4Valuations at rent review, lease renewal and lease end

Free ebooks ==> www.Ebook777.com

Chapter 11â•… Lease Pricing



253



„—

„—

„—

„—

„—

„—



„—



„—



the premises are vacant and available to let;

both landlord and tenant are willing parties to the contract;

the premises are fit for occupation and use;

the premises are to be let on the same terms as the actual lease;

the tenant has complied with lease terms;

there is a 15-year term to expiry at each review and a prospect of renewal at

the end of the lease;

the value of the tenant’s actual occupation and any effect of goodwill are

disregarded;

the value of any tenant’s improvement is also disregarded.



A rent review is usually activated by the landlord giving notice to the tenant of the

new rent. If the tenant is not happy then the mechanism for agreeing it is specified

in the clause in the lease. The rent review clause usually specifies the rent as market rent assuming the premises are fitted out and ready for occupation and that

the tenant has received a rent-free in respect of fit-out.



11.4.2 Surrender and renewal of leases

Sometimes a tenant may wish to surrender the current lease before its term has

expired in order to preserve goodwill attached to a particular location or

remove future uncertainty surrounding the terms of a new lease. If the landlord

agrees to accept the surrender of the current lease for the grant of a new one

then the capital value of any profit rent that the tenant was entitled to should

be reflected in a rent reduction or some other financial benefit under the terms

of the proposed lease. Valuations are undertaken to ensure that neither the

landlord nor tenant jeopardise their existing financial positions. This is

achieved by calculating the capital value of each party’s present and proposed

interests in order to determine the rent that should be reserved under the

�proposed lease. In practice a negotiated settlement between the landlord and

Â�tenant’s positions usually takes place and the impact of landlord and tenant

legislation strengthens the tenant’s bargaining position in a ‘surrender and

renewal’ situation.

For example, a tenant wishes to surrender the remainder of an existing lease

in return for the grant of a new, longer one. The present lease has three years

to run with no review and the rent passing is £20,000 per annum. The estimated market rent is £27,000 per annum and comparable evidence suggests

that the current all-risks yield for freehold investments in similar properties is

10%. The landlord is willing to accept a surrender of the current lease and

grant a new 15-year lease with rent reviews every five years. The rent that

should be reserved for the first five years of the proposed lease is calculated by

valuing the landlord’s and tenant’s interests under the present and proposed

terms:



www.Ebook777.com



Part C



clauses, so assumptions are often made. Examples of rent review assumptions

include:



254



Property Valuation



Valuation of the landlord’s present interest:

Term (Contract) rent (£)

YP 3 years @ 9%



20,000

2.5313



Part C



50,626

Reversion to market rent (£)

YP perpetuity @ 10%

PV£1 3 years @ 10%



27,000

10.0000

0.7513

202,851

253,477



Valuation (£)



Valuation of the landlord’s proposed interest:

Let new rent be (£)

YP 5 years @ 9%



x

3.8897

3.8897x



Reversion to market rent (£)

YP perpetuity @ 10%

PV£1 5 years @ 10%



27,000

10.0000

0.6209

167,643

167,643â•›+â•›3.8897x



Valuation (£)



If the landlord is to be in the same financial position under the proposed terms as

under the present terms then:

167,643â•›+â•›3.8897xâ•› = 253,477

x (new rent)

= £22,067



Valuation of the tenant’s present interest:

Market rent (£)

Less Contract rent (£)

Profit rent (£)

YP 3 years @ 12% [a]

Valuation (£)



27,000

-20,000

7,000

2.4018

16,813



[a] This is the freehold all-risks yield adjusted upwards to reflect the additional risk and relative

unattractiveness of a short leasehold investment



Valuation of the tenant’s proposed interest:

Market rent (£)

Less new rent (£)

Profit rent (£)

YP 5 years @ 12%

Valuation (£)



27,000

-x

27,000 - x

3.6048



97,330 - 3.6048x



Assuming the value of the tenant’s present interest should equal the value of the

proposed interest:



Free ebooks ==> www.Ebook777.com

Chapter 11â•… Lease Pricing



255



A single figure is usually negotiated that lies somewhere between the two rental

values estimated from the landlord and tenant perspectives. In fact, in nominal

cash-flow terms, the rent forgone by the landlord is the same as the profit rent

gained by the tenant; the only reason different rental values are calculated is

because the yields are different. This means that transferring the valuation to a

spreadsheet is very straightforward and the value impact of yield selection can

easily be modelled. In practice the agreed amount will depend on the relative bargaining strength of the parties.



