Appraising Partial and Other Ownership Interests

Chapter 13: Appraising Partial and Other Ownership Interests

I. INTRODUCTION

Real estate appraisal often involves valuing the complete bundle of rights associated with fee simple ownership. However, situations arise where only a portion of these rights, or specific types of ownership structures, are subject to appraisal. Understanding the nature of these partial and other ownership interests and their impact on value is crucial for accurate appraisal practice. This chapter will explore the theory and application of appraising various partial interests, including leasehold and leased fee interests, easements, liens, shared ownership interests, and other unique forms of ownership such as condominiums, cooperatives, timeshares, manufactured homes, prefabricated homes, and ground leases.

II. APPRAISING PARTIAL INTERESTS

A. Leasehold and Leased Fee Interests

1. Definition and Overview
   a. Leasehold Interest: The right to use and occupy a property for a specified period under the terms of a lease. The lessee (tenant) holds this interest.
   b. Leased Fee Interest: The lessor’s (landlord’s) right to receive rent and reversion of the property at the end of the lease term.
   c. These interests represent a division of the fee simple estate, where the lessee holds a temporary right of use and occupancy, and the lessor retains ownership with the right to receive income and regain possession.

2. Valuation Principles
   a. Leasehold Valuation: The value of the leasehold interest is the present value of the difference between the market rent and the contract rent over the remaining lease term, plus the present value of any reversionary interest the lessee may have (e.g., improvements made by the tenant).
   b. Leased Fee Valuation: The value of the leased fee interest is the present value of the contract rent payments over the remaining lease term, plus the present value of the reversionary interest (the value of the property at the end of the lease).
   c. Key Considerations:
   i. Contract Rent: The rent specified in the lease agreement.
   ii. Market Rent: The rent that the property would command in the open market.
   iii. Lease Term: The remaining duration of the lease.
   iv. Discount Rate: Reflects the risk associated with the income stream and the reversionary interest.
   v. Reversionary Value: The estimated value of the property at the end of the lease term.

3. Mathematical Formulas and Equations
   a. Present Value of Leasehold Interest:

   PV_Leasehold = ∑ [ (Market Rent - Contract Rent) / (1 + r)^t ] + [ (Reversionary Value - Demolition Costs) / (1 + r)^n ]

    *Where:*
       *PV_Leasehold* = Present Value of Leasehold Interest
       *Market Rent* = Expected Market Rental Income
       *Contract Rent* = Agreed Rental Income based on the contract
       *r* = Discount Rate
       *t* = Year number
       *n* = Number of years of lease.
       *Reversionary Value* = Value of the property at the end of the lease term
       *Demolition Costs* = Expected costs to demolish improvements at end of lease term
   

   b. Present Value of Leased Fee Interest:

   PV_LeasedFee = ∑ [ (Contract Rent) / (1 + r)^t ] + [ Reversionary Value / (1 + r)^n ]

    *Where:*
       *PV_LeasedFee* = Present Value of Leased Fee Interest
       *Contract Rent* = Agreed Rental Income based on the contract
       *r* = Discount Rate
       *t* = Year number
       *n* = Number of years of lease.
       *Reversionary Value* = Value of the property at the end of the lease term
   

4. Practical Applications and Examples

a. Example 1: Leasehold Valuation
A retail property is leased for 10 years at $10,000 per month. The market rent is $12,000 per month. The appropriate discount rate is 10%. At the end of the 10-year lease the tenant is expected to pay $5,000 to remove improvements. The land is expected to be valued at $1,000,000 after 10 years.
PV_Leasehold = ∑ [ ($12,000 - $10,000) * 12 / (1 + 0.10)^t ] + [ ($1,000,000 - $5,000) / (1 + 0.10)^10 ]
Calculate the present value of the monthly rent difference over the 10 years and then add that to the present value of the expected land at the end of the lease term, minus the expected costs.
b. Example 2: Leased Fee Valuation
Using the same retail property, calculate the value of the leased fee interest
PV_LeasedFee = ∑ [ ($10,000 * 12) / (1 + 0.10)^t ] + [ $1,000,000 / (1 + 0.10)^10 ]
Calculate the present value of the monthly rent over the 10 years and then add that to the present value of the expected land value at the end of the lease term.

5. Related Experiments/Sensitivity Analysis:
   a. Conduct sensitivity analyses by varying the discount rate and market rent to observe the impact on the leasehold and leased fee values.
   b. Explore scenarios with different lease terms and their effect on the present value calculations.

