You have two identical buildings - one with an above market lease and one with a below market lease. Which one do you use a higher/lower cap rate for? Explain please.
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The building with the above market lease is more valuable and therefore would use a lower cap rate.
I don't agree. You are correct that the above-market building has more value at this point in time, but 1) that lease is finite and will almost certainly return to market, and 2) you wouldn't "use a lower cap rate" in order to offer a higher valuation, the increased NOI that (presumably) results from an above-market lease would result in the higher valuation when using the same cap rate.
So in my opinion, one would use a slightly higher cap rate to value the building with an above-market lease, because that higher NOI will eventually revert to market. Alternatively, you could use adjust your NOI stream to reflect market rents/NOI and apply a market cap rate. Then add the NPV the above-market portion of the rent/NOI in order to give the seller credit for their temporary above-market lease.
What? Don't agree with the above. An above market lease is higher risk because your income stream is finite and there's a high probability that the tenant blows out or has a fat reset/decrease once the contract term is over. Think about it. A good selling point/recurring theme on ICOM memos is that there are 'below market rents'. You never see the same said about above market rents being a positive when pitching to investment committee. There's a reason that you hear about sub 4 cap industrial deals on the west coast - it's because the rent growth is projected to be so high or there is such a big spread between in-place and market rent that you're going to get a substantial bump once it rolls.
If you buy a 5 cap and it turns into a 3 cap into the duration of your hold, you aren't ever going to make money. But if you buy a 3 cap and it resets to a 5 cap, you will make a ton of money on your exit.
The way OP posed the question assumes that the in-place rate as it relates to the current market rent is relevant (otherwise, as I mentioned, the above/below market qualifier doesn't come into play). You're grasping at straws to try and defend your point, but this isn't a good leg to stand on. The credit of the tenant doesn't come into play as it relates to above or below market rent. If it's a GSA tenant on a 5 year lease, it's still going to be a higher cap rate if it's above market. Since it's gov credit, you may go from a 5 to a 4, instead of a 6 to a 5 if it was lesser quality credit, but that doesn't change the logic relative to the above market rent.
If it's a 15+ year lease there's a completely different set of buyers for that product and they aren't going to be focusing on an exit, so the rent as it relates to market is a moot point, they will only care about the going in yield.
It's also extremely rare for anything to be on a 99 year term other than a ground lease, just FYI.
Above market rents will receive a higher cap rate - period. It's important to keep in mind the quality and quantity of the income AND the risk/potential upside associated with said income. Above market rent is not as secure as below market rent and a higher cap rate will be applied to it.
We see this exact example all the time in the valuation world where a fully rent stabilized apartment building in Manhattan will trade at a lower cap rate than an identical building leased fully at or above market rent.