Leasehold Valuation: Capital Value Approaches

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Chapter: Leasehold Valuation: Capital Value Approaches

Introduction

This chapter delves into the capital value approaches used in leasehold valuation, focusing on methodologies for determining the present worth of future income streams generated by leasehold interests. We will examine the theoretical underpinnings of these approaches, explore their practical applications, and address their limitations. A leasehold interest is a wasting asset, decreasing in value over time as the lease term approaches expiry. Therefore, leasehold valuation techniques must account for this time-dependent depreciation and the inherent risks associated with leasehold ownership.

6.1 Understanding Leasehold Interests as Wasting Assets

• The Concept of Wasting Assets: A wasting asset is an asset whose value diminishes over time due to use or the passage of time. Leasehold interests fall squarely into this category. As the expiry date approaches, the remaining period during which the leaseholder can derive income from the property decreases, and so does the value of the leasehold.
• Loss of Capital: Upon lease expiry (after any statutory protection is considered), the leaseholder loses their right to occupy and derive income from the property. The original❓ capital outlay, representing a premium paid for the lease or expenditure incurred on improvements as a condition of the lease, is effectively lost.
• Profit Rent and Time Limitation: Even if the profit rent (the difference between the rent received from a sublease and the rent paid under the head lease) is equivalent to what a freeholder might receive, its value is inherently lower for the leaseholder because the income stream is limited by the lease term.

6.2 Factors Affecting Leasehold Value

Several factors influence the capital value of a leasehold interest:

1. Profit Rent: The magnitude of the profit rent is a key determinant of value. A higher profit rent generally translates to a higher capital value, all else being equal.
2. Lease Term: The remaining term of the lease has a significant impact. Longer lease terms are more valuable as they provide a longer period of income generation.
3. Head Rent: The rent payable under the head lease (the rent the leaseholder pays to the freeholder or superior leaseholder). A lower head rent increases the profit rent and, consequently, the capital value.
4. Sublease Terms: The terms of any subleases in place, including the rental rate, rent review provisions, and tenant covenant strength. A sublease to a strong tenant at a favorable rent enhances the leasehold value.
5. Discount Rate/Yield: The discount rate (or yield) used to convert the future income stream into a present value. This rate reflects the risk associated with the leasehold investment. Higher perceived risk leads to higher discount rates, resulting in lower capital values.
6. Rent Review Patterns: Frequency and mechanism of rent reviews on both the head lease and sublease.
7. Potential liabilities: Such as potential dilapidations.

6.3 Capital Value Approaches: An Overview

Two main approaches are used to establish the capital value of a leasehold interest:

• The Conventional or Historic Approach (All Risks Yield): This approach capitalizes the net profit rent using a yield slightly higher than a comparable freehold yield. While historically common, this method has been criticized for its mathematical inaccuracies and simplified assumptions.
• Discounted Cash Flow (DCF) Analysis: This approach treats the profit rent as a cash flow, discounting each period’s income to its present value using a risk-adjusted discount rate. The DCF method is increasingly favored for its accuracy and flexibility in handling complex leasehold scenarios.

6.4 Discounted Cash Flow (DCF) Analysis: A Deep Dive

The DCF approach is a robust valuation technique based on the fundamental principle that the value of an asset is the present value of its expected future cash flows.

6.4.1 Principles of DCF

• Time Value of Money: The core concept underlying DCF is the time value of money. A dollar received today is worth more than a dollar received in the future due to the potential for earning interest or returns.
• Discount Rate: The discount rate reflects the opportunity cost of capital and the risk associated with the investment. It represents the rate of return an investor requires to compensate for the time value of money and the perceived risk.
• Cash Flow Projections: Accurate cash flow projections are crucial. These projections must consider factors such as rental income, operating expenses, capital expenditures (if any), and potential changes in these factors over time.

