Ground lease provisions--a case study for leasehold valuation.
This case study examines an office building subject to a ground lease to show the difficulties that arise in the valuation of a negative leasehold interest and suggests a course of action that can be followed to reach a credible estimate of value. The subject of the case is encumbered by an above-market ground lease payment and restrictions on ownership. The suggested valuation methodology is by no means a perfect and all-inclusive treatise of the concept but one that will guide practitioners in the right direction. The methodology applies conventional appraisal techniques while considering the various estates and how they interact with each other. In addition, a framework is presented to estimate investor yield expectations for types of real estate that are thinly traded by segmenting income and building up on the risk-free rate.
This article presents a case study analysis of an office building that is encumbered by an above-market ground lease payment and restrictions on ownership. The following sections will discuss the nuances of the case and offer a technique to estimate the appropriate yield rate and value. This case considers the application of conventional appraisal techniques to a segment of the real estate market that is thinly traded.
Ground Lease Provisions and Interests
Ground lease provisions can introduce unique challenges when valuing different lease interests. For example, in the instance of the case study property, a lease provision prohibits the lease payment to the ground lessor (leased fee estate) from ever declining, and a second lease provision prohibits assignment of the leasehold interest to a lessee with a credit rating inferior to that of the original lessee. The later of these provisions creates a marketing dilemma, while the former has quantifiable implications for an interest in the leasehold estate.
Both of these lease clauses are clearly advantageous to the ground lessor. Absent bankruptcy, and other exogenous events, the leased fee is a quite secure annuity. An endeavor into its value will be discussed shortly.
The real conundrum is determining the value of a lessee's interest, if any, in the leasehold position. Because the combined income between the leased fee and leasehold remains unchanged regardless of how the income is allocated, traditional appraisal theory suggests that the value of the leasehold estate is measured in the difference between the fee simple and leased fee estates. However, in practice this is not always the case, and an analyst must consider the issue before proceeding with his or her analysis. (1) In some cases, as depicted in Figure 1, intangible value may be gained or lost when the leasehold and leased fee interests are separated. Note that in the current case study, the analyst has concluded no intangible value was gained or lost and that residual techniques can be appropriately applied.
Valuation of the Fee Simple Estate
The case study property in a 30,000-square-foot parcel of land. In 1975, the owner and developer leased back to its development arm--a related entity--the subject parcel for a 99-year term at a yield rate tied to the then-prevailing market conditions. Local valuers believe the leasing terms to be reflective of market rates in 1975. The developer/lessor has a Fitch credit rating of "A." (2) The lease contains a clause whereby the lease rate is tied to escalations in the Consumer Price Index for All Urban Consumers (CPI-U), a common measurement of inflation, and the rate adjustment is applied every five years. The lease payment can never be lower than the prior lease rate and can only be assumed or assigned by an entity bearing the same credit rating as the original lessor.
In 1975, the land was valued at $8.00 per square foot, or $240,000. The initial lease rate to the land was based on a 10% rate of return ([R.sub.L]), resulting in an annual ground lease payment of $24,000. A 60,000-square-foot, speculative, multitenant office building was subsequently constructed on the property at a cost of $2,400,000. The total value of the fee simple estate in 1975 was estimated to be $2,640,000.
Thirty-seven years later, in 2012, an appraisal is ordered to determine the current value of the leasehold position. Determining the value of the fee simple estate is also part of the scope of the assignment as the client wants to use the appraisal as a basis for negotiating the acquisition of the leased fee estate.
In the course of the assignment, the value of the land is estimated to be $15.00 per square foot, or $450,000, and the improvements are estimated to contribute approximately $6,900,000, on a depreciated basis, for a total estimated value via a cost approach of $7,350,000.
In the income capitalization approach (Table 1), market rent is estimated to be $19.80 per square foot, annually, on a full service gross basis. Vacancy and collection loss is estimated to be 15%, with operating expenses of $7.35 per square foot, annually.
An 8% overall capitalization rate was estimated to convert the net operating income into a value estimate of $7,235,000 for the hypothetical fee simple estate via the income approach. When the terms of the ground lease are at market, the value of the leased fee interest should equal the value of the fee simple interest in the land. (5) Absent any value gain from assembling the interests, this theoretical assumption is without challenge and when the leased fee terms do not emulate market, you are likely "valuing the estates upside down."
