Alternative Valuation Methods for Leasehold Properties

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Published in Spring 1986 Issue

The Real Estate Appraiser & Analyst

Society of Real Estate Appraisers

By Tony Sevelka, AACI, SREA, MAI, CRE

Introduction

The case study presented in this article pertains to the appraisal of an actual strip plaza

subject to a ground lease. Included is the traditional Income Approach, which is used

primarily to test the reliability of the value estimate employing a modified method of

the Direct Sales Comparison Approach normally considered inappropriate for

properties on ground leases. As an additional check against the value estimate, an

Investment Analysis reflecting the anticipated economic performance of the property

has been prepared to correspond with the remaining term of the ground lease.

The subject property, built in 1967, is a small, basementless strip plaza containing

three commercial units and situated on a 0.507 acre parcel of land held under a ground

lease. The effective date of appraisal is July 1, 1985 and the ground lease expires in 13

years and 9 months, on March 31, 1999. During the remaining term of the ground lease,

the Head Lessee is entitled to the revenue generated from the three commercial sub-

lessees, and is responsible for the payment of ground rent. Consequently, the

leasehold interest is represented by the value of the difference in the income collected

from the subtenants and the ground rent paid by the Head Lessee to the owner of the

site until the expiry of the ground lease on March 31, 1999. Particulars of the ground

lease and commercial subleases are detailed as follows:

Ground Lease Particulars

Remaining term as at 1-Jul-85: 13 years and 9 months

Expiry Date: March 31, 1999

Ground Rent: 1) 1-Apr-84 – 31-Mar-89: $29,160 p.a.

($2,430 payable monthly, in advance)

2) 1-Apr-89 – 31-Mar-94: $34,020 p.a.

($2,835 payable monthly, in advance)

3) 1-Apr-94 – 31-Mar-99: $38,880 p.a.

($3,240 payable monthly, in advance)

Subsequently merged with the American Institute of Real Estate Appraisers to form The Appraisal

Institute.

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Schedule of Leases

Area Rent Annual Monthly

Tenant Lease Term (SF) PSF Rent Rental

A 1-Oct-79 – 30-Sep-84 2,186 $11.00 $24,046.00 $2,003.83

1-Oct-84 – 30-Sep-89 $12.10 $26,450.00 $2,204.21

B 1-Mar-83 – 30-Nov-84 1,390 $12.00 $16,680.00 $1,390.00

1-Dec-84 – 30-Nov-89 $13.20 $18,348.00 $1,529.00

1-Dec-89 – 30-Nov-94 $14.52 $20,182.00 $1,681.90

1-Dec-94 – 31-Mar-99 $15.97 $22,198.30 $1,849.85

C 1-Aug-82 – 31-Dec-84 1,210 $12.00 $14,520.00 $1,210.00

1-Jan-85 – 31-Mar-99 $13.00 $15,730.00 $1,310.84

Indicates current income (current income totals $60,528.00)

Income Approach

All three units are currently under lease or sublease as detailed on the Schedule of Leases

chart. As an income-producing property, its value is a direct function of the amount of

revenue that the commercial space can generate. Accordingly, the Income Approach –

with its focus on potential earnings, the costs required to maintain those earnings and

investor yield expectations – is an appropriate method of valuation.

As an integral part of the valuation process, numerous steps have been followed in

determining the anticipated economic performance of the property. Included are the

following:

1. All available leases have been examined and the essential details noted.

2. Although the property is fully leased, an ongoing allowance of 3.0 percent

against unexpected vacancies, including bad debt, has been projected.

3. Anticipated realty taxes and common area maintenance charges, including

administrative fees, for the ensuing year ending June 30, 1986, have been

estimated.

4. Administrative fees attributable to the Tenant A space are the only non-

recoverable expenses and have been calculated as $1,511.

5. Rental payments from the Head lessee to the owner have been included as

ground rent.

Lease Income

As currently leased, the income from the property for the upcoming year, commencing

July 1, 1985 and ending June 30, 1986, will be:

Tenant Area (sf) Annual Income

A 2,186 $26,450

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B 1,390 18,348

C 1,210 15,730

Total 4,786 $60,528

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Vacancy & Bad Debt

Presently, the strip plaza is fully leased. However, as a provision against future

vacancies, including bad debt, $1,816, equivalent to 3.0 percent of the lease income, has

been set aside.

Non-Recoverable Expenses

Non-recoverable expenses have been calculated to be $1,511, based on the projected

common area maintenance charges, realty taxes and administrative fees.

The non-payment of administrative fees in the Tenant A lease amounts to $1,511, in

non-recoverable expenses, computed as follows:

2,186 sf x $3,308 = $1,511

4,786 sf

Structural Repair

An allowance of $605, which is equivalent to 1.0 percent of the lease income, has been

set aside for structural repairs.

