A related-party lease that 'makes the numbers work'
A registered valuer receives a mortgage valuation instruction from a commercial bank for a four-storey freehold shophouse in Johor Bahru. The building was completed in 1985 and refurbished in 2023 under an approved building plan, with a CCC issued on completion. It has 1,800 sq ft per floor. The ground floor is a café operated by the proprietor; floors two to four have been converted into nine guest rooms. Two months before the instruction the proprietor granted a five-year lease of the whole building to a company sharing a common director, at RM38,000 per month with 8% annual escalation and a 3+2 renewal option; the tenant also paid a RM250,000 premium. The guesthouse accounts show gross revenue of RM1.15 million and net operating income of RM410,000 after a management fee of 12% of gross paid to the same related company. Comparable shophouses in the row let at RM22,000–RM26,000 per month. A neighbouring unit sold recently for RM6.8 million, including café fittings and the goodwill of an unrelated food business. The bank's credit officer asks for 'market value on a going concern basis, using the lease rent, because it supports the loan amount'.
1. State the basis of value you would adopt for the lender and explain, with reasons, whether the RM38,000 monthly rent can be capitalised.
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Basis of value. The security is the real estate, so the correct basis is market value of the freehold interest, defined in the Malaysian Valuation Standards in the usual willing-buyer/willing-seller terms, with the property assumed free of encumbrances unless the tenancy is to be reflected. A going-concern basis values a business in operation, including goodwill, licences, workforce, stock and fittings. None of those are mortgage security, and the lender could not realise them on default without selling the business as an entity. Going concern is therefore the wrong instruction and should be declined in writing, unless the lender separately wants a business valuation from a valuer competent in that field.
Can the rent be used? Test it against arm's-length indicators:
- Relationship: landlord and tenant share a director. There is no negotiation between independent parties.
- Price: RM38,000 per month is roughly 55% above the RM22,000–RM26,000 range evidenced in the same row.
- Timing and structure: signed two months before the valuation, with a capital premium, escalation and 3+2 options - features that inflate capitalised value and lock in a purchaser.
- Covenant: a related company with no demonstrated independent balance sheet is a weak covenant.
Capitalising RM456,000 a year at 6.5% would produce about RM6.6 million after outgoings - precisely the outcome the borrower wants and precisely why it must be rejected. A hypothetical purchaser would investigate the lease, see a non-arm's-length rent above market supported by a weak covenant, and price the interest on the rent the market would actually pay, not the rent written on paper. The lease should be disclosed, and legal advice recommended on whether it binds a purchaser, but it cannot be the earning basis of the valuation.
2. Value the property, showing your workings and reconciling the result with the client's expectation.
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Step 1 - Market rent. The comparable range is RM22,000–RM26,000; adopt RM24,000 per month for a refurbished unit of this size and frontage: RM288,000 per annum.
Step 2 - Outgoings. Quit rent, assessment, insurance, repairs and management at about 10%: RM28,800. Net rent: RM259,200 (say RM259,000).
Step 3 - Capitalisation. Adopt 6.5%, reflecting a 1985 building with a finite remaining economic life, a secondary Johor Bahru location and a small lot size. RM259,000 ÷ 0.065 = RM3,984,600, say RM3.98 million.
Step 4 - Trading cross-check. The reported net operating income of RM410,000 is struck after a 12% management fee to a related party. Restate at a market 15% (extra 3% of RM1.15 million = RM34,500), giving RM375,500. Deduct a fair operator's return of 10% of gross revenue (RM115,000) to leave the rent the guesthouse could actually bear: about RM260,500. That is within 1% of the comparable-derived net rent, so the income approach is corroborated.
Step 5 - Sales cross-check. RM6.8 million for the neighbouring unit less, say, RM200,000 of fittings and RM1.5 million of business goodwill leaves about RM5.1 million for bricks and mortar. Adjust downward for the subject's inferior position and smaller floorplate (about −15%) to roughly RM4.3 million. This supports the range.
Conclusion. Market value with vacant possession: RM4.0 million (rounded). Market value subject to the existing lease, on the assumption the lease is enforceable and the covenant is as it appears, would be lower, not higher, because the rent is uncollectible in substance. The client's implied target of RM6.6–7.0 million is not supportable. Report the figure as a range of RM3.9–4.3 million with RM4.0 million adopted, and never state the value as a single 'bank-friendly' number without the workings.
3. What disclosures, assumptions and limitations would you put in the report, and why does each matter to the lender?
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- Basis and definition. State market value in full, and state expressly that no going-concern element, business goodwill, café chattels, fittings, licences or trading accounts have been valued. This prevents the bank from later arguing it lent against a business.
- The lease. Disclose the existence, date, parties, common directorship, rent, premium, escalation and options. State that it has not been relied upon as evidence of market rent because it is not an arm's-length transaction. Recommend independent legal advice on enforceability and on whether it binds a purchaser.
- Alternative values. Give market value with vacant possession and, separately, subject to the lease on stated assumptions about the covenant. The lender needs both to size the loan.
- Highest and best use. Note that the guesthouse fit-out is use-specific and that the comparables support a retail/café or general commercial use; conversion cost is sunk and not reflected.
- Sources and verification. Confirm the floor areas were measured (state the basis) or are unverified; confirm that no title search, building survey, structural inspection or check for enforcement notices was carried out.
- Date and inspection. Date of inspection and date of valuation, with a statement that values can move.
- Reliance and liability. Report addressed to the bank, no reliance by third parties, valuer's and firm's registration details, professional indemnity cover, fee not contingent on value.
- Marketing. State that the property has not been exposed to the market and that the figure is an opinion, not an offer.
Each of these matters because a mortgage valuation is relied upon for credit decisions and, on default, for recovery. Omissions here would expose the valuer to a negligence claim and to disciplinary action for misleading reporting.