A flat ground rent is a bond and a geared one is a share of the building's rent for a century: the review clause, not the yield, sets the price.
Value a commercial ground rent as a discounted cash flow of the rent each review will set, not as today's rent divided by a market yield. On an illustrative ground lease with 99 years unexpired, a ground rent geared to 10 per cent of the building's rental value and reviewed every five years, a 120,000 rent is worth 3,153,192 at a 6.0 per cent discount rate, an initial yield of 3.81 per cent. Capitalising the same rent at the building's 6.0 per cent yield gives 2,000,000 and misses 36.6 per cent of the value.
Worked in full in Commercial Real Estate Investing by Julian R. Sterling, with every figure reproduced in a free workbook.See the book on Amazon →
A ground rent is the income the freeholder receives from a long leaseholder who owns and lets the building on the site. The freeholder has no building to maintain, no voids to fund and a rent covered many times over by the occupational income, which is why ground rents trade on low yields. What decides the value is the review clause: a flat ground rent is a bond, a geared one is a share of the building's rent for the rest of the lease.
| Input | Value |
|---|---|
| Open market rental value (ERV) of the building today | 1,200,000 |
| Gearing: ground rent as a share of the building ERV | 10% |
| Ground rent today, just reviewed | 120,000 |
| ERV growth per year | 2.5% |
| Review pattern | every 5 years, upward only |
| Unexpired term | 99 years |
| Discount rate (target return on the ground rent) | 6.0% |
| Initial yield on the rack-rented building, for comparison | 6.0% |
Rent is taken annually in arrears and the freehold reversion in 99 years is ignored: discounted at 6.0 per cent over that horizon it is worth very little, and the building may be obsolete by then. The ground rent is covered 10.0 times by the building's rental value, which is the security the low yield pays for.
Ground rent from review year r = gearing × ERV0 × (1 + g)r
Years 1 to 5: 10% × 1,200,000 = 120,000
Years 6 to 10: 10% × 1,200,000 × 1.0255 = 135,769
Years 11 to 15: 10% × 1,200,000 × 1.02510 = 153,610
The rent steps up every five years and is flat in between. By year 21 it is 196,634, by year 51 it is 412,453, and over the last cycle of the lease it reaches 1,252,992, more than ten times today’s figure, because it tracks a building rent compounding at 2.5 per cent for 95 years.
Value = Σt=1..99 rentt ÷ (1 + 6.0%)t = 3,153,192
Initial yield = 120,000 ÷ 3,153,192 = 3.81%
Excel, with years in A2:A100: rent in B2 =0.1*1200000*1.025^(FLOOR(A2-1,5)), then =NPV(6%,B2:B100)
The first 30 years produce 2,076,257 of the value, 65.8 per cent; years 31 to 99 add 1,076,936, or 34.2 per cent. That tail is the part a buyer is paying for with a growth assumption, and it is why the unexpired term matters less than people expect: with 50 years left the same ground rent is still worth 2,660,457 and yields 4.51 per cent; with 125 years it is worth 3,221,573.
| Method | Value | Initial yield |
|---|---|---|
| DCF of the geared rent, 5-yearly reviews | 3,153,192 | 3.81% |
| Flat ground rent for 99 years (YP 16.6146 at 6.0%) | 1,993,752 | 6.02% |
| Rent capitalised at the building's 6.0% yield | 2,000,000 | 6.0% |
The flat ground rent is what the same 120,000 would be worth if it never moved: a 99-year annuity, valued with the years' purchase at 6.0 per cent. Gearing to the building's rental value adds 1,159,441, or 58.2 per cent. The initial yield falls from 6.02 to 3.81 per cent, which is roughly the discount rate less growth (3.5 per cent) plus a little for the lag between reviews and the finite term.
| Discount rate | Growth 0.0% | Growth 1.5% | Growth 2.5% | Growth 3.5% |
|---|---|---|---|---|
| 5.5% | 2,170,933 (5.53%) | 2,852,532 (4.21%) | 3,595,954 (3.34%) | 4,771,955 (2.51%) |
| 6.0% | 1,993,752 (6.02%) | 2,557,030 (4.69%) | 3,153,192 (3.81%) | 4,071,151 (2.95%) |
| 6.5% | 1,842,534 (6.51%) | 2,313,491 (5.19%) | 2,798,020 (4.29%) | 3,524,918 (3.40%) |
The value is far more sensitive to growth than an occupational investment of the same size, because the cash flow runs for 99 years and keeps compounding. Moving growth from 2.5 to 3.5 per cent adds 917,958 at a 6.0 per cent discount rate; the same one point taken off growth removes 596,162. A buyer paying a 2.95 per cent yield at a 6.0 per cent discount rate is underwriting growth of 3.5 per cent a year for a century, whether the appraisal says so or not.
The review pattern matters too. If the same gearing were applied every year instead of every five, the ground rent would be worth 3,305,120: the five-yearly lag costs 151,928, or 4.6 per cent of that figure. The same logic, applied to occupational leases, is in what an upward-only rent review is worth.
Applying the yield of a rack-rented building to a ground rent. The 6.0 per cent at which the building trades already prices its own rental growth, its voids, its capital expenditure and its depreciation. A geared ground rent has the growth without most of the costs, and dividing 120,000 by 6.0 per cent values it at 2,000,000, 1,153,192 or 36.6 per cent below the DCF. The opposite error is as costly: buying a flat or fixed-uplift ground rent on the yield of geared ones, which pays a growth premium for income that grows slowly or not at all.
Read the gearing clause before the yield. “10 per cent of the rack rent” can mean the rental value of the whole building, the rent actually received, or the rent received less a share of voids. The second and third pass vacancy straight through to the freeholder, and they need a lower growth rate or a higher discount rate than this case assumes.
A ground rent is worth the present value of every rent its review clause will set, and with 99 years to run and gearing to the building's rental value, most of that value is growth. On this case it is 3,153,192, an initial yield of 3.81 per cent, against 2,000,000 for the shortcut. The hold-period and income account workbooks on the companion page for the book show the same discipline applied to the occupational leases underneath the ground rent.
It depends on the review clause more than on the market. In the illustrative case a 120,000 ground rent geared to 10% of the building's rental value, with 2.5% growth and a 6.0% target return, is worth 3,153,192, an initial yield of 3.81%. The same rent, flat for 99 years, is worth 1,993,752 and yields 6.02%.
A ground rent fixed at each review as a percentage of the rental value of the building on the site, here 10%. The freeholder shares in the building's rental growth without paying for voids or capital expenditure. With a 1,200,000 rental value the ground rent is 120,000, covered 10.0 times.
Less than expected, because distant rents are heavily discounted. At a 6.0% discount rate and 2.5% growth the illustrative ground rent is worth 2,660,457 with 50 years left, 3,153,192 with 99 and 3,221,573 with 125. The first 30 years carry 65.8% of the 99-year value.
This article is one calculation from Commercial Real Estate Investing. The book takes the same case from first principles to the decision, chapter by chapter, and every figure it prints is a live formula in the free companion workbooks.
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