Chapter 9: Leased Fee and Leasehold Valuation

1. Chapter9:Leased Fee and Leasehold Valuation

2. Introduction • Leases affect typical investment returns by impacting: • Net operating income • Reversionary value estimate • Financing options • Investment risk

3. 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

4. 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

5. 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 differ • Investment horizons may differ

6. 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

7. Cash-flow forecasting with existing leases: the lease agreement • Payment amount and method of calculation of rent: • Contract rent • Fixed • Based on price index • Percentage rent • Overage rent • Excess rent • Expenses: • Gross lease • Absolute net lease • Net lease • Net net net lease (triple net lease) • Expense pass-through • Remaining lease provisions

8. Net operating income forecast • Contract rents • Absorption of unleased space • Vacancy and collection loss allowances • Income from other sources • Operating expenses • Expense pass-through • Fixed expenses • Variable expenses

9. Resale proceeds forecast • Methods • Actual dollar forecast • Change in value over the holding period • Terminal capitalization rate • Leased fee NOI may change at a different rate than market NOI

10. 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

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

12. 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

13. 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

14. 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

15. 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

16. Example: Existing Leases Present

17. 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