After a hypothetical value for the fee simple estate is estimated then the analyst can move on to the valuation of other parts of the "pie" displayed in Figure 1. The analyst already concluded there is no gain or loss in value when combining the leasehold and leased fee estate and can now use residual techniques to estimate the value of the leasehold interest.
Through market analysis and interviews with market participants, current rates of return ([R.sub.L]) for commercial land were found to be around 5%. By applying [R.sub.L] to the land value of $450,000, the analyst estimates the ground lease payment to be about $22,500 per year if tied to current market conditions. Recall, the original ground lease was $24,000 annually, escalating with the CPI-U under the proviso that its annual payment would never be less than the prior year's payment. Only once since 1975 has the CPI-U declined, and that was calendar year 2009. (4)
Applying the annual increases to the original ground lease payment results in a current annual rental payment to the ground lessor of $109,886.05, and this is where "valuing upside down" begins.
So let's explore the financial conundrum; net operating income was previously estimated to be $578,898, fee simple unencumbered, which was converted to a value of $7,255,000 (rounded) applying an 8% overall capitalization rate. However, the terms of the original ground lease encumber the property to a much greater degree than market terms, so the leased fee estate is quite valuable and the leasehold estate may be significantly impacted by the value imbedded in the leased fee estate.
The market is silent as to where rates of returns for properties like this one should trade. Conventional logic steers to a higher rate of return for application to the above-market lease for the ground as these rents would not be fully replaced in the event of default. But, this is a very secure income stream given the credit worthiness of the lessee. Mathematically, the higher the discount rate applied, the lower the expected sales proceeds to the ground lessor. There is a low probability the ground lessor will part with this annuity at a discount unless forced to do so by externalities or an atypical condition of sale. The question remains, what is the value of the leasehold estate?
In selecting an appropriate yield rate, an analyst has to interpret the attitudes and expectations of market participants. (5) In situations where the market for a particular asset is thinly traded, as is the case in this assignment, selecting an appropriate yield rate can be difficult. In these situations, an analyst's only guidance may be in assessing and comparing competing prospective investments of a similar investment quality.
In Table 2, the current yield rates of select investments are listed, which may prove useful in narrowing the range of indicated yield rates. In the world of finance, investors typically view US Treasuries as a risk-free investment. Therefore, it is logical to assume the yield rate of a US Treasury of similar duration would set the floor for market participants. For further reference, the average unlevered equity return for institutional-grade office properties has been 8.81% since 1978. (6)
To narrow the range of indicated yield rates further, the analyst must measure the durability of the income generated from a particular investment. More uncertainty associated with a stream of cash flows suggests a higher yield requirement from an investor. (7) In this analysis of yield rates, the following variables may be utilized. (8)
[V.sub.FS] Fee Simple Value of Overall Property
[V.sub.LF] Leased Fee Value of Ground Lease
[V.sub.LH] Leasehold Value of Ground Lease
[I.sub.FS] Income for the Fee Simple Interest
[I.sub.LF] Contractual Ground Lease Payment
[I.sub.L] Income to the Land as if Ground Lease was set to Market
[I.sub.LFL] Excess Rent Attributed to the Above-Market Ground Rent
[I.sub.LH] Income for the Leasehold Interest of the Ground Lease
[Y.sub.LF] Yield for the Leased Fee Interest of the Ground Lease
[Y.sub.L] Yield for the Land as if Ground Lease was set to Market
[Y.sub.LF-L] Yield for the Excess Rent of the Ground Lease
[R.sub.FS] Capitalization Rate for the Fee Simple Interest
[R.sub.LF] Capitalization Rate for the Leased Fee Interest
[R.sub.LH] Capitalization Rate for the Leasehold Interest
[R.sub.L] Capitalization Rate for the Land Unencumbered
[V.sub.N] Reversion Value
The analyst can separate the ground rent into two groups: (1) the market ground rent, which could be generated from the property if unencumbered ([I.sub.L), and (2) the excess ground rent, which is above what could currently be generated in the open market ([I.sub.LF=L]). The excess rent creates a negative leasehold interest. (9) Because the risk associated with each group of income is different, two different yield rates should be derived: [Y.sub.L] and [Y.sub.LF-L].