11.4.3 Compensation for disturbance and improvements

In the UK there is a substantial body of legislation and case law – known as landlord and tenant law – that governs the legal relations between parties to a lease.

Key statutes that regulate business tenancies and affect their valuation are

described below.

The Landlord and Tenant Act 1927 (as amended by Landlord and Tenant Act

1954 Part III): This statute requires the landlord to compensate a tenant who

leaves at the end of a lease for ‘qualifying’2 improvements made during the lease.

Shops, for example, are quite likely to have been subject to tenant’s improvements – perhaps a staircase or an escalator was constructed at the front of the

shop (in the valuable Zone A area) to entice shoppers to venture up to the first

floor. Landlord’s consent is normally required before the improvements can qualify

but, under the Landlord and Tenant Act 1988, this consent cannot be unreasonably withheld. The amount of compensation is calculated as the lesser of the

value added as a result of the improvements or the cost of the improvements at

the lease termination date. The value added must relate to the intended use so no

compensation is payable if the property is to be demolished. If the tenant renews

the lease, the value of the improvement is disregarded (deducted) from the estimated market rent for a period of 21 years. Assuming the improvements qualify

for compensation the initial valuation problem is determining the extent to which

they impact on value.

The Landlord and Tenant Act 1954 Part II (as amended by the Law of Property

Act 1969): This statute provides business tenants with security of tenure by

allowing the original lease term to continue but subject to certain grounds that

the landlord can establish to regain possession. The occupying tenant is entitled

to automatic continuance of the original lease until terminated in accordance

with the Act, i.e. as a result of some positive action by either party, usually the

serving of a notice. The tenant’s interest is assignable and therefore valuable. In

addition to the right of automatic continuance the landlord or tenant can apply

for new lease. Where a new lease is granted to the existing tenant the rent payable

is normally the market rent but disregarding the effect on rental value of; the fact

that the tenant or predecessors in title have been in occupation; any goodwill

from the existing tenant; qualifying improvements for a period of 21 years;3 and

any licences that belong to the tenant in respect of licensed premises. In practice



www.Ebook777.com



Part C



97,330 – 3.6048x = 16,813

x (new rent)

= £22,336



256



Property Valuation



Part C



the quantification of the financial effect of these ‘disregards’ on market rent is

very difficult. The tenant may continue to pay the existing rent beyond the end of

the lease (known as ‘holding over’) but, while the terms of the new lease are being

agreed, the landlord or the tenant can apply for an interim rent. In cases where

the lease is not renewed or renewal proceedings are opposed, the interim rent is

determined under Section 34(1) and (2) of the 1954 Act (i.e. a market rent disregarding any qualifying tenant’s improvements) but assuming that; the tenancy is

from year to year, the rent would be reasonable for a tenant to pay; regard is paid

to the passing rent and rent payable under any sub-leases within the property. If

the renewal is unopposed, the interim rent is the same as the rent agreed under

the new lease (usually a market rent) subject to adjustment to reflect any difference in market conditions or lease terms during the interim period. In such cases

the determination rules under an opposed renewal apply subject to these adjustments. Landlords could try and have an ‘upward-only penultimate day review’

drafted into the lease to ensure that the interim rent is not less than the rent

passing.

If the parties cannot agree the terms of the new tenancy then the courts are able

to grant the tenant a new lease of up to 15 years on expiry of the existing lease at

the market rent assuming similar terms as the original lease. The prospective landlord and tenant can agree in writing to ‘contract out’ of (exclude themselves from)

the provisions of the 1954 Act but the lease must be for a fixed term and the

landlord cannot contract out of disturbance compensation (see below) liability if

lease is longer than five years. Baum (2003) notes that contracting out occurs only

occasionally but is more prevalent in the case of secondary and tertiary properties

and may be increasing as landlords try to avoid renewals of short leases. Baum

also found that, at lease renewal, tenants who secure a short lease do not pay a

rent premium nor is a rent premium paid if a break clause is inserted. But, as with

rent reviews, there is a precedent suggesting that a landlord’s option to break

leads to a rent discount.

The landlord is entitled to counter the tenant’s application for a new lease by

establishing one of seven grounds for possession prescribed by the Act. If the

landlord regains possession on the grounds that the rent for the property would

be increased if let as a whole, redevelopment is intended or the property is required

for own occupation, then the tenant is entitled to ‘disturbance compensation’ for

loss of goodwill. The amount of disturbance compensation that is payable is

equivalent to the rateable value (RV) of the property (or twice the RV if the business has been in continuous occupation for the past 14 years or more).

Two examples will help illustrate the impact of some of the legislative points

described above on the valuation of business property.



