I am appraising a commercial property (20 acre shopping center, land lease, leased fee interest) encumbered by a 49 year lease with 50 years worth of extension options. Flat rent, essentially, all 99 years, minimal chance to participate in percentage rents above the flat rent, so your income is a below market flat land rent subject to another 25% or 30% more rent above the very low base rent, and that is as good as it gets on the income side. The land has incredible residual value as it is one of the best located parcels in the best part suburban part a city of 2.85 million. The location has 150 years of steady growth and even the worst part of nearby areas have already been gentrified almost completely in the past 50 years, so 50 years from now this is likely to be a highly desirable parcel, improved with a 25 to 50 year old functional in line retail shopping center. The reversion will occur in about 57 years, unless the tenant under the land lease decides not to exercise an extension option (there are 5 more options at flat rents, no increases over the 99 year term). Under a DCF analysis (if appropriate) how would you value the reversion? Current land value plus some estimate of land value growth (CPI, historical trends, etc..). Is this really a market value appraisal problem or investment value ? The owner of the leased fee has a future interest of potentially great value, and they are an institution, so their investment horizon is in decades and centuries, unlike a natural person (investor) or the typical institutional investor (10 or 20 year horizon?). The leased fee value is obviously huge, the right to use and release a $15 million piece of property for less than 1% of its current market value for 57 years into the future. Nice deal for the land lease tenant, better than owning, really. In a Market Value Appraisal we attempt to reflect the behavior of typical market participants, but how many investors want to buy a land lease with ridiculously low annual cash flow for 57 years for a likely definite windfall (cash value of reversion, could be $50 million if the land appreciated at only a low rate of inflation over 57 years). RCN (less depreciation) of the buildings that will remain on the site is probably already $18 million, but they will probably be replaced with more valuable (newer) building assets at least once and maybe twice in the next 57 years based upon the choice location of the subject property. So is the reversion worth in 57 years worth anything to a current investor? There are at least two conflicting schools of thought on this ? What do you think? How would you value this?
Unless I am misunderstanding your appraisal problem, which since this post is a few days old may be moot anyway, I think you may be over complicating the analysis. Having said that, it's not entirely clear, by your post, exactly what you are appraising. In order to respond I will assume that your analysis is to appraise the leased fee interest, in the land, held by the underlying land owner, of the shopping center.
Keep in mind you could be appraising the leasehold interest, plus the value of the improvements held by the ground lease, lessee. I quote "I am appraising a commercial property (20 acre shopping center, land lease, leased fee interest) encumbered by a 49 year lease with 50 years worth of extension options." Assuming, that you are in fact appraising the land, subject to the ground lease might I suggest the following statement:
"I am appraising a 20 acre commercial property of land encumbered by a ground lease with 49 years remaining on the initial term, +50 years worth of extension options. The land is substantially improved with a retail shopping center, but all improvements, and any income thereof, are owned by the lessee, of the ground lease."
Assuming the above statement is reflective of your appraisal assignment allow me to offer the following comments, and, or, questions:
1. I would be inclined to value the leased fee interest of the land owner, via a discounted cash flow analysis, because of the long-term ground lease and the "flat" nature of the lease.
2. The question of how many years the DCF analysis should cover is a judgment call. Having said that, and based on memory, but not an actual analysis in this case, it may not make a significant amount of difference because of the factors you outlined in your post, i.e. very long-term lease with flat rates, and low anticipated inflation.
3. I would want to put some thought into it, but from the hip I would suggest either a 10 year DCF, or a DCF, which is co-terminus with the land lease term; or a DCF, which is co-terminus with the remaining land lease term, plus the option years.
4. Given what you have outlined, once you set up your DCF spreadsheet it should be a relatively simple matter to do all three. I would be inclined to do all three and see if it makes much, if any difference on value. I'm guessing that it will not.
5. A fourth alternative would be to survey market participants to ascertain the typical holding period of such an investment. Assuming that such information could be gathered, this would make the most persuasive argument for the length of the anticipated "Holding Period"
"I am appraising a 20 acre tract of commercial land encumbered by a ground lease with 49 years remaining on the initial term, plus 50 years worth of extension options. The land is substantially improved with a retail shopping center, but all improvements, and any income thereof, are owned by the lessee, of the ground lease."
Assuming the above statement is reflective of your appraisal assignment allow me to offer the following comments, and, or, questions:
1. I would be inclined to value the leased fee interest of the land owner, via a discounted cash flow analysis, because of the long-term ground lease, and the "flat" nature of the lease.
