"Valuing the leased fee interest subject to a ground lease--how and why the details matter".
I found the article "Valuing the Leased Fee Interest Subject to a Ground Lease--How and Why the Details Matter" (Winter 2017), by Gary S. DeWeese, MAI, to be particularly practical and informative. Ground leases frequently contain unique language, drafted on a customized basis by the attorneys who created the agreement. Mr. DeWeese identified at least 20 different lease provisions that are sometimes found in such documents and provided a direct, common-sense approach to the valuation impact, and valuation methodology, applicable to these provisions. The guidance from this article can be applied to situations that require the appraiser to consider the attributes of the local market in addition to the technical advice provided by Mr. DeWeese. The article is also helpful in suggesting what types of questions an appraiser needs to ask when he or she is performing an analysis of the property interests created by a complex ground lease. In terms of identifying the relevant issues to consider in the analysis of the ground lease, this is the best article I have seen on the topic. My thanks to Mr. DeWeese for taking the time to write it.
John G. Ellis, MAI
To the Editor
Gary S. DeWeese, MAI, wrote an interesting and informative article for The Appraisal Journal on leased fee land valuation, "Valuing the Leased Fee Interest Subject to a Ground Lease--How and Why the Details Matter" (Winter 2017). I would like to add a few considerations that I have found to be very important in leased fee land valuation assignments.
I have appraised in Hawaii for over forty years.
You may have heard that Hawaii had a surfeit of leasehold properties, especially in the residential arena. Laws were passed in the late 1960s and the 1970s entitling a sufficient number of lessees in a given subdivision to petition the state to condemn the leased fee interests under their properties and sell them to the lessees. The law was challenged and went to the US Supreme Court where it was declared constitutional (Ed.--see http://bit.ly/NYTimesReport). The first condemnation cases went to trial in 1985, and I was hired by the attorneys for Bishop Estate to value the leased fees under several subdivisions.
What I discovered in analyzing the available comparable sales was that the nature of the buyer has a profound effect on the discount rate and that the pattern of the payments can also be a critical factor.
I used comparable sales of leased fees to single-family residential lessees. I could estimate the fee value of the lots sold, either from normal appraisal techniques or from descriptions from the lessors on how they determined the prices they would accept for the leased fees. I then used a computer program to find the discount rate that reduced the income stream to the leased fee purchase price.
It is important to note here that residential leases went through several "styles" over the thirty or so years covered by the comparables.
Leases written in the 1950s typically had rents flat for 25 or 30 years and then another 25 years or so of renegotiated rent, sometimes for the entire period at one time or sometimes every 10 years or so. If the lease rate for renegotiation was specified, it could be 3% or 4% of land value or "the going rate." Typical lease rents in the initial fixed period were in the $15 to $50 per month range.
As the 1960s saw dramatic residential development, the leases changed and complied with FHA requirements. The typical rate for rent renegotiation was 4%, though there were some subdivisions in which the rate was 6%. The fixed term of the lease typically was 30 years, usually broken into three 10-year periods with specified rent increases. The renegotiation periods usually were 30 to 35 years, broken into 10-year segments. Many of the leases specified credits to be deducted from the lot's fee value as recognition that the lessee had paid for "offsite improvements," such as roads and utility lines.
Because most lenders required a fixed-rent term at least as long as the mortgage term, lessees were discovering in the late 1960s and early 1970s that they had to renegotiate rents for new 30-year periods when they sold their houses. Lease rents that had been in the $250 to $500 per year range were jumping to rates ten times that or more. Representing a sizable voter block, the lessees got the state legislature to pass two laws. One required that at rent renegotiation, lessees be given credit for the offsite improvements they had paid for as part of the original purchase of the leasehold and that the rent be set at 4% of the fee simple value of the finished lot less the lessee contribution to the cost of the offsites. The second law gave the lessees the right to petition the state to condemn their leased fees and sell them to the respective lessees at the price determined at trial.
As noted above, I used sales of residential leased fees that were similar to the leased fees being condemned. The appraisers for the lessees, however, chose to use sales of leased fee interests under high-rise condominium projects as their comparable sales. Because I couldn't predict the future values of the lots 10 to 40 years in the future, I used several appreciation assumptions: 0%, 6%, and 10% per year. My results indicated that the respective discount rates were 4-7%, 10%, and 13.5%. I was able to use research in numerous neighborhoods from 1937 (the oldest tax office sales records) to the early 1980s demonstrating 10%/year average annual appreciation of vacant lot values.
The lessees' appraisers took a different view. They said that since they couldn't predict values far into the future, they were going to use 0% per year appreciation. The leases they were analyzing differed from residential leases in several ways. First, they often had longer terms, more frequent step-ups (predetermined rent increases), more frequent rent renegotiations and rent rates of at least 6% and frequently 7% or higher. Second, the buyers of these leased fees almost universally were investors. This is key. Investors have to take into account management and credit losses. They have to pay taxes on the rent received. The residential lessees were terminating lease payments so they had no management or credit loss and no taxes to pay on the rent they no longer paid. If they financed the purchase, they could get a tax advantage from the mortgage interest. As a result, the lessees' appraisers produced discount rates of 10% with a 0% appreciation rate. In one case in which the jury accepted my valuation, the lessees' appraiser was saying the leased fees were worth about $15,000 while my calculations put the leased fees in the $50,000 to $60,000 range.
An interesting point is that when a 10% per year appreciation rate was used on the condominium leased fees, the resulting discount was 13.5%. So the two different income streams produced the same yield rate/appreciation rate pair at one point.
Andrew H. Rothstein, MAI, AI-GRS, AI-RRS
The Appraisal Institute has developed a new seminar entitled Advanced Land Valuation: Sound Solutions to Perplexing Problems, which includes a case study involving the valuation of land subject to a ground lease. Valuation professionals interested in learning more about how to address unusual land valuation assignments can find information regarding this seminar at http://bit.ly/AdvancedLandValuation.
Nancy K. Bannon
The Appraisal Journal
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|Title Annotation:||Letters to the Editor|
|Author:||Ellis, John G.; Rothstein, Andrew H.|
|Article Type:||Letter to the editor|
|Date:||Mar 22, 2017|
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