Leasehold Interest Overview: How Leasehold Interest Works

Leasehold interest is the legal right to use a piece of real property for a set period, granted by a real estate contract between a lessee (the tenant) and a lessor (the landlord or property management company). Possession of leasehold interest in a non-freehold estate (or leased property) grants the lessee legal use of the land or property for the term of the lease, rather than the indefinite rights that accompany simple ownership of a freehold estate.

Ownership rights of the leased premises remain with the lessor throughout the lease, meaning that they may be responsible for the building’s insurance, upkeep, and property taxes (though certain commercial real estate agreements, like net leases, put these responsibilities on the tenant).

Leasehold interest agreements can involve either commercial or residential real estate. The tenants may make leasehold improvements to the inside of the space that add to the property’s value if the landlord approves them. Subletting the leased property may also be possible, but the landlord must also approve. However, the tenant is typically not allowed to do major works to the property without approval, nor do they have the right to manage the space or the right of resale.

Here are the four types of leasehold interest that can apply to any leased property:

1. 1. Tenancy for years: A tenancy for years has a definite start and end date, which determines the period of time that the grantee will hold the property. This type of year lease agreement between landlords and tenants is standard for rental properties. Commercial real estate agreements often last for many years (as many as ten or fifteen).
2. 2. Periodic tenancy: Periodic tenancy has no definite end date, similar to tenancy for years. Instead, it is a short lease in which the tenant and landlord agree on a period that the rental agreement renews, like year-to-year, month-to-month, or week-to-week. This is typically a short-term tenancy, though these agreements can go on for years. Tenants and landlords will agree on a lease extension to prolong the tenancy.
3. 3. Tenancy at will: This type of tenancy is an agreement between a tenant and property owner that either party can terminate at any time. The rental agreement may include a specified end of the lease, but the tenant or landlord can terminate the agreement before then.
4. 4. Tenancy at sufferance: A tenancy for sufferance occurs when a tenant in one of the above agreements retains possession of the property after the terms of their lease agreement have ceased. This is an unlawful tenancy, often referred to as squatting. A tenant at sufferance may return to a tenant from year to year upon payment of rent or agreement of terms with the property owner.

Leasehold interest refers to the occupancy rights that a property lessee has for a limited time under a lease in a non-freehold estate, which is a real estate agreement that does not convey ownership interest or rights to the title of a piece of real property. Freehold means that a person retains ownership of the property along with the full spectrum of ownership rights that come along with the title. Owners of a freehold estate can use their property freely for an indeterminate amount of time.

​Here are some of the advantages of entering a leasehold interest agreement between a lessor and lessee for a piece of real property:

• Affordability: Leasehold properties are often cheaper than freehold estates because the tenant doesn’t need to go through bank financing with mortgage lenders, which often involves paying a large lump sum upfront or during the life of the loan in a balloon payment. Also, a residential tenant typically won’t be responsible for property taxes or maintenance fees in a leasehold agreement. However, in the case of a net lease, a commercial tenant may be responsible for those fees.
• Flexibility: People who have freehold interest in a property must go through the property sale process to get rid of the asset. People who have a leasehold interest in their residential property can simply end their lease and move away.
• Landlord revenue: Granting a lessee leasehold interest in a property allows a landlord to continuously collect revenue on an asset of which they already retain ownership. They also have the option of renegotiating the lease terms on the property to their benefit.

Here are some of the potential downsides that both the lessor and lessee may experience with leasehold interest:

• Rising rents: Without rent control, a landlord can always raise the rent on a leasehold interest property to reflect the current market value, which subjects tenants to higher ground rents that they may not be able to afford.
• Unreliable tenants: Landlords may be subject to tenants who do not pay their rent on time, or who simply do not pay their rent at all. They may be able to evict their tenants in that case, but it is typically a long process involving litigation.
• Limited freedom: Renters do not reap the benefits of full ownership that a freehold estate grants. The value of the land itself poses no benefit for someone with leasehold interest in the property. Rent payments do not build equity in the property for the lessee, because the lessor is the owner of the property.

All investments, including real estate investments, come with inherent risks which may involve the depreciation of assets, financial losses, or legal ramifications. The information presented in this article is for educational, informational, and referential purposes only. Consult a licensed real estate or financial professional before making any legal or financial commitments.

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