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A reality check on ground lease reversions.

ABSTRACT

In leased fee valuation of ground leases, conventional appraisal practices often disregard the potential contributory value of improvements in the reversion. Empirical evidence in this article shows that such practices are often inconsistent with the most probable outcome. When the lease contains a surrender clause and the useful life of improvements can be expected to exceed the lease term, failure to reconcile the discrepancy can produce misleading results. Case studies provide examples of where conventional appraisal assumptions do not correspond with the most probable outcome.

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The reversion is one of the most important valuation variables of an income-producing investment, but it has not attracted adequate attention in appraisal literature. Defined as "a lump-sum benefit that an investor receives or expects to receive at the termination of an investment," (1) the reversion is discussed on only 6 of the 742 pages in The Appraisal of Real Estate, thirteenth edition. Only two articles published in The Appraisal Journal over the last four decades have been devoted specifically to the study of reversions. One of these articles warns that "the conceptual basis of the reversion estimate is among the least understood and insufficiently explained parts of appraisal reports," (2) yet The Appraisal of Real Estate notes, "the reversion is often a major portion of the total benefit to be received from an investment in income-producing property." (3)

In leased fee valuations of ground leases, estimating the reversion can be especially problematic for at least three reasons. First' ground leases are long-term contracts, sometimes exceeding sixty years, and the reversion is usually projected at the end of the lease. The general perception is that the more distant the reversion, the greater the uncertainty. Second, most ground leases contain a surrender clause, (4) but the physical condition of the improvements at the end of the lease may be in question at an earlier valuation date. When a cost guide identifies the life expectancy of a building to be sixty years, can it be said that a thirty-year-old building subject to a lease with thirty remaining years will be at the end of its life when the lease expires? Third, it is commonly believed that a reversion will essentially be discounted into oblivion after being subjected to a reversion factor where the number of annual periods approaches or exceeds thirty. Accordingly, the longer the lease, the smaller the reversion, until eventually it seemingly becomes irrelevant. These are all factors that seem to suggest that the reversion of improvements in long-term leases is often vague or unknowable, risky, and diminutive.

In Hawaii, ground leases are common and frequently associated with residential condominium projects, so leased fee estates are often the subject of appraisal practice. Local appraisal conventions in Hawaii rarely, if ever, recognize any potential contributory value in the improvements. Instead, reversions are based on land value alone. Appraisers identify this practice as market derived, supported by interviews with market participants and by market indicators mathematically extracted from sales. The underlying presumption is that the land reversion is associated with low risk, while the potential reversion of improvements would, at best, represent a level of risk high enough to completely erode any contributory value. (5)

Appraisal principles recognize a relationship between reversion estimates and market perspectives: "The appraiser analyzes and interprets the market and estimates the value of the future reversion based on the direction and the amount or percentage of change that investors expect." (6) However, the estimating of a reversion is also understood to be a function of forecasting, which is defined as
 predicting a future happening or condition based on
 past trends and the perceptions of market participants,
 tempered with analytical judgment concerning the
 continuation of these trends and the realization of these
 perceptions in the future. (7)


In this article, the definition's operative words "realization of these perceptions in the future" are tested, and the following questions are investigated:

1. Are perceptions supporting the exclusion of improvements in the reversion consistent with realities of structural longevity?

2. Does a land-only reversion assumption square with the physical, legal, and financial circumstances that will be confronted at the time of reversion?

3. What are the potential impacts of dichotomous reversion scenarios?

4. Are the reversion scenarios used in land-only appraisals consistent with appraisal principles?

The article also examines the issues appraisers face when market expectations about reversions drift from rationally plausible to highly improbable and unsupported by a preponderance of evidence.

Life Expectancy of Improvements: The Realities of Structural Longevity

A consideration of whether improvements should be included in the reversion can begin with analysis of the life expectancy of improvements. The analysis should consider (1) life expectancy guidelines, (2) market and location externalities, (5) physical and functional attributes, (4) housing stock historic characteristics, (5) demolition profiles, (6) building maintenance patterns, (7) project management, and (8) ownership and occupancy profiles.

Life Expectancy Guidelines from Cost Services

Among appraisers, the life expectancy guidelines developed and published by cost services are probably the most popular reference for estimating life expectancy and depreciation. However, the guidelines may be misleading or of no use when estimating the contributory value of improvements to the value of the whole if the analysis includes real estate interests subject to long-term leases.

In keeping with an old adage that more buildings are torn down than fall down, useful life can generally be expected to exceed economic life. A short economic life may result in the demolition of improvements that have not reached the end of their full useful life. However, renovations and remodeling typically prolong useful life and often extend economic life. Thus, other evidence beyond the cost guide life expectancy tables must be considered to estimate economic life and fully understand the potential contribution of the improvement to a reversion.

Market and Locational Externalities

It is established in the appraisal literature that all aspects of a property and its market must be considered when estimating a property's economic life; relevant aspects include market conditions, locational externalities, and physical/functional considerations. (8) Analyses of market forces--such as current supply and demand, historic patterns, and future prospects--are important variables in the prognosis of long-term market viability. Externalities can include issues as broad as international economic conditions and as narrow as neighborhood trends. Broad issues or macroeconomic events can change as quickly and decisively as a hurricane. But, depending upon their nature, macroeconomic events may or may not have a direct effect on real property values in a given location or over an extended timeframe. In contrast, long-term neighborhood trends tend to follow a more consistent and discernable pattern. In many respects, long-term neighborhood trends may have more influence on the economic life of improvements than many short-lived macroeconomic events.

