In June 2004, Los Angeles-based The Kor Group sold the 224-unit Villa Venetia apartment community (13900 Fiji Way, Marina Del Rey, CA 90292) to Lyon Capital Ventures, LLC for $34.25 million or $154,279 per unit. The 1960s-built Villa Venetia apartment community consisted of four three-story buildings totaling 292,808 square feet situated on 6.4 acres of land, primarily consisting of large one-bedroom and two-bedroom units. In 1961, the 6.4 acre land parcel had been leased from Los Angeles County, as were all other parcels in Marina Del Rey. The 60-year lease was scheduled to expire in 2021, at which time the lease specified that the property’s improvements would revert back to the county.
In August 2011, Lyon Capital Ventures negotiated a complex agreement with Los Angeles County, which extended the lease term 33 years (from 2021 to 2054.) Simultaneously with the lease extension, Lyon Capital Ventures sold the Villa Venetia apartment complex to Archstone for $44.8 million or $200,000 per unit.
Immediately after acquiring the property, Archstone completed a thorough $30 million renovation, which would revitalize the outdated Villa Venetia apartment community and rebrand into a luxury apartment community named Archstone Breakwater. As of 2017, the newly-renovated Archstone Breakwater apartment community generates upwards of $9 million in annual rental revenues, resulting in a healthy return for its owners.
History of Marina Del Rey (Development, land leases, parcels)
The story of modern-day Marina Del Rey starts in 1887, when developer M.C. Wicks proposed building a commercial harbor at the Playa Del Rey Estuary to serve the Western United States. The plan would eventually be scrapped, as would several similar plans for commercial harbors over the following decades.
Eventually, in 1936 the Government decided that the main commercial harbor serving the Western United States would be located in San Pedro and Long Beach. Following the Government’s decision, the plan for a harbor in modern-day Marina Del Rey persisted, however now as a recreational harbor. In 1949, the Army Corps of Engineers prepared a report detailing the feasibility of constructing a recreational harbor in modern-day Marina Del Rey.
In 1965, after fifteen years of planning and construction, the Marina Del Rey harbor was constructed at a final cost of approximately $36,250,000 using funds from the federal government, state government, county government, a motor vehicle fund, and public bond sales.
The County of Los Angeles was the largest source of funds, contributing over $15 million for land acquisition plus 50% of certain specified infrastructure costs. Upon the Marina’s completion, the County would ultimately own hundreds of acres of waterfront land plus the right to earn rental income from thousands of boat slips in the harbor.
Upon completion, Marina Del Rey included 8 basins and over a hundred parcels of developable land, altogether totaling almost 1,000 acres. During the early 1960s, as the marina was nearing completion, the County solicitied proposals from developers to lease parcels on which the developers could develop projects including apartment complexes, retail centers, hotels and office buildings. Within a few years, most of Marina Del Rey’s parcels were leased to developers and business owners, typically for 60 year terms. The remaining parcels were designated as public parking lots, parks or other recreational uses. (Click here for a detailed up-to-date land use map for Marina Del Rey.) In an act of transparency, all of the leases between the County and the lessees are available for review on the County’s website.
During the following decades, Marina Del Rey thrived and was transformed into one of the most affluent communities in Los Angeles, with a population of over 8,000 residents and over 5,000 boats.
Now, let’s delve into the story behind Parcel 64.
Lease Agreement Signed for Parcel 64 between Los Angeles County and Jackbilt, Inc.
On May 10, 1961, Los Angeles County and Jackbilt, Inc signed a lease agreement for Parcel 64. Parcel 64 is an irregularly-shaped 6.45-acre parcel, located at the end of Fiji Way. Interestingly, Parcel 64 is the only apartment complex located on Fiji Way, whereas the surrounding parcels are restaurants, retail shopping centers, boat repair businesses, and public parking lots. Also, the 6.45-acre parcel is the only residential parcel in Marina Del Rey with frontage on both Ballona Creek and on the main Marina Del Rey waterway.
