An appraiser is valuing a retail plaza subject to a 20-year triple net lease with 12 years remaining. The contract rent is $24 per square foot annually, while current market rent for comparable space is $18 per square foot. The leased fee interest is being appraised for estate tax purposes. Which statement is correct regarding the income approach?
Correct Answer
C) The appraiser must capitalize contract rent for the remaining lease term and then apply a reversion to market rent at lease expiration, as the leased fee interest includes both the leased period and the reversionary interest.
Why this is correct: The leased fee is the landlord's interest, and it consists of two things: the right to receive the contract rent for the remainder of the lease, and the reversion when the lease ends. With contract rent at $24 and market rent at $18, the lease is above market and that advantage runs only for the 12 years remaining, so the analysis must capitalize or discount the contract rent over that period and then value the reversion on market terms. Collapsing the two into one step would either extend the above-market rent forever or ignore it altogether. Why the other choices are wrong: 'The appraiser must capitalize only the contract rent, because the lease is binding and enforceable' treats a 12-year advantage as perpetual and leaves the reversion unvalued. 'The appraiser must capitalize market rent, because USPAP requires market value to reflect market conditions regardless of existing leases' confuses the definition of value with the identification of the interest; market value can be estimated for a leased fee, and the leased fee is defined by the lease. 'The appraiser should ignore the lease entirely and value the property as if vacant and available for lease at market rent, since estate tax valuation requires highest and best use as if unencumbered' misstates the assignment; the interest transferred at death is the encumbered one, and valuing an unencumbered estate would require a hypothetical condition, disclosed as such. Exam tip: Identifying the real property interest is part of problem identification and it drives everything that follows. Leased fee means contract rent for the term plus a reversion; fee simple means market rent throughout.
Why This Is the Correct Answer
Capitalizing or discounting contract rent for the remaining term and then applying a reversion at market rent is the correct model because the leased fee comprises exactly those two rights. It recognizes that the above-market rent is a temporary advantage rather than a permanent characteristic of the real estate. The approach applies whether contract rent is above or below market, with the sign of the advantage simply reversing. Estate tax valuation values the interest actually held, which here is the leased fee.
Why the Other Options Are Wrong
Option A: The appraiser must capitalize only the contract rent, because the lease is binding and enforceable.
Capitalizing only the contract rent implicitly treats a twelve-year income stream as perpetual, which overstates value by carrying the above-market premium forever. The lease's binding character is real but bounded by its term. Omitting the reversion also ignores that the buyer receives the property itself at the end.
Option B: The appraiser must capitalize market rent, because USPAP requires market value to reflect market conditions regardless of existing leases.
Capitalizing market rent alone would value a fee simple interest and would ignore the landlord's contractual right to collect $24 for twelve more years, understating the leased fee. USPAP does not require market value to disregard existing leases; it requires the appraiser to identify and value the interest specified in the assignment. Market conditions inform the analysis, but the interest defines what is being valued.
Option D: The appraiser should ignore the lease entirely and value the property as if vacant and available for lease at market rent, since estate tax valuation requires highest and best use as if unencumbered.
Estate tax valuation values the property interest the decedent actually held, which is the leased fee subject to its lease, not a hypothetical unencumbered estate. Ignoring the lease would require a hypothetical condition and prominent disclosure, and would answer a question the assignment did not ask. Highest and best use analysis also operates within the existing legal constraints, including recorded leases.
Rent Now, Reversion Later
A leased fee has two halves. The lease pays you for a while, then the building comes back. Value both. Contract rent controls the first half; market conditions control the second.
How to use: When a stem gives a remaining term and both contract and market rent, model contract rent through the term and market rent at reversion. Reject answers using only one rent for the whole life.
Exam Tip
Above-market contract rent enhances the leased fee and above-market rent carries tenant credit risk. A higher discount rate on the excess portion is often the sophisticated refinement an exam is probing.
Common Mistakes to Avoid
- -Capitalizing contract rent in perpetuity and omitting the reversion
- -Valuing a fee simple when the assignment calls for the leased fee
- -Applying a single discount rate to contract and above-market rent components alike
Concept Deep Dive
Analysis
The leased fee is the landlord's interest and it has two components: the contract rent receivable over the remaining lease term and the reversion of the property at expiration. Valuing it requires modeling both, because a buyer of the leased fee acquires both. Here the contract rent of $24 exceeds market rent of $18, so the landlord holds a favorable position for twelve years, and the leased fee is worth more than an unencumbered fee simple would be. That premium is real but finite: it lasts only until the lease expires, at which point the space reverts to whatever the market will then pay. Discounting contract rent for twelve years and then capitalizing a market-rent-based reversion captures both facts. Two refinements matter in practice. The above-market portion of the rent depends entirely on the tenant's ability to keep paying, so it carries more credit risk than the market-rent component and may warrant a higher discount rate. And the reversion should reflect market conditions at expiration rather than today's market rent held constant.
Background Knowledge
You need the definitions of fee simple, leased fee, and leasehold, the components of leased fee value as contract rent plus reversion, and the effect of above-market versus below-market contract rent. You should also know discounted cash flow mechanics, terminal capitalization, and the requirement to identify the interest appraised in problem identification.
Real-World Application
An appraiser valuing a retail plaza for estate tax discounts twelve years of $24 rent, applies a higher rate to the above-market portion given the tenant's credit, capitalizes a market-rent-based reversion at a terminal rate, deducts costs of sale, and states plainly that the leased fee was the interest appraised.
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:
Building A (new, credit tenant, 20-year lease) and Building B (older, month-to-month tenants) sell the same week. Their cap rates should differ how?
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?
What is the primary distinction, for appraisal purposes, between 'vacancy loss' and 'collection loss'?
An appraiser is analyzing a mixed-use property with retail and office components. The retail segment has a potential gross income of $180,000 with a market vacancy of 8%. The office segment has a potential gross income of $120,000 with a market vacancy of 12%. What is the overall effective gross income for the property?
The mortgage constant represents:
People Also Study
Real Estate Market
13.6% of exam
Property Description
11.8% of exam
Land or Site Valuation
4.5% of exam
Sales Comparison Approach
16.4% of exam
Cost Approach
13.6% of exam