When is a Leasehold Investment Right for You?

As published on wealthmanagement.com June 14, 2021

Simply stated, you get your profits sooner with the leasehold investment.

When is a leasehold investment a good option—and more importantly, when is it right for you?

If, like many investors, you would answer with an emphatic “Never!”, you could be missing out on some excellent opportunities to increase your commercial property portfolio yield and cash flow. In this article, we will explore some of the benefits of investing in leasehold estates and how to price them versus their fee simple counterparts.

First, let’s be clear on exactly what we are referring to when we use the term “leasehold investment.” We are referring to commercial investment property that is situated on land that is leased from a third party under a long-term ground lease agreement. During the term of the lease, your leasehold estate will may decline in value each year as the lease term burns off and will eventually have no value at all, at least no value to you-–the investor.

Investing in a commercial real estate asset that is guaranteed to have no saleable value at the end of the holding period is a non-starter for many investors. But, at the end of the day, doesn’t it make more sense to judge the value of any investment based on profitability?

How to value and price leasehold investment

When considering multiple investment opportunities, we will usually choose the one with the highest internal rate of return (IRR). I have heard and read many definitions of IRR, but in a nutshell, I think we can all agree that it measures the profitability of an investment.

Of the four elements that determine the IRR—present value (initial investment), cash flow, time, and future value - we usually only have control over the present value, or how much we pay for the asset. It makes sense, then, that to achieve the same IRR as a comparable fee simple opportunity, we will need to adjust the present value--or purchase price--of the leasehold to compensate for its zero future value.

To determine by how much you will need to adjust the purchase price, you must first ascertain what the unleveraged IRR would be if the deal were a fee simple investment. Then, calculate the present value of the projected sales proceeds using the fee simple investment’s IRR as your discount rate. The answer to that calculation will equal the amount by which you will have to adjust the purchase price of the leasehold deal to get the same IRR as the fee simple deal. To keep you from having to re-read this paragraph five or six times, let’s consider the following example.

You are considering purchasing a 25-year NNN lease with a credit tenant. The net rent for the first five years is $60,000 and the rent increases by 10 percent every five years. The deal appeals to you because it is being offered at an attractive 7 percent cap rate and you know this tenant and lease structure usually trade around a 6 percent cap rate. You learn that the property is on a long-term ground lease that runs concurrently with the tenant lease.

You know that if the deal were fee simple, it would trade at a 6 percent cap rate resulting in a purchase price of $1,000,000. You would enjoy a pre-tax cash flow of $60,000, beginning in year one. Because of the rent increases, your cash flow would increase by 10 percent every five years. After 25 years, you project that you will sell the property and net $1,500,000 after costs. If you plug that scenario into Excel or a financial calculator, you will learn that the unleveraged IRR for the fee simple deal would be 7.58 percent (Table 1).

Unleveraged Fee Simple IRR 7.58%

Now let’s consider the leasehold investment. The only difference between the two, are, that with the leasehold, at the end of the 25-year term you will walk away without receiving any sale proceeds.

When we deduct the $1,500,000 from year 25, the IRR drops to 4.87 percent (Table 2).

Unleveraged Leasehold IRR 4.87%

If we increase the cap rate to 7% per the asking price, that only gets us to 6.33 percent (Table 3).

Unleveraged Leasehold IRR 6.33%

To make the leasehold deal as attractive as its fee simple alternative, we need to calculate the present value of the $1,500,000 projected net sale proceeds using a discount rate of 7.58 percent (the IRR of the fee simple model).

Your answer will be a negative $241,436. This means that if you paid $241,436 less than the $1,000,000 fee simple model, or $758,564, your IRR would be equal to the fee simple deal (Table 4).

Unleveraged Leasehold IRR 7.58%

In this case, the leasehold would have to be purchased at a price representative of a 7.9 percent cap rate for it to be as attractive as a fee simple deal at a 6 percent cap rate, unleveraged.

Let’s assume the seller accepted your offer, and logic, and take a look at some of the benefits you can expect to realize.

The benefits of a leasehold investment

First, positive leverage will have a much greater impact on the IRR and CoC of the leasehold investment than that of the fee simple deal.

let’s apply a 25-year loan with a 5 percent interest rate and 75 percent LTV to each scenario. Table 5 shows the cash flow of the leveraged fee simple investment while Table 6 reflects the cash flow of the leveraged leasehold investment.

Leveraged Fee Simple IRR 10.5%

Leveraged Leasehold IRR 13.11%

Applying leverage to the fee simple deal increases the IRR from 7.58 percent to 10.5 percent. The same loan applied to the leasehold deal increases the IRR from 7.58 percent to 13.11 percent.

The fee simple deal starts out with a cash-on-cash return of 2.95 percent for the first five years and eventually grows to 14 percent during the last five years.

The leasehold starts off with a cash-on-cash return of 10.59 percent for the first five years and grows to 25.17 during the last five years.

Simply stated, you get your profits sooner with the leasehold investment.

There is also a higher level of predictability with the leasehold investment. You can predict the sale price at the end of the holding period to the penny with nearly absolute certainty. You know going in that it will be zero.

The $1.5 million we used as sale proceeds in our fee simple model is just our best guess. What happens to your IRR if you can only sell the building for $1,200,000? And how good are any of us, really, at predicting values 25 years from now?

Perhaps the best benefit to a leasehold investment is that you will not have to worry about selling the property at the end of the lease. You will just walk away with a smile on your face because you will have already received 100 percent of your investment profit. There will be no sale expenses, no time or hassle to sell the property, and no brokers to hire.

Finally, if you are considering a leasehold investment, you will want to discuss the tax ramifications with your trusted tax advisor.

According to experts I have consulted with, if the investment has a shelf life of 25 years, as in our example, then we may be able to justify a 25-year depreciation schedule instead of the normal 39 years for commercial property. This would have a significant positive impact on the after-tax cash flow. In addition, 100 percent of the leasehold investment should be depreciable. 

The bottom line

If your motivation for investing is to build wealth, think “Fee Simple”, unless you have a very good plan to reinvest your cash flow. On the other hand, if your motivation for investing is to generate cash flow, then a leasehold estate could very well be the perfect vehicle for your situation.