Ground lease appraisal

[Gobears81]

I am doing an appraisal of a ground lease. There are two buildings on the site (and two different uses) and land which has some potential for future development. One of the buildings is fully depreciated-it is not feasible to demolish or renovate at this time. The other building has a few years left on the lease and I was told wants out of their lease. The ground rents are based on a % of the rents for the leasehold. If the property is 100% vacant, they receive $100 per year. I have never seen rents for any ground leases structured that way.

I am struggling with what the appropriate discount rate would be. Normally, it would be a discount rate based on what would be appropriate for other ground leases. But in this case, would it be based on discount rates commensurate with fee simple properties of similar use (I am referencing the improvements)? That frame of logic seems off to me, but at the same time, if the income is based on the improvements, I am having trouble finding logic for using ground lease discount rates.

 

[leasedfee]

@Gobears81
You are valuing the leased fee position if I read this correctly? If I understand what you are writing:
You need to consider the H&BU once this ground lease expires? At that time, the partition in the property rights is reassembled into a fee simple estate.

You might possibly want to consider this reversionary H&BU as a fee simple parcel for purposes of the baseline valuation, as the leasehold has very little value remaining. However, I would report it as a "Leased Fee" valuation as a third party, the leasee, still has control over the property for the foreseeable future. Normally, if, say, there are 5 years remaining, then the leasehold contributes only about 35% or so of the leasehold value -- but you suggest that the cash flows are basically little to nothing for the remainder of the term? So 35% of nothin' is nothin'. So maybe perhaps all of the value is the reversionary value multiplied by a PV factor as it won't be received by the property owner at today's valuation at year = 0. For example: If the land will be worth $10/sf in reversion year 5, you'd hit with a PV factor of 0.7129 using a regular land yield rate (Y_L) of, for this example, of 7%. Thus this fictional scenario gives a value of $7.13/sf. Perhaps there'd be some minor value during the leased fee period of years 1-5 and a simple DCF could render it and adding it on. If it is no ground rents being generated then the discount rate wouldn't make much of an impact either way.

 

[nstanbru]

How much time is left on the ground lease? Also, can the lessee (per the ground lease terms) build anything else or are the "stuck" with the existing buildings?

 

[Gobears81]

Whoops, forgot to post that, which would be relevant. There are more than 40-years remaining on both ground leases.

 

[nstanbru]

Whoops, forgot to post that, which would be relevant. There are more than 40-years remaining on both ground leases.

Wow, I've never seen a ground lease with wackier terms. If I understand correctly, the Lessor enters into a ground lease with the Lessee. The ground rent is a % of the building rent(s) collected by the Lessee with a minimum of $100 per year if the buildings are vacant. Assuming there is no way to cancel the ground lease, I would have look at discount rates for other ground leases only as a starting point. Also, I would try to find rates associated with properties that have percentage leases for the buildings (if they even exist any more). This data may provide an additional starting point to determine your discount rate.

 

[leasedfee]

GoBears,
My first post won't be relevant then to your situation as I guessed that a "few years" was in the single digits.

You might consider an Extraordinary Assumption about the leasee's intentions if they want out yet have a 40 year obligation. Perhaps the owner would want a lousy tenant gone too? The EA would be simply a yellow-flag that your valuation may change rapidly based on "unknown knowns." I am most perplexed about trying to understand the land rent residual. The H&BU is a big priority. On the other hand, I'm least worried about the discount rate because nobody can really figure out such a thing for such an unstable use. Who'd want a long-term leasedfee position that is deliberately under-performing and contractually has little to no rent obligation so the tenant has no motivation to make the property work and no motivation to default yet every likelihood of doing so? You sorta need to tell us more.

 

[Gobears81]

GoBears,
My first post won't be relevant then to your situation as I guessed that a "few years" was in the single digits.

You might consider an Extraordinary Assumption about the leasee's intentions if they want out yet have a 40 year obligation. Perhaps the owner would want a lousy tenant gone too? The EA would be simply a yellow-flag that your valuation may change rapidly based on "unknown knowns." I am most perplexed about trying to understand the land rent residual. The H&BU is a big priority. On the other hand, I'm least worried about the discount rate because nobody can really figure out such a thing for such an unstable use. Who'd want a long-term leasedfee position that is deliberately under-performing and contractually has little to no rent obligation so the tenant has no motivation to make the property work and no motivation to default yet every likelihood of doing so? You sorta need to tell us more.

The devil is in the details, as always.

The lease was created around 1960 and encompassed a larger area. The original lease was hard to see, but it looks like a pretty normal ground lease initially. Then in 1965 or so, they amended the lease to where they are receiving a percentage of the rents on the property. I don't know what the back story is there, although the percentage is more consistent with what rates ground lease rents are determined at, so it is now a low rate for this type of arrangement.

There is some vacant land on the site which has potential for development, although it has technically been vacant since everything else around it has been built up, so demand probably isn't off the charts. There is also a building that has a couple years left on the initial term of the lease, although it is at above market rents and to a tenant that reportedly wanted to vacate after the lease was signed. The remaining building has ceilings falling in and is functionally obsolescent. I also determined that it is not feasible to demolish, given the land value relative to demolition, so the highest and best use for that area is to let it sit until land values presumably appreciate faster than demolition costs, provided that the city doesn't step in and force action.

