Leases: Contract vs Market Rent
~11 min read · Value leased fee vs leasehold and handle contract rent above or below market.
Leases are the income property's operating system: gross to absolute-net allocations of expense, contract-vs-market rent splitting value between leased fee and leasehold, and the clause set — escalations, options, percentage rent — that the income analyst must read before projecting anything.
Lease types by expense allocation
Gross lease: landlord pays operating expenses (residential standard); tenant pays rent, period. Modified gross: shared — often base-year stops where the tenant pays increases over a base. Net (N/NN/NNN): tenant progressively assumes taxes (single), plus insurance (double), plus maintenance (triple net — the bond-like commercial standard where the landlord's NOI ≈ rent). Absolute net: tenant bears everything including structure. Comparing rents across lease types requires converting to a common (effective) basis.
- Gross → modified → NNN → absolute: the expense slide
- NNN: tenant pays taxes, insurance, maintenance
- Rents compare only on a common expense basis
Contract vs market, and the split
Contract rent is what the lease says; market rent is what space would fetch today. Below-market contracts make the leasehold valuable (the tenant's bargain = PV of the rent savings) and the leased fee worth less than fee simple; above-market contracts reverse it, discounted for the credit risk of a tenant overpaying. Long leases to strong tenants at market make leased fee ≈ fee simple. Valuing the RIGHT interest — the recurring theme — starts by reading the rent roll against the market.
- Leasehold value = PV of (market − contract) rent, when positive
- Leased fee + leasehold ≈ fee simple (with risk adjustments)
- Above-market rent is worth its credit risk, not its face
Clauses the analyst must read
Escalations (fixed steps, CPI, expense stops) shape the income projection; percentage rent (retail: base plus % of sales over a breakpoint) ties income to tenant performance; renewal and purchase options cap upside (assume tenants exercise below-market options); TI/LC obligations at rollover hit cash flow; assignment/sublet and co-tenancy clauses shift risk. The rent roll plus lease abstracts are the DCF's source documents.
Worked example
A single-tenant retail box: 8 years remain at $18/sq ft NNN; market NNN rent is $24. 10,000 sq ft; discount rate 8%. The tenant also holds a renewal option at $19. Who holds the value, and roughly how much of it?
The tenant sits $6/sq ft below market: $60,000/year of advantage for 8 years. PV at 8% (annuity factor ≈ 5.747) ≈ $345,000 — the leasehold's value, assignable if the lease allows. The leased fee: contract income of $180,000/year (NNN, so essentially net) capitalized/discounted plus a reversion — but the $19 renewal option means the landlord may NOT recover market rent at year 8: assume exercise (it's deeply favorable), extending the below-market stream and further depressing the leased fee. Fee simple ≈ leased fee + leasehold, reconciling the pieces. Reading two lease terms — the rate and the option — reallocated a third of a million dollars between the parties; that is why lease abstraction precedes valuation.
Common exam pitfalls
Comparing a gross rent to an NNN rent.
Convert to a common basis first — $24 NNN and $30 gross may be the same economics.
Valuing above-market rent at face value.
An overpaying tenant is a credit risk — discount the excess stream for the chance it defaults or renegotiates.
Projecting market rent past a below-market option.
Assume rational tenants exercise favorable options — the landlord's upside is capped at the option rate.
Who pays the expenses names the lease; who holds the bargain holds the value; and the options belong to the tenant.
Recap
- Gross / modified / NNN / absolute: the expense allocation ladder
- NNN rent ≈ landlord's net income
- Leasehold = PV of below-market advantage; leased fee bears it
- Above-market streams discount for credit risk
- Escalations, percentage rent, options, TI/LC shape projections
- Abstract the leases before valuing the income
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