Jackbilt, Inc is a real estate investment and property management company founded in 1947 by Jack Howard. Seventy years later, Jackbilt is still owned and operated by the Howard Family, with corporate offices in Santa Barbara and Los Angeles.
The original lease signed between Los Angeles County on Jackbilt, Inc included the following general terms:
- 60 year lease (May 10, 1961 – May 9, 2021)
- Annual minimum base rent (minimum rent) to be $30,927.05/year ($.11/SF/year)
- Percentage rent to be 7.5% of apartment rental receipts, 20% of gross parking income, and 5% of gross laundry income. If minimum rent exceeds percentage rent, then only minimum rent is due (no percentage rent due). If percentage rent exceeds minimum rent, then only percentage rent is due (minimum rent not paid in addition to percentage rent)
- Upon lease expiration, all of the parcel’s improvements revert to the county in good condition. Alternatively, county may instruct Lessee to demolish the improvements at Lessee’s sole cost and expense
Shortly after signing the lease, Jackbilt constructed the Villa Venetia Apartment Community, a 224-unit garden apartment complex consisting of four three-story buildings totaling approximately 300,000 SF. The buildings depicted on the below diagram as 13900 & 13902 Fiji Way were constructed in 1963, and the buildings depicted on the below diagram as 13904 – 13910 Fiji Way were constructed in 1968. Other improvements constructed on the parcel included a leasing office, clubhouse, two swimming pools, a tennis court and subterranean parking.
The original developer, Jackbilt, continued to own Villa Venetia apartment community for over 35 years. During Jackbilt’s owernship, thanks to the favorable terms of the lease (7.5% percentage rent on multifamily rental income) as well as rapidly increasing rents in Southern California, the net income of the property would significantly outpace inflation. To provide some additional context, inflation-adjusted median rents in the United States increased by approximately 64% between 1960 and 2014.
About 20 years into the lease, the rental rate was renegotiated, as was called for in the original lease agreement. The negotiations resulted in the following outcome:
- Starting from May 10, 1982 until May 9, 1986, the percentage rent was increased from 7.5% to 9% of apartment rental income
- Starting from May 10, 1987, the percentage rent was increased from 9% of the apartment rental income to 10.5% of apartment rental income, at which level it would remain until 2011.
During the early 2000s, Jackbilt sold the Villa Venetia apartment complex to The Kor Group, a Los Angeles-based fully-integrated investment, development and property management company founded in 1999.
June 2004: The Kor Group Sells Villa Venetia Apartment Community to Lyon Management
In June 2004, The Kor Group, who owned the apartment community for less than five years, sold the community to Lyon Management for $34.25 million or $154,279 per unit. At the time of the sale, the lease was scheduled to expire in less than 17 years, which was certainly factored into the sales price.
Let’s estimate the net operating income at the time of the 2004 sale:
- Estimated 2004 Net Operating Income Calculation
- Gross Rental Income (Estimated by Costar in 2004 as $1,600-$4,000 per unit. For our purposes, we’ll assume an average of $2,750/month or $2.75/PSF):
- Apartment Income: $2,750/month * 12 months * 224 units = $7,392,000
- Parking Income: $50/month*12 months * 224 spaces = $134,400
- Less: 5% vacancy = .05 * 7,526,400= (376,320)
- Total Gross Income: $7,526,400 – 376,320 = $7,150,080
- Expense estimates:
- 25% of Gross Rental Income (Estimated): $1,787,520
- Ground Lease Expenses: 10.5%*$7,392,000 + 20%*$134,400 = $803,040
- Total Estimated Expenses: $2,590,560
- 2004 Estimated Annual Net Operating Income: $4,559,520
- Gross Rental Income (Estimated by Costar in 2004 as $1,600-$4,000 per unit. For our purposes, we’ll assume an average of $2,750/month or $2.75/PSF):
Therefore, the estimated cap rate of the 2004 sale was 13.3% ($4,559,520/$34,250,000), compared to a cap rate which would have likely been about 6% if the property had 50 years remaining on the lease term, and would have likely been about 4% if the land was included in the sale of the property (conventional sale). Therefore, the price was definitely adjusted downward to account for the upcoming 2021 lease expiration.
