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Leasehold Interest

Step-by-Step Guide to Understanding Leasehold Interest (LI)

Last Updated February 27, 2024

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Leasehold Interest

What is the Definition of Leasehold Interest?

In the commercial real estate (CRE) market, one of the more standard transaction structures is termed a leasehold interest.

In short, leasehold interest (LI) is real estate jargon referring to leasing a property for a pre-defined period of time as outlined in the terms and conditions of a contractual agreement.

The contract that formalizes and upholds the agreement – i.e. the lease – provides the tenant with the right to use (or possess) a real estate asset, which is most often a property.

  • Property Interest → The tenant (the “lessee”) can lease a property from the property owner or landlord (the “lessor”) for a specified duration, which is usually a prolonged period given the circumstances.
  • Land Interest → Or, in other scenarios, a property developer obtains the right to build an asset on the leased space, such as a building, in which the developer is obligated to pay monthly rent, i.e. a “ground lease”. Once fully constructed, the developer can sublease the property (or units) to tenants to receive periodic rental payments per the terms stated in the original contract. The property could even be sold on the market, but not without the formal receipt of approval from the landowner, and the transaction terms can easily become rather complicated (e.g. a set percentage fee of the transaction value).

Over the term of the lease, the developer is under obligation to meet the operating expenses incurred while running the property, such as property taxes, maintenance fees, and property insurance.

In a leasehold interest transaction structure, the property owner continues to retain their position (i.e. title) as the owner of the land, whereas the developer usually owns the improvements applied to the land itself for the time being.

But once the ending date per the contract arrives, the lessee is required to return the property (and land), including the leasehold improvements, to the original owner.

From the perspective of real estate investors, a leasehold interest only makes sense economically if the rental income from tenants post-development (or improvements) and the cash flow generated from the improvements – upon meeting all payment obligations – is enough to produce a strong return on investment (ROI).

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What are the Four Different Leasehold Interests?

The four types of leasehold interests are: 1) Tenancy for Years, 2) Periodic Tenancy, 3) Tenancy at Will, and 4) Tenancy at Sufferance.

Leasehold Interest Description
Tenancy for Years
  • The length of the leasing term is pre-determined on the initial date on which the contract was agreed upon and executed by all relevant parties.
  • For instance, if a tenant signs a lease expected to last fifty years, the ending date is formally stated on the contract, and all parties involved are aware of when the lease expires.
Periodic Tenancy
  • The tenant continues to lease for a not-yet-defined duration – instead, the agreement duration is on a rolling basis, e.g., month-to-month.
  • But while the discretion belongs to the tenant, there are usually provisions stated in the contract requiring a minimum time before an adequate notice of the plan to discontinue the lease is provided to the landlord in advance.
Tenancy at Will
  • The property owner (i.e., landlord) and tenant each possess the right to terminate the lease at any given time.
  • But like a periodic tenancy, the other party must be notified in advance to reduce the risk of incurring losses from an abrupt, unexpected change in plans.
Tenancy at Sufferance
  • The lease agreement is no longer valid – usually if the expiration date has come or the contract was terminated – however, the tenant continues to wrongfully remain on the premises of the property, i.e., is still in possession of the property.
  • Therefore, the lessee still occupies the property past the ending date of the contract, so the terms have been violated.

What are the Pros and Cons of a Leasehold Interest?

There are several notable benefits and drawbacks to the tenant and the property owner in a leasehold interest transaction, as outlined in the following section:

Benefits of a Leasehold Interest

  • Less Upfront Capital Investment → In a leasehold interest transaction, the right to build on a leased property is acquired for a substantially lower cost upfront. In comparison to an outright acquisition, the investor can avoid a commitment to issue a significant payment, resulting in material cost savings.
  • Ownership Retention → On the other hand, a leasehold interest can be favorable to the landowner in that the ownership stake in the leased property continues to be under their name. In the meantime, the landowner earns a steady, predictable stream of income in the form of rental payments.
  • Long-Term Leasing Term → The stated duration in the contract, as mentioned earlier, is most often on a long-term basis. Thus, the tenant and landowner can receive rental income from their respective tenants for up to several decades.

Drawbacks of a Leasehold Interest

  • Subordination Clause → The lease interest structure is frequent in commercial transactions, in which debt financing is usually a necessary component. Since the tenant is not the owner of the property, securing financing without offering collateral – i.e. legally, the borrower cannot pledge the property as collateral – the tenant must instead convince the landowner to subordinate their interest to the lender. As part of the subordination, the landowner must agree to be “second” to the developer in terms of the order of repayment, which poses a significant risk under the worst-case scenario, e.g. refusal to pay rent, default on debt payments like interest, and substantial reduction in the property market value.
  • Misalignment in Objective → The constructed property to be built upon the property could deviate from the original agreement, i.e. there can be a misalignment in the vision for the real estate project. Once the development of the property is complete, the expenditures incurred by the landowner to implement noticeable changes beyond basic modernization can be significant. Hence, the agreement can specifically state the type of project to be built and the improvements to be made, which can be challenging given the long-term nature of such transactions.

Leasehold Interest vs. Freehold Interest: What is the Difference?

In a standard commercial real estate transaction (CRE), the ownership transfer between buyer and seller is straightforward.

The buyer issues a payment to the seller to obtain a fee simple ownership of the property in question.

  • Freehold Interest → The fee simple ownership, or “freehold interest”, is inclusive of the land and property, including all future leasehold improvements. After the transaction is complete, the buyer is transferred ownership of the property, along with full discretion on the strategic decisions.
  • Leasehold Interest→ The seller is occasionally not interested in a full transfer of ownership, however, which is where the buyer could instead pursue a leasehold interest. Unlike a fee-simple ownership transaction, there is no transfer of ownership in the leasehold interest structure. Instead, the tenant only owns the leasehold improvements, while the property owner retains ownership and receives monthly rent payments until the end of the term.

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What is an Example of Leasehold Interest in Real Estate?

Suppose a landowner in a densely populated area with a positive long-term outlook on the market value of properties declines an offer from a property developer to sell the land.

In response, the property developer offers to construct a residential building on the land as part of a leasehold interest agreement with a stated term of forty years.

The landowner agrees to the transaction structure if the rental income is enough, and because ownership is retained, the property must be returned at the end of the forty-year lease term.

The rental income generated by the residential building belongs to the property developer.

However, rental payments must be paid to the landowner as part of the agreement.

In our hypothetical scenario, the example arrangement between the landowner and the property developer constructing the residential building is an example of a leasehold interest (LI) in real estate.

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