If value is "the present worth of anticipated future benefits," then future economic and neighborhood trends--and their influence on longevity and the reversion--should be of as great or greater concern to appraisers (and market participants) as customary assumptions.

Physical and Functional Attributes

Physical considerations include the quality and condition of improvements. Physical deterioration refers to wear and tear on physical components, which are a function of the use of the property, the maintenance standards, quality of construction, and the effect of natural elements. Functional considerations include changes in construction technology, tastes in architecture, and building design. These factors can render a building obsolete, regardless of its age or condition.

A building's actual age refers to the number of years that have elapsed since the building construction was completed. The notion of actual age can be misleading in certain circumstances; for example, when considering the age of many structures in Europe or portions of the eastern United States. Many older structures may retain all or part of the original building, but over their chronological lives may have undergone replacements that create new lives, belying their lives based solely on original date of construction. Thus, actual age does not necessarily correspond with effective age-the age indicated by the condition and utility of the structure. Although the condominium form of ownership has been legally recognized in the United States for less than fifty years, there are many buildings over one hundred years old that have been converted to condominium ownership and are considered prime real estate.

To better understand the relationship of building age and housing viability, it is useful to examine the age dynamics of the existing housing stock in the United States, evidence from demolitions, and other factors affecting building maintenance and longevity.

Housing Stock Historic Characteristics

Certainly past performance is not a guarantee of future results, but it can be used to determine if future expectations are reasonable in light of historical evidence. Fostered in part by the life expectancy tables published by cost services, there is a tendency to think of homes aging in the familiar human pattern where youth gives way to maturity, followed by decline, and inevitably death. A 60-year life expectancy implies that this familiar pattern will play out over a 60-year period. However, a review of the age characteristics of U.S. housing stock shows that homes have a dimensionally different aging pattern than the humans who build and occupy them.

The U.S. census began tracking total inventory of housing units in 1940. The 2001 census reported that almost one-third of the current housing stock was more than 50 years old, and about 8% of the total inventory-some 10 million homes-was more than 80 years old. The distribution of existing housing inventory by age is depicted in Figure 1.

A comparison of dwelling-unit counts reported by the census for each decade with the cumulative number of dwelling units currently in the housing stock (accumulated by age) produces an indicated attrition rate (Table 1).

Table 1 shows that of the 37.4 million houses existing in 1940 (comprising homes built in 1940 and earlier), about 42% have dropped out of today's housing inventory? This equates to an annual attrition rate of about 0.7%. For homes built in the two decades that followed, the annual rate of attrition was greater, suggesting that survival probability may improve when a house makes it past the first fifty years. However, the annual attrition rate increases to around 1% for homes built in the 1920s and 1930s if unit counts are estimated by inference from household numbers.

Nonetheless, the rate of attrition for older homes is surprisingly low, considering the acceleration of major technological advances in the post-WWII era, as well as changes in geographic preferences and household composition. The rural population has declined by 16% over the last fifty years, while metro area populations increased by 167%. About 80% of Americans now live in a metropolitan area. Average household size decreased dramatically during the twentieth century; in 1900, the average household consisted of 4.6 persons, compared with 2.6 persons in 2000. However, while the average household size has decreased by 40% over the last eighty years, the median home size has increased by 3%.

[FIGURE 1 OMITTED]

Although home size has not changed significantly, features have. Only 28% of pre-1920s homes have two or more bathrooms; in comparison, 88% of new homes have at least two bathrooms. Because residential air-conditioning equipment was not marketed until the 1920s, nearly all old homes were built without this feature. By 2001, 20% of old residential units had central air-conditioning installed and over 80% of new homes had central air-conditioning. Garages also have become more prevalent and are in 68% of newer homes compared with 46% of older homes.

Advances in home technology during the twenty-first century are certain, but it will be hard to match the revolutionary changes that plumbing, electricity, and HVAC brought to homes during the previous hundred years. Likewise, changes in household composition and geographic preferences are not likely to exceed those of recent history. Thus, it is highly improbable that a thirty-year-old home today will become irreversibly obsolete in the next thirty to fifty years.

Census data describes residents' opinions of their own structures. Residents were asked to rate their dwellings as a place to live, based on a 1-to-10 scale ("1" being the worst). In Figure 2, the distribution of resident opinions at older homes is compared with the opinions of residents at newer homes. Residents of newer structures (built since 1990) tended to give their homes superior ratings, with 83% rating their homes an "8" or higher and only 3% giving a rating below a "6" Nonetheless, buildings constructed prior to also 1920 fared well: just 13% scored their homes below a "6," and 63% rated their homes an "8" or higher. In fact, 23% scored the highest rating of" 10." Thus, the data show no strong correlation between structural age and homeowner satisfaction.

Responses in neighborhood rating, shown in Figure 3, reveal a similar pattern. About 78% of residents in newer houses ranked their neighborhoods an "8" or better, while 62% of residents in older buildings applied the same rating. Neighborhood ratings below "6" were scored by 16% of older building residents, compared with 7% in newer buildings.

