Identifying and Valuing Real Property Interests

Chapter: Identifying and Valuing Real Property Interests

Introduction

Real property valuation requires a thorough understanding of the various interests that can exist within a single piece of land. The value of real property is directly tied to the specific rights associated with it. This chapter focuses on identifying and valuing these real property interests, providing a scientific perspective that incorporates relevant legal and economic principles.

1. Defining Real Property Interests

A real property interest is a right or claim enforceable by law that one party has in or over a parcel of real property. These interests can range from complete ownership to more limited rights. Understanding the different types of interests is crucial for accurate valuation.

• Estate vs. Interest: It is important to distinguish between an estate and an interest. An estate in land provides possession, either now or in the future, and specifies duration. An interest, on the other hand, is a right or claim without necessarily conveying possession or specifying a duration.

• Bundle of Rights: Real property ownership is often described as a “bundle of rights.” This bundle includes the rights to:

  1. Possess: Occupy and control the property.
  2. Use: Enjoy the property for any legal purpose.
  3. Transfer: Sell, lease, or otherwise convey the property.
  4. Encumber: Mortgage or otherwise use the property as collateral.
  5. Exclude: Prevent others from entering or using the property.

  The value of a real property interest is directly related to the extent of these rights included.

2. Fee Simple Estate

The fee simple estate represents the highest form of ownership in real property. It signifies absolute ownership, subject only to governmental powers.

• Definition: A fee simple estate is 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.
• Duration: A fee simple estate endures for an indefinite period, lasting until the current holder dies without heirs.
• Valuation Significance: The fee simple estate serves as a benchmark for valuing other property interests. The value of other interests can be determined by comparing their rights and limitations to those of a fee simple estate.
• Practical Application: While theoretically a fee simple estate is unencumbered, in practice, many properties have encumbrances like easements. Appraisers typically consider these encumbrances when valuing a fee simple estate. They are accounted for under the fee simple classification.
• Legal vs. Valuation Perspective: Legally, fee simple focuses on indefinite duration, while in valuation, the focus includes an assessment of encumbrances.

3. Partial Interests

Any interest or group of interests that constitutes less than the entire bundle of rights is considered a partial interest. These can be created economically, legally, physically, or financially.

3.1 Economic Interests: Leases

Leases create economic interests in real property. The lessor (landlord) and lessee (tenant) each hold partial interests defined by the lease agreement.

• Leasehold Estate: This is the tenant’s right to possess and use the property for a specified period. Its value is tied to the difference between contract rent and market rent.

  • Value Determination:

    $Value_{Leasehold} = PV(Market Rent - Contract Rent)$

    Where:

    • $PV$ is the present value operator.
    • Market Rent is the rent a property could command on the open market.
    • Contract Rent is the rent stipulated in the lease agreement.

  • If Market Rent > Contract Rent, the leasehold has positive value.

  • If Market Rent < Contract Rent, the leasehold has negative value.
  • Practical Example: A tenant has a lease requiring rent of $1,000/month. Market rent for similar properties is $1,500/month. The lease has five years remaining. The leasehold interest has value calculated as the present value of the $500/month savings over five years.

• Leased Fee Estate: This is the landlord’s interest, representing the right to receive rent and regain possession at the lease’s termination. The value of the leased fee is affected by the lease terms, especially the rental rate compared to the market rate.

  • Value Determination: The value of a Leased Fee estate ($V_{LF}$) can be calculated as the present value of the rental income stream plus the present value of the reversionary interest.

    $V_{LF} = PV(Rental Income) + PV(Reversionary Interest)$

    The reversionary interest represents the future value of the property when the lease ends. Its present value depends on the discount rate and the length of the lease term.

• sandwich leasehold❓❓ (Sublease): This arises when a tenant subleases the property. The original tenant becomes a sublessor, holding a sandwich leasehold interest between the landlord and the sublessee. Its value depends on the difference between the rent paid by the sublessee and the rent owed to the landlord.

  • Value Determination: The Sandwich Leasehold value ($V_{SL}$) can be defined as the difference between the income received from the sublessee ($I_{sublease}$) and the expenses of the underlying lease payment ($E_{underlying}$), discounted to its present value:
    $V_{SL} = PV(I_{sublease} - E_{underlying})$
  • Experiment: A developer leases land for 99 years and builds an office building. The developer then subleases office spaces. The developer’s leasehold interest is the Sandwich Leasehold.

3.2 Legal Interests: Easements, Life Estates, and TDRs

Legal instruments and regulations create partial interests like easements, life estates, and transferable development rights (TDRs).

