The Cost Approach in a Leasehold Interest Valuation

[Deleted member 152047]

A colleague of mine reached out a couple of days ago to talk through an appraisal problem regarding a leasehold interest valuation. He was working on the valuation of a behavioral health facility on a long-term ground lease at a nominal rent (30 years remaining on base term with plenty of renewal options and annual rent at $1 per annum with no escalations).

He prepared the report and included no deductions for ownership interest in the SCA, furthermore he valued the underlying land and included it in the cost approach (also without deductions for ownership interest). The reviewers came back and questioned why he didn't adjust the sales downward for their superior (fee simple) ownership and why he included the land value in the cost approach without an adjustment for ownership interest?

My knee jerk reaction was that you don't include the land value in the cost approach when performing a leasehold valuation. However, as we talked through it, he explained that the value of the leased fee interest as though vacant is minimal and that the value of the leasehold interest is the same as the fee simple interest. I thought it was a pretty interesting valuation problem and it is definitely something to consider in the future.

 

[CANative]

Hmmm..

 

[Gobears81]

I clicked on this thinking that this was the other leasehold thread

However, as we talked through it, he explained that the value of the leased fee interest as though vacant is minimal and that the value of the leasehold interest is the same as the fee simple interest.

Sounds like a good deal for the leasehold owner. I always include a land value in the cost approach and deduct the leased fee value after since it probably doesn't equal the fee simple value of the land. It would seem that concluding Vfs = Vlh is very much supportable. Just throwing something out there though, may or may not be applicable in this case - what about the psychological aspect of the leasehold to a potential purchaser? Even if the potential purchaser is not projecting a holding period after 10-years, much less 30, if they are choosing between a property that they can own in fee to perpetuity vs one that they HAVE to do something in 30-years, all else equal, they'd probably opt for the fee simple property. Though the remaining economic or useful life of the improvements is presumably 30-years or less in this case, ongoing renovations would extend that life as the years go on. No right or wrong answer to that question, just an observation of the market's preference for fee simple that goes past the calculations of us back office number crunchers.

 

[Deleted member 152047]

It is not often that we need to develop the cost approach in leasehold properties (typically its income driven), but when it has happened in the past, the value of the leasehold interest as though vacant has been negligible.

I don't think the psychological aspect comes into play when you have renewal options beyond one's lifetime. It was 30 years remaining on the base term with another 60+ years of options at the same rate. The best case NPV of the reversionary value and income stream was less than our rounding.

 

[Terrel L. Shields]

Strikes me for all practical purposes they hold title to the surface for more than the anticipated life of the facility therefore should be almost identical to a fee simple title.

 

[Michael P Jacobs MAI]

In an interesting way this is a terrific HBU exercise. Who is the most probable buyer and how are they most likely to underwrite value to them? This is a unique long term land bank situation for somebody that will never see any meaningful reversion... no present value (negative, actually), for a long term. Thanks for sharing!

 

[Deleted member 152047]

The HBU as though vacant was a behavioral health facility. I think most buyers in this space would recognize the leasehold value, but it is worth mentioning that the fee simple value of the underlying land (hypothetically) is minimal (less than $100k).

The buyer is going to worry more about revenues upon completion and the cost of construction for this market as the land value is minimal compared to the overall value of this type of project.

To everyone's point, even if the facility were newly constructed today, the likelihood that the improvements will outlive the lease is minimal. Things start to get hairy when you have less than 50 years remaining on a ground lease term.