[FIGURE 2 OMITTED]

Opinion ratings are clearly a subjective measurement. But the similar opinion pattern of the old-building residents and new-building residents reveals no imperative or rule-of-thumb that older buildings are substantially handicapped or that they significantly underperform relative to their newer counterparts. The vast majority of older homes still satisfy resident needs.

Demolition Profiles

A recent survey on 225 demolished buildings in a major North American city captured data on building age, building type, structural material, and reason for demolition. The survey researched buildings demolished between 2000 and 2003 in Minneapolis/St. Paul, Minnesota. This area was selected because of the availability of detailed records and the mix of structural materials used in its buildings. It is also noted that buildings in this area are subject to severe climate, which could accelerate aging or sorely test building materials. Demolition-permit records were collected and owners were surveyed for about 75% of the total demolitions completed in the region. Of the total, 103 buildings were commercial or institutional and 122 were residential. (10)

Results of the survey show that the actual service life of buildings varies considerably. Of all the buildings in the survey, 6% were less than 26 years old, while 13% were over 100 years old. Figure 4 depicts the distribution of building life by age class according to use type-residential and nonresidential. More than half of the nonresidential structures were razed before they were 50 years old, while about three-quarters of the residential buildings were over 75 years old.

Wood is typically perceived as having a short life expectancy due to the risk of fire or biodegradation, while durable structural materials such as concrete and steel are believed to provide the longest life. But the wood buildings in the demolition study had the longest life spans. The majority of wood buildings were older than 75 years, while over half of all the demolished concrete buildings fell into the category of 26-50 years. This data indicates that wood structural systems are fully capable of meeting extended longevity expectations.

Although the wood buildings in this sample lasted longest, the research paper concluded that no meaningful relationship exists between structural material and average service life, and that most buildings are demolished for reasons that have nothing to do with the physical state of the structural systems. The popular industry belief that some structural materials last longer than others is most likely the result of confusion over how long a building theoretically could last versus how long a building actually is kept in service.

[FIGURE 3 OMITTED]

Reasons for demolition are shown in Figure 5. The vast majority of buildings in the study fell into just three categories of reasons for demolition: area redevelopment, lack of maintenance, and building no longer suitable for intended use. The most common reason was redevelopment, accounting for 34% of demolitions. This represents a change in land use and is not directly related to physical components of the building. Buildings in the "no longer suitable" category were typically too small and were replaced with a larger version of the same type building (as sometimes occurs with single-family houses), although some were considered unsuitable due to technical obsolescence and upgrading was deemed too costly. But in none of these cases was the failure of a building component identified as the reason for demolition.

Thus, evidence from the demolition study indicates that there is no significant relationship between the structural system and the actual service life of the building. Reasons for demolition were instead related to area redevelopment, lack of suitability for current needs, and lack of maintenance of various nonstructural components.

Building Maintenance Patterns

Building maintenance influences longevity. In the early history of condominiums in the United States, a basic framework for long-term maintenance and management was not well developed. In recent years, though, the understanding and management of condominiums has become more sophisticated and condominium law has matured. The capacity for extending the economic life of condominium projects has been recognized, and strategies have been developed to increase longevity, improve performance, and preserve value.

Likewise, Japan, with a stock of about 3.9 million condominium units, is now undergoing a paradigm shift from its conventional scrap-and-build practice to a stock-and-renovate policy. Figure 6 illustrates the conceptual framework for maintenance and improvement that is used by Japan's National Institute for Land & Infrastructure Management (NILIM). The NILIM defines repair as restoring deteriorated structure members or parts (paint, tile, etc.) to the point where there is "no problem in practical terms" Renovation is to partially rework construction sections (walls, roofs, etc.) that have deteriorated over time from "current problem levels" to the level where there is "no problem in practical use" Improvement means to elevate functioning/performance to levels higher than what existed at the time of original construction. Raising performance levels beyond mere improvement is called modernization, generally intended to strategically increase the property value. Renovations and improvements are seen as essential to economically maintain satisfactory environments, functions, and to prolong the useful life span."

The form of ownership affects maintenance practices and project longevity. The term condominium does not refer to the outward appearance of a structure; rather, it refers to a form of real property ownership consisting of both individual and common ownership interests. Ownership in a condominium or other common interest development (CID) comes with the rights and mandatory obligations that are specified in the condominium project documents and in state condominium laws. Hawaii is known for having some of the most comprehensive state condominium laws. In Hawaii, Act 132 (Session Law Hawaii 1991) was enacted to ensure that condominium associations have adequate funds on hand for repairs and replacements of components as needed. The law defines replacement reserves as funds for the upkeep, repair, or replacement of those parts of the association's assets that the association is obligated to maintain.

Condominium associations with adequate reserves generally do not defer needed repairs or replacements of common elements, and do not impose large special assessments on owners. Robert Nordlund, an engineer and nationally-recognized specialist in association finance, put it this way,
 If advanced planning is not done, major expenditures
 too large to be absorbed by the operating budget will hit
 the association like a wrecking ball. If the association
 cannot collect the funds in a timely manner, the bills
 only get larger due to deferred maintenance. The association,
 physically and financially, begins to deteriorate
 as if a wrecking ball has indeed hit. (12)


[FIGURE 6 OMITTED]

California recently passed the Laird Bill, requiring associations to provide members and prospective homeowners with financial disclosure statements regarding reserve funding and current and future assessments. (13) Condominium law in Hawaii not only mandates disclosure, but sets a bare minimum funding level, requiring associations to collect a minimum of 50% of the full amount required to fund the estimated replacement reserves for that fiscal year. The viability of an association will depend a great deal on its ability to replace components as they wear out and to avoid delaying major maintenance items. For this reason, associations are advised to consider funding reserves at levels higher than required by law. (14) While the legal requirement in Hawaii is 50% funding, some experts recommend 75%, while other professionals say reserves should be 100%. Table 2 shows a range of funding levels and their associated special assessment risks.

