Valuation of Lease Interests

VALUATION
OF
LEASE INTERESTS
Comprehensive Real Estate Appraisal Seminar and Training (CREASAT) RTPunzalan, CPV
LEASE INTERESTS
Bundle of Rights
 Rights generally inherent in the ownership of real estate
include but are not limited to the following:
 The right to sell
 The right to lease
 The right to mortgage
 The right to sell or lease a partial interest
 The right to build improvements thereon
 The right not to do any of the above
 The bundle of rights can be divided through various
instruments including leases, easements, and mortgages.
 Through these instruments, one party owns or controls certain
rights whereby another party owns or controls other rights.
LEASE INTERESTS
Lease interests are a form of real property –
 arising from the contractual relationship (the terms of which

are conveyed by a lease) between
 a lessor, one who owns the property leased to another, and
 a lessee, or tenant, one who typically receives a non-permanent

right to use the leased property in return for rental payments or
other valuable economic consideration.
LEASE INTERESTS
DEFINITION OF TERMS
Lease.
• A contract arrangement in which rights of use and possession
are conveyed from a property’s title owner (called the
landlord, or lessor) in return for a promise by another (called
a tenant, or lessee) to pay rents as prescribed by the lease.
• A lease is an agreement whereby the lessor (owner of
property) allows the lessee use of the property in exchange
for lease payments.
• In practice the rights and the duties of the parties can be
complex, and are dependent on the specified terms of their
contract.
LEASE INTERESTS
DEFINITION OF TERMS
Lease.
• Classification of Leases
• Operating Lease
• Operating leases give the lessee the use of property
without ownership.
• Financing Lease
• More popularly known locally as lease-to-own
• Financing leases transfer ownership from lessor to
lessee.
LEASE INTERESTS
DEFINITION OF TERMS
Leased Fee or Lessor’s Interest,

• Represents the ownership interest of a lessor owning real
estate that is subject to lease to others
• In operating leases, the value of the Leased Fee or Lessor’s
Interest is the value of the remaining rental payments and the
value of the property at the end of the lease period, the
reversion value of the property
• In financial leases, the value of the Leased Fee or Lessor’s
Interest is the value of the remaining lease payments
LEASE INTERESTS
DEFINITION OF TERMS
Leasehold or Lessee’s Interest, or Leasehold Estate.

• The ownership interest that is created by the terms of a lease
• The lease interest is subject to the terms of a specific lease
arrangement, expires within a specified time, and may be
capable of subdivision, or subleasing to other parties
• In operating lease, the value of the Lessee’s Interest is
estimated as the value of rental gain/(loss), if any, and the
value of the leasehold improvement/s, if any
• In financial lease, the value of the Lessee’s Interest is
estimated as market value of the property less the remaining
lease payments.
LEASE INTERESTS
DEFINITION OF TERMS
Rent Types
Market Rent.
• The estimated amount for which a property, or space within a
property, should lease on the date of valuation between a
willing lessor and a willing lessee on appropriate lease terms in
an arm’s-length transaction, after proper marketing wherein
the parties had each acted knowledgeably, prudently, and
without compulsion
Contract Rent, or Passing Rent.

• The rent specified by a given lease arrangement; although a
given contract rent may equate to the Market Rent, in practice
they may differ substantially, particularly for older leases with
fixed rental terms.
LEASE INTERESTS
DEFINITION OF TERMS
Turnover Rent or Participation Rent.

