Real Property: Estates, Highest and Best Use, and Capitalization
Real Property tests interests in land and improvements: fee simple, leased fee, and leasehold. The exam focuses on highest and best use, the three approaches, direct capitalization, and the effect of existing leases. Real estate valuation is about property rights and income, not just physical assets.
Core rules
- Highest and best use: legally permissible, physically possible, financially feasible, and maximally productive. It must be tested for the property as if vacant and as improved.
- Sales comparison: adjust comparables for location, size, age, condition, and transaction terms; make adjustments to the comparable, not the subject.
- Cost approach: replacement cost new less depreciation plus land value. Land is not depreciated.
- Income approach: direct capitalization uses V = NOI ÷ cap rate. The cap rate must come from comparable sales, not from the subject’s own price.
- Leased fee and leasehold: contract rent below market creates a leasehold value; above-market contract rent creates a leased fee premium. Value the actual lease rights, not just market rent.
Worked example
Market NOI is $180,000 and the market cap rate is 7.5%, so fee simple value is $180,000 ÷ 0.075 = $2.4 million. The subject has a three-year lease at $120,000 contract rent. At 7.5%, the present value of three $120,000 payments is about $312,000, and the present value of the $2.4 million reversion at year 3 is about $1.932 million. Leased fee value is about $2.244 million. Leasehold value is the difference, about $156,000. The contract rent, not market rent, drives the leased fee.
Traps that cost marks
- Capitalizing market rent when valuing a leased fee.
- Deriving a cap rate by dividing the subject’s NOI by its asking price.
- Depreciating land in the cost approach.
- Adjusting the subject instead of the comparable in sales comparison.
- Ignoring lease terms, escalations, and renewal options.