Leasehold security that the credit note wants to call freehold
A bank's credit team is considering a ₹3.5 crore term loan against a first charge on a 320 sq m office floor in a suburban Mumbai building. The borrower holds the floor under a 30-year registered lease dated 1 April 2010 from the landowner. The lease permits mortgage only with the lessor's prior written consent, which has not been obtained, and provides that on expiry the building vests in the lessor without compensation. Ground rent is fixed at ₹1.80 lakh a year. The floor is self-occupied and could be let for ₹45 lakh a year, with outgoings borne by the lessee at 18% of gross rent. Freehold office floors in comparable buildings are valued at a 7.5% capitalisation rate, and land values in the locality are rising about 5% a year. The valuer's discount rate for leasehold interests of this type is 11%. The credit note says 'leasehold may be treated as freehold since the unexpired term exceeds 15 years'.
1. Value the interest the bank can actually charge, showing each component of the calculation.
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Identify the interest first: a leasehold interest with about 17 years unexpired, no compensation on expiry, and a vesting clause in the lessor's favour.
Net rent to the lessee. Gross market rent ₹45.00 lakh; less outgoings at 18% = ₹8.10 lakh; less ground rent ₹1.80 lakh. Net = 45.00 − 8.10 − 1.80 = ₹35.10 lakh a year.
Present value over the unexpired term. The lessee's benefit is an annuity of 17 years. Annuity factor at 11% = (1 − 1.11⁻¹⁷)/0.11. Since 1.11¹⁷ = 5.895, the factor is (1 − 0.1696)/0.11 = 7.549. Value = 35.10 × 7.549 = ₹265 lakh, i.e. about ₹2.65 crore.
Reversion. Nil to the lessee, because the building vests in the lessor without compensation at expiry. No second component arises. Rising land values are irrelevant to the lessee's interest here, which is why the growth rate given is a distractor.
Comparison with freehold. A freehold floor would be valued at 36.90/0.075 = ₹492 lakh, about ₹4.92 crore. The leasehold interest is therefore roughly 54% of the freehold value.
Security test. A ₹3.5 crore loan is 132% of the leasehold value and 71% of the freehold value. On the interest actually available as security, the loan is unsecured by a wide margin.
Note also that using the freehold capitalisation rate of 7.5% as the discount rate is a second common error: it would give 35.10 × 9.43 = ₹3.31 crore, still far below freehold, because the 17-year truncation, not the discount rate, drives the gap.
2. The credit note says leasehold can be treated as freehold because the unexpired term exceeds 15 years. Respond to that, and state the conditions you would attach.
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The 15-year rule is a credit-policy shortcut, not a valuation basis. It has no support in IVS 104, which requires the interest valued to be defined and the valuation to reflect the rights actually held. Two interests with the same physical floor can differ by half their value depending on tenure, and this one vests in the lessor in 17 years with no compensation. Reporting it as freehold would be a misdescription of the asset and would mislead the lender, the borrower and any subsequent purchaser.
Rights that must be verified before any reliance: whether the lease is registered and adequately stamped; the exact expiry date and any extension or renewal clause; the lessor's right of re-entry and forfeiture; restrictions on assignment and mortgage, and the consent requirement; who bears repairs, insurance and property tax; and whether the vesting clause can be varied for consideration.
Conditions to attach to the report: value is of the leasehold interest only, assuming the lessor's written consent to mortgage is obtained before disbursement - without it the security is not chargeable; the property must be insured with the bank's interest noted and the policy assigned; the borrower must be barred from surrendering or varying the lease without consent; loan tenor must sit comfortably within the unexpired term, since the security amortises to nil; and the bank should apply its leasehold LTV limits, not freehold limits.
If the lessor's consent is granted on payment of a premium or a share of unearned increment, re-run the valuation with that cost deducted. If renewal at market on expiry is customary and documented, it may be treated as a separate, disclosed assumption, but never as a certainty.