Leasehold versus freehold: An argument that will go on until the cows come home

By Alan Cheong / Savills, The Edge Property | May 28, 2015 9:00 AM SGT
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Many have always debated over the issue of whether to buy a leasehold or freehold property. (In this article, we shall treat 999-year leaseholds as if they are freehold in nature.) In their quest to find out more about these two tenures of properties, one thing they will encounter is the question of what premium a freehold property commands over one that has a limited legal lifespan. However, one thing that many will notice is that wherever they turn to for an answer, there doesn’t seem to be a definitive one. Even professionals like valuers would condition their reply with an approximate percentage. Often a 10% premium is used.
Mathematically, the difference in value between 60 to 99-year leasehold and a freehold land is negligible. It is only when the remaining lease gets down to 78 years that the difference amounts to 10%. The discount for a leasehold of varying tenures to a freehold have been tabulated by the Singapore Land Authority (SLA) which valuers refer to. What goes into the math behind typical tables of such nature is straightforward. It generally is an accelerated rate of decay in value for leaseholds as its tenure approaches zero. In practice, there are other factors to consider which adds to the complexity of analysis and therefore why the difference in value in a real life case may stray from simple decay formulas.
Before we try to look at the discount a leasehold property has over a freehold, one should ask whether there is one to begin with. From a theoretical standpoint, there is. This is the fact that a leasehold has a limited lifespan in them and because in an investment, there are two components, namely the return of capital and the return on capital, the need to recoup the former over the life of the lease means that the return for a leasehold should be greater than that of a comparable freehold. What this means is that a leasehold value should be at a discount to freehold. As the rental market does not distinguish between leasehold and freehold, rents should be similar for both comparables. Therefore, the rental yield from a leasehold is higher than that for a freehold. That “excess” return for leasehold is to compensate for the decaying tenure.
Some may then argue that a freehold has en bloc redevelopment potential or for that matter even leaseholds. Again, from a purely desktop angle, there isn’t. The reason is that unless there have been value added works to the property’s surrounding, for example, a new MRT station, the rise of a new regional centre, shopping malls etc, all of which was never public domain information at the time of purchase, there is no difference between the two types of properties. For a leasehold, it still has en bloc potential, but again, theoretically, the developer has to pay a differential premium when topping up the lease, thereby whittling off the excess return.
There is however a catch, namely that lending institutions do not finance homes with on short leases and CPF cannot be used to purchase a home with less than 30 years remaining lease left. This distorts the analysis somewhat. Nevertheless, if we ignore leases that are less than 60 years, so long as the remaining lease does not overlap well into the no-bank financing and no-CPF use range, then theoretically, a freehold property is not superior to a leasehold. Rather than spending an inordinate amount of time over this perplexing issue, the key to buying a property for investment should be to look at the factors which were mentioned in the preceding paragraph. Factors like how the Master Plan for the region may evolve over time are instead the key value drivers here.
So back to the question. What is the freehold premium to a leasehold then? To begin with, one has to set the base and we use a newly launched residential property (which is still under construction). A poll with 5 senior valuers, each of them with over 10 years experience gave a range of 10-15 percent. If one uses the SLA table, the premium is about 4-5 percent.
What about sub-sale and resale non-landed properties? From URA’s statistics, the islandwide premium for all transacted properties of all ages in Q1/2015 was a whopping 29%. As many of the properties in the Luxury Segment are freehold in nature, we narrow down the search to just the mid-tier and mass market segment. The premium is 14%. Coming down to a finer line, for projects completed 10 years old, that is those completed in 2005, the premium is 16%. A multitude of comparisons can be made, but by now, we are beginning to get an idea that a significant premium does exist for freehold to leasehold. In fact, if we assign a typical rent of say S$2.60 psf pm to both kinds of properties, the gross rental yield for a leasehold is up to 50 basis point greater than a freehold. That “excess” return could be the amount that is needed to recoup the declining leasehold tenure i.e. the return of capital.
However, there is a catch though. This premium may not be constant over time. Valuers have noted in the past that during times when the market was in a bull run, the difference is almost negligible, that is new leasehold launches are priced at launch at almost similar values to freeholds.
In the final analysis, what can we say about the freehold versus leasehold premium? Well, for one, it isn’t constant and secondly, if the market is stable, as is currently, then we will begin to see things in better perspective and the premium that valuers are opining about may be true, at around 10-15%. The discount a leasehold has would raise the imputed rental yield for a such a property, more out of the need to recoup the investment due to a declining lease tenure. That said, the argument of which is a superior investment is not an argument on the nature of the tenure itself. Rather one should instead refocus one’s analysis to the factors that are impact each property’s returns over time. These can be changes to land use, plot ratios, rejuvenation of surroundings, land use premiums and other non-tenure related factors. So one could have ended the argument long before the cows come home.
This article appeared in The Edge Property Pullout of Issue 677 (May 18) of The Edge Singapore.
Alan Cheong is head of research and consultancy at Savills Singapore.