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Valuation Of Leasehold Interest

A property is made up of “Bundle of Rights”, and freehold right is the highest form of right with regard to real estate. However, there are contractual limitations on ownership, which are usually contained in deeds such as easements and leases or mortgage instruments.

When an owner of real estate dose not wish to personally use the property or wants to derive some measure of income from its ownership, he or she can allow another person to use it in exchange for valuable consideration.

This is usually accomplished by means of an agreement known as a lease. A lease is a contract between a property owner (known as the lessor) and a tenant (the lessee) that transfers the right to Exclusive possession and use of the landlord's property to the tenant for a specified period of time. This agreement sets forth the length of time the contract is to run, the amount to be paid by the lessee for the right to use the property, and other rights and obligations of the parties.
In effect, the lease agreement conveys an interest in the real property and includes a contract to pay rent and assume other obligations. The landlord/ lessor grants the tenant/ lessee the right to occupy the premises and use them for purposes stated in the lease. In return, the landlord retains the right to receive payment for the use of premises plus a reversionary right to retake possession after the lease term has expired.
The lessor's interest in leased property is called a fee plus reversionary right. In America the statute of frauds in most states requires that for enforceable, a lease for a term of more than one year must be in writing signed by both lessor and lessee.

When an owner of real property leases his or her property to a tenant, the tenant's right to occupy the land for the duration of the lease is called a leasehold, or less-than-freehold, estate. Leasehold estates are chattels real. Although they give their owner (the tenant/ lessee) an interest in real property, they are in fact personal property and are governed by laws applicable to personal property. When the contract is a lease for life or more than 99 years under which the tenant assumes many of the obligations of the landowner, it also give the tenant some of the benefits and privileges of a property owner.

The four most important types of leasehold estates are:
(1) estate for years,
(2) estate from period to period (periodic
(3) estate at will, and
(4) estate at sufferance.


Leasehold Estates

Estate for Years:
An estate for years is a leasehold estate that continues for a definite period of time - one month, one year, five years, and so on. When a definite term is specified in a written or oral lease and that period of time expires, the tenant (lessee) is required to vacate the premise and surrender possession to the landlord (lessor), unless the parties agree to renew the lease for another specified term. No notice is required to terminate such an estate; the termination date was established in the lease. This type of leasehold conveys more rights to the tenant than any the other three.

Estate from Period to Period:
An estate from period to period, or a periodic estate, is created when the landlord and tenant enter into an agreement that continues for an indefinite number of definite periods. These estates are generally created by agreement or operation of law to run for a certain amount of time; for example, from month to month, quarter to quarter, or year to year. The agreement is automatically renewed for identical succeeding periods until one of the parties gives notice to terminate. This type of tenancy is more common in residential than in commercial leases.

Estate at Will:
An estate at will is an estate of indefinite duration. It is created at the will of the landlord and will continue to exist until either landlord or tenant serves proper notice to the other of a desire to terminate the estate. Death of either party, or sale of the property, automatically terminates this type of estate.

Estate at Sufferance:
An estate at sufferance arises when a tenant who lawfully came into possession of real property continues to hold possession of the premises after his or her rights have expired, without the consent of the landlord. Because the tenant's original possession was legal, however, the tenant is not considered a trespasser. It is an estate of indefinite duration because the landlord can institute legal action to regain possession of the property at any time.

In determining the validity of a lease, the courts apply the rules governing contracts. If the intention to convey temporary possession of a certain parcel of real estate from one person to another is expressed, the courts generally hold that a lease has been created. The lease may be written, oral, or implied, depending on the circumstances.
Once a valid lease has been signed, the lessor, as the owner of the real estate, is usually bound by the implied covenant of quiet possession. Under this covenant, the lessor guarantees that the lessee may take possession of the leased premises and that he or she will not be evicted from these premises by any person who successfully claims to have a title superior to that of the lessor.


The requirements are essentially the same as those for any other real estate contract. Generally, the essentials of a valid lease are competent parties, mutual assent, legality of object, contract in writing, valuable consideration, description of the premises and signatures.

Competent Parties:
The parties must have the legal capacity to contract.
Mutual Assent: The parties must reach a mutual agreement on all the terms of the contract.

