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Best Way To Value Leased House

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Jerry Lieb

Junior Member
Joined
Aug 14, 2004
Professional Status
Certified General Appraiser
State
California
Am appraising a single family residence in an established tract for estate purposes.

The subject is leased at market rate with 20 months remaining on the lease.

The area is primarily owner-occupied but there are a few rentals. The rentals are typically month to month. Cannot find any sales of leased houses in this neighborhood or surrounding neighborhoods. There are plenty of standard sales, so no problem with "comps". Just no comps of long-term leased houses.

How would you value this house?
 
I would do it based on sales comparables and include the income approach if you want but I would place the most weight on the sales comparison approach.
 
I thought this was a great valuation problem to discuss.

Your appraisal requires the "fair market value" definition. So I'm guessing this is for estate purposes. There isn't much material difference between "Fair Market Value", the GSE's definition of value, or the IAEG's definition of value. They can all be summed up as, "Based on who the likely buyer is, what would they pay for the property if they were knowledgeable and informed, without any undue pressure?"

The "Based on who the likely buyer is..." is important in your scenario.
The fact that you've been able to determine the contract rents are "market" indicates that while the predominant ownership may be owner-user, there is sufficient rentals to come up with a market rent estimate.

I spoke to Howard about your post and he pointed out the following:
If the rents are at market, in theory, there is no leasehold value, so the fair market value of the leased fee interest should be close to the fee simple interest.
I cannot argue with this.

However, I'll add the following:
A 20-month existing lease likely narrows the pool of owner-users significantly. Is an owner-user going to purchase the house and wait 20 months before they can occupy it? Maybe, but most won't.
Therefore, in the H&BU analysis, the potential of an investor being the likely buyer has to be explored.
If an investor is the likely buyer, then the income approach takes on more significance in the reconciliation process.

Your problem may be the lack of investor-to-investor sales within your market. If you had them, you could develop a GRM based on local data.
While many appraisers pro forma the GRM (they take owner-user sales, apply a market rent to them, and use that to calculate the GRM), in my opinion, that is a last-resort technique and should be supported by actual GRMs based on investor sales.
If this assignment were mine, I'd go to competing markets where I could find investor-to-investor sales and use the rents to calculate a GRM. After doing a number of these, I'll come up with a range (let's just say the range is 150 to 180). Then, you could pro forma owner-user sales with market rents to see what their indicated GRMs are. My "guess" is that it will be higher (if it were lower, investors, in theory, would start buying these homes and renting them out). Let's just say the pro forma range is 170 to 200.
You can see what we have here under this example: an intersection of the two data sets between 170 and 180. It would not be unreasonable to pick a GRM for the subject closer to the higher range, nor (IMO) unreasonable to go a bit (185?) higher.
Using the GRM, you can complete the income approach. Again, based on the data in the example, the sales comparison approach will likely conclude a value that is higher than the income approach (purists will argue that a GRM is not a true income-approach; they'd be correct but for residential work, it is a recognized technique).
If I believed the likely buyer of the property is an investor (given the lease terms), then I'd give more consideration to the income approach vs. the sales comparison approach. My final opinion of fair market value may be below the indicated range of the sales comparison approach.
Alternatively, if I believed that, despite the lease, an owner-user would compete for the property, I might give both approaches equal consideration (you get the picture).

One last thing for you to confirm (and Howard pointed this out to me): Is there a cancellation clause in the lease that is triggered upon the sale of the property? If so, and if this is an owner-user market for the subject, I'd still do the income approach but reconcile to the sales comparison approach.


I won't get into the technicalities of being sure to match the risk-profile of your subject with the comparable rentals you use to extract the GRMs; if this is for a simple estate assignment, then while you wouldn't want to compare a triplex GRMs to use for your SFR, I think you have flexibility in comparing SFRs with some differences in their risk profile to use for this assignment.

Good luck!
 
Last edited:
One other thing I forgot to bring up that Howard and I discussed:

20 months, in the big scheme of things, isn't that long. If there is a difference in value between owner-user and investor, it may be prudent to add in the discussion that the closer one gets to the expiration of the lease, the greater the likelihood of a shift in the potential buyer pool (from investor to owner-user); that shift could impact value.

That tells the entire story.

Good luck!
 
