In a tenant occupied property, the property owner has transferred their rights of use and occupancy to the tenant in exchange for the acceptance of the tenant's payment of rent. Consequently, if that owner decides to sell their property during the term of the lease, the buyer has to understand they're buying the value of the owner's real property rights and has to form their opinion of the value that property accordingly.
This article will explain how to estimate the value a tenant occupied property.
As we know, all of the real property rights that can be owned are called the "Bundle of Rights" which represents the Fee Simple Estate. And, when an owner of a Fee Simple Estate transfers the rights of Use and Occupancy to a tenant on a temporary basis in exchange for the tenant's payment of rent, the Fee Simple Estate is broken into two lesser "estates" with the tenant holding the rights of Use and Occupancy in what's known as the Leasehold Estate and the rights the owner retains are called the Leased Fee Estate.
Among the rights the owner retains in the Leased Fee Estate is the Right of Reversion, which is the owner's right to reacquire the rights of Use and Occupancy of the real estate at the conclusion of the tenancy.
However, when an owner decides to sell the property while the tenant possesses the rights of Use and Occupancy, the owner can only sell their Leased Fee Estate. It's essential that a buyer forms a realistic opinion of the value of that Leased Fee Estate and not to confuse the value of that real estate with its value as a Fee Simple Estate because the Leased Fee value may be either more or less valuable than the Fee Simple Estate value. Let me explain why ...
The value of a Leased Fee Estate is strictly based on the value of the rent stated in the property's lease; it's not based on what the fair market value of the rent for the property might be on the date of value.
Thus, if the fair market rent for the property being valued is higher than its the rent stated in the lease contract , the Leased Fee value will likely be somewhat lower than the Fee Simple value.
Conversely, if the fair market rent for that property is lower than its lease contract rent, the Leased Fee value will likely be somewhat higher than the Fee Simple value.
The Valuation Methods
When valuing an income producing property we're necessarily going to develop and rely on only the investment valuation method (a/k/a income capitalization method).
We don't compare an income property to the sale of another income property because the sale price of every income producing property is based on the specifics of the income and expenses unique to each income producing property.
Therefore, using the sales comparison method which only compares the physical attributes of one property to another will provide a misleading result.
Using the investment analysis valuation method, there are two possible procedures that can be used; direct capitalization and yield capitalization.
Direct capitalization considers only the current years' net operating income (NOI) and converts it into a capital sum. This is done by dividing the current year NOI by an appropriate overall capitalization rate (Ro). And, while Direct Capitalization provides a quick "down and dirty" value estimate, it's also somewhat inaccurate since it ignores the future changes in the cash-flow, especially when there's a long-term lease in place with years remaining on that lease. This is where Yield Capitalization becomes the preferred procedure.
And, for valuing a property with years remaining on an existing lease, the preferred valuation technique within the Yield Capitalization method is the Discounted Cash Flow or DCF technique which is developed as explained in the following example.
Discounted Cash Flow Example
Joe leases his 5,000 square foot store to Jane for 5 years starting on July 1, 2020. They agree that Jane will pay $20.00 per square foot (/sf) base rent plus all other expenses of the property, including taxes, insurance, repair and maintenance, etc., as additional rent.
They also agree the base rent of $20.00/sf will increase by 3% on every anniversary of the lease.
It's now August 22, 2022 and Joe's decided to sell his property and we've been asked to help Joe to sell his property which requires us to estimate the Leased Fee value of Joe's property.
We're now into the third year of the lease with 10 months remaining in the 3rd year of the lease followed by 2 more full years. The current rent is $21.22/sf ($20.00/sf Y1 x 1.03% = $20.60/sf Y2 x 1.03% = $21.22 Y3) and we'll calculate the remaining amount of rent scheduled to be collected as follows:
At the end of the lease, Jane the tenant vacates the property and the property rights of Use and Occupancy revert back to Joe, the owner who now holds the entire Bundle of Rights, a/k/a the Fee Simple Estate. This requires us to estimate the value of the Fee Simple property rights of Joe's property at end of the lease which is called the "Reversion Value."
While there are several methods that can be used to estimate the future "Reversion Value" of Joe's property, we're simply going to do a Direct Capitalization of the last year's NOI. And, for the sake of this example, we're going to select a hypothetical Overall Capitalization Rate (Ro) of 7.5% to convert the last year's NOI to a capital sum which represents the value of Joe's property at the point of the reversion at the end of the lease as follows:
FORMULA: Income (NOI) / Rate (Ro) = Value
Thus: $112,579 (Y5 NOI) / 0.075 (Ro) = $1,501,053 (Value)
But, what's the Present Value of all of this future income?
Since we need to know how much Joe's property is worth today (August 2022 per the example), we have to convert all future dollars back to present value using the "Discounting Procedure."
The discounting procedure is a commonly used procedure and something that's used by every state lottery system in the United States and elsewhere. For example, if the jackpot is $100 million, you can collect that whole $100 million at the rate of $5 million a year for the next 20 years.
BUT - if you want to be paid all at once, the lottery system "discounts" that $100 million to present value which removes all the risk of you waiting 20 years to collect that $100 million.
And, for example, if the lottery system uses a discount rate of 5% annually, you'll wind up collecting about $38 million of that $100 million today (before paying income taxes).
The concept of "present value" is based on the "time-value of money" theory which says, a dollar to be collected in the future is worth more than a dollar in-hand today. The basis of this theory considers various risk factors related to unknown problems which may occur in the future that may jeopardize the value of that future dollar, such as loss in value due to inflation among other factors.
When dealing with risks associated with future income to be generated by real estate, there are additional factors, such as the tenant going out of business, damage to the property by fire, flood, or another disaster that may prevent the tenant from using the property which causes them to stop paying rent. Thus, the greater the risk, the greater the discount to present value.
The Present Value formula is: Present Value (PV) = Future Value (FV) / 1/1+r (rate) x n (the number of periods). Actually, it sounds more complicated that it is, especially if you know how to use a financial calculator like the HP-12c or use a free online calculator.
Assuming we've researched the market data and evaluated the risk associated with owning Joe's property and we've decided that 5% is a reasonable interest rate to be paid to take the risk of owning Joe's property with its current lease in place. Therefore, we'll develop the Present Value Factor (PV) Factor for each year and apply it to each year's rent and the Reversion Value as shown in the following table.
Having calculated the Net Present Value (NPV) of each year's rent and the Reversion Value of Joe's property at the end of the lease contract, we've added all of these NPVs to reach our indication of the Net Present Value of Joe's Leased Fee Estate as of August 2022 which is $1,577,522 which we'll round to $1,575,000.
Having this value estimate is a benefit to both Joe, the seller and any prospective buyer in that it provides an indication of a "fair" sale price to both parties.
And, if you're the broker for either party, you now have a reasonable basis for negotiating a "fair" deal for your client.
Contact me for a complimentary consultation about how we can help you're interested in selling, leasing, or buying a commercial property.