Yes. A tenancy can affect the market value of a property.
This is because, for investment properties, market value is closely linked to the income that the property can generate. Where a property is subject to a tenancy, the terms of that tenancy, including the rental, tenancy period, termination provisions, renewal provisions and rent review clauses may influence the price a willing buyer is prepared to pay.
However, not every tenancy will necessarily reduce or increase the market value of a property. The effect depends on the specific terms of the tenancy and how they compare with prevailing market conditions.
The following are some of the key factors to consider:
1.Tenancy Period and Break Clause
Where the landlord has no right to terminate the tenancy at will, the landlord is generally bound by the agreed terms of the tenancy for the committed period, subject to the provisions of the tenancy agreement and applicable law.
Therefore, if a property owner intends to sell the property during the committed tenancy period, the purchaser may acquire the property subject to the existing tenancy.
Even where the landlord has a break clause allowing termination subject to payment of a specified compensation amount, this may still have an impact on the property’s market value, depending on the circumstances and the amount of compensation involved.
2.Agreed Rental Compared with Market Rental
The agreed rental is another important factor.
If the contractual rental is lower than the prevailing market rental, the property may produce less income than a comparable property that is available at market rental. This can have an adverse effect on its investment value during the committed tenancy period.
Conversely, where the contractual rental is higher than market rental, the existing tenancy may potentially have a positive effect on market value during the period for which the higher rental is secured, although the sustainability of that rental and the terms of the tenancy must also be considered.
3.Tenant’s Reputation and Covenant Strength
The quality and reputation of the tenant can also influence the attractiveness of a tenanted property to investors.
For example, a property occupied by a well-established bank, multinational corporation or reputable conglomerate may be perceived as having a stronger rental covenant and a lower risk of rental default.
A purchaser may therefore place greater confidence in the security and continuity of the rental income, subject to the tenant’s financial strength, the remaining tenancy period and other tenancy terms.
4.Renewal and Rent Review Provisions
The renewal provisions and rent review mechanisms in a tenancy agreement can also affect value.
For example, if a tenant has a contractual right to renew the tenancy for a further period at a rental that is significantly below the prevailing market rental, this may adversely affect the property’s market value.
On the other hand, a well-structured rent review mechanism that allows the rental to be reviewed towards market levels may help preserve the property’s income potential.
How Does Tenancy Affect Market Value?
To understand this better, it is useful to first understand the Investment Method of Valuation.
Under the Investment Method, the rental income generated or expected to be generated from a property is estimated. The expenses and outgoings attributable to the ownership of the property are then deducted to arrive at the net annual income.
The net annual income is subsequently capitalised at an appropriate capitalisation rate or yield to arrive at the capital value (or market value) of the property.
The adopted market yield reflects the return expected by investors for comparable properties, taking into consideration factors such as:
risk;
security and reliability of income;
quality of the tenant;
ease of sale;
management requirements;
location and property characteristics; and
prevailing economic and investment conditions.
Therefore, ceteris paribus, a higher sustainable rental income generally results in a higher capital value.
Example: Property Let at Market Rental
Assume the following:
Monthly rental: RM11,000
Annual rental: RM132,000
Annual outgoings: RM12,000
Net annual rental income: RM120,000
Market yield: 5%
The capital value can be simplified as:
Market Value = Net Annual Income ÷ Market Yield
= RM120,000 ÷ 5%
= RM2,400,000
In this example, we assume that RM11,000 per month represents the fair market rental.
Therefore, a tenancy agreement at RM11,000 per month, assuming otherwise normal terms, would generally not create a rental shortfall compared with the market.
What Happens if the Property Is Let Below Market Rental?
Now assume that the property owner has entered into a tenancy agreement at only RM8,000 per month, whereas the fair market rental is RM11,000 per month.
The tenancy is for a period of three years, with an unexpired term of a further two years, with no break clause available to the landlord.
This means that a purchaser acquiring the property during the remaining tenancy period would be committed to receiving the lower contractual rental of RM8,000 per month, rather than the prevailing market rental of RM11,000 per month.
The valuation can therefore be considered in two components:
1.Existing Term
Contractual monthly rental: RM8,000
Annual rental: RM96,000
Annual outgoings: RM12,000
Net annual rental income: RM84,000
Market yield: 5%
For a two-year existing term, the Years’ Purchase (YP)* at 5% is:
YP = 1/(1.05) + 1/(1.05)²
= 0.9524 + 0.9070
= 1.8594
*Years’ Purchase (YP) is a valuation factor used to convert an annual income into a capital value, based on an assumed yield or discount rate and the period over which the income is received.