B. Easements

1. Definition and Overview
   a. An easement is a right granted to a party to use another party’s land for a specific purpose. It’s a nonpossessory interest.
   b. Types of Easements:
   i. Easement Appurtenant: Benefits a specific parcel of land (dominant tenement) and burdens another (servient tenement).
   ii. Easement in Gross: Benefits an individual or entity, not a specific parcel of land (e.g., utility easements).

2. Valuation Principles
   a. Easement Valuation for the Dominant Estate: The value is typically the increase in the value of the dominant estate due to the easement.
   b. Easement Valuation for the Servient Estate: The value is typically the diminution in the value of the servient estate due to the easement. This can involve analyzing the loss of use, potential development restrictions, or other negative impacts.
   c. Methods of Valuation:
   i. Before and After Method: Estimate the value of the servient estate before and after the easement is granted. The difference represents the value of the easement.
   ii. Income Capitalization: If the easement generates income (e.g., through a cell tower lease), capitalize the income stream.
   iii. Cost Approach: Estimate the cost to create a substitute easement or to mitigate the negative impacts of the easement.

3. Mathematical Formulas and Equations
   a. Value of Easement (Servient Estate):

   Value_Easement = Value_Before - Value_After

    *Where:*
       *Value_Easement* = Value of Easement
       *Value_Before* = Value of the servient property before the easement
       *Value_After* = Value of the servient property after the easement
   

4. Practical Applications and Examples

a. Example: An easement allows access to a landlocked parcel. The landlocked parcel is worth $50,000 without access. With the easement, its value increases to $200,000. The value of the easement to the dominant estate is $150,000. The servient estate decreases in value by $20,000 because of the easement.

5. Related Experiments/Sensitivity Analysis:
   a. Conduct market research to determine how easements impact property values in the area.
   b. Analyze comparable sales of properties with and without similar easements.

C. Liens

1. Definition and Overview
   a. A lien is a legal claim against a property as security for a debt or obligation.
   b. Types of Liens:
   i. Mortgage Liens: Used to secure loans for the purchase of real estate.
   ii. Tax Liens: Imposed by government entities for unpaid property taxes.
   iii. Mechanic’s Liens: Filed by contractors or suppliers for unpaid work or materials.
   iv. Judgment Liens: Result from court judgments against the property owner.

2. Valuation Principles
   a. The presence of a lien generally reduces the equity value of a property.
   b. The value of a property encumbered by a lien is the total property value less the outstanding balance of the lien.
   c. Important Considerations:
   i. Lien Priority: Determines the order in which liens are paid in case of foreclosure.
   ii. Interest Rate: Affects the cost of carrying the debt.
   iii. Maturity Date: The date the debt is due.
   iv. Foreclosure Risk: The likelihood of the lienholder initiating foreclosure proceedings.

3. Mathematical Formulas and Equations
   a. Equity Value with Lien:

   Equity_Value = Total_Property_Value - Outstanding_Lien_Balance

    *Where:*
       *Equity_Value* = The remaining value of the property after settling the lien
       *Total_Property_Value* = Total market value of the property
       *Outstanding_Lien_Balance* = The outstanding amount of the lien, interest, and any fees.
   

4. Practical Applications and Examples

a. Example: A property is valued at $500,000 and has a mortgage lien with an outstanding balance of $300,000. The equity value is $200,000.

5. Related Experiments/Sensitivity Analysis:
   a. Analyze the impact of varying interest rates on the affordability and marketability of properties with mortgage liens.
   b. Explore the effect of foreclosure risk on property values in different market conditions.

D. Shared Ownership Interests

1. Definition and Overview
   a. Shared ownership involves multiple parties holding an interest in the same property.
   b. Types of Shared Ownership:
   i. Tenancy in Common: Each owner holds an undivided interest, which can be sold or inherited independently.
   ii. joint tenancy❓❓: Owners have equal rights and interests, with the right of survivorship (the deceased owner’s interest automatically transfers to the surviving owners).
   iii. Tenancy by the Entirety: Similar to joint tenancy but only available to married couples, with protection from individual creditors.

2. Valuation Principles
   a. The value of a shared ownership interest may not be directly proportional to the percentage ownership. Factors such as marketability, control, and potential for partition can affect value.
   b. Discounts for Lack of Control and Marketability:
   i. Lack of Control: The inability of a minority owner to make decisions about the property can reduce its value.
   ii. Lack of Marketability: Difficulty in selling a partial interest can also decrease value.
   c. Partition Action: A legal proceeding to divide the property or force its sale, with proceeds divided among the owners. The potential for a partition action can influence the value of a shared interest.

