 This is State Tech Hawaii, Community Matters here. Aloha and welcome to The Condo Insider, everything you ever wanted to know about living in a condo, owning a condo, maybe even being on the board of directors of a condo. And today we've got a very interesting subject that we haven't touched on before, but I thought it would be a good one for us to do. And that is in regards to leasehold condominiums, and my guest is an old friend and sitting commissioner right now on the Hawaii Real Estate Commission, and that's Mike Payne. I am glad to have you here, Mike. Me too. Are you sure about that now? We'll see. Well, before we get into this issue of leasehold condominiums, why don't you give us a little background on how you got involved in leasehold issues on condominium associations. Good place to start right from the beginning. Thank you. And pardon me if I refer to my notes. People will find in this half hour that leasehold is a ton of stuff. Oh, yes. And I'd have to say on track here. 1991, the Honolulu Board of Realtors was asked by the council to opine on land reform for condos, forced condo sales. Everybody looked at each other and had to have a clue of what to say. So they convened the task force and being the newest member of the Honolulu Board of Realtors, they gave it to me. But it was a heck of an education. We met with landowners, lessors, lessie groups, attorneys, appraisers. We looked at everything and came to the conclusion that the one imbalance we had was information. Having the right information on both sides and having a balance of information would balance the playing field. And so with that, they went off and they gave their opinion to the council. What happened to me, though, is the phone rang one day and somebody says, I've got a fee offer and I think it's too high. Can I negotiate it? So, well, everything's negotiable. So we took on a case more informally and then the phone rang the next day and says, I have a rent renegotiation. I've got to go through. Can you help us with that? And the phone kept ringing and ringing. So a few years later, the phone rang so much, I decided I would get into representing condo projects and fee conversions and rent renegotiation, ultimately lease extensions. To the point where, before I retired a couple of years ago, we had done about 80% of the condo fee conversions in the state over the past 15 years and the majority of rent renegotiation. It's a deep subject people find and so no one else really came around to take a piece of that marketplace and so we just got very busy with it. Well, you got a good chunk of that marketplace, but you also had to take an additional aspirin every day for dealing with it, right? Two. Okay. Well, you know, leasehold condominiums are a subject that's not talked about often and the reason I wanted you on the show is I taught a class recently and there were a few young students in there who really didn't understand the concept of a leasehold condominium or what it really means. So I thought, hey, this is a perfect subject for the condo insider as well. I think it is an excellent subject because people still have a very low understanding of the concepts and even realtors, even some attorneys. Sorry, Jay. Anyhow, I think what we should do is start at the beginning. How do we get into the system and what is the system basically? I think post-World War II, the GIs coming home, starting families, suddenly there was a great demand for housing on Oahu, but there wasn't a lot of landowners willing to sell their land outright for development. We didn't have condominiums. We didn't have co-ops. We had some apartment buildings. So there was this great demand. So in 1951, somebody came up with the idea of doing a leasehold co-op and they created the lease and here's the problem with the structure of roughly 55 years, 30 years of known lease rent. That was for mortgage purposes or fixed amounts of rent. You know exactly what it's going to be, and then you rent through some renegotiation periods. We'll talk about that in a minute. Lease rents went sky-high, but they also then stuck in a surrender clause at the end. The landowner was going to get the building and the land back. Everybody would have to leave at the end of the lease. Finally, landowners in bunches says, I'll sign on to that. So from 1951 to 1961, 39 leasehold cooperatives were developed on Oahu. Mostly on Oahu, mostly Waikiki, but a few outside of Waikiki. In 1961, Hawaii passed the first condo statute. And sure enough, the first condos to be developed, they did it in leasehold. Landowners couldn't wait to give up their land. They get a bunch of money up front, units in the building, lease rent for the next 55 years. And they get this great concrete building back in 55 years. And they went on and on. At the high, we had about 600 plus or minus leasehold condo and co-op projects in the state, encompassing about 70,000 apartments. That was more than what we had in Fee Simple. We also had 25,000 or so leasehold single-family homes. We had almost 100,000 housing dwellets in a leasehold system that required unlimited lease rent increases during renegotiation times, uncapped, and a surrender of the property at the end of the