Aloha Coast Realty’s Blog of the Big Island

A lot of people are saying right now “oh, don’t buy now, things are still going to go down”. Whether or not that’s true, I don’t know, but I think people are forgetting the inherent advantages of home ownership. This is all obvious, so if you’re familiar with this, you can skip this blog entry. Same thing for people that already own a home; this may not apply to you.

Let’s say you are renting a 3 bedroom house for $1200 a month (a common price here on the East Side of the Big Island). That’s $14,400 a year.

Now, let’s say that you find a great house for $200,000 or $250,000 (you can find a really good house, pretty new, for $250,000 in HPP right now). Let’s say you have nothing to put down, but have really good credit (yes, 100% mortgages ARE still possible). Your payment will be in the $1700 a month range (including taxes, insurance and private mortgage insurance). So, at first blush, it looks like you’re taking a loss of $500 a month.

Factor in the tax advantages though and the picture changes. First of all, the interest is deductible from your income, so on the $250,000 mortgage you’re paying about $14,400 a year in interest plus another $1200 in private mortgage insurance and about $600 or so in property taxes. All of these are deductible and total just over $16,000 a year. So, if it totals $16,200 (the total of the example figures I used), you can deduct that from your taxable income. At a 25% tax rate (a common one), that will save you $4,050 a year or $337.50 a month. So the actual amount paid, in real terms, comes down to $1362.50 a month.

Still higher than rent, that’s true. But if you look at the equity build-up, you’ve paid down the mortgage by somewhere near $3000.

Note: these figures are rounded and are generalizations – everyone’s situation is different, so trust a tax person or your accountant to give you the real figures for you. Your actual cash out of pocket is about the same, but you’ve stuck a few grand in the “bank”, so to speak.

Let’s look at the scenario where prices decline another 10%. So that $250,000 house is now $225,000. Man, you’ve lost money! Not really. You’d save about $200 a month in the payments, so maybe now you’re at breakeven versus the rent. In the meantime, you’ve lost months worth of tax savings and have paid someone else’s mortgage. Its not like your rent went down.

If you have a job or other income, decent credit and don’t plan to leave the island in the next year or so, homeownership always makes sense. Gyrations of the market not withstanding.

One of the areas of Hawaiian real estate that is not clear to a lot of people from the mainland is the issue of “leasehold” versus “fee simple”. If fact, this confusion (especially on the mainland) is so prevalent that I’ve had people say to me “well, you can’t own property in Hawaii, can you?”. Of course, that is completely false. While fee-simple ownership is the most complete form of ownership, its not as if leasehold ownership is without any of the rights or privileges of ownership.

It is true that until recently, up to 85% of all non-governmental land was occupied under a long-term lease. However, in recent years that has changed. There have been a lot of legislative changes, as well as changes in public opinion that have lead to more land becoming available through fee-simple ownership.

Let’s start by defining the terms:

Leasehold: the land remains in the hands of the underlying owner (the “lessor”), however, the lessee (the person occupying the property) has a long-term lease giving them the right to use or sell the improvements on the property. Since many leases are 55 years or longer, this has the effect of the giving effective ownership to the leaseholder. The leaseholder just never owns the underlying land.

Fee simple: this is the type of ownership that most people know. You own the land, you own what’s on the land and you own them both forever or until you decide to sell.

Leased Fee: this is the interest in the property that the underlying owner (“lessor”) has in the property. Sometimes, the person, trust or entity will decide to sell their interest in the property and will offer the “leased fee interest” in the property to the existing leaseholders.

In Hawaii, leasehold property is still common. Its far less common on the Big Island and actually, its quite rare on the Hilo side of the Big Island. Of the properties on the market at any one time, less than 5% are leasehold, at least here (it is more common on other islands).

Leasehold properties can be bought and sold just like any other, with this one big caveat and exception. A leasehold property always has an end date – and on that end date, the current leasehold owner may have nothing. It seems strange, but you can live in a house for 30 years, have enjoyed all the benefits of owning it and one day, without the building or anything changes, you own nothing. The lease has expired and the property has reverted back to the fee simple owner.

For this reason, leasehold properties tend to sell for less than “fee simple” properties, because the ownership in fee simple properties never ends. The law of supply and demand limits the prices of leasehold property. After all, if you had the choice of two properties, one where the ownership was unlimited and perpetual and one where your ownership ends on a specified date in the future with no compensation for loss of use of the property, obviously you’d pay less for the one with an expiration date.

Another thing to consider when considering leasehold property is the limitations on financing. For reasons that should be fairly obvious, a bank is not going to give you a thirty-year mortgage on a property whose lease expires in 22 years.