2. The question of how many years the DCF analysis should cover is a judgment call. Having said that, and based on memory, but not an actual analysis in this case, it may not make a significant amount of difference because of the factors you outlined in your post, i.e. very long-term lease with flat rates, and low anticipated inflation.
3. I would want to put some thought into it, but, from the hip, I would suggest either a 10 year DCF, or a DCF, which is co-terminus with the land lease term; or a DCF, which is co-terminus with the remaining land lease term, plus the option years.
4. Given what you have outlined what you set up your DCF spreadsheet it should be a relatively simple matter to do all three. I would be inclined to do all three and see if it makes much, if any difference on value. I'm guessing that it will not.
5. A fourth alternative would be to survey market participants to ascertain the typical holding period of such an investment. Assuming that such information could be gathered, this would make the most persuasive argument for the length of the anticipated "Holding Period". I am a commercial real estate appraiser in Florida, and most of the scenarios that I have seen over the years, and similar to yours, were long-term investments often held in a trust, owned by a wealthy family. Typically, in the scenarios, a patriarch, or other family members, who were sitting on a substantial amount of cash, or other resources, are looking for a long-term investment with what is perceived to be little or no risk; produces a steady cash flow; and which will have some hedge against inflation. Accordingly, it is been my experience, anecdotal as it may be, that these investments are typically anticipated to be held for an extremely long period of time, if not into perpetuity.
6. Forgive me if I misinterpreting your statement, but it appears that you have offered somewhat conflicting viewpoints on whether or not the will be any increases in the land rental rate over the anticipated holding period. On the one hand you state: "minimal chance to participate in percentage rents above the flat rent, so your income is a below market flat land rent". On the other hand, this statement is followed by the following quote: "subject to another 25% or 30% more rent above the very low base rent".
So which is it? Do you anticipate the rent levels to be flat for the entire holding period, or do you anticipate them to increase at a rate of 25%, or 30%, and if so, when do you anticipate the increases to the rental rate?
For the sake of this discussion, I don't know that it is entirely necessary to know the answer to that question. Accordingly, subject to your response I will assume there is little, to no chance of appreciation in the rental rate for the remainder of the current lease term.
7. Obviously, in any DCF analysis, and in particular one that is of a longer period, the discount rate can have a profound effect on value. Accordingly, care should be taken in selecting the appropriate discount rate.
8. In this scenario, as I understand it, the appropriate discount rate selection is a little more straightforward than it might otherwise be. That is rate selected which will convert the future cash-flows of a very tall long-term lease with no increase in the rental rate, and little to no risk of default.
9. You have laid out a scenario which would indicate that an investment in the land would be an extremely safe investment, because it is encumbered by the very long-term lease, at below market rates. All other factors being equal, the discount rate should reflect the very low level of risk of investing in income stream generated by the long-term land lease. I would suggest that your appropriate discount rate should be close to that being paid in the marketplace for government securities of a commensurate term. If you are doing a 10 year discounted cash flow analysis this will be easier to determine.
10. Remember, the default rate of US securities is typically considered to be nominal if not zero; as a result the yield rate reflects anticipated inflation, plus the real rate of return. In the scenario that you've laid out I would argue that there is little to no probability of default on the ground lease. In this scenario you have laid out, unlike a treasury security, if there were a default, the value of the interest would actually rise; whereas, theoretically, if the US government defaulted, the treasury would have zero value.
11. Regarding item 6 above, go back and reread the land lease. My experience has been that typically these very long-term land leases will include a clause which allows escalation in the event of significant, or hyper, inflation. Otherwise the investments value would depreciate appreciably under any appreciable inflation. Remember, if the lease does include such a clause then, all other factors being equal, the discount rate would be lower because the risk of the investment would also be lower.
12. When developing your discount rate remember to keep alternative investments in mind, particularly the U.S. Treasury rates. I would argue that in a long-term land lease scenario this is more appropriate than what it is when comparing the investment in say a class A office building. Ask yourself, why would a wealthy investor purchase such an investment as opposed to a U.S. Treasury, which theoretically would have significantly greater liquidity, with limited transaction cost? I would argue that the response is attributable to several factors, including, but not limited to the following: the longer-term of the "guaranteed" income of the investment; as a hedge against inflation; and, for diversification.
13. With regard to the Overall Rate to calculate the reversion, in the DCF, if this cannot be extracted from the market, you should be able to build one, through several methods, all of which would likely have more credibility than it would for say a more typical real estate investment. Keep in mind, based in the scenario that you outlined, the value of the reversion should have very low risk and therefore a very low cap rate. Remember the cap rate is designed to reflect the probability, and durability of the anticipated income stream. In your scenario the durability would be a long, and the probability of being achieved should be very high. All these factors argue for a lower Overall Rate.
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