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What is Leasehold Interest?

A leasehold interest is created when two parties agree to a lease contract defining the use of the property. The agreement occurs between a fee simple owner (lessor) and another person or entity (lessee). The lessee pays the property owner for the use of the property during the time the lease dictates. Buyers of leasehold real estate do not own the property.

Understanding the difference between leasing and renting

Common rental agreements usually automatically renew if both parties are willing. Leases do not automatically renew upon expiration. Typically, a landlord cannot raise the rent or change terms during the lease unless periodic increases are built into the contract. The landlord may only change rent amounts or tenancy terms if the tenant agrees to those changes. With a renter’s agreement, the terms or rental amounts can change rental terms with written notice.

Fee simple real estate vs. leasehold interest

Fee simple is the most commonly known form of ownership in real estate. It is also called freehold or fee simple absolute. This type of ownership is the complete ownership of property. It includes any land or extra buildings that come with the property upon purchase. A fee simple property owner has the right to use it for any legal purpose, such as a residence, rental, trade or donation.

Leasehold interest differs from fee simple interest in real estate. The leaseholder can still use leasehold real estate that changes to a new owner. However, the leaseholder is only able to use the land for the remaining time the original lease dictates. At that time, the property reverts to the new fee simple owner. This is called reversion.

Surrender clause

A surrender clause in a lease contains the legal terms concerning the reversion. These terms are dependent upon the clause. Improvements to any land or buildings on the property could revert to the owner. Use of the property, as well as any maintenance or alteration, is subject to restrictions listed in the lease. Both landlord and tenant duties should be established in the leasehold agreement. The agreement should mention any landlord tort liabilities if not stated by state or federal statutes. Not all states allow leasehold property. It is important to learn any rules specific to your state.

Useful terms when considering a leasehold

Leasehold contracts frequently use the following words or phrases.

  • Lease term – the length of the lease period.
  • Lease Rent – the amount of money paid to the landlord to use the property.
  • Leasehold expiration date – the date ending the lease.
  • Fixed period – the amount of time the lease terms do not fluctuate.
  • Renegotiation date – the date the lease terms are renegotiated after the fixed period. Both parties must agree to the renegotiation and the statements listed in the leasehold document.
  • Leased fee interest – the payment a landlord will make for fee simple ownership.
  • Leasehold mortgage – a lien or another burden on a renter’s interest on the lease. This is carried out as collateral for loans. Often it is used for a long-term lease to get financing for any major updates to the leased property.
  • Condemnation clause – describes the events that will occur if a leased property is taken from a landlord. The clause covers property seizure by a government agency, eminent domain, or when it is condemned.

Condemnation of property by an appropriate authority

If the leasehold property is condemned, either the lessor or the lessee may assert the right to terminate the lease.  Either party may be entitled to damages and awards. Usually, such rights depend on the state and the leasehold agreement.

Typically, the tenant is not allowed to receive any part of an award made to the landlord. However, the tenant may bring a separate legal action against the authority that condemned the property. This includes legal action for moving expenses, any applicable loss of business, personal property damage, and displacement expenses. The lessor may bring legal action against the authority as well. The lease terminates when the condemning authority takes possession.

Understanding commercial leasehold interest

Vacant or mostly vacant commercial properties produce no income for the owner. Landlords can make tenancy more attractive by offering lower lease rates. The landlord generates more income than during a property’s vacancy.

Commercial leasehold interest protects by tenants shielding them from additional financial harm from loss of a favorable lease. A favorable lease is if the rate per square foot is less than comparable local commercial spaces. This means tenants pay less than the market rate for that space. In commercial property, the tenant uses the space for business purposes.

Leasehold interest for oil and gas

Leasehold interest is also known as operating interest or working interest. It is granted to whoever is responsible for taking natural resources out of a mineral estate. The lease documents will say which entity can access a mineral estate. The documents also define the term length for that permission.

In the oil and gas industry, a lack of production creates a financial loss. However, owners of leasehold interest here get a percentage of total revenue that sales produce. The lease needs to be reviewed thoroughly to understand possible liabilities, profits, and revenues.

Royalty interest

Parties owning royalty interest do not have to subsidize the costs of selling refined products such as oil or gas. Owners of royalty interest have zero liability for the government regarding property or subsurface damages. They also do not have a legal right to work in a mineral estate if the goal is locating or developing oil or gas.

Leasehold interest insurance coverage

Leasehold interest insurance covers a tenant’s loss or damages listed in the coverage. This is typically only used upon lease termination because of a covered cause of damage. Alternate names for net leasehold interest are principal coverage and leasehold coverage.

There is a specific equation used to calculate this interest value. It is the difference between the total pay for the unexpired part of the lease minus the total rental value estimate for the same time.

Covered assets

Leasehold interest coverage protects four property assets: improvements made by the tenant to the property, prepaid rent, bonus payments, and tenants lease interest.

Leasehold interest reimbursement usually qualifies under only three conditions

  1. There is direct damage to property.
  2. The cause of loss is covered.
  3. The damage directly leads to a favorable lease cancellation.

Leasehold interest coverage typically does not cover money required to rent another location while the property is being fixed.

Bonus payments in leasehold property

A bonus payment is a nonrefundable amount the tenant pays to obtain a reduced lease. A tenant may offer this favorable lease purchase, or the landlord may suggest it. Both tenant and landlord benefit If space is leased for less than market value, especially in areas where a fee simple owner has trouble finding reliable tenants. The tenant gains a lease that saves them money, and the landlord gets revenue and long-term occupancy of the space.

Making improvements to leasehold property

Tenants are often allowed to make upgrades to the property. However, once these are part of the real property, the upgrades cannot be removed. This causes them to become the building owner’s property. If the favorable lease is canceled, leasehold interest coverage protects the tenant. However, improvements are not covered if these upgrades are specifically and separately insured on the policy. Otherwise, it would create separate multiple payments on the same property.

Prepaying rent for leasehold property

Prepaid rent is when the tenant makes early payments that are not returned if the lease becomes void. The amount of loss is calculated based on how many months are left regarding the lease when this loss occurs. Leasehold interest applies to these situations as well.

Positive or negative lease interest

Leases do not always have or create positive financial interest. Positive leaseholds are created when market rent prices go above the contract rent price. On the other hand, contract rent can be higher, which causes negative leasehold interest.

If leasehold interest remains positive, it can still be of low to no value. Low-value positive interest occurs when the interest cannot be transferred to a third party by the lease agreement. It also happens if there is no demand for that leasehold.

Leasehold properties and calculating leasehold interest coverage are complex issues. If further assistance is needed, contact an Expert online.

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