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The Leasehold Conundrum

Posted by Aaron Tunstall on 06, Dec 2013

Should investors ever buy leasehold apartments?  Aaron Tunstall outlines the pros and cons of leasehold units

 

Leasehold properties are complicated and off-putting for many buyers.  Yet some smart investors buy leasehold apartments with great success.  Should you consider a leasehold property?

What is leasehold?

When you buy leasehold, you're effectively just buying your apartment.  You don't own any portion of the land, although you are buying into the right to the leasehold and the right to occupy the land.  The land itself is owned by a landlord, and ground rent is one of your annual costs.  The ground rent is reviewed, often every seven or 10 years, but can range from five to 21 years.  There are two major types of leasehold: Perpetual and terminating. 

Perpetual leasehold means that when the current lease expires, the building's owners will have an infinite right to renew the lease.  Terminating leasehold means that the leasehold will end completely after a certain time period, usually between 60 and 150 years.  When your lease expires, you no longer have occupancy rights to your apartment.  Whether or not the owner can remove the building will depend on the terms of the lease.  Terminating leases are less desirable than perpetual leases. 

What are the pros and cons of leasehold?

Pros: Leasehold apartments are usually in prime locations, such as Auckland's waterfront precinct.  They are very cheap when compared to similar freehold properties.  This allows people to live in a good area, in a luxury apartment, at an affordable price (until you factor in the ground rent, as discussed below).  For these reasons leasehold apartments are sometimes purchased by first-time homebuyers who can live it up in a lovely apartment in the city while their friends languish in cheap freehold houses in the distant suburbs.  For investors, the big plus is that although values are low, leasehold status has no impact on tenants or rents.  If you can buy a bargain leasehold apartment, you can still charge the same high rents. 

Cons: Because you are not buying any part of the land, you are missing out on the appreciating value of that land, which makes up the vast majority of any capital gains that investors get over time.  Ground rents can jump up at a rent review by a startling amount: Auckland's Scene Three apartment building, for instance, saw the annual ground rent per unit jump by 450% in 2012, from $1,400 to $8,000. 

This type of increase has a catastrophic effect on values, and buyers in general are frightened away from leasehold properties.  The result is that it may be hard in the future to sell a leasehold unit, particularly if it is approaching the end of a terminating lease - I imagine that in the final few years of that type of lease it would be next to impossible.  Also, banks aren't nearly as keen to lend on leasehold land as they are on freehold; you'll need a hefty deposit. 

How could leasehold work for an investor?

With that list of problems, you can see that an investor needs to tread carefully with leasehold apartments.  But they can be a good buy if you do all your homework and all your sums. 

An ideal leasehold apartment would be one with a perpetual lease that had a built-in formula for ground rent increases, to avoid nasty surprises.  It would fetch a high market rent.  A better yield is imperative, because the cashflow needs to make up for the fact that you won't be getting much capital gain. 

Considering how difficult it is to find cashflow positive properties, this type of set-up may appeal to some investors.  If you keep the property for many years, the positive cashflow may be enough to offset the modest capital gains.  You'll need to be well informed, lawyered up and careful to buy a good leasehold apartment; yet the gains can be appealing given the attractive prices.  If investors are supposed to swim against the tide, buying leasehold certainly qualifies.

One final note: The leasehold market in New Zealand is an immature one.  In the UK, leasehold properties are well accepted and well understood.  Buyers can look forward confidently to capital gains at similar percentages as freehold property.  If that is the way the local market will move in the future, the leasehold outlook becomes much brighter. 

 

 

 

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