lease. It was the greatest concentration of residential leasehold ever in the world. Although Japan is trying right now to catch us up very quickly for some reason. And a few little smidges of it around the United States, but not very much at all. The concept that we developed here became problematic right away because it was designed on a commercial leasehold concept. Known rents, unlimited rent renegotiation tied to land value fluctuation and surrender of the property at the end. It doesn't really work well in a residential context when it's people's homes. By 1969, the state legislature figured this out. Remember, this is only eight years after we started leasehold condos. And it passed land reform, which was mandatory conversion for... It was supposed to be for all properties in Hawaii. It didn't get adjudicated for 15 years. It had to go through a lot of appeals and challenges up to the US Supreme Court. It was finally cleared for use in 1984. By 1990, 80% of single-family leasehold was converted to fee simple. And I'll add to that is that my father lived in a single-family home in IAEA that was on leasehold land. Then he moved, sells it, moves to Maui, buys fee simple. He was so excited he got this house on half an acre that was fee simple. And then he sat there in the dining room one night and said, What the hell am I going to do with half an acre? For the rest of his life, you know, yeah, yeah, yeah. So the system created some problems. The government started to get involved. But condos were eliminated from land reform along the way based on the concept of oligopoly. In other words, a few large landowners controlled almost all of the single-family leasehold. But many, many condo landowners controlled the condo leaseholds. And so based on oligopoly or the failure of oligopoly, they got tossed. And there was really nothing for condos until 1991 when the city council of Oahu, for Oahu only passed chapter 38 single, I'm sorry, condo mandatory fee conversion if you had certain qualifying amounts. By 1998, about seven years later, the law was fully adjudicated to the U.S. Supreme Court. And people started converting. At that time, there were about 50,000 leasehold condos and co-ops in Hawaii. By 2005, when the law got repealed, so seven years later, the law got repealed by the council, by a new council, we're down to about 15,000. So looking at single-family and condos, mandatory conversion laws result in what the original legislative intent was, was to get out of this leasehold system because it's onerous on people. It was a great argument, though, because landowners looked at the contract, the lessees looked at the social issues, and they had to be balanced very carefully. Well, there's also been this conception for years, I've heard it as well, is that the idea also was, well, if I buy the unit and rent the land, it's going to be cheaper to do it that way than buying a fee-simple condo. But even in my experience in the 80s and 90s, it didn't matter if it was leasehold or fee-simple, they were basically selling it about the same price, depending on where they were located at. Yeah, we'll get into valuation of things, but market trends, especially when the marketplace is very tight and there's not a lot of housing available, people in the 80s were buying up leasehold condos to be almost the same value as fee-simple, and they paid too much, but that was the market influences. They would buy anything, and it just got up quite a bit that way. And I'm glad you did bring up the subject of the leasehold single family, because that's sort of a little bit of history that people have forgotten that there was a period of time a good chunk of residential property, at least here on Oahu, was held in leasehold, and so that mandatory conversion, some people have forgotten about that little bit of history. Yeah, all of Kailua, all of Hawaii, and big chunks of A.I. were developed single family leasehold, and all of Waikiki, except for the Iliqai, was developed as leasehold condominiums. You know, 70% of Waikiki, so it was a rampant at one time. You'll see we're down to probably 60, I'm sorry, 6,000 or 7,000 leasehold condos left in the state, but it's been hard slugging it all out. Well, one of the points you made is on the residential leasehold, there were just a few large landowners who were involved in that, and that was part of the reason they got the mandatory conversion, but the individual condo buildings on leasehold land, a lot of times that was just family land or put into trust by the family for future use and things like that, so that's why it wasn't, let's say, a monopoly. Yeah, it's a period of numbers game. Many landowners, I think about 250 at one time owning leasehold condominiums under roughly 600 projects. The Waimea School was the largest with 112, and a lot of them were one-to-mom-and-pop landowners, as we call them, so there were many, many more of those, and it just didn't stand the test of oligopoly for the court. Because I've gotten that question before. Well, if they forced the residential wide in, they forced the condo, and that was basically the issue right there. Right, right. So, we got our little history lesson. And as you pointed