Therefore, appraisers should not only regard current physical condition and maintenance levels as a barometer of current health, but examine the reserve study as an indicator of a project's resistance to future maintenance ailments and commitment to long-term viability.

Project Management

Project management can also influence the long-term sustainability of a common interest development. Board members, who are laypeople, often self-manage what can be multimillion-dollar corporations. Most CID professionals say that it is crucial for CIDs to have professional management. While professionals may be biased toward the need for outside management, their point is hard to dispute. Evidence suggests that boards of directors sometimes do a poor job of managing and that association governance is sometimes ineffective. A commonly reported problem of nonprofessional management is an association's lack of knowledge about, and failure to comply with, local laws. Also, homeowners tend to be less concerned about the financial state of their associations than management professionals. (15)

In a 1991 study done for the California Department of Real Estate, Ernst & Young found that approximately 80% of California CID homeowners said that their CID had a reserve study and sufficient funds were being put away for future repairs. In contrast, more than 40% of professional managers, real estate attorneys, accountants, and other CID professionals felt that insufficient reserve funds were being set aside for future maintenance. (16) Insurance providers estimate that between 14% and 20% of the lawsuits against boards are for financial mismanagement; of these, the number one issue is lack of reserve funds. (17)

Project Profile: Occupancy and Ownership

Occupancy is another factor that can affect the quality, condition, and ultimately the longevity of a CID. A high percentage of rental units is a danger sign. One study reports that renters tend to care less about the project in which they live because they are not financially vested in the property and absentee owners are more likely to object to an increase in homeowner dues, even if it will improve project quality. (18)

The presence of renters is not always a negative. Most notably in Hawaii, some projects are part of a short-stay vacation rental program. While these are subject to the rigors of short-stay visitation, they are also under daily supervision and routine maintenance. Also, they are occasionally used by the individual unit owners and their guests. Furthermore, these projects have the added appeal of being considered income-producing properties. An owner can use the unit at any time, but will also receive a portion of the income generated from short-term vacation rentals. Thus, short-stay rental units are not necessarily a negative indicator.

The composition of fee simple owners to leaseholders is another factor of interest. Many condominium projects in Hawaii consist of a mix of leaseholders and fee simple owners, which can fortify the potential for extended longevity. Leaseholders, unlike fee simple owners, must surrender the premises at the end of the lease; therefore they will have less incentive to maintain the project and preserve property values toward the end of the lease term. For this and legal reasons discussed later, a project that includes some fee simple ownership is a positive attribute.

The Realities of a Land-Only Reversion Assumption

If it turns out that the improvements are at the end of their economic life when the lease expires, will the reversion amount to land value? The physical and legal circumstances suggest otherwise.

Physical Realities

Appraisal principles hold that "when a property is expected to be sold, the appraiser projects the reversion amount and considers the net proceeds of resale.... The transaction price may have to be adjusted to reflect extraordinary costs incurred by either party." (19) If the improvements were to be at the end of their economic life, they would have to be demolished before redevelopment could commence. Therefore, the cost of demolition would have to be deducted from land value in order to accurately reflect the net proceeds of resale. Particularly with respect to high-rise construction, demolition costs could wipe out a substantial portion of the gross land value.

In addition to the cost of removing the defunct structure, land value may be impacted by downzoning. In some areas of Hawaii, such as Waikiki, downzoning after the original construction has resulted in a density allowance loss. Both the high cost of demolition and the potential loss of density would deter a scrape-and-build strategy.

Legal Ownership Realities

In the case of a ground leased condominium, there will be three primary legal ownership components on the date of appraisal: the leasehold estate, the leased fee estate, and the condominium regime. When there is a surrender clause, the leasehold and leased fee positions will converge at the reversion into a variation of a fee simple estate that is subject to the condominium regime. For condominiums, what is sometimes loosely referred to as the fee simple estate is more accurately described as the absolute ownership of a unit in a multi-unit building based on a legal description of the airspace the unit actually occupies, plus an undivided common tenancy in the physical components of the condominium buildings and land. (20)

The term ground lease implies an ownership interest in the land, but this is a misnomer. Because of the surrender clause, the ground lease is effectively a long-term apartment lease; and because of the condominium regime, any individual unit ownership has only a common tenancy in the land and common areas. Partial interests in real property are typically associated value discounts for limited control and liquidity risks.

As previously noted in the project profile discussion, there are many projects in Hawaii where some of the leaseholders have purchased the underlying leased fee position. In these mixed-ownership projects, any wholesale demolition of improvements or voluntary collapse of the condominium regime would require the 100% approval of owners and lien holders. Redevelopment could not proceed without buying out any and all dissenting parties. Even in instances where a unit is not part of a mixed-ownership project on the date of appraisal, such a project could become mixed-ownership in the future, and is therefore subject to the same risk. Thus, there are significant legal impediments to accessing land value, as envisioned in land-only reversion scenarios.

