I’m currently searching for a new investment property to buy when the sale of our current apartment building is completed (this Friday!). In my search, I found a building in Orange County, California that looks very attractive, both physically and in terms of cash flow, but it’s subject to a land lease. In my last post, I discussed some of the information I learned that makes land leased property less desirable. This is part 2.
Read the Lease: What Happens Upon Expiration?
When I was scoping out that property I mentioned with the good numbers, I noticed that the MLS listing mentioned a land lease, so I asked the agent if I could see a copy of the lease. He said that it would be provided with the disclosures, but if I had a specific question, he could look it up and get back to me. He did say that the lease provided for quarterly payments of about $948, adjusted upwards to meet the CPI increase every 10 years. He also said that the land lease was good until 2063. (The MLS said until 2067, based on the owner’s recollection. The agent said he was going to update it.)
That was useful information, but the key piece of information I needed was what the lease said about what would happen upon expiration of the lease. There are several possibilities for what could happen, some of which are a benefit to the building owner (like an option to buy the property), and some of which are a benefit to the land owner (like obtaining possession of the land and getting any buildings on the land for free). Without reading the lease, you don’t know what you’re going to get.
I asked the real estate agent what the lease said about the parties’ rights upon expiration. Here’s what he said, word for word:
Most land leases that I have ran across in Orange County over the years, ended up with an arrangements for the buildings / home owners to purchase the land from the land owner.
Theoretically, anything can happen, but I cannot see any city officials allowing the land owner to take the existing dwellings from the property owners. I would assume based on my experience that there will be an offer made from the property owners to the land owner to purchase the land at that time. All the adjacent buildings are on the same land lease.
Be Careful: Some Real Estate Agents will Tell You Anything
The dishonest real estate agent is about as cliche as the dishonest attorney. To be fair, I think most real estate agents are honest (the same with most attorneys). But there is a lot of pressure to sell, and the listing agents have specifically committed themselves to selling the houses that they’ve listed. That means that if the property they’re selling has a flaw, they will often fudge the truth a little to get that property sold.
In this case, the agent fudged his answer at least a couple of different ways. Regarding his first point: most of the land leases he’s seen in Orange County “ended up with arrangements” for the building owner to buy the land. This is generally true in my experience as well. BUT, huge caveat: those leases have a provision that gives the building owner the right to purchase the land, either at a fixed buy-out price, or based on an appraised value with a fixed discount. If a land lease has no such provision, there’s no guarantee at all that the land owner will sell the land to the building owner.
Regarding his second point: “Theoretically, anything can happen.” This is the truth. But then he goes on to assert an opinion, and this is where the truth gets fudged beyond all recognition: “I cannot see any city officials allowing the land owner to take the existing dwellings from the property owners.” Whoa, there. The city doesn’t have any right to interfere with a contract like that. If the land lease doesn’t give the building owner the right to buy the land, then the property will simply revert to the land owner at the end of the lease, buildings and all. Any buyer who would consider buying the land in hopes that the city would step up to save them is a fool.
Finally, he said: “I would assume based on my experience that there will be an offer made from the property owners to the land owner to purchase the land at that time.” This is a statement meant to sound like reassurance, but it really doesn’t mean anything. Of course the property owners will offer to buy the land from the land owner at the end of the lease. Unless they’ve let their building fall into complete disrepair, they will want to buy the land in order to preserve the value of the building. But the fact that they’ve made the offer doesn’t mean the land owner will accept it.
This brings us to the crux of the problem:
Land Lease Expiration = Hostage Negotiation
There are many possibilities for what can happen at the end of a land lease. The land lease could provide that the land owner is required to pay the building owner for the value of the building. Or it could say that the building owner has the option to purchase the land from the land owner. Or it could say that the land reverts back to the land owner along with whatever buildings are present on the land, without paying any compensation to the building owner. Or, worst of all, it could provide that the building owner is responsible for removing the building and returning the land to its original condition at the end of the lease.
If you are the building owner, and the lease doesn’t give you the option to buy the land at the end, you could find yourself in a really bad spot. There is literally no incentive for the land owner to cut you a fair deal on the property. In fact, the opposite is true: the land owner knows that you’ve put a good deal of time and money into your building, and that you will probably pay a good amount of money to try to hang on to your investment. Negotiating isn’t any fun when the other guy holds all the power.
I talked to a friend about this land lease issue, and he told me about his negative experience with land leases. His family has a mobile home park on land owned by the Port Authority. They have owned and operated the business for many, many years, but it was subject to a land lease. Well before the expiration of the lease, my friend contacted the Port Authority to try to negotiate a new lease term or to buy the land.
Negotiations did not go well. He said the Port Authority’s demands were highly unreasonable. They demanded a newer, much higher base rent amount, as well as a percentage of the rents. The new arrangement would have shaved their profits significantly. The discussion got heated several times, and my friend had to simply walk away from the negotiating table for lengthy periods of time. It’s a good thing he started the process early, because it took 8 years to finally get the situation handled.
Plan Ahead: Way, Way Ahead
If you’ve explored all of the possible downsides and you still think you want to go ahead with a land lease, make sure you’re thinking far enough ahead before you dive in. If you’re buying a building on a land lease that has 35 years left on it, you may be able to qualify for a regular 30-year mortgage, and the cash flow might be good enough to cover the land lease payments and still beat out the numbers for neighboring properties. But consider what will happen when you plan to sell the property. If you sell it after 20 years, it will only have 15 years of lease left. The next guy will have to either pay all cash for the building, or take out a 10 year loan term or less, assuming that you can find a buyer who want to buy a building knowing that there is a 15-year expiration date on it.
So if you’re thinking about resale value, you should make sure the land lease has a long enough term to cover the time you want to own the building, and have enough time left over to cover the average loan term (30 years), plus a margin of 5 or so years so the banks will make that loan. If you’re planning on owning the building for 30 years yourself, you’ve got to make sure the land lease will last for at least 65 years!
If you’re really planning ahead, you’ll realize that when you sell your building to your next buyer, they will probably be thinking about their own resale value at the end of their ownership of the building. If they might want to own the building for 15 years and sell it afterward, then you should tack that time onto the lease term you calculated in the last paragraph. So add the following: your ownership time + the next owner’s time + average loan term (30 years) + margin of 5 years. If you decide that you want to own the building for 20 years, but the average owner will own the building for 15 years, the equation might look like this: 20 + 15 + 30 + 5 = 70. So if the lease has at least 70 years left on it, it might make sense to buy the leased property so long as the other numbers look good. If the lease has only 60 years left, you might only choose to buy if you can shave your ownership time down to 10 years.
What I Ended up Deciding
After learning all of the information covered in these two posts, I ultimately decided not to buy that building. The land lease only had 47 years left on it, and I plan to own my next building for 30 years or more. It might turn out to be less if I move out of the area and decide to do a 1031 exchange, but I don’t want to feel compelled to sell the building early because of an expiring land lease. If I own the property for 30 years, I would be selling it with only 17 years left on the land lease. That would limit me to selling to an all-cash buyer, or a buyer who had enough of a down payment that they could afford a very short term loan, like 10 years. It just didn’t seem to make financial sense to me, especially given that the lease provides no protections for the building owner at the end of the lease.
Would you ever buy a building subject to a land lease? Why or why not?