Valuation of Lease Interests

Comprehensive Real Estate Appraisal Seminar & Training (CREASAT)

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 INTRODUCTION

Bundle of Rights
Rights generally inherent in the ownership of real estate include but
are not limited to the following:
The right to sell
The right to lease
The right to mortgage
The right to sell or lease a partial interest
The right to build improvements thereon
The right not to do any of the above
The bundle of rights can be divided through various instruments
including leases, easements, and mortgages.
Through these instruments, one party owns or controls certain rights
whereby another party owns or controls other rights.

2
INTRODUCTION

Appraisers must understand partial and fractional

interest to define appraisal problems.
At the start of any appraisal assignments, the
property rights to be valued must be clearly
identified
Valuations of partial and fractional interests are
often required because many forms of real
property ownership and lease agreements
involve less than the complete bundle of rights

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INTRODUCTION

In valuing the economic and legal interests created by

leases, appraisers must consider the following factors,
among others:
The relationship between contract rent and market rent
The length of the lease
The credit (risk) rating of the tenant
The division of expenses between the landlord and tenant

These factors strongly influence the selection of

discount rates

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LEASE INTERESTS DEFINITION OF TERMS

Tenancy
When the bundle of rights is owned as separate
property interests, tenancy is created.
In real estate tenancy has two meanings:
The holding of property by any form of title

The right to use and occupy property as conveyed in a

lease (concerns the nature of the relationship between a
landlord and a tenant

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LEASE INTERESTS DEFINITION OF TERMS

Reversion
Future cash, represents the anticipated return of a capital
sum at the end of the investment

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 Hierarchy of Property Rights & Tenancy

Entity A Entity A
Fee Simple Leased Fee

Entity B Entity B
Leasehold Subleased Fee

Entity C
Entity C
Subordinate
Sublease hold
Subleased Fee

Absolute and The Right to Occupy and
Unencumbered Interest use the Property for a
Bundle of Rights specific period and a
specified consideration as
set out in a lease agreement
Between Entity A & B
The Right to Occupy and
use the Property for a
specific period and a
specified consideration as
set out in a lease agreement
Between Entity B & C
Entity D
Subordinate
Sublease hold
The Right to Occupy and
use the Property for a
specific period and a
specified consideration as
set out in a lease agreement
Between Entity C & D
7
 Hierarchy of Property Rights & Tenancy

FREE HOLD INTEREST

INFINITY
YEAR 0

LEASE INTEREST
SUB LEASE INTEREST
SUB LEASE INTEREST
Tenancy only on a specified Tenancy only on a specified
Entity A Entity A period but cannot exceed period but cannot exceed
Fee Simple Leased Fee the rights granted in the the rights granted in the
lease between A & B lease between B & C
Entity B Entity B
Leasehold Subleased Fee

Entity C
Entity C
Absolute Ownership Tenancy only on a specified Sublease hold
Subordinate
period Subleased Fee

Entity D
Subordinate
Sublease hold

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THE LEASE AGREEMENT
A contractual arrangement in which rights of use and
possession are conveyed from a propertys title owner (called
the landlord, or lessor) in return for a promise by another
(called a tenant, or lessee) to pay rents as prescribed by the
lease.

A lease is an agreement whereby the lessor (owner of

property) allows the lessee use of the property in exchange
for lease payments.

In practice the rights and the duties of the parties can be

complex, and are dependent on the specified terms of their
contract.
THE LEASE AGREEMENT

General Requisite of a Valid Lease

Be in writing
Contain the name of the parties who must be competent to
enter a contract
Sufficient description of the Leased Property
Contains an agreement for the rental to be paid and time and
manner of such payment
State the term of the lease
THE LEASE AGREEMENT

General Requisite of a Valid Lease

Be in writing
Contain the name of the parties who must be competent to
enter a contract
Sufficient description of the Leased Property
Contains an agreement for the rental to be paid and time and
manner of such payment
State the term of the lease
LEASED FEE OR LESSORS INTEREST
Basic Lease Provisions
Date of agreement and parties to the lease;
Description of the leased premises;
Uses allowed for the property;
Commencement date and length of time of the lease;
Payment amount or method of calculation of rent;
Responsibility for expenses
RPT
Insurance
Utilities
CAM
Management