Potential Impact of Dichotomous Reversion Scenarios

To what extent does the inclusion of improvements in the reversion impact the present value of the leased fee position? Can the discounting process be expected to marginalize the value contribution of the improvements, particularly for leases extending beyond thirty years? If market prices are based on land-only reversion assumptions, what are sellers sacrificing and buyers gaining?

To answer the first question, Tables 3 and 4 provide two hypothetical valuation scenarios that break out the value components of income, land reversion, and improvements reversion. The first scenario (Table 3) depicts a model where the most sensitive variable-the ratio of land value to improvements value-reflects a typical 30% ratio found in mature, suburban low-rise condominium projects. The second scenario (Table 4) mirrors the first, except for a lower land-to-improvements value ratio typical of high-rise urban projects (10%). The inclusion of improvements increases the net present value by 57% in the suburban model and 172% in the urban model. While these are hypothetical models, their function is to give the reader a sense of the magnitude of the effect that could result from an inclusive reversion. Different discount rates, growth rates, lease durations, or other variables could produce different results, and diminish, eliminate, or increase the value added.

It is helpful to remember that rental income can represent a relatively small portion of the total return of a ground lease. Contract rents and their step-ups are usually based on formulas applying yield rates to land value, not full value. Because many ground leases are long-term contracts negotiated years or even decades ago, it is not unusual to find contract rents differing from those prevailing on the date of valuation. Rent adjustment periods may be infrequent, allowing contract rental income to fall increasingly behind market potential. Thus, unlike most commercial income-producing property, rental income from a ground lease does not necessarily compete as a dominant source of revenue, which makes analysis of the reversion all the more important_

Figure 7 reflects on the issue of the potential impact of discounting by considering how much the improvements might add to the total present value over time. Carrying forward the previous two hypothetical models, at no point in the 10-year to 50-year period is the value-added component marginalized into insignificance. Using the same inputs as in Tables 5 and 4, the improvements increase total present value by 70% in a 50-year urban analysis and 25% in a 50-year suburban analysis (compared with land-only reversions). As the number of years to the reversion decreases, the present value of the improvements adds progressively more value than if the improvements were excluded. For a 10-year term, the value-added approximates a factor of 1.5 in the suburban model and 4.5 in the urban model. Again, to illustrate the effect of discounting, the Figure 7 graph is based on hypothetical models where all variables are held constant except the lease term (years to reversion). Appraisers should select inputs and discount rates to reflect the individual circumstances and different lease terms of the subject improvements.

Finally, if market prices are based on land-only reversion assumptions, what will sellers lose and buyers gain when a full reversion outcome is realized? To answer this question, the cash flow models in the preceding analyses were employed to solve for rate of return using a full reversion scenario, but with the sale price based on a land-only reversion. The difference between the imputed rate of return and initial rate of return is the yield spread-a bonus (measured in basis points) that the full-term investor will realize with a full reversion outcome, but purchased at a land-only reversion price.

Figure 8 shows the basis point spread for different lease terms. For a 50-year analysis, the spread is about 70 basis points in the suburban model and 170 basis points in the urban model. In the 20-year analysis, the basis point spreads increase to about 430 in the suburban model and 830 in the urban model, and then more than doubles in the 10-year analysis. Thus, when a price is based on a land-only reversion and a full reversion outcome is realized, the full-term buyer may recover a substantial yield bonus at the seller's expense.

Conclusions

Analysis of empirical evidence reveals that in certain instances, such as condominium projects in Hawaii, the economic life of improvements will likely extend well beyond the term of the ground lease. Therefore, market-derived perspectives about the irrelevance of improvements in Hawaii are not consistent with realities of structural longevity.

[FIGURE 7 OMITTED]

[FIGURE 8 OMITTED]

Examination of physical and legal limitations in Hawaii show that land-only reversion scenarios are often "contrary to known facts about physical, legal, or economic characteristics of the subject property." When this occurs, the Uniform Standards of Professional Appraisal Practice (USPAP) requires appraisers to disclose a land-only reversion as a hypothetical condition. (21)

The potential financial impacts of dichotomous reversion scenarios have been shown to be significant in most cases; in some instances they can be extraordinary. Even in the case of forty- and filly-year leases, the discounting process is not likely to render the reversion insignificant.

This article examines specific evidence as it applies to the condominium market in Hawaii-evidence that speaks conclusively about the longevity of improvements, the physical and legal limitations of a resale, the magnitude of potential financial impacts, and the conflict between past appraisal practices and generally accepted valuation principles. But these conclusions do not apply uniformly to all ground leases for all product types across all markets. Analysts should not replace one dogma (always ignore improvements in ground lease reversions) with another dogma (improvements will always exceed lease term and add value). This article does not resolve other issues appraisers face when market expectations about reversions drift from rationally plausible to improbable and unsupported. When market and reality become diametric forces, analysts are sometimes left in a quandary where facts alone do not answer all questions:

* While the importance of market-derived input is an indisputably critical component in any market value opinion, is simply "following the market" sufficient?

* What professional obligations do appraisers face if and when market expectations about reversions are contrary to the most probable outcome, and cannot be reconciled with imminent physical and legal circumstances?

