Appraising Less-Than-Fee-Simple Interests

Introduction

A fee simple estate represents the highest form of ownership in real property, granting the owner the full “bundle of rights,” subject only to governmental powers like taxation, eminent domain❓, police power, and escheat. However, many real estate situations involve interests that are less than fee simple, often referred to as partial interests. These interests represent a division of the bundle of rights and require specialized valuation techniques. This chapter explores the various types of less-than-fee-simple interests and provides guidance on their appraisal.

Defining Fee Simple Estate

According to The Dictionary of Real Estate Appraisal, 6th ed., the term fee simple estate is defined as Absolute ownership unencumbered by any other interest or estate, subject only to the limitations imposed by the governmental powers of taxation, eminent domain, police power, and escheat.
Legal professions define the term fee simple slightly differently than the valuation profession does because legal definitions generally serve a different purpose. Whereas definitions of fee simple used by the appraisers highlight the encumbrances on property, legal definitions tend to focus on duration.

The Concept of Possession: As a legal concept, possession is the power to exclude others, and it is what makes an estate different from an interest in property. To be an estate in land, the legal right or interest must allow possession—now or in the future—and specify duration. Possession (the power to exclude) is not identical to occupancy (the actual physical use of the property), and more than one party may have possessory rights at any given time.

Importance of Clear Identification

Appraisers must clearly identify—and appraisal reports must clearly convey— the property rights that are the subject of an appraisal. In the case of a fee simple estate, a definition on its own may not be adequate. The appraisal report should clearly state any encumbrances affecting the property. The underlying premises of the valuation, including any expectations about occupancy, must be identified by the appraiser and clearly stated in the appraisal report. The methods applied to arrive at the value opinion must reflect the presumed conditions.
In some cases, “what is to be valued”—particularly the interest to be appraised and the definition of that interest—is dictated by applicable law or regulation. Ap- praisers are responsible for knowing which laws or regulations apply and for com- plying with those laws and regulations.

Types of Less-Than-Fee-Simple Interests

A partial interest is any interest or group of interests that makes up less than the entire bundle of rights. Partial interests can be created in several ways:
* Economically
* Legally
* Physically
* Financially

Partial interests can arise from various sources, including:

• Leases: Creating leasehold and leased fee estates❓❓.
• Easements: Granting specific rights to use another’s property.
• Life Estates: Providing ownership for the duration of a person’s life.
• Subsurface and Air Rights: Separating the rights to the land below or above the surface.
• Mortgages and Liens: Encumbering the property with financial obligations.
• Transferable Development Rights (TDRs): Separating and transferring development potential.

Economic Interests: Leasehold and Leased Fee Estates

The most common type of economic interest in property is created by a lease. In this arrangement, a lessor and a lessee each hold partial interests, which are stipulated in contract form and are subject to contract law. In the case of subleases, additional leasehold interests are created. In those cases, an occupant’s interest is commonly referred to a subleasehold. The intervening leasehold interest is commonly referred to as a sandwich leasehold❓❓ because the holder of the sandwich leasehold is the tenant on one lease and the landlord on another.

Leases specify the rights of the lessor (e.g., to collect rent, to get the property back when the lease expires, to dispose of the property through sale or transfer) and the rights of the lessee (e.g., to use, occupy, and, in some cases, to improve or to sublease the property). Terms such as fee simple, leased fee, and leasehold should be used with care. Appraisers should recognize that these terms may have different meanings outside of appraisal practice and in different jurisdictions, and that the terms used alone may be inadequate to convey the meaning of what is being valued, i.e., both the estate and the interests as well as the premises of the valuation.

Leasehold Estate

The leasehold is the lessee’s, or tenant’s, estate. When a lease is created, the tenant usually acquires the rights to possess the property for the lease period, to sublease the property (if this is allowed by the lease), and perhaps to improve the property under the restrictions specified in the lease. In return, the tenant is obligated to pay rent, to give the property back at the end of the lease term, to remove any improvements that the lessee has modified or constructed (if specified), and to abide by the lease provisions. The most important obligation of a tenant is to pay rent.
The relationship between contract rent and market rent greatly affects the value of a leasehold. A leasehold may have value if contract rent is less than market rent, creat- ing a rental advantage for the tenant. However, the contract advantage of the lease- hold may not be marketable. For example, the original lease contract may prohibit subletting or assigning, or the remaining lease term may be too short to be marketable to potential sublease tenants or assignees. This relationship, in turn, is likely to affect the value of the leased fee. The value of a leased fee encumbered with a fixed rent that is below market rates may be less than the value of the fee simple or the leased fee with rent at market levels. When contract rent exceeds market rent, the leasehold is said to have negative value. Even in such circumstances, the tenant still has the right to occupy the premises and, despite the contractual disadvantage, may have other benefits that warrant continued occupancy. It is also possible that the contract disad- vantage hurts the tenant’s business and increases the risk of continued occupancy.

