How Can We Use Leasehold Estates Creatively

Topics: Landlording

     Leasehold Estates extend to Land Leases under the terms of which a fee simple land title holder agrees to let another person erect or buy the improvements in whole or in part situated on his land without paying for the land itself. They then sign a long term lease spelling out the rental scheme for the duration of the leasehold estate's term. Land Leases can be created either by a Lease or by a Deed in combination with a Lease. Here's how:

     Suppose you and I wanted to buy an existing property. The cost is $250,000. Neither of us has enough money or credit to swing the whole thing, so we try to work it out according to our objectives. You want to earn current income without any effort or risk. I want to operate a business in order to build my estate and to guarantee myself an executive position.

     Here's what we can do to make it all work out.

     First, we'll agree that the land alone will equal 20% of the value of the entire building. Then I'll contract with the owner to buy the land only for $50,000 and you'll contract to buy the building only, for $200,000 Your purchase will be conditional upon obtaining from me a 99 year Land Lease based upon 8% of the land's cost the first year, and on any subsequent value which will be adjusted to reflect 20% of the appraised value of the total property each year thereafter.

     We'll both settle on the entire parcel at one closing. I'll pay for the land and receive a deed only to it. Next. I'll sign a land lea to the former owner
For 99 years as explained above, then he'll convey the building and the lease to you. Because the building is appurtenanced to the land, it is real estate and will be conveyed in fee simple by a deed, subject to the Land Lease.

     The Land Lease is considered to be an interest in real estate because it extends for more than 30 years. It's a good idea to include the lease as an integral part of the building deed and to provide in it somewhere that either the land title holder or the improvements owner, or both or them, has the right to buy the interests of the other party out under an agreed upon formula at some point in the future.

     In the foregoing illustration, we've each been able to accomplish our objectives without becoming embroiled with each other's business lives as partners, co-tenants, beneficiaries, shareholders, etc. For most practical purposes, we won't create any risk for each other so long as we don't violate any EPA regulations. The one big potential threat might be in the way the acquisition is financed.

     There are 'subordinated' leases and 'unsubordinated' leases. When any Lease is recorded in the public records, it resembles a mortgage lien and has a priority over any subsequently filed liens. When it is subordinated to a loan, it legally gives the lender the right to 'bump ahead' in the lien line so to speak. Thus, if the loan is in default, foreclosure could wipe out the lien as well as the fee title interest in the property. An unsubordinated Lease won't be wiped out by a foreclosure. Regardless who winds up with the title to the property, the lessee will still have the right to possess and occupy it.

     Suppose I financed the land, but you paid cash for the building? It would be easy for me to obtain nothing down financing even with bad credit. Why? Because any potential lender would see that the land, even financed at 100% of value, would only be worth 20% of the property, and the building sitting on it would secure the leasehold payments for 99 years. Anytime the loan payments weren't received, a foreclosure would wipe out the land lease. This would create a legal situation in which the building would be forfeited to the new owner, or at least one in which he/she/it would be able to renegotiate the land lease at extremely favorable rates.

     The lender would be in the same relative position insofar as loan security is involved if the owner of the improvements defaulted on the lease. In such case, the building would become the property of the land owner, and further secure the lender. Getting the owner of the improvements to agree to having the land lease subordinated to a loan might be difficult at best. What about the other way around? I wouldn't want to subordinate my leased land.

     Suppose I paid cash for the land, but you wanted to finance the building. The lender would normally request that I agree to subordinate my land interest to your loan. This would be tantamount to my guaranteeing your loan with my land value. If you defaulted in your loan payments, I could lose my land. It's unlikely that I'd do such a thing unless you gave me a financial incentive. This could be in the form of higher rent payments, say, I 0% rather than 8%. Or I might ask for an Option to take over your building and loan anytime the loan wasn't paid on time.

     When land is separated from improvements by a deed, it is called 'splitting the fee' or a 'vertical break-up'. This more often is used by people who already own land to tempt others to use it. I'm currently negotiating with a major company who wants to buy a large block of vacant apartments. They have offered to pay $1,300,000 for fee simple title in the form of a Limited Partnership interest. The Limited Partnership would then rehabilitate the property using government program grants and subsidies, and operate the property as low income housing. This would qualify it for massive tax credits which would be shared with the Limited Partners.

     We have countered with an offer to sign a 99 year lease with them which values the land only at $900,000. The Lease would pay us $6000 per month which is 8% of $900,000 divided by 12 months. During the period when the improvements were being gutted and rehabilitated, the Lease would be secured by a Letter of Credit or a first Mortgage of $900,000. Once the apartments are completely rebuilt and rented up, this security would be released and the apartments themselves would be security for the lease. This offers several benefits for everyone.

     From our standpoint, we'll avoid large capital gains from the sale of the low basis property. And we'll have a secure, indexed income stream for almost 100 years with which to fund a Dynasty Trust for future generations of the family. Or, we could pledge, sell or exchange the lease for more property after a few years if we wanted to raise money or acquire other property.

     From the standpoint of the buyer, he saves $1,300,000 in diluted partnership interests, has fewer partners to account to or divide the profits with, has less invested in the property but retains the same tax benefits and subsidies as before, has more operating expense tax deductions, and thus increases his overall yield.

     To bring this down a little in scale, about 10 years ago a retiree wanted to get rid often rental houses that were worth about $75,000 each and which had fully assumable FHA loans on them which averaged about $35,000 each. His property equity above the loans was $40,000 each. He needed a little cash 'up front' but was willing to trade off profit and yield for security and flexibility.

     Here's what we structured. First of all, we agreed that the land value would be $35,000 against which, by agreement, we'd allocate none of the debt. The improvement value would be deemed to be $40,000 per house, subject to $35,000 in debt. I'd pay $5000 down and take title subject to the $35,000 loans which called for payments that were about $150 less than the rents on each house. He'd convey the houses to me and sign a 35 year land lease calling for payments of $1000 per year over the entire term. I'd pay for all other expenses as well as the mortgage payments as a condition of the lease and our transaction.

     For 3 years, I'd have the right to buy the land under any or all houses for a note and mortgage with interest at 9% per year amortized over the remaining period of the original land lease. After 3 years, he'd have an Option to purchase or sell any of the houses sitting on land that I'd not yet purchased by that time at appraised fair market value for cash we agreed to.

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