* When the perceptions of market participants are outside the realm of palpable economic realities, are market-derived inputs compatible with the market value definitions, i.e., sellers "acting prudently and knowledgably" (22) or being "well informed or well advised?" (23)

* Particularly in a post-bubble economy, if the appraisal profession's responsibilities go no further than to simply mimic an undisciplined market, will it soon earn the distrust of the public?

Forty years ago, Charles Seymour made an observation that is more relevant today than ever: "An appraisal is not an end; it is a means to an end. Value is always incidental to the solution of some other problem." (24) Notwithstanding the market requirement in market value appraisals, if appraisers do not embrace a professional obligation to disclose compelling evidence of market deviations from rational plausibility, then they risk inhibiting market corrections by promulgating disinformation, thereby becoming a complicit part of the problem and losing the opportunity to better inform their clients and elevate their profession.

Additional Reading

Condominium Association Training Manual. Silver Spring, MD: Cooperative Housing Foundation, in collaboration with Metropolitan Research Institute and Magyar Iparszovetseg Oktatasi Kozpont, December 1996.

Hasegawa Hiroshi. "Manual for Smoothing Consensus-building of Condominium Reconstruction:' In 2003 Annual Report of NILIM. National Institute for Land & Infrastructure Management, Ministry of Land, Infrastructure and Transport, 2003.

Hasegawa Hiroshi. "Preparation of a Draft Manual on Condominium Reuse Methods Based on Expansion and Reconstruction" In 2004 Annual Report of NILIM. National Institute for Land & Infrastructure Management, Ministry of Land, Infrastructure and Transport, 2004.

Haurin, Donald R., Robert D. Dietz, and Bruce A. Weinberg. "The Impact of Neighborhood Homeownership Rates: A Review of the Theoretical and Empirical Literature" Journal of Housing Research 13, no. 2 (2003): 119-152.

Hawaii Real Estate Research and Education Center. A Proposal for a Residential Leasehold Land Tax Reform Act: An Evaluation of the Advantages of Reforming the Internal Revenue Code to Quality Residential Ground Lease Financing for Deductions or Tax Credits. Honolulu: University of Hawaii, May 1, 1995.

Palfin, Richard A. "Lease and Fee-Hold Price Differentials in Hawaii" The Appraisal Journal (April 1979): 227-242.

Tong, Zhong Yi, and John L. Glascock. "Price Dynamics of Owner-Occupied Housing in the Baltimore-Washington Area: Does Structure Type Matter?" Journal of Housing Research 11, no. 1 (2000): 29-66.

Weiser, Jay, and Zheng Wang. "Judicial Review Standards and Litigation Frequency: An Empirical Study of Community Association Decisions and the Business Judgment Rule" Working paper 2 presented at American Law & Economics Association 15th Annual Meeting, 2005.

Williams, Barbara T. These Old Houses: 2001. Washington, D.C.: U.S. Census Bureau, February 2004.

(1.) Appraisal Institute, The Dictionary of Real Estate Appraisal, 4th ed. (Chicago: Appraisal institute, 2002), 249.

(2.) Kenneth M. Lusht, "Estimating Reversion Value in Discounted Cash Flow Models," The Appraisal Journal (April 1987): 191.

(3.) Appraisal Institute, The Appraisal of Real Estate, 13th ed. (Chicago: Appraisal Institute, 2008), 527.

(4.) While the terms and conditions of ground leases vary, most leases require the lessee to surrender the improvements in good condition, less normal wear and tear, and sometimes provide financial incentives for compliance.

(5.) Land ownership in Hawaii has been highly concentrated in the hands of a few. The eight largest landowners control approximately half of the privately owned land in the state; Department of Business, Economic Development, and Tourism, "Land Use and Ownership," in 2006 State of Hawaii Data Book (Honolulu: State of Hawaii, 2007). The forty largest landowners control about 87% of the private land in Hawaii. Sonia P Juvik, James O. Juvik, and Thomas R. Paradise, Atlas of Hawai'i, 3rd ed. (Honolulu: University of Hawai'i Press, October 1998). Leased fee interests in ground leases are sold nearly exclusively to the affiliated lessee. Thus, Hawaii has attributes of an inefficient market.

(6.) The Appraisal of Real Estate, 13th ed., 528.

(7.) The Dictionary of Real Estate Appraisal, 4th ed., 118. Although this definition uses the word predicting and later adds the concept of "temper(ing) with analytical judgment," a forecast should not be considered a prediction. Many appraisal courses over the past decades have distinguished projections (extensions of empirical data to the future), predictions (statements of expected truths to occur in the future), and forecasts (statements of likelihoods expected to occur in the future, often accompanied with statistical or forecast probabilities). Appraisers should use precise language when dealing with future anticipations.

(8.) The Appraisal of Real Estate, 13th ed., 412-415.

(9.) As homes age, they can be removed from inventory by accidental causes, such as fire, and by selection, as in demolition.

(10.) Jennifer O'Connor, "Survey on Actual Service Lives for North American Buildings" (paper presented at Woodframe Housing Durability and Disaster Issues Conference of the Forest Products Society, Las Vegas, NV, October 2004).

(11.) Hasegawa Naoji and Inukai Mizuo, "Structural Diagnosis, Renovation/ Repairs, and Renewal Technologies," in 2004 Annual Report of NILIM (National Institute for Land & Infrastructure Management, Ministry of Land, Infrastructure and Transport, 2004).

