Valuing the Leased-fee Interest under a Ground Lease

When a property is leased employing a ground lease, two separate interests are created: the first is the leasehold interest, held by the tenant; the second is the leased-fee interest, held by the landowner/lessor. What is unique about properties subject to a ground lease is that the lease conveys to the first tenant not only the right to use and possess the property but also the right to develop it, subject to the terms of the ground lease.
Once the property is improved, the leasehold interest may be transferred to a new owner who acquires title to the improvements. The leased-fee owner may also transfer title to a successor-in -interest, but the title transfers subject-to the ground lease.

At expiry, virtually all  modern ground leases provide that the improvements on the land revert to ownership by the landowner/lessor. During the term of the ground lease the landowner is said to hold an estate in reversion, which is the leasehold interest which awaits him/her at expiry.
During the term of the ground lease the landowner is free to trade, sell, exchange, or gift the leased-fee interest. He is also free to mortgage the leased-fee interest secured by a mortgage or trust deed recorded against the leased-fee interest only, and not by the leasehold interest.

The value of  the leased-fee interest is the present value of the rent payments to be paid in the future, together with the present value of the appreciated value of the land at the time of expiry. While it is inappropriate to capitalize rent flowing from a leasehold interest, it is doubly inappropriate to capitalize the rent from a leased-fee interest because it ignores the reversion value of the land. The simplest method of arriving at the value of the interest is to use a spreadsheet to discount both the rent stream and the appreciated value of the land.

On the spreadsheet, construct a vertical column listing by year the scheduled rents and the appropriate increases. Most, but not all, ground leases will specify scheduled increases during the prime term of the lease. Initially, do not include option years since these years are under the control of the tenant who has the right, but not the obligation, to extend the lease and should carry a higher discount rate.

In a parallel column enter the present value of the underlying land. Increase this value at the rate of 3.0% per year, an historical inflation rate, extending the land values for the prime term of the lease.

At the bottom of the vertical rent column enter the following financial (Excel) function:
= NPV(discount rate, Value(2)….Value (n) + Value (1)). This function is chosen rather than the “=PV ( )” financial function because the NPV function discounts changing Values whereas the PV function is limited to one Value. (The NPV function in Excel delivers the Present Value and not the Net Present Value. It also assumes that all values occur the end of the period.)
Value (1) is excluded from the discounting function since the first lease payment occurs at the beginning of the period and should not be discounted. Its full value, however,  is added later to the resultant NPV.

The same function can be used to discount the land values, except that the Values should not exclude the first year’s value:
=NPV(discount rate, Value (1)…Value(n))

The discount rate is the desired yield from the cash flows and, with respect to the rents, is a function of the financial strength of the tenant. It is prudent not to enter into a ground lease with a developer who lacks a strong financial record and a strong performance history.
The discount rate for the land can afford to be less than that from the rents if the ground lease is unsubordinated to a loan on the improvements. In the event of  default on the leasehold loan, a lender will invariably step-up to foreclose on the mortgage leaving the lender as the tenant.

If the property is in a desirable location the 3.0% rate used to inflate the land value should be considered a minimum.  If the land cannot be expected to appreciate at this rate the value of the location should be reexamined since the value of the land at expiry of a long ground lease will be the greater source of the investor’s total return.

The full value of the leased-fee interest is the sum of the NPVs from rent and the NPV of the  appreciated value of the land.

NOTE: The same formula can be used to estimate the Present Value of the rents under a leasehold interest. But the discount rate should be much higher since the ground tenant has no share in the appreciated value of  the underlying land.



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