Most loans are secured by property that's owned outright by the borrower. But in some cases, a loan can also be secured by the borrower's leasehold interest in property, which is a special type of ownership whereby the homeowner has the right to own the property for a fixed period of time. Leasehold financing can help tenants get the cash they need to buy or improve leasehold real estate, but it's complicated. Few lenders offer leasehold mortgages, and things can get messy in unexpected ways.
When you buy a leasehold property, you're buying the right to own the property for a certain period, usually 30–99 years. A leasehold mortgage is a lien put on the homeowner's temporary right to own the property that the homeowner offers up as collateral for the mortgage loan.
Understanding Fee Simple vs. Leasehold Ownership
Most people are familiar with one type of real estate ownership: the one where they own the property and the land beneath it outright. This type of ownership is called "fee simple" or "freehold" ownership. With a few exceptions, owning a property freehold means you can use, possess, modify, improve and dispose of the property however you want – meaning you can sell it, lease it to others, pass it to heirs, build on it or even give it away if you wish.
A leasehold title is different. Here, a fee simple owner (the lessor or landowner) grants something called a ground lease to another person (the lessee or homeowner). With a ground lease, the homeowner gets the right to use and enjoy the property for a fixed period but he does not own the land and he's restricted in what he can do with it.
When the lease term ends, the property reverts to the lessor. Simply put, this means that the landowner has the right to take back the property (and any improvements made to it) at the end of the lease term, with no money owed to the homeowner.
Leasehold Ownership vs. Residential Rentals
To be clear, when we talk about leasehold ownership, we're not talking about the type of lease you get when you rent a house or apartment. A standard residential lease agreement usually lasts around 12 months. You get the right to live in the home until the term ends, but you don't have to "buy" the rental agreement – you just have to pay the monthly rent.
Ground leases, on the other hand, tend to be for much longer terms – anywhere from 30–99 years is common. The homeowner has the right to live in the property for the lease term and usually can sell the leasehold interest to someone else, although the sale may be subject to the landlord's approval. The new owner will get the right to use of the land for the remaining years covered by lease.
As such, leasehold ownership is a marketable interest in real estate, meaning it is worth money. Often, the homeowner will pay hundreds of thousands of dollars to buy a leasehold interest in property, which may not be much less than what she'd pay to purchase a fee simple ownership in the same building.
Who Uses Leasehold Ownership?
Leasehold ownership is fairly common in commercial real estate where offices, malls and industrial units may be constructed on leased land. They are much less common in residential real estate. However, some parts of the United States still use the leasehold system. These include places like Hawaii, Palm Springs, Delaware and the Los Angeles suburbs.
In Hawaii, for instance, around 12 percent of the condos and 2 percent of the single-family homes on the market are leasehold. These properties come in around 25 percent cheaper than a comparable fee simple unit. So, whereas a freehold condominium in Waikiki might be offered for sale at $400,000, the list price of a similar leasehold unit might be $300,000.
This sounds like a bargain until you realize that you're only buying a temporary right to hold the property. The lease on the condominium might expire in 2050, at which time the condo goes back to the landlord and you no longer own it.
Leasehold Mortgage Explained
In the context of residential properties, a leasehold mortgage is simply a mortgage that's secured on the homeowner's leasehold interest in the property. So if you wanted to buy the $300,000 leasehold condo in Waikiki, then you might apply for a leasehold mortgage to get a loan for the purchase money. The homeowner takes out the loan, not the landowner.
How to Mortgage a Leasehold Interest
If you apply for a leasehold mortgage, then the process itself is going to look a lot like a standard "fee" mortgage application. The lender will evaluate your income, debt load and credit score before approving the leasehold mortgage application, and then you'll agree to the amount of the mortgage loan and the interest rate. Once the loan is finalized, you will make payments in accordance with the payment schedule.
The difficulty comes in getting the mortgage in the first place. Financing for residential leasehold properties is incredibly tough to get. That's because the collateral you're pledging – the lease – is much less valuable to the bank than pledging a fee simple property where you own the home and the land it sits on forever.
A Primer on Collateral
With every type of mortgage arrangement, you have to pledge some type of collateral, or security, for the loan. Usually, the collateral is your fee interest in the property. So with a fee simple type of mortgage, if you miss your mortgage payments, the bank would foreclose, seize the property and sell it to recover the money the bank is owed.