out, the original idea on leasehold was more of a commercial idea, but they were applying it to residential. Yeah, that was the mistake. Yeah, yeah. Well, the legislature very rarely makes mistakes, so. So, then we get into this issue that, and I dealt with them, and that's one of the reasons I know you the way I do is because you do lease rent and renegotiations, or did before you retired. And I've been involved in a couple. And that's where it really shocks some homeowners sometimes. Yeah, just going through one will be a surprise to a lot of people because there's no cap, there's no set dollar amount. Rent renegotiations occur generally three times during a lease. We talk the structure of about a 55-year lease, 30 years of fixed or known rent, but then they reopen or renegotiate once every 10 years. And that's so the landlord can bring their rents up to current market value for the time. The rent renegotiations clauses in the typical lease is based on a percentage of land value. For example, if you had a condominium with 100 units and a $10 million land value, and they had a lease that said the rent will be based on land value times 8%, it's $100,000 per unit, 8% of that is $8,000, and that would be the new rent for the next 10 years. Yeah. And they go through the whole process again. So lease rents are based on land value fluctuation over time, and in Hawaii, land values generally tend to only go up. And so the first rent re-openings, because landowners did a lousy job of estimating up front, were 7, 10, I saw 15 times higher than what the original was, and that was a surprise to a lot of people. Well, even one that I had on the outskirts of being involved in, they went from an average of, depending on the unit, $95 a month to $120 a month, and then they shot over $600 a month after renegotiation, and they were oceanfront. Especially for oceanfront. But that makes it unaffordable to some people. There's always going to be some people with marginal affordability that may be just retired, that kind of a bump they just can't handle, and so it jeopardizes their ownership or jeopardizes their staying there, which was the social issue. Okay, well let's take a quick break, and when we come back we'll learn some more about leasehold condominiums right here on the condo insider. This is Think Tech Hawaii, raising public awareness. Aloha. I'm RV Kelly, host of Out of the Comfort Zone. And Think Tech is important to our community because it gives us a chance to learn more. We get to learn more, we get to give more, we get to grow more. 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It's not just a wahoo that are either on their last renegotiation or maybe coming close to the end of the lease. So in the time we have left, that'd be a great place because I think owners and realtors need to understand what those issues are. Yeah, and this is where it gets a little hard. The history lesson is pretty easy. This is where the difficulty comes. So I thought we'd start with understanding the different interests in real estate. Leasehold, leased fee and fee simple. So I decided to use a prop. I brought a piece of paper here. Sorry, it's a bad prop. This is the full bundle of rights. This is what the landowner owned before they committed their land to a lease and then somebody put up a leasehold condominium. Full feasible bundle of rights. Once they signed the lease with the developer to put the building up, they no longer own the fee simple value. They own what they call the leased fee interest. It's the fee interest subject to the lease. They don't own the use right of the bundle of rights. They've given that and they were leased to the lessees. So the apartment owner is a lessee under the lease. The lessor is the landowner is under the lease of the leased fee interest. And it stays like this until the end of the lease. At the end of the lease, the leasehold interest reverts back to the fee owner. The lease is gone and he owns the building and everything on it, the land and everything on it in fee. During the term here though, what's happened many times, remember we started with 70,000 condos. We're down to about 6,000 now. Many, many condominiums have converted to fee. So the leasehold apartment owner has bought the lease fee interest from the lessor and made a fee simple condominium unit. That's how the interest works. Very simple plane. The pi thing here works very well for that. The problem comes in valuing this stuff. Because in valuing the value of a leasehold apartment plus the value of the fee doesn't necessarily equal the full fee civil value. Or the mistake people have been making is they look at the full value of the fee. They say, well, some units of my project have sold at this value. So the difference must be the lease fee from the fee owner. And that's what I'll go in and offer them to buy the fee. Not necessarily the case. Case in example here, before I retired a couple years ago, one of the last conversions we handled was for a project. And I'm going to use round numbers. The units were selling for $500,000 fee simple. It was a mixed project. So there were also some leasehold units of the building. And they were selling for $200,000 leasehold. So