Chapter 9:Leased Fee and Leasehold Valuation

IntroductionLeases affect typical investment returns by

impacting:Net operating incomeReversionary value estimateFinancing optionsInvestment risk

Ownership interests subject to leases

Leased fee interest (leased fee estate)

Could be greater than, less than, or equal to the market value of the fee simple interest

Typical purchaser is a real estate investor

Value = PV of NOI considering existing leases + PV of reversion from resale of property at end of holding period

Discount rate used is that desired by the purchasers of leased fee interests

Ownership interests subject to leases

Leasehold interest (leasehold estate)

Typical purchaser is a tenant

Value = PV of rent differentials between the contract rent and market rent

Discount rate is the rate desired by purchasers of leasehold interests

Ownership interests subject to leases

Value of leased fee interest plus the value of the leasehold interest may or may not equal the value of the fee simple interest

Investors of leased fee interests operate in different markets than investors in leasehold interests.

Investment criteria may differInvestment horizons may differ

Cash-flow forecasting with existing leases: the lease agreement

Important considerations affecting cash flow in the lease agreement:

Date of agreement Date of execution of the lease Date the rental payments begin Date the lease expires Date of any renewal options Date of notice

Parties to the lease (check for arm’s length agreement)

Description of the leased premises

Uses allowed for the property

Cash-flow forecasting with existing leases: the lease agreementPayment amount and method of calculation of rent:

Contract rentFixedBased on price index

Percentage rentOverage rentExcess rent

Expenses:Gross leaseAbsolute net leaseNet leaseNet net net lease (triple net lease)Expense pass-through

Remaining lease provisions

Net operating income forecast

Contract rents

Absorption of unleased space

Vacancy and collection loss allowances

Income from other sources

Operating expensesExpense pass-throughFixed expensesVariable expenses

Resale proceeds forecast

MethodsActual dollar forecastChange in value over the holding periodTerminal capitalization rate

Leased fee NOI may change at a different rate than market NOI

Resale proceeds forecast

A significant change in NOI because of lease renewals may not induce an equal change in the value of the lease-fee estate over the same time period

Value of the lease-fee estate depends on both the NOI from the existing leases and the proceeds from resale of the property at the end of the holding period

The resale price of the property at the end of the holding period depends on the expected NOI in the years after the property is sold

Resale proceeds forecast

Terminal capitalization rate may have to be adjusted if leases have not expired at end of holding period.

Leased-fee discount (yield) rate

May be higher, lower or equal to fee simple discount rate

Depends on credit rating of tenants and whether leases are above or below market

Example: Market Assumptions

Gross building area: 24,000 sqft

Net building area: 20,000 sqft

Market rent: $15/sqft

Income: Increasing at 4% per year for 5 years

Vacancy: Level at 6% per year

Management: 5% of EGI

Property tax: $11,900 level for 3 years, increasing to $15,000 in years 4-6

Insurance: $0.20 per sqft of net rentable area, increasing by 3% per year

Utilities: $1.25 per sqft of gross area, increasing by 5% per year

Janitorial: $0.90 per sqft of net rentable area, increasing by 4% per year

Maintenance: $4,000 per year increasing by 3% per year

Example: Fee simple value estimate

Assuming a 5 year holding period, if I=12%, solving for NPV gives a value estimate of $2,142,209

1 2 3 4 5 6PGI 300,000 312,000 324,480 337,459 350,958 364,996Less vacancy and credit loss 18,000 18,720 19,469 20,248 21,057 21,900

EGI 282,000 293,280 305,011 317,211 329,901 343,096Less operating expense 82,000 85,024 88,138 94,580 98,021 101,616

NOI 200,000 208,256 216,873 222,631 231,880 241,480

Net resale proceeds2,414,80

0

Example: Market Assumptions

Gross building area: 24,000 sqft

Net building area: 20,000 sqft

Market rent: Increasing by 4% per year

Vacancy: 6% of released space; 0% during term of existing leases

Management: 5% of EGI

Property tax: $11,900 level for 3 years, increasing to $15,000 in years 4-6

Insurance: $0.20 per sqft of net rentable area, increasing by 3% per year

Utilities: $1.25 per sqft of gross area, increasing by 5% per year

Janitorial: $0.90 per sqft of net rentable area, increasing by 4% per year

Maintenance: $4,000 per year increasing by 3% per year

Example: Existing Leases Present

Tenant

Leased area(sqft

)

Current annual

rent

Contract rent/sqf

tRemainin

g term

Market rent/s

qft Comments

C&B Bank 10,000 $100,000 $10.00 4 year $15.00 Tax stop above $0.20 per sqft

Valley Mortgage 6,000 $69,000 $11.50 1 year $15.00

2-year option @$13 per sqft

Apex Insurance 4,000 $48,000 $12.00 3 years $15.00

2% annual increase

Example: Leased fee value estimate

Assuming a 5 year holding period, if I=12%, solving for NPV gives a value estimate of $1,962,344

Year 1 2 3 4 5Income  C&B Bank $100,000 $100,000 $100,000 $100,000 $175,479 Valley Mortgage $69,000 $78,000 $78,000 $101,238 $105,287 Apex Insurance $48,000 $48,960 $49,939 $67,492 $70,192 Total $217,000 $226,960 $227,939 $268,730 $350,958 Vacancy @ 6% $0 $0 $0 $10,124 $21,057 EGI $217,000 $226,960 $227,939 $258,606 $329,901    Expenses  Management $10,850 $11,348 $11,397 $12,930 $16,495 Property tax $11,900 $11,900 $11,900 $15,000 $15,000 Insurance $4,000 $4,120 $4,244 $4,371 $4,502 Utilities $30,000 $31,500 $33,075 $34,729 $36,465 Janitorial $18,000 $18,720 $19,469 $20,248 $21,057 Maintenance $4,000 $4,120 $4,244 $4,371 $4,502 Total expenses $78,750 $81,708 $84,328 $91,649 $98,022 Pass-throughs $3,950 $3,950 $3,950 $5,500 0NOI $142,200 $149,202 $147,561 $172,457 $231,879