There are two scenarios in which excess rent ([I.sub.LF-L]) may not be collected. The first would be default by the lessee. The second would involve an amendment to the lease, which a rational lessor would only agree to in order to prevent the first scenario. Therefore, the durability of [I.sub.F-L] is solely reliant on the credit of the lessee. The yield for the excess rent of the ground lease, [Y.sub.LF-L], can then be derived by comparing yield rates of an investment with a similar duration and comparable credit quality or credit rating. Because the lessee has a Fitch credit rating of "A," it would be appropriate to look at the yield rate of bonds issued by the lessee (or similar "A" credit-rated companies) with a similar duration. This logic still contains one major flaw--liquidity. Investors today can liquidate stocks and bonds in a matter of minutes; this is not the case with real estate (excluding publicly traded REITs and other structured products collateralized by real estate). In this example, the analyst must then factor in a liquidity premium sufficient to induce a buyer. (10)
[Y.sub.LF-L] = [Y.sub.comparable financial instrument] + Liquidity Premium
A study of liquidity for real property during 1970-1988, conducted by David Leggett, found mean liquidity premiums of 288 basis points to 370 basis points. The liquidity premiums derived are roughly 32% to 41% of the average ten-year treasury yield of 9% during this period. To estimate a contemporary liquidity premium, an analyst can interview market participants or use matched pairs to look at the yields on bondable real estate transactions within the market and compare them to the yields of the similar credit-rated investments. After interviewing market participants and reviewing bondable real estate transactions, a liquidity premium of 100 basis points (33% of the Treasury yield in Table 2) was estimated. Referencing Table 2, the analyst has also reconciled to a yield rate of 5.25% for a comparably rated financial instrument, so [Y.sub.LF-L] can now be calculated at 6.25% (5.25% + 1.00%).
In the event of default by the lessee, the income to the land set at market [I.sub.L] could be replaced by the income generated from the property improvements. It is therefore generally considered a less risky form of income. In some cases a lessee with extremely strong credit may negate any other market influences. Consequently, [Y.sub.L] should be less than or equal to [Y.sub.LF-L]. Logic implies the following:
[Y.sub.Risk-Free] < [Y.sub.L] [less than or equal to] [Y.sub.LF-L]
Over time, [I.sub.L] will change so it is still necessary to discount it appropriately. To determine [Y.sub.L], one must look at the yield rate of the land component in market rate transactions while still factoring in the credit of the existing lessee and the duration of the lease. In aggregate, the yield rate of the leased fee position should be as follows:
[Y.sub.LF] = ([I.sub.L]/[I.sub.LF]) * [Y.sub.L] + ([I.sub.LF-L]/[I.sub.LF]) * [Y.sub.LF-L]
In the case study, after reviewing investor surveys and local land sales, and interviewing market participants, a yield rate of 5.5% for the land was estimated when the lease was tied to market conditions ([Y.sub.L]). It should be noted that this rate is not the same as an overall yield rate ([Y.sub.O]), which is often referenced in investor surveys. The analyst can now solve for the leased fee yield rate in this example.
[Y.sub.LF] = ($22,500/$ 109,886) * 5.5% + ($87,386/$ 109,886) * 6.25%
[Y.sub.LF] = 6.1%, or 6.0% rounded
There are 62 years remaining on the ground lease, and the office improvements are 37 years old. While not always true, for the purpose of simplifying this example, the analyst assumed the improvements have no value at the end of the 62-year ground lease term, and the reversion value ([V.sub.N]) is equal to the present value of the land in the future. (11) Analysts must be prudent to accurately estimate the reversion on properties with shorter remaining lease terms as it can have significant impact on value. To reflect inflation expectations going forward, a general inflation assumption of 3.0% was estimated for the remainder of the ground lease term and the value of the land. The resulting value estimate for the leased fee estate ([V.sub.LF]) is $3,128,000 (Table 3). This is the analysts' market-supported estimate of the value of the leased fee estate.
The value estimate implies a [R.sub.LF] of 3.5% ($109,886/$3,128,000). The resulting change rate (CR) is approximately 2.6% (6.1% - 3.5%), which is a product of the five-year staggered rent escalations using 3% annual inflation and the reversionary assumption. (12)
Y = R + CR
6.1% = 3.5% + 2.6%
As noted earlier, the fee simple value of the unencumbered site was $15.00 per square foot or $450,000. It is clear from the analysis that the lessor is entitled to a handsome premium. Unfortunately, this premium is to the detriment of the leasehold estate.
Having concluded residual techniques can be appropriately applied to this analysis, an estimated value of $4,100,000 (rounded) can be derived for the leasehold estate ([V.sub.LH]).