However, Lyon still saw some value and potential in acquiring the diminishing leasehold position for $34.25 million. In hindsight, it’s evident that Lyon was willing to risk that Los Angeles County wouldn’t seek to repossess the property at the end of the lease term. Lyon was betting that the County would cooperate to renegotiate and extend the lease at favorable terms, thereby significantly increasing the value of the leasehold interest.
During the decades leading up to August 2011, the Villa Venetia apartment complex had been gradually aging and losing its appeal. In order to remain competitive over many decades, apartments generally require major renovations every 20-30 years. Such renovations include replacing the building’s roof, mechanical systems (HVAC), parking surfaces, landscaping, configurations/floor plans, facade, and more.
For a property like Villa Venetia, a major renovation can cost tens of millions of dollars. Because of the property’s 2021 lease expiration, the property’s owner wasn’t incentivized to spend tens of millions of dollars on buildings that were scheduled to be repossessed by the County in a few years. Moreover, any renovations made to the property could be seen as negatively effecting the lessee’s interests in the upcoming lease negotiations, as the County would likely become more difficult to negotiate with if the improvements on the parcel were more valuable (since the lease called for the ownership of the improvements to revert to the County in good working condition.)
The above circumstances set the stage for the 2011 renegotiation of the lease and simultaneous sale of the property to Archstone.
August 2011: Lyon Management Group Renegotiates Lease and Sells Villa Venetia Apartment Community to Archstone
In August 2011, Lyon Management Group finalized an agreement with the county to renegotiate and extend the lease for an additional 33 years (from a 2021 lease expiration to a 2054 lease expiration). Simultaneously with the lease execution, Lyon sold Villa Venetia to Archstone for $44.8 million, or $200,000 per unit.
The general terms of the renegotiated lease were as follows:
- Lessee agrees to immediately spend at least $24,890,000 on major renovation (essentially re-building the property with new plumbing, new electrical, new facade, new mechanical systems, etc.)
- Until January 1, 2013 (during renovation period) rent to be the annual average of the previous three years (2008-2011) (Approximately $1,000,000/year)
- After January 1, 2013, minimum rent is $1.1 million/year. Percentage rent to be 13% gross receipts for building rents, 5% of laundry gross receipts, and 20% of parking receipts
Following Archstone’s acquisition of the apartment community, the property was renamed Archstone Breakwater.
The Renovation: 2011-2013
In carrying out its obligations to thoroughly renovate the apartment complex, Archstone hired Mike Rovner Construction, a prominent contractor based in Southern California. The 20-month renovation spanned until September 2013 and costed $29 million, according to a renovation summary on the contractor’s website.
The renovation plans called for the floor plans of the buildings and the site plans of the project to remain unchanged. The new Archstone Breakwater apartment complex would have the same exact structure, layout, and interior walls as the original Villa Venetia apartment complex, except all of its components would be brand new.
According to the property’s leasing website, asking rents for one-bedroom units are between $2,800 and $4,600 (approximately $4/SF month) and asking rents for two-bedroom units are between $4,089 and $4,294 (approximately $3/SF) month. The variance in prices largely depends on whether the units have views of the Marina, Ballona Creek, an interior courtyard, or a road.