The leasehold is the tenant’s right to use and occupy the property for a specified term. The value of a leasehold is primarily influenced by the difference between the contract rent (the rent the tenant pays) and the market rent (the rent the property would command if leased today).

• Valuation:

  • Identify the remaining lease term (n).
  • Determine the market rent (MR) and the contract rent (CR).
  • Calculate the rental advantage (or disadvantage) per period: RA = MR - CR.
  • Discount the stream of rental advantages to the present value using an appropriate discount rate (r).

  Equation:

  Leasehold Value = Σ [RA / (1 + r)^t] from t = 1 to n
  Where:
  RA = Rental advantage (Market Rent - Contract Rent)
  r = Discount rate
  t = Time period

  Example:
  A tenant has a 10-year lease with a contract rent of $10,000 per year. The current market rent is $15,000 per year. The appropriate discount rate is 8%.

  • Rental advantage (RA) = $15,000 - $10,000 = $5,000
  • Leasehold Value = Σ [$5,000 / (1 + 0.08)^t] from t = 1 to 10
  • Leasehold Value ≈ $33,550 (using present value of annuity formula or spreadsheet)

Leased Fee Estate

In appraisal practice, the lessor’s, or landlord’s, position is referred to as the leased fee. The rights of the lessor and the lessee are specified by contract terms contained in the lease. Although the specific details of leases vary, a lease generally provides the lessor with the following:
* Rent to be paid by the lessee under stipulated terms
* The right of repossession at the termination of the lease
* Default provisions

In appraisal practice, the lessor’s interest in a property is considered a leased fee regardless of the duration of the lease, the specified rent, the parties to the lease, or any of the terms in the lease contract.

The leased fee is the landlord’s interest in the property, representing the right to receive rent and reversion of the property at the end of the lease term. The value of the leased fee is affected by the terms of the lease, the creditworthiness of the tenant, and the prevailing market rents.

• Valuation:

  • Project the rental income stream over the lease term.
  • Estimate the reversionary value of the property at the end of the lease term.
  • Discount both the rental income stream and the reversionary value to their present values using an appropriate discount rate.

  Equation:

  Leased Fee Value = Σ [CR / (1 + r)^t] + [Reversion / (1 + r)^n] from t = 1 to n
  Where:
  CR = Contract Rent
  r = Discount rate
  t = Time period
  n = Lease Term
  Reversion = Value of the property at the end of the lease term.

  Example:
  A property is leased for 5 years with a contract rent of $12,000 per year. At the end of the lease, the estimated reversionary value is $150,000. The appropriate discount rate is 9%.

  • Present Value of Rental Income Stream = Σ [$12,000 / (1 + 0.09)^t] from t = 1 to 5 ≈ $46,650
  • Present Value of Reversion = $150,000 / (1 + 0.09)^5 ≈ $97,430
  • Leased Fee Value = $46,650 + $97,430 = $144,080

Subleasehold or Sandwich Interests

A lease contract may allow a tenant to sublease all or part of a property, but many leases require that the landlord’s consent be obtained. A sublease is an agreement in which the tenant in an existing lease conveys to a third party the interest that the lessee enjoys (the right of use and occupancy of part or all of the property) for part or all of the remaining term of the lease. In a sublease, the original lessee is “sandwiched” between a lessor and a sublessee. The original lessee’s interest has value if the contract rent is less than the rent collected from the sublessee or if the lease conveys other economic advantages. Subleasing does not release the lessee from the obligations to the lessor defined in the lease agreement. A sublease may affect all the parties, including the leased fee position.

As an example, consider a developer who builds a five-story building on land that is leased for 99 years and who then leases parts of the buildings to others. The vacant land owner is the lessor, the developer is the lessee (and sublessor), and the tenants in the building are sublessees.

A lease contract may contain a provision that explicitly forbids subletting. Without either the right to sublet or a term that is long enough to be marketable, a leasehold position may have no market value. Furthermore, the value of the leased fee estate would likely be diminished in this case because a lessee who no longer has need of the leased premises and is not allowed to sublease the space is more likely to default on the lease, thus increasing the riskiness of the income stream to be received by the lessor.

The original lessee’s interest in a sublease is called a sandwich leasehold. Its value depends on the difference between the rent the original lessee pays (the primary lease rent) and the rent they receive from the sublessee (the sublease rent).

• Valuation:

  • Determine the primary lease rent (PLR) and the sublease rent (SLR).
  • Calculate the rental spread (RS) per period: RS = SLR - PLR.
  • Discount the stream of rental spreads to the present value using an appropriate discount rate.