[V.sub.FS] = [V.sub.LF] + [V.sub.LH] or [V.sub.LH] = [V.sub.FS] - [V.sub.LF]
$4,100,000 = $7,235,000 - $3,128,000 (rounded)
[I.sub.FS]/[R.sub.FS] = [L.sub.LF] + [I.sub.LH]/[R.sub.LH]
$578,898/8.0% = $109,886/3.5% + $469,012/[R.sub.LH]
[R.sub.LH] = 1/[([I.sub.FS]/[R.sub.FS][I.sub.LH]) - ([I.sub.LF]/[R.sub.LF][I.sub.LH])]
[R.sub.LH] = 11.4%
Valuing a leasehold interest, where the lessee's position is considerably "upside down" by comparison to market conditions, is complicated and requires a bit more research and investigation for the analyst to derive a credible value estimate acceptable to owners of both the leasehold and leased fee interest. By combining different appraisal principals and building up to an appropriate yield rate, analysts can competently work through more complicated leasehold appraisal assignments and better serve their clients.
Internet resources suggested by the Y. T. and Louise Lee Lum Library
American Institute of CPAs, "Sec. 754 and Ground Leases"
Commercial Ground Leases
--"The Truth about Ground Leases"
--"Base Rent and Other Payments"
Ground Leases: Basic Legal Issues
National Association of Realtors, "Field Guide to Ground Leases"
by Don Guarino, MAI, Cameron Chehrazi, MAI and Brad A. Bohl
(1.) Appraisal Institute, "Appropriate Leasehold/Leased Fee Residuals and Summary," in General Appraiser Income Approach/Part 1 (Chicago: Appraisal Institute, 2006), 349-362.
(2.) For more information on Fitch Ratings, see https://www.fitchratings.com/creditdesk/public/ratings_defintions/index.cfm.
(3.) Appraisal institute, The Appraisal of Real Estate, 14th ed. (Chicago: Appraisal Institute, 2013), 371.
(4.) Bureau of Labor Statistics, Consumer Price Index, http://www.bls.gov/cpi/ (January 2013).
(5.) The Appraisal of Real Estate, 14th ed., 513-514.
(6.) National Council of Real Estate Investment Fiduciaries, http://www.ncreif.org/ (September 2013).
(7.) Richard L. Parli and Jeffrey D. Fisher, "Risk and Reasonableness for Nonmarket Occupancy--A Second Look During a Recession," The Appraisal Journal (Winter 2010): 95.
(8.) Note: some concepts presented do not have any formal protocol. Please refer to the listed variables to understand the meaning of the subscripts used in the discussion.
(9.) The Appraisal of Real Estate, 14th ed. (Chicago: Appraisal Institute, 2013), 506.
(10.) David N. Leggett, "An Empirical Analysis of Efficient Real Property Liquidity Premiums," in Alternative Ideas in Real Estate Investment, ed. Arthur L. Schwartz, Jr., and Steven D. Kapplin (Boston: Kluwer Academic Publishers, 1995), 113-127.
(11.) David Rothermich, "A Reality Check on Ground Lease Reversions," The Appraisal Journal (Winter 2009): 37.
(12.) The Appraisal of Real Estate, 14th ed., 522.
Don Guarino, MAI, CRE, CCIM, FRICS, is vice president of valuation and research/chief appraiser for AEGON USA Realty Advisors, LLC (AURA). Guarino is responsible for the management and oversight of the mortgage loan analysts, appraisers, and applied research group, who monitor AURA'S mortgage loan portfolio. Prior to joining AURA, he was a real estate appraiser and consultant for Bank of America in Los Angeles and Houston. Guarino received his BS from the University of Houston.
Cameron Chehrazi, MAI, has more than 30 years of experience in commercial real estate valuation, financial analysis, consulting, and feasibility and acquisition analysis. Chehrazi specializes in complex valuation assignments in leased fee, leaseholds, easements, partial takings, and special-purpose properties in Southern and Northern California. He received his BA from Swarthmore College and his MBA from the University of California, Los Angeles. Chehrazi is ARGUS-software certified. He has previously served on the Appraisal Institute's Grievance Committee and held the CRE and the ASA designations.