NOI Calculation and Estimated Return
Now, let’s estimate the net operating income and return achieved by Archstone after it’s acquisition and subsequent renovation:
- Estimated 2017 Net Operating Income Calculation
- Gross Rental Income (Let’s assume $3,500/month or approximately $3.50/SF):
- Apartment Income: Average unit size 1,000 SF * 3.50/SF * 12 months * 224 units = $9,408,000
- Parking Income: $50/month*12 months * 224 spaces = $134,400
- Less: 5% vacancy = .05*9,408,000= (470,400)
- Total Income: $9,408,000+134,400 -470,400 = $9,132,000
- Expenses estimates:
- 25% of Gross Rental Income ($9,132,080*.25) = $2,283,000
- Ground Lease Expenses: 13%*$9,408,000 + 20%*$134,400 = $1,249,920
- Total Estimated Expenses: $3,532,920
- 2017 Estimated Annual Net Operating Income: $5,599,000
- Gross Rental Income (Let’s assume $3,500/month or approximately $3.50/SF):
Below is an estimated 5-year cash flow calculation for Archstone following its acquisition. The 5-year cash flow calculation assumes the following:
- Purchase price: $44,800,000
- Renovation and holding costs during years 1 & 2 estimated at $17,000,000/year
- Year 3 Stablized NOI of $5,600,000 (see above for calculation) with 3% annual increases in NOI
- Property is sold for a 5 cap rate based on Year 6 NOI. We decided on projecting a 5 cap rate for the following reasons:
- We believe that the estimated cap rate of this property would be a 3.5 cap rate if the land was included in the purchase. This was our starting point
- Considering that there are 40 years remaining on a land lease (but also keeping in mind that the land is county-owned, and therefore there’s a good chance that Lessee will be able to renew), we adjusted the cap rate upwards
- It’s also important to keep in mind that since Lessee is paying $1,249,000 of yearly lease payments, this expense reduces the property’s NOI by that amount, thereby reducing the property’s value by $25,000,000 (based on a 5 cap rate). For this reason, the exclusion of the land is already partially reflected in the 2017 NOI .
Although a 14.38% internal rate of return is generally satisfactory, Archstone’s return was nothing spectacular considering all of the invested resources and accompanying risk. This transaction most likely represented the Archstone REIT adding 224 units of well-located apartment units to its portfolio, which at the time totaled over 77,000 apartment units.
However, Archstone wouldn’t see the property all the way through to its completion. In November 2012, during the property’s renovation, Archstone REIT was acquired by Equity Residential and Avalon Bay Communities for $9 billion. The Archstone Breakwater property was acquired solely by Equity Residential, who continues to own the property until today.
Controversy Arising from the County’s Role as Landlord
Reasons why the existing lease rates are justified:
- During the early 1960s, developers exposed themselves to significant risk by leasing land from the County and developing the land, and therefore deserve to earn substantial returns on their investments. Here’s a direct quote from the Los Angeles Times article supporting this idea:
“It was just a dirty old slough, a mess,” said Deane Dana, chairman of the Board of Supervisors, whose district includes the marina. “Nobody envisioned it becoming the wonderful playground that it is now. . . . It was a risky venture.”
- Unlike private investors, the County’s decisions are not purely financial decisions, because the County is not purely motivated by financial interests, but rather is also motivated by non-financial interests. Here’s a direct quote from the Los Angeles Times article:
The county’s management of the marina, Dana said, should not be judged by the standards of private business because the government is subject to pressures from numerous directions–including the public, marina residents, boat owners and leaseholders. “It’s difficult to run the county like a business,” he said. “Government just can’t get away with what you can in the private sector.” As a public facility, Dana said, part of the marina’s purpose is to enhance the quality of life for county residents. “I liken (it) to our parks,” he said. “Money isn’t everything.”
Reasons why the existing lease rates are unethical:
- Over the years, leaseholders have nurtured “close relationships” with County representatives, thereby providing reason to challenge the fairness and neutrality of the negotiations. Here’s a direct quote from the Los Angeles Times article:
The six largest leaseholders, who control nearly two-thirds of the leased property at the marina, are major campaign contributors to supervisors. Marina leaseholders and developers have given more than $500,000 over the past six years. Some leaseholders also give gifts, such as more than $30,000 in free food and lodging at hotels and memberships in yacht and athletic clubs, to top officials in the Department of Beaches and Harbors, which manages the marina.
