A leasehold interest is an interest in land or equipment in which a lessee or tenant buys the right to occupy or use the land or property for a specified period of time from a lessor under the terms of a lease contract. Most small businesses sign a long term lease that allows them as well as the lessor to have a peace of mind knowing that they have a fixed rent expense for the length of the lease.
This has a big impact on the company’s cash flow and affects the company’s long-term strategy. Due to increases in real estate values over the years, a fixed rent for a determined period of time provides certainty, peace of mind as well as financial advantages (savings in the long run) for the company.
In a valuation engagement how does a lease agreement affect the value of the business?
To answer this question Let's take an example: How to determine the value of a favorable lease?
Take the Present value of the benefits over the term of the lease contract, discount it to the present using a discount rate similar to the rate the lessee would be subject to under similar terms as those contained in the lease agreement.
For Example: ABC Firm leases its headquarters offices from Offices Inc. The lease agreement is a triple net lease (lessee is responsible for real estate taxes, net building insurance, and all common area maintenance) requiring ABC Firm to pay Offices Inc. $25,000 a month for 120 months. A Member of the Appraisal Institute (MAI) analysis of lease rates in similar locations for this type of building is approximately $30,000 a month under similar terms. The estimated annual incremental borrowing rate for ABC Firm for similar debt is 15%.
FMV of Lease Payments $30,000
Less: Existing Lease Payments - $25,000
Monthly Benefits $5,000
Multiply by: Present Value of a monthly annuity
for 120 months @ 15% annual rate x 61.983
Value of Leasehold Interest: $309,914
Leases can be classified either as operating leases or capital leases. As operating leases, lease payments are considered operating expenses which reduces operating and net income although they are tax deductible. As capital leases, they are treated like assets subject to depreciations and the imputed interest payments on the lease are tax deductible instead of the lease payments themselves.
As you can see the reduction on net income has a direct impact on the value of the company.
Achille Ekeu, MBA, CVA
President/CEO of The Washington Valuation Group. A Certified Valuation Analyst and Member of the National Association of Certified Valuators and Analysts (NACVA) in the DC-MD Chapter.He is also a Management Consultant Member of the Institute of Management Consultants (IMC-USA) in the National Capital Chapter. He also serves as an IMC-USA National Academy Committee Member.