Legality of Object:
The objectives of the lease must be legal.
Contract in Writing: The law requires that to be enforceable in the court the lease must be in writing.
Valuable consideration: As discussed earlier, the laws of contract control the creation of a landlord-tenant relationship. Every contract must be supported by a valid, valuable consideration. In leasing real estate, rent is the usual consideration granted for the right to occupy the leased premises; however, the payment of rent is not essential as long as consideration was granted in creation of the lease itself. Some courts have construed rent as being any consideration that support lease, thus not limiting its definition to the payment of monthly rent. For example most ground leases and long-term leases provide that the tenant must pay property charges-such as real estate taxes, insurance premiums, and the like addition to the rent. The courts consider a lease to be a contract. Even if a rent concession reduced the monthly rent to zero for a period of time, the tenant's payment of the property charges would be sufficient consideration to establish lease as a valid contract. As such, the agreement is not subject to later change the rent or other terms unless these changes are in writing and executed in same manner as the original lease.
The amount of rent the tenant must pay for use of the premises is set for the lease contract and is known as the contract rent. The amount of rent property would command in a fully informed competitive marketplace is known as the economic rent or market rent. When the lease contract is negotiated contract rent and the economic rent are normally the same. But as the lease runs its term, the two may come to differ greatly. To prevent this from happening, the lessor, in long-term lease situations, will quite often use a form of lease that provides for adjustments in the amount of rent throughout the term of the lease.
In this regard, if a lease contract does not specify the amount of rent to be paid, the court will usually infer the rent to be a "fair and reasonable" amount. Likewise, in making a rental agreement, it is important to state specifically when the rent is to be paid to the lessor. If it is to be paid in advance or at any time other than the end of the term, the contract should state that fact. The law states that rent becomes due only at the end of the term unless it is specifically agreed to the contrary. Thus, in the absence of usage or contract to the contrary, rent is payable at the termination of the successive period of the holding-weekly, monthly, or yearly, as the case may be.

Description of the Premises:
A description of the leased premises should be clearly stated. If the lease covers land, the legal description of the real estate should be used. If the lease is for a part of the building, such as office space or an apartment, the space itself or the apartment designation should be clearly and carefully described. If supplemental space is to be included, the lease should clearly identify the space.

To be valid, a lease must be signed by the landlord, since the courts consider a lease to be a conveyance of an interest in real estate.

Use of Premises
A lessor may restrict a lessee's use of the premises through provisions included in the lease. This is most important in leases for stores or commercial space. For example, a lease may provide that the lease premises are to be used only for the purpose of a real estate office and for no other. In the absence of such limitations, a lessee may use the premises for any lawful purpose.

Term of the Lease
The term of a lease is the period for which the lease will run; thus it should be set out precisely. Good practice requires that the date of the beginning of the term and the date of its ending be stated together with statement of the total period of the lease, for example, "for a term of 30 years beginning June 1, 2000, and ending May 31, 2030." Courts hold that a lease with an indefinite term is not valid unless the language of the lease and the surrounding circumstances clearly indicate that a perpetual lease is the intention of the parties.

Possession of the property by the lessee is constructive notice to the world of his or her rights, and an inspection of the property will result in actual notice of the lessee's leasehold interest.

Possession of the Leased Premises:
Leases carry the implied covenant that the landlord will give the tenant possession of the premises and the right of quiet enjoyment. The landlord must give the tenant actual possession, or occupancy, of the leased premises. Thus, if the premises are occupied by a holdover tenant, or adverse claimant, at the beginning of the new lease period, it is the landlord's duty to bring whatever action is necessary to recover possession as well as to bear the expense of this action.

Maintenance of Premises:
Under the principle of caveat emptor ("let the buyer beware"), a landlord is not obligated to make any repairs to leased premises. However, many states of America, now require a lessor to maintain dwelling units in a habitable condition and to make any necessary repairs to common elements, such as hallways, stairs, or elevators. The tenant does not have to make any repairs, but he or she must return the premises in the same condition as they were when received, with certain allowances for ordinary use.

The tenant may make improvements with the landlord's permission, but any such alterations generally become the property of the landlord; that is, they become fixtures. However, a tenant may be given the right to install trade fixtures by the terms of the lease. Such trade fixtures may be removed by the tenant before the expiration of the lease provided the tenant restores the premises to the condition they were in when he or she took possession.

