by David Keating, MAI
Published by the Appraisal Institute, 1998
Copyright © 2000 Property Valuation Advisors, Newburyport, MA
Having recently completed a two-day seminar on appraising partial interests, I found this book to be a good introductory manual. Although it does not have the depth one would get in two days in the classroom, it provides a good introduction for a small investment of time and money.
A partial interest is a division of the rights associated with owning or using real estate. Rights can be divided legally, economically, or physically. The book examines these divisions and methods to value them.
Often the bundle of property rights is depicted as a bundle of sticks. These sticks represent the sum of the real property rights associated with a parcel of real estate. This concept distinguishes the rights of ownership and use from the physical real estate.
Some rights are public and some are private. Public rights include eminent domain (the right to take a parcel for the public good with just compensation), and the right to tax the property. Private interests or rights consist of everything that is not a public right.
Private rights can be divided. For example, one right may represent the right to use the property, another the right to sell, and another the right to lease it, etc. A lease subdivides the property rights by conveying the right to use the property from the owner to the tenant.
Easements, such as utility line easements, are a legal division of rights. Also, an easement can encompass the entire property but only remove one right, such as a conservation easement in which the right to develop is removed. The rights given up and the rights remaining can be valued separately.
When sole ownership is divided, fractional interests are created. Each owner has less than 100% of the estate. Multiple ownership types include joint tenancy, tenancy by the entirety, and community property. Sub-forms of ownership divisions include condominiums, timeshares, REITs, and limited partnerships.
Some divisions result in majority and minority positions. Majority interests represent the controlling interests, while a minority interest typically has little control over managerial decisions.
Interests also can be divided physically, even vertically, as in the case of subsurface mineral rights or above-the-surface air rights.
The book includes 21 partial interest valuation problems. The first chapter discusses leased fee estates in which the rights of use and occupancy are transferred to the tenant. The owner enjoys compensation for giving up these rights as specified in an agreement or lease.
If the actual rent exceeds the market rent, the value of the leased fee estate is enhanced. The portion of rent above market is at greater risk than the portion up to the market level. If a tenant were not to meet lease obligations and the property were re-rented, the above-market portion of rent would cease. When capitalizing excess income a higher risk or discount rate is required. The increased proportion of excess rent, therefore, will not create a proportionate increase to the property value.
A leasehold estate is the interest held by the tenant for a stated term. If contract rent is below market rent a beneficial leasehold estate value is created, because the tenant theoretically could sublease the space at a profit.
A further level of complexity is a sandwich lease. This is a leasehold estate created by a sublease. Two tenants exist: the original tenant and the subtenant. The owner of the sandwich interest is the original tenant who transfers the right to use the space to another tenant. The original tenant is sandwiched between the owner and the sub-lessee.
Chapter Five examines the legal division of rights in the form of a life estate. One individual has the right to use the property for the duration of his/her life, while another owns the property. The property owner is termed the remainderman because the remaining rights (rights of future use and reversion) belong to the property owner upon the death of the life tenant.
To determine the value of a property encumbered by a life estate, 1) estimate the most likely time of death of the life tenant; 2) forecast the future value of the property; and 3) discount the future value to a present value. The author recommends the use of actuarial tables. Men versus women and even different races have different life expectancies.
The most subjective part of the process is estimating the value of the property in the future. Typically, one estimates the present value and then adjusts it for expected appreciation. Property in a declining area would have less appreciation and more risk than one in a growing neighborhood. Also the shorter the life expectancy, the lower the discount rate. This is similar to the rate differential one sees between short-term and long-term bonds.
To estimate the value of the life estate itself, one would discount the annual rental savings over the expected life of the occupant. The author provides comprehensive case studies.
Next, he examines conservation easements. These limit the future use of a property to preservation, conservation, or wildlife habitat.
...thus the term "less than fee"
Primarily, the public sector and environmental groups acquire these rights, because it is less expensive than 100% fee simple purchase of the land, thus the term "less than fee". A legal subdivision of rights conveys use, but not ownership. Rights are granted for payment or as a donation, but are not rented. Consequently, the underlying property owner is left with limited uses
According to the author, the most accurate way to value a conservation easement is to identify recent sales of similar easements. Beware of atypical motivations behind the sales you use, however. The best sales are private entities granting easement to other private sector entities, but these are rare. Therefore, a before and after analysis can be performed to value the rights acquired. The value is simply the difference between the before and after value. An accurate highest and best use assumption for the before and the after is necessary, however.
Here, the case studies are simple, and do not approach the complexity one typically finds in reality.
The form of ownership can create a division of interests. If multiple owners are involved, then each owns a fraction of the whole. Partnerships and REITs are examples of multiple owners of one or more properties.
A minority interest owner's share may be worth a smaller percentage of value than the percentage of ownership. Disagreements among owners can occur. One owner may want to sell or renovate, while another owner may not. Under certain situations, a partner can force another to sell, but this is costly.
When appraising a fractional ownership interest, therefore, recognize that it may sell at a discount to reflect lack of control, illiquidity, and delays and costs of selling a piece of it. Therefore, a 25% interest may not sell for 25% of the worth of the underlying real estate.
Legal cases exist to justify this concept and cases are cited. The discount should be based on the case and not on what a court found reasonable in another case involving different evidence. The discount is a function of the interest appraised, the property type, market conditions, and other factors. Typically, the burden of proof is on the appraiser.
First, estimate the value of the entire property as if under sole ownership. The most comparable partial interest sales are the best indicators to see if a discount is warranted. Examples highlight appropriate methods to estimate these discounts.
The book is a good overview into this often complex topic. Each topic is brief, yet clear and accurate. One criticism: because of the brevity of the chapters, they did not warrant chapter summaries. Still, despite its brevity, when solving partial interest valuation problems, the book will get you at least partially there.
The book above, Appraising Partial Interests, is available on-line at Amazon Books.
Stephen Traub, ASA, the reviewer, is chief commercial appraiser for Property Valuation Advisors, 63 Hill St., Newburyport, MA 01950. He is a certified general appraiser in NH, ME, and MA.
To contact the author of this review, e-mail to: firstname.lastname@example.org or contact him at the address above, or call 978-462-4347.
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