What Is a Leasehold Interest?
A leasehold interest is a tenant’s right to use and occupy a property for a set period under a lease agreement. Unlike owning a property outright (fee simple ownership), a leasehold interest grants possession but not full ownership.
The landlord, also known as the lessor, retains ownership of the land or building, while the tenant, or lessee, holds the right to use it under the agreed terms.
Leasehold interests are common in commercial real estate, where businesses lease office spaces, retail locations, and industrial properties instead of purchasing them. This arrangement allows tenants to operate in prime locations without the significant upfront investment of buying property.
Key Characteristics of Leasehold Interests
Fixed term: Leasehold interests are defined by a lease agreement, which specifies the lease duration (e.g., 10, 20, or 99 years).
Rent payments: The lessee must pay rent to the lessor, typically on a monthly or annual basis.
Limited rights: The lessee has rights to use the property but must comply with lease terms, including permitted uses and maintenance responsibilities.
Lease expiration: Once the lease term ends, the property reverts to the lessor unless an extension or renewal is negotiated.
Improvements & depreciation: Tenants may be responsible for maintaining or upgrading the property, but improvements typically revert to the landlord at lease expiration.
Types of Leasehold Interests
Leasehold interests in commercial real estate generally fall into four categories:
Estate for years: A lease with a fixed term that automatically terminates at the end of the agreed period.
Periodic estate: A lease that renews automatically (e.g., month-to-month or year-to-year) until either party gives proper notice to terminate.
Estate at will: A lease with no fixed term that continues until either the landlord or tenant decides to end it.
Estate at sufferance: A situation where a tenant remains in possession of a property after the lease expires without the landlord’s permission.
Advantages of Leasehold Interests for Commercial Property Owners
For commercial property owners, leasing out space instead of selling provides a steady income stream while keeping ownership of the property. This means owners can collect rent to cover expenses, invest in other opportunities, and build long-term wealth, all without giving up control of their asset.
Another big financial advantage is flexibility in lease terms. Owners can include rent increases, renewal options, and expense-sharing clauses to make sure the property remains profitable as the market changes. Customizing lease agreements can also help keep good tenants longer, reducing the hassle and cost of vacancies.
Leasing can also boost a property's value. A building with long-term, reliable tenants becomes more attractive to investors, which can drive up its market price. If an owner ever decides to sell, a well-leased property can command a higher price because it offers immediate income potential for buyers.
Challenges and Risks of Leasehold Interests
While leasehold arrangements offer benefits, they also come with challenges. One of the biggest risks is lease depreciation — as the lease term gets shorter, the value of the leasehold interest can decline, making it harder to sell or transfer. This can be a concern for businesses or investors looking for long-term stability.
Another factor is market fluctuations. If demand for commercial space declines or the economy slows, rental income can suffer. Property owners must be prepared for changing market conditions and have effective strategies in place to manage potential downturns.
Tenant default is another risk to consider. If a tenant fails to pay rent or breaches the lease agreement, the property owner may face financial strain and legal challenges. Having strong lease terms, security deposits, and contingency plans in place can help minimize these risks.
Finally, depending on the lease terms, the owner may still be responsible for property repairs and upgrades. Regular upkeep is essential to maintaining the property’s value and attracting quality tenants, but it can also be a costly obligation.
Leasehold vs. Fee Simple Ownership
Feature | Leasehold Interest | Fee Simple Ownership |
|---|---|---|
Ownership Rights | Tenant has use rights but not full ownership | The owner has complete control |
Lease Expiration | Ends after the lease term | Never expires |
Control Over Property | Limited by lease terms | Full control |
Market Value Impact | Can decrease as the lease term shortens | Typically appreciates over time |
Capital Investment | Lower upfront cost | Higher upfront cost |
Key Considerations for Leasehold Property Investors
If you're considering investing in a leasehold property, keep the following in mind:
Lease terms: Review rent escalation clauses, renewal options, and tenant responsibilities.
Ground rent: If leasing land (e.g., in a ground lease scenario), factor in annual rent increases.
Financing challenges: Leasehold properties can be harder to finance, as lenders may be wary of properties with limited ownership rights.
End-of-lease planning: Have a strategy for lease expiration, whether negotiating a renewal or planning for relocation.
How Leasehold Interests Affect Property Taxes
Leasehold interests can have property tax implications that vary by jurisdiction. In some areas, tenants with long-term leases may be responsible for paying property taxes.
Property tax rates may also differ between leasehold and fee simple properties. Some states allow tenants to appeal property tax assessments if they believe the valuation is incorrect.
Understanding Leasehold Valuation for Property Tax Purposes
When a property is over-assessed, owners may face higher tax bills that reduce their profitability.
The good news is that they can challenge the assessment and possibly lower their tax bill, saving money and protecting their profits. If there are any errors, owners should address them as soon as possible to avoid overpaying.
Review Property Tax Assessments
Leasehold properties can sometimes be assessed at a higher value than they should be, leading to inflated tax bills. Owners should carefully review their assessment notices to make sure the valuation is accurate.
Understand Lease Tax Responsibilities
Some lease agreements pass tax obligations onto tenants, while others require landlords to handle payments. Knowing who is responsible is key to avoiding surprises. For tenants, a sudden tax increase could mean higher operating costs.
For landlords, miscalculations in lease agreements could lead to unexpected expenses that affect overall returns.
Some states allow tenants to appeal property tax assessments if they believe the valuation is incorrect. Property tax rates may also differ between leasehold and fee simple properties.
Gather Supporting Evidence
If the assessment seems excessive, property owners or tenants should collect comparable property data, rental income records, or independent appraisals to challenge the valuation. This documentation strengthens the case for an appeal by demonstrating that the assessed value does not align with market conditions. Owners should also verify that assessors used appropriate valuation methods for leasehold properties.
File a Property Tax Appeal
Most jurisdictions allow appeals, but deadlines and processes vary. Property owners should familiarize themselves with local procedures and deadlines when filing an appeal. Many appeals require additional documentation and possibly a hearing, so early preparation is key to achieving a favorable outcome.
Final Thoughts
Understanding leasehold interests is crucial for commercial property owners looking to lease out space or invest in leasehold properties.
While lease agreements can provide stable income and strategic flexibility, they also require careful management to mitigate risks. Whether you’re a property owner or a commercial tenant, it’s important to review lease terms, understand tax implications, and plan for the long term.
Need help navigating leasehold interests and property taxes? Our property tax consultants at Ownwell can help. On average, clients achieve 31% higher savings with Ownwell compared to competitors. Contact Ownwell to explore strategies for maximizing your commercial real estate investments!