Leased Fee Interest And The Cost Approach

[Deleted member 152047]

I find myself chasing my tail on a few assignments that I am working on right now. The client specifically asked me to develop the Cost Approach, even though it is not applicable. The projects that I am working on are large sale-leaseback office buildings with long-term leases in-place and rates that exceed market rates. The client asked for the value of the leased fee interest only and I am torn. I don't know whether to show the cost approach with the fee simple number and completely disqualify the approach as it is not applicable. Or, do I attempt to discount the "above market" rent over 15 years to arrive at an upward adjustment giving an indication of the value of the leased fee interest (then completely discount the approach as inapplicable)? These deals typically have leased fee values that exceed replacement cost (PWC reports that sale prices average 116% of the replacement cost).

 

[BRCJR]

In this case should the CA show and discuss the external influence (economic) to be completed properly and meet assignment conditions (SOW)?

 

[Red Flint]

Client may want to know a current land value, so develop the cost approach, then explain why the approach is not credible for the leased fee interest determination.

 

[Gobears81]

I don't know whether to show the cost approach with the fee simple number and completely disqualify the approach as it is not applicable. Or, do I attempt to discount the "above market" rent over 15 years to arrive at an upward adjustment giving an indication of the value of the leased fee interest (then completely discount the approach as inapplicable)? These deals typically have leased fee values that exceed replacement cost (PWC reports that sale prices average 116% of the replacement cost).

You could develop a cost approach based on leased fee by adding a property rights adjustment that is calculated as the present value of the additional NOI attributable to the above-market leases. Whether it is still has any applicability at that point is of course based on your judgment and expertise.

 

[Deleted member 152047]

Now that I think about it more....what about jacking up the entrepreneurial profit? The sale-leasebacks are driving this market and owners are essentially able to pull significantly more profit out of the real estate by increasing their lease rate (within reason). This would be for the leased fee interest only of course.

I was leaning toward what you said gobears.

 

[Red Flint]

Now that I think about it more....what about jacking up the entrepreneurial profit? The sale-leasebacks are driving this market and owners are essentially able to pull significantly more profit out of the real estate by increasing their lease rate (within reason). This would be for the leased fee interest only of course.

I was leaning toward what you said gobears.

Changing the entrepreneurial incentive to match a market income stream seems like inbreeding. The cost approach is not a reliable method for this case, I would not try to fit it other than due a lump sum adjustment at the end as mentioned. The cost approach result (fee simple) could be vastly different from the income approach result (leased fee) even with normal market leases. If a second approach is needed for reliability, then the market approach is usually best to support a leased fee valuation, depending on your market.

Still, the fee simple position is best valued in the cost approach, and may be the basis for assessment. A spread between the fee simple and leased fee value could be what the client is after. If it were me, the scope of work development would include some questioning as to why the client is interested in having the cost approach included. Good luck.

 

[Deleted member 152047]

Good points, appreciate the help. Definitely not relying on the cost approach. Sales and income provide the best indications. I'm still scratching my head wondering why they want cost for NNN leased assets owned by an active REIT in this space.

 

[gregb]

Cost Approach was considered, found not applicable due to X, Y & Z, with no compromise to the appraisal.

 

[Terrel L. Shields]

You can calculate the value of the leased fee. Back to your books. Should be no trouble to value it once you understand what you are valuing. Sometimes you have get your head wrapped around it first.

http://nerej.com/fee-simple-vs-leased-fee-in-valuation-by-steve-hurlbut

https://mountainseed.com/2017/05/23/leased-fee-fee-simple/

AI has a PDF on the subject, google it up

However you are basically comparing the value between market rent and actual rents. The CA therefore acts as another check between the economic rents and market rents. You won't weight the CA normally for leased fee. It is an income problem.

 

[RCA]

You can calculate the value of the leased fee. Back to your books. Should be no trouble to value it once you understand what you are valuing. Sometimes you have get your head wrapped around it first.

http://nerej.com/fee-simple-vs-leased-fee-in-valuation-by-steve-hurlbut

https://mountainseed.com/2017/05/23/leased-fee-fee-simple/

AI has a PDF on the subject, google it up

However you are basically comparing the value between market rent and actual rents. The CA therefore acts as another check between the economic rents and market rents. You won't weight the CA normally for leased fee. It is an income problem.

Steve Hurlbut's article makes reference to the more extensive https://www.appraisalinstitute.org/file.aspx?Document=Property_Symposium_Exp_12-21-17_-_Final.pdf. From reading this, the core issue seems to be in the conclusion:

"Potential implications of these proposals are that valuers would need to determine, and valuation reports clearly state, the estate (fee simple, leasehold, or life estate) as well as the actual or assumed interests associated with the real estate that are reflected in the valuation. Depending on the question to be answered by the valuation (i.e., the problem to be solved) for a property that is leased, or would likely be leased, the valuation could be subject to the existing lease, subject to leases at market rates and terms, or as though vacant and available to be leased at market rates and terms. The valuer generally must consult with the client for the service to clarify which interests to value."

A little interpretation on the bold:

a) "the valuation could be subject to the existing lease" means we add or deduct the value of the difference between the current leases and market rates from the fee simple value if they are above or below market.

b) "subject to leases at market rates and terms" means we use the current leases, but apply market rates to their value,

c) "... as though vacant and available to be leased at market rates and terms." Oh, this is just great, now we are free to reconfigure the leases to achieve maximum profitability: Single Net, Double Net, Triple Net, Absolute Triple Net, Gross Lease, and so on! (I guess one could argue that the choice of lease type should not impact value, as the rate will be correspondingly adjusted, but I would say - that all depends). - But no, I am sure this is not what they meant, they most likely mean we have to calculate in vacancy, marketing and other startup costs. Who knows? Maybe they mean the whole works. - I guess that is up to the appraiser.

But then, (c) implies a new kind of basis for (a) and (b). That is (c) seems to be what you would want to consider for the income approach in your opinion of fee simple value.

In any case the discussion, at least as of the date of the article (December 2017) appears to be only a discussion. Makes sense, as it stands, (c) might make things a lot messier than they already are.