Leasehold Land

Buying a property on leasehold land can be a tricky affair. So what’s it all about?

In this scenario you own the buildings and any other improvements on the site, but you lease or rent the land from another owner. Leasehold land is not very common in New Zealand, but when you do come across it you need to know how the leasehold estate affects the properties value.

Whenever you see a leasehold property for sale the sale price is often remarkably lower than what you would expect. It can look like an absolute bargain. A 3 bedroom house that might normally fetch $400,000, on the market asking only $260,000. Wow!

The nitty gritty of the matter is that if you purchase a leasehold property, you enter into a contractual agreement with the land owner (lessor) to lease the land from them. This means you must pay an annual lease fee. The lease fee is normally calculated as a percentage of the lands freehold value.

So say the land has a freehold value of $200,000. A typical lease fee might be 5% of the freehold value. Thus $200,000 X 5% = $10,000 per annum.

Don’t forget that you are also still responsible for council rates, property insurance, maintenance etc. So the $10,000 is on top of those usual annual costs.

A benefit to the buyer is that the lease fee is normally fixed for a substantial period of time – say 14 years. So, taking the example above, the annual lease fee remains at $10,000 for 14 years. At this this gives you some surety.

However, once that period is over, the freehold land value is reassessed – and after 14 years the land value could have risen dramatically. When the lease fee (say 5% again) is calculated on the new land value, the annual lease fee can quadruple.

This has happened to many leasehold property owners in the last 10 years. They may have had their last lease review in say 1995. The freehold land value at that time may have been say, $50,000. So the lease fee, for the last 14 years at 5% would have been – $50,000 X 5% = $2500 per annum. Now, in 2009 the freehold land value jumps to $200,000. The lease fee is now $200,000 X 5% = $10,000 per annum!

So what’s the rub? Why would you get involved in one of these scenarios?

The trick is to look very closely at the lease, determine when the next review is, look at the freehold value of the land and estimate just when and by how much the annual rental will increase.

The value of a leasehold property is based around what is considered the ‘discount’ that the lease fee is set at, below what it would cost to finance a purchase of the freehold. What???

Ok, say you wanted to buy the freehold. In other words purchase the land off the owner. The owner is renting the land to you at 5% of the freehold value (say $200,000 X 5% = $10,000).

Now say you went to the bank and wanted to borrow $200,000 to buy the land. The bank were going to charge you say 7% interest (or $14,000 per annum). So, you are actually getting a 2% discount ($4,000 per annum) by leasing the land, rather than owning it. That 2% discount is an annual discount, every year, at least until the next review period – say in 14 years time. This is often called an annuity in finance circles.

To work out what the property is worth now, you have to calculate what that total discount is worth now, in today's dollars, until the next review. So we are talking about the present value of a $4,000 saving, every year, for say 14 years.

Phew this is taking longer than I thought – more to come soon