people bought it for $200,000. One day I'll buy the fee, it'll be $300,000. They went to the fee owner and said, can I buy the fee? The fee owner says, well, appraise it. They appraise it and come back $450,000 just for the least fee interest. And so they just suddenly went, you know, I just bought and owned for $200,000 and went down to $50,000. The real answer on that is they didn't know what they were buying. They didn't know how to value it. They didn't know how to come to the value. So they paid too much for their leasehold interest. And that's very common out there. If there's only two things that everybody takes away from this today, is to understand that the value of the leasehold, the value of the leasefeed owner owns, doesn't necessarily equal the fee simple value of the unit. Here's why. Leasehold apartments, if you want to sell a leasehold apartment, you give it to your realtor. They stick it on the open market. The marketplace comes and they pay a certain amount of money. You look at the last three sales and you're building for similar leasehold units and that's roughly what your value is going to be. The same thing if you have a fee simple apartment. Okay. You go on the open market. The last three sales pretty much determine what your value is there. Lease fee sales are closed market transactions. You don't put them on the open market. You could. But the fact has been from the very beginning that the buyer that will pay the most is the leasehold owner of the apartment. The person who owns that leasehold interest. Yeah. They will pay the most. So why would a landowner stick it out looking for other people to pay a fraction of that? They just go right to the lessee of the apartment or the condo association. So because of that, the least fee interest, what the fee owner holds and sells and what you need to make your apartment fee simple is done by an economic calculation called discounted cash flow to determine the full present value of the lessor's interest. What is the value of the land today grown to the end of the lease? Discounted to today's present value by a discount rate. And all you need to know is a discount rate is the opposite of an interest rate where you grow interest, discounts into present value. And what is all the lease rent that you might pay to the end of the lease in today's dollar value? So then you come up with the present value of the lessor's lease fee interest and that's roughly what the market value would be for that interest. And as the leases get short and more of the interest proportions to the fee owner as funny things occur when it gets very short, like the appraisal start considering the improvements of the units and things, the value of the fee tends to spike upwards towards the end of the lease and things like that will happen. Okay, now I got to wrap my head around all that financial stuff, but I think one of the issues, not just on the pricing though, is a person who owns a lease hold, if they have the opportunity to go into fee, that's their incentive personally because they want to be whole, so to speak. And so that's where you have emotion and finance sort of working against or with each other, it depends on how it's working out. That's true, but we came up with an interesting stat. We kept a lot of stats when I was doing this. We kept interesting stats and in a condo project, whenever the fee came available, just so everybody could do it, would do it. That's owner occupants and investors who you think would be more cerebral with these things but for some reason they were equally incentivized to buy the fee. You would think the homeowner to protect their home would have more incentive, but they bought in the same proportions to investors. That was very interesting. There's also a misconception there as well. The last one was my own building that I was in a number of years ago. We converted to fee simple. All but three people bought fee and the board at that time says, okay, well, the association bought the fee for the other three units. Their thought process as well, once we own the fee, we can jack up the rent, the lease rent on those people. Of course, then they had a hard learning lesson after that from the person who was involved. Even the simple thought that you have to follow the formula and the lease to set the rents is escaped by a lot of people. Exactly. You had pointed out earlier that there's not as many leasehold units, so to speak, out there. I can remember there was an article in the Star Bulletin or something a number of years back who was sort of like the sky is falling type of article what's going to happen to all these condo units when their lease expires. I haven't seen the sky fall yet. Well, the reason is it hasn't fallen yet. Look at this very interesting thought. At one point we had 70,000 leasehold condos fast-forward roughly 20 years and suddenly we're down to 50,000. And then land reform comes or mandatory conversion for condo comes in 91 and by 2005 we're down to 15. And between 2005 and now, which is 12 years later, we're down to 6. Fee conversions happen without having to overly incentivize the fee owners. And the reason is the economics. It is more economically beneficial that