11.4.4 Example 1

A factory is held on a 15-year lease with five years left at a contract rent of £5,000

per annum. The tenant carried out qualifying improvements four years ago which

increased the market rent by 20%. The cost of these improvements today would

be £7,500. The market rent, including the value of the improvements, is £10,000

per annum, the rateable value of the property is £12,000 and the all-risks yield for



Free ebooks ==> www.Ebook777.com

Chapter 11â•… Lease Pricing



257



a)â•… the tenant vacates at the end of the existing lease;

b)â•… a new ten-year lease with a rent review in year five (with a clause that states

that the value of improvements is disregarded) is granted to the existing

�tenant on expiry of the current lease;

c)â•… the landlord repossesses the property at the end of the existing lease for own

occupation;

d)â•… the landlord repossesses the property at the end of the existing lease for redevelopment and the site value is estimated to be £100,000.

The tenant has the right to two types of compensation if required to vacate the

premises at the expiry of the existing lease:

1.â•… Disturbance compensation at twice the current rateable value of the premises.

This equates to £24,000.

2.â•… Improvements compensation at the lesser of the cost of the works or value

added. The cost (as at the valuation date) is £7,500 and the value added is

calculated as the capital value of the increase in rent resulting from the

improvements.

Increase in Market Rent (£) [a]

YP perpetuity @ 8% [b]

Capital value of improvements (£)



1,000

12.5

12,500



[a] 20% of the £5,000 contract rent

[b] All-risks yield



Cost therefore prevails as improvements compensation.

But these are future liabilities of the landlord and it is important to consider possible changes in the amounts due to a rating revaluation or inflation in building

costs for example. Here it is assumed that the rateable value remains constant and

building costs rise at 3 per cent per annum.

a)â•… Valuation assuming the tenant vacates on termination:

Term (Contract) Rent (£)

YP 5 years @ 7% [a]



5,000

4.1002

20,501



Reversion to Market Rent (£)

YP in perpetuity @ 8%

PV £1 5 years @ 8%

Less cost of improvements (£)

inflated over 5 years @ 3% pa



10,000

12.5000

0.6806

-7,500

1.1593



PV £1 5 years @ 7% [b]

Valuation (£)



85,075

105,576

-8,695

0.7130



-6,199

99,377



[a] Term yield based on all-risks yield of 8% but reduced to reflect security of term rent

[b] Cost of improvements has been discounted at same rate as term rent was capitalised



www.Ebook777.com



Part C



investments in this type of property average 8%. Value the landlord’s interest in

the property assuming:



258



Property Valuation



Part C

Figure 11.1â•… Events time-line.

b)â•… Valuation assuming a new lease is granted at end of lease.

It is helpful to sketch a time-line and mark important dates as in Figure 11.1.

It is easier to spot when the rent reduction in respect of improvements runs

out. In this case the tenant benefits from a rent reduction for 20 years that

reflects the value added by the improvements, after which the rent reverts to

the market rent including the value added by the improvements.

Capital value of first 5 years’ rent (as above) (£)

Subsequent 15 years rent (£)[a]

YP 15â•›yrs @ 8%

PV 5â•›yrs @ 8%



20,501

8,000

8.5595

0.6806

46,605



Final reversion Market Rent

YP in perpetuity @ 8%

PV £1 20 years @ 8%



10,000

12.5000

0.2145

26,813

93,919



Valuation (£)



[a] This is the market rent of £10,000 less 20% to reflect value added by tenant’s

improvements



c)â•… Valuation assuming the landlord repossesses at the end of current lease for

own occupation:

Value (as (a)) (£)

Less improvements (as (a)) (£)

Less disturbance; 2 x RV

PV £1 5 years @ 7% [a]

Valuation (£)



-6,199

-24,000

-30,199

0.7130



105,576



-21,532

84,044



[a] This discount rate should reflect the risk of an increase in improvement compensation and

disturbance compensation may increase if there is a rating revaluation.



d)â•… Valuation assuming the landlord repossesses at end of existing lease for

�redevelopment. The landlord must have owned the property for at least



Free ebooks ==> www.Ebook777.com

259



five years to regain the property at the end of the lease. There is no

�compensation for improvements because their value to the landlord will

be zero in the case of redevelopment. In practice, few tenants receive

compensation under the 1927 Act due to the negating impact of

�

dilapidations.

