Discount Rates on Long Term Ground Leases

[Michael S]

I'm trying to find some market support for discount rates on long term ground leases (30+ years). I've spoken to a sophisticated investor who threw out a range of 5.00% to 7.00% but there's not a lot of these things that trade so it's hard to find any data.

I've got a couple of long term ground lease sales in CBD markets that I've been able to get cap rates from. They range from about 4% to 6% which I consider low indicators as a discount rate is generally the cap rate plus expected income growth. Assuming 3% CPI that means a range of 7% to 9%.

Walgreens, CVS, and McDonald's, bank branch ground leases will sell at cap rates in the 4-6% range and those are generally 25 years or less. I would think that a CBD site with a long term lease would sell at or below this rate.

 

[Terrel L. Shields]

After 10 - 15 years, the time value of money pretty much wipes out the value, so I don't see that a 20 v 30 year time line should be very different but certainly the lower rate range is the place to look.

 

[hastalavista]

A very experienced forumite helped me on a similar problem.
I was of the opinion that a good piece of land leased to a solid tenant is a pretty safe bet, and that there should be a relationship between the long-term safe rate and the an appropriate discount rate. He agreed, and helped me put the picture together.

30-year treasury bond has been bouncing around between 2.75 to 4.00% in the last year.
Take the average (3.50, rounded).
Land has two things the treasury doesn't; a risk and liquidity premium.
We get to decide how much that should be: assume 3-5% (which is consistent with your investor indicator). That would imply a discount rate of 6.5% to 8.5%.
If your cap rates are 4-6%, that certainly fits into the picture.
Your investor source says 5-7%; the higher end is captured in the built-up rate analysis.

Combined, a reasonable range begins to emerge: probably somewhere between 6-8%.
How's that fit with the OAR value?

 

[Michael S]

A very experienced forumite helped me on a similar problem.
I was of the opinion that a good piece of land leased to a solid tenant is a pretty safe bet, and that there should be a relationship between the long-term safe rate and the an appropriate discount rate. He agreed, and helped me put the picture together.

30-year treasury bond has been bouncing around between 2.75 to 4.00% in the last year.
Take the average (3.50, rounded).
Land has two things the treasury doesn't; a risk and liquidity premium.
We get to decide how much that should be: assume 3-5% (which is consistent with your investor indicator). That would imply a discount rate of 6.5% to 8.5%.
If your cap rates are 4-6%, that certainly fits into the picture.
Your investor source says 5-7%; the higher end is captured in the built-up rate analysis.

Combined, a reasonable range begins to emerge: probably somewhere between 6-8%.
How's that fit with the OAR value?

The current rent is probably a little below market. Based on my concluded leased fee value and the current rent, I'm right at a 4% cap rate. However, depending on what discount rate I use, and what the projected annual inflation is over the remaining lease (lease escalates every three years based on inflation as measured by the producer price index - all commodities) the value could be $1.5 million or $2.0 million, and that's within a relatively narrow range of inflation rates and discount rates. Fee simple value is higher (assuming no ground lease in place) which provides additional support that the current rent is below market. Therefore an even lower cap rate/discount rate than normal makes sense.

I did a similar built up analysis in my head but I didn't really have enough information to nail down a liquidity and risk premium so I choose not to include it in the report.

 

[leasedfee]

I'm trying to find some market support for discount rates on long term ground leases . . . .

I think you're on the right track, Michael. I always survey long-term non-callable corporate bonds as an alternative investment comparison. While real estate is considered to be risky, the ground lease landlord gets the property back upon default, and likely an improvement. Using a variety of techniques, including backing out and building-up from an overall cap rate of which there is relatively ample dating, I've been shocked at how low CBD ground cap rates and yields are. But it makes sense. There's no recapture of depreciation or return of investment, just pure return on investment.