The focus is now on the value of the lease, which may change as market conditions change. Similarly, the user’s need for space may change as business needs change. The value of a lease (or sublease) is evaluated under conditions where market rents are both higher and lower than contract rent.
When a user signs a lease, that leasehold interest has a value.
From the user’s perspective, the value is a cost, but it can be a positive value compared to other alternatives. For example, if the user is leasing space that costs $60,000 per year and the market cost for similar space is $70,000 per year, then the leasehold interest has a $10,000 benefit with respect to the market. That gives the user a slight competitive advantage. Conversely, if a user is paying $70,000 but could get similar space for $60,000, then the value is negative $10,000.
Current accounting rules require the projected loss to be recognized when the company has made the decision to cease use of the leased property. In practice, companies must certainly be careful to not make this decision unless they are aware of the loss impact and must be mindful of the timing of the exit or sublease decision.
Leasehold Interest and Subleases
Market Rent Is Higher than Contract Rent
In this situation, a lessee is renting space at a rate that is lower than current market rates. For example, two years ago the tenant leased a property for 10 years at $60,000 per year, but the market rent of comparable space is now $70,000 per year. Thus, the contract rent is below current market and represents a positive value to the lessee.
The value of the leasehold interest is the value of the lessee’s interest if the lessee entered into a sublease at the market rate. Even if the lessee’s leasehold is non-marketable, the lessee is enjoying the value of the differential in the form of a rent “bargain.”
Market Rent Is Lower than Contract Rent
In this situation, a lessee is renting space at a rate that is higher than current market rates. For instance, two years ago the tenant leased a property for 10 years at $60,000 per year, but the annual market rent of comparable space is now $50,000. Thus, the contract rent is above current market rent and represents a negative value to the lessee. The lessee is committed to pay above market rates.
It is costing the lessee that amount in rent to stay in place rather than move to an alternative location and pay current market rents
Sublease Rent Is Higher than Contract, but Lower than Market
The contract rent is below market, and the original lessee (who leased two years ago) wants to move and realize some of the value of his leasehold interest. In this case, the lessee may be able to find a sandwich lessee, commonly called a sublessee, to lease their space at a rate that is lower than the market rate (in this case, $48,000 per year), but higher than the contract rate (in this case, $45,000 per year). The sublease lease term would be eight years.The sublessee in this case has a similar interest, since the market rent is still above the sublease rent.
The value of the sublessee’s interest is the differential between the sublease rent and the market rent.
Sublease Rent Is Lower than Contract Rent
Sometimes a user needs to sublease at a rate below the contract rent to move out of a space. In this example, consider that the space is sublet at $45,000 per year, and the contract rent is $50,000 per year.
The differential between the contract rent and the sublease rent is the amount it costs the primary lessee to get out of the lease.
It’s clear that in some cases the leasehold interest may or may not be of value to the lessee and may be of value only to the owner. The relative positions of contract and market rent create these situations, but in other occasions, they are created by the realities of the user’s business and the owner’s investment objectives. For various reasons, either the owner or the lessee might want to sell their interest in the leasehold.
Decisions about when and whether to sublease or whether to negotiate a lease buyout and who should do the buying all are linked. Changing market conditions, remaining lease life, and changes in needs and objectives cause the position of strength between the user and owner to swing like a pendulum.
From an economic perspective, when the leasehold value is positive (market rent is higher than contract rent), the owner is motivated to buy out the user, but the user has an economic motivation to maintain its leasehold position. Similarly, when the leasehold value is negative (market rent is lower than contract rent), the user has a motive to buy out the lease, while the owner has little financial motivation to remove the user from the lease obligation.
Owner and user motivations are not based on the leasehold economic value alone. The owner fears vacancy, while the user fears wasted space (which costs money) and the risks associated with subletting.
Thus, the timing of the lease, the relationship of contract rent to market rent, and the user’s business needs all contribute to pushing the pendulum to one side or the other.
When a user signs a lease, that leasehold interest has a value.