  Equation:

  Sandwich Leasehold Value = Σ [RS / (1 + r)^t] from t = 1 to n
  Where:
  RS = Rental Spread (Sublease Rent - Primary Lease Rent)
  r = Discount rate
  t = Time period
  n = Remaining term of the primary lease

Legal Interests: Life Estates and Easements

Life Estates

A life estate is defined as the rights of use, occupancy, and control of a specified prop- erty limited to the lifetime of a designated party. The designated party is generally known as the life tenant and is obligated to maintain the property in good condition and pay all applicable taxes during the term of the life estate. Two interests are created by a life estate, and both may need to be valued by an appraiser. The first interest is that of the life tenant. The second is the remainder interest, i.e., the possessory interest in the property upon the death of the life tenant. Life estates can be created in several ways:
* By operations of law
* By wills
* By deeds of conveyance

For example, a fee owner may leave a will that gives land to his widow for her re- maining lifetime and, at her death, the land is passed on to their children. Thus, the widow acquires a life estate and functions as a life tenant with the children becoming the holders of the remainder interest. A living fee owner may deed his property to a family member as the holder of the remainder interest and, by the terms of the con- veyance, retain a life estate. This practice might eliminate the expense of probating the will after the owner dies, but it may also call for the assessment of a gift tax.

A related property interest that an appraiser may be asked to value is known as a “springing executory interest.” Like a life estate, a springing (or “shifting”) interest transfers certain rights of ownership to a designated party under certain contractual conditions such as the occurrence of a specific event. An example of a springing inter- est would be the right of use of a property assigned to a parent that is extinguished in the future when that person’s child reaches a certain age—say, 21—at which point the rights of ownership are transferred to the child.

A life estate grants ownership rights for the lifetime of a specified person (the life tenant). Upon the life tenant’s death, the property reverts to another party (the remainderman). Valuation of life estates involves calculating the present value of the income stream generated during the life tenant’s expected lifespan. Actuarial tables are used to estimate the life expectancy of the life tenant.

• Valuation:

  • Estimate the annual income generated by the property (I).
  • Determine the life tenant’s life expectancy (LE) using actuarial tables.
  • Select an appropriate discount rate (r).
  • Calculate the present value of the income stream for the life expectancy period.
  • Calculate the present value of the reversion to the remainderman

  Equation (Simplified):
  ```
  Life Estate Value = I * PVAF(r, LE)

  Remainder Interest = Property Value - Life Estate Value
  ```

  Where:
  I = Annual Income
  PVAF(r,LE) = Present Value Annuity Factor for discount rate r and life expectancy LE.

  Note: More sophisticated valuations may involve using continuous compounding and actuarial present value factors.

Easements

An easement is an interest in real estate that transfers use, but not ownership, of a portion of an owner’s property. Easements usually permit a specific portion of a property to be used for identified purposes, such as access to an adjoining property or as the location of a certain underground utility. Although surface easements are the most common, subterranean and overhead easements are used for public utili- ties, fiber-optic cables, subways, and bridges. Other types of easements such as scenic easements and facade easements may prohibit the owner of the underlying fee simple estate from certain uses of the property without giving the holder of the ease- ment any possessory interest in the real estate.
Clearly a property that enjoys the benefit of an easement gains additional rights, while a property that is subject to an easement is burdened. The easement attaches to the property benefitted and is referred to as an easement appurtenant. The property that is benefitted by an appurtenant easement is known as the dominant tenement. The property that is subject to the easement is called the servient tenement.

Easement rights can be transferred in perpetuity or for a limited time period. An easement can be created in several ways:
* By a contract between private parties
* By prescription or implication
* By governmental entities or public utilities through the exercise of eminent domain

A conservation easement is a typical example of a contract between private parties, in which case a landowner enters into an agreement with a qualified conservation group that limits the future use of a portion of the owner’s property, often to ensure that some natural environment will not be developed. The property owner hands over certain specified rights of use and receives a tax deduction. In exchange, the con- servation group may or may not pay compensation (and offer ongoing property tax savings). An example of an easement created by prescription might be a right of ac- cess granted to the public who for many years have used a trail as a shortcut through a parcel of privately owned land. Public utilities often have certain limited powers of eminent domain that they may use to impose a temporary construction easement and an access easement on private property to install and maintain equipment such as a natural gas pipeline or electrical lines and towers.

An easement grants a specific right to use another person’s property for a particular purpose (e.g., access, utilities). The value of an easement is the difference between the value of the property with and without the easement. The property benefiting from the easement (dominant tenement) typically increases in value, while the property burdened by the easement (servient tenement) decreases.

