Hawaii has two types of ownership: Leasehold and Fee Simple.  Leasehold properties typically sell substantially less than fee simple properties, which may seem like a great deal, however, be aware that there are risks associated with buying leasehold property.  Each leasehold property has different lease terms, which impacts the market value of the unit.  For more information on the two types of ownership in Hawaii, see the article What is the difference between leasehold and fee simple ownership in Hawaii.

Purchasing Leasehold property has risks associated with it as outlined below:

1. Leasehold Properties May Decline in Value

Leasehold properties may potentially decline in value, even during a market rise. There is no hard rule on when leasehold property values will fall. However, they appear to drop when there are between 25-35 years remaining on the lease.  There are a few reasons for this decline.  The first reason is that a leasehold property is perceived as a higher risk since the time remaining on the lease is lower, and therefore it will take longer to recoup your money back.  For example, you purchase a property at a great price with ten years remaining on the lease.  Seven years later you decide to sell the property, but now you only have three years remaining on the lease.  The new buyer will need to get an even a better deal since the lease is close to expiring.  In Hawaii, most leases that expire have a surrender clause, meaning the land reverts back to the landowner.    Although most leases have a surrender clause, most leases do get re-negotiated for a longer period.

The second reason leasehold properties can drop in value is due to financing.  A bank will not give you a 30-year amortized loan on a property with 20 years remaining on the lease.  If there are 20 years remaining on the lease, they may give you a 15-year loan, which means that your monthly payments will be substantially higher than if you had a 30-year amortized loan.

2. You May Not be Allowed to do a 1031 Exchange

If you are an investor, the IRS will not allow a 1031 exchange on a leasehold property with less than 30 years remaining on the lease.  A 1031 exchange allows you to sell your property and exchange it for a “like-kind” exchange, which defers capital gains tax.  A leasehold property with less than 30 years remaining on the lease is considered personal property, so it does not qualify for a 1031 exchange.  If the lease is over 30 years, it will be eligible for a 1031 exchange.

3. Your Lease Rent May Drastically Increase

Your monthly lease rent may drastically increase at the renegotiation date as outlined in your lease.  Various reasons could arise during a lease renegotiation that could trigger a substantially higher lease rent.  One likely scenario in which this could occur is if the monthly lease rent was determined over 30 years ago, and therefore the monthly lease rent could be substantially below market.  For example, there have been some leasehold properties on the island of Oahu with lease rent below $100 per month, which was set 30 years ago.  When these below-market lease rents renegotiate to market rent, the lease rent could raise $300 to $400 per month.

4. You Could Surrender Your Property to the Land Owner

Leasehold properties have an expiration date and depending on the terms of the lease; you can lose your property at the end of the lease.  Landowners have taken back property from leasehold owners on the island of Oahu, Hawaii in the past so it can happen.  A lot of it depends on the landowner, the lease agreement, and the laws at the time your lease expires.   

5. You May be Financially Pressured to Purchase the Fee

Sometimes the landowner decides to sell the fee to the homeowners.  Although this seems like great news for the homeowner, sometimes it may not be as good as it may seem.  In many cases, the landowner wants to sell all of the fee, not just a portion of it.  This would be the case for properties in an association, where the landowner works with the association to purchase the fee. During this scenario, the association typically gets the majority of leasehold units to buy the fee, and the association acquires the remaining units.  The association would usually finance the remaining units.  If you do not have the funds or capability to get a bank loan and finance the fee, you may opt to keep your unit as a leasehold unit.  In some cases, the building or your unit may not be financeable, so you would need to pay cash for the fee.   If you are one of the units that did not purchase the fee, the new landowner is now the association.  The association will charge you lease rent as outlined by the lease agreement, so nothing changes with that respect, but if later down the road you decide to purchase the fee, the new association can charge you whatever they wish for it.  

Ultimately there is risk associated with the unknown in regards to what price you will have to purchase the fee for in the future.  In many cases, the association will charge you the finance charges, as well as some additional fees if later you decide to purchase the fee.  In this case, the fee price will most likely be increasing each month, whether or not the market is going up.  Because of this, you may feel pressure to buy the fee since the price will continue to rise each month you keep your unit leasehold.