• Life Estate: The right to use, occupy, and control a property for the lifetime of a designated person (life tenant). Upon their death, the property reverts to a remainder interest holder.

  • Valuation: Requires valuing both the life tenant’s interest and the remainder interest. This involves actuarial calculations and present value techniques.
    • Life Estate Value: $V_{LE} = PV(Expected Income Stream \ during \ Life \ Tenant’s \ Life)$
    • Remainder Interest Value: $V_{RI} = \frac{Future \ Value}{(1 + r)^n}$ where $n$ = number❓ of years until life tenant’s death, $r$ = discount rate.
  • Experiment: A mother grants her son a life estate to a property, with the remainder interest going to her granddaughter upon the son’s death. Calculate the values of both interests, given the property’s annual rental income, the son’s age, and a suitable discount rate.

• Easement: A right granted to a third party to use a portion of an owner’s property for a specific purpose (e.g., access, utilities). The property benefiting from the easement is the dominant tenement, while the property burdened is the servient tenement.

  • Valuation: The value of an easement is determined by the loss in value to the servient tenement (before and after valuation) or the increase in value to the dominant tenement.
    • $Value_{Easement} = Value_{Property \ Before \ Easement} - Value_{Property \ After \ Easement}$
  • Experiment: A utility company requires an easement to run a power line across a property. Determine the impact on the property’s value due to the easement by comparing the value of the property before and after the easement’s imposition.

• Transferable Development Rights (TDRs): Allow landowners to transfer development potential from one property (sending site) to another (receiving site). Often used for preservation of agricultural land or historic sites.

  • Valuation: The value of a TDR is determined by the demand for increased density in the receiving area, the zoning regulations, and the cost of developing at higher densities.
  • Formula: $Value_{TDR} = (Density_{Receiving Site, with TDR} - Density_{Receiving Site, without TDR}) * Value_{Additional Units}$
  • Experiment: A city allows the transfer of development rights from historic buildings to new development sites. Calculate the value of these rights based on the increased building height and density permitted in the receiving zone.

3.3 Physical Interests: Subsurface and Air Rights

Physical divisions of real property can create partial interests, particularly concerning subsurface and air rights.

• Subsurface Rights: The right to use and profit from the underground portion of a property, usually for mineral extraction or underground storage.

  • Valuation: The value depends on the quantity and quality of the resources, extraction costs, and market prices.
  • Formula: Present Value of Projected Cash Flow: $\sum_{t=1}^{n} \frac{Revenue_t - Cost_t}{(1 + r)^t}$ where r is the discount rate.
  • Experiment: Estimate the value of subsurface mineral rights on a property, considering the estimated mineral reserves, extraction costs, market prices, and a suitable discount rate.

• Air Rights: The right to use the space above a property. Increasingly valuable in dense urban areas for development purposes.

  • Valuation: The value depends on the potential uses of the air space, zoning regulations, and construction costs.
  • Formula: $Value_{Air Rights} = (Value_{Developed Property} - Value_{Underlying Property}) - Construction Costs$. This requires a hypothetical development scenario.
  • Experiment: Determine the value of air rights above an existing building, considering the potential for constructing additional floors, the zoning regulations, construction costs, and the value of comparable properties.

4. Identifying the Rights to Be Appraised

Accurately identifying the property rights❓ to be appraised is paramount. This requires:

1. Legal Due Diligence: Reviewing deeds, leases, easements, and other legal documents.
2. Physical Inspection: Assessing the physical characteristics of the property and any visible encumbrances.
3. Market Research: Understanding the local market conditions and how they affect the value of specific property interests.
4. Clear Communication: Communicating with the client to understand the purpose of the appraisal and the specific rights they want valued.

5. Valuation Methodologies for Partial Interests

Valuing partial interests requires specific methodologies tailored to the nature of the interest.

• Discounted Cash Flow (DCF) Analysis: Used to value income-producing interests like leaseholds and leased fees.
• Before and After Valuation: Used to value easements by assessing the impact on the servient tenement.
• Market Extraction: Analyzing sales of comparable properties with similar partial interests.
• Cost Approach: Applicable in valuing specialized partial interests where market data is scarce.

Conclusion

Understanding and accurately valuing real property interests is fundamental to sound real estate appraisal. This chapter has provided a detailed overview of the various types of interests, their characteristics, and the methodologies used to value them. By applying the scientific principles and practical examples outlined in this chapter, appraisers can ensure accurate and reliable valuations that reflect the true economic value of real property interests.