An appraiser is valuing a retail strip center subject to multiple leases with varying terms. One tenant occupies 40% of the leasable area under a 10-year lease at $22.50/sf/year, while market rent for comparable space is $28.00/sf/year. The lease includes a fixed 3% annual rent escalation and no renewal options. To estimate the leased fee value using the income approach, the appraiser must first determine the present value of:
Correct Answer
C) The difference between contract rent and market rent over the lease term, discounted at an appropriate rate, plus the present value of market rent for the reversion.
Under USPAP Standards Rule 1-2 and the Income Approach guidance in the Appraisal of Real Estate (12th ed.), the leased fee value equals the present value of the contract rent for the lease term plus the present value of market rent for the reversionary interest (i.e., post-lease term). Because contract rent ($22.50) is below market ($28.00), the leased fee is worth less than the fee simple — the shortfall (the 'rental adjustment') must be quantified and discounted. Option C correctly identifies both components: (1) the present value of the below-market contract rent stream, and (2) the present value of market rent for the reversion. Option A ignores the reversion; Option B conflates leased fee with fee simple; Option D omits discounting and misapplies reversion treatment.
Why This Is the Correct Answer
Valuing the leased fee from market rent requires discounting the contract-to-market rent shortfall over the lease term and adding the present value of market rent from the reversion onward.
Why the Other Options Are Wrong
Option A: The contract rent stream only, because the lease is legally binding and enforceable.
Discounting contract rent alone omits the reversion, which is a substantial part of the leased fee where the lease is below market.
Option B: The market rent stream for the entire property, because market value reflects what a willing buyer would pay for the fee interest.
Market rent for the entire property values an unencumbered fee and ignores the below-market lease burdening it.
Option D: The contract rent stream for the leased portion and market rent for the vacant portion, with no reversion adjustment since the lease has no renewal clause.
The fact pattern describes no vacant portion, and the absence of a renewal option does not remove the reversion — it defines when it occurs.
Market Value Less What the Lease Gives Away
Market Value Less What the Lease Gives Away, plus the day it comes back. Term and reversion, always both.
How to use: Whichever route you take, check that the reversion is in the model. Its omission is the most common structural error.
Exam Tip
Escalations narrow the shortfall each year, so the differential stream is not level and must be modelled year by year.
Common Mistakes to Avoid
- -Omitting the reversion
- -Treating the rent differential as level despite escalations
- -Valuing the property at market rent as though unencumbered
Concept Deep Dive
Analysis
The subject is leased at $22.50 against market rent of $28.00, so the owner is receiving less than the space would command and the leased fee is worth less than an unencumbered fee would be. There are two equivalent routes to the value, and the question asks for the one built from market rent: value the property as though it earned market rent, then subtract the present value of what the lease gives away. That subtraction is the discounted stream of the difference between contract and market rent over the lease term — reducing each year by the escalations, since 3 percent annual increases narrow the gap as the lease runs — and to it is added the present value of market rent from the lease's expiry onward, the reversion, when the space returns to market. The alternatives fail on structure. Contract rent alone omits the reversion. Market rent for the whole property ignores the encumbrance entirely. And the fourth answer misreads the fact pattern, which describes no vacant portion and does not dispense with a reversion merely because there is no renewal option.
Background Knowledge
Leased fee value comprises the right to contract rent for the remaining term plus the reversion. Where contract rent is below market, the value may be developed from market rent less the discounted rent shortfall, plus the reversion at market.
Real-World Application
An appraiser discounts a declining rent shortfall over ten years, adds the present value of market rent from year eleven, and reports the leased fee below the unencumbered indication.
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:
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An appraiser is analyzing a small office building. Market rent is $22 per square foot, and the building has 5,000 rentable square feet. Historically, the property has achieved 100% occupancy, but the appraiser's market study indicates a 7% vacancy and collection loss for comparable properties. There is no other income. What is the estimated annual Effective Gross Income for a market value appraisal?