The leasehold estate is the interest which a tenant or lessee acquires under a lease including rights of use and occupancy for a stated term under certain conditions (e.g., the payment of a premium and/or rent). Leasehold estates have different durations: such as, 25 years, 60 years, and 99 years, etc. (Appraisal Institute, The Dictionary of Real Estate Appraisal, 5th ed., 2010.) Leasehold estates present a unique and difficult assignment for real estate appraisers because there are numerous factors which can impact the valuation of the leasehold interests. Individuals who acquire leasehold interests and lenders who finance them each take on substantial risks, either in the acquisition of or in the financing of these transactions. In this issue, we take a look at some of the most important factors that affect the valuation of leasehold interests.
General Valuation Methodology
The valuation of a leasehold or a sandwich leasehold position is equal to the present value of the difference between the current market rental rates and the contract rents in accordance with the lease terms over the holding period. Ideally, comparable sales of similar interests should be analyzed. They generally do not exist and one must compare the current market rental rate and lease terms to the contract rental rate and lease terms. Over time, variations occur because market rents, tenant improvement costs, rental concessions and lease terms change based upon supply and demand factors.
Additional deductions are required to clearly indicate the potential cash flow to the leasehold position in the event that a specific property is subleased or a leasehold or sandwich leasehold position is sold. These additional charges include leasing or brokerage commissions and legal or closing costs, along with any potential tenant improvement costs that currently are being paid in the marketplace. These items affect the cash flow to the leasehold interest. Current leases, occupancy rates, concessions and other information must be analyzed. In addition, leasing agents must be contacted to obtain the competitive market rents for similar space in comparable locations.
Remember, at the end of the lease, there is no residual or reversionary value to the tenant that is similar to the reversion received by the landlord’s position or the leased fee estate. They get the property back. The leasehold interest has nothing at the expiration of the lease.
Positive or Negative Leasehold Interests
Believe it or not, not all leases have a positive leasehold interest. A positive leasehold is created when the market rent is greater than the contract rent. In the current market, many leases were negotiated in 2005 through 2007 and the contract rent is higher than the current market rent creating a negative leasehold interest. 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. There also might not be any demand. For example, in Manhattan, typical lease terms are a minimum of five years, often with options to renew. Who would want to acquire a leasehold interest that only has a remaining term of three years, unless it was for a temporary use?
Market Rent Analysis
The unit of comparison for each property is, typically, the rent per square foot of space. It may be based on usable space, net rentable area, gross floor area, etc. The following represents some of the adjustment factors that should be considered in analyzing the market rent of the comparables:
- Market conditions as of the date of lease
- Vacancy and credit loss
- Corner influence
- Physical characteristics, including size and below and above grade space
- Term of lease
- Rent escalations
- Expense reimbursements
- Use restrictions
- Age and condition of the building and tenant improvements.
Leases that were negotiated in 2005 through 2007 were negotiated in a landlord’s market and the current terms that are available for tenants are more favorable today. Therefore, tenants who are valuing their leasehold position may actually have a negative leasehold interest when all these factors are correctly analyzed.
A forecast is generally required to compare the expected cash flow to the leasehold position. Assumptions concerning future increases in rent, such as percentage rent, CPI, expenses, etc., are difficult and affect the potential risk, hence, the discount rate.
Discounted Cash Flow Analysis
This approach is a set of procedures in which the quantity, variability, timing and duration of the periodic income, as well as the quantity and timing of the reversion, if any, are modeled and discounted to the present value at a specified yield rate. Certain assumptions are critical to the analysis, such as the time required to locate a sub-tenant and rollover assumptions. In addition, the proper discount or yield rate must be selected which represents the total expected yield to the ownership position. The discount rate or the anticipated IRR for leasehold interests should be based on current market expectations and historical performance of similar investments, but there is no database available that provides this information or surveys that provide any benchmarks for guidance.
In this limited space, it is impossible to discuss all the issues that affect the valuation of leasehold interests in real property. We have tried to highlight some important issues to consider and point out the difficult issues that appraisers are confronted with in the valuation of leasehold interests. This is definitely not a science, but common sense and proper analysis can produce meaningful results to protect lenders and buyers of leasehold interests. Please feel free to leave comments on this subject and point out other issues that you deem to be important when many tenants are trying to sell their leasehold interest in or sublease the space that they occupy.