How to Determine the Value of a Leasehold Interest

A leasehold interest is a tenant’s right to occupy and use a property for a specified duration, as defined by a lease. This interest is an asset that can hold significant value. It stands in contrast to the “leased fee interest,” which belongs to the property owner, or lessor. The leased fee interest includes the owner’s right to receive rent and reclaim the property after the lease expires.

The Foundation of Leasehold Value

The value of a leasehold interest comes from the difference between the rent specified in the lease and the current rent for a similar property. The rent in the lease is the “contract rent,” while “market rent” is the going rate for comparable spaces. When the contract rent is lower than the market rent, the tenant has a “positive leasehold interest.” This financial advantage is an asset, as the tenant is paying less than the current market rate. Conversely, a “negative leasehold interest” occurs when the contract rent is higher than the market rent, creating a liability for the tenant.

Key Factors Influencing Leasehold Value

Several factors influence the gap between contract and market rent, which determines the value of a leasehold interest.

• The remaining term of the lease is a factor; a longer term with a favorable rent differential is more valuable. Rent escalation clauses and renewal options also impact value by affecting future rent costs.
• Current real estate market trends affect market rent. In a booming market with high demand, market rents rise, which can increase a positive leasehold interest for tenants with fixed-rate leases.
• A property’s location, including its visibility, accessibility, and proximity to amenities, is a driver of value. The physical condition, size, and permitted uses also affect what a new tenant would pay.
• Significant improvements paid for by the tenant, such as custom build-outs or upgraded fixtures, can increase the property’s market rental value and the value of their leasehold interest.
• The ability to sublease the property or assign the lease allows a tenant to profit from a positive rent differential by subletting the space at the higher market rate.

Calculating the Value of a Leasehold Interest

The most common method for calculating the value of a leasehold interest is the Discounted Cash Flow (DCF) analysis. This technique measures the present value of the future financial advantage generated by the lease. The first step is to determine the annual rent differential by subtracting the annual contract rent from the projected annual market rent. For example, if contract rent is $100,000 per year and market rent is $120,000, the annual rent differential is a positive $20,000.

Next, this annual advantage is projected over the remaining term of the lease. An appropriate discount rate must then be selected, which is a percentage that reflects the time value of money and the risk associated with the future cash flows. A higher discount rate implies greater risk and results in a lower present value.

Finally, the present value is calculated by applying the discount rate to each year’s projected rent differential. Using the example above, the present value of a five-year stream of $20,000 annual payments at an 8% discount rate is approximately $79,854. This figure represents the current value of the leasehold interest.

Accounting for a Leasehold Interest on Financial Statements

Under current accounting standards, a leasehold interest is recognized on a company’s financial statements. For nearly all leases, a tenant must record a “Right-of-Use” asset and a corresponding lease liability on its balance sheet. The Right-of-Use asset represents the tenant’s right to use the property, while the lease liability reflects its obligation to make future rent payments. This Right-of-Use asset is then expensed over the lease term, with the expense recorded on the income statement each period.

From a tax perspective, the treatment can differ from accounting rules. For federal income tax purposes, rent deductions follow the payment schedule outlined in the lease, not the amortization used for financial reporting. If a tenant sells their leasehold interest for a profit, that profit is treated as a capital gain. If sold at a loss, it may be treated as a capital loss, subject to prevailing tax laws and regulations.