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Leasehold Land Ownership Structures

9 November 2006

Who Gets The Value Growth?

Who benefits most from the investment growth that occurs when a title is subject to a land or ground lease and effectively divided into separate lessor and lessee interests?

The key factors for successful long term lessor and lessee relationships with mutual benefits are likely to be one or more of the following:

• A unique location, by the sea, a port or other natural features.
• An opportunity to create an economic benefit that is central to wealth production such as pastoral rural activity, coupled with non-income producing characteristics such as 'farming is a way of life'.
• A central location in a major city of high values and urban renewal.
• A key locational advantage such as a new town centre with existing planning in place and the opportunity to create and control the development of the town centre.
• Where there are no alternatives other than by participating in a leasehold form of tenure, such as where the community controls the land for the benefit of its resident population or there is one or only a limited number of property owners controlling the land.

New Zealanders are well acquainted with the term 'freehold title' but many are uncertain about the rights, obligations and, more importantly, who gets the benefits when leasehold interests are created.

What is also not commonly understood is that numerous parcels of New Zealand land are leasehold, either leased directly from the Crown, Maori or a raft of territorial local authorities, port authorities, trusts, companies and individuals.

Leasehold Land Structures 

Leases are normally registrations against a freehold title. Leasehold structures therefore commonly divide the freehold title into two interests, each with specific rights and obligations under a lease agreement. The lessor continues to own the land and the lessee pays rent to utilise the land under an agreement that sets out the basis of the terms agreed to by the parties.

Creation of Leasehold Portfolios 

What is of particular interest in recent years has been the revival of this once common practice of splitting the freehold tenure of land into separate saleable interests. As an example, in the 19^th and 20^th centuries very large leasehold land portfolios were created as land was 'reclaimed' from the sea by creating deep anchorage ports around New Zealand. These include 'downtown' Auckland and Wellington, and land at Lyttleton, Otago and the provincial centres of Tauranga, Whangarei, Nelson and Wanganui.

The impact of reclamation activities created some of New Zealand's more distinct and now very valuable leasehold portfolios where the reclaimed land owned by one party, the lessor, was then subdivided into smaller parcels and leased for development to second parties, the lessees. Earlier still and into the 20^th Century the Crown entered into ground leases of significant areas of land in New Zealand including the high country of the South Island and parts of Taranaki.

Glasgow Lease Form 

For the most part, these leases were perpetually renewable leases with 21 year rent reviews, often referred to as 'Glasgow' leases. 'Glasgow' leases were a typical leasehold structure that required the rental to be fixed at a rent per annum that did not change for a term of 21 years; then was reviewed either to a predetermined percentage of the land value or to a market rental for a further 21 year term. The improvements on the land were developed, owned and managed by the lessee.

There have always been tensions in this leasehold land system as each rent review brings about competing perspectives, the lessor seeking the maximum rental after a long period of no rental increase and the lessee endeavouring to protect its interest in the investment by keeping the rent at the minimum level.

However, although there had been problems in the past, it was not until the 1980's following rapid inflation that it became apparent the 'Glasgow' lease system had serious disadvantages to both parties, particularly for residential land. The most obvious was that the lessor was receiving a declining return for the ownership of the asset with no rent increase over a prolonged period but, when the rental was reviewed, the lessee faced a rental increase in percentage terms that often bore no relationship to the existing use of the land or the value of the improvements on the land. Redevelopment was not favoured when rents were low and a lessee's interest high, and became well nigh impossible when the rent was reviewed to a market level, particularly as old leasehold subdivisions had fragmented the land.

Ministerial Inquiry into Leasehold Land

Lessee concerns in Auckland gave rise to the 'Lusk Report' commissioned by Government [1] that concluded that the increases and the rents payable under residential property leases were for the most part reasonable, fair and lawful, although the leases themselves may not have been administered in a particularly helpful way that fostered an understanding of the ownership structure and assisted the lessees. The report concluded there were insufficient submissions for the committee to look at commercial or industrial (business activity) leases.

Residential lessees who had been paying what amounted to peppercorn rents did not understand that they did not own the land and any rental benefit or 'goodwill' interest would fluctuate during the lease term. Although lessees had benefited from an initial saving by not having to buy the land and only construct the improvements, significant illusory lessee's interest value had been built up over time because of the low rentals. This lessee interest of course largely disappeared when the rent was reviewed to a market level.

Although the lessee interest also fluctuates for business activity and rural economy leased lands, these land classes have two distinct advantages over residential land. Firstly, uses on the land have some relationship to the economics of alternative investment opportunities rather than owning land that provides a low return because of its low risk profile. Secondly, business lessees have the right to a tax deduction for the rent payable, as with any business expense.

Nevertheless, it became clear in the 1980's that during periods of high inflation and/or a rapid increase in values, (normally exceeding the inflation rate), there were deficiencies in the lessor/lessee land division system that could appear to penalise a lessee.

Lease Amendments 

Various amendments to leases have been tried to better identify the rights and obligations of the parties. The most notable was the introduction of rent reviews at more frequent intervals of 5 years or 7 years rather than at 21 years, ostensibly to ease the burden of pain on the lessee by reflecting rent increases more frequently, but of equal if not greater benefit to the lessor who could then receive an increase in the rental, as a result of increasing land values, more frequently. No modern leases allow for rent reviews at 21 year terms.