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LEASED FEE OR LESSORS INTEREST
Basic Lease Provisions (contd)

Method of handling of delinquent payments

Records and books of accounts
Alterations or improvement restrictions
Restrictions on the operations of the tenants business
Restriction on assignment or subletting
Use of common areas and facilities
Responsibility for maintenance of tenant Space
Conditions for surrender of premises
Rules and regulations
Liability Insurance
Indemnification of land lord

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LEASED FEE OR LESSORS INTEREST
Basic Lease Provisions (contd)

Remedies in the event of total or partial destruction

Rights in the event of condemnation
Right of entry
Responsibility for legal expense
Statement that the lease represents the entire agreement
Requirement for any notices
Future options in the lease
Subordination and partial invalidity of the lease

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LEASEHOLD OR LESSEES INTEREST

The ownership interest that is created by the terms of a

lease
The lease interest is subject to the terms of a specific
lease arrangement, expires within a specified time, and
may be capable of subdivision, or subleasing to other
parties
In operating lease, the value of the Lessees Interest is
estimated as the value of rental gain/(loss), if any, and
the value of the leasehold improvement/s, if any
In financial lease, the value of the Lessees Interest is
estimated as market value of the property less the
remaining lease payments.
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SUBLEASEHOLD POSITION

Normally, a tenant is free to sublease all or part of a

property, but many leases require that the lessors
consent be obtained.
Sublease an agreement in which the lessee in a
prior lease conveys to a third party the same interest
that the lessee enjoys (the right of use and
occupancy), but for a shorter term than that of the
lessee.
Assignment a written transfer by the lessee of the
entirety of interests the lessee enjoys in the
property (the right of use and occupancy) to be held
by another legal entity or to be used for the benefit
of creditors
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SUBORDINATE SUBLEASE

A leasing arrangement in which an entity leases

property from one party and leases that same
property to another party.
In this arrangement, the entity is both a lessee and a
lessor, so it both pays and collects rent on the same
property.

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TYPES OF LEASES

Flat rental lease - specifies a level of rent that

continues throughout the duration of the lease
Graduated rental lease provide for specified
changes in the amount of rent at one or more
points during the lease term
Step-up lease allows for smaller rent payments in the
early years
Step-down leases less common than step-up leases
Revaluation lease provide for periodic rent
adjustments based on revaluation of the real estate
under prevailing market conditions
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TYPES OF LEASES

Index lease generally long term leases that provide

for periodic rent adjustment based on the change in a
specific index, such as nationally published, cost-of-
living index. The Consumer Price Index (CPI) is
frequently the index selected.
Percentage lease in which some or all of the rent
charged is based on a specified percentage of the
volume of business, productivity, or use achieved by
the tenant
A straight percentage lease may have no minimum rent,
but most specify a guaranteed minimum rent and an
overage rent (a percentage to be paid on sales that
exceeds a specified level, known as breakpoint). 19
TYPES OF RENT

Market Rent
The estimated amount for which a property, or space within
a property, should lease on the date of valuation between a
willing lessor and a willing lessee on appropriate lease
terms in an arms-length transaction, after proper
marketing wherein the parties had each acted
knowledgeably, prudently, and without compulsion

Contract Rent, or Passing Rent

The rent specified by a given lease arrangement; although a
given contract rent may equate to the Market Rent, in
practice they may differ substantially, particularly for older
leases with fixed rental terms.
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TYPES OF RENT

Turnover Rent or Participation Rent.