3. Mathematical Formulas and Equations
   a. Discounted Value of Partial Interest:

   Value_Partial_Interest = (Ownership_Percentage * Total_Property_Value) * (1 - Discount_Rate)

    *Where:*
       *Value_Partial_Interest* = The value of the partial interest, incorporating discount for any disadvantages.
       *Ownership_Percentage* = The percentage of ownership each party has
       *Total_Property_Value* = The total market value of the property.
       *Discount_Rate* = The discount rate for any lack of control or marketability issues.
   

4. Practical Applications and Examples

a. Example: A property is worth $400,000, and two tenants in common each own 50%. Due to lack of marketability and control, a 10% discount is applied to each interest. The value of each partial interest is ($200,000) * (1-0.10) = $180,000.

5. Related Experiments/Sensitivity Analysis:
   a. Research case studies of partition actions and their impact on the value of shared ownership interests.
   b. Interview real estate attorneys specializing in shared ownership disputes to gather insights on valuation considerations.

III. OTHER FORMS OF OWNERSHIP

A. Condominiums and PUDs (Planned Unit Developments)

1. Definition and Overview
   a. Condominium: Individual ownership of a unit within a multi-unit building, along with shared ownership of common areas.
   b. PUD: A planned development with a mix of housing types, clustered lots, and common areas owned and maintained by an association.

2. Valuation Principles
   a. Condominium Valuation:
   i. Direct Comparison: Use sales of comparable condominium units.
   ii. Consider association fees and special assessments.
   iii. Analyze the condition and amenities of the unit and the building.
   b. PUD Valuation:
   i. Compare to similar homes in other PUDs or conventional subdivisions.
   ii. Evaluate the attractiveness and maintenance of common areas.
   iii. Assess the impact of association rules and regulations.

B. Cooperatives

1. Definition and Overview
   a. Cooperative: Ownership of shares in a corporation that owns the building. Shareholders receive a proprietary lease granting them the right to occupy a specific unit.

2. Valuation Principles
   a. Cooperative Share Valuation:
   i. Compare to sales of similar cooperative shares.
   ii. Consider the financial health of the cooperative corporation.
   iii. Analyze monthly maintenance fees and any underlying mortgage debt.
   iv. Assess transfer restrictions and board approval requirements.

C. Timeshares

1. Definition and Overview
   a. Timeshare: Ownership of the right to use a property for a specific period each year.

2. Valuation Principles
   a. Timeshare Valuation:
   i. Compare to sales of similar timeshare interests.
   ii. Consider the location, season, and unit size.
   iii. Analyze maintenance fees and exchange options.
   iv. Be aware of the high sales commissions and marketing costs associated with timeshares, which can inflate prices.

D. Manufactured Homes

1. Definition and Overview
   a. Manufactured Home: A factory-built dwelling constructed to HUD (Housing and Urban Development) standards. It can be personal property (chattel) or real property, depending on whether it’s permanently affixed to land.

2. Valuation Principles
   a. Manufactured Home Valuation:
   i. Compare to sales of similar manufactured homes in the area.
   ii. Consider the age, size, condition, and features of the home.
   iii. If the home is real property, use standard appraisal techniques.
   iv. If the home is personal property, use methods appropriate for chattel appraisal.

E. Prefabricated/Modular Homes

1. Definition and Overview
   a. Prefabricated/Modular Home: A factory-built dwelling constructed in modules and assembled on-site. It’s typically considered real property.

2. Valuation Principles
   a. Prefabricated/Modular Home Valuation:
   i. Use standard appraisal techniques for site-built homes.
   ii. Compare to sales of similar homes in the area.
   iii. Consider the quality of construction and design.

F. Ground Leases

1. Definition and Overview
   a. Ground Lease: A lease of land only, where the lessee constructs improvements on the land.

2. Valuation Principles
   a. Ground Lease Valuation (Lessor/Leased Fee):
   i. The same as Leased Fee valuation (see Section II.A.2.b)
   b. Ground Lease Valuation (Lessee/Leasehold):
   i. The same as Leasehold valuation (see Section II.A.2.a)
   c. Consider the lease terms, including rent, term length, and renewal options.
   d. Analyze the value of the improvements and their remaining economic life.

IV. CHAPTER SUMMARY

Appraising partial and other ownership interests requires a thorough understanding of the specific rights and restrictions associated with each type of interest. Accurate valuation involves considering legal factors, market conditions, and applying appropriate appraisal techniques. This chapter has provided a comprehensive overview of the principles and methods for valuing various partial interests and unique ownership structures, equipping appraisers with the knowledge to handle these complex assignments effectively.

V. CHAPTER QUIZ
The chapter quiz can include multiple-choice questions, true/false statements, and short-answer questions to assess the reader’s understanding of the concepts covered in the chapter.