Purchasing property always gives you total control over that property and its land… or does it? In reality, there are different types of ownership for single-family homes, commercial properties, and shared properties like townhomes or condos.
Properties are owned with either fee simple ownership or leasehold ownership contracts. Today, let’s break down fee simple vs. leasehold ownership in detail and look at their key differences.
What is Fee Simple Ownership?
Fee simple ownership is the most common type of ownership for residential real estate owners. In a nutshell, fee simple ownership means that the buyer is given the title or ownership of the property, including the land and any improvements to the land, in perpetuity and with no limitations on its use. As a result, no one can legally take the real estate from the owner so long as they have the fee simple title. Fee simple ownership is also called fee simple absolute.
Additionally, a fee simple owner can use or possess the land or dispose of it as they wish, including selling it, trading it for other things, leasing it, passing it to others upon death, or giving it away freely.
Bottom line: fee simple ownership means that the owner has complete and absolute ownership of their property without any strings attached.
Fee Simple Defeasible vs. Fee Simple Absolute
Fee simple defeasible is similar to fee simple absolute, but they are not exactly the same thing. With fee simple defeasible, the prior owner sells the property to the next owner, but the deed includes a condition restricting how the next owner uses the land. If the condition isn’t followed, the ownership of the property reverts to the original owner.
Say that a piece of real estate is sold from one owner to a new owner. The previous owner includes a condition on the contract that states a family burial yard has to remain untouched in perpetuity. But the current owner decides to bulldoze over the burial grounds.
In such a scenario, the previous owner has the right to take the property back in retribution. In most cases, fee simple defeasible is done to preserve part of a property, like a usage intention or a physical feature. In many cases, this is done to make sure land is used the way it is intended by the original owner or developer so that many years of hard work aren’t wasted.
Fee Simple Rights
Fee simple ownership includes many rights that give owners tons of flexibility when modifying or developing their property and land, including:
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Air rights or the right to build above the land
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Mineral rights, including oil, natural gases, precious metals and more
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Inheritance rights<, determining how the property can be passed to decendants/p>
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The right to modify existing structures on the land
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Unrestricted rights to rent the property (within city or state regulations) or to sell the property at any price they deem acceptable
Remember, fee simple real estate owners must still obey laws or regulations from their local communities or state governments. Additionally, the government can always exercise the right of eminent domain and take control of a portion or all of a private property in exchange for “just compensation” regardless of whether the owner agrees to the sale.
Even with these caveats, fee simple absolute is as close as a person can get to complete, unrestricted land or property ownership.
Does Fee Simple Matter to Lenders?
Absolutely. When underwriters assess loans for their viability, they usually rank single-family homes with fee simple ownership as the highest and best since there are fewer contingencies or things to consider. Fee simple townhouses are ranked the next highest and best for a lender’s purposes.
In contrast, condos and plan developments that include leasehold rights (more on those below) are riskiest and are the least likely to result in a loan from most lending institutions. Why? It’s usually more difficult to get approval for a condo or planned development from federal institutions, even for larger lending firms like Fannie Mae or Freddie Mac.
Disadvantages of Fee Simple Ownership
While fee simple ownership certainly has its advantages, there are some downsides you need to keep in mind.
For a lot of individuals, fee simple ownership is more trouble than it is worth. For example, an HOA-governed townhouse or shared property might need a lot of repair work, such as repainting or fixes to doors and windows. The odds are that no individual person in the townhouse will want full responsibility for repairing the property to HOA specifications.
In such a scenario, most individuals will find leasehold ownership more flexible and more beneficial. In general, if a property needs a lot of work and is somewhat shared, fee simple ownership might not be as attractive.
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What is a Leasehold?
A leasehold or leasehold interest is made whenever a lessor signs a contract with a lessee. The contract is called a ground lease when dealing with commercial real estate.
In a nutshell, the lessee pays rent to the lessor and enjoys most of the same rights found in fee simple ownership. However, there are several significant differences to keep in mind.
For starters, lessors don’t own the land they pay for. Instead, they get to use the land or property for a specific period of time noted in the contract. For residential real estate, that can be months or years. For commercial real estate, it could be decades.