Term (Contract) rent (£)

YP 5â•›yrs @ 7% [a]



5,000

4.1002

20,501



Reversion to site value (£)

Less disturbance; 2 × RV

PV £1 5 years @ 7% [b]



100,000

(24,000)

76,000

0.7130

54,188

74,689



Valuation (£)

[a] Term yield



[b] This is a relatively low yield to reflect attraction of redevelopment potential



11.4.5 Example 2

The tenant of a shop in a prime position holds a 15-year internal repairing (IR)

lease granted 11 years ago at a current rent of £24,000 per annum. Six years ago

the tenant obtained consent to carry out improvements costing £60,000. The current freehold all-risks yield is 6%, the market rent on full repairing and insuring

(FRI) terms is £50,000 per annum, £5,000 of which can be attributed to the

improvements made by the tenant. The rateable value of the premises is £50,000

and building cost inflation is averaging 10% per annum. Value the current interests of the landlord and tenant assuming:

a)â•… The landlord will get permission for his own occupation at the end of the

lease

b)â•… The tenant will continue in occupation under a new lease with a typical rent

review pattern

As in the previous example, disturbance compensation is twice the rateable value,

producing a figure of £100,000. Compensation for improvements is estimated as

the lesser of the cost of or value added by the improvements:

Value added by improvements (£)

YP perpetuity @ 6%



5,000

16.6667

83,333



Cost of improvements (£)

Inflated at 10% pa over 6 years



60,000

1.7716

106,296



The value added produced the lower figure in this case.



www.Ebook777.com



Part C



Chapter 11â•… Lease Pricing



260



Property Valuation



a)â•… Valuation assuming the landlord gets permission for his own occupation at

the end of the lease:

Valuation of the landlord’s interest:

Part C



Term (Contract) Rent (£)

Less external repairs @ 10% of market rent on FRI

terms (£)

Less insurance @ 2% of market rent on FRI terms (£)

Net income (£)

YP 4 years @ 5%



24,000

-5,000

-1,000

18,000

3.5460

63,828



Reversion to Market Rent on FRI terms (£)

YP perpetuity @ 6%

PV £1 4 years @ 6%



50,000

16.6667

0.7921

-100,000

-83,333

-183,333

0.8227



Less disturbance compensation (£)

Less improvements compensation (£)

PV £1 4 years @ 5%

Valuation (£)



Valuation of the tenant’s interest:

Market Rent on FRI terms (£)

Plus external repairs (£)

Plus insurance (£)

Market Rent on IR terms (£)

Less rent paid (£)

Profit rent (£)

YP 4 years @ 10% [a]

Plus compensation (as above) (£)

Valuation (£)

[a] Risky, terminable, non-growth investment



Figure 11.2â•… Events time-line.



50,000

5,000

1,000

56,000

-24,000

32,000

3.1699

101,437

125,216

226,653



660,085



-150,828

573,085



Free ebooks ==> www.Ebook777.com

Chapter 11â•… Lease Pricing



261



b)â•… Valuation assuming the tenant will continue in occupation under a new lease

with a typical rent review pattern. Figure 11.2 illustrates the time-line.



Term net income (as above) (£)

YP 4 years @ 6%



18,000

3.4651

62,372



Reversion to market rent on internal

repairing (IR) terms, excluding

improvements (£) [a]

Market rent on FRI terms, excluding

improvements

less external repairs (calculated as above)

less insurance (calculated as above)



45,000

-5,000

-1,000

39,000

9.7122

0.7921



YP 15 years @ 6% [b]

PV £1 4 years @ 6%



300,028

Reversion to market rent on internal

repairing (IR) terms, including

improvements (£)

Market rent on FRI terms, including

improvements

less external repairs (calculated as above)

less insurance (calculated as above)



50,000

-5,000

-1,000

44,000

16.6667

0.3305



YP perpetuity @ 6%

PV £1 for 19 years @ 6%



242,367

604,767



Valuation (£)



[a] Under the 1954 Landlord & Tenant Act the terms of the new lease will be based on the

terms of the existing lease

[b] This yield may be reduced below the freehold all-risks yield to reflect security afforded to a

tenant occupying on IR terms but the unattractiveness of an investment returning a

non-market rent for 15 years may counter this. Consequently the yield remains at 6%.



Valuation of the tenant’s interest:

Profit rent (as above) (£)

YP 4 years @ 10%



32,000

3.1699

101,437



Reversion to profit rent equal to the

increase in market rent made by

improvements at lease renewal (£)

YP 15 years @ 9% [a]

Valuation (£)



5,000

8.0607

40,304

141,741



[a] Growth potential due to possible rent reviews in sub-lease, so yield is based on freehold

yield plus leasehold risk premium.



www.Ebook777.com



Part C



Valuation of the landlord’s interest:



262



Property Valuation



Key points

Part C



„—



„—



„—



„—



„—



„—



As far as rented commercial property is concerned, different businesses require

different types of accommodation and, increasingly, a single firm requires a range

of accommodation types. The differentiation occurs along physical and legal lines;

flexible space and flexible leases. This has significant implications for valuation.

