Leasehold Condominiums in Hawaii
Some have recently inquired as to whether leasehold condominiums are a viable option for the development of residential and/or commercial for-sale projects. The short answer is "yes," but there are a number of considerations for the developer.
In the 1960s through the early part of the 1980s, leasehold condominiums, mostly in the residential context, were utilized frequently. It offered developers the opportunity to minimize the up-front cost of land acquisition and made projects more economically attractive. These projects were accepted by the market back then, as the lease terms were generally of long duration (55-75 years), and buyers (and their lenders) were not concerned about the eventual expiration of the lease term. All of that changed when those leasehold estates faced periodic rent escalations due to increasing land values, and as the lease terms became shorter. The issue of the potential for the loss of the fee interest due to the possibility of forced condemnation also reared its head, thus resulting in a chilling effect in the market.
Today, because of inflated land values and the inability or reluctance of certain fee owners to sell their land in fee, the leasehold condominium is being looked at as a viable alternative to fee simple ownership.
If one proceeds with a leasehold development, there are some issues that will need to be carefully addressed.
Tax Considerations
In a leasehold project, if sales proceeds are deemed to constitute consideration for the leasehold interest as opposed to consideration paid for the improvements, such proceeds may be characterized by the IRS as rent paid in advance or "prepaid lease rent." This would result in the developer not being able to deduct the expenses of project construction against sales proceeds, thus resulting in a larger tax liability. This issue may be addressed through carefully drafted condominium documents and in the conveyance instrument to assure that the sums paid by buyers are for the improvements and not for the lease.
Leasehold Disclosures
Under Chapter 516D of the Hawaii Revised Statutes, certain disclosures are required when a residential leasehold property interest is sold. No later than ten calendar days after the acceptance of the deposit, receipt, offer, and acceptance contract or other similar contract, the developer must provide to the buyer for the buyer's approval and acceptance, one of the following lease documents which provide the major provisions of the lease, such as the length of the lease, lease rent terms, lease rent negotiation dates, how renegotiated lease rents will be calculated, and surrender clause provisions: (1) the master lease and any amendments thereto; (2) the apartment or unit lease and any amendments thereto; or (3) for initial buyers of condominium units only, a public report. Upon receipt of the applicable lease document, the buyer has ten calendar days to review, accept or reject the terms of the lease. The parties may agree to reduce or extend the time period provided under Chapter 516D for the production and review of the applicable lease documents; provided that such agreement is not considered a waiver of the requirement to provide the applicable lease documents to the buyer.
Non-Disturbance and Attornment Provisions; Right to Notice and Cure
The lease documents should contain provisions that protect the efficacy of the leasehold estate, which is what the lender will be taking as security for the loan, in order to assure the ability to finance the lease. If a subleasehold interest is involved, developers should confirm that adequate non-disturbance and attornment provisions are included in the sublease to ensure that the sublease will continue to survive so long as the sublessee is not in default under the sublease. Lenders will also want to ensure that adequate rights to notice and cure are contained within the lease.
Secondary Market Requirements
Fannie Mae and Freddie Mac have a number of requirements for leasehold estate loans including, among other things, (1) that the term of the leasehold estate runs for at least five years beyond the maturity date of the loan, unless the fee simple title will vest at an earlier date in the borrower; (2) that the leasehold can be assigned, transferred, mortgaged, and sublet an unlimited number of times; and (3) that the borrower retain voting rights in any homeowner's association.
Leasehold condominiums offer certain advantages for developers. Where there is market acceptance of this concept, it provides a viable option for the development of condominiums in Hawaii.