(12.) Robert M. Nordlund, "Why Perform a Reserve Study," Association Reserves, Inc., http://www.reservestudy.com/q2.html.

(13.) California Civil Code [section] 1365.2.5.

(14.) Hawaii Real Estate Research and Education Center, Condominium Reserves Reference Manual (Honolulu: State of Hawaii, October 1992).

(15.) Julia Lave Johnston and Kimberly Johnston-Dodds, Common Interest Developments: Housing at Risk? (Sacramento, CA: California Research Bureau, CRB 02-012, August 2002).

(16.) Ernst & Young, Study of the Future Outlook of California Common Interest Developments (Sacramento, CA: California Department of Real Estate, May 1991).

(17.) Johnston and Johnston-Dodds.

(18.) Ibid.

(19.) The Appraisal of Real Estate, 13th ed., 528.

(20.) Hawaii Revised Statutes [section] 514B provides a limited number of definitions associated with Hawaii condominium law, but does not provide definitions for condominium fee simple or leasehold estates. With respect to leasehold units, [section] 514B-36 states, "The conveyance of the unit with an accompanying lease of an interest in the land shall not constitute a division or partition of the common elements, or a separation of the common interest from its unit. Where a deed of a unit is accompanied by a lease of an interest in the land, the deed shall not be construed as conveying title to the land included in the common elements."

(21.) The Uniform Standards of Professional Appraisal Practice (USPAP) defines hypothetical condition as, "that which is contrary to what exists but is supposed for the purpose of analysis," and the Comment states, "Hypothetical conditions assume conditions contrary to known facts about physical, legal, or economic characteristics of the subject property; or about the conditions external to the property, such as market conditions or trends; or about the integrity of data used in an analysis." Appraisal Standards Board, Uniform Standards of Professional Appraisal Practice, 2008-2009 ed. (Washington, D.C.: The Appraisal Foundation), U-3. Standards Rule 2-2(a-c)(x) of USPAP states that each written appraisal report must "clearly and conspicuously: state all extraordinary assumptions and hypothetical conditions; and state that their use might have affected the assignment results."

(22.) The Dictionary of Real Estate Appraisal, 4th ed., 177.

(23.) Real Estate Lending and Appraisals, "Definitions," 12 C.ER. Part 34.42(g).

(24.) Charles F. Seymour, "More and More My Reports Are Valueless," The Appraisal Journal (October 1987): 453.

David Rothermich, MAI, is a principal of Keane Rothermich Group in San Francisco, California. His real estate consulting practice includes valuations and research assignments pertaining to limited-market properties, land economics, and related issues. He received a BA in anthropology from the University of California, Berkeley. Rothermich is a previous contributor to The Appraisal Journal and was the 2002 recipient of the Armstrong/Kahn Award.

Contact: Rothermich@ KR-Group.com
Table 1 Attrition Rate Analysis, 1940-1990

 Attrition (%)

 Total Count * Remaining * Loss * Total Annual

1940 37,439 21,685 15,754 42.1 0.7
1950 46,137 29,880 16,257 35.2 1.0
1960 58,326 43,503 14,823 25.4 1.2
1970 68,704 59,212 9,492 13.8 0.7
1980 88,411 82,450 5,961 6.7 0.4
1990 102,264 98,992 3,272 3.2 0.3

Source: 2001 Census

* (000)

Table 2 Reserves Funding Risk Table

Percent Funded Special Assessment
 (%) Risk (%)

 0-10 53.5
 10-20 36.9
 20-30 26.6
 30-40 17.6
 40-50 11.6
 50-60 6.0
 60-70 3.5
 70-80 2.4
 80-90 2.3
 90-100 0.5

Source: Community Association Institute

Table 3 Leased Fee Cash Flow-Suburban Model, 30-Year Analysis

Assumptions
Growth rate, land 5.0%
Growth rate, bldg. 3.0%
Contract rent
(% of land value) 5.0%
Rent adjustments Every 10 years
Allocations
Land $250,000 25%

Improvements +750,000 75%
Total $1,000,000 100%
Cumulative Revenues
Income $660,274 20%
Land reversion +1,026,461 32%
Subtotal $1,686,735 52%
Improvements reversion +1,547,380 48%
Total $3,234,115 100%
Present Value
Discount rate 7.0%
PV of Income $220,691 39%
PV of Land reversion +134,843 24%
PV of Land total $355,534 64%
PV of Improvements +203,275 36%
PV of Total $558,809 100%
Value added 57%

Land reversion *
Bldg. Reversion
 ([dagger])

