Fee Simple vs Leased Fee

[jt]

Quote from the Appraisal of Real Estate, Tenth Edition, "The rights of ownership in income-producing real estate are seldom held in fee simple by individual owners". Can anyone state when income-producing real estate would be held(or appraised) in fee simple?

 

[Paul Ness MAI]

I can see where that statement can be confusing. It is really not a very useful statement. I have a problem with the author's use of the term "income-producing" in that statement. Theoretically, any property can be income-producing and can have a leased fee interest. A house that is leased would have a leased-fee interest. It would have to be leased for an extended period and/or way above or below market to be substantially different from the value of the fee simple interest, but that's another issue.

Any property can also have a fee simple interest at a given time. Now - getting to the point of the author's statement and your question, any property that is typically bought and sold for its income-producing capability (I think this is what the author meant) can have a fee simple interest if it is not leased. A distribution warehouse is one of those types of properties that just as easily can be owner-occupied as it can be leased, and a vacant warehouse would be one common example. Another less common example would be a vacant shopping center....i.e. any vacant property.

 

[jt]

Paul, thanks for your eye opening response. You hit the nail on the head, I'm referring to a large mfg, warehouse, distribution building which is both tenant and owner occupied, the owner occupies most of the space, the building has a history of being tenant occupied, however, the current lease has only four months to expiration and there is no renewable clause... lease fee/fee simple?

 

[Paul Ness MAI]

I would appraise the fee simple interest. If the rent on the remaining lease is not extremely (and I mean extremely) different from market rent, I would state that you have concluded the remaining short term of the existing lease (on a small portion of the building) would have no impact on value. Base your income approach on market-derived rent for the entire building.

 

[Bill_FL]

Another great response from Paul. So are you going to put on an advanced income approach class at the forum meeting?

 

[Austin]

Speaking of lease fee and fee simple, I am in the middle of an interesting one. Subject is a 6,400 sf restaurant under a 10-year lease/option to purchase. Lease date is September 1, 2000, and we are two years into the lease. Seller, lessor, is largest commercial development company in the region, and purchaser is the lessee. My first thought was: The interest in this property is lease fee to seller, leasehold to purchaser, however, after closing the interest will be fee simple to purchaser. The date of the appraisal has to be before the date of closing, so which interest do I appraise, lease fee, leasehold, fee simple, or all three?
Fortunately, I did a thorough summary of the lease and gleaned some interesting information. The first thing I noticed was a flat rental rate at absolute net for ten years with no adjustments. Not characteristic of this seller. There were three option prices. First two year at like $1m; at years 3-5 prices goes to $1.2 million, then from years 6-9 the price goes to $1.4 million.
Then I extracted the IRR for each year to find the lease fee yield rate for each year of the options assuming the option was exercise in any of the years. Very interesting information. This lease was actually setup to force a sale. The lease fee yield rate the 1st two years was 8.2%. Year 3 was 14%, year 4 was 12%, year 5 was 11%, and then in years 6-9 the 14% to 11% rate repeats. This is all due to the option price changes during these years. My conclusion is that this lease is more of a delayed sale agreement than a lease. Basically it gave the lessee time to see if he could make a go of it, gave him an out if he didn’t, and gave a high incentive not to exercise the option within the 1st two year period. It took be four hours to summarize this 25-page lease. These people rap things up real tight. The only thing they didn’t foresee took place 10 days after the lease was signed: 9/11.

 

[Fred]

Austin,
First off, I think there are more than ten days from Sep 1, 2000 and Sept 11, 2001. :usa

Second, you should be cautious of my answer because I certainly do not concur with Paul's analysis of jt's question (above); so obviously there are schools of thought.
"which interest do I appraise, lease fee, leasehold, fee simple, or all three?"
The short answer is it depends. I'm still needing info – you know, all that purpose, intended use stuff – for a confident answer. Since they have an option price, why do they need an appraisal?

Reading between the lines, I suspect that the buyer needs an appraisal because (s)he is borrowing some of the option money? In that case, I would say you need fee simple value, because those are the rights/benefits that the buyer acquires in exchange for the cash consideration. The closing upon which the loan is contingent simultaneously terminates the lease and disencumbers the property. Your appraisal, like all market value appraisals, is subject to the hypothetical condition that a sale takes place on the date of appraisal. Here, you have the additional extraordinary assumption that the hypothesized sale is one that terminates the lease.

 

[Austin]

I pose a general question about my above described appraisal in progress. Would any of you guys use this sale as a comp in another appraisal? The reason I ask is, the seller is selling a highly questionable lease fee interest as evidenced by the terms of this lease; the purchaser is being possibly motivated to purchase by the creation of a negative leasehold interest in the property if only on paper if he doesn’t purchase now on the order of a 3 to 6% yield rate difference; and the purchaser will acquire a fee simple interest in the property at closing. Another reason purchaser may be exercising the option is to protect his enterprise value in the business operation or take advantage of a gift from heaven in the form of low interest rates. In my view, to answer these questions would require an appraised value of the lease fee, fee simple, leasehold, and the business enterprise value assuming the purpose is a mortgage loan. Otherwise, if you use this sale it may be misleading because you are not sure which interest’s value is driving the sale. Giving consideration to 9/11, whichever year it is in, and interest rate drop since that date, does this sale tell us anything about this market? We have time adjustsments due to market conditions and adjustments due to huge interest rate shifts; questions about which interest is being sold and which interest value is being purchased, etc. I not sure that commercial sales that have taken place or been negotiated prior to 9/11/01 are relavant at all and any sales negotiated since that time are equally suspicious.

 

[Fred]

"Would any of you guys use this sale as a comp in another appraisal?"
The short answer is, yes. Every sale is comp for SOMETHING, even if it is just for the elements you cite.

Although, I must say the structure of the deal seems backwards. You have flat rent and rapidly accelerating option prices. I would expect more stable option prices and a rapidly accelerating rent that starts very low to give the tenant a chance to get going, but then the rent shoots up to a market level or even a little above, so the owner can make back some of the early concession in case the tenant does not buy.