Leasehold property makes for an interesting option

by Alistair Helm in


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The article in this week’s NZ Herald titled ‘Buyers wary of house bargain’ got me thinking of the subject of leasehold property.

Leasehold residential property is certainly a rarer commodity than in other countries; I always marveled at the concept of a 99 year lease for London property when living there, imagining the world in 2087!

We do have a few such properties in NZ but I think we have even less understanding of the concept of leasehold and recent stories has probably only added to a sense of apprehension in them and a sense of “steer a wide berth” and stick to freehold properties.

The property in question in the article which is for sale in Greenlane, Auckland is a substantial 4 bedroom home on a large quarter acre section of 1,093 m2 on the edge of Cornwall Park. The property has a ground rent fixed until 20127 at $30,000 a year. It is being sold with an asking price of $475,000.

The Auckland Council in their rating assessment value the land at  $830,000; with the improvements (being the building itself valued at $460,000). This is one case where the Current Capital Value actually bears relevance to the value of the land and property. The land rent of $30,000 a year represents a 3.6% yield on the value of the land at $830,000. The selling price of the improvement at $475,000 is in line with the assessment of $460,000.

So why is the property, as the article says, attracting so little interest in what is a very hot and active property market in Auckland; a market where as we constantly hear demand is very strong and supply very weak?

Simply people in my view, cannot rationalize the inconsistency of a property of this size being sold for less than half a million dollars when other similar properties in the same area attract prices well in excess of a million dollars. It has all the hallmarks of “too good to be true”! Equally I believe they perceive that the ground rent will suddenly and unexpectedly double overnight without any notice and lastly I think they believe that in 5 or 10 years the property will be worth nothing at all and they will have lost $475,000.

Lets look at the reality of the situation and in doing so expose what might actually turn out to be a great financial decision for a prospective future owner.

I have not examined the actual lease document for the property but the listing advert states that the ground rent is fixed at $30,000 a year until 2027, 14 years from now. Real estate agents have a legal responsibility to provide such information with full accountability so I would believe that as an owner you will be liable to pay $30,000 in 2014, 2015 and so on through to 2025, 2026 and 20027. No adjustment, no inflation just $30,000 a year.

As to the residual value of the property – well the value of the physical property, described, as the improvements in the assessment are valued at $460,000 now. The owner of the land who is providing the lease for the property has no right or ownership in the property. It is very likely that in 2027 the owner of the land will have little or no interest in the land aside from continuing to lease it. I do not know, but would doubt that the owner of the land has any prior right to occupy the land (they would certainly have no right to occupy the property as it is not theirs). So the property will always have a residual value in 2027 or anytime between then and now.

So armed with these facts lets look at this property not so much as a property to buy at $475,000 with a annual leasehold cost of the land of $30,000, but rather as a rental property that costs $577 per week to rent.

This level of rent is considerably cheaper than the market rent in the area which for this type and size of house is more comparable to this house for rent in the same area at $800 per week. However to be able to rent this 4 bedroom house at $577 a week you have to pay a bond, a pretty significant bond of $475,000. That bond has benefits:

  1. You have complete right of tenure – for the next 14 years

  2. You have a fixed rent per week that will not rise by any form of inflation for 14 years – you will pay $577 a week in 2027

  3. You can do what ever you like to the property in the form of improvement without any recourse to the landlord

  4. You can at any stage decide to move house – cancel the lease and recover some or maybe the entire bond

Seen from this perspective the leasehold property takes on a somewhat different perspective. In terms of financials it could be a smart decision as the following scenario shows. I have assumed that a prospective buyer has $475,000 in cash. As i see it there are 3 options to live in this area in a 4 bedroom house:

 

  1. Buy a property with the $475,000 as a deposit and finance the balance of the $1.2m purchase price with a 20 yr mortgage – assume rate of 6.6%

  2. Rent a property at $800 a week with a rent inflation of 4% per annum with the $475,000 being invested at 5.1% on term deposit

  3. Buy the leasehold property with the $475,000 and pay the annual fixed lease of $30,000

 

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In terms of monthly costs the leasehold property costs significantly less than buying an equivalent freehold property: $2,825 as compared to $5,773; however if the option 2 was taken and a rent of $800 a week was paid and the $475,000 invested the net cost would be the lowest of the 3 options at $2,054 per month.

However what is more useful to examine would the comparable situation set over a 7 year period, that being an average occupancy period for a property.

As the details show below the cost of the outright purchase of a property is the most expense option at $488,449 over 7 years with the rental costing a net cost of $212,935 after recovery of interest; whilst the leasehold net cost is $240,817.

 

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Now of course this assessment would not be complete without looking at the true impact of the investment of the original $475,000. As the spreadsheet shows with a property price appreciation of 4% per annum the outright purchase option shows an increase in asset value of $388,270 on top of the original $475,000 this being the increase in value of the property plus the repayment component of the 20 year mortgage after 7 years. Taking this into consideration the outright purchase over 7 years costs just $100,179.

The option 2 of renting and investing the sum of $475,000 sees a compound asset appreciation of $115,634 which means the net cost is $212,935 over 7 years.

The third option of the leasehold property has a gain in asset value of $35,943. This has been assessed as being the apportionment of the 4% of the property appreciation per year applied to the improvements; the land equally will increase by 4%. Allowing for this asset gain the net cost over 7 years of the leasehold property is $204,874, less than for renting but twice the cost as for outright purchase.

Out if interest I did an extreme scenario to see what would happen if say rents rose at 6% a year as opposed to 4% and at the same time property appreciation only rose at an equivalent of 2% per annum. Based on this situation the differential becomes much closer with a 20% variance between all 3 scenarios.

What I think this shows is that the cost of property ownership / occupancy can in theory be pretty similar based on the options of rent, buy or lease if property appreciation in the long term is on average low – if that takes off to anything well over inflation the leverage factor of borrowing certainly benefits purchasing a home. For leasehold property – this analysis shows that certainly it could be considered as an option, especially if you do not have the income to support this scale of mortgage.