Furthermore, if a new leasehold owner takes control of the property, their usage of the land is restricted to the time noted in the original lease. As soon as the leasehold lease ends, the land use goes back to the owner through “reversion,” which may include buildings or land improvements put down by the leasehold owner.
Lastly, a leasehold ownership contract can include limitations on how the land can be used, maintained, or approved. In other words, leasehold ownership is much more limited and controlled compared to fee simple ownership.
It’s very similar to long-term renting, which is why it is an ideal contract choice for investors in commercial real estate, condo development or investment, and so on.
Important Leasehold Terms You Should Know
Leaseholds are something that many people, even those in the real estate industry, are unfamiliar with. As such, it can be helpful to review a few terms commonly used when discussing a leasehold:
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Expiration Date: An expiration date refers to the date the lease ends.
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Lease Rent: The amount due in exchange for the use of the land.
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Lease Term: The term is the length of time the lease covers.
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Lease Fee Interest: This is the amount the owner will accept to transfer fee simple ownership.
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Reversion: Reversion refers to the process of giving the land back to the original owner.
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Surrender: The surrender outlines the terms of the reversion.
Pros of Leasehold Real Estate
Despite its apparent limitations, leasehold real estate does come with several advantages, including:
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Lessees typically pay much less to obtain leasehold properties, and especially less than the 20% standard down payment needed for fee simple ownership
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Lessees are also able to sell their leases to other parties without the permission of the lessor, which is very common in commercial real estate
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Leasehold ownership typically costs landlords only a fraction of what they would need to get into regular real estate investment
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Long-term leasehold leases may provide very steady, affordable rental rates for lessees for up to decades in the future, making them ideal for tenants with fixed incomes
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Lessors can sell the remaining interest on their land, which may provide excellent opportunities for lessees
Cons of Leasehold Real Estate
With all that said, leasehold real estate investment also comes with a few significant downsides, like:
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An inability to build equity with a leasehold estate. At the end of a leasehold contract, lessees don’t have any ownership of the property and have to start from scratch
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Land value still depreciates with every year on the lease
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If a leasehold contract has less than 10 years remaining, the lessee will usually need to find a cash buyer because financing for sub-10 year leasehold contracts is very rare
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HOA fees are always charged separately from the lease payment, which can impact a lessee’s bottom line
Fee Simple vs. Leasehold
Many investors or renters are confused by leasehold ownership because it is very similar to long-term renting. However, leasehold ownership can also apply to condo ownership. For example, suppose you purchase a condo as a leasehold owner. In that case, you own the structure effectively and definitely, but you don’t technically own the land beneath the home or on which the property is built.
Similarly, many townhouses or planned unit developments are classified or leased in this way. So, you could own your condo unit, but you may not own the patio that isn’t technically a part of the property you purchased. Additionally, you don’t own the parking spaces on the associated lot, the grassy lawn in front of your condo, and so on.
Because of these limitations, it’s essential to do a lot of research when looking into a property to buy, especially if you are shopping for residential real estate. If you’re looking for your dream home, just member that townhouse or condo ownership is usually classified as leasehold ownership, not fee simple ownership.
If you want absolute control over your property and anything that looks like it’s part of your property, fee simple ownership is the only way to go. A traditional single-family house might be a better option in that case.
Is My Property Fee Simple or Leasehold?
Not sure whether your property classifies as fee simple or leasehold? Let’s look at a couple of examples:
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The vast majority of single-family homes are fee simple
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Most condos are leasehold rather than fee simple
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Co-ops are not fee simple, but they often aren’t leasehold either. They technically classify as neither leasehold nor fee simple
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If the home is in a planned development or PUD, odds are it uses leasehold ownership rather than fee simple
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Homes in gated communities can be fee simple, but they can also be leasehold depending on the contracts offered by the community
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Townhomes are generally fee simple. However, if the town known development is covered by a homeowner’s association, they might still be able to enforce maintenance and upkeep across the complex very similarly to a leasehold situation
Summary
In the end, understanding the differences between fee simple vs. leasehold ownership is key if you want to make sure you get your dream home and you enter into a contract that’s right for your budget and development plans. If you’re a commercial investor, leasehold ownership might be your only path. But if you’re a residential investor, you have many more options. Before purchasing a property, do lots of research, and make sure you understand your ownership freedoms and limitations before signing on the dotted line.
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