A medical office building is leased to a physician group under a 12-year lease with rent set at $24.00/sf/year, escalating 3% annually. Market rent for similar space is currently $26.50/sf/year and is projected to grow at 2.75% annually. The appraiser calculates the present value of the rent differential (market minus contract) over the lease term at a 7.5% discount rate and arrives at $1,024,000. What does this figure represent?
Correct Answer
B) The value of the leasehold interest.
Why this is correct: The leasehold is the tenant's interest, and it has positive value only to the extent the tenant occupies for less than the space is worth. Contract rent begins at $24.00 per square foot against market rent of $26.50, so the tenant enjoys a positive differential from the outset; discounting market minus contract over the remaining term at 7.5% converts that advantage into a present sum, and $1,024,000 is the value of the tenant's position. Why the other choices are wrong: 'The value of the leased fee interest' is the landlord's position, which is the present value of the contract rent the landlord actually collects plus the reversion at lease end; a rent differential is not that stream. 'The amount of functional obsolescence in the building' confuses a contractual advantage with a physical or design deficiency; functional obsolescence arises from the improvements themselves, not from the terms of a lease. 'The value of the fee simple interest' presumes an unencumbered estate valued at market rent, and the whole premise here is that the property is encumbered by a below-market lease. Exam tip: Contract rent below market means the tenant is ahead, so the leasehold has value. Contract rent above market means the leasehold is a burden, and the advantage sits with the landlord's leased fee instead.
Why This Is the Correct Answer
The present value of market rent minus contract rent over the remaining term is the standard measure of the leasehold interest's value, sometimes called the leasehold advantage. It captures precisely what the tenant gains by holding a below-market lease rather than renting at market. The figure belongs to the tenant's side of the divided bundle, which is why it is not the landlord's leased fee and not the undivided fee simple. In practice the appraiser would also consider whether the lease is assignable or sublettable, since a leasehold advantage the tenant cannot monetize is worth less in the market than the raw arithmetic suggests.
Why the Other Options Are Wrong
Option A: The value of the leased fee interest.
Leased fee value is the present value of the contract rent the landlord actually receives plus the present value of the reversion at lease expiration. It is built from the contract rent stream itself, not from the differential, and it is diminished rather than defined by a below-market lease. Selecting it means assigning the tenant's benefit to the landlord, which reverses who holds the advantage.
Option C: The amount of functional obsolescence in the building.
Functional obsolescence is a loss in improvement value caused by a design deficiency, a superadequacy, or an outdated layout, and it is measured against what the market expects of the physical building. A rent differential arising from lease terms says nothing about the building's design or utility. The two would only intersect if the space itself were deficient, which is not what the stem describes.
Option D: The value of the fee simple interest.
Fee simple value assumes the property is unencumbered and available at market rent, so it would be derived by capitalizing or discounting market rent rather than a differential. The differential is by definition only a piece of the whole, the piece that shifted to the tenant. As a rough check, leased fee plus leasehold approximates fee simple, so no single one of them can equal a differential.
The Gap Belongs to the Tenant
Draw two lines on a chart, market rent above and contract rent below. The space between them is money the tenant is not paying. Discount that space and you have the leasehold. The landlord's interest is the lower line plus the building at the end.
How to use: When a question presents a rent differential and asks what a present value represents, answer leasehold. When it presents the contract rent stream plus a reversion, answer leased fee. When it presents market rent with no lease, answer fee simple.
Exam Tip
Check the direction before naming the interest. Contract below market gives the tenant a positive leasehold; contract above market gives the landlord an advantage and the tenant a negative position.
Common Mistakes to Avoid
- -Assigning the rent differential to the landlord's leased fee
- -Forgetting the reversion when valuing a leased fee
- -Ignoring assignment and sublease restrictions that limit a leasehold's marketability
Concept Deep Dive
Analysis
When a property is leased, the fee simple bundle divides into two interests that together equal the whole. The landlord holds the leased fee: the right to receive contract rent for the remaining term plus the reversion of the property at expiration. The tenant holds the leasehold: the right to occupy for the term at the contract rent. A leasehold has positive value only when the tenant is paying less than the space is worth, because the tenant then enjoys a benefit measured by the gap between what he pays and what he would have to pay at market. Quantifying that benefit is a present value exercise: project market rent and contract rent separately over the remaining term, take the difference year by year, and discount at a rate reflecting the risk of that differential stream. Here contract rent starts at $24.00 against market at $26.50 and, because the escalators are close, contract remains below market throughout the twelve years, so the differential is positive in every period and the $1,024,000 present value is the tenant's advantage.
Background Knowledge
You need the bundle of rights and the definitions of fee simple, leased fee, and leasehold, plus the rule that leased fee value rests on contract rent and the reversion. You should also be comfortable discounting a differential stream and know that assignability and sublease rights affect how much of a leasehold advantage is marketable.
Real-World Application
An appraiser retained by a physician group considering an early buyout computes the present value of their below-market rent over the remaining term, explains that the figure represents their leasehold advantage, and notes that its realizable value depends on whether the lease permits assignment to a successor practice.
More Income Approach Questions
In a percentage lease, rent is commonly structured as:
In a DCF, what is the reversion?
Potential gross income differs from effective gross income in that PGI assumes:
The reversion in a discounted cash flow model represents:
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An overall rate extracted from a sale whose NOI excluded reserves, applied to a subject NOI that includes them, will:
Replacement reserves cover which kind of expenditure?
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The mortgage constant represents:
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