There is actually a second, separate lease, but it is to a strong tenant on a nice building. It has a below-market rent (thus increasing the likelihood of renewal) so the modeling creates a lower implied cap rate than on this one. I am also more confident in that one, although who wouldn't be? The variance is probably much lower.

 

[leasedfee]

Glad it's you, and not me doing this assignment.

I think you might want to know -- for either your own file data, peace of mind, and possibly H&BU write-up -- the as-if-unencumbered fee simple value. This serves as a baseline for your analysis. When we value a parcel using sales comparison, extraction, or allocation, the marketplace has given us the great courtesy of figuring out the future. Not that they know the future, they don't, unlike the Efficient Market Hypothesis school of thought, but they did "put their money where their mouth is." And that's the price it takes to be in that game at that point in time.

The future consists of

• anticipated land residual or land rent (impacted by zoning, H&BU, regional trends, neighborhood, etc.),
• its appreciation/decline rate (pet peeve: not going to use the word "depreciation" for describing changes in land value or market conditions),
• and the holding times and interim switch-over, etc etc.

The problem you have GoBear is that YOU have to figure out the future here. It'll be a real bear, pun intended, to figure out the residuals/rents on this one. And 40 years of it!

Ah the discount rate. Once you've punished the future use of this property enough for not being a great participant in that experience called capitalism, I'd be hesitant to go too wild about over loading the yield rate. You would have 40 years discounted at the land leased fee yield rate (Y_L, LF) followed by years 41+ at a land yield (Y_L). You might considered a DCF in this case as the overall capitalization rate is so difficult to extract, calculate or compare on such an ugly income stream. Unless you have data suggesting otherwise, once you've determined the miserable NOI (I_L) there is no need to declare it to be super riskier than a normal Y_L or Y_L, LF. What's the risk to the investor? Earn little to nothin' for 40 years, or maybe just maybe have the tenant default and get the fee simple (so there may be a possible upside). Who pays the taxes -- and what happens to the leased fee position and the contract if and when they're not paid. I'm open of course to countering opinions, however.

Parenthetically, demolition costs should definitely be subtracted sooner or later from the cash flows. Perhaps discount them at a safe rate several years from now?

 

[Gobears81]

Glad it's you, and not me doing this assignment.

I think you might want to know -- for either your own file data, peace of mind, and possibly H&BU write-up -- the as-if-unencumbered fee simple value. This serves as a baseline for your analysis. When we value a parcel using sales comparison, extraction, or allocation, the marketplace has given us the great courtesy of figuring out the future. Not that they know the future, they don't, unlike the Efficient Market Hypothesis school of thought, but they did "put their money where their mouth is." And that's the price it takes to be in that game at that point in time.

The future consists of

• anticipated land residual or land rent (impacted by zoning, H&BU, regional trends, neighborhood, etc.),
• its appreciation/decline rate (pet peeve: not going to use the word "depreciation" for describing changes in land value or market conditions),
• and the holding times and interim switch-over, etc etc.

The problem you have GoBear is that YOU have to figure out the future here. It'll be a real bear, pun intended, to figure out the residuals/rents on this one. And 40 years of it!

Ah the discount rate. Once you've punished the future use of this property enough for not being a great participant in that experience called capitalism, I'd be hesitant to go too wild about over loading the yield rate. You would have 40 years discounted at the land leased fee yield rate (Y_L, LF) followed by years 41+ at a land yield (Y_L). You might considered a DCF in this case as the overall capitalization rate is so difficult to extract, calculate or compare on such an ugly income stream. Unless you have data suggesting otherwise, once you've determined the miserable NOI (I_L) there is no need to declare it to be super riskier than a normal Y_L or Y_L, LF. What's the risk to the investor? Earn little to nothin' for 40 years, or maybe just maybe have the tenant default and get the fee simple (so there may be a possible upside). Who pays the taxes -- and what happens to the leased fee position and the contract if and when they're not paid. I'm open of course to countering opinions, however.

Parenthetically, demolition costs should definitely be subtracted sooner or later from the cash flows. Perhaps discount them at a safe rate several years from now?

That is an interesting post, plenty to think about. You are probably right about the discount rate-my initial model had a higher implied cap rate than what you would find with ground leases to national tenants, although it is not an extremely high rate. Thanks for the feedback.

 

[Howard Klahr]

Parenthetically, demolition costs should definitely be subtracted sooner or later from the cash flows. Perhaps discount them at a safe rate several years from now?

That is assuming that they are not the tenant's obligation

One of the buildings is fully depreciated-it is not feasible to demolish or renovate at this time. The other building has a few years left on the lease and I was told wants out of their lease. The ground rents are based on a % of the rents for the leasehold. If the property is 100% vacant, they receive $100 per year.

Rents as a percentage of leasehold rents are often used in a lease when the land owner is attempting to participate in the business operation but would rather outsource the property operating functions. I've mostly seen this with some type of government entity as the land owner.

Does the lease have a provision requiring the tenant to maintain the property to certain standards? If so, would the lack of this not be a way to terminate the lease? What is the landlords desire to terminate the lease? What type of businesses are the leasehold tenants in? Would there be a reason for them to retain the lease to prevent competitors from utilizing the location? i.e. closed gas stations, branch banks, etc