Another variable is that most leases have clauses in them for lease rent “renegotiation” or even statements that automatically adjust the lease rents at fixed intervals. Interestingly, the lease rents tend to go up and almost never down. Hmmm…. All joking aside, the possible lease rents increases are governed by Hawaii law and do have established ceilings. However, if someone is considering a leasehold property, its is vital that they know the current lease rents, the lease expiration and when the rent reviews/renegotiations are scheduled in the lease. These dates are fixed at the beginning of the lease and will only change if the lease is renegotiated for some reason (significant change in the property, new owners of the fee simple interest, and other factors of this kind).

One important thing to know is that, by law, any leasehold property MUST clearly state that it is leasehold property. In many advertisements, this is abbreviated to “LH” but the advertisements must make it clear that the property is not “fee simple” but “leasehold”.

As alluded to earlier, a common question is “what happens when the lease expires”. The worst-case scenario is the leasehold owner will end up with nothing. The building may be intact and everything could look perfect, but the leaseholder no longer owns anything. Of course, depending on current zoning, the owner’s plans for the property and just about any other factor you can think of, other events could occur – bulldozing and redevelopment of the property, condemnation by the county, a new lease – just about anything. Many leases contain a “right of first refusal” that give the current leaseholder the first rights to any new lease, should one be offered.

So, given these limitations, are leasehold properties out of the question to buy? Of course not. It depends on your wants and needs. Many leasehold properties are in very desirable locations (which often is why the fee-simple owner chooses to lease rather than sell – they can keep their valuable interest in the land, but still generate income from it). Its like everything else in real estate, it depends on your wants and needs. Condominiums may be right for some people and totally wrong for others. A house on several acres may be right for some and wrong for others. In the same vein – leasehold properties may be right for some and completely wrong for others.

photo credit: Claire L. Evans

I’m going to be starting an on-going series of blogs on real estate investment and I welcome any questions, experiences or concerns anyone out there in the blogosphere might have. Bring it on!

PS: I’d like to thank in advance all the people that I’ve been getting information, thoughts and experiences from already, your experience is invaluable.

photo credit: sunshinecity

I recently had the opportunity to spend some time with Julie Tumbaga, a Vice-President of OREXCO, which is a qualified 1031 exchange intermediary company. It was a great learning experience and I thought I’d share some Q&A with her to the readers of the blog. If you would like to reach Julie, she and her associates can be reached at (877) 591-1031 (toll-free from the neighbor islands) or 524-6737 on O’ahu.

Q: A 1031 exchange seems simple on the surface, but in learning more about them with you, I found that there was a lot more to them (and a lot more options for investors) than I had previously thought. In principle the idea is simple, but there are a lot of nuances to the process and legalities of a 1031 exchange. In your experience, what are several of the biggest areas of confusion for people considering or executing a 1031 exchange?

A: There are a number of things…

1. They have to reinvest both their basis and their gain, not the net proceeds. So, if they sell something for 500K, the replacement property needs to be equal to or greater than 500K for 100% deferral.

2. They need to be selling and purchasing like-kind property. Like-Kind is any combination of real property to include single family homes, condominiums, vacant land, commercial, industrial, golf courses and leasehold property with more that 30 years remaining on the lease. All properties need to be used for investment or for productive use in a business or trade.

Q: In continuing in the same general area of question, what is the single largest mistake you see people make (that could risk their tax-deferral) when doing a 1031 exchange?

A: A couple of things…..

1. They don’t identify property timely

2. They don’t use all of their money because they got a mortgage that is too high.

3. Don’t consult with their CPA or tax advisor.

Q: I know that depending on the type of exchange, the duties and responsibilities of a Qualified Intermediary (QI) can vary greatly but can you give us a description of some of the duties of a Qualified Intermediary (QI) in most tax-deferred 1031 exchanges?

A: Some of the duties include:

• Consult with your tax advisor to assure your transaction is properly structured to qualify for tax-deferred status;
• Prepare the legal documents necessary to facilitate your transaction, including: the exchange agreement, the assignment, the exchange contract addendum and the exchange account closing summary.
• Execute closing documents and where necessary, reviews and executes financing documents;
• Acts as the principal, by way of an assignment, in your purchase and sale transactions
• Holds your exchange proceeds so that you do not have actual or constructive receipt of the funds; and
• Coordinates with your real estate agent, tax advisor and/or attorney, escrow/closing officer and lender to ensure the smooth and accurate processing of your exchange transaction.
  