Assignment and Subleasing:
A lessee may assign the lease or may sublease the premises as long as the terms of the lease contract do not prohibit these actions. An assignment is the total transfer to another person (assignee) of all the tenant's (assignor's) right, title, and interest in the leasehold estate. After an assignment is completed, the assignee becomes known as the tenant. The original tenant has no further interest in the leasehold estate, but does remain secondarily liable for the payment of rent.
A sublease involves a transfer of only a portion of the rights held under a leasehold estate. Therefore, a sublease may concern only a portion of the leased premises or only a part of the lease term. The party acquiring the rights under a sublease is known as the sublessee, while the original tenant becomes the sublessor. Generally, the sublessee pays rent to the sublessor, who in turn pays rent to the landlord. Because the interest of the original tenant is located between the interest of the property owner (landlord) and the end-user of the property (sub-lessee), in America it is known as a sandwich lease.

The landed property is durable and capable of producing income overtime. This capability to produce income overtime provides the basis for the “Investment Method” of Valuation.

“An investment can be defined as the outlay of funds on the purchase of any asset which is not consumed immediately but instead yields up its benefits in a stream over period of time.”

A potential purchaser of an interest in land and buildings may regard the transaction from two possible points of view. He may view the interest in terms of personal benefits to be obtained from actual occupation and use of the property, or he may view it as an investment, which will yield him an annual income. For the owner-occupier, the income received on his investment in the property, is the rent he would otherwise have had to pay someone else for the same occupation and use.

Rates of Interest :
When an investor makes a decision about investment be expects certain return on his investment. This return expressed as a percentage is called the Remunerative Rate of Interest i.e. the rate at which the capital is remunerated. The investor will be concerned about the following things when he makes an investment decision.
1. Security and regularity of income.
2. Security of Capital.
3. Liquidity of Capital.
4. Costs of transfer.
5. Tax advantages.
6. Divisibility.

1. Security and regularity of income:
Main function of an investment is to provide the Investor with regular income. Therefore, if there is risk that his income may not be regular i.e. house let to number of tenants in poor residential locality, such as chawl, investor will demand much higher yield to compensate him for this disadvantage. In short, if income is secured and regular, the investor is ready to accept lower rate of interest than the investment, which is not giving regular income and thus less secured.
2. Security of Capital:
Sometimes, it is quite possible that though the return from an investment may be fairly regular, there is less security to the capital invested. An investor will not be willing to sink his capital into an investment, if he suspects that his capital is insecure, unless he is rewarded very high yield to compensate him for any risk that he is taking. For an investment, where there is some risk of capital depreciation or loosing of capital, the investor will expect to pay relatively low price.
3. Liquidity of Capital:
If the liquidity of the investment is greater than that of another investment, then the investment, which has more liquidity, can be sold more quickly; which means asset value can be realized at a short notice, if the circumstances so require and hence this will be of advantage, which will attract the investors. Therefore the yield will tend to be higher, where liquidity of investment is rather poor.
4. Costs of transfer:
Costs of transfer are the costs of purchasing an investment, in the first instance and of any subsequent stage. Where these costs are comparatively high, this will be disadvantage in the eyes of the investor.
5. Tax advantages:
If there is any tax advantages in particular investment, this will be of considerable attraction to the prospective investor, who will be prepared to accept relatively low return, in order to gain this advantage. Example is the Bonds recently issued by IDBI or ICICI or RESERVE BANK.
6. Divisibility:
In case of emergency, if the investor wants to convert the part of his investment in the monetary form, then he will prefer the investment, which can be divided into parts. Therefore, divisibility of investment is added attraction for the investor.
Relative advantages and disadvantages of an investment will be reflected in the yield, which carries with the price. As the price of investment goes up yield decreases and as the price of the investment goes down the yield increases.
Whenever there is some disadvantage attached to an investment, an investor expects a higher return on such investment. Naturally, the investor in leaseholds who is faced with the aforesaid leaseholds disadvantages, would expect a higher return or yield to compensate him for these disadvantages.
While considering the above factors, he also has to take into account the general underlying economic situation in the country. During the period of inflation, the investor is not only concerned with the security of his capital and income, but also will consider whether the value of his money is also maintained in real terms.
To illustrate this, let us consider one example. A security was purchased 10 years ago for Rs.10,000. It produces an income of Rs. 700 per annum.
Assuming that the value of the security and the income have remained same over the period of 10 years, but the purchasing power of the Rupee has reduced to 50 paise; the value of the capital in real terms would be Rs. 5,000 and not Rs10,000.
Similarly the value of the income would be Rs. 350 and not Rs. 700.
In this case, one can say that the investment has not been secure in real terms because though the value of the security and the income from it have remained unchanged, considering the reduction in the purchasing power of the Rupee, the value of both is reduced by 50%.
If this investment can be considered on the basis of 7% yield, an investor would have accepted a lower yield (3½%) than if the investment had maintained value over time in real terms.
An investment, which appreciates so as to maintain its real value during the time when the purchasing power of a Rupee is falling, provides the investor, with a security which is referred to as a "hedge against inflation".
An investor may be willing to accept a lower yield; that is he will be willing to pay a higher price for an investment, which can provide a “hedge against inflation".