Since the value of fee property tends to go up over time (depending on economic conditions), the bank is confident that it can get its money back if the borrower defaults on the loan.
The Challenges of Mortgage Lease Collateral
The same foreclosure process happens with a leasehold mortgage only this time when the bank forecloses, it only gets the leasehold interest in the property. The problem here is that the value of leasehold property tends to go down over time. A condo that's worth $300,000 with 30 years of the lease left to run might only be worth $50,000 if the lease is due to expire in five years' time because in five years, all your ownership rights will be canceled!
In other words, it may be much harder for the lender to get its money back if the borrower defaults on a leasehold mortgage than with a "fee" mortgage. The duration of the lease is incredibly important to leasehold financing.
If the bank looks at the lease and sees that it has 99 years left to run, that indicates a fair amount of price stability. The bank potentially could foreclose, sell the leasehold interest to a buyer, and make enough money to cover the outstanding mortgage balance. If the lease has only 10 or 20 years left to run, however, there's a risk that the condo may become valueless in a few years' time. You're unlikely to get financing for a leasehold property with less than 30 years left on the lease.
Expect a Shorter Repayment Period
Since the availability of a leasehold mortgage is dependent upon the lease term, it makes sense that the length of your loan will also be limited by the number of years left on the lease. Most lenders will only consider making a loan for 90 percent of the time left on the lease. For instance, if the lease has 30 years remaining, the most you'll get is a 27-year loan.
Shorter term mortgages cost more each month because the repayments are spread over a shorter period. However, you will pay the balance off quicker.
Bear in mind that if you need to refinance in 10 years' time when there's only 20 years left on the lease, you may be out of luck.
Status of the Landlord Matters
Another major difference between a freehold and a leasehold mortgage is the presence of a third party – the landlord. While landlords are not part of the leasehold mortgage application process, most lenders want to check that the landlord exists and is in good financial standing.
It's common for investment companies to own the freehold of condominium units, for instance. But if the landlord company goes bust, things can get messy pretty quickly. You'll be faced with a lot of legal challenges when there's no freeholder – who do you pay rent to, who maintains the unit, who gets the reversion (ownership) when the lease comes to an end?
Most lenders will regard the situation as too risky when there are question marks about the landowner. So, even if your own financials are strong, if the landowner is weak, you may not get the financing you're after.
Other Problems of Leasehold Mortgages
Some other things to consider if you're thinking about applying for a leasehold mortgage include:
Lease rent. The homeowner will typically pay a lease rent during the term of a ground lease, although this isn't the same as the market rent you pay under a short-term residential lease agreement. For example, you may pay just $300 or $500 per year ground rent on your $300,000 Waikiki condominium unit. However, the bank will add this rent to the loan payment when determining if you qualify for a loan. If your financials are borderline, this additional expense could disqualify you for the loan.
Landowner consent. Depending on the terms of the ground lease, you may need a written consent from the landowner before you can mortgage the property. Some leases may block you from mortgaging the property entirely – be sure to read the lease conditions.
Liquidity. Liquidity refers to how quickly you can sell something for cash and generally, real estate is an illiquid asset. It can be hard to find a buyer for a house, for instance, because there's only a small pool of buyers looking for a house of your size and type in your neighborhood. Plus, real estate is expensive, which puts it out of reach for many buyers.
Leasehold property is even more difficult to resell. That's because it loses value as the lease gets shorter. What this means is that if you're struggling to make the mortgage payment and want to sell the property quickly to avoid foreclosure, or if you want to move home for other reasons, you may have trouble finding a buyer.
What If You Can't Get Leasehold Mortgage Financing?
If you have your heart set on purchasing that Waikiki condo but can't get leasehold mortgage financing, the only solution is to speak to the freeholder. Leasehold property owners have the power to extend the lease so you can negotiate a 30-year extension for example. The new term should be long enough to satisfy the lender's minimum-term requirements. The property owner also can sell the fee simple to you.
For some lenders, the homeowner's right to obtain a lease-term extension or a new lease when the current lease expires is key to protecting the bank's investment. The bank may refuse to finance the purchase unless you have the option of extending the term. It's imperative you find out everything you can about the terms of the lease, and the landowner's plans, before you shop around for a lender.