to do that troll blogs and try to bring people down.  Nice try - go back to your bong.  And yes, I know who you are.  You are a sick person - get help.

But one comment, nasty as it was, bears investigation and merit.  In my posting on bad financial mistakes, I noted that on our island, our leases were up for renewal, and some older people refused to sign the new leases, which were on favorable terms ($500 a year to live on a resort island?  Sounds OK to me!).

But is a lease the same as owning?  And are there problems with buying a house or condo on leased land?

In Real Estate law, a 99-year (or long-term) lease is often treated the same as ownership for many purposes.  For example, if you lease a property (you are the lessee) on a long-term basis, you often have to pay property taxes on the property, while the lessor.  For all intents and purposes, you are the owner of the land.

But when the 99 years comes up, what then?  As the British found out in Hong Kong, it can mean handing over your property and walking away - although that rarely happens.

However, as the example on our island illustrates, more often than not, leases are extended, rather than just allowed to expire.  Usually, the extension is on more onerous terms than the original lease, however, as inflation, in the interim, has increased the value of the land.

For example, we looked at a penthouse condo in Arlington, Virginia, which was attractively priced, with a view of the Mall and even a fireplace.  There was one problem, though, it was on a land-lease and the lease had only about 20 years left in it.

The problem with a short remaining term on the lease is that banks won't lend on a property unless the lease is longer than the term of the mortgage, plus ten years. So when a lease drops down to less than 40 years, as happened here on the island, properties can be difficult to sell. 

Now, of course, the leaseholder could just say "OK, we'll let the lease expire and at the end of the term, you all go vamoose!" - but there are problems with that approach.

If that is the case, the property values would decline - to be equal to the amount of money one could get for renting the homes, times the remainder of the lease.  In other words, the properties would be worth their cash-flow.  Thus, for example, a property with a 40 year lease, than rents at a fair market value of $1200 a month, would be worth the equivalent of the future payments totaling $576,000 over 40 years (about $250,000, according to this calculator).

The problem with that approach, is that during the last decade before the land lease expires, the homeowners would have no incentive to do any repairs to their properties, which would then quickly devolve into a ghetto.  So yes, you can reclaim the land - but it is a long and arduous process and gets messy.

And in the case of the Penthouse (which we declined to buy) the condo owners reached an agreement with the land owners for a renewed lease.  It was worth a lot to a developer, but worth more to the condo owners - and the land owners wanted a nice steady income stream, not the uncertainties of a new development.

Of course, some leases have renewal options - which could extend the term for some time.  But due to the Law of Perpetuities you cannot have a perpetual lot lease.  Or put another way, if you did, you'd own it.

Is owning fee simple better than leasing?  Generally, yes.  Although the idea that you can really "own land" is, as I have noted before, suspect.  The government owns the land, really, and if you doubt this, stop paying your property taxes and see how long it is before you no longer own the land.  In a way, we all "lease" our land from the government, in the form of tax payments, and the like (not to mention sewer and water and fire fees, for urban properties).

And while you may think you can "do what you want" with a fee simple property, the zoning board, the board of architectural review and the Department of Environmental Conservation have other ideas - and the power to back them up.

And if you think that with a fee simple property that you can "stay as long as you want" you'd better think again - and check out some of the latest case law on eminent domain - the government can boot you off your land (paying you for your troubles, of course) and build a shopping mall - if they think your economic use of the land is not optimal.

In other words, you live at the suffrage of the government - the ultimate landlord.  Owning property in fee simple merely eliminates one landlord in the chain of landlords that we all have.

And of course, if you own a condo, you really don't own anything at all, except a share in a really poorly amateur-run corporation.  You have a right to occupy the condo, and that's it.  And if 2/3 of the owners decide to sell the building to a developer, well, you don't even own that, anymore (but you might get a nice fat check, as is happening with a Condo we still own).

But all that being said, a fee simple property is preferable to a land lease, in most cases.  But in many cases, a fee simple property is not available.  For example, we live inside a State Park, which I can tell you, is a pretty sweet deal.  The land belongs to the State, and they cannot sell it.  But they can lease it, and they do.  There is no option to buy, here.  You can buy a home on a neighboring island, but be prepared to add another comma to the price.  It was not a hard choice to make.

And with an 80-year lease, the lease will certainly outlive me.  And also, this sort of long-term lease is basically the equivalent of owning the property - as reflected by the property values as well as the property taxes we have to pay.  When I decide to move, the property will sell for what I paid for it, if not more. 

Because, when it is all said and done, buying Real Estate is little more than buying the right to live on it or use it.

And that is all Real Estate is - something to be used, like every other possession in your life - a means to an end, and not an end in and of itself.

UPDATED: January 25, 2017 (corrected use of terms Lessor and Lessee)