Consider the above example:
10 years back
capital value Rs. 10,000 and income Rs.700.
Capital value appreciates to Rs. 20,000 and income increases to Rs.1400.
Then we can say that the value is maintained in real terms.
Thus we can say that an investment that is likely to maintain its value in real terms will:
a) Produce a relatively low yield
b) Provide hedge against inflation
c) Be attractive to investors
d) Offset the fall in the value of money in
real terms.
Sometimes, it is quite possible that the investment may be expected to increase in value at a faster rate than the fall in money values. This will provide the purchaser with a capital gain in real terms.
Considering the various forms of landed property, and their suitability as an investment, an order of priority, which an investor would consider before making an investment decision, can be listed below:

Remunerative Rates of interest
If Government security is considered as a datum line, we can derive the rate of interest appropriate to various forms of the landed property, depending upon various factors that an investor would consider while making the investment decision. Agricultural lands are considered as the most secure form of investment as far as landed property is considered. These properties rank next to Government securities.
The security of commercial properties situated in the heart of the center in, say the Central Business District, can be regarded as at per with urban lands. Commercial properties in secondary position and commercial properties let out to several tenants are comparatively less secured and hence the expected remunerative rate of interest would be more.
During to the process of urbanization, consequent on the influx of large population, residential properties in urban areas are always in demand. Residential properties, therefore, offer some security as an investment. Amongst residential properties, the small single dwelling house is less onerous to mange as compared to the residential flats. Industries require some specific considerations for their establishment and they cannot be established anywhere and everywhere. The over all national economy and national policies as regards industrial development have a great impact on industrial investment. Besides, a great risk is involved in making investment decisions in industrial properties.
Although investment in agricultural lands is a good form of investment for the various reasons explained earlier, the income from agricultural land where irrigation facilities etc. are not fully available, crop yields depend entirely on rainwater, which is irregular. Therefore, when agricultural lands are to be valued by capitalizing the income they produce, the appropriate rate of interest chosen for capitalization purposes should be slightly high to correspond to the risk involved.
Based on the above discussion the remunerative Rate of Interest adopted in India, are given in following table:

Remunerative Rates of Interest
for different types of the Landed property in India
Source: Unofficial circular from valuation Dept. of Govt. of Maharashtra.

The landed property is not owned per se; what a person owns is an interest, may be either a freehold interest or leasehold interest.
We have also noted earlier that even though a lessor gives property to a lessee on lease, he still continues to own an interest in the property. It is therefore possible for there to be many different persons having interest in the property, so that there may be a hierarchy of interests in that property at any given time.
The payment of rent by the lessee to the lessor, the terms of the lease and the other conditions for the use of the premises are laid down in an agreement between the lessor and the lessee, usually called a “Lease Deed”. The various conditions of the lease are called “Lease covenants”.
Thus, while in the case of freehold properties there is absolute freedom regarding use, enjoyment and the disposal of the land, in the case of leasehold properties, this freedom regarding use, enjoyment and disposal is restricted by the covenants of the lease and naturally, the investor in leasehold properties is faced with certain disadvantages, which do not occur with in freehold ownership.

