This walkthrough, our seventh in the series, explains how the Ground Lease Valuation Module works and how to implement this tool into your analysis. The All-in-One Model includes two methods to account for a ground lease. The first is to simply include the ground lease payments in the operating expenses (above NOI), thus reducing the value of the investment by the amount of the ground lease payment at the assumed cap rate. This method, however is imprecise.
The Ground Lease Valuation Module, in contrast, puts the ground lease payments below NOI and seeks to calculate the value of the land by finding the present value of the ground lease cash flows at some user-defined discount rate. Then, the land value is subtracted from the gross investment value to more accurately account for the impact of the ground lease.
In an effort to provide greater instruction on how to use our All-in-One Underwriting Tool for Real Estate Development and Acquisition, we’re developing this series of walkthrough videos and posts on the methodology behind the various components of the model. Our hope is that if you are empowered with the how, you’ll be more willing/able to provide feedback to improve the model.
If you haven’t already, you can download the model here. This walkthrough uses beta version 0.4.3 of the All-in-One Model.
Video Walkthrough – Using the Ground Lease Valuation Module
When to Use the Ground Lease Valuation Module?
Imagine this scenario. You’re offered an opportunity to purchase a grocery-anchored retail center. The improvements sit on land encumbered by a 40 year ground lease – or in other words the investment opportunity is only for the leasehold (improvements) interest. How do you properly value this investment opportunity, considering you wouldn’t own the land, would have to relinquish ownership of the improvements in 40 years, and must make ground lease payments each year through the end of the hold period?
The Ground Lease Valuation Module seeks to provide a means to evaluate this opportunity. The module calculates the present value of the land based on the annual ground lease payments and reversion value of the property at the end of the lease. It then reduces the value of the investment by the present value of the land to determine an opportunity acquisition price and to calculate an appropriate terminal value. It also models the ground lease payments below net operating income such that the impact is reflected in the various metrics such as DSCR, DY, IRR, and EMx.
Turning the Module On via the Summary Tab
Turning the Ground Lease Valuation Module on is simple. Go to the Summary tab. Under the ‘Include Modules?’ section, turn the ‘Ground Lease Valuation Module’ drop-down menu to ‘Yes’.
Once you’ve turned the module on, a new tab called GL will become available where you can add the terms of the ground lease and other assumptions.
Using the Ground Lease Valuation Module
On the left side of the GL tab, first set the land size encumbered by the ground lease. This doesn’t have any quantitative impact, but is helpful in understanding what proportion of the improvements are on ground-leased land.
Set the ground lease start and end dates. The model will then calculate the ‘Years Remaining’ with the max being 99.
Set the discount rate and general growth rate. The discount rate is the rate at which the ground lease payments and residual investment value (Column I) are discounted to arrive at the present value of the ground lease. The general growth rate drives the residual investment value.
On the right side of the GL tab, enter the annual ground lease payments (Column J) per the terms of the lease. Then, in Column I assess the default calculation for the residual investment value to determine if it is appropriate. Column I is marked with oranged font cells, to signify an option input. This is because the residual investment value may be the gross value of the land plus improvements, the value of the land, or $0 depending on the terms of the ground lease.
If you have any questions, please don’t hesitate to reach out.
About the Author: Born and raised in the Northwest United States, Spencer Burton has over 15 years of real estate investment and development experience. In his current position, Spencer assesses new acquisition, development, and debt opportunities for a $45bn real estate fund. He resides in Dallas, TX.