Therefore:
Capital Value of Existing Term
= RM84,000 × 1.8594
= RM156,190
2.Reversionary Term
After the existing tenancy expires, the property is assumed to revert to its fair market rental of RM11,000 per month.
Market rental: RM11,000 per month
Annual rental: RM132,000
Annual outgoings: RM12,000
Net annual rental income: RM120,000
Market yield: 5%
Therefore:
Capital Value at Reversion
= RM120,000 ÷ 5%
= RM2,400,000
However, the RM2,400,000 represents the capital value at the beginning of the reversionary period (i.e., the immediate first day after the 2-year Existing Term). Since the reversion occurs two years from the valuation date, it must be discounted back to the valuation date.
At a 5% discount rate:
Present Value Factor for 2 years
= 1/(1.05)²
= 0.9070
Therefore:
Present Value of Reversionary Value
= RM2,400,000 × 0.9070
= RM2,176,800
3.Estimated Market Value
The estimated market value is therefore:
Existing Term: RM156,190
Present Value of Reversion: RM2,176,800
Estimated Market Value = RM2,332,990
Compared with the market value of RM2,400,000 if the property were receiving the fair market rental throughout, the difference is approximately:
RM2,400,000 − RM2,332,990 = RM67,010
or approximately:
2.79% lower.
This illustrates how a tenancy at below-market rental can affect the market value of a property.
The adjustment is economically understandable because a purchaser would be required to accept the lower contractual rental for the remaining two years before being able to obtain the assumed market rental.
What If There Is a Break Clause?
Consider another scenario.
Assume the property is otherwise worth RM2,400,000, but the tenancy agreement allows the landlord to terminate the tenancy by paying a fixed compensation of RM50,000.
The actual valuation would depend on the precise wording of the break clause, the likelihood of exercising it, timing, legal considerations and other relevant factors.
For a simplified illustration only, if the RM50,000 represents the economic cost required to terminate the tenancy and restore the property to the assumed market rental position (RM11,000 per month), the market value could be considered approximately as:
RM2,400,000 − RM50,000 = RM2,350,000
The actual valuation should, however, consider the specific contractual provisions and circumstances rather than automatically deducting the compensation amount.
Conclusion
Tenancy can affect the market value of a property, particularly where the contractual terms differ materially from prevailing market conditions.
The impact is more significant where:
the agreed rental is substantially below or above market rental;
the remaining tenancy period is relatively long;
the landlord has limited or no termination rights;
there is a significant break-clause compensation;
the renewal rental is fixed below market level;
the tenant’s covenant strength presents additional risk or security; or
the tenancy contains other terms that affect the property’s future income potential.
Therefore, property owners should consider the market rental and the potential valuation implications before entering into a tenancy agreement.
This is particularly important if the owner expects to sell the property in the near future. A long-term tenancy at below market rental may result in the property being valued below the level that could otherwise be achieved if the property were available at prevailing market rental.
Before committing to a tenancy, property owners may wish to obtain an independent rental valuation from a registered valuer to establish the prevailing market rental and understand the potential implications of the proposed tenancy terms.
Agility Valuers & Property Consultants provides professional property valuation and consultancy services. If you require clarification or assistance regarding property valuation, market rental assessment or tenancy-related valuation matters, please contact us.
For more information about our professional services, please visit “https://www.agilitymy.com/our-services/advisory-en/valuation-and-advisory-services/”
Frequently Asked Questions
Yes. A tenancy can affect the market value of a property, particularly where the contractual rental, remaining tenancy period, termination provisions, renewal terms or rent review clauses differ materially from prevailing market conditions.
It can. If the contractual rental is below the prevailing market rental and the landlord is committed to the tenancy for a significant period, the property’s income during that period will be lower. This may result in a lower market value compared with a similar property receiving market rental.
Yes. A reputable tenant, such as a well-established bank, multinational corporation or major conglomerate, may provide greater confidence in the security and continuity of rental income. This may make the property more attractive to investors.
Yes. A break clause may affect market value depending on its terms, including the compensation payable for termination, the timing of termination and the circumstances under which the clause can be exercised. The actual impact should be assessed based on the specific tenancy agreement.
It is advisable, particularly when considering a long-term tenancy or where the proposed rental may be below prevailing market rental. An independent rental valuation by a registered valuer can help a property owner understand the prevailing market rental and the potential impact of the proposed tenancy terms on the property’s market value.
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