Ground Rent

Ground rent payments are as follows:

1) 1-Apr-84 – 31-Mar-89: $29,160 p.a. ($2,430 payable monthly, in advance)

2) 1-Apr-89 – 31-Mar-94: $34,020 p.a. ($2,835 payable monthly, in advance)

3) 1-Apr-94 – 31-Mar-99: $38,880 p.a. ($3,240 payable monthly, in advance)

As of July 1, 1985, the remaining term of the ground lease is 13 years and 9 months

and the current annual rental payment is $29,160.

Reconstructed Operating Statement

The preceding income and expense items are summarized as follows:

Tenant A 2,186 sf $26,450

Tenant B 1,390 sf 18,348

Tenant C 1,210 sf 15,730

Sub-total 4,786 sf $60,528

Less: Vacancy & Bad Debt (3.0%) $1,816

Non-recoverable Expenses 1,511

Structural Repair (1.0%) 605

3,932

Net Income (before payment of ground rent) $56,596

Less: Ground Rent 29,160

Net Income $27,436

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Overall Capitalization Rate

Recorded on the “Capitalization Rate Analysis” chart are nine strip plaza transactions

located in the City of Scarborough and the Borough of East York. The overall

capitalization rates range from 8.36 percent to 11.61 percent and provide an indication

of the returns available from similar investments.

Capitalization Rate Analysis Chart

Sale Lot Area GLA Net Price Income Overall

No. Sale Date (ac±) (sf±) Income Consideration PSF PSF Cap. Rate

1 31-Jul-81 0.696 12,130 $72,800 $750,000 $61.83 $6.00 9.71%

2 25-Mar-82 0.668 11,560 $141,400 $1,340,000 $115.92 $12.23 10.55%

3 31-Dec-82 1.083 8,560 $121,220 $1,150,000 $134.35 $14.16 10.54%

4 8-Aug-83 0.704 7,400 $90,000 $1,050,000 $141.89 $12.16 8.57%

5 16-Aug-83 0.459 7,700 $116,220 $1,040,000 $135.06 $15.09 11.18%

6 27-Apr-84 0.898 15,715 $69,000 $825,000 $52.50 $4.39 8.36%

7 13-Sep-84 0.696 12,130 $81,240 $700,000 $57.71 $6.70 11.61%

8 11-Feb-85 0.696 12,130 $81,240 $770,000 $63.48 $6.70 10.55%

9 May-85 0.085 4,300 $32,000 $350,000 $81.40 $7.44 9.14%

Considering the age and condition of the improvements, including the limited

potential for income growth and capital appreciation, an annual return of 11.0 percent

would be required to attract prospective purchasers/investors to the subject property.

The duration of the income stream under the ground lease is 13 years and 9 months and

the equivalent factor for 11.0 percent is 6.926116.

Capitalized Value of Income Stream

Present Worth of $27,436 per annum

for 13 years 9 months Discounted @ 11.0% $190,025

($27,436 x 6.926116 = $190,025) Say $190,000

Direct Sales Comparison Approach

Due to the limited holding period of the investment (13 years and 9 months), it is

difficult to make direct comparisons between similar properties that have recently sold

under freehold ownership. As an investment, it has been concluded that in order to

attract capital to the subject property, given its restrictive leasehold investment

opportunities and the aging nature of the improvements, an overall return of 11.0

percent would be required.

At 11.0 percent, the factor for 13 years and 9 months is 6.926116 and in perpetuity

the factor is 9.090909. Therefore, the holding of an investment for a duration of 13 years

and 9 months at 11.0 percent, expressed as a ratio or percentage in relation to the

holding of a property in perpetuity, is 76.19 percent, calculated as follows:

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13 year 9 month factor @ 11.0% = 6.926116

Factor in perpetuity @ 11.0% = 9.090909 = 0.7619 or 76.19%

In other words, the holding of an investment for a duration of 13 years and 9 months

at 11.0 percent is equivalent to 76.19 percent of the value of the same property held

indefinitely.

The nine strip plazas analyzed are summarized as follows in ascending order of

income per square foot and the corresponding price per square foot of building is

shown.

Sale No. Date of Sale Income PSF Price PSF of Building

6 Apr-84 $4.39 $52.50

1 Jul-81 $6.00 $61.83

7 Sep-84 $6.70 $57.71

8 Feb-85 $6.70 $63.48

9 May-85 $7.44 $81.40

4 Aug-83 $12.16 $141.89

2 Mar-82 $12.23 $115.92

3 Dec-82 $14.16 $134.35

5 Aug-83 $15.09 $135.06

It is apparent that as the income per square foot increases, there is a corresponding

increase in the value per square foot of building area. During the upcoming year, the

subject property will generate $27,436 in net income or $5.73 psf. Superimposing the

rental rate on the previous chart indicates a value of approximately $55.00 psf of

building if the ownership of the subject property were freehold.

