Cap Rates: Leasehold vs. Lease Fee

[barcelona]

What kind of spread should there be between a Leasehold valuation and a Lease Fee valuation for the SAME property.

Looking for input on valution of an improved commercial property under two scenarios:

1. Leasehold Estate on a commercial property subject to a long-term ground lease with 25 years remaining on the ground lease.

2. Leased Fee Estate (same property but client wants to assume land and improvements are owned outright subject to normal leases).

Property is well located and fully leased.

Thanks for any input.

I have heard other appraisers say a 50 to 75 basis point spread is a good rule of thumb but I have not heard why or how to arrive at such a conclusion.

Thanks!!!!

 

[Lost Cause]

I have not heard why to arrive at such a conclusion.

As far as why there might be a spread between the two, generally, a leasehold is riskier than the fee position.

What spread is appropriate, if any, will depend. There are numerous variables that impact the risks of each position. Some include the terms of the lease itself, the relative strength of the feeholder vs the leaseholder, and the prevalence of leaseholds in your market.

 

[Howard Klahr]

What are the differences between the contract terms and market derived terms? Until this is known any response would be pure speculation. Also, how is the reversion treated?

 

[barcelona]

What are the differences between the contract terms and market derived terms? Until this is known any response would be pure speculation. Also, how is the reversion treated?

Market rent and contract rent are basically at par. Leases are written on three year terms (for most tenants).

The DCF analysis uses NO reversion and just discounts the cash flows over the 25 year remaining on the ground lease.

For the direct capitalization, I have sale comps which are leased fee more or less at market rent. So presumably implicit in those cap rates there is the future benefit of reversion.

 

[Howard Klahr]

Market rent and contract rent are basically at par. Leases are written on three year terms (for most tenants).

Not for the tenants occupying the propery, the terms for the land lease.

You are looking to value the leasehold vs the leased fee of the tenant to the land lease, correct? Any differential in cap rates would be due to above/below market terms and anticipated growth rates for land values as compared to rental rates (of land leases) during the remaining lease term.

 

[Vernon Martin]

Appraising a leasehold interest on a ground lease

It is hard enough to find leasehold comps, but then you have to adjust cap rates for remaining lease term and any unique tenancy situations, such as leases at above or below-market rents. Considering that cap rates vary with remaining economic life, which can differ dramatically in leasehold situations. I once was asked by a lender to appraise a leasehold interest with only one year remaining. My response: Don't even consider this for collateral.

Rather than use direct capitalization, I prefer to use a DCF model with no reversion, and I think that is the way investors would look at it.

Irvine Company?

 

[barcelona]

Not for the tenants occupying the propery, the terms for the land lease.

You are looking to value the leasehold vs the leased fee of the tenant to the land lease, correct? Any differential in cap rates would be due to above/below market terms and anticipated growth rates for land values as compared to rental rates (of land leases) during the remaining lease term.

I apologize for not being very clear.

My question(s) are:

What is the difference (or spread) between the capitalization rate for a "Leasehold Interest" and a "Leased Fee" interest for similar commercial properties?

In other words, I am appraising the "leasehold interest" of Building X but have cap rates for buildings A, B, and C which are all owned in "leased fee". I suspect that the cap rates for the comparables (A, B, and C) would be LOWER, all things being equal. The owners of the "leased fee" have a reversionary interest where as the "leasehold interest" does not (after the 25 year lease ends).

 

[George Hatch]

It is hard enough to find leasehold comps, but then you have to adjust cap rates for remaining lease term and any unique tenancy situations, such as leases at above or below-market rents. Rather than use direct capitalization, I prefer to use a DCF model with no reversion.

+1

I think that method better demonstrates the impact of rental payment increases and lease option renewals at different intervals, too. When they're present, that is.

 

[Pittsburgh Pete]

I apologize for not being very clear.

My question(s) are:

What is the difference (or spread) between the capitalization rate for a "Leasehold Interest" and a "Leased Fee" interest for similar commercial properties?

In other words, I am appraising the "leasehold interest" of Building X but have cap rates for buildings A, B, and C which are all owned in "leased fee". I suspect that the cap rates for the comparbles (A, B, and C) would be LOWER, all thing being equal. The owners of the "leased fee" have a reversionary interest where as the "leasehold interest" does not (after the 25 year lease ends).

Therein lies the answer to your question--direct cap is inappropriate for valuing the leasehold. Think discount rate as suggested by Mr. Vernon.

 

[barcelona]

It is hard enough to find leasehold comps, but then you have to adjust cap rates for remaining lease term and any unique tenancy situations, such as leases at above or below-market rents. Rather than use direct capitalization, I prefer to use a DCF model with no reversion.

Irvine Company?

Vernon: Yes, that is the method I am using: A DCF model with no reversion. The ground lease has 25 more years to go.

HOWEVER, as a check I am also doing a direct capitalzation as that is how most sales are reported. That is "leased fee" sales. I don't have ANY "leasehold interest" sale comps. The trick is trying to figure out how much higher the cap rate for the "leasehold interest" should be as compared to the "leased fee" sale comps.

By the way, this is not the Irvine Company. Location is in LA County.