- The County should follow customary industry practices and tie its rental income to the value of the land, rather than tying its rental income to a percentage of the leaseholder’s income. Below is a quote, explaining the argument in greater detail:
Case and other real estate experts say it is a fundamental precept of commercial real estate management that landowners seek an annual profit linked to the value of the land itself, whether publicly or privately owned. “If the county is going to keep county resources tied up in marina land, it is in the interest of the taxpayer that the county be earning a market return based on the value of the asset,” said David Dale-Johnson, director of the real estate program at USC’s School of Business Administration…..If the marina is worth $1.4 billion, the county’s $15.7-million profit last year was a return of 1.1%. In general, Case and other real estate experts say, an annual return of 10% on the value of the land is considered good, 8% is adequate, and 5% or below is substandard.
- As the taxpayers’ representative, the County needs to negotiate in the financial interests of the County’s taxpayers. If not, the County is essentially providing a taxpayer subsidy to the Lessee’s. The only way to ensure that the extensions are being executed at fair-market-value is to open up bidding to the general public.
A Potential Solution: Privatizing Ownership of Marina Del Rey Parcels
- This approach would increase the county’s property tax revenues. Under the current situation, each of the lessees are responsible for payment of property taxes based on the value of the leasehold interests (excluding land ownership). Although I have no way of confirming the exact amount of property taxes being paid by the Marina Del Rey lessees, it is likely much lower than what the property taxes would be if the county sold the land. For example, in the case of the Villa Venetia apartment community, the existing Lessee may be paying property taxes based on a value of $70 million. However, if the County sold the underlying land, the County would not only earn a lump sum of approximately $30 million through the sale, but the County would also receive an additional $400,000 per year in property tax receipts because of the property taxes that would be due by the new landowner. Moreover, because private ownership of the land would encourage properties to be developed to higher-and-better uses, property taxes would also increase due to the increases in the value of the buildings/improvements situated the Marina Del Rey parcels.
- This approach will also incentivize developers to develop land to “higher and better” uses, rather than tailoring investment strategies depending on the number of years remaining on leases. The marina is filled with numerous properties which have remained stubbornly underutilized and/or dilapidated, solely because of an upcoming lease expiration (Fisherman Village is a prominent example). Some leasehold owners have even used the state of their dilapidated buildings and medium-term leases (10-20 year remaining), in order to pressure the County into granting lease extensions using justifications along the lines of “We want to develop this property, but with only 10-20 years remaining it just doesn’t make financial sense. If you extend our lease at a low rent, we’ll redevelop the property and everyone will be better off.” By privatizing ownership of the land (and offering the leasehold owners an opportunity to own the underlying land), the cycle (of buildings falling into disrepair and the county succumbing to granting lease extensions) will eventually end. The end result will be developers who are thinking more long term, who are building better-quality buildings and who are more quickly developing properties to higher-and-better uses.
- This approach will ensure that the county (taxpayers) are able to sell the parcels for their current market values. Leased-fee interests in land leases could be marketed as bond-like passive investments with major potential upside for the Lessor upon the termination of the lease. Furthermore, well-publicized auctions would ensure that the land parcels are sold for market value.
- Another benefit resulting from the County selling its Marina Del Rey land holdings would be less opportunity for corruption (bribery, favors, gifts, etc.). In the aforementioned 1992 Los Angeles Times article, it writes:
Over the years, the leaseholders have cultivated a close relationship with supervisors and officials who administer the marina, according to records and interviews.
The six largest leaseholders, who control nearly two-thirds of the leased property at the marina, are major campaign contributors to supervisors. Marina leaseholders and developers have given more than $500,000 over the past six years.
Some leaseholders also give gifts, such as more than $30,000 in free food and lodging at hotels and memberships in yacht and athletic clubs, to top officials in the Department of Beaches and Harbors, which manages the marina.
Over the last 15 years, the supervisors have made decisions that have greatly increased the income of the leaseholders and added tens of millions of dollars to the value of their marina holdings.
