In my search for a new investment property to replace my share in the  apartment building that my family is currently selling, I have come across a number of attractive options.  One building looks particularly attractive to me, but it is on land leased property, so I reached out to the real estate agent to ask a few questions. The responses that I got, and some outside advice I received from a friend of mine, made me think a lot harder about whether buying property on leased land is a good idea.  There’s a lot of information to cover, so I’ll have to break it up, but I’ll share with you what I’ve learned about land leases and talk about whether it’s a good idea or a bad idea to buy land subject to a lease.

How Land Leases Work

Land leases can be used in a number of different situations.  One common land lease situation is in common interest developments (CIDs), where many individuals own buildings or portions of buildings on the land.  A condo development might have a land lease.  The individual condo owners might own their portion of the building, or just the airspace within their unit, and the land may be leased from the homeowner’s association or even from the original property developer.

When land leases are first put into place, the difference in property values between a fee simple property and a land lease property can be fairly small.  To the initial buyers of property subject to a 100-year land lease, the lease doesn’t really matter much, because it won’t expire in their lifetimes.  The trouble mostly comes later, as the lease term gets closer to expiration.

Property Tax Implications of Land Leases

The rules of your state may vary, so check into your own state’s laws on this.  In California, though, the property tax implications of owning investment property on a land lease may be huge.

In general, in California, you pay property taxes based on the value of the property at the time of purchase.  The amount may increase annually with inflation, but only up to a maximum of 2% per year, thanks to Proposition 13.  As a result, if you’ve owned property for a very long time without triggering a change in ownership, you could be paying property tax on a tax basis that is substantially lower than the fair market value of the property.

Case in point: my extended family bought a mobile home park in the 1970s.  Due to a change in ownership of interests within the partnership, it finally had to be reassessed in about 2008.  Just prior to the reassessment, it was being taxed at a value of only $1 million, due to Prop 13’s limit on tax increases, even though the value was closer to $11 million.  The reassessment led to us having to pay property taxes that were about 11 times what they were before.  That’s a major difference.

Land leases are taxed in virtually the same manner as property that is owned outright, with one big exception: the definition of “change in ownership” of the property is entirely different, and can be triggered a number of different ways, some of which you can control, and some of which you can’t.  With fee simple property (regular property where you own the land and everything on it), you’re assessed for property taxes when you purchase, and then you’re generally not assessed again until you sell the property (or until 51% of the ownership of the property changes).  That gives you some stability and predictability when it comes to planning for property taxes.  But with a land lease, you could buy the building and take over the lease, and then five or ten or twenty years into it, the land owner could assign his or her rights to someone else, and you could be stuck being reassessed and paying higher property taxes again.  Yikes!

Because land-leased property can be reassessed upon change in “ownership” of the tenant or change in ownership of the landlord, land-leased property is likely to be reassessed more often than fee simple property.  In states with similar tax structures to California, you could end up signing yourself up for far higher property taxes with land leased property than you would be if you bought fee simple property and held it for a very long time.

To add insult to injury, a “change in ownership” under the property tax rules might also require the payment of an additional documentary transfer tax, which is a tax normally paid to the county recorder when you buy or sell property and record the transfer deed.  An extension in the lease term which provides an occupancy right of 35 years or more is enough to trigger another documentary transfer tax as well.  On a $1 million property, that could be approximately $1,100, and on a $5 million property, $5,500.  That may not sound like much, but if you’re already getting hit with higher property taxes which will take a good chunk out of your cash flow, the additional transfer tax is an aggravating expense.

Financing Issues with Land Leases

Another downside to buying property on leased land is that it can be difficult to get financing for it.  As time runs out on the lease term, the value of the property will drop pretty dramatically. As you can imagine, someone buying a building with only 5 years left on the land lease isn’t going to want to pay much for it, knowing there’s a deadline on their investment.  The most you would pay is the net amount of income you could realize from the property during that five year period, discounted to present value of the cash flow.  That’s going to be a far smaller amount than you would pay for a property where you could continue to own and operate the property for 30 years, or 50, or forever.

The precipitous drop in value toward the end of the land lease is a problem for the bank as much as it is for the building owner.  The bank won’t want to loan to someone using the building as security if the value of the building is going to plummet over the next few years.  If the borrower defaults, it wouldn’t be worth the bank’s effort to foreclose on the property only to end up with a building that is worth virtually nothing at the end of the lease.

Lending restrictions are different at different banks, but expect to encounter some difficulty when you’re trying to finance the purchase of a building subject to a land lease.  Some banks won’t lend at all.  Other banks might require a lease term that is longer than the term of the loan, to protect their interest.  Some banks might lend on leased property now, but if another banking crisis happens and lending tightens up again, unusual loans like loans on land leased property are the first to be on the chopping block.

I just talked to my favorite loan officer at Bank of America, and asked him about the bank’s policies for lending on land leased property. He said that he didn’t think the bank would make those sorts of loans.  He had a client who wanted to refinance his loan on leased property, and the bank refused to do it.  It was only after the client wrote several letters to highers-up at the bank that the bank finally agreed to do it, and the only reason they considered flexing their policy was because the existing loan on the property was through Bank of America as well.  The refinance application was being done through the Home Affordable Modification Program, the federally sponsored program that incentivized refinancing by relaxing restrictions on loan-to-value ratios.

What that story tells me is that the bank used to loan on leased property prior to the housing crash, but after the crash, they chose not to make those loans anymore.  The initial loan was with Bank of America, so obviously there was a time that they did make those loans.  The refinance occurred when the HAMP program had just come into effect, which was after the housing crash.  I think the takeaway from that story is that when lending restrictions are generally loose in the market, getting financing for land leased property is easy.  When restrictions tighten, beware.  You could be stuck without the ability to get a loan on your property.  If you have an existing loan that you’re happy with, then no big deal.  But if you need to refinance, you’re stuck.  If you need to sell the property, you’re stuck, because the buyer won’t be able to find a loan, either.  You may have to wait for a cash buyer, and that probably means you would have to unload the property at a substantial discount.

Anyway, I asked my loan guy to double-check and see if the bank had changed its policies.  He asked around, and got the answer that the bank is doing those loans now, but they require that the term of the land lease extend at least 5 years beyond the term of the mortgage.  So if you want a 30-year loan, you have to have at least 35 years left on the land lease.

If you have a long land lease, say 100 years or so, then financing will be a piece of cake.  If you have a shorter term, say 50 years, financing for you will be a piece of cake.  But how long do you plan to own the property?  If you plan to own it for 20 years before re-selling it, you might have a problem finding a buyer.  Your buyer may not be able to get a 30-year mortgage at that point, because only 30 years will remain on the land lease.  You can hope to find a buyer who has more cash for a down payment, or who only needs a 20 year mortgage, but it’s going to make your life more difficult, and will narrow down the pool of potential buyers.

To be continued in next post…  In the meantime, if you have had any experiences with land leases, scroll down and tell us about it in the comments.