LEASEHOLD INTEREST INVESTMENTS
Can one entity serve as the landlord and the tenant, without actually owning the land or occupying the building? The answer is yes, and the legal structure is commonly known as a leasehold interest. Leasehold interest properties have been long viewed as the unknown and unfamiliar within the net lease arena. Ironically, this unknown and often misunderstood investment structure is neither new nor unique. Leaseholds originated from the feudal system of the United Kingdom where it is still widely used today, even in the residential market. While the pace of investments around the world has pushed capitalization rates to record low levels, leasehold interests consistently trade at higher cap rates. The yield is further enhanced by allowing for the depreciation of improvements to the leased property.
In its simplest form, a leasehold investment requires three separate parties; a land owner, a building owner, and a tenant. The leasehold interest is ownership of the building. This entity will have a long term ground lease arrangement with the land owner, and in order to generate a profit, must have a tenant in the building paying a higher rental rate than the underlying ground lease. The return is then created from the difference of the rent paid by the tenant and the ground rent paid to the land owner.
In the competitive market for US based investment real estate, there is a never ending search for quality properties in strong locations yielding acceptable returns measured both from a cash-on-cash basis and over the ownership period of the investment. The seemingly endless supply of capital originating from the institutional investors has handicapped the private markets by significantly compressing cap rates and thus returns. According to Real Capital Analytics, retail cap rates have fallen nearly 200 basis points since 2003; levels some feel are unreasonable and unaffordable.
In an effort to secure a higher yield, investors have been diversifying geographically and as to the creditworthiness of the tenant. The overall determination of investors to find desirable yields has expanded the demand for properties into secondary and tertiary markets often with leases guaranteed by an unrated company. While initially these investments provided investors with greater returns, the yield has been narrowed to levels often found in primary markets regardless of the higher risk of the location and quality of the tenant. While non-investment grade tenants still offer some additional return based on the associated risk, tenants falling at or below the S&P rated BBB- investment grade threshold can still demand a premium based upon current press and positive outlooks from industry analysts. For these reasons, a leasehold interest may in fact be an alternative worth considering.
As an example, in the highly competitive market of California, an Albertsons leasehold interest has been recently marketed at a 7.25% cap rate. Conversely, an Albertsons featuring fee simple ownership has been advertised at a 5.25% cap rate. While comparing each of these two investments would need additional analysis as to location and financial benefits, the example shows how a quality and well known tenant can provide an investor a 200 basis point spread between a fee simple and leasehold interest investment.
In most properties, the cost of improvements constitutes a significant portion of the property value. Leasehold interest owners benefit from owning the structure, creating additional return through tax savings generated from depreciation. As with all non-residential buildings, depreciation is calculated on a straight line method over 39 years, providing for over $25,000 in depreciation per year for a one million dollar building. This helps to reduce the taxable income, further growing the after tax yield of the investment. In addition to this annual depreciation, upon disposition of the building, a taxable loss may be recognized. The loss, whether classified as a capital or ordinary loss, will be equal to the adjusted basis in the property. This amount is calculated as the amount the property was acquired for, plus any capital improvements, minus depreciation taken1.
The net income for a leasehold interest is the difference between rents paid by the tenant and the ground lease payments made to the land owner. As a result of this structure, the cash flow provided in a leasehold is typically small when compared to the income generated in a fee simple arrangement. Capitalizing this income amount assuming the higher cap rate noted above can result in prices for leasehold interest properties such that they can be acquired for as little as a few hundred thousand dollars. This pricing threshold allows the smaller investor an opportunity to reap benefits often limited to the more affluent investor.
Ultimately, the decision of what asset class or lease structure offers the best investment is a business decision each investor must make for themselves. Leaseholds are not for everyone, and may be best understood as a form of a bond or cash annuity than a real property asset, but in the endless chase for enhancing returns, the investor willing to consider these types of offerings may be rewarded with a wonderful return on their investment.
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