how to value lease-option?

[freebeer]

For net worth calculation purposes I'd like to be able to impute a value to a lease-option in a substantial waterfront recreational property with the following somewhat unusual terms:

1. Exclusive use of the property for next 20 years, rent free other than paying property taxes and maintaining a liability insurance policy.

2. Option to purchase the property after 20 years for 50% of its value, based on an independent appraisal procedure to be conducted at that time.

Intuitively I would think the NPV of this bundle of rights could be obtained by summing:

a. 50% of the current market value of the property, as a proxy for the NPV of the 50% discount on the future value;

and

b. NPV of market rents for the next 20 years less estimated tax and insurance payments.

But I have no idea if this is in fact a reasonable valuation methodology. Any thoughts welcomed. Thanks!

 

[CybrMike]

what the heck kind of deal is that? Where in the world did you get into something like that? Divorce?

 

[freebeer]

Not divorce, but it's admittedly quite an unusual situation.

One of the things I'm struggling with in valuing it is that there doesn't seem to be much if any value to the "option premium": like a deep in the money call option, it's always going to be economic to exercise at the end of the term. Yet the "strike price" inflates with the value.

The only "downside protection" from the option structure that I can imagine is that in the unlikely event of future deflation it would be possible to come out ahead (vs. the more straightforward scenario of immediate purchase at 50% discount) by putting 50% of current value into TIPS. But that's a bet - arguably more likely (given a 20 year horizon) is that TIPS won't keep up with real estate values, in which case one would have been better off with the immediate buy.

 

[dex]

what is your ultimate objective of this exercise?

 

[freebeer]

dex,

The immediate reason is simply an anal desire to have a reasonably accurate estimate of net worth relative to FIRE-readiness, hence the post to this forum.

The other reason is that this lease-option is cooperatively owned by a small set of shareholders. Very infrequently shares are sold but to the extent that there's any prevailing methodology for setting a price it has been to discount the original lump-sum paid based on the fraction of the original lease period remaining. For example if the original payment was $18K for 30 years then with 20 years remaining the current price should be $12K.

It's not a big deal as the primary purpose of the group is to conserve the land with some recreational enjoyment thereof, and there is far more likelihood of a future transfer to public ownership than any speculative profit. But it seems like our prevailing methodology is fundamentally flawed given the looming 50% discount purchase option (not to mention the value of the rent-free use going up with inflation). Just based on intellectual curiosity I'm curious what an appropriate valuation algorithm would be.

 

[dex]

Freebeer,
Interesting question. Assuming you can not sell it now or rent it to someone else; I would guess the following.
For FIRE - you would only include net profit in year 20 (I think of FIRE as cash accounting.) to analyze your FIRE viability.
For the selling of shares; I think the market value rules. This is where an accounting "arms length" transaction would the the standard. If anything, assuming this is a somewhat desirable real estate location; the share prices should be rising towards the market value as you get closer to the end of the lease. There should not be any link to the original lease purchase price.

 

[haha]

It's not a big deal as the primary purpose of the group is to conserve the land with some recreational enjoyment thereof, and there is far more likelihood of a future transfer to public ownership than any speculative profit.

If this is true, your best bet would be to invent any number, and then multiply it by 0. Then divide by the number of holders. This dividend is then each owner's economic value, suitably discounted to the present.

Ha

 

[freebeer]

dex - thanks, that's a very good point re: thinking about FIRE as cash accounting.

haha - joking aside, even in the case of a future transfer to public ownership there could be a financial benefit over and above the philanthropically desirable outcome. For example the leaseholder group could exercise the half-price purchase option and then sell to land trust at the same price, harvesting a substantial tax deduction since that would be a charitable/bargain sale vs. FMV.