A site is leased at $30,000 a year, while market ground rent for similar sites is $36,000. The market land capitalization rate is 6%. What is the indicated market value of the fee simple interest in the site?
Correct Answer
D) $600,000
Because the contract rent is not at market levels, it must be adjusted to market before capitalizing to estimate the fee simple value: $36,000 ÷ 0.06 = $600,000. Capitalizing the contract rent ($500,000) values the encumbered interest instead.
Why This Is the Correct Answer
Option D is correct because the fee simple value is based on market rent, so the contract rent must first be adjusted to market. Capitalizing $36,000 at 6% gives $36,000 ÷ 0.06 = $600,000. This reflects what the unencumbered site would earn in the market.
Why the Other Options Are Wrong
Option A: $500,000
Option A, $500,000, comes from capitalizing the contract rent: $30,000 ÷ 0.06 = $500,000. That reflects the interest encumbered by the below-market lease, not the fee simple; the correct figure is $36,000 ÷ 0.06 = $600,000.
Option B: $100,000
Option B, $100,000, capitalizes only the rent shortfall: $6,000 ÷ 0.06 = $100,000. The shortfall is not the whole site income; the fee simple value is $36,000 ÷ 0.06 = $600,000.
Option C: $550,000
Option C, $550,000, capitalizes the average of contract and market rent: ($30,000 + $36,000) ÷ 2 = $33,000, and $33,000 ÷ 0.06 = $550,000. Averaging has no basis; the fee simple uses market rent, $36,000 ÷ 0.06 = $600,000.
Fee simple means market rent
Fee simple is free of the lease, so it earns market rent. Contract rent belongs to the leased fee.
How to use: Use this whenever a question asks for fee simple value but gives both contract and market rent.
Exam Tip
Read which interest is being valued before choosing the rent. For fee simple, capitalize market rent.
Common Mistakes to Avoid
- -Capitalizing the below-market contract rent to estimate fee simple value
- -Capitalizing only the difference between market and contract rent
- -Averaging contract and market rent
Concept Deep Dive
Analysis
This question tests ground rent capitalization when the contract rent differs from market rent. Because the goal is the fee simple interest, the appraiser must capitalize market ground rent, not the below-market contract rent. Dividing the $36,000 market rent by the 6% land capitalization rate gives the fee simple indication.
Background Knowledge
Ground rent capitalization converts a site's net ground income into value using a land capitalization rate. The fee simple interest assumes the property is unencumbered, so its income must be market rent. Capitalizing a contract rent that differs from market measures a leased interest instead.
Real-World Application
An appraiser values a pad site ground-leased decades ago at a rent now below market. For a fee simple assignment, she derives market ground rent from comparable ground leases and capitalizes it at a market-derived land rate, noting separately that the existing lease would lower the leased fee value.
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