• Valuation (Before-and-After Method):

  • Determine the market value of the servient property without the easement (Before Value - BV).
  • Determine the market value of the servient property with the easement in place (After Value - AV).
  • The value of the easement is the difference between the two: Easement Value = BV - AV.

  Example:
  A property owner grants a utility company an easement to run underground power lines across their land. The appraiser determines that the property would be worth $500,000 without the easement, but with the easement, it is worth $475,000.

  • Easement Value = $500,000 - $475,000 = $25,000

Other Legal Interests

Transferable Development Rights

Transferable development rights (TDRs)—sometimes referred to as severable use rights (SURs) and often associated with air rights—emerged in the real estate industry dur- ing the 1970s. A transferable development right is a development right that is separat- ed from a landowner’s bundle of rights and transferred, generally by sale, to another landowner in another location. Some TDRs preserve property uses for agricultural production, open space, or historic buildings. In this arrangement, a preservation, or sending, district and a development, or receiving, district are identified. Landowners in the preservation district are assigned development rights, which they cannot use to develop their own land but can sell to landowners in the development district. The landowners in the development district can use the transferred rights to build at high- er densities than zoning laws in the development district would normally permit. Another situation in which development rights are transferred results from the constrained capacity of an existing utility. For example, consider a community that decides to impose a construction moratorium pending the expansion of its present sewage plant or the building of a new plant. Before the moratorium, a landowner was granted the right to hook up 100 projected single-unit residences to the existing plant. A second landowner, however, did not obtain the right to link up 50 proposed single-unit residences to the sewage treatment plant and will have to wait for expan- sion of the plant’s capacity. The second landowner risks financial loss if that individ- ual cannot develop the land immediately, so the second landowner eagerly purchases the right to link up 50 residential units to the plant from the first landowner.

Although transferable development rights may vary from state to state, these rights are generally real property only as long as they are attached to the land. When they are sold, they become personal property, only becoming real property again when they are attached to another tract of land. TDRs can often be banked to facili- tate the timing of the transfer of rights.

TDRs allow landowners to sell unused development rights from one property (sending site) to another (receiving site), enabling higher-density development in the receiving site while preserving open space or historic buildings in the sending site. The value of TDRs is determined by supply and demand in the specific TDR market.

Physical Interests

Physical interests in real property can be separated either horizontally or vertically. The most common methods of creating horizontal divisions of real property are through subdivision and assemblage. In subdivision, a large tract of land is broken down into smaller units, which are then marketed individually. In assemblage, two or more parcels of real estate are combined into one parcel. When the value of the assembled parcel is greater than the sum of the values of the individual parcels, the incremental value created❓❓ by the assemblage is known as plottage value. Consider two adjacent, half-acre office sites in a central business district where one-acre sites are more desirable. The value of each half-acre site is $500,000, but when assembled the one-acre site has a value of $1,200,000. Conversely, when potential buyers prefer smaller sites, the unit values of larger sites will likely be lower.
The most common vertical interests in real property are (a) subsurface rights and (b) air rights. A subsurface right is the right to the use of and profits from the underground portion of a designated property. The term usually refers to the right to extract minerals from below

Subsurface Rights

Subsurface rights represent the ownership of minerals, oil, gas, and other resources beneath the surface of the land. Their valuation involves estimating the quantity and quality of the resources, projecting future production and prices, and discounting the expected cash flows to present value. Geostatistical methods are often used to estimate resource quantities.

Air Rights

Air rights are the rights to use the space above the surface of the land. They are often used for constructing buildings above existing structures, such as highways or railroads. Their value is influenced by zoning regulations, development potential, and the costs of constructing supporting structures.

Valuation Challenges and Considerations

Appraising less-than-fee-simple interests presents several challenges:

• Data Availability: Market data for partial interests may be limited, requiring appraisers to rely on more complex valuation techniques.
• Legal Complexity: Understanding the legal documents and regulations governing the interest is crucial.
• Highest and Best Use: Determining the highest and best use of the property, considering the limitations imposed by the partial interest, is critical.
• Discount Rate Selection: Selecting an appropriate discount rate that reflects the risk associated with the specific partial interest is essential.
• Impact of Market Conditions: Partial interests are particularly sensitive to changes in market conditions, such as interest rates, rental rates, and commodity prices.

Conclusion

Appraising less-than-fee-simple interests requires a thorough understanding of the various types of interests, their legal implications, and the appropriate valuation techniques. Appraisers must carefully analyze the specific characteristics of the interest, gather relevant market data, and apply sound judgment to arrive at a credible value opinion. The complexity of these assignments underscores the importance of expertise and attention to detail in real estate valuation.