CitationDownload as .RIS
Emerald Group Publishing Limited
Copyright © 2008, Emerald Group Publishing Limited
The valuation of leasehold property
Article Type: Education briefing From: Journal of Property Investment & Finance, Volume 26, Issue 5
The market value of any interest be it freehold or leasehold, represents the discounted value of the predicted future benefits derived from the ownership of that interest. Thus the underlying function of any valuation is to accurately predict those benefits and derive its present value. This section reviews that premise in relation to leasehold valuations.
The nature of leasehold interests
A leasehold interest is an interest in a property, for a limited number of years, arising from the grant of a lease by a freeholder. The VALUE of a leasehold interest arises when the leaseholder sublets the property at a rent (MR) that is greater than the rent currently being paid to the freeholder (Figure 1).
This arrangement produces two leasehold interests, the (investment) intermediate leasehold and the occupying leasehold. In this instance, it is the intermediate leasehold that achieves a profit rent.
Intermediate leasehold (B): profit rent
Rent receivable - £100,000.
Rent paid - £20,000.
Profit rent for ten years - £80,000.
Profit rent=Market Rent (MR) - rent currently passing (or rent paid on sublease).
The profit rent may be either:
Actual: the leaseholder actually sublets the property and receives the profit rent.
Notional: the leaseholder occupies the property; the profit rent representing the saving to the leaseholder, as she/he is not paying MR for the property.
Comparison between freeholds and leasehold interests
The valuation of leasehold is the discounted value of the net cash flow as it would with a freehold valuation. However the major difference is that the net income stream of the leasehold is finite (see Figure 1 - ten years).
DCF application to the valuation of leaseholds
It is useful to consider the nature of a leasehold investment. If a leasehold investment has two fixed leases in place, then the income profile being acquired is a fixed income for a defined period of time. If the covenant strength of the tenant were strong, this would be equivalent to a government stock for the same duration. If we assume, for illustration, that the stock dividend is paid annually in arrears, the stock can be valued at using a discounted cash Flow technique (DCF) as illustrated in Table I. It can be seen that the capital value is derived by a valuation of a finite cash flow with the use of a DCF technique. Why should the property investment be valued in any other way? This can be illustrated in Table II.
Table I Government stock (net) valuation
Table II DCF leasehold (net) valuation
The advantage of the DCF basis is that this IRR of the leasehold investment can be determined by reference to the stock market with a relevant risk adjustment for the additional risk of the property investment. Thus it is possible to “value” such property investments when there is little or no evidence of recent sale. As with the Freehold valuations covered in previous sections, the advocates of DCF are simply suggesting that the valuation profession should return to fundamentals, and not rely solely on the benchmark comparisons of the traditional methodology. The use of DCF valuations for leaseholds can be applied practically. Indeed in certain circumstances, traditional methods have been proved to under-value investments by failing to address the fundamental elements of the cash flow being purchased such as gearing. Thus where a Leasehold property has a rent review in the sub-lease, as the growth is applied explicitly to the MR, the effect of the gearing can be allowed for within the calculation of the profit rents. This can be illustrated in Figure 2).
The valuation of leaseholds has traditionally been seen as a sub-set of freehold valuations. The traditional dual rate valuation (to be discussed in the next briefing) is intrinsically tied with the freehold. However, it can be seen that in the case of short leaseholds, the cash flow is more akin to a gilt investment and as such there is an even greater argument to use DCF techniques as the principle method of valuation.