In a typical commercial real estate transaction, the transfer of ownership between buyer and seller is clear. The buyer pays a sum of money to the seller to acquire “fee simple” ownership of the property, which includes the land and all improvements built on top of it. But, this isn’t that case in all transactions. Sometimes, for a variety of reasons, the seller does not want to transfer ownership of the land. In such cases, the buyer could seek to acquire a “leasehold interest” in the property.
In this article, we are going to define what a leasehold interest is, identify the various types, and discuss the pros and cons of acquiring one. By the end, readers should be able to determine if an investment in a project that includes a leasehold interest is a good fit for their individual real estate preferences.
At First National Realty Partners, we specialize in the acquisition and management of grocery store anchored retail centers. Typically, we acquire a fee simple interest in a property, but there are certain circumstances under which we could acquire or sell a leasehold interest in a property. For this reason, we feel it is important to understand what it is. To learn more about our current investment opportunities, click here.
Leasehold Interest Explained
The real estate term, leasehold interest, refers to a tenant’s right to use or possess a certain space for a defined period of time. In a commercial real estate transaction, there are two types of leasehold interests that are frequently found.
First, when a tenant leases a space from a landlord, they technically obtain a leasehold interest in the leased premises. The terms and conditions of the deal are outlined in a contractual document known as a lease. But, this isn’t the type of leasehold interest that we are going to focus on in this article.
Another common scenario occurs when a developer or builder finds a piece of land upon which they would like to build something. But, the owner may not be willing to sell the property outright. However, they may be willing to lease the property to the builder. In such a transaction, the developer would be required to pay monthly rent to the property owner, but they would gain the right to construct a project on the vacant land and then “sublease” the completed property to end user tenants. The property owner would retain tile to the land, but the builder would own all of the improvements constructed upon it. The builder would also be responsible for all of the operating expenses associated with running the property like: property taxes, insurance, and maintenance.
So, in commercial property parlance, acquiring a leasehold interest in something just means leasing it.
Types of Leaseholds
There are four types of leaseholds in commercial real estate.
1. Tenancy For Years
In a “tenancy for years” leasehold, the lease term is known at the time it is created. For example, if a tenant signs a five year lease, it is a tenancy for years leasehold because the term is known when the lease is signed.
2. Periodic Tenancy
In a periodic tenancy leasehold, the tenant leases space for an indefinite amount of time, but can notify the landlord at their discretion that they wish to terminate their lease agreement. For example, a tenant on a month to month lease has a periodic tenancy leasehold.
3. Tenancy at Sufferance
In a tenancy at sufferance leasehold, the lessee occupies the property in violation of the terms of their lease. For example, if a lease has expired, but the tenant continues to occupy their space, they do so in violation of their lease terms. As such, it could be considered tenancy at sufferance.
4. Tenancy at Will
Finally, a tenancy at will leasehold means that both the tenant and the landlord have the right to terminate the lease at any time, so long as they provide adequate notice.
For real estate investors, it is important to understand the type of leasehold held by existing tenants because it has an impact on the risk/return profile of the property. For example, if there are a number of tenants who have tenancy at will, there is an increased risk that they could terminate their lease at any moment, which would reduce the property’s rental income.
Benefits of a Leasehold Interest
There are benefits to acquiring a leasehold interest for both real estate investors and property owners.
For the real estate investor, the major benefit of a leasehold interest is that they are able to acquire access to a real property for substantially less money upfront than they would have to pay if they acquired it outright. In the scenario described above, the investor does not have to make a major down payment. Instead, they just need to commit to a commercial lease, which has a relatively small upfront cost.
For the property owner, the major benefit of a leasehold interest is that they get to retain their ownership interest in the property while receiving a steady stream of rental income. Often, this type of “ground lease” has a term of years or even decades, so the stream of income may last for many years or even decades.
Drawbacks of a Leasehold Interest
There are also drawbacks to a leasehold interest. In this case, the major drawback is the same for both investors and property owners.
This can get a bit tricky, but the bottom line is that obtaining financing for a transaction that involves a leasehold interest can be challenging. This is because the borrower doesn’t technically own the land so they can’t provide it as collateral for the loan, which is a required covenant. Instead, they need to get the property owner to “subordinate” their interest in the property to the lender.
Essentially, this means that the property owner must agree to move into second place in the order of repayment. If everything goes smoothly, this is a non-event. But, if there are issues such as the developer (the renter) refusing to pay rent on the leased property or there is a substantial decline in the market value of the property, subordination can present a big risk for the property owner. In an absolute worst case scenario, they could lose their property without receiving any compensation for it.
Leasehold Interest vs. Freehold Interest
The term “freehold interest” is another way of saying “fee simple interest.” The key difference between a leasehold interest in a property and a freehold interest is what exactly is owned.
Again, in a leasehold interest, an investor does not own the ground. They only own the “leasehold improvements” that are built on top of the ground. The lessor (the property owner) retains ownership of the ground and receives a monthly lease payment until the end of the lease term.
In a freehold interest, also called a fee simple interest, the investor has title to the entire property and has the right to possess, lease, improve, or sell the land as they wish.
Leasehold Interests & Private Equity Real Estate
When working with a private equity firm, there are a number of ways that investors could encounter a property with a leasehold interest. For the purpose of this article, we want to focus on one that is common in our deals.
As described above, we specialize in the purchase and management of grocery store anchored retail centers. We like to acquire a fee simple interest in a property which sometimes contains undeveloped “outparcels.” Instead of developing these parcels ourselves, we could work with a third party developer to provide a leasehold interest in the outparcel. Doing so generates a stream of income for us because the developer/tenant pays rent and it enhances the value of our property by adding another attractive business to the center. When this strategy is executed correctly, it can increase a property’s occupancy and be profitable for all properties involved.
Summary of Leasehold Interest in Commercial Real Estate
When an investor acquires a leasehold interest in a property, it means that they have the right to possess and/or occupy it, but they do not have ownership of the underlying real estate.
There are four types of leaseholds that could be found in a commercial real estate transaction: tenancy for years, periodic tenancy, tenancy at will, and tenancy at sufferance.
For investors, the benefit of a leasehold interest is that they get access to a property with substantially less upfront investment than buying it outright.
For property owners, the benefit of a leasehold interest is that they get to retain ownership of the property while receiving periodic rent.
For both investors and property owners, the major drawback to a leasehold interest is that it can be tricky to get financing without the owner subordinating their interest in the property to the lender.
Finally, it is possible that leasehold interest deals can be found when working with a private equity firm. In our own deals, we like to offer a leasehold interest in undeveloped retail outparcels, which generates another stream of income for our properties.
Interested In Learning More?
First National Realty Partners is one of the country’s leading private equity commercial real estate investment firms. With an intentional focus on finding world-class, multi-tenanted assets well below intrinsic value, we seek to create superior long-term, risk-adjusted returns for our investors while creating strong economic assets for the communities we invest in.
If you would like to learn more about our commercial real estate investment opportunities, contact us at (800) 605-4966 or firstname.lastname@example.org for more information.