• Any form of lease rental arrangement in which the lessor
receives a form of rental that is based on the earnings of the
lessee. Percentage rent is an example of a turnover rent.
LEASE INTERESTS
DEFINITION OF TERMS
Positive Leasehold Interest
• A positive leasehold is created when the market rent is greater
than the contract rent.
Negative Leasehold Interest
• Negative leasehold interest is created when the contract rent is
higher than the current market rent.
• Even if the leasehold interest is positive, there may be no value
because the leasehold interest is not transferable to a third
party. The lease agreement may prevent a transfer.
• If the contract rent and the market rent are equal, the
Leasehold or Lessee’s Interest is zero, assuming there is no
leasehold improvements.
VALUATION OF LEASE INTERESTS
CONSIDERATIONS
 Leasehold or Lease interests are valued on the same general

principles as freeholds, but with recognition of the
differences created by the lease contract encumbering the
freehold interest, which may cause the interest to be
unmarketable or restricted.
 Leasehold or Lease interests, in particular, are often subject
to restrictive covenants or alienation provisions.
CONSIDERATIONS
 The importance of the distinction between the physical
matter and the legal interest in it is critical to valuation.
 For example, a lease might specify that the lessee has no
right to sell or transfer the leasehold interest, causing it to be
unmarketable during the term of the lease.
 Its value to the lessee, therefore, lies solely in the rights of
use and occupancy. The leasehold value may be expressed in
monetary terms but is not a Market Value as the interest
cannot be sold in the market.
 However, the lessor’s interest (leased fee value) does have a
Market Value, based on the value of the rental income during
the lease together with any residual value remaining at the
end of the lease.
METHOD OF VALUATION
• The valuation of a lease interest is anchored on the economic

principle of anticipation. Value is created by the future
benefits (income stream) of ownership (whole or partial).
• The income capitalization approach is based on the same

principle. The approach perceives value as created by the
expectation of future benefits (income streams).
• Income capitalization employs processes that consider the

present value of anticipated future income benefits.
METHOD OF VALUATION
• The approach considers income and expense data relating to

the property being valued and estimates value through a
capitalization process.
• Capitalization relates income (usually a net income figure)

and a defined value type by converting an income amount
into a value estimate.
• This process may consider direct relationships (known as

capitalization rates), yield or discount rates (reflecting
measures of return on investment), or both.
• Basic Formula: Value = Income / Rate
METHOD OF VALUATION
• One of the accepted methodologies within the income

capitalization approach to valuation is the Discounted Cash
Flow (DCF) analysis.
• Discounted Cash Flow (DCF) analysis is a financial modeling

technique based on explicit assumptions regarding the
prospective income and expenses of a property or business.
• Such assumptions pertain to the quantity, quality, variability,

timing, and duration of inflows and outflows that are
discounted to present value.
 Income Approach – Discounted Cash Flow
0 1 2 3 4 5 6
PV1
+ pwf x I 1
I1
PV2
+ pwf x I 2
I2
PV3
+ pwf x I 3 I3
PV4
+ pwf x I 4 I4 I5
PV5
+ pwf x I5
RV
= pwf x RV
MV Reversion Value
(end of period)
EXAMPLE:
Mr. Lessor owns a property consisting of a parcel of land leased to Mr. Lessee
at an annual lease of P100,000. The lease which is about to commence is for 5
years. The lease is payable at the end of each year. Based on market data, the
capitalization rate for similar properties is 8% per year. The market value of
the property at the end of the lease is estimated at P1,500,000. Determine
the Lessor’s Interest.
Given Data:
Rental Rate is P100,000 per year
Lease Period is 5 years
Capitalization Rate is 8% per year
Value of Property at the end of Lease is P1,500,000
CASH FLOW DIAGRAM:
LESSOR’S INTEREST = NET PRESENT VALUE (NPV) OF RENTALS +
REVERSION VALUE OF PROPERTY
0 1 2 3 4 5
I1
P10,000 x NPV factor

