Yield Capitalization: Fee Simple, Leased Fee, and Leasehold

Yield Capitalization Across Property Interests

Define the Model Before Entering Cash Flows

Yield capitalization explicitly models the amounts and timing of future benefits. A common property DCF discounts annual NOI and net resale proceeds to the effective date. An equity DCF instead considers cash after debt service, initial equity, and loan payoff. Choose one level and maintain it throughout. A yield is a total-return requirement; an overall capitalization rate is a one-year income-to-price ratio and is not automatically interchangeable with it.

The general end-of-year property model is:

$$V_0=\sum_{t=1}^{n}\frac{NOI_t}{(1+y)^t}+\frac{V_n-C_n}{(1+y)^n}$$

Here $y$ is an annual effective property yield, $V_n$ is gross resale value at the end of year $n$, and $C_n$ is selling cost. If the terminal value comes from capitalization, a common convention uses the following year's stabilized NOI divided by a supported terminal rate. Make the timing explicit; do not accidentally capitalize year-three income while calling it year-four stabilized income.

A Consistent Three-Year Fee-Simple Case

Assume market NOI is $30,000 at each year-end for three years, net resale proceeds are $500,000 at the end of year three, and the market-supported property yield for this simplified teaching model is 8 percent. The net resale figure already accounts for selling costs, so do not deduct them again.

The terminal proceeds are not current value. Discounting all benefits to one date makes the comparison meaningful. This scenario assumes market rent is attainable under the rights and premise being analyzed; it is not an assertion that actual occupied property can be delivered vacant immediately.

Change the Lease, Not the Timeline

Now assume an enforceable existing lease reduces the landlord's annual NOI to $24,000 for all three years. At the end of year three it expires, and the same assumed unencumbered net resale of $500,000 applies. For illustration only, keep the same 8 percent yield and assume no additional tenant-improvement, turnover, or transaction costs.

The present value of the three $24,000 receipts is approximately $61,850.33. Adding the discounted reversion of $396,916.12 gives a leased-fee indication of $458,766.45. The $6,000 annual shortfall affects only three years. It does not reduce the property forever after the lease expires.

A real leased-fee analysis may need a different yield because tenant credit or lease risk differs. It may also require market rent-up time, leasing costs, required repairs, renewal probabilities, or legal restrictions. The teaching model deliberately holds those factors constant so that the effect of a finite below-market lease can be seen rather than hidden among several changing assumptions.

Value the Tenant's Advantage

Assume the tenant can legally transfer the favorable lease and receives a $6,000 annual net advantage for three years with no residual benefit. At the illustrative 8 percent yield:

$$V_{LH}=\frac{6{,}000}{1.08}+\frac{6{,}000}{1.08^2}+\frac{6{,}000}{1.08^3}=\$15{,}462.58$$

In this deliberately consistent model, $458,766.45 plus $15,462.58 equals $474,229.03. The relationship follows because the same benefits, timing, risk convention, and reversion were used. It is a useful calculation check, not proof that separately observed interests always add perfectly in real markets.

If assignment is prohibited, the tenant may enjoy use savings but lack a saleable leasehold benefit. If subletting requires consent, subtract supported costs and evaluate enforceability. If the tenant must restore the premises at expiration, model that obligation. Above-market rent can create an unfavorable tenant position, but liability, termination options, and marketability require careful legal and market analysis.

Test Growth, Reversion, and Risk

Resale value often contributes a large share of a residential DCF. Test the assumptions supporting it. A higher terminal capitalization rate reduces the terminal value if income is held constant. A higher discount yield reduces the present value of positive future receipts. A higher forecast rent does not guarantee higher value if expenses or required return also rise.

Use sensitivity analysis to identify which inputs drive the conclusion. Change one input at a time for a diagnostic comparison, then consider whether inputs move together economically. For example, optimistic rent growth combined with lower vacancy and a lower terminal rate can compound unsupported optimism. Show a reasoned base case rather than selecting the scenario that reaches a desired value.

Reconcile With Observable Transactions

An elaborate spreadsheet cannot compensate for unsupported inputs. Compare the implied current overall rate, price per unit, rent multiple, and lease premium or discount with relevant transactions. Investigate discrepancies and explain whether they arise from timing, property differences, rights, or weak evidence.

Report the forecast period, cash-flow convention, yield basis, terminal calculation, material lease terms, and significant assumptions. Preserve the model and supporting data. The intended user should be able to understand why the forecast and reversion represent the interest appraised without assuming that a computer-generated output is independent market evidence.