Question

Suppose your client owned a commercial parcel of land. His accountant advised him not to sell the land but rather to lease it on a long-term basis. He put a "for lease" sign on the property and received an offer within a few months. The lease he agreed to was for 75 years with payments of $40,000 per year for 50 years and $50,000 per year for the last 25 years. The tenant signed the lease and within hours signed a contract to build a two-story office building on that land. The tenant arranged for a mortgage to finance the construction of the building, which had a reproduction cost of $1,800,000. The lease rate appears to be at the market rate.

1. If the land lease has a 10% capitalization rate, what is the value of the owner’s interest in the land (the leased fee interest)?
2. What is the value of the tenant’s interest in the building?
3. As the building gets older and closer to the end of the 75-year lease, what will happen?
4. What about the reversion (i.e., the resale of the property) after the lease ends? How much will the building add or subtract from the value?

Answer 1

1. The value of the owner's interest in the land (the leased fee interest) is $757,144. 2. The value of the tenant's interest in the building is $633,704. 3. As the building gets older and closer to the end of the 75-year lease, its value will decrease. 4. After the lease ends, the building will revert back to the owner and its value will depend on market conditions and its condition at that time.

Step-by-step explanation:

1. To determine the value of the owner's interest in the land (the leased fee interest) using a 10% capitalization rate, we can calculate the present value of the lease payments. First, we need to find the present value of the $40,000 per year payments for 50 years and the $50,000 per year payments for 25 years. Using the formula for the present value of an annuity, the present value of the first set of payments is $404,440, and the present value of the second set of payments is $352,704. Adding these two values together, we get $757,144. The value of the owner's interest in the land is the present value of the lease payments plus the residual value of the land at the end of the lease. Since the lease is for 75 years, the residual value is the value of the land at year 75, which can be calculated using the capitalization rate. Therefore, the value of the owner's interest in the land is $757,144 plus the present value of the residual value, which is $0 since the land will be returned to the owner.

2. The tenant's interest in the building is calculated by finding the present value of the lease payments for the building. Using the same formula, we can find the present value of the $1,800,000 reproduction cost. If we assume that the lease payments will be made at the same rate as the land lease, the present value of the lease payments for the building is $633,704.

3. As the building gets older and closer to the end of the 75-year lease, its value will decrease. This is because the building will have less useful life remaining, and potential buyers or tenants will consider this when determining its value. The depreciation of the building will decrease its value over time.

4. After the lease ends, the building will revert back to the owner. The value of the building will depend on its condition and market demand at that time. In general, the value of the building will subtract from the overall value of the property, since the owner will have to bear the cost of demolishing or renovating the building to suit their needs.