6.4.2 DCF Formula

The basic DCF formula is:

PV = CF1 / (1 + r)^1 + CF2 / (1 + r)^2 + ... + CFn / (1 + r)^n

Where:

• PV = Present Value (Capital Value)
• CFt = Cash Flow in period t
• r = Discount Rate
• n = Number of periods

6.4.3 Application to Leasehold Valuation

In leasehold valuation, the CFt represents the profit rent in each period. The discount rate (r) is a risk-adjusted rate reflecting the inherent risks of leasehold ownership. This rate is typically higher than a comparable freehold yield to account for the wasting asset nature of the lease and the potential for tenant default.

6.4.4 Determining the Appropriate Discount Rate

Selecting the appropriate discount rate is critical. Factors to consider include:

• Risk-Free Rate: The return on a risk-free investment, such as government bonds.
• Risk Premium: An additional return required to compensate for the specific risks of the leasehold investment. This premium should reflect:
  • The length of the lease term.
  • The creditworthiness of the sub-lessee (tenant covenant strength).
  • The liquidity of the property market.
  • Potential for obsolescence.
  • The complexities of the lease agreement.

A common approach is to add a risk premium to a comparable freehold yield to arrive at the leasehold discount rate. For example, as illustrated in the provided text, a 5% risk premium might be added to a freehold equated yield of 11%, resulting in a leasehold yield of 16%.

6.4.5 Example: Simple Leasehold Profit Rent (DCF)

(Adapted from Example 6.1 in the provided text)

A property is held on a head lease with four years remaining at a fixed head rent of £10,000 p.a. The head lessee has sublet the premises on a co-terminus sublease at £110,000 p.a. with no further reviews. Assume the freehold equated yield is 11%, and an extra 5% risk premium is added so the leasehold equated yield is 16%.

Table 6.1: DCF Layout for Appraisal of a Head Leasehold

The PV factor for year n = 1 / (1 + r)^n, where r = 0.16

6.4.6 Short-Cut Layout

When income is constant, the DCF approach can be shortened to:

Capital Value = Profit Rent * YP

Where YP (Years Purchase) is the sum of PV factors, and can be looked up from YP tables, or calculated. In the above example:

Capital Value = £100,000 * 2.7982 = £279,820

6.4.7 Sinking Fund Illustration

Example 6.2 in the provided text illustrates how the profit rent can be considered as providing both a return on the capital, and a return of the capital, through the use of a sinking fund:

• The investor receives a 16% return on their initial £280,000 investment.
• A portion of the profit rent is allocated to a sinking fund, accumulating interest at 16% per annum.
• By the end of the four-year lease term, the sinking fund’s balance is sufficient to replace the original £280,000 capital investment.

However, in practical application, investors are likely to reinvest the full profit rent rather than separating it into return on and return of capital components.

6.4.8. Geared Leasehold Profit Rent

This is where the head rent is fixed, and the sublease is at market rent, with regular reviews. The profit rent therefore has growth potential. Example 6.3 in the provided text covers this:

• A retail shop is held on a ground lease with 15 years unexpired at a fixed ground rent of £10,000 p.a.
• The head lessee has sublet the shop at Market Rent (MR) of £200,000 p.a. on a modern lease with five-yearly rent reviews.
• Assume the freehold all risks yield is 6%.
• We need to determine the expected growth rate in the Market Rent.

The Market Rent growth rate is derived from the formula:

(1 + g)^n = (YP_perp_k - YP_n_e) / (YP_perp_k * PV_n_e)

Where:

• g = annual growth rate❓
• n = Review period (in years)
• YP_perp_k = Years’ Purchase in perpetuity at all risks yield k.
• YP_n_e = Years’ Purchase for n years at freehold equated yield e.
• PV_n_e = Present Value of £1 in n years at the freehold equated yield e.

In this example:

• n = 5 years
• k = 6%
• e = 11%
• YP_perp_k = 1 / 0.06 = 16.6667
• PV_n_e = 1 / (1 + 0.11)^5 = 0.5935
• YP_n_e = (1 - PV_n_e) / 0.11 = (1 - 0.5935) / 0.11 = 3.6955

Therefore:

(1 + g)^5 = (16.6667 - 3.6955) / (16.6667 * 0.5935) = 1.3113
g = (1.3113^(1/5)) - 1 = 0.0557 = 5.57%

So, the market rental growth rate is 5.57% per annum.