The main disadvantages are:
1. The income from the leasehold property is available for limited number of years. Hence, the capital of an investor is sinking slowly to the zero level at the end of the term of the lease. The lessee is, therefore, expected to set aside a certain amount / fund to ' recoup the sinking capital'.
This fund is called a “Sinking Fund”. The provision and management of this sinking fund create additional difficulties of management of leasehold property.
Besides a lessee has to make payment of rent to the lessor and at the end of the term re-invest the capital in some other form of investment. This adds to his managerial responsibilities.
2. As the unexpired period of the lease goes on diminishing the difficulties in selling such interest goes on increasing. Thus liquidity of capital becomes rigid.
3. The lessee is governed by the covenants of the lease. Therefore, he has less freedom as compared to the freeholder.
As stated earlier, whenever there are some disadvantages attached to an investment, an investor expects a higher return on such investment. Naturally, the investor in leaseholds who is faced with the above mentioned disadvantages, would expect a higher return or yield to compensate for these disadvantages.
It is the usual practice to consider remunerative rates of interests in case of leasehold properties higher by 0.5% to 2% than the corresponding remunerative rates of interests in freehold interest. The smaller increase will apply to the more secure type of investments and the larger increases to the less secure properties such as factories, warehouses etc.
In case of leasehold properties, the value of the lessee's interest in the property, when the term of the lease begins, is maximum and on the date of expiry of the lease, it becomes zero, because on the expiry of the lease, the income from the property is zero. Thus in case of leasehold property, the value of the property (value of lessee's interest) goes on diminishing as the time elapses. It is maximum on the date of beginning of the terms of the lease. It then gradually reduces and becomes zero on the date of the expiry of the terms of the lease. A prudent investor will have to make provision in such a way that he recoups the investment at the end of the term of the lease. This can be done by setting aside certain amount and investing it so that by the end of the term of the lease that amount accumulates to original value of investment. This investment, which gives him his original invested amount, will have to be invested in the safest form of investment. It is, therefore, axiomatic that it would be at the less rate of interest. Thus while valuing the leasehold interest we have to use dual rates; namely, Remunerative Rate of Interest, at which the capital is remunerated and the other Accumulative Rate of Interest at which the capital is accumulated. Hence while valuing the leasehold properties we use dual rate valuation tables to find out Year's Purchase (Multiplier) to find out value from net income.
While valuing the leased property, we have to find out lessee's interest and lessor's interest. Value of lessee's interest will be capitalized value of the net income for the unexpired period of lease. (Dual rate Table). Value of lessor's interest will be capitalized value of the lease rent (net value) for unexpired period of the lease plus the present value of the stream of income, which he is likely to receive from the property after the expiry of the lease. This later part is called reversion of the estate to the lessor.
This can be explained by following example.
Example :
A leasehold property is let on lease at a net rack rent of Rs. 12,500 per annum for a term of 70 years unexpired. The ground rent payable to freeholder is Rs. 2,500 per annum. The net income from this leasehold property is receivable by 'A' for the next 30 years, after which it will be receivable by 'B' for the remainder of the term.
Find out 'A' and 'B' s interest in this property assuming in each case that interest on capital is expected @ 7% and that on annual sinking fund can be invested @ 5%.

Value of 'A' s interest.

Net Rack Rent value Rs. 12,500 p.a.
Deduct Ground Rent. Rs. 2,500 p.a.
Profit Rent Rs. 10,000 p.a.

Y.P. for 30 years @ 7% and 5% 11.758
Capital Value Rs. 1,17,580.00
Say Rs. 1,17,600/-

Value of 'B' s Interest.
Net Rack Rent value Rs. 12,500 p.a.
Deduct Ground Rent. Rs. 2,500 p.a.
Profit Rent Rs. 10,000 p.a.

Y.P. for 40 years @ 7% and 5% 12.775
Capital Value (as it will be 30 years from now)

Rs. 1,17580.00
Present Value of Rs.1 in 30 years @ 7% 0.13
Rs. 16,607
Say Rs. 16,600

Thus it can be seen from these valuations that income due in the future is first converted into a capital value.
Its value to-day is, theoretically, the sum that should be invested now at a rate of compound interest which reflects the security of the investment i.e. in this example 7% and which will accumulate during the period of deferment to the future capital value.
No question arises for providing for a sinking fund during this initial period. The investment is in effect appreciating in value as the reversion comes closer. The capital value does not begin to depreciate until the future income commences.
Whenever the reversionary income is perpetual, or for any other reason where the single rate method is adopted, the following rule may be used.
Take the Year's Purchase as given in the Table for the whole period extending from the present time up to the time that income will cease, and subtract there from the Year's Purchase at the same rate percent for the period which must elapse before the income begins to accrue. The result will be the 'Year's Purchase' at which to value the deferred income.

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