Author: Greg Holt, Appraiser, Mercantile Bank
Valuation theory holds that interests or rights in real estate are to be valued rather than physical land and buildings themselves. Standards require that interests or rights be identified and reported. In ordering and completing appraisal reports then, the issue of which property rights should be valued often comes up. The primary property rights in appraisals are Fee Simple Estate or Leased Fee Estate. Fee simple includes the “full bundle” of rights while leases convey partial property rights to tenants for their use and occupancy. Following are definitions currently in use by the valuation profession (Dictionary of Real Estate Appraisal, 6th edition):
Fee Simple Estate – Absolute ownership unencumbered by any other interest or estate, subject only to the limitations imposed by the governmental powers of taxation, eminent domain, police power, and escheat.
Leased Fee Estate – The ownership interest that the landlord or lessor maintains in a property under a lease with the rights of use and occupancy being conveyed or granted to a tenant or lessee. The ownership interest in a leased property.
If not spelled out specifically, there may be some differences in interpretation among appraisers as to whether a leased fee or fee simple value should be presented. Many banks may take a generally prevailing view that if there is a lease, you must present the leased fee interest. However, as an appraiser it often generates questions such as, “shouldn’t we be determining how a typical buyer would view the lease and its impact on value? Should you really present the leased fee interest if there’s only a short term lease or leases remaining?
A desire for more consistency on these matters prompted the Appraisal Institute to hold discussions on and draft a Property Rights Symposium Discussion Paper (12/21/17). When a property is leased and the value of a lease interest is sought, the valuation process will reflect the lease and account for any loss or benefit due to the rent being above or below market or loss due to the time and cost to lease vacant space. But when the assignment is to value the fee simple estate in property that is typically leased and sold as leased, questions arise as to whether it should be valued as though occupied or as though vacant. This question is critical in eminent domain and property taxation where law or regulation generally requires the valuation of the fee simple estate, even if a lease exists. It is also an important question in mortgage lending when lease income is needed to repay the loan but there is risk of unexpected vacancy. The paper brings up the issue: does fee simple mean vacant and available for lease or occupancy? If so, should deductions be made for lease up time and cost? Does fee simple imply a “go dark” scenario? Also, how does the interest valued relate to your selection and adjustment of comps, and selection of an appropriate capitalization rate? The symposium concludes that the definition of fee simple may need changes. They suggest: “Fee simple estate. The highest estate allowed by law. An inheritable ownership interest of indefinite duration.” In addition, it was suggested that the valuation profession discontinue use of the terms leased fee and leased fee estate. Potential implications of these proposals are that valuers would need to determine, and valuation reports clearly state, the estate (fee simple, leasehold, or life estate) as well as the actual or assumed interests associated with the real estate that are reflected in the valuation. Depending on the question to be answered by the valuation for a property that is leased, or would likely be leased, the valuation could be subject to the existing lease, subject to leases at market rates and terms, or as though vacant and available to be leased at market rates and terms. The valuer generally must consult with the client to clarify which interests to value.
Application in sale and income approaches: the concept of “market value” is linked to specified property rights. It is the “transfer” (a hypothetical sale, the foundation of an opinion of value by an appraiser) where property rights intersect with the concept of market value, because every sale will have a transfer of some rights. So to appraise a subject property we hypothetically create the situation of a “transfer” or sale, and with that hypothetical sale we have to specify which set of property rights are transferred so that the type of value we are opining is clear. Accordingly, every sale comparable that has transferred did so with a specified set of property rights, and thus has to either match the property rights stated in the appraisal of the subject property or be adjusted appropriately. When the fee simple interest is valued, the presumption is that the property is available to be leased at market rates. A lease at market rent would not increase the market value of real property rights to the fee simple estate. Any potential value increment in excess of a fee simple estate is attributable to the particular lease contract”. (The Appraisal of Real Estate, 14th Ed., Chapter 21: The Income Capitalization Approach, p. 441). In the development and analysis for the Income Approach to Value, an appraiser may find that the lease terms are in line with current market conditions, and therefore, the value of the leased fee estate may be equivalent to the fee simple estate, but the property rights appraised and market value label should be leased fee estate for technical accuracy and consistency with appraisal industry standards and practice. Conversely, if the market rent is found to be greater or less than the contract rent, a leasehold estate exists in which the tenant holds positive or negative leasehold position.
I often order appraisal reports requesting that both a “leased fee” and a hypothetical “fee simple” value estimate are to be provided. This may help a bank to better analyze collateral from a lease contract/risk perspective, as well as a hypothetical “fee simple” with an assumption made that the property is available for lease at market rates and market risk. Usually, a “stabilized value” is sought in this fee simple hypothetical as though the property has achieved stabilized leaseup at market rents. An alternative value could also be sought in some cases for a “go dark” scenario with assumption that the property is vacated and available for sale.
Disclaimer: this blog is the opinion of the writer only and does not necessarily reflect the views of the writer’s employer.