The original intention of Germany’s leasehold rights legislation was to ensure that heritable building rights would enable people with little income to own their own homes and prevent land speculation. However, the leasehold as such offers more than affordable housing only.

“Today, leaseholds open up opportunities for several types of investors with different risk appetite,” said Mathias Pleissner, a director in the covered bonds team of Scope Ratings and co-author of a report out today. “Since they allow commercial real estate to be split into two separate estates – ownership of land and ownership of any property built on it – it provides opportunities to risk-seeking property investors as well as risk-averse land investors.”

Investing in property built on leased land exposes investors to commercial real estate risks, which require management of tenants as well as maintaining the condition of the property. Investing in the land and leasing the right to build a property presents a lower-risk profile due to stable cash flows supported by strong security packages granted by the legal framework and contractual rights.

Acting as a lessor under the leasehold presents investors with remote risks only, since this is an interest-only product secured by very high credit enhancement. Investors are also protected by dual recourse to contractual and mortgage rights (claims in rem) supported by a strong legislative framework.

The most common use of leasehold is to build residential property. But it can also be applied to commercial real estate, where various economic benefits accrue from splitting ownership of the land and the property on it. For example the property owner, renting out the property built on the plot under the leasehold, can deduct the leasehold payments from his taxable income. On the other hand, tax-relevant write-downs on the land itself are not possible.

A company can create liquid assets if it legally splits the self-owned land and property and sells the land accordingly. This releases equity for investments while the interest due remains tax-deductible. Further, a property seller can earn a premium if a commercial property is sold separate from the land it is built on; again serving the needs of different investor types.

“Scope rates such instruments reflecting the long risk horizon and legal specifics,” said Sebastian Dietzsch, a director in Scope’s structured finance team and co-author of today’s report. “In this context,” he added, “location and durability are key, as are strong contractual agreements ensuring stable cash flows in the future.”

The full report can be downloaded here.