I2
I3
I4 I5
P1,500,000 x NPV factor
COMPUTATION:
A. NET PRESENT VALUE OF RENTAL
YEAR RENTAL NPV FACTOR NPV

1 100,000 0.9259 92,590
2 100,000 0.8573 85,730
3 100,000 0.7938 79,380
4 100,000 0.7350 73,500
5 100,000 0.6806 68,060
399,260
B. REVERSION VALUE
YEAR MV END OF LEASE
5 1,500,000 0.6806 1,020,900
LESSOR'S INTEREST 1,420,160
EXAMPLE:
Corp. A owns an industrial land and leases it to Corp. B. The lease is for 10 years and
commenced in 2008. Corp. B built a warehouse on the land and as stipulated on the
lease agreement, the warehouse will be turned over to Corp. A upon the expiration of
the lease. The starting rental rate is P80,000 per year and is subject to an increase of
P5,000 per year henceforth. Based on market data the capitalization rate of similar
properties is 6% per annum. The value of the land and the building are estimated at
P2,000,000 and P1,500,000, respectively, at the end of the lease. The rentals are
payable at the start of every year. Determine the Lessor’s Interest.
Given Data:
Date of Appraisal is 2010
Lessor is Corp. A
Remaining Lease Period is 8 years
Rental Rate is P80,000 per annum subject to increase payable at the start of the year
Capitzalization Rate is 6% per annum
Value of Land at the end of the Lease is P2,000,000
Value of the Building at the end of the Lease is P1,500,000
COMPUTATION:
LESSOR’S INTEREST = NET PRESENT VALUE (NPV) OF RENTALS + REVERSION VALUE OF THE
LAND VALUE + REVERSION OF BUILDING VALUE
A. Net Present Value of Remaining Lease
Year per Lease NPV Factor at 6% per

Year Rental per Annum NPV
Agrmt. annum
2008 1 80,000 paid -

2009 2 85,000 paid -
2010 3 90,000 paid -
2011 4 95,000 0.9434 89,623
2012 5 100,000 0.8900 89,000
2013 6 105,000 0.8396 88,158
2014 7 110,000 0.7921 87,131
2015 8 115,000 0.7373 84,790
2016 9 120,000 0.7050 84,600
2017 10 125,000 0.6651 83,138
Subtotal 606,439
B. Reversion of Land Value
2,000,000 0.6651 1,330,200
C. Reversion of Building Value
1,500,000 0.6651 997,650
Lessor's Interest 2,934,289
EXAMPLE:
Corp. C leases an office condominium unit in Makati. The lease is for 8 years
and will commence on January, 2011. Monthly rental is P20,000 payable on the
first day of every month. Based on market data, the prevailing rental rate for
condominium units is P25,000, and the capitalization rate is 6% per annum.
The unit is fully-furnished complete with telephone lines and air-conditioning
system. Determine the Lessee’s Interest.
Given Data:
Contract Rate is P20,000 per month
Market Rent is P25,000 per month
Rental Gain is P5,000 per month or P60,000 per year
Capitalization Rate is 6% per year
COMPUTATION:
LESSEE’S INTEREST = NET PRESENT VALUE (NPV) OF RENTAL GAIN
Lessee's Interest = Present Net Value of Rental Gain

Year per
Rental Gain per NPV Factor at
Lease NPV
Annum 6% per annum
Agrmt.
1 60,000 0.9434 56,604
2 60,000 0.8900 53,400
3 60,000 0.8396 50,376
4 60,000 0.7921 47,526
5 60,000 0.7473 44,838
6 60,000 0.7050 42,300
7 60,000 0.6651 39,906
8 60,000 0.6274 37,644
Lessee's Interest = 372,594
EXAMPLE:
Corp. D is leasing a parcel of land in an industrial subdivision is Laguna for 20
years. The lease started in 2005. The rental rate is P1,000,000 per year. Corp. D
constructed buildings of the land but the buildings will be turned over to the
land owner upon expiration of the lease contract. As of the data of appraisal,
2010, the value of the buildings is estimated at P8,500,000, the prevailing
capitalization rate is 6%, the prevailing rental rate for similar land is
P1,200,000, and the remaining life of the buildings is 35 years. Determine the
Lesee’s Interest.
Given Data:
Appraisal date is 2010
Remaining Life of Lease Contract is 15 years
Contract Life Ratio is 15 years / 20 years or 75%
Capitalization Rate is 6%
Contract Rent is P1,000,000 per year
Market Rent is P1,200,000 per year
Rental Gain is P200,000 per year
Value of Buildings is P8,500,000
COMPUTATION:
LESSEE’S INTEREST = NET PRESENT VALUE (NPV) OF RENTAL GAIN + LEASEHOLD VALUE OF
IMPROVEMENTS (BUILDINGS)
A. Present Worth of Rental Gain