Any form of lease rental arrangement in which the lessor
receives a form of rental that is based on the earnings of
the lessee. Percentage rent is an example of a turnover
rent.
Excess Rent
The amount by which contract rent exceeds market rent

CR>MR
Any value ascribed to the excess rent must be identified as
attributable to the contract, not the market value of the real
estate itself
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TYPES OF RENT
Deficit Rent
The amount by which market rent exceeds contract rent at the time of the
appraisal

MR>CR
Effective Rent
Total of base rent, or minimum rent stipulated in a lease, over the specified
lease term less rental concessions such as free rent, above standard tenant
improvements, moving allowances, lease buyouts, cash allowances and other
leasing incentives

Overage rent
Percentage rent paid over and above the guaranteed minimum rent or base
rent

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RENTAL PAYMENTS

Gross lease - a lease in which the landlord receives

stipulated rent and is obligated to pay all or most of
the operating expenses and real estate taxes
Modified gross lease a lease in which the
landlord and tenant share the expenses according
to the proportions specified by the lease
Net lease a lease in which the tenant pays all or
most of the property charges in addition to the
stipulated rent

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OPERATING LEASE VS FINANCING LEASE

An operating lease is a lease whose term is short compared

to the useful life of the asset or piece of equipment being
leased.
SIMPLY PUT: rent expense to lessee and rent income to lessor

At the end of an operating lease, the lessee has several

possibilities:
Pursuit of the lease
Return of the equipment
Renewal of equipment
Restoration of equipment
Purchase of equipment at their market value

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OPERATING LEASE VS FINANCING LEASE

A finance lease or capital lease is a type of lease. It is

a commercial arrangement where:
the lessor will recover a large part or all of the cost of the
asset plus earn interest from the rentals paid by the lessee;
the lessee has the option to acquire ownership of the asset
(e.g. paying the last rental, or bargain option purchase
price);
A finance lease is a lease that is primarily a method of
raising finance to pay for assets, rather than a genuine
rental.

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OPERATING LEASE VS FINANCING LEASE

The key difference between a finance lease and an

operating lease is whether the lessor (the legal owner
who rents out the assets) or lessee (who uses the
asset) takes on the risks of ownership of the leased
assets.
The classification of a lease (as an operating or
finance lease) also affects how it is reported in the
accounts.

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OPERATING LEASE VS FINANCING LEASE

While financial lease is a long term

arrangement between the lessee (user of the
asset) and the owner of the asset, whereas
operating lease is a relatively short term
arrangement between the lessee and the
owner of asset.

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OPERATING LEASE VS FINANCING LEASE

Under financial lease all expenses such as

taxes, insurance are paid by the lessee while
under operating lease all expenses are paid by
the owner of the asset.
The lease term under financial lease covers the
entire economic life of the asset which is not
the case under operating lease.

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OPERATING LEASE VS FINANCING LEASE

Under financial lease the lessee cannot

terminate or end the lease unless otherwise
provided in the contract which is not the case
with operating lease where lessee can end the
lease anytime before expiration date of lease.
While the rent which is paid by the lessee
under financial lease is enough to fully
amortize the asset, which is not the case under
operating lease.
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TYPES OF LEASEHOLD INTEREST

Positive Leasehold Interest

A positive leasehold is created when the market rent is
greater than the contract rent.
Negative Leasehold Interest
Negative leasehold interest is created when the contract rent
is higher than the current market rent.
Even if the leasehold interest is positive, there may be no
value because the leasehold interest is not transferable to a
third party. The lease agreement may prevent a transfer.
If the contract rent and the market rent are equal, the
Leasehold or Lessees Interest is zero, assuming there is no
leasehold improvements. 30
VALUATION OF LEASE INTERESTS -
CONSIDERATIONS
Leasehold or Lease interests are valued on the same
general principles as freeholds, but with recognition
of the differences created by the lease contract
encumbering the freehold interest, which may cause
the interest to be unmarketable or restricted.
Leasehold or Lease interests, in particular, are often
subject to restrictive covenants or alienation
provisions.

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VALUATION OF LEASE INTERESTS -
CONSIDERATIONS
The importance of the distinction between the physical
matter and the legal interest in it is critical to valuation.

For example, a lease might specify that the lessee has no

right to sell or transfer the leasehold interest, causing it to
be unmarketable during the term of the lease.

