Comments on "You Can't Get the Value Right If You Get the Rights Wrong".
I read with interest the numerous and lengthy letters reacting to David C. Lennhoff's article, "You Can't Get the Value Right If You Get the Rights Wrong" (Winter 2009). Then I went back to the original article to see what all the fuss was about. It is encouraging to see so much attention to an article in The Appraisal Journal.Mr. Lennhoff's argument, if I understand it, is that in situations like tax assessment and condemnation (but not mortgage lending or pricing for sale), custom-built commercial properties ought to be valued by disregarding both their leases (where the lease rates exceed the market rent for comparable noncustom-built space) and the excess construction costs involved in customization. The critics find a great deal of discomfort in putting aside the contract rent and construction cost. They contend that it is inappropriate to disregard the high-rent, first-generation lease rates and actual custom-construction costs.
For myself as a practicing appraiser, when confronted with a question of what method of analysis and what data are appropriate to solving the question of market value, I find it useful to ground myself in the situation an appraiser is asked to assume: If a for-sale sign were planted in front of the property, what would happen?
Mr. Lennhoff gives us the example of a two-year-old, custom-built fitness club where the contract rent is about $2 million and the market rent (for users who would put the property to a different use, like a call center) is about $1 million. Mr. Lennhoff's approach for the valuation of the fee simple estate (the fee simple estate being the estate where the $2 million lease is not in place) is to put the lease aside, as though it did not exist. But not only does he put the lease aside, he puts the existence of the tenant-the fitness club-aside as well. A better alternative, I would argue, would be to put the lease aside but not to disregard the presence of the occupant, the fitness club, that commissioned the construction of the building in the first place because, even if the lease is put aside, that potential tenant is still on the scene.
Assume, in the fee simple case, that the building has no lease, is vacant, and is for sale. Buyers would recognize that the market rent for most potential occupants is $1 million. They would also recognize that the building suits the custom needs of the fitness club, a national chain, which pays $2 million rent in order to have buildings of this kind constructed elsewhere. The chain apparently does not have another facility in this market. This market is well suited to the chain (as evidenced that it has had the facility built). Buyers would recognize that there is a possibility that the facility can be leased to this fitness club at $2 million per year, because the fitness club cannot get what it wants from anyone else for any lesser amount.
The situation is complicated. There is reason to think that, in the absence of a preexisting lease, the fitness club would pay a premium above the $2 million, in order to avoid the lengthy wait for a new facility to be built, to get into this building (which, in fact, it is already in), and to be able to do business right away. In that sense, the building owner has the fitness club over a barrel. But in another sense, it is the fitness club that has the building owner over a barrel. The building owner cannot get the $2 million rent from anyone else. Why should the fitness club pay any more than $1 million, when no one else would? This is the answer to the fee simple question.
The fee simple valuation, by definition, demands that we throw out the lease. And by throwing out the lease, we open up all these possibilities. There is no easy solution. Probably, no sale would happen until a lease had been signed, likely with the fitness club as the tenant. The rent could be any number from $1 million to more than $2 million.
We would like these numbers to be nailed down. We would like everything to be cut and dried. But it can't be. For the sake of arriving at one number, we might say, it makes sense to split the difference, and the rent ought to be $1.5 million or a little more. From that, a one-number value estimate can be reached. To do otherwise in assigning rent would be to go to one extreme or the other of a range from $1 million to more than $2 million. It would falsify the situation. Mr. Lennhoff falsifies the situation by avoiding the existence of the fitness club and its desire to do business entirely. His critics falsify the situation by clinging to a lease that, in the fee simple situation, is void.
Count me among those who only partially agree with Mr. Lennhoff's argument. Count me also among those who want to thank him for bringing a thought-provoking argument to The Appraisal Journal for debate.
Eric Reenstierna, MAI
Cambridge, MA
Author's Response
I appreciate the balanced professional tone of Mr. Reenstierna's letter to the editor and have the following comments relating to its content.
First, Mr. Reenstierna suggests it is best for the appraiser to consider: "If a for-sale sign were planted in front of the property, what would happen?" The problem with this is it does not comport with the appraisal problem, which is an estimate of the market value of the fee interest. If the property were to be put on the market-as this type frequently is-what would be sold would be the leased fee interest in the property, based on a lease that is simply an amortization of original construction costs. As a result, answering such a question would result in an estimate of the value in use of the leased fee estate: the right answer to the wrong question, which is the whole point of my article.
A second point taken is to suggest we should assume that if the fitness club were not in the facility, well then it would be looking for something exactly like it and would snap this one up if available. This is clever but inappropriate. Market value is necessarily silent when it comes to a specific buyer and seller. It has to be. Furthermore, the assumption must be that an informed buyer would not be willing to pay a penny more than any other competitive, informed buyer, and that gets us back to recognizing the distinction between value in use and market value.
Think in terms of a residential example. Suppose you were appraising a house with a brand new pool. The owner loves the pool and paid a pretty penny for it. If offered on the market, however, the pool probably wouldn't attract near the value bestowed upon it by the owner, and probably wouldn't result in an increase in the price of the house that would approach the cost of the pool. Now assume that if the owner were not in the house, then he would be available and willing to buy it at a price that recognized his love for the pool. Perfect match, and a great way to do away with the whole concept of functional obsolescence or superadequacy. Alas, inappropriate for a market value estimate.
David C. Lennhoff, MAI, SRA
Rockville, MD
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| Title Annotation: | LETTERS TO THE EDITOR |
|---|---|
| Author: | Reenstierna, Eric |
| Publication: | Appraisal Journal |
| Article Type: | Letter to the editor |
| Date: | Sep 22, 2009 |
| Words: | 1244 |
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