A 3-story office building is leased to a single tenant under a 10-year gross lease with 7 years remaining. The tenant pays a flat $36,000 annual rent, which includes all operating expenses. Market rent for similar space is $30,000 annually *net* of expenses, and typical operating expenses for such properties average $12,000 per year. What is the annual effective gross income attributable to the leasehold interest for valuation purposes?
Correct Answer
B) $6,000 — the difference between contract gross rent ($36,000) and market gross rent ($42,000), representing the annual benefit to the tenant.
The leasehold interest’s value derives from the present value of the difference between market rent and contract rent, adjusted for expense responsibilities (USPAP Standards Interpretation 11). Here, both rents are on a gross basis: contract rent = $36,000 gross; market rent = $42,000 gross. The tenant pays $6,000 less per year than market, creating a favorable leasehold interest. Option A is incorrect because contract rent is *below* market, conferring value. Option C misidentifies expenses as the benefit — expenses are a cost allocation, not the rent differential. Option D incorrectly treats market net rent as the valuation basis; leasehold valuation requires comparison of equivalent lease structures — here, gross-to-gross. Thus, $6,000 is the correct annual effective gross income attributable to the leasehold interest.
Why This Is the Correct Answer
Converting the market net rent of $30,000 to a gross equivalent by adding $12,000 of operating expenses gives $42,000, against a contract gross rent of $36,000 — an annual tenant advantage of $6,000.
Why the Other Options Are Wrong
Option A: $0 — the leasehold has no value because contract rent is higher than market rent.
Contract rent is not higher than market once both are stated on the same basis. The gross equivalents are $36,000 against $42,000.
Option C: $12,000 — the amount of annual operating expenses shifted to the landlord under the gross lease.
The $12,000 is the expense figure used to convert net to gross. It is an input to the comparison, not the advantage itself.
Option D: $30,000 — the market net rent, which is the appropriate basis for leasehold valuation under USPAP.
The $30,000 is market rent on a net basis and cannot be compared directly with a gross contract rent.
Same Basis Before You Subtract
Same Basis Before You Subtract. Net plus expenses equals gross — only then compare.
How to use: Write both figures as gross or both as net before doing any arithmetic. That step resolves most leasehold problems.
Exam Tip
The annual differential is not the leasehold value. Converting it requires discounting over the remaining term.
Common Mistakes to Avoid
- -Comparing gross contract rent to net market rent directly
- -Treating the annual differential as the leasehold value
- -Reversing the direction of the advantage
Concept Deep Dive
Analysis
A leasehold has value to the tenant when the lease costs less than the market would charge for the same occupancy, and the whole difficulty here is putting contract and market on the same basis. The contract is a gross lease: $36,000 buys the space and all operating expenses. The market figure is quoted net — $30,000 for the space with the tenant paying expenses separately — so its gross equivalent is $30,000 plus the $12,000 of typical operating expenses, or $42,000. Comparing like with like, the tenant occupies for $36,000 what the market would cost $42,000, an annual advantage of $6,000. That advantage, running for the seven years remaining, is what the leasehold represents. Note what the question is not asking: the $6,000 is the annual benefit, and converting it into a value would require discounting it over the remaining term. Mixing gross and net figures is the single most common error in leasehold problems.
Background Knowledge
A leasehold interest has value when contract rent is below market rent. Comparing the two requires both to be stated on the same basis, converting net rent to a gross equivalent by adding operating expenses.
Real-World Application
An appraiser converts a $30,000 net market rent to a $42,000 gross equivalent, compares it with $36,000 contract gross rent, and identifies a $6,000 annual leasehold advantage over seven years.
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