Its value to the lessee, therefore, lies solely in the rights

of use and occupancy. The leasehold value may be
expressed in monetary terms but is not a Market Value as
the interest cannot be sold in the market.

32
VALUATION OF LEASE INTERESTS -
CONSIDERATIONS
However, the lessors interest (leased fee value) does
have a Market Value, based on the value of the rental
income during the lease together with any residual
value remaining at the end of the lease.

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VALUATION OF LEASE INTERESTS
METHOD OF VALUATION
The valuation of a lease interest is anchored on the economic
principle of anticipation. Value is created by the future benefits
(income stream) of ownership (whole or partial).

The income capitalization approach is based on the same

principle. The approach perceives value as created by the
expectation of future benefits (income streams).

Income capitalization employs processes that consider the

present value of anticipated future income benefits.

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VALUATION OF LEASE INTERESTS
METHOD OF VALUATION
The approach considers income and expense data relating to
the property being valued and estimates value through a
capitalization process.

Capitalization relates income (usually a net income figure) and

a defined value type by converting an income amount into a
value estimate.

This process may consider direct relationships (known as

capitalization rates), yield or discount rates (reflecting
measures of return on investment), or both.

Basic Formula: Value = Income / Rate

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VALUATION OF LEASE INTERESTS
METHOD OF VALUATION
One of the accepted methodologies within the income
capitalization approach to valuation is the Discounted Cash
Flow (DCF) analysis.

Discounted Cash Flow (DCF) analysis is a financial modeling

technique based on explicit assumptions regarding the
prospective income and expenses of a property or business.

Such assumptions pertain to the quantity, quality, variability,

timing, and duration of inflows and outflows that are
discounted to present value.

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VALUATION OF LEASE INTERESTS
Income Approach Discounted Cash Flow

0 1 2 3 4 5 6
PV1
+ pwf x I 1
I1
PV2
+ pwf x I 2
I2
PV3
+ pwf x I 3 I3
PV4
+ pwf x I 4 I4
PV5

+ pwf x I5

RV
= pwf x RV pwf x I6

MV Reversion Value
(end of period)

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VALUATION OF LEASE INTERESTS
EXAMPLE

Mr. Lessor owns a property consisting of a parcel of

land leased to Mr. Lessee at an annual lease of
P100,000. The lease which is about to commence is
for 5 years. The lease is payable at the end of each
year. Based on market data, the capitalization rate for
similar properties is 8% per year. The market value of
the property at the end of the lease is estimated at
P1,500,000. Determine the LESSORS Interest.

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VALUATION OF LEASE INTERESTS
EXAMPLE

Given Data:
Rental Rate is P100,000 per year
Lease Period is 5 years
Capitalization Rate is 8% per year
Value of Property at the end of Lease is P1,500,000

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 CASH FLOW DIAGRAM:

LESSORS INTEREST = NET PRESENT VALUE (NPV) OF RENTALS + REVERSION VALUE OF PROPERTY
0 1 2 3 4 5
I1
P10,000 x NPV factor

P10,000 x NPV factor

I2

I3
P10,000 x NPV factor

I4 I5
P10,000 x NPV factor

P10,000 x NPV factor

P1,500,000 x NPV factor

 VALUATION OF LEASE INTERESTS
COMPUTATION
A. Net Present Value of Rental
Year Rental NPV Factor NPV Rounded
1 100,000.00 0.9259 92,592.59 92,590.00
2 100,000.00 0.8573 85,733.88 85,730.00
3 100,000.00 0.7938 79,383.22 79,380.00
4 100,000.00 0.7350 73,502.99 73,500.00
5 100,000.00 0.6806 68,058.32 68,060.00
399,260.00
Factor = 1/(1+ i) n

