Real Estate Appraisal Unit 16

Form 1073 contains sections that

- describe the scope of work to be performed (see page 4 of the form); - identify the intended use of the appraiser's opinions and conclusions; - identify the client and other intended users; - define market value; - list the appraiser's assumptions and limiting condition; and - list the appraiser's certifications.

Percentage lease

- the tenant usually pays a minimum guaranteed base rent plus a percentage of gross income earned by the business. The amount paid over the base is called overage rent. The percentage paid may change (usually, it decreases) as gross income increases. For example, the rent may be $1,000 per month plus 3 % of gross income over $6,000 per month and 1 % of gross income over $10,000 per month. - Either a gross lease or a net lease may be a percentage lease.

Using the figures given in the example above, what is the value of the leased fee interest if scheduled rent is $54,000? If scheduled rent is $50,000?

1. $419,100 2. $393,200

To compensate for inflation, what type of clause does the lessor often include in a lease agreement?

escalator

To compensate for inflation, what type of clause does the lessor often include in a lease agreement?

escalator - An escalator clause provides for periodic increases in rents based on any increase in one of a number of indexes, such as the consumer price index (CPI) or the wholesale price index (WPI)

In which type of lease agreement does the tenant know exactly how much rent will be due and payable each month during the term of the lease?

gross lease

A lease of land only, on which the tenant owns a building, is called a:

ground lease

When scheduled rent is higher than market rent, the value of the lessor's interest ____.

increases

Which of the following is correct regarding tenants in common?

(A)They share an undivided interest in the property. (B)Each tenant has the right to use the entire property regardless of the fractional interest owned. (C)It is a form of co-ownership.

Planned Unit Developments

- A planned unit development (PUD) is a subdivision consisting of individually owned parcels or lots, as well as areas owned in common. - A PUD may feature detached residences, condominiums, or townhouses (houses on separately owned lots that have adjacent or party walls) and may include both residential and commercial property. Security and convenience are major advantages of planned unit developments. Some PUDs comprise hundreds of separately owned lots with detached residences, one or more swimming pools, tennis courts, a clubhouse, and other amenities. Property owners pay fees and assessments to the property owners' association for upkeep of common areas. Of course, the more extensive the common areas, the higher will be the fees and other assessments required for proper maintenance, although spreading costs over many units can help keep expenses manageable. - The best valuation method for a PUD home or condominium unit is the sales comparison approach, ideally using similar properties in the same development.

Summary

- A property interest to be appraised is not always an undivided fee simple interest. A condominium is the undivided ownership of the airspace that a unit actually occupies, plus an undivided interest in the ownership of the common elements, which are owned jointly with the other condominium unit owners. A planned unit development (PUD) includes individual ownership of a detached home and lot, town home and lot, or condominium, along with shared ownership of common areas. A time-share divides ownership into increments of time or a percentage interest. Manufactured homes require special consideration of their location. - Property under co-ownership may be difficult to sell, and its value will be affected commensurately if all owners do not take part in the transaction. - Excess rent is any amount by which scheduled rent is greater than market rent. Deficit rent is the amount by which market rent exceeds scheduled rent. A lessee may mortgage property improvements. A subleasehold is the interest of a sublessee. - A lease may be described by the manner in which rent is determined, as in a gross lease, net lease, triple-net lease (net, net, net lease), or percentage lease. Overage rent is any amount paid over the base minimum under a percentage lease. With an escalator clause, lease payments can increase on the basis of an index (for example, the consumer price index). - The lessee may have the right to renew the lease under the same or revised terms. The lease also may provide the lessee a purchase option or right of first refusal. Tenant improvements are made to suit the tenant and may be paid for by either landlord or tenant. The tax-stop clause and expense-stop clause work to pass on to the lessee any increase in tax or expense payments that would otherwise be the obligation of the landlord. - Because the annuity method of capitalization is based on the premise that income will remain scheduled and predictable throughout the term of a long lease, it is almost always used in valuing leased fee and leasehold interests. - A leasehold interest can have value only if the scheduled rent under the lease is less than the market rent value of the property free of lease. A leasehold interest has many of the characterist

