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Fee Simple and Leased Fee Values

Published On 05-22-2013 , 10:35 AM

I have restrained myself over these past two months since I kicked off the Appraisers Arc, but I can hold back no longer. This week’s blog post is dedicated to my pet peeve as a reviewer. Last week I shared some small, seemingly innocuous issues that plague review appraisers. But this week, I am focusing on a single issue. In my experience, this may be the one thing that consistently trips up even some of the best of appraisers.


More and more over the years, I have seen short cuts that blur the lines between fee simple and leased fee valuation. These short cuts come in various forms:


·         Once the contract rent is determined to fall within the range of reasonableness for market rent, the leased fee interest and the fee simple interest are declared to be the same and only one is valued. In fact, rental income is just one facet of a lease agreement. Expense reimbursements (if any and which ones), lease duration, primary lease scheduled rent increases, renewal options, and any other terms and conditions that are different from the typical can influence the leased fee value. It is only via separate analyses that the appraiser can thoroughly analyze all the moving parts. Basically, even when it is concluded that market rent is similar to contract rent, it does not necessarily follow that the leased fee and fee simple values will be equivalent.

·         A fee simple value is concluded in the sales comparison approach and/or cost approach while the income approach concludes a leased fee value. The values are then reconciled and a single value is concluded that is either labeled a leased fee or a fee simple market value conclusion. It is never appropriate to blend the two interests. Instead, the approach that concludes a fee simple value can be adjusted so that it concludes a leased fee value. Probably the simplest solution, however, is for the appraiser to conclude a separate value for each of the real property interests that has been analyzed.

·         Direct capitalization is applied to conclude the value of the leased fee interest. I recognize that direct capitalization is easier and may get the report out the door faster. I also recognize that appraisal theory allows for manipulation of the cap rate to reflect greater or lesser risk or expectation of appreciating cash flows or value. But few appraisers go through the exercise of building into the cap rate the sort of detailed elements that would be expressed in a DCF. In reality, DCFs are tailor-made for analysis of income and expenses over a finite period of time; such as a lease term. Use of direct capitalization in lieu of yield capitalization becomes particularly problematic when a lease has built-in rent escalations. My personal preference is direct capitalization for fee simple valuation and yield capitalization for leased fee valuation.

·         In situations where the income approach concludes both fee simple and leased fee values, it is rare for an appraiser to use different cap rates or discount rates,  even when there may be different rental income (particularly annual market rent escalations when the contract rent stays level), different risk of tenant quality, different reimbursement levels, different vacancy rates, difference in expense allocations, and/or atypical lease duration.

·         Another short cut that bothers me is the assumption that market rent increases every year when, in fact, that is rarely the case. Even in times when rental rates are escalating annually, the fee simple valuation using yield capitalization should project all market lease terms and not just market rent. In markets where contract rent always increases annually to keep pace with annual market rent, then such annual increases in the fee simple analysis is acceptable. However, in most markets, leases are flat over the primary lease term and then – via re-lease or renewal – the rent goes to market at the end of the primary term. Thus, to be accurate, a DCF that values the fee simple estate should reflect rent plateaus and periodic increases, not annual increases.

·         In dealing with triple net lease situations, the reimbursed expenses should not be assumed away, as the landlord is responsible for fixed expenses during times of vacancy.

·         When valuing a fee simple interest it is important to reflect the market. Thus, it is not appropriate to convert gross leases to triple net if the market typically leases that property type on a gross basis.


Basically, the fee simple estate and the leased fee interest are two separate conditions. Think of them as parallel universes. In Universe A, the property is leased. In Universe B, the property is not leased and available for immediate sale or lease at market terms. By definition, the two are not the same. Legally, they are not the same. In practice they are not the same – even though the values concluded for the two may be the same in some instances. When that happens, the report should list a separate value for each property interest (what the property is worth in one space-time continuum and what the property is worth in a parallel universe).



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