THE USE OF THE DUAL RATE IN LEASEHOLD VALUATION

Use of the Dual Rate in Leasehold Valuation

Use of the Dual Rate in Leasehold Valuation

Introduction

The valuation of leasehold interests in real estate has posed problems for valuation surveyors for more than a hundred years. Initially leaseholds were viewed as being a marginally more risky investment than a freehold investment in a similar parcel of real estate (Johnson, 2000). The growing eighteenth and nineteenth century urban demands for land for housing, industry and commerce was met by the landed estate owners releasing agricultural land on long building leases without any provision for rent review. The construction and letting of buildings on occupational leases, with or without premium payments, for terms a few days shorter than the head leases, created transferable leasehold rights in land. A substantial quantity of new homes were owner occupied on long leases and could be valued by comparison or on an investment basis using a years purchase marginally lower than that used for the valuation of the freehold ground rent in the same property subject to the lease. The length of lease, which might have ranged from 99 to 999 years without review, created a near perpetual income stream (Merrett, 2001).

Discussion

The position began to change in the early twentieth century when the unexpired term for some leases fell below 60 years, the long held cut off period that the market felt could be considered as equivalent to a perpetual income (Baum, 2005). What happened next, and why, is history, but a history which is surprisingly difficult to piece together even though a growing number of valuation books were being published at that time. There is no justifiable reason, and there never has been any justifiable reason, for developing the dual rate approach for valuing a leasehold interest in real estate (Webb, 2000).

Leaseholds and the reinvestment assumption

Baum (2005) provides one of the lengthier discussions by a valuation surveyor on the reinvestment assumption that underpins the dual rate principle of valuation and analysis of leasehold investments. He quotes extensively from various authorities on investment analysis from general investment literature and property literature. He notes the views of Baum (2005) that the reinvestment assumption is “a common and remarkably persistent misconception” and they go further to state that:

Yield, or discounted cash flow return, is correctly defined as the rate of return on the capital outstanding in a project during every year of its life. The interpretation no more assumes that recovered funds are reinvested at the project's rate of return than that a bank is receiving a 6% rate of interest on an overdraft implies that the bank is reinvesting the overdraft repayments at 6%.

Baum (2005) explores the Hoskold, or dual rate, approach to capitalisation, but notes that the reinvestment problem is dealt with by the use of dual rates of interest, one rate being a relatively high remunerative rate on capital invested, the other rate being a relatively low accumulative (or reinvestment) rate on cash ...