B. Reversion Value
Year MV End of the Lease
5 1,500,000.00 0.6806 1,020,874.80 1,020,900.00

Lessor's Interest 1,420,160.00

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 VALUATION OF LEASE INTERESTS
COMPUTATION

C = 100,000.00
i = 8%
n = 5

PV factor = 1 - (1+i) -n
C = Cash flow per period
i
i = interest rate
= 1-(1.08) -5
n = number of payments
0.08
= 0.319416803
0.08
= 3.992710037
PV = 399,271.00

Reversion Value 1,020,900.00

Lessed Fee = 1,420,171.00

SUMMARY OF INCOMES AND REVERSIONS ASSOCIATED
WITH VARIOUS REAL PROPERTY INTERESTS

Real Property Interest Income Reversion

Fee simple Net operating income Net proceeds of resale
Leased fee Net operating income Property reversion or net
based on contract rents proceeds of resale of
leased fee estate
Leasehold Rental advantage when None if held to end of
contract rent is below lease or net proceeds of
market rent; rental resale of leasehold estate
disadvantage when
contract rent is above
market rent

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VALUATION OF LEASE INTERESTS
EXAMPLE
Corp. A owns an industrial land and leases it to Corp. B. The
lease is for 10 years and commenced in 2008. Corp. B built a
warehouse on the land and as stipulated on the lease
agreement, the warehouse will be turned over to Corp. A upon
the expiration of the lease. The starting rental rate is P80,000
per year and is subject to an increase of P5,000 per year
henceforth. Based on market data the capitalization rate of
similar properties is 6% per annum. The value of the land and
the building are estimated at P2,000,000 and P1,500,000,
respectively, at the end of the lease. The rentals are payable at
the start of every year. Determine the Lessors Interest.

44
VALUATION OF LEASE INTERESTS
EXAMPLE
Given Data:
Date of Appraisal is 2010
Lessor is Corp. A
Lease Period is 10 years
Remaining Lease Period is 8 years
Rental Rate is P80,000 per annum subject to increase payable
at the start of the year
Capitzalization Rate is 6% per annum
Value of Land at the end of the Lease is P2,000,000
Value of the Building at the end of the Lease is P1,500,000

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VALUATION OF LEASE INTERESTS
COMPUTATION
Lessor's Interest = Net Present Value (NPV) of Rentals + Reversion Value
of Land + Reversion Value of Building
Year per Lease
Year Agreement Rental per annum NPV Factor NPV Rounded
2008 1 80,000.00 Paid -
2009 2 85,000.00 Paid - -
2010 3 90,000.00 Paid - -
2011 4 95,000.00 Paid - -
2012 5 100,000.00 0.9434 94,339.62 94,340.00
2013 6 105,000.00 0.8900 93,449.63 93,450.00
2014 7 110,000.00 0.8396 92,358.12 92,360.00
2015 8 115,000.00 0.7921 91,090.77 91,090.00
2016 9 120,000.00 0.7473 89,670.98 89,670.00
2017 10 125,000.00 0.7050 88,120.07 88,120.00
549,030.00
Factor = 1/(1+ i) n

B. Reversion Value of Land

Year MV End of the Lease
10 2,000,000.00 0.7050 1,409,921.08 1,409,900.00

C. Reversion Value of Building

10 1,500,000.00 0.7050 1,057,440.81 1,057,400.00

Lessor's Interest 3,016,330.00

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 VALUATION OF LEASE INTERESTS
EXAMPLE
Corp. C leases an office condominium unit in Makati.
The lease is for 8 years and will commence on
January, 2012. Monthly rental is P20,000 payable on
the first day of every month. Based on market data,
the prevailing rental rate for condominium units is
P25,000, and the capitalization rate is 6% per annum.
The unit is fully-furnished complete with telephone
lines and air-conditioning system. Determine the
Lessees Interest.

