Comments on "you can't get the value right if you get the rights wrong".

I read with much interest David Lennhoff's article in The Appraisal Journal, "You Can't Get the Value Right If You Get the Rights Wrong" (Winter 2009), as well as the letters to the editor and author's responses published in the Summer 2009 issue. Many interesting and important issues were raised and debated. As usual, the appraisal process begins with the appraisal problem. If the assignment is for condemnation or real estate taxes, then fee simple value will likely be involved.

Most assessment jurisdictions and condemnation proceedings require a determination of fee simple market value, which often invokes a jurisdictional exception when appraising a leased property. How do you handle a leased property under that jurisdictional requirement? Must you, as the article suggests, "suspend reality" by ignoring the lease to appraise the fee simple? Mr. Lennhoff advises that this approach is permitted under USPAP Frequently Asked Questions (FAQ) No. 159, which appears to be the case. In addition, jurisdictional exception permits fee simple value if required by statute or the courts. In my opinion, appraising fee simple for taxes or condemnation fall under jurisdictional exception, not hypothetical condition. Therefore, there is no need to suspend reality; for a discussion on this see Mark Pomykacz, "Relationships between the Overall Property and Its Parts, and the Three Approaches to Value," The Appraisal Journal (Winter 2009): 69.

If we proceed from the assertion that appraising the fee simple value is the appropriate methodology, then how should market rent be treated? Must we analyze a leased property "as if available" at market rent? Does fee simple value require that a leased property be vacant? The risk factor and marketability are quite different for the property "as is" leased, as opposed to "as if available" vacant. The introduction of vacancy seems to unduly penalize the property's value.

It was suggested that a CVS or Walgreens contract rent reflects high construction costs, and specialized construction and use. Is the high contract rent equivalent to market rent? It depends on market support and whether other strong locations generate similar rents. A recent lease often is the best indicator of market participant actions and fee simple value. If comparable market rents do support the contract rent, and the contract rent is equal to market rent, then fee simple value equals leased fee value. Second-generation rents for alternative uses are not comparable because they do not reflect the same highest and best use of the subject property.

An issue is that "as if available" should not apply unless the space is in fact vacant. The value of a vacant store is much different from the value of an occupied store at market rent. Vacancy implies absorption, leasing costs, and lower contract rent that would unnecessarily penalize a leased, economically productive property. This approach appears to be excessive, especially while a tenant still occupies the space. If the space is or becomes vacant, then the prefix "as if available" would be more applicable. I question Mr. Lennhoff's statement, "Even if the lease is at market rent' the fee does not necessarily equal the leased fee" Then, how are the fee value and leased fee value distinguished? A further explanation of this is not provided in the article.

Regarding appraisal approaches, the income capitalization approach is best suited for this appraisal problem. In some cases, leased fee value derived by the income capitalization approach may be an investment value, rather than value in use as Mr. Lennhoff suggests. Value in use has little relevance in these cases. Every property owner values his ownership, but the value in use is subjective and therefore meaningless in the market context. The sales comparison approach is important' but adjustments may prove difficult. I believe it better to include and explain differences than exclude this relevant approach. The cost approach is little help in valuing a financially split property interest. Ground leased property is an extreme example. This approach is most applicable for estimating the fee simple value.

Pharmacies, restaurants, banks, and even fitness clubs are not traditional specialized use properties with limited marketability. While corporate operators might pay well above market value for a property, it is highly unlikely and against rational economic sense to say that an investor would do the same. All of these sales are not sale-leaseback transactions as the article implies. Although some of these investor transactions may represent investment values, investor capital is still at risk and expects a market return. In the event of eminent domain, the methodology proposed in the article would result in lower compensation for the property owner or tenant. Valuation for eminent domain is based on a fee simple, market rent model. If the first generation contract rent is disregarded instead of being compared to other first generation market rents, the resulting valuation could underestimate the market value. To the property's detriment, the contract cash flow and its present value would be lost.

In tax assessment appeals, the "suspend reality" approach would result in lower assessed values and taxes. By extrapolation, could other commercial, industrial, and even residential owners and tenants argue that their first generation leases are above market? Then, is all new construction above the market? One of the pitfalls in this approach is the appearance of advocacy.

Another interesting issue not addressed in the article is the difference in risk, cap rate, and possible value allocation for different tenant qualities. Assuming CVS Pharmacy and Rite Aid, or Walmart and Kmart, are located on two opposite corners, and they have the same rent, land size, building size, building condition, and other factors. The rent is for real estate only, no business component is included. Is the value difference resulting from the lower cap rate for the superior credit tenant real estate value or business value? Does Walmart or Kmart, or some other tenant constitute the market tenant for determining market rent for fee simple appraising? How is the proper fee market value estimated? This issue remains a gray area and more discussion among us is required.

Mark T. Kenney, MAI

Lansdale, PA

Author's Response

I continue to be delighted by the thoughlful responses to this article. Since this letter raises questions similar to those in previous letters, I will attempt to respond succinctly.

* As a long-term USPAP instructor, I assure readers that appraising the fee simple interest of a property that is leased does not require either a hypothetical condition or a jurisdictional exception. See USPAP, FAQ 139.

* My reference to suspending reality was simply meant to illustrate the fact that when the assignment involves an opinion of the fee interest in a leased property, the appraiser will be answering a different question than if asked for most probable selling price. That is the "suspend reality" part. I meant nothing more by it.

* Mr. Kenney asks, "Does fee simple value require that a leased property be vacant? The introduction of vacancy seems to unduly penalize the property's value." The answer to these questions is yes and no. Yes, fee simple requires the assumption the property is available to be leased at market. In order for the buyer to be buying the entire bundle of rights--including the rights to occupy and lease--the property cannot be encumbered. No, the introduction of vacancy does not unduly penalize the property's value. It simply accurately reflects the market value of the fee interest. To include the value of an existing lease potentially overstates the property's value. If the lease is to be included, then the property appraised would be the leased fee estate.

* There is no question that a recent lease often is the best indicator of market participant actions. However, when the recent lease did not benefit from exposure on the open market, it is likely it does not comport with market rent. These sale-leaseback properties are not offered on the market for a normal exposure; rather, they are simply financing arrangements between the occupant and the buyer. For this reason they better reflect use value/rent than market value/rent.

* Mr. Kenney suggests that a pitfall of this approach is the appearance of advocacy. He seems concerned that if applied in eminent domain matters the methodology will result in "lower compensation for the property owner or tenant." I fear what is escaping him is that there is no honor in being "high." Whether one is high or low is equally wrong and, if intentional, advocacy of the worst kind. This methodology simply responds to the question being asked the appraiser, "what is the market value of the fee interest?" If the result of properly applying the methodology is a value conclusion that is lower than one that would be obtained if the wrong question had been answered, so be it. That is not advocacy. The appearance of advocacy would be more likely if the appraiser answered the wrong question, "what is the value in use of the leased fee interest?" in order to end up with a higher number for the property owner or tenant.

David C. Lennhoff, MAI, SRA

Rockville, MD

Article Details

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Title Annotation:	LETTERS TO THE EDITOR
Author:	Kenney, Mark T.
Publication:	Appraisal Journal
Article Type:	Letter to the editor
Date:	Jan 1, 2010
Words:	1505
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