valuing a property rented below market rates

[Abester]

If the below-market rent expires

WHEN the below market expires, then look at the reversion. Was this not in a class somewhere? You have two present value calculations - cash flow and reversionary interest at the end of the lease term. A typical holding / analysis period has nothing to do with it.

 

[Howard Klahr]

Before we get too far out of the barn ... what is the assignment? What interest are you appraising, fee simple, leased fee or leasehold? Also, what is the intended use and who is the intended user?

The answers to these questions will point you in the correct direction.

 

[PropertyEconomics]

Estimation of market rent is important and it should be capitalized into a value .. WITH .. the difference between the market rent and the contract rent, discounted to a present value and DEDUCTED from the capitalized market value indication in order to provide the appropriate Value of the Leased Fee Estate.
Recognition of the contract rent must be made as it was in place as of the date of the owners death, if I am understanding this is for estate tax purposes correctly. Actual rents must be accounted for in your analysis.

Market NOI / Market Cap Rate
MINUS
Discounted Rent Loss Over the Contract Period

The only discounted cash flow model I see is for that of the rent loss over the contract period (market rent - contract rent = rent loss). I would think the appropriate discount rate would be the overall rate plus the rate of change ... but I dont know your market.

 

[Vernon Martin]

What I would do is first use direct capitalization with market rents to establish fee simple value, then apply DCF analysis to the difference between actual and contract rents and subtract this discounted number from the fee simple value. Be sure to use a market-derived cap rate and discount rate.

 

[Abester]

PE - Does your method work when Yo and Ro are different?

 

[Fred]

Assuming the gap between contract and market is significant enough to care about. I suuppose, in theory, it's possible to go either way. One could start with market rent and discount for the underage; or one could capitalize actual and add the PV of the reversion.

Which way I did it, would depend on the length of the below-market lease, because as a general principle, I want to be direct-capping the big amount and using discounting on the small amount.

 

[aussie ken]

What I would do is first use direct capitalization with market rents to establish fee simple value, then apply DCF analysis to the difference between actual and contract rents and subtract this discounted number from the fee simple value. Be sure to use a market-derived cap rate and discount rate.

On the button Vernon!!!

 

[Louis Pompeo]

PE has it right.

Don't forget to discount the rent loss over the holding period.

 

[PropertyEconomics]

Assuming the gap between contract and market is significant enough to care about. I suuppose, in theory, it's possible to go either way. One could start with market rent and discount for the underage; or one could capitalize actual and add the PV of the reversion.

Which way I did it, would depend on the length of the below-market lease, because as a general principle, I want to be direct-capping the big amount and using discounting on the small amount.

Steven .. I just have one question for you if I may.
While I agree with you that actual could be capitalized with the PV of the reversion added, wouldnt you have to have other sales which were leased at below market rates in order to develop your cap rate? I would not think use of market overall rates when applied to below market NOI would result in a reliable report. Granted there my not be a significant difference, and each would be on a case by case basis, but in theory wouldnt you need cap rates derived from properties which had similar below market lease conditions?

 

[PropertyEconomics]

PE - Does your method work when Yo and Ro are different?

In my experience Yo and Ro are typically different. I have seldom seen the overall rate equal the IRR. Over the past several years I have seen very low Ro, actually lower than the cost of capital, and given that an IRR typically must atleast cover the cost of capital (a borrowers or owners cost of capital), I think it more typical that they are different.
I hope this answered your question.

Each portion of the equation measures risk, and the risks are different, ... one to the market levels of real estate (ie income property at market rates) and one to the under market rent loss realized as a result of the lease in place.