In an ideal world all leases of commercial property would be on the same terms

and estimating rental value would simply be a case of making adjustments to

reflect differences in location, physical attributes and unexpired term. But whereas

in the past leases were fairly standard and comparison fairly straightforward, it is

now necessary to identify the main features of flexi-leases and their scope for variation. These centre on lease length, incentive arrangements such as break clauses,

rent free periods and reverse premiums, and rent revision arrangements such as

stepped rents or turnover rents. There may be other arrangements too, such as a

non-standard rent review pattern or a first review that is sooner or later, but the

valuation principle is the same.

The scarcity and variability of rental value evidence means that valuers find it difficult to analyse, adjust and apply data from what may appear to be physically

comparable properties but which differ because of flexi-lease arrangements. This

all sounds pretty hopeless but it must be remembered that valuation is all about

quantifying economic benefits or costs financially in terms of rental or capital

value. With this in mind any flexi-lease arrangement that is made in lieu of rent

paid should be reflected in the valuer’s estimate of rental and capital value. This

typically involves amortising any financial benefit received by the occupier in

place of rent over a period that has regard to the estimated life of the benefit, the

lease term and rent review provisions in the lease contract.

A lot of the flexi-lease arrangements can be regarded as short-term cash bonus to

the tenant at the expense of increased rent later (similar to unsecured borrowing)

and the financial impact can be modelled in a spreadsheet using ‘goal-seek’ to

determine effective rent by changing various input variables. But flexi-leases can

lead to a more uncertain cash-flow than a standard lease and the valuer needs to

be able to reflect this uncertainty in the rental value.

Legislation has a considerable influence on valuations undertaken in connection

with the termination and possible renewal of business leases. It is essential that

valuers have a full understanding of the relevant statutes and their impact on

rental value.

Conventionally a number of these types of valuations were undertaken from the

perspective of the landlord and the tenant, the difference in value often resulting

from the different yields that were used to capitalise income. Nowadays, the use

of spreadsheets enables a more straightforward approach where various yields

and other variables can be trialled and their impact on rental value measured.



Notes

1.â•… The NPV function on a spreadsheet discounts each subsequent row in a cash-flow for

an additional period at a specified discount rate, in this case 8%.

2.â•… To qualify for compensation the improvements must have been made after 25 March

1928 and not in pursuance of a statutory or contractual obligation (except that after

1954 those in pursuance of a statutory obligation will qualify).



Free ebooks ==> www.Ebook777.com

263



3.â•… The value of improvements may not be disregarded (i.e. may be included) in the rent

fixed at rent reviews within this 21-year period if the lease does not mention how they

should be treated (Ponsford v HMS Aerosols Ltd 1978). However, most leases now

explicitly state that the value of any tenant’s qualifying improvements should be disregarded at rent reviews.



References

Baum, A. (2003) Pricing the options inherent in leased commercial property: a UK case

study, European Real Estate Society conference, Stockholm, Sweden.

Crosby, N., Lizieri, C., Murdoch, S. and Ward, C. (1998) Implications of changing lease

structures on the pricing of lease contracts, The Cutting Edge Conference, Royal

Institution of Chartered Surveyors.

Crosby, N. and Murdoch, S. (1994) Capital valuation implications of rent-free periods,

Journal of Property Valuation and Investment, 12(2): 51–64.

French, N., Evans, M. and Atherton, E. (2000) Flexibility: pricing the uncertainty, Cutting

Edge Conference, RICS, London, September.

French, N. (2001) Uncertainty in property valuation: the pricing of flexible leases, Journal

of Corporate Real Estate, 3(1): 17–27.

McAllister, P. (1996) Turnover rents: comparative valuation issues, Journal of Property

Valuation & Investment, 14(2): 6–23.

McAllister, P. (2001) Offices with services or serviced offices? Exploring the valuation

issues, Journal of Property Investment & Finance, 19(4): 412–426.

RICS (2006) The analysis of commercial lease transactions, Valuation Information Paper

8, Royal Institution of Chartered Surveyors, London.

Sayce, S., Smith, J., Cooper, R. and Venmore-Rowland, P. (2006) Real Estate Appraisal:

From Value to Worth, Blackwell Publishers, Oxford.



www.Ebook777.com



Part C



Chapter 11â•… Lease Pricing