Q: One of the things I learned from you is that there are no established standards or guidelines for someone to call themself a QI. No national licensing, no experience or financial requirements and no genuine oversight. Since a QI is often handling significant amounts of money and/or titles to real estate, this is a serious risk to consumers and investors. What questions should someone considering a 1031 exchange ask of their Qualified Intermediary to be sure that their money and property are safe?

A: Some things to ask would be:

• What is the QIs financial strength? Obtain a copy of the QIs annual financial statement.
• Does the QI have a fidelity bond? If so, what is the amount?
• Does the QI have professional liability insurance? If so, what is the amount?
• Can the QI provide a written guarantee?
• Where is the QI holding the funds? In an investment account or bank account?
• Is an account summary available on demand?
• Is the QI subject to and compliant with Sarbanes-Oxley?
• Is the QI an independent organization/entity or is it affiliated with a larger corporate parent and/or sister company (ies) with substantial assets?

Q: In most real estate transactions, we already have buyers, sellers, buyer’s agent, seller’s agent and the escrow officer involved. When its a 1031 tax-deferred exchange, we also have the Qualified Intermediary company and its representatives involved to make sure that the IRS deadlines and requirements are met to ensure a legal exchange. What would your advice be to these other parties so that the transaction can move ahead quickly efficiently and legally?

A: Whenever there is an exchange, everyone needs to talk to each other. Agents, Lenders and Escrow….we all have our own specialties, however, when there is an exchange involved, some of the normal everyday practices don’t suit the exchange. So constant communication is vital so there are no surprises at the end.

Recently I was asked “why should I pay for a surveyor, if I or a pinfinder can locate the pins at the corners of my property?” This was my response.

I’ve also heard horror stories where the pinning crews accidentally started measuring from the wrong end of a block and each lot may be off by as much as 6 feet. Having a licensed survey will uncover these errors and give you a true and accurate picture of the lot’s location and dimension. Plus they are licensed, bonded and insured to give you recourse if an error should occur. A pinfinder has none of those protections for you.

And no, I am not paid by the Surveyor’s Licensing Board or whatever they may be called. I’ve just personally been witness to too many horror stories.

Recently, I was asked a couple of questions about “packaged” homes. For those that may not be familiar with the term as its used here on the Big Island, a packaged home is one where a company has a pre-designed home, an architect ready to approve them in preparation for permits issued, as well as materials lists and other materials to make it easy to get construction started quickly and relatively cheaply.The question(s) posed to me were:

• Why are packaged home often less-expensive than similar custom-designed homes of the same size, number of bedrooms, etc?
• If I find a packaged home that is almost exactly what I want, can I make changes or am I stuck with the design they already have?

Here’s some of my thoughts on those issues.

Often “packaged homes” are cheaper because of several factors:

1) the pre-packaged designs are often arranged to keep construction costs low — by doing things like centralizing the plumbing to one area of the house (i.e. bathrooms back up to each other and one bathroom is just a wall away from the kitchen, etc). Easy to build = cheaper.

2) the pre-packaged homes have detailed materials lists already made for them. Changing the design will require the contractor or materials supplier to recalculate the materials list and, of course, can change the cost of materials or construction cost significantly.

3) even seemingly minor changes can be significant. People think that “I just want the bathroom on this side of the room instead of the other side” is not a big change, but that can have HUGE implications on cost. I’ve seen cases where something like “lets put this exact house up on post-and-pier rather than slab so I can park underneath” was a $50,000 change. In that case, the rules for fire-retardant materials necessary, beam changes for proper support and addition of a staircase from the carport to the main house dramatically affected the plans and cost. In this example, beams shorted by the addition of the “hole” for the staircase were important load-bearing beams and when shortened, had to be of greater thickness and strength. Higher cost, too.

4) Very forget that one of the reasons that packaged homes have standardized a lot of the preliminary work, materials and off-site labor involved in getting things ready to the construction phase. Those costs are shared by all the people using the same design. In addition, if a building supply outfit has 3 or 4 of the same design in process at the same time, with no modifications, they are in a better position to order common materials in larger quantity and can potentially give a better discount on the materials. [Big thanks to Bob O. for reminding me of this factor to consider]

Changing a “packaged home” plans can have a lot of costs beyond just new draftsman plans and a new review/approval by an architect.

All that being said, “yes, of course you have input and can make changes.” Just be sure that as you discuss the changes, you are working with someone REALLY knowledgeable about the implications of the changes and how it can affect your costs. I would recommend discussing them with your contractor or experienced architect/draftsperson before you commit to the changes.

Sometimes the architect is expensive and a draftsperson could answer your questions and advise you on the implications of a change for far less cost — the architect will still have to review and approve it in the end, though.