I say that right. It is more economically beneficial for the fee owners to sell the fee to the lesses than do anything else. And so we've seen as some of these leases have come up. And I'm only talking condos now. About 15 condo leases have come up for expirations so far. And none of them have the lessors or the lender come back to retake the property and kick the people out. Number one reason is nobody wants to kick anybody out. But the bigger one is the economics. Famously, the last vehicle version I did was for two co-ops in Makiki. And the landowner said, for decades and decades I'll never sell, don't even ask, so they never even tried. Just before the lease expired a few years ago, he went in to see his attorney and he said, what should I do at the end of the lease? I'm going to get this thing back in six months. And the attorney, like a smart attorney says, I'm going to get an appraise to value all of your end uses. But they did. And they went and they valued selling the fee to the lesses, taking the building back, refurbishing selling fee-simple condominiums, extending the lease for the lesses, taking the building back and doing it as a rental project long-term. And the economic fact was, selling it to the lesses was far more lucrative than any other of their other end uses from that end-use analysis. The funeral then goes, well, okay, I'm pushing 90 and I would like to set up my family, so let's just sell the thing. And that happens over and over again. We see today that when the landowner finally wants to look and address what to do at the end, they'll look at these end-use analyses and decide to sell it. And some who really have an attachment to the land will extend the leases. I expect from this point forward that most condo owners, not talking co-op, most condo owners will either have a chance to buy the fee or extend the leases and very few, I can think of one famous example on the coast of Kahala, but very few will actually have to surrender and get kicked out and the lander will take back the property just because it's against their economic benefit to do so. So do you think in your mind with what is left out there in leasehold condominiums that there is a market, there's still somebody who's going to buy a leasehold condominium? There's always risk takers. And I would say that buying a leasehold condominium has many risks. Rent renegotiations in the future, will the land want to take it back? Will they sell? If so, when? And for how much? Are they going to be what I call overly aggressive? Because they can ask whatever they want and it's up to you to take it or not. Or are they going to be fair and do it on a praise value? Are they going to be decent about it? And that's a lot of risk to take on if you don't understand each one of those different aspects to analyze whether you should buy it or how much should you pay or not. What we do see though is when leases get really short under 10 years and certainly by 5 years people will spend a certain amount of money on buying a leasehold condo just because it's cheaper than rents. I might kick in $20,000 here because that and plus maintenance fees is cheaper than rent for me over the next 10 years. And maybe I'll get a chance to buy it towards the end. It's funny you bring that up because I had a friend of mine who bought a very, very cheap leasehold unit paid 25 for it about 10 or 11 years later sold it for $2,500 because the lease was really getting close to ending. And I asked him, I said, were you upset about the difference in the price? And he says, no, it was a vacation rental all these years. I made my money back so the $2,500 was just gravy. Unfortunately, the realtor who sold it could only go to McDonald's dollar menu for her commission check. But like you said, there's always risk takers in any kind of environment like that. Oh, yeah. And they're there. And when leases get short, they'll buy them for $10,000, $20,000, and take their chances. But what will happen though, we've got leases, a lot of them are expiring now. Harvey Shapiro, who was the economist for the Board of Realtors, did amazing amount of statistics because there's no clearinghouse for leasehold information. When the lease is renegotiated, when's the peak of that, when they expire, when the end of it. I'm hoping that in the next few decades, we'll see the end of residential leasehold. I agree, I agree. It was a system that had really good intentions of creating housing, and it did. But then the concept that was brought into place to make it attractive for landowners, otherwise they wouldn't have done it, I think went a little overboard and had some social issues to it. So I think it'll be gone. Well, again, 30 minutes goes amazingly fast and you did a lot of information in that 30 minutes. So I want to thank you again for being here on The Condo Insider. It's been a pleasure to talk to you about this and maybe we'll get you in again, talk a little more about this later on once you've recovered from this episode. My pleasure as well. Thank you Scott. And again, thank you for joining us here on The Condo Insider. Be sure to tune in on Thursdays at 3 o'clock for more information on what it is to be in the condo world.