Leasehold estate

- A second interest created by a lease belongs to the tenant. It is referred to as the leasehold estate, or the lessee's interest and rights in the real estate. Because the lessee is obligated under the terms of the lease to pay rent, the lessee's interest in the property can have value only if the agreed-on scheduled rent is less than the prevailing market rent, or economic rent. If the agreed-on scheduled rent is higher than the prevailing market rent, the difference is termed excess rent and the tenant has a negative leasehold interest. - A lessee may make substantial improvements to a parcel under the terms of a ground lease. A ground lease is defined as a lease of land only, on which the tenant usually owns a building or is required to build as specified in the lease. The ground lease has been used most often with commercial property, but is also used for residential complexes in areas of high property values. - An important benefit of the lessee's leasehold estate is the right to mortgage leasehold improvements by using them as security for the repayment of a debt. The lessee's interest in the improvements usually is subordinated (made secondary) to the interest of the mortgagee (the holder of the mortgage).

IN PRACTICE

- A time-share is best valued by the sales comparison approach. Initial sales prices are set by the developer based on amenities of the unit (size, special features, view) and the time of year involved. At a ski resort, for instance, a week in January is more valuable than a week in May. Holiday periods typically have the highest premium. If percentage shares are sold, the minimum share available typically will purchase the right to use the smallest unit for the minimum time, usually at least one week. The owner is assessed for maintenance and common area expenses based on the percentage of ownership in the property. - For some time-share projects, high initial marketing costs and limited resale potential have resulted in heavily discounted resale prices. The appraiser should examine the local market carefully, especially noting the exact ownership interest involved and the sales price and length of time on the market for resales.

Leased Fee and Leasehold Valuations

- Because changing conditions affect the value of real estate, leases made prior to the current period may be for amounts above or below what the current market can command. If market rent exceeds scheduled rent, the property owner is, in effect, transferring part of the property interest to the tenant, thus creating a positive leasehold interest. On the other hand, if scheduled rent exceeds market rent, a negative leasehold interest (called a lease premium) exists, and the unfavorable lease, in a sense, is a liability of the lessee. If the difference between scheduled rent and market rent becomes too heavily weighted in the owner's favor, the tenant may try to renegotiate the terms of the lease (perhaps exchanging a longer lease term for a lower lease payment). If scheduled rent and market rent are the same, the tenant's interest in the property is of zero value. - The principle involved in the valuation of lease interests is similar to that of capitalized income valuation under the annuity method. The value of the lessor's and the lessee's interests is found by capitalizing the present value of the income each receives and adding the reversionary value of the land, or land and building, at the expiration of the lease term. Ordinarily, the lessor receives the reversionary value of the property. But some leases provide for payments to the lessee by the lessor for any improvements made by the lessee that will ultimately revert to the lessor. - In valuing lease interests, the appraiser must first carefully study the detailed provisions of the lease to determine the rights and obligations of the owner and tenant. Then, the valuation of leased fee and leasehold interests is basically a matter of dividing the value of the property into separate values attributable to each of the various interests. - As a rule, the total of the various interests in the property will approximate the value of the property under free and clear ownership, but may be somewhat more or less.

Manufactured Homes

- Factory-built homes now account for one-third of all new single-family home purchases in the United States. The federal government refers to a home constructed in a factory, including both completely enclosed homes and those that consist of components to be assembled on site, as a manufactured home. Such homes must meet the National Manufactured Home Construction and Safety Standards covering design, construction, durability, fire resistance, and energy efficiency. - Well-maintained manufactured home subdivisions, offering generous lot space with lawn areas, well-paved streets, swimming pools, and other facilities, can be inviting places to live and may increase in value. Manufactured homes offer housing that usually is much more affordable than alternatives. Unfortunately, strict zoning has limited their availability in most urban areas. - Special considerations for manufactured homes appraised by the sales comparison approach include the age and size of the home, its location, and, if applicable, space rental cost, lease term, subdivision amenities, and upkeep of the subdivision grounds and other units. - Some forms of manufactured housing, such as those using panelized construction, may be required to conform to local building codes and thus are considered equivalent to homes constructed entirely on site.