Assumptions Revenue Schedule
Growth rate, land Starting rent $12,500 Disc.
Growth rate, bldg. Period Income Factor PV
Contract rent 1 $12,500 x 0.9346 = $11,682
(% of land value) 2 $12,500 x 0.8734 = $10,918
Rent adjustments 3 $12,500 x 0.8163 = $10,204
Allocations 4 $12,500 x 0.7629 = $9,536
Land 5 $12,500 x 0.7130 = $8,912
 6 $12,500 x 0.6663 = $8,329
Improvements 7 $12,500 x 0.6227 = $7,784
Total 8 $12,500 x 0.5820 = $7,275
Cumulative Revenues 9 $12,500 x 0.5439 = $6,799
Income 10 $12,500 x 0.5083 = $6,354
Land reversion 11 $20,361 x 0.4751 = $9,673
Subtotal 12 $20,361 x 0.4440 = $9,041
Improvements reversion 13 $20,361 x 0.4150 = $8,449
Total 14 $20,361 x 0.3878 = $7,896
Present Value 15 $20,361 x 0.3624 = $7,380
Discount rate 16 $20,361 x 0.3387 = $6,897
PV of Income 17 $20,361 x 0.3166 = $6,446
PV of Land reversion 18 $20,361 x 0.2959 = $6,024
PV of Land total 19 $20,361 x 0.2765 = $5,630
PV of Improvements 20 $20,361 x 0.2584 = $5,262
PV of Total 21 $33,166 x 0.2415 = $8,010
Value added 22 $33,166 x 0.2257 = $7,486
 23 $33,166 x 0.2109 = $6,996
 24 $33,166 x 0.1971 = $6,539
 25 $33,166 x 0.1842 = $6,111
 26 $33,166 x 0.1722 = $5,711
 27 $33,166 x 0.1609 = $5,337
 28 $33,166 x 0.1504 = $4,988
 29 $33,166 x 0.1406 = $4,662
 30 $33,166 x 0.1314 = $4,357

Land reversion * $1,026,461 x 0.1314 = $134,843
Bldg. Reversion $1,547,380 x 0.1314 = $203,275
 ([dagger])

Note: Totals may not add up due to rounding

* Net land reversion after 5% sale costs Note: Totals may not add up
due to rounding

([dagger]) Net building reversion after 15% sale costs and
renovation allowance

Table 4 Leased Fee Cash Flow-Urban Model, 30-Year Analysis

Assumptions
Growth rate land 5.0%
Growth rate bldg. 3.0%
Contract rent
(% of land value) 5.0%
Rent adjustments Every 10 years
Allocations
Land $100,000 10%
Improvements 90%
Total +900,000 100%
Cumulative Revenues $1,000,000
Income 10%
Land reversion $264,110 16%
Subtotal +410,585 27%
Improvements reversion $674,694 73%
Total +1,856,856 100%
Present Value $2,531,550
Discount rate
PV of Income 7.0% 23%
PV of Land reversion $88,276 14%
PV of Land total +53,937 37%
PV of Improvements $142,214 63%
PV of Total +243,930 100%
Value added $386,143
 172%

Land reversion *
Bldg. reversions
 ([dagger])

Assumptions Revenue Schedule
Growth rate land Starting rent $5,000 Disc.
Growth rate bldg. Period Income Factor PV
Contract rent 1 $5,000 x 0.9346 = $4,673
(% of land value) 2 $5,000 x 0.8734 = $4,367
Rent adjustments 3 $5,000 x 0.8163 = $4,081
Allocations 4 $5,000 x 0.7629 = $3,814
Land 5 $5,000 x 0.7130 = $3,565
Improvements 6 $5,000 x 0.6663 = $3,332
Total 7 $5,000 x 0.6227 = $3,114
Cumulative Revenues 8 $5,000 x 0.5820 = $2,910
Income 9 $5,000 x 0.5439 = $2,720
Land reversion 10 $5,000 x 0.5083 = $2,542
Subtotal 11 $8,144 x 0.4751 = $3,869
Improvements reversion 12 $8,144 x 0.4440 = $3,616
Total 13 $8,144 x 0.4150 = $3,380
Present Value 14 $8,144 x 0.3878 = $3,159
Discount rate 15 $8,144 x 0.3624 = $2,952
PV of Income 16 $8,144 x 0.3387 = $2,759
PV of Land reversion 17 $8,144 x 0.3166 = $2,578
PV of Land total 18 $8,144 x 0.2959 = $2,410
PV of Improvements 19 $8,144 x 0.2765 = $2,252
PV of Total 20 $8,144 x 0.2584 = $2,105
Value added 21 $13,266 x 0.2415 = $3,204
 22 $13,266 x 0.2257 = $2,994
 23 $13,266 x 0.2109 = $2,799
 24 $13,266 x 0.1971 = $2,615
 25 $13,266 x 0.1842 = $2,444
 26 $13,266 x 0.1722 = $2,284
 27 $13,266 x 0.1609 = $2,135
 28 $13,266 x 0.1504 = $1,995
 29 $13,266 x 0.1406 = $1,865
 30 $13,266 x 0.1314 = $1,743
Land reversion * $410,585 x 0.1314 = $53,937
Bldg. reversions $1,856,856 x 0.1314 = $243,930
 ([dagger])

Note: Totals may not add up due to rounding

* Net land reversion after 5% sale costs

([dagger]) Net building reversion after 15% sale costs and
renovation allowance

Figure 4 Distribution of Demolished Buildings by Age Class

 Non-Res. Residential

0-25 yrs. 12% 2%
26-50 yrs. 46% 5%
51-75 yrs. 17% 20%
76-100 yrs. 18% 54%
100+ yrs. 7% 19%

Source: J. O'Connor

Note: Table made from bar graph.

Figure 5 Reasons for Demolition, Survey Results

No longer suitable for needs 22%
Lack of maintenance 24%
Other physical condition issue 7%
Fire damage 7%
Code upgrade too expensive 1.8%
Other 3.6%
Area redevelopment 34%

Note: Table made from pie chart.
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Date:Jan 1, 2009
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