The review frequency amendments did little to alleviate tensions between the lessor and the lessee, each of whom had an interest to protect, the lessor to obtain the maximum return on land value and the lessee to pay the minimum rent from business or private income.

There can be other repercussions with leasehold properties such as properties falling into disrepair or being difficult to redevelop; the lessee interest in such properties being difficult to sell, particularly where the ground lease absorbs all or even more than the income that can be derived from the improvements on the land.

Property Crash Implications 

Following the sharemarket and then property crash of the late 1980's lessees often found themselves in the position of paying a ground rental fixed under earlier boom conditions that did not relate to the current value of the property and could not be reassessed until the next rent review. Although in many cases there was no 'ratchet clause' [2] the lease rental had to be paid at the existing rate until the lease rent was due for review. Lessors knew that from the date the rent was reviewed it would reduce and erode the value of a portfolio, so were reluctant to reduce rents.

There are other traditional leasehold structures including terminating leases of 50 - 100 years. These were not at all fashionable investments in the 1980's as they suffered the same disadvantages of the commercial 'Glasgow' style lease, but with the added certainty of 'reversion' of the land to the lessor at the end of the lease term, usually without compensation for the value of the lessee's improvements.

Property Investment in the 1990s 

Against this background, why is it then that over the past 15 years there has been resurgence in interest to create lessor and lessee interests in freehold titles?

The most obvious is that, following the 1980's property crash, property slowly regained acceptance as an investment class but investment in land development had been slow to respond and when it did prime land was often under the control of a limited number of key market players. From the mid to late 1990's, following a worldwide trend, property has been strongly sought after by companies, trusts and individuals. The demand for investment property continues to outstrip supply.

Land values have increased faster than inflation in almost all New Zealand investment markets. Holding a portfolio of lessors' interests has proven over time to be a very good investment. Owners of property have identified new opportunities to hold land for long term capital gain and sell off either land interests as leases or developed property as leasehold investments.

The result of a seemingly insatiable demand for investment property in recent years has fuelled the opportunity for land owners to exploit the advantages that land offers as a fixed long-term investment. Many end investors by comparison do not fully understand that the return required when buying a leasehold interest should be significantly greater than a freehold return. Nor do they understand how to quantify what that return difference should be.

Advantage of Splitting Interests

The advantage to an owner by splitting the freehold into lessor and lessee interests is readily apparent as two saleable interests are created. Whether the lease is a long-term terminating lease or a perpetually renewable lease the lessor of land will always receive a return that relates to both the present value and the future value of the land. That return can be quite low, akin to a bond rate as it tends to be inflation protected. Conversely the lessee will only ever receive a benefit in the land when the rental is below the market plus a 'goodwill' value for the long term or perpetual renewal value of the lease. The principal return that the lessee can obtain arises by constructing, owning and managing a wasting asset, being the improvements on the land.

The major component of the so called lessee's interest in the land being a below market rent only exists for a limited period of time, until the rent is reviewed. A building erected on the land depreciates from the time it is constructed. [3]

Modern Land Leases

New lease vehicles have been considered to overcome the resistance of investors to the leasehold form of 'ownership'. These have included lease structures considered by local government to protect the interests of the community, normally by the creation of terminating leases and control over development, and/or repurchase.

Individuals and companies have created both perpetually renewable and terminating leases with master plans to maximise the value creation in the form of say a downtown centre of mixed residential and commercial use or even the creation of a new township embracing a shopping centre, business activity and residential development. A number of these proposals have been initiated for the purpose of creating a comprehensive development on the land to maximise its value.

The one thing these 'modern' leasehold structures have in common is that they are almost always promoted over areas of prime real estate where the demand for the use of land is likely to be very high, forcing developers and end users into leases, whether or not they prefer that method of ownership. It would be fair to say that most land users would prefer freehold land ownership to a leasehold tenure.

The modern lease structures that have been created are entrepreneurial and innovative, but their long term market acceptance is untested. How they will fare when the market cools, as inevitably it will, and the buildings become older is something we can only wait for and observe at the time.

The re emergence of a division of land into lessor and lessee interests has prospered over the past 10 - 15 years because demand for investment property is high and the opportunities to invest in key locations on a freehold basis have been limited, either because available alternatives are non-existent or because the land is under the control of a monopoly or oligopoly. In situations where these conditions do not apply leaseholding is likely to have mixed fortunes into the future.

The Lessor benefits most from Value Growth

It is inescapable that of the two parties to a lease agreement over land the lessor will enjoy the more secure return and therefore be exposed to the lesser risk. Leasehold interests have their place, but in investment terms the low opportunity for growth in a leasehold investment requires that there should be a significant return margin over a freehold investment and an even greater margin over the return required on a lessor interest in land. The difference in the required return for leasehold investments should, in the writer's opinion, be significant to counter the limitations of growth in the investment value.

In conclusion, it is the lessor that gains the most growth in value from leasehold land tenure. The lessee's interest is regarded as an inferior property investment to freehold.

Evan Gamby

[1] Ministerial Committee of Inquiry A A Lusk QC and R P Young of Robertson Young Telfer Auckland Limited

[2] 'ratchet clauses' allow a lease rental to remain static or increase but does not enable a rental to decline.

[3] A building may appear to increase in value with the change in the value of money as a result of inflation, but this is illusory as a building must be maintained, services and fit-out must be replaced and ultimately the structure reaches the end of its physical and economic life.

This monthly paper reflects the views of the writer and may not represent the views of all TelferYoung staff.