Rental Gain per NPV Factor at
NPV
Annum 6% per annum*
200,000 9.7122 1,942,440
* NPV factor for annuity
B. Leasehold Value in Improvements

Contract Life
Value of Buildings
Factor
8,500,000 0.75 6,375,000
Lessee's Interest = 8,317,440
EXERCISE No. 1:
A retail space is rented out by its owner to a merchandiser at P40,000 per year. The
lease contract is for 5 years with a remaining life of 3 years. The tenant pays the
lease every first day of the year. Similar retail spaces in the area have a prevailing
rental rate of P46,000 per year.
Assuming a capitalization rate of 10% per year and the value of the retail space is
estimated to be P2,400,000 after 3 years, compute the Leased Fee and Leasehold
Fee.
EXERCISE No. 2:
Company A is renting an office condominium unit from Company B for P200,000

per year. The lease is for 5 years, with a remaining life of 3 years . Similar office
spaces have prevailing rental of P210,000 per year. Company A introduced
improvements to the unit amounting to P500,000 and, as agreed with the owner,
these improvements will be turned over to the owner at the end of the lease.
Assuming a capitalization rate of 10% per year, compute the Leasehold Fee.
EXERCISE No. 3:
Mr. Cruz rented out his land to Mr. Reyes for P100,0000 per year for 5 years subject
to 10% increase in rental every year. Mr. Reyes constructed a small building on the
lot, which as agreed with Mr. Cruz, the ownership shall be transferred to Mr. Cruz
at the end of the lease agreement.
Assuming a capitalization rate of 10% per year and the values of the land and the
building are estimated to be P640,000 and P500,000, respectively at the end of the
lease , compute the Leased Fee.
EXERCISE No. 4:
Company A is leasing a commercial space for P50,000 per month. Included in the
lease agreement, is that Company A will pay additional rental of 3% for gross sales
revenue in excess of P100,000 per month. Last year Company A, had a gross sales
revenue of P2,360,000. How much rental was paid by Company A?

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Valuation of Lease Interests

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VALUATION

Lease interests are a form of real property –

 arising from the contractual relationship (the terms of which

 a lessor, one who owns the property leased to another, and

 a lessee, or tenant, one who typically receives a non-permanent

Leased Fee or Lessor’s Interest,

Leasehold or Lessee’s Interest, or Leasehold Estate.

Contract Rent, or Passing Rent.

Turnover Rent or Participation Rent.

 Leasehold or Lease interests are valued on the same general

• The valuation of a lease interest is anchored on the economic

• The income capitalization approach is based on the same

• Income capitalization employs processes that consider the

• The approach considers income and expense data relating to

• Capitalization relates income (usually a net income figure)

• This process may consider direct relationships (known as

• Basic Formula: Value = Income / Rate

• One of the accepted methodologies within the income

• Discounted Cash Flow (DCF) analysis is a financial modeling

• Such assumptions pertain to the quantity, quality, variability,

P10,000 x NPV factor

P10,000 x NPV factor

P1,500,000 x NPV factor

YEAR RENTAL NPV FACTOR NPV

A. Net Present Value of Remaining Lease

Year per Lease NPV Factor at 6% per

2008 1 80,000 paid -

Lessee's Interest = Present Net Value of Rental Gain

A. Present Worth of Rental Gain

B. Leasehold Value in Improvements

Company A is renting an office condominium unit from Company B for P200,000

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