Brad A. Bohl, has four years of experience in real estate valuation, applied research, and financial analysis, and he currently works as an analyst for AEGON USA Realty Advisors, LLC (AURA). His work has included the surveillance and valuation of institutional quality real estate assets for core property types across the United States as well as portfolio-level research for investors in real estate debt and securitized real estate. Bohl is a Practicing Affiliate of the Appraisal Institute and received his BBA from the University of Iowa with a double major in finance and economics.
Table 1 Direct Capitalization Techniques--Fee Simple Estate % of Effective Data Input Annual Revenue Gross Income Office Rent 60,000 sq. ft. x $19.80 $1,188,000 116% per sq. ft. = Other Income @ 1% $11,880 1% Gross Rental Income $1,199,880 118% Vacancy & Collection Loss @ 15% ($179,982) 18% Effective Gross Income $1,019,898 100% Total Expenses 60,000 sq. ft. x ($441,000) 43% $7.35 per sq. ft. = Total Net Operating Income $578,898 57% Table 2 Yield Rates of Select Investments Maturity Date Investment (mo./yr.) Fitch Rating Current Yield US Treasury Bond November/41 AAA 3.00% Anheuser Busch Bond February/43 A 4.68% Boeing Co Bond October/43 A 4.81% BellSouth Telecom Bond December/95 A 5.65% Citigroup Bond February/98 A 6.39% Cummings Bond March/98 A 5.69% Source: Yahoo! Finance: Bond Screener, January 15, 2013. Table 3 Leased Fee Valuation--Lease Fee Estate Yield Rate: 6.00% General Inflation Assumption: 3.00% Year Payment PV Factor PV 0 $109,886 1.0000 $109,886 1 $109,886 0.9434 $103,666 2 $109,886 0.8900 $97,798 3 $109,886 0.8396 $92,262 4 $109,886 0.7921 $87,040 5 $127,388 0.7473 $95,192 6 $127,388 0.7050 $89,804 7 $127,388 0.6651 $84,720 8 $127,388 0.6274 $79,925 9 $127,388 0.5919 $75,401 10 $147,678 0.5584 $82,462 11 $147,678 0.5268 $77,795 12 $147,678 0.4970 $73,391 13 $147,678 0.4688 $69,237 14 $147,678 0.4423 $65,318 15 $171,199 0.4173 $71,435 16 $171,199 0.3936 $67,392 17 $171,199 0.3714 $63,577 18 $171,199 0.3503 $59,978 19 $171,199 0.3305 $56,583 20 $198,466 0.3118 $61,883 21 $198,466 0.2942 $58,380 22 $198,466 0.2775 $55,075 23 $198,466 0.2618 $51,958 24 $198,466 0.2470 $49,017 25 $230,077 0.2330 $53,608 26 $230,077 0.2198 $50,573 27 $230,077 0.2074 $47,711 28 $230,077 0.1956 $45,010 29 $230,077 0.1846 $42,462 30 $266,722 0.1741 $46,439 31 $266,722 0.1643 $43,810 32 $266,722 0.1550 $41,331 33 $266,722 0.1462 $38,991 34 $266,722 0.1379 $36,784 35 $309,204 0.1301 $40,229 36 $309,204 0.1227 $37,952 37 309,204 0.1158 $35,804 38 $309,204 0.1092 $33,777 39 $309,204 0.1031 $31,865 40 $358,452 0.0972 $34,850 41 $358,452 0.0917 $32,877 42 $358,452 0.0865 $31,016 43 $358,452 0.0816 $29,260 44 $358,452 0.0770 $27,604 45 $415,545 0.0727 $30,189 46 $415,545 0.0685 $28,481 47 $415,545 0.0647 $26,868 48 $415,545 0.0610 $25,348 49 $415,545 0.0575 $23,913 50 $481,730 0.0543 $26,152 51 $481,730 0.0512 $24,672 52 $481,730 0.0483 $23,275 53 $481,730 0.0456 $21,958 54 $481,730 0.0430 $20,715 55 $558,457 0.0406 $22,655 56 $558,457 0.0383 $21,373 57 $558,457 0.0361 $20,163 58 $558,457 0.0341 $19,022 59 $558,457 0.0321 $17,945 60 $647,405 0.0303 $19,626 61 $647,405 0.0286 $18,515 [V.sub.N] $2,812,681 0.0270 $75,885 [V.sub.LF] $3,127,885
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|Author:||Guarino, Don; Chehrazi, Cameron; Bohl, Brad A.|
|Article Type:||Case study|
|Date:||Mar 22, 2014|
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