From the user’s perspective, the value is a cost, but it can be a positive value compared to other alternatives. For example, if the user is leasing space that costs $60,000 per year and the market cost for similar space is $70,000 per year, then the leasehold interest has a $10,000 benefit with respect to the market. That gives the user a slight competitive advantage. Conversely, if a user is paying $70,000 but could get similar space for $60,000, then the value is negative $10,000.
Current accounting rules require the projected loss to be recognized when the company has made the decision to cease use of the leased property. In practice, companies must certainly be careful to not make this decision unless they are aware of the loss impact and must be mindful of the timing of the exit or sublease decision.
Leasehold Interest and Subleases
Market Rent Is Higher than Contract Rent
In this situation, a lessee is renting space at a rate that is lower than current market rates. For example, two years ago the tenant leased a property for 10 years at $60,000 per year, but the market rent of comparable space is now $70,000 per year. Thus, the contract rent is below current market and represents a positive value to the lessee.
The value of the leasehold interest is the value of the lessee’s interest if the lessee entered into a sublease at the market rate. Even if the lessee’s leasehold is non-marketable, the lessee is enjoying the value of the differential in the form of a rent “bargain.”
Market Rent Is Lower than Contract Rent
In this situation, a lessee is renting space at a rate that is higher than current market rates. For instance, two years ago the tenant leased a property for 10 years at $60,000 per year, but the annual market rent of comparable space is now $50,000. Thus, the contract rent is above current market rent and represents a negative value to the lessee. The lessee is committed to pay above market rates.
It is costing the lessee that amount in rent to stay in place rather than move to an alternative location and pay current market rents
Sublease Rent Is Higher than Contract, but Lower than Market
The contract rent is below market, and the original lessee (who leased two years ago) wants to move and realize some of the value of his leasehold interest. In this case, the lessee may be able to find a sandwich lessee, commonly called a sublessee, to lease their space at a rate that is lower than the market rate (in this case, $48,000 per year), but higher than the contract rate (in this case, $45,000 per year). The sublease lease term would be eight years.The sublessee in this case has a similar interest, since the market rent is still above the sublease rent.
The value of the sublessee’s interest is the differential between the sublease rent and the market rent.
Sublease Rent Is Lower than Contract Rent
Sometimes a user needs to sublease at a rate below the contract rent to move out of a space. In this example, consider that the space is sublet at $45,000 per year, and the contract rent is $50,000 per year.
The differential between the contract rent and the sublease rent is the amount it costs the primary lessee to get out of the lease.
It’s clear that in some cases the leasehold interest may or may not be of value to the lessee and may be of value only to the owner. The relative positions of contract and market rent create these situations, but in other occasions, they are created by the realities of the user’s business and the owner’s investment objectives. For various reasons, either the owner or the lessee might want to sell their interest in the leasehold.
Decisions about when and whether to sublease or whether to negotiate a lease buyout and who should do the buying all are linked. Changing market conditions, remaining lease life, and changes in needs and objectives cause the position of strength between the user and owner to swing like a pendulum.
From an economic perspective, when the leasehold value is positive (market rent is higher than contract rent), the owner is motivated to buy out the user, but the user has an economic motivation to maintain its leasehold position. Similarly, when the leasehold value is negative (market rent is lower than contract rent), the user has a motive to buy out the lease, while the owner has little financial motivation to remove the user from the lease obligation.
Owner and user motivations are not based on the leasehold economic value alone. The owner fears vacancy, while the user fears wasted space (which costs money) and the risks associated with subletting.
Thus, the timing of the lease, the relationship of contract rent to market rent, and the user’s business needs all contribute to pushing the pendulum to one side or the other.
COMMERCIAL REAL ESTATE
TRANSPARENCY | CAPITAL PRESERVATION | INCOME STREAM | TAX SHELTER | HEDGE AGAINST INFLATION
VALUE APPRECIATION | PRIDE OF OWNERSHIP
TRANSPARENCY | CAPITAL PRESERVATION | INCOME STREAM | TAX SHELTER | HEDGE AGAINST INFLATION
VALUE APPRECIATION | PRIDE OF OWNERSHIP