As previously stated, the holding of the subject property for 13 years and 9 months

is equivalent to 76.19 percent of the freehold value, i.e., holding in perpetuity, at 11.0

percent. If the price per square foot of building for each comparable is divided by the

corresponding income per square foot, and if the result is multiplied by the income per

square foot generated by the subject property, adjusted by 76.19 percent, it is possible

to develop indications of value for the subject property, shown as follows.

Subject Percentage Adjusted

Sale Price PSF ÷ Income PSF x Income PSF x Adjustment = Price PSF

No. of Building of Building of Building (76.19%) of Building

1 $61.83 $6.00 $5.73 0.7619 $44.99

2 $115.92 $12.23 $5.73 0.7619 $41.38

3 $134.35 $14.16 $5.73 0.7619 $41.42

4 $141.89 $12.16 $5.73 0.7619 $50.94

5 $135.06 $15.09 $5.73 0.7619 $39.07

6 $52.50 $4.39 $5.73 0.7619 $52.21

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7 $57.71 $6.70 $5.73 0.7619 $37.60

8 $63.48 $6.70 $5.73 0.7619 $41.36

9 $81.40 $7.44 $5.73 0.7619 $47.76

The adjusted price per square foot of building ranges from $37.60 to $52.21.

Statistically, the following values are indicated:

Mean$44.08 psf of building

Median: $41.42 psf of building

The unit rate of $41.42 psf of building, representing the median value, is considered

the most reliable as it eliminates the extremes of both ends of the range. Therefore, the

value of the leasehold interest is $198,000, calculated as follows,

Building Area Rate PSF Value Estimate

4,786 sf @ $41.42 = $198,236

Say $198,000

Investment Analysis

As a check against the value estimates, a 13 year and 9 month income and expense

forecast has been prepared. The following assumptions are contained in the forecast:

1. Rents paid by the tenants will continue throughout the term of each lease.

2. Tenant A will exercise both renewal options at the prescribed rental rates of $13.30

psf commencing 1-Oct-89 and $14.60 psf commencing 1-Oct-94.

3. The 1,390 square feet occupied by Tenant B will be re-leased at five year intervals at

$14.30 psf commencing 1-Dec-89 and $15.73 psf commencing 1-Dec-94.

4. Vacancy and bad debt will amount to 3.0 percent of the annual income throughout

the forecast.

5. Non-recoverable expenses of $1,511 will escalate 5.0%, simple interest, annually.

6. Structural repair will represent 1.0 percent of the annual income collected in each

year.

7. The Head Lessee will make annual ground rental payments of $29,160 until 31-Mar-

89; $34,020 until 31-Mar-94; and $38,880 until 31-Mar-99 when the ground lease

expires.

8. 14.0 percent is an adequate investment return.

Present Value of Income Discounted @ 14.0%

Year 1 $27,436 $ 24,067

Year 2 $27,360 21,053

Year 3 $27,284 18,416

Year 4 $25,993 15,390

Year 5 $26,069 13,539

Year 6 $27,985 12,750

Year 7 $27,909 11,153

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Year 8 $27,833 9,757

Year 9 $26,542 8,162

Year 10 $26,965 7,274

Year 11 $29,071 6,879

Year 12 $28,995 6,018

Year 13 $28,919 5,265

Year 14 (9 months) $21,632 3,570

Net Present Value $163,293

Say $163,000

Summary

Value by Income Approach: $190,000

Value by Direct Sales Comparison Approach: $198,000

Both approaches provide similar indications of value and the Investment Analysis

at $163,000 tends generally to support the value estimate.

The application of the Income Approach and the Direct Sales Comparison

Approach, in its modified version, illustrates that the two valuation techniques are not

mutually exclusive and that there is a definite correlation between the level of income

and the price per square foot of building. Furthermore, it has been demonstrated that

the sales prices of the comparable properties, held under freehold ownership,

expressed as rates per square foot of building area, are synonymous with the net

incomes per square foot capitalized in perpetuity at appropriate rates. Given the

relationship between the two units of comparison, it is possible to employ the Direct

Sales Comparison Approach in the valuation of leased properties.

Once an appropriate rate of return is established, it is possible to cross over from

the Income Approach to the Direct Sales Comparison Approach as a means of valuing

leasehold interests. As shown, the holding of the subject property for 13 years and 9

months at 11.0 percent represents a factor of 6.926116 compared to a factor of 9.090909 at

11.0 percent in perpetuity. This means that the holding of the investment for 13 years

and 9 months represents 76.19 percent of the property’s value if held indefinitely,

calculated as follows:

6.926116 = 0.7619 or 76.19%

9.090909

After adjustment of the comparable properties by rent level in the Direct Sales

Comparison Approach, it is simply a matter of calculating the rate per square foot of

building at 76.19 percent of the freehold value, to correspond with the duration of the

holding period of the investment.