Other Forms of Ownership

- Other partial interests include the life estate, easement, cooperative, and various forms of co-ownership. Tenants in common (TICs) share an undivided interest in the property that is the subject of the cotenancy. This means that each tenant has the right to use the entire property, regardless of the fractional interest owned. The value of a tenant in common's interest is based on that fraction. - Joint tenants, who share the unities of title, time, interest, and possession, cannot have unequal interests. A joint tenancy also includes the right of survivorship, which means that a joint tenant cannot convey the property interest without destroying the joint tenancy. The joint tenancy has value while the tenant lives because the tenant is entitled to full use of the property, but the ultimate value of a joint tenant's interest depends on the actuarial likelihood that the joint tenant will be the last survivor. - If all cotenants are willing to join in a conveyance of co-ownership property, the property's value should be the same as it would be under individual ownership of the fee simple title. An individual tenant's interest, valued separately, will depend on the type of property and the terms of the cotenancy. The appraiser must consider the likely desirability of the property to a potential buyer. If use of the property is easily divisible, such as a three-unit building owned by three tenants in common under an agreement giving each the right to occupy a separate unit, the valuation process will be less complicated.

Condominium

- The apartment condominium has some of the same benefits and drawbacks as rental apartment livinglack of privacy being a primary consideration. The townhouse condominium offers greater privacy and generally more living and storage space. For those who cannot afford or choose not to invest in other types of property, however, the condominium is a way to own property (with all the tax and estate planning advantages that entails) yet avoid onerous yard and building maintenance. - Special appraisal considerations for condominiums include specification of both private and public areas, mention of the exact location of the subject property within the building or site, and consideration of the upkeep of both public areas and other units. The appraiser should note the condominium and/or management association that cares for common areas, the amount of monthly fees or other assessments charged, and any special facilities provided (such as a tennis court or swimming pool). - Appraisers generally use the sales comparison approach to value individual condominium units. In areas of high population density, well-designed and well-maintained residential condominiums have appreciated in value, though typically not as much as detached homes, if those are available. If a surfeit of building has resulted in more condominiums than the available demand has warranted, prices will decrease to reflect the reduced demand. When a substantial number of condominium units are owned for rental investment purposes, maintenance may be more difficult, particularly if absentee landlords are slow in paying homeowner assessments. Investors contributed to the run-up of property prices in many areas, particularly in Florida. - Comparable condominium properties should be similar in building size, unit size, number of owner-occupied units, extent of common areas, and type of amenities.

Condominiums

- The condominium form of ownership, long popular in Europe, has been used widely in this country only since the early 1960s. It is particularly attractive to those who want the security of owning property without the maintenance and care that a house requires. The owner of each unit holds a fee simple title to the unit. Ownership includes exclusive right to the airspace that encompasses that unit, as well as an interest in the common areas. - Common areas typically include such items as the land, courtyard, walkways, parking spaces, foundation, outside walls, roof, lobby, hallways, elevators, and stairways, as well as recreational facilities such as swimming pools, golf courses, and tennis courts (see Figure 16.1). Unit owners must pay a proportional share of the maintenance and upkeep expenses of the common areas. Many residential apartments, townhouses, offices, and retail stores now are held in the condominium form of legal ownership.

Creation of Lease Interests

- The statute of frauds in most states requires that a lease that will terminate more than one year from the date of agreement must be in writing to be enforceable in a court of law. Oral agreements for leases of one year or less are usually enforceable; however, it is good business practice to put all lease agreements in writing. - A lease agreement may cover one or more of the following topics.

What special considerations would be taken into account when appraising the following property interests? 1. Condominium 2. PUD 3. Time-share 4. Manufactured home

1. Condominium building size, unit size, number of owner-occupied units, common areas, amenities, monthly fees, or other assessments 2. PUD size of development, common areas, amenities, fees, or assessments, use of comparable properties in the same development 3. Time-share ownership interest, amenities, time of year, resale market, maintenance fees 4. Manufactured home age and size of home, lot size, lawn areas, streets, park amenities, upkeep, space rental cost, and lease term

Other lease provisions

A lease may contain a tax-stop clause that allows the landlord to charge the tenant for any increase in taxes over a specified level. An expense-stop clause works in the same way to pass increases in building maintenance expenses on to tenants on a pro rata basis. A purchase option, or right of first refusal, may accompany a lease of real property. The purchase price may be provided in the lease agreement or it may be based on a stated formula.

Explain how a leasehold estate is created

A leasehold estate is created (may be valued) when scheduled rent under the lease is less than the fair market rental, or economic rent.

