Imagine an investment property that you could buy for a fraction of its market price and collect rent on, all without the hassle of having to pay the ongoing costs of being a landlord. If this seems too good to be true, you need only look to our friends in the Aloha State to see that this is 100% possible…and you don’t have to live in Hawaii to take full advantage. Let’s cover some background information before exploring the intriguing world of leased-fee interests, an investment avenue that can be far less technical than it sounds and more lucrative than you may expect.
Interested in learning more about Hawaiian real estate with your retirement plan? Contact Dan Falardeau in our Hawaiian office today!
Understanding Property Purchases
A Hawaiian real estate investor will see one of three options when browsing properties:
This describes what one might consider a standard real estate transaction. A property is purchased, owned, and ideally appreciates over time. Owning real estate Fee Simple means incurring the usual expenses as well as having to pay a mortgage, if applicable.
In addition to paying for the property and the ongoing costs of homeownership, purchasing a leasehold property means paying additional rent to the company that developed the land on which the property sits. These leases can last up to 60 years.
Leasehold with the Option to Buy the Lease
This leasehold arrangement allows for the property owner to purchase the lease from the developer, at which point the owner would obtain the property on a Fee Simple basis and no longer have to make additional payments.
Buying the Lease – Investing in Leased-Fee Interests
Rather than buying a property with a lease on top, investors have the unique opportunity to purchase the lease alone. This is called investing in a leased-fee interest. If tenants decline the option to purchase their own lease, it may be put up for sale to investors.
By purchasing the lease without also paying for the property itself, the investor—or his or her self-directed retirement plan—can enjoy the remarkable trifecta of:
- Buying the lease only, which typically costs a fraction of the value of the property itself.
- Collecting rent payments without having to handle the mortgage, HOA, or other expenses tied to ownership of the actual real estate; and
- Taking Fee Simple ownership of the property once the lease term ends, at which point you can continue to rent it or sell it for, ideally, an impressive profit.
Example Case Study
This example case study illustrates how this can work for your self-directed IRA, 401(k), or Health Savings Account:
- Year #1 – A company develops a condominium complex in Hawaii. They sell a unit to a tenant for a $150,000 Leasehold with an option to buy the lease. The tenant will pay $400 per month for the lease in addition to a mortgage.
- Year #40 – A company offers the tenant the option of purchasing the lease, but they decline. The lease is instead made available to investors. You elect to purchase the lease for $200,000 with your self-directed IRA. Your retirement plan is now collecting the $400-per-month lease payments.
- Year #50 – A plumbing issue arises in the building, resulting in a significant repair expense for your IRA-held unit. Even though your IRA has collected lease payments for 10 years, and will continue to do so, your account will not have to cover the costs—the Leasehold tenant will.
- Year #60 – The lease expires and your IRA takes ownership of the property on a Fee Simple basis. Your account will no longer receive lease payments, but the property has appreciated to a value of $600,000.
- The bottom line – Your tax-advantaged account collected $400 lease payments over 20 years for a modest $96,000 gain, but the asset itself tripled in value. You purchased a $200,000 lease and finished with a $600,000 property.
Buy and Hold Without the Hassle
Obviously, a 20-year wait for a return on investment is considerable, but so is tripling a sizable investment. Leased-fee interests present the chance to invest in real estate without having to contend with property management issues. You also won’t have to submit annual fair market valuations for leased-fee interests because the asset itself will be valued the same until the lease expires.
As with any rental arrangement, there’s always the risk that your Leasehold tenant will default. However, if this happens, the lease may be terminated for breach of contract, at which point your account will own the property sooner. This is less than ideal, but it is at least secure. Your tax-advantaged plan comes away with real property even in the worst-case scenario.
Contact New Direction Trust Company to Learn More
Leased-fee interests are not widely known outside of the Hawaii real estate market, nor are they limited to Hawaiian residents. Please feel free to give Dan and our Hawaii office a call at 808-521-4472 or submit a question through the Client Portal.