Uncommon ground: ground lease assignments can be complex but rewarding for appraisers who enjoy a challenge and can make the most of limited resources.
With today's ground leases, a landowner leases the land to a tenant on a long-term basis--usually for decades. The tenant, who often is a developer, then builds a structure on the land. Thus, the lessee owns the building but not the land on which it's built. Because of their long-term nature, ground leases typically are reevaluated at predetermined intervals over the life of the lease.
The valuing of ground leases, while something of a niche market, represents a significant opportunity for appraisers. Their expertise can provide input for the initial lease, for the later lease renegotiation and for the resolution of disagreements through arbitration.
But working with ground leases presents special challenges, and Hubbard says that about half of the ground lease appraisals he's seen have needed revisions. The problem, however, is not with the appraisers themselves. As Hubbard explains, ground leases are complex, "and there is a lack of formal, quality information out there for appraisers to draw on."
Why a ground lease?
For landowners, a ground lease can be appealing because it offers a long-term, low-risk income stream while they retain ownership of a property. For tenants, a ground lease can provide access to land that otherwise is unavailable. Governments, for example, may have valuable land that can't be put on the market. "The San Diego Unified Port District owns nearly all the oceanfront in San Diego Bay, but it doesn't have the authority to sell the land," says Hubbard. Instead, the district makes that prime real estate available through ground leases. Similarly, the Port Authority of New York and New Jersey owns and leases to developers the World Trade Center site in Manhattan.
Quite often, ground leases are used when a chain store needs locations but does not want to be in the real estate business. "Think single-tenant building on the corner of Main and Main--McDonald's, AutoZone and so on," Hubbard says. "Almost every Walgreens out there is on a ground lease because Walgreens doesn't want to own the land."
Appraisers often become involved in ground leases long after the original agreement was formed--when, for example, a lease calls for a reevaluation after 10, 20 or 50 years, or when a sale or other transaction takes place. Appraisers can be called on to provide an opinion of value of the leased fee interest for the landowner, the leasehold interest of the tenant under the ground lease, or the market rental rate for the land.
Ideally, the ground lease itself would offer some guidance to an appraiser and spell out the approach to be used for valuing the land when it comes time to reset the rent. But that's not always the case. "Appraisers are often confronted with the challenge of trying to understand reappraisal language that might have been written 25 years ago by real estate attorneys who may or may not have had any appraisers helping them write it," says Gary DeWeese, MAI, principal at Real Estate Strategic Solutions in Walnut Creek, California. As a result, the language may be confusing, vague or conflicting--or simply nonexistent.
For example, a lease might simply say the land will be appraised in 25 years, with each party hiring an appraiser. "Well, is the land to be appraised at the then-highest and best use, or is the land to be appraised based on the improvements that are in place?" DeWeese asks. "Those are two radically different premises, and you're going to get two radically different opinions of value." The appraiser might have to consult with his or her client's attorney to sort it all out. Of course, each side will pick the approach that benefits it most, and the difference can lead to arbitration or litigation.
Appraisers also can run into difficulty because a ground lease involves more than just the value of the land. "A ground lease is a concept--you can't kick a ground lease," says Hubbard. "So when you're walking on a property that's ground-leased, the land or the building isn't the asset you're valuing. You're literally valuing a contract. So you consider all the elements within the lease and how they affect the overall question at hand." Assessing those variables is "like playing 3-D chess," he adds.
"The sheer complexity of ground leases can make them difficult to understand," DeWeese says. "They can often run in the hundreds of pages." And there can be a lot to consider in those pages. For example, a ground lease may call for the landowner to receive some portion of the income generated by the tenant, which may be the building developer. "That might be gross rent or net income from the property, or some of the cash flow after debt service from the property, with or without a priority return to the tenant based on development costs or equity in the property," he explains. Or, the owner might receive a portion of net proceeds if the developer refinances to take cash out of its property, or a transfer fee if the developer sells its interest to another party.
"The appraiser has to know whether or not any of these financial benefits are subordinated to a lender's receipt of debt-service payments," DeWeese says. "These are all future benefits that the landowner is entitled to, and if the landowner wants to sell his interest, they are all part of what a buyer would receive. So they all have to be estimated, including the reversion of the land and improvements, and then discounted to present value. It can be a challenge to estimate the future value of all these participation features that might be occurring constantly or periodically over long periods of time."
A range of seemingly simple details also can complicate matters, says Chris Ponsar, MAI, SRA, of Ponsar Valuation in Honolulu. For example, imagine a fast-food restaurant with 10 years of known rent left on its ground lease, and another restaurant across the street that physically is similar but has just five years of known rent left on a 10-year lease. "People are going to pay less for the property that only has five years of known rent remaining because there is uncertainty about future lease expenses," he says. "So, even if you have two properties right next door to each other, the value of the property interests being valued can be quite different."