Leased fee

An owner who leases property for a given period owns a leased fee, which represents the lessor's interest and rights in the real estate. In return for the lease that permits the tenant to occupy and use the property, the lessor receives a stipulated fee or rental and retains the right to repossess the property at the termination of the lease. The value of the rental payments plus the remaining property value at the end of the lease period, known as the reversion, make up the lessor's interest in the property. This leased fee interest may be sold or mortgaged, subject to the rights of the tenant.

A property earning a net operating income of $48,000 per year is rented on an annual basis to one tenant. The remaining economic life of the building is 25 years, and the current market value of the land is estimated at $100,000. The rate of interest for similar investments is 14 %. Based on these facts, and using the building residual technique, the value of the property is obtained:

Estimated land value: $100,000 - Net operating income: $48,000 - Interest on land value ($100,000 × 14%): - $14,000 - Residual income to building: $34,000 - Capitalization rate for building: 14% - Interest rate: 4% - Recapture rate: 18% - Building value ($34,000 ÷ 18%): $188,889 Total property value: $288,900 (rounded)

The appraiser is not permitted to make changes to this form, with the following exceptions:

Fannie Mae will allow additional certifications to be added on a separate page if such certifications are required by state law, or if they cover such things as the appraiser's continuing education or membership in an appraisal organization. The appraiser may expand the scope of work to include any additional research or analysis necessary, based on the complexity of the appraisal assignment.

Lease Terminology

Leaseholds and leased fee interests are reviewed here and additional terms are discussed.

Tenant improvements

Most leased office and other commercial buildings are built, finished, or remodeled according to the requirements of a particular tenant. Frequently, original construction does not include interior partitioning, which is completed only after a lease is entered into so that the space can be finished to suit the tenant's needs. Either the lessor or the lessee may be obligated to pay for such tenant improvements, as the lease provides. If the lessor pays, the rent will be higher than it would be otherwise; if improvements are made by the tenant, the rent may be lower than otherwise.

The property is leased to a nationally known company on a 25-year lease, but the net operating income is only $40,000, $8,000 below the market rent. The appraiser in this instance must estimate the value of the two affected interests—leased fee and leasehold. Because of the greatly reduced risk brought on by the long lease to a national company at a scheduled rent well below the market rent, the interest rate has been lowered to 11 %. The interest rate applicable to reversion is unchanged at the 14 % rate assumed earlier. The leased fee interest can be computed as follows:

Net operating income: $40,000 Annuity factor1 (25 yrs @ 11%)× 8.422 Present worth of net income: $336,900 (rounded) Present worth of reversion (25 yrs @ 14%) ($100,000 × 0.038 reversion factor^2): $3,800 Value of the leased fee interest: $340,700 The leasehold interest can be computed as follows: - Market rent: $48,000 - Scheduled rent: $40,000 - Excess rent: $8,000 - Present worth of excess rent discounted @ 15%: $6,464 - Value of leasehold interest: $51,700 (rounded) - Total value of leased fee and leasehold - interests ($340,700 + $51,700): $392,400

Assume that the property described in the previous example is now leased to a nationally known company on a 25-year lease at the same net annual rent of $48,000, equal to market rent. The building is considered of no value at the end of the lease term. Because of the increased security, and therefore the decreased risk, in having the property leased for a long period of time by a national company, the interest rate (sometimes called risk rate) has been lowered from 14 % to 12 %. The interest rate applicable to reversion is assumed to be 14 %. Based on these facts, and using the annuity method of capitalization, the value of the leased fee is derived as follows:

Net operating income: $48,000 Annuity factor (25 yrs @ 12%) × 7.843 Present worth of net income: $376,500 (rounded) Present worth of reversion (25 yrs @ 14%) ($100,000 × 0.038 reversion factor): $3,800 - Total property value: $380,300

Renewal options

The lease may provide that the lessee has the right at the end of the lease term to renew the lease for the same term or some other stated period. A renewal option usually includes a rent increase at a stated percentage or based on an index or other formula. The existence of a renewal option at a rate favorable to the lessee will make the lessee's interest that much more valuable and the lessor's interest that much less valuable. Because the right to exercise a renewal option is entirely at the discretion of the lessee, it usually is considered a benefit to the lessee rather than the lessor.

The scheduled rent is $52,000 per year, or $4,000 higher than the current market rent. A higher interest rate (15 %) will be applied to the excess rent portion of the total income because it may not continue for the length of the lease.