Table 6.3: Appraisal of a Rising Profit Rent (Simplified for Illustration)

Calculation notes:

• Growth factor is (1+g)^n where n is the number of years since commencement of the sublease. The growth factor for year 1-5 is 1.
• PV Factor takes account of the years until the beginning of the next rental tranche.

6.4.9 Tax Considerations in DCF

The DCF analysis can be performed on pre-tax or post-tax cash flows. Using a post-tax approach requires adjusting both the profit rent and the discount rate to reflect the investor’s tax rate.

If the profit rent and leasehold equated yield have been adjusted for tax at 40% so that the net of tax yield is 16% × 0.6 = 9.6%, the formula becomes:

PV = (CF1 * (1 - TaxRate)) / (1 + r_tax)^1 + (CF2 * (1 - TaxRate)) / (1 + r_tax)^2 + ... + (CFn * (1 - TaxRate)) / (1 + r_tax)^n

Where:

• TaxRate is the investors tax rate.
• r_tax is the post tax discount rate.

A simplified view of the effect of tax on the “rising profit rent” example above can be seen in Table 6.4 in the original text. Applying the post tax rate of 9.6% the capital value falls to £1,109,823.

6.4.10 Complex Cash Flows and Non-Coinciding Rent Reviews

DCF analysis is particularly valuable when dealing with complex cash flows, such as situations where rent reviews on subleases and head leases do not coincide. This can lead to periods of positive and negative profit rents. The DCF approach allows you to model these scenarios accurately by projecting the individual rent streams and discounting them appropriately.

6.4.11 Valuation of Short Leasehold Investments

DCF is also useful for valuing short leasehold investments (e.g., five years or less). The timing of income (e.g., quarterly in advance), specific outgoings (e.g., rent review fees, repairs, maintenance), and inflation can all be incorporated into the analysis.

6.5 The Conventional or Historic Approach (All Risks Yield)

This approach, while historically prevalent, has significant limitations. It involves capitalizing the net profit rent using a yield slightly higher (typically 1-2%) than the all-risks yield for comparable freehold properties.

6.5.1 Formula:

Capital Value = Profit Rent / (Freehold All Risks Yield + Risk Premium)

6.5.2 Limitations:

• Oversimplification: It assumes a constant income stream throughout the lease term, neglecting potential rent reviews or changes in market conditions.
• Ignoring Time Value of Money: It does not explicitly account for the time value of money or the decreasing value of the leasehold as it approaches expiry.
• Subjectivity: Determining the appropriate risk premium is subjective and lacks a rigorous scientific basis.
• Inaccuracy: Studies have demonstrated its mathematical inaccuracies compared to DCF analysis.

Due to these limitations, the DCF approach is increasingly favored for its accuracy and flexibility.

6.6 Practical Application and Related Experiments

• Sensitivity Analysis: Experiment with varying the discount rate in the DCF model to assess the sensitivity of the capital value to changes in perceived risk. This can be done using readily available spreadsheet software.
• Scenario Planning: Develop different cash flow scenarios based on optimistic, pessimistic, and most likely rent review outcomes. Model these scenarios in a DCF to understand the range of potential values.
• Market Data Comparison: Compare DCF-derived valuations with observed transaction prices for similar leasehold properties. This helps validate the assumptions used in the DCF and refine the discount rate selection.
• Software Solutions: Many software packages exist to aid in DCF valuation. These generally have the ability to model various scenarios and rent patterns.
• Real world projects: Undertake comparative leasehold valuations of properties.

Conclusion

Capital value approaches, particularly DCF analysis, provide a robust framework for valuing leasehold interests. By explicitly accounting for the time value of money, risk, and potential changes in cash flows, DCF analysis offers a more accurate and defensible valuation than the conventional all-risks yield approach. While the conventional approach may still be encountered in practice, understanding its limitations and embracing the DCF methodology is essential for informed leasehold valuation.