- Lastly, the County/taxpayers would benefit from less county resources spent on administering the existing leases and renegotiations. As the lease expiration map shows, leases on 23 parcels will be expiring within 10-15 years. Each of these lease expirations represents thousands of hours of work by County employees and tens of thousands of dollars of County expenditures on consultants, attorneys and third party vendors. By simply eliminating the County’s role as lessor/negotiator in these leases, the County (specifically the Los Angeles County Department of Beaches and Harbors) could reduce its operating expenses by hundreds of thousands of dollars annually.
Marina Del Rey is a priceless asset for Los Angeles County. Almost ten thousand residents live in Marina Del Rey, over 5,000 boats are anchored in the Marina, and millions of tourists and residents enjoy visiting the neighborhood each year. Although not operating at its full potential, the Marina has come a long way since the 1960s and is something that the County and developers are responsible for bringing about.
Now, let’s go through some lessons which we could learn from the above transaction and circumstances:
Lessons and Takeaways
Lesson #1: Negotiating Tip: Know what the goals and interests of each party are. This can help in deciding on how to approach the negotiation and what to ask for
One lesson can be learned through understanding the negotiating savvy of Lyon Capital Ventures, LLC. Lyon acquired Villa Venetia apartment complex for $34.5 million in 2004, with only 17 years remaining on the lease, and soon after began negotiating a lease extension with the County. Because Lyon acquired a diminishing leasehold interest with only 17 years remaining for $34.5 million, the value of the leasehold interest by 2011 (with only 10 years remaining) should have been much lower, possibly in the $20 million range. However, Lyon negotiated a favorable lease extension, which enabled it to sell the exact same property it acquired, except now with a lease extension, for $44.8 million.
The question is: why would the County agree to an extension which would instantly increase the value of the leasehold interest by $25 million, even though the County could have gained possession of the leasehold interest upon the leasehold’s expiration in 2021? The reason is because the County is not solely financially motivated, but rather is also motivated by many other reasons such as:
- Providing the best possible quality of life for its residents
- Demonstrating that the County is working hard to maintain a fair/defensible level income for the County’s landholdings, rather than just caving in to developers
- Avoiding messy disputes/lawsuits with developers which would take up a lot of the County’s time and resources
- Avoiding day-to-day involvement in the operations of apartment buildings or real estate (something that the County isn’t in a position to do)
Lyon understood the county’s unique interests and was able to reach an agreement with the County based on the following general terms:
- Lease extended by 33 years, from 2021 to 2054
- Lessee agrees to invest $25 million in rebuilding/renovating the apartment community
- Lessee’s rent payments are increased from 10.5% of apartment rental income to 13% of apartment rental income
Although, an astute, financially-motivated, private investor would almost certainly not agree to a lease based on the above terms, it was in the County’s best interests to agree because of its unique non-financial interests.
Also, in more general situations private investors and developers can gain immense benefits by negotiating and working with the government organizations. For example, government organizations may be able to offer investors tax credits, property tax abatements, subsidies for property renovations, etc, which can increase the viability and financial return of a developer’s projects.
Best of all, the county’s interests are often aligned with developers’/investors’ interests. For example, just like it was in the county’s best interests for the Villa Venetia apartment complex to undergo a $25 million renovation, the renovation was also in the best interests of the property’s owners, as it would significantly increase the property’s rents and income. For these reasons, public entities can often make excellent negotiating adversaries.
This idea of knowing your negotiating partners’ interests, also holds valuable in negotiations between two private owners. For example, if an investor notices that the seller of a property is motivated to sell a property extremely quickly (for financial, personal, or other reasons) an investor can offer a quick closing period and acquire a property for a lower price than otherwise possible. To cite another example, if an investor notices that a seller is planning on retiring and keeping their cash in a low-yielding savings account, an investor can offer the seller an opportunity to lend the investor 75% of the purchase price at a higher interest rate than the seller would earn in the bank. Such a scenario may be a win-win situation, and only possibly by knowing and understanding the interests of each of the parties in a deal.