The leased fee interest can be computed as follows: - Present value of market rent (from above): $376,500 - Value of reversion: $3,800 = $380,300 - Excess rent discounted @ 15% - ($4,000 × 6.464 annuity factor): $25,900 (rounded) Value of leased fee interest: $406,200

Appraising Lease Interests

We have referred to the owner of a leased property as the lessor, or landlord, and to the person who leases the property as the lessee, or tenant. When the scheduled rent the lessee pays is the same as the market rent, or economic potential of the property, both parties receive full value for their lease and investment dollar. If the scheduled rent (contract rent) is lower or higher than market rent, however, one party gains and the other loses the amount of the difference. How the lessor's and lessee's interests are defined and evaluated is discussed next.

Sandwich lease

When a tenant has a leasehold estate of value, the tenant may sublet that interest. By doing so, the tenant creates what is known as a sandwich lease, and the value of the property is then divided among three interests: the lessor's, the original or prime lessee's, and the sublessee's. The interest of the sublessee under a sandwich lease is called a subleasehold.

The owner of each unit holds

a fee simple title to the unit. Ownership includes exclusive right to the airspace that encompasses that unit, and an interest in common areas

Time-Share Projects

a relatively new and heavily promoted form of vacation property ownership, ranging from campgrounds to city apartments. A time-share purchaser receives the right to exclusive use of a portion of the property for a particular period each year (usually in units of one week) or a fractional or percentage share of ownership, frequently expressed as a number of points that can be traded for the use of a unit for a certain period of time. A time-share estate includes an estate (ownership) interest in the property; a time-share use, on the other hand, consists of the right to occupy and use the facilities for a specified period with no ownership interest involved.

There is a right of possession included in ownership of

a time-share use

Triple-net lease

also known as a net, net, net lease, absolute net lease, or 3N lease, the tenant pays all operating and other expenses plus a fixed rent. These expenses include taxes, assessments, insurance, utilities, and maintenance.

A planned unit development (PUD) is a subdivision consisting of individually owned parcels or lots as well as:

areas owned in common

"An exclusive right to the airspace of the unit" describes a:

condominium ownership

Net lease

in addition to the rent, the tenant pays part or all of the property charges, such as taxes, assessments, insurance, and maintenance.

Deficit rent

is the amount by which market rent exceeds scheduled rent at the time of the appraisal. Deficit rent is created by a lease favorable to the tenant and is usually the result of a weak rental market. Because excess rent and deficit rent result from a lease contract rather than the income potential of the property, their effect is often considered a nonrealty element of value.

Fannie Mae Form 1073: Individual Condominium Unit Appraisal Report

is used to appraise a unit in a condominium project or a condominium unit in a PUD. Entries to this form must comply with UAD requirements and the Market Conditions Addendum must be included.

If scheduled rent exceeds market rent, a negative leasehold interest exists called a ____.

lease premium

What party to a lease owns the legal interest called the leasehold estate?

lessee

While property is being leased, the leased fee interest is held by the:

lessor

Capitalization rates must always have adequate ____.

market support

A lease where the tenant pays a minimum guaranteed base amount plus a percentage of gross income is called a:

percentage lease

A special type of land use that allows a mixture of different land uses or densities is referred to as:

planned unit development

Escalator clause

provides for periodic increases in rents based on any increase in one of a number of indices, such as the consumer price index (CPI) or the wholesale price index (WPI).

Generally, the total value of leased fee and leasehold is

the same as the value of free and clear ownership

A tenant who subleases the property creates a

sandwich lease

Special considerations in appraising manufactured homes include:

space rental cost, lease term, park amenities

In valuing lease interests, the appraiser must first carefully

study the detailed provisions of the lease to determine the rights and obligations of the owner and tenant

Excess rent Excess rent is the amount by which scheduled rent exceeds market rent at the time of the appraisal. Excess rent is created by a lease that is favorable to the lessor and is likely the result of a strong rental market.

the amount by which scheduled rent exceeds market rent at the time of the appraisal. Excess rent is created by a lease that is favorable to the lessor and is likely the result of a strong rental market

Other partial interests include

the life estate, easement, cooperative, and various forms of co-ownership

Gross lease

the tenant usually pays a fixed rental over the period of the lease, and the landlord pays all expenses of ownership, such as taxes, assessments, and insurance.

There is no underlying property ownership interest in a:

time-share use