When valuing the underlying land on which a building has been sold for the next 20-99 yrs, do you direct cap the sale year payments or project out expected lease payments throughout the entire leasehold and discount it back at some discount rate? If the latter, what discount rate is fair to assume? Also, what would the argument be for not direct capping the income?
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When valuing a Ground Lease, due to the lower risk generally associated with these investments, you'll likely run a 10 year discounted cash flow analysis with a projection of terminal sales proceeds at the end of Year 10. Unless you're at an opportunistic fund acquiring the tract for redevelopment, the underlying land value is marginal compared to that of the value tied to the income thrown off by the ground lease. You can certainly run a DCF analysis for a 99 year ground lease, but it's hardly worth it unless you plan to hold in perpetuity. Applying a cap rate to the forward 12-months of net operating income can give you a good ballpark of value (effectively, it's before debt yield on cost), but going through the process of a DCF will help you understand the full range of expenses for which the owner might be liable, thus providing a better understanding of value.
As for targeted discount rates, it really depends on your assessment of risk / the creditworthiness of the tenant. I've seen ground leases for Walgreens, CVS and Starbucks trade at sub 5% cap rates. Just depends on your market.
I don't think it's as simple as hillhopper " suggests. What is the sale year? Year 21? Year 22? You can't sell in year 20 as there is potentially 0 income, so you have to factor in renewal or re-tenanting costs. After that, How would you come up with a cap rate 20+ years in the future? In my opinion predicting caps 10 years in the future is a mostly useless exercise. Those are just the issues that arise if the ground lease is on the shortest end of the spectrum you suggest.
I think if you're a GL investor buying a leasehold interest in a property that has a ground lessee for that long of a term, I think it's a PV calculation discounted back at that investor's cost of capital. Given the extremely low risk of a long term ground lease, I'm just guessing that would fall somewhere in the 5-6% range.
And again to reference the above, there's an important distinction between the leased fee and leasehold interest. If Walgreens, CVS, Starbucks etc. are trading at sub 5% cap rates that's probably a sale of the leased-fee interest and thus not indicative of the underlying value of the ground lease.
To echo off this - I would never assume you should cap a 99-yr ground lease; the only buyer of those interests is likely to be a long-term holder, thus PV the future cash flows at a low discount rate which is commensurate of the level of risk would be my assumption. If it's a credit-worthy tenant, I would probably assume 4-5% discount rate.
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