Some properties, such as higher priced housing in my market, have a predominance of owner occupants in part because the rents produce a return that is not adequate for investors. For example, a $25,000 house might rent for $500 per month (50 GRM), but a $500,000 house probably couldn't rent for more than $2,500-$3,000 per month (prices set by owner occupants would imply a 167-200 GRM). That doesn't tell the whole story, of course, but an investor has an array of options with a better return than a $500,000 house, at least from the perspective of buying and holding. In the case of the OP, it sounds like owner occupants are the predominant buyer-is that due to "typical" GRM and market rents implying a lower fee simple value through the ICA than that indicated by the sales comparison approach? In that case, the lease could be a drag on the value, even if the rents are above market, since the investors will require a lower entrance price than that suggested by the owner-occupied sales, while some owner occupants will not be willing to wait 20 months and will just keep looking for houses which they can move into earlier.

With the above said, the first thing that comes to mind is the tenant possibly being the most likely purchaser and they frequently buy based on the fee simple value, or structuring their rents to an RTO deal

Edit-I looked through each post but re-read Denis' post and just realized that the above said something nearly identical. Apologies
 
Last edited:
Denis DeSaix said:
I thought this was a great valuation problem to discuss.

Your appraisal requires the "fair market value" definition. So I'm guessing this is for estate purposes. There isn't much material difference between "Fair Market Value", the GSE's definition of value, or the IAEG's definition of value. They can all be summed up as, "Based on who the likely buyer is, what would they pay for the property if they were knowledgeable and informed, without any undue pressure?"

The "Based on who the likely buyer is..." is important in your scenario.
The fact that you've been able to determine the contract rents are "market" indicates that while the predominant ownership may be owner-user, there is sufficient rentals to come up with a market rent estimate.

I spoke to Howard about your post and he pointed out the following:
If the rents are at market, in theory, there is no leasehold value, so the fair market value of the leased fee interest should be close to the fee simple interest.
I cannot argue with this.

However, I'll add the following:
A 20-month existing lease likely narrows the pool of owner-users significantly. Is an owner-user going to purchase the house and wait 20 months before they can occupy it? Maybe, but most won't.
Therefore, in the H&BU analysis, the potential of an investor being the likely buyer has to be explored.
If an investor is the likely buyer, then the income approach takes on more significance in the reconciliation process.

Your problem may be the lack of investor-to-investor sales within your market. If you had them, you could develop a GRM based on local data.
While many appraisers pro forma the GRM (they take owner-user sales, apply a market rent to them, and use that to calculate the GRM), in my opinion, that is a last-resort technique and should be supported by actual GRMs based on investor sales.
If this assignment were mine, I'd go to competing markets where I could find investor-to-investor sales and use the rents to calculate a GRM. After doing a number of these, I'll come up with a range (let's just say the range is 150 to 180). Then, you could pro forma owner-user sales with market rents to see what their indicated GRMs are. My "guess" is that it will be higher (if it were lower, investors, in theory, would start buying these homes and renting them out). Let's just say the pro forma range is 170 to 200.
You can see what we have here under this example: an intersection of the two data sets between 170 and 180. It would not be unreasonable to pick a GRM for the subject closer to the higher range, nor (IMO) unreasonable to go a bit (185?) higher.
Using the GRM, you can complete the income approach. Again, based on the data in the example, the sales comparison approach will likely conclude a value that is higher than the income approach (purists will argue that a GRM is not a true income-approach; they'd be correct but for residential work, it is a recognized technique).
If I believed the likely buyer of the property is an investor (given the lease terms), then I'd give more consideration to the income approach vs. the sales comparison approach. My final opinion of fair market value may be below the indicated range of the sales comparison approach.
Alternatively, if I believed that, despite the lease, an owner-user would compete for the property, I might give both approaches equal consideration (you get the picture).

One last thing for you to confirm (and Howard pointed this out to me): Is there a cancellation clause in the lease that is triggered upon the sale of the property? If so, and if this is an owner-user market for the subject, I'd still do the income approach but reconcile to the sales comparison approach.


I won't get into the technicalities of being sure to match the risk-profile of your subject with the comparable rentals you use to extract the GRMs; if this is for a simple estate assignment, then while you wouldn't want to compare a triplex GRMs to use for your SFR, I think you have flexibility in comparing SFRs with some differences in their risk profile to use for this assignment.

Good luck!
Click to expand...


This is to thank all who took the time to read my post and to reply.

Denis - your suggestions are well taken. I feel uncomfortable placing too much weight on the Sales Comparison approach due to the 20 months remaining on the lease. I'll look beyond the local area to see if I can find some leased-SFR sales that will allow me to derive a supportable GRM. I agree that it is most likely that the Income Approach will reflect a lower value than the SC Approach.

P.S. Thank "Howard" for his input.

Jerry
 
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