Contract rent above market rent creates, from the landlord's perspective:
Correct Answer
B) A leased fee advantage lasting until the lease expires
Why this is correct: The governing concept is the leased fee estate, which is the landlord's interest subject to a lease. When contract rent exceeds market rent, the landlord receives an above-market income stream. This creates a positive leasehold advantage for the landlord, known as a leased fee advantage. The original explanation correctly states this is an asset acquired with the property, valued as the present value of the excess rent over the remaining lease term. Why the other choices are wrong: 'An immediate reduction in the property's value' is wrong because above-market rent increases the landlord's income stream, which typically increases value. 'A leasehold advantage belonging to the tenant' is wrong; a leasehold advantage for the tenant occurs when contract rent is below market rent. 'No effect, since market rent governs all valuations' is wrong because appraisers must analyze the actual lease contract; above-market rent directly impacts the leased fee value. Exam tip: Remember the mirror relationship: above-market rent = leased fee advantage; below-market rent = leasehold advantage.
Why This Is the Correct Answer
Option B is right because above-market contract rent creates an advantage in the leased fee that persists until the lease expires. Valuing it means treating the property's income in two pieces: the market-rent portion, which is as secure as the space itself, and the excess, which is only as secure as the tenant's covenant and only as long as the remaining term. Because the excess carries higher risk, it is customarily discounted or capitalized separately at a higher rate rather than blended into the whole. The result is a leased fee value that may exceed the fee simple value of the same property.
Why the Other Options Are Wrong
Option A: An immediate reduction in the property's value
An above-market income stream raises the value of the landlord's interest rather than reducing it; more income at the same risk is worth more, not less. The option would be correct if the rents were reversed - below-market contract rent burdens the leased fee. Reading the direction wrong is the single most common error in this topic.
Option C: A leasehold advantage belonging to the tenant
A leasehold advantage belongs to the tenant when contract rent is below market, because the tenant occupies space worth more than it pays for and can sometimes realize that by subletting or assigning. Here the tenant is overpaying, so its leasehold position is a burden rather than an advantage. The two estates hold mirror-image positions, and this option attaches the surplus to the wrong one.
Option D: No effect, since market rent governs all valuations
Market rent governs the fee simple analysis; it does not govern every valuation. When the interest being appraised is the leased fee, the actual lease contract is what produces the income the owner receives, and USPAP requires the appraiser to identify the real property interest to be valued. Ignoring an above-market lease would value an interest nobody holds.
Whoever is overpaying loses the advantage
Find who is overpaying. Tenant overpays - contract above market - and the landlord's leased fee holds the advantage. Landlord undercharges - contract below market - and the tenant's leasehold holds it. Whoever is overpaying is the one without the advantage.
How to use: When a stem compares contract to market rent, name the two estates before choosing. Then check the option assigns the advantage to the right party and recognizes it ends at lease expiration. Reject any option claiming the lease is irrelevant.
Exam Tip
Note that a leased fee value can exceed fee simple value and that the difference is not a market anomaly but a contract right; exam items sometimes test whether that seems impossible to you.
Common Mistakes to Avoid
- -Assigning the advantage of above-market rent to the tenant
- -Blending excess rent into the whole income stream at a single rate
- -Valuing the reversion at contract rent instead of market rent
- -Appraising fee simple when the interest actually held is a leased fee
Concept Deep Dive
Analysis
This question tests the two estates a lease creates and which one benefits when rents diverge. A lease splits the fee simple into a leased fee estate, held by the landlord and consisting of the right to receive rent plus the reversion at expiration, and a leasehold estate, held by the tenant and consisting of the right to use and occupy on the lease terms. Contract rent is what the lease requires; market rent is what the space would command today on comparable terms. When contract rent exceeds market rent, the landlord is collecting more than the space is worth, and that surplus belongs to the leased fee - it is an advantage of the landlord's position, not the tenant's. The advantage is finite in two ways worth remembering. It lasts only until the lease expires, after which the space reverts to market rent, and it depends entirely on the tenant continuing to pay, since a default converts an above-market income stream into a vacant suite at market.
Background Knowledge
You need the definitions of fee simple estate, leased fee estate, and leasehold estate, and the relationship between contract rent and market rent that produces excess rent or a leasehold advantage. You should also know that USPAP requires identification of the real property interest to be valued, that excess rent is typically capitalized or discounted separately at a higher rate reflecting tenant credit and lease term, and that the reversion at lease expiration must be valued at market rent.
Real-World Application
An investor buying an office building with a tenant three years into a ten-year lease at four dollars above market pays a premium for the leased fee. The appraiser values the market-rent income stream at the going capitalization rate and the excess separately at a higher rate keyed to the tenant's credit, then adds the reversion at market rent.
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:
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The mortgage constant represents:
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