LESSEE’S
& LESSOR’S INTERESTS
The
elements under this standard are:
 interpret outcomes of analysis
 analyse data on subject partial interest
 determine lessee's or lessor's interest values.
 record value, analytical approaches used and
qualifications required.
The
most common use of compound formulae is for the valuation of
investment properties subject to a lease. If the lessee is not paying
market rent then the sale price needs adjustment to bring it to an
unencumbered in
possession value, a
datum value that can be used for comparison and analysis purposes.
That is, it is assumed for comparison purposes that the analyzed sale
is a property with vacant possession and unencumbered with any
interest. This is known as the unencumbered
fee simple in possession.
To
adjust a sale to this common datum the valuer needs to determine the
lessee's and lessor's interest. The valuer is also called upon to
determine these interests when determining market value of a property
subject to a lease. That is, the encumbered
fee simple.
PROFIT
RENTAL (PR)
If
the lessee is paying LESS than the market rental value of the
property, he/she is enjoying a profit rental. The profit rental is
the difference between the market rent and the rent being paid by the
lessee under the lease agreement. For example:
MARKET RENT: 
$100 000 pa 
LESS LEASE RENT

$ (50 000) pa 

 
PROFIT RENT: 
$ 50 000 pa 
The
difference is called a profit rental because the lessee enjoys the
difference as a profit. For example, he/she is able to sublet (if
allowed to under the lease agreement) the premises for $100 000pa and
thus enjoy a profit of $50 000pa. If the lessee cannot sublet he/she
still enjoys $50 000pa profit as opportunity
cost. That is, the
lessee enjoys the benefit of a $100 000pa premises for only $50
000pa.
LESSEE'S
INTEREST (LEEI)
The
lessee's interest (LEEI) in an investment property is the present
value of the profit rental. Therefore, there is no lessee's interest
if there is no profit rental. The lessee's interest as used in this
context is an economic interest as the lessee paying market rent
still has a legal interest in the property while the lease is
current.
Where
the tenant is paying market rent, it has been held that the only
claim for compensation is for disturbance  Keogh
v Housing Commission
[1969] VR 809.
EXAMPLE
The
remainder of the lease for the tenancy above is 10 years.
Using
12%pa what is the lessee’s interest?
The
value of the lessee's interest is found using the PVPMT formula:
PVPMT
= (1 PV)/(i/100) = (1 0.3220)/0.12 = 5.650
LEEI
= PR * PV.PMT= 50 000 * 5.650= 282 500
Lessee's
interest say $283 000
LESSOR'S
INTEREST (LORI)
The
lessor's interest (LORI) in an investment property is the
unencumbered market value (that is, the value assuming that the
property is vacant) less the lessee's interest (LEEI). The market
rental for the above property is $100 000 pa and a capitalization
rate of 12% pa has been analyzed from sales of comparable properties.
Therefore, the unencumbered value is:
100
000 * 100/12 = $833 333
Because
the subject property is occupied by the lessee under an old lease,
the owner is receiving a rent less than market rent. The lessor's
interest (LORI) is:
LORI
= UMV LEEI
Where:
LORI
= lessor's interest
UMV
= unencumbered market value
LEEI
= lessee's interest
LORI
= 833 333 282 500 = $550 833
Lessor’s
interest say $551 000
Therefore,
the market value (that is, encumbered fee simple) is $551 000.
This
is equal to the amount that the property will sell for on the open
market. All sales of tenanted properties are lessor’s interests and
should be analysed as above.
SUM
OF THE PARTS (SYNERGY)
It
is common practice to assume that the lessor's or lessee's interest
can be calculated by subtracting the other party's interest from the
unencumbered value. However, in practice it is found that the sum of
the two parts exceeds the unencumbered value. Why is this?
For
this reason the courts have held that the assessment of compensation
of lessee’s and lessor’s interest must be assessed on an
individual basis and not by subtracting one determination from the
unencumbered fee simple to find the other value.
The
reason appears to be that there is a legal "subdivision" of
the property into the two interests which required time, expense and
effort. Therefore, an existing and proved tenancy is worth more than
the sum of the value of an expected tenancy and the expected lessor's
interest. The analogy can be made between the value of in
globo land not
subdivided and the value of otherwise comparable land subdivided into
two allotments.
ADJUSTING
TO UNENCUMBERED VALUE
From
the above formula, the unencumbered market value (UMV) is found as
follows:
UMV
= LORI + LEEI= 550 833 + 282 500 = $833 333
As
a general rule (subject to the synergy argument above), the
unencumbered value of a tenanted investment property is the sum of
the lessee's and lessor's interests.
The
adjusted sale price of $833 333 can now be used for comparison
purposes with another comparable investment property to determine
it's unencumbered market value.
REVERSIONARY
INTEREST
It
can be seen that the lessor's or owner's interest in a leased
property consists of 2 parts:
 the period of the lease
 the unencumbered value of the property at the end of the
lease.
The
unencumbered value due at the end of the lease term is known as the
reversionary interest because the vacant property reverts to the
owner at the end of the lease term. This is shown on a time line as
follows:
DIAGRAM
Lease
period Reversionary period
=======================10===========>perpetuity
YEARS  >
USING
THE REVERSIONARY METHOD TO DETERMINE THE LESSOR’S INTEREST
The
reversionary value can also be used as an alternative method for
determining the lessor's, owners, or encumbered market value of the
property:
• STEP
1:
Determine
the value of the lease to the lessor (owner). This is the present
value of the net rental income during the lease term:
50
000 * 5.6502 (PVPMT) = $282 511
• STEP
2:
Determine
the value of reversion. This is the present value of the expected
unencumbered value in 10 years:
833
333 * 0.322 (PV) = $268 333
• STEP
3:
Determine
the lessor's interest (LORI):
LORI
= value of lease + reversionary value
282511
+ 258333 = $550 844
say
$551000
See
shortfall method
4