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VALUATION OF LEASE INTERESTS
EXAMPLE

Given Data:
Lease Period is 8 years
Contract Rate is P20,000 per month
Market Rent is P25,000 per month
Rental Gain is P5,000 per month or P60,000 per year
Capitalization Rate is 6% per year

48
 VALUATION OF LEASE INTERESTS
COMPUTATION
Lessee's Interest = Net Present Value (NPV) of Rental Gain

Year per Lease Rental Gain per

Agreement Annum NPV Factor NPV Rounded
1 60,000.00 0.9434 56,603.77 56,604.00
2 60,000.00 0.8900 53,399.79 53,400.00
3 60,000.00 0.8396 50,377.16 50,377.00
4 60,000.00 0.7921 47,525.62 47,526.00
5 60,000.00 0.7473 44,835.49 44,835.00
6 60,000.00 0.7050 42,297.63 42,298.00
7 60,000.00 0.6651 39,903.43 39,903.00
8 60,000.00 0.6274 37,644.74 37,645.00
Lessee's Interest 372,588.00
-
Factor = 1/(1+ i) n

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 VALUATION OF LEASE INTERESTS
EXAMPLE
Corp. D is leasing a parcel of land in an industrial
subdivision is Laguna for 20 years. The lease started in
2005. The rental rate is P1,000,000 per year. Corp. D
constructed buildings of the land but the buildings
will be turned over to the land owner upon expiration
of the lease contract. As of the data of appraisal,
2010, the value of the buildings is estimated at
P8,500,000, the prevailing capitalization rate is 6%,
the prevailing rental rate for similar land is
P1,200,000, and the remaining life of the buildings is
35 years. Determine the Lesees Interest.
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 VALUATION OF LEASE INTERESTS
EXAMPLE
Given Data:
Appraisal date is 2010
Lease Period is 20 years
Remaining Life of Lease Contract is 15 years
Contract Life Ratio is 15 years / 20 years or 75%
Capitalization Rate is 6%
Contract Rent is P1,000,000 per year
Market Rent is P1,200,000 per year
Rental Gain is P200,000 per year
Value of Buildings is P8,500,000

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 VALUATION OF LEASE INTERESTS
COMPUTATION
Lessee's Interest = Net Present Value (NPV) of Rental Gain + Leasehold Value of Improvements (Building)

A. Present Worth of Rental Gain

Rental Gain per
Annum NPV Factor NPV Rounded
200,000.00 9.7122 1,942,440.00 1,942,440.00

B. Leasehold Value of Improvements

Value of
Buildings Contract Life Factor
8,500,000.00 0.7500 6,375,000.00 6,375,000.00

Lessee's Interest 8,317,440.00

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 VALUATION OF LEASE INTERESTS (SANDWICH AND
SUBLEASEHOLD INTERESTS)- EXAMPLE

Given Data:
Appraisal date is current
Rent specified in the base lease P600,000 per year
Rent specified in the sublease P650,000 per year
Rent obtainable in the market P700,000 per year
Lease terms (sandwich and subleasehold positions) 20 years
Discount rates:
Sandwich leasehold position 13%
Subleasehold position 18%

53
VALUATION OF LEASE INTERESTS (SANDWICH LEASEHOLD
INTERESTS)- COMPUTATION

Procedure for valuing the sandwich leasehold position:

Advantage to sandwich leasehold

Rent received under sublease 650,000.00
Rent paid to leased fee 600,000.00
Advantage 50,000.00
Present value of initial payment 1,000.00 50,000.00
Present value of additional 19 payments =
at 13% for 19 payments
Factor = 6.937969
Multiply 50,000 by the factor 346,898.45
Add present value of initial payment
and present value of additional 19
payments 396,898.45
Present value of sandwich leasehold Say 396,900.00
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VALUATION OF LEASE INTERESTS
(SUBLEASEHOLD INTERESTS)- COMPUTATION
Procedure for valuing the subleasehold position:

Advantage to subleasehold
Market rent 700,000.00
Rent paid under sublease 650,000.00
Advantage 50,000.00
Present value of initial payment 1,000.00 50,000.00
Present value of additional 19 payments =
at 18% for 19 payments
Factor = 5.316241
Multiply 50,000 by the factor 265,812.71
Add present value of initial payment
and present value of additional 19
payments 315,812.71
Present value of subleasehold Say 315,800.00
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