Lesson #2: Negotiating Tip: Always know the strength of your negotiating position
Another lesson that can be learned is the importance of each party in a negotiation knowing the strength of their position. Based on the terms of the lease of Parcel 64, the County was scheduled to receive possession of the fully functional and occupied 224-unit apartment community on May 10, 2021. Based on an estimated annual income of $5 million, this property (building and land included) would be worth approximately $100 million upon the lease’s expiration. However, instead of allowing the lease to expire, the County extended the existing lease, under which the County would be receiving approximately $1.25 million annually until 2054, an annuity which would likely have a present value of about $40-50 million, including the value of the future reversion value in 2054. In other words, the County lost out on over $50 million of value, simply because it didn’t fully comprehend (or wish to wait or work for) its strong position in the negotiations.
Lesson #3: Multi-Family rents are a great hedge against inflation
We can learn another lesson from this analysis through understanding the financial mechanisms that led to the high levels of net operating income of the Villa Venetia apartment community. Real estate investors have long known of one of the most attractive benefits of real estate ownership: serving as a hedge against inflation. The effects of rent growth are especially noticeable in Marina Del Rey, which has been exempted from the 1979 rent control ordinances prevalent throughout Los Angeles.
For example, the purchasing power of $100 in the year 2000 was equal to the purchasing power of $17.19 in the year 1960 (582% difference). Over the same period, median rents in California increased from $79 to $747 (945% difference). Rents in California increased at almost double the rate of inflation during the 40 years between 1960 and 2000. Considering that Marina Del Rey is a high-demand, supply-constrained market, the gross rent increase between 1960 and 2000 likely well exceeded the 945% statewide increase. With this information in mind, it’s not surprising that by 2004, the leaseholder’s annual net operating income had skyrocketed to over $4.5 million.
Lesson #4: Calculate an investment’s valuation through discounting the investment’s cash flows. Even though owners of Leasehold interests will eventually be left empty handed, leasehold interests can sometimes provide better returns than conventional property ownership
One of the most appealing aspects of investing in real estate is that an investor can indefinitely retain possession and reap a property’s income indefinitely. On the other hand, an entrepreneur leasing a space and opening a business will almost certainly not be operating in 50 years. This permanent, perpetuity-like characteristic of real estate is one of the main advantages of real estate investments.
For this reason, when investors are faced with the opportunity of acquiring relatively short-term, temporary leasehold interests, most investors immediately brush off the opportunities using justifications such as: “I don’t want to end up with nothing after the lease ends” or “unless the opportunity is priced at pennies-on-the-dollar I’d rather pay a much higher price to acquire a building including the underlying land.” However, these investors may be wrong to overlook leasehold interests. After all, there must be attractive opportunities in acquiring leasehold interests when prominent developers are quoted in the Los Angeles times singing the praises of a leasehold interest:
One major leaseholder, Douglas Ring, described Marina del Rey as “the greatest real estate investment in Southern California.” Apartment developer Jerry Epstein said: “I’m not crying poverty. . . . We do very, very well.”
In light of this information, how can we objectively analyze leasehold opportunities without being deterred by their finite natures? By conducting a discount cash flow analysis, investors can objectively calculate whether a leasehold interest is an attractive opportunity, regardless of whether there are 5 years, 20 years, or 50 years remaining on the lease term.
For example, let’s consider two $1 million properties: One property is a leasehold interest with a net operating income of $300,000, with 10 years remaining on the lease term. The second property is a building including the underlying land, with $60,000 of annual income, which an investor would be able to resell in 10 years for $1.5 million. By inputing the annual cash flows of these two properties into a discounted cash flow analysis, an investor will find that the internal rate of return of the leasehold interest is much higher than the property including the building and land. Therefore, the leasehold opportunity would provide a much more attractive return, even though the owner of the leasehold would no longer own the property (or have anything to sell) after 10 years.
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