Meanwhile, Hubbard says, "appraisers must think about the impact on value if the tenant has the right of first refusal to purchase when the owner wants to sell land." In that case, prospective buyers might be reluctant to put the effort into researching an offer that easily could be superseded by the tenant's offer, which essentially narrows the market for the property.
Looking at comparable ground leases that recently have sold or been renegotiated can help appraisers sort through the complexities. But again, that's not necessarily a simple exercise, because leases often have different language. Traditionally, when looking for land comparables, Ponsar says, "you look for sales of sites in similar locations that are physically similar to the subject, and that may be sufficient. But in a leasehold situation, you have a lot more homework ahead of you to determine whether or not the lease terms are similar enough to be comparable." Different leases, for example, might have different rents that will be reset or terminate at different times, or different language about density or uses. "In my experience valuing leasehold properties in Hawaii, finding a sale of a truly identical property interest is almost impossible," he says.
Determining capitalization rates for comparison also can be difficult. That's because there are relatively few transactions to look at in the market--and because leases can be specific to a given tenant and location. "Comparing cap rates is a primary way of appraising a ground lease," Hubbard says. But those rates must be analyzed. For example, if an appraiser is looking at six cap rates, ranging from 4 to 6 percent, the rates can't simply be averaged. Instead, an appraiser must look into the details of the leases involved. "You need to extract all the reasons that went into those differences," he says. "Maybe one tenant has good credit and another doesn't. Maybe one is paying rent that's way under market. Appraisers have to really look at all of those things and note them in the report so the reader understands the methodology."
The search for guidance
Appraisers need to augment their traditional approaches with their own judgment and experience when it comes to ground leases, Ponsar says. They can often find themselves in a "data-poor environment, where they have to think on their feet and adapt to the available data. They can use logic and training in those situations."
Appraisers interested in getting involved in ground leases find that there is a lot to learn, but not a lot of resources. Hubbard notes that while there is a fair amount of legal material for attorneys, the lack of quality "how-to" information for appraisers can leave gaps in their knowledge. He says what's needed is "bona fide, peer-reviewed courses that could be taught anywhere in the nation."
In the meantime, appraisers interested in ground leases need to find information from legal materials and existing ground lease valuations, as well as from mentors and colleagues who have experience with ground leases. For the time being, says Hubbard, "it's about self-education."
Peter Haapaniemi is a. freelance writer based in metro Detroit.
The arbitration opportunity
Ground leases often have clauses requiring arbitration to resolve a disagreement between parties, which can mean opportunity for appraisers.
When ground-lease rental rates are being renegotiated and a landlord and tenant cannot agree on a new amount, the issue may go to arbitration. Each party typically hires its own appraiser in the renegotiation. During arbitration, the appraisal reports might be submitted to a third appraiser who acts as the arbitrator, following whatever approach is spelled out in the lease. Or, the process might involve a panel of three arbitrators, some or all of whom are appraisers. These arbitrators conduct hearings and issue a ruling (or "award") much like a court would, but the process is faster and less expensive than litigation. "Testimony is taken, exhibits and expert reports are entered, and information is presented to the trier of fact--the arbitration panel," says Paula K. Konikoff, JD, MAI, AI-GRS, an arbitrator and litigation expert in Los Angeles.
For appraisers thinking about being an arbitrator, it's important to understand that the position differs significantly from their traditional role. As an arbitrator, the appraiser is not expected to produce an opinion of value, but rather to look at the facts being presented and determine what a reasonable solution would be, which typically is presented in a short but critical award. "Arbitration decisions are binding," Konikoff says. "It's a tremendous responsibility. Once you do this, people are going to live with it."
Appraisers may find the prospect of being an arbitrator daunting, but they shouldn't. "Legal knowledge is not needed; common sense and logic are," Konikoff says.
"There are lots of good ways to learn about being an arbitrator," Konikoff adds. Local bar associations often host seminars on the topic. The American Arbitration Association offers webinars "that are very good, with specific topics such as making decisions about what evidence to hear or even how to control an unruly attorney," she says.
* Guide Note 16 focuses on arbitration and can be downloaded at http://bit.ly/guided-note-16.
Caption: The One World Trade Center tower in Manhattan anchors the World Trade Center site--land that is owned by the Port Authority of New York and New Jersey and leased to developers.
Caption: For prime real estate that can't be sold, such as oceanfront property owned by the San Diego Unified Port District, the value is in ground leases.
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|Title Annotation:||Property Analysis|
|Date:||Jan 1, 2017|
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