Leased Fee Versus Fee Simple in a Center With a Below-Market Anchor
A lender asks for an opinion of value on a 14,400 sf strip center with twelve units, to be used in underwriting a loan to a buyer who will take title subject to existing leases. One 4,800 sf anchor tenant has four years remaining on a lease at $14.00/sf; the remaining 9,600 sf is leased at the market rent of $24.00/sf. Rents are gross, the landlord pays all operating expenses ($6.20/sf) with no reimbursement, and stabilized vacancy and credit loss is 5%. Market participants use a 7.25% overall rate for comparable unencumbered centers and a 7.25% discount rate. The anchor has no renewal option. The buyer's broker argues that the property is worth far less than a market-rent center and suggests simply capitalizing the actual in-place income at 7.25%.
1. Compute the fee simple value and the broker's proposed direct-capitalization value using contract rent. Lay out both income statements.
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Fee simple (market rent for all space)
| Item | Amount |
|---|---|
| Potential gross income (14,400 x $24.00) | $345,600 |
| Less vacancy and credit loss, 5% | ($17,280) |
| Effective gross income | $328,320 |
| Less operating expenses (14,400 x $6.20) | ($89,280) |
| Net operating income | $239,040 |
| Capitalized at 7.25% | $3,297,103 |
Broker's in-place capitalization
| Item | Amount |
|---|---|
| PGI (9,600 x $24.00 = $230,400; 4,800 x $14.00 = $67,200) | $297,600 |
| Less vacancy and credit loss, 5% | ($14,880) |
| Effective gross income | $282,720 |
| Less operating expenses | ($89,280) |
| Net operating income | $193,440 |
| Capitalized at 7.25% | $2,668,138 |
The spread is about $629,000, or roughly 19% of the fee simple value.
2. Explain why capitalizing the in-place income at the market overall rate misstates the leased fee interest, even though every input in the calculation is correct.
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The defect is conceptual, not arithmetic. Direct capitalization converts a stabilized, perpetual income stream into value. The contract rent here is neither stabilized nor perpetual - it is a four-year annuity of $10.00/sf below market on 4,800 sf, after which the space reverts to market and to the landlord.
Capitalizing a temporary shortfall as if it were permanent applies a going-concern multiplier to a loss that has a known end date. The error is easy to see in the reverse direction: no one would value a four-year above-market lease by capitalizing the excess at 7.25% and adding it to fee simple value, since that would value the excess forever. Yet that is exactly what the $629,000 figure does with the shortfall.
The correct treatment is to value the fee simple interest first, then deduct the present value of the rent loss over the remaining term. The mechanics of the discount - not the overall rate - control how large the deduction is. The broker has confused a timing problem with a yield problem, and the error grows with the length of the remaining term.
3. Compute the supported leased fee value, state which value the appraiser should report given the assignment, and describe the fact pattern that would justify the broker's method instead.
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Present value of the rent shortfall
- Annual shortfall: 4,800 sf x ($24.00 - $14.00) = $48,000
- Four-year annuity factor at 7.25%: 0.93240 + 0.86939 + 0.81061 + 0.75578 = 3.36818
- Present value: $48,000 x 3.36818 = $161,673, say $161,700
Supported leased fee value: $3,297,103 - $161,673 = $3,135,430, say $3,135,000.
This compares with the broker's $2,668,138 - a $467,000 understatement that would materially harm the borrower. The fee simple interest is $3,297,000; the leased fee is $3,135,000; the leasehold interest held by the anchor is the $161,700 difference.
Which to report. The loan is secured by the property subject to the existing leases, so the leased fee interest is the appropriate interest to value, and the appraiser should say so in the scope and in the definition of value. If the lender also wants a market-rent benchmark, the fee simple value can be reported as supporting information, clearly labeled as a different interest.
When the broker's method would be right. Only if the below-market rent were effectively perpetual. If the anchor held three five-year renewal options at a fixed $14.00, or if market rents were expected to fall to $14.00 by expiration, then there is no reversion upside and a single-year capitalization - with a rate derived from sales of similarly encumbered centers - becomes defensible. The appraiser should test that assumption explicitly rather than assume it away.