A Professional Courtesy of:
Mark T. Kenney, MAI, SRPA, MBA
American Valuation Group, Inc.
207 Abbey Lane
Lansdale, Pennsylvania 19446
5201 Ocean Avenue #2007
Wildwood, New Jersey 08260
Specializing in Real Estate Appraisal and Property Tax Consulting


In This Issue:

  • Leasehold Valuation
  • Appraisal Reporting Options
  • Functional Obsolescence
  • Principle of Substitution

  • Leasehold Valuation

    A leasehold interest is created when a lease agreement is executed between lessor and lessee. A leasehold is "the interest held by the lessee (the tenant or renter) through a lease conveying the rights of use and occupancy for a stated term under certain conditions" (The Appraisal of Real Estate, 12th Edition).

    Unlike leased fee or fee simple interests, leasehold interests terminate upon the expiration of the lease and thus have no reversionary value. Leaseholds may have market value (value to persons or entities other than the lessee). The primary determinants of leasehold value are

    • Remaining term;
    • Transferability (or lack of same); and
    • Degree to which lease rate is below market rent.
    The remaining term is of obvious importance, because the benefits of below-market contract rent are limited to such a period. The longer the remaining term, the greater the market value of the leasehold, all factors being equal. The reverse is, of course, also true.

    Most leases contain sections dealing with the issue of transferability. In some cases, the tenant retains the right to transfer without limitation. In many others, the lessor retains the right to approve any such transfer or to restrict transfer in any event. Such language is often negotiated prior to execution. The relative strength of market conditions influence the outcome of such negotiations. During weak market dynamics, tenants are better positioned to obtain the right to transfer their leasehold interests than if the opposite were true. Lessors obviously wish to take advantage of rising rental rates, rather than allow tenants to reap such benefits, and they are positioned to do so if they have the right to approve or reject such transfers.

    The valuation of leasehold interests is nearly always based upon the income capitalization approach. The sales comparison approach is rarely applicable due to the dearth of sales of similar leasehold interests. Similarly, the cost approach is not useful in such valuations.

    Leasehold valuation requires careful consideration of the specific terms of the lease, most importantly the remaining term and the magnitude of the differential between market and contract rent. Leasehold interests are generally regarded as riskier than leased fee positions. Since value arises from the aforementioned rental differential, small changes in market rent may have an inordinately large effect on the value of the leasehold, similar to the effect of leverage. Accordingly, yield rates for leasehold valuation are typically higher than those for the leased fee interest in the same property.

    Many times the lessee will remain responsible for the rent due over the remaining term of the lease. In such cases, the credit worthiness of the sub-lessee is of considerable importance to the lessee. When the lessee subleases the premises, a "sandwich lease" is created, whereby the lessee becomes the lessor to the sublease.

    Professional real estate appraisers are often relied upon to analyze and quantify leasehold interests.

    Appraisal Reporting Options

    Real estate appraisers communicate assignment results (descriptive information, analyses, opinions and conclusions) in the form of appraisal reports. The essential content of such reports is governed by the Uniform Standards of Professional Appraisal Practice (USPAP). All state-certified appraisers are required to comply with USPAP.

    USPAP specifies three different reporting options: self-contained, summary and restricted use reports. Regardless of the reporting options used, USPAP requires that all reports

    • "clearly and accurately set forth the appraisal in a manner that will not be misleading;
    • "contain sufficient information to enable the intended users of the appraisal to understand the report properly; and
    • "clearly and accurately disclose all assumptions, extraordinary assumptions, hypothetical conditions and limiting conditions used in the assignment."
    The choice of reporting option is dictated by the intended user(s) and the intended use of the report. The primary concern is the degree to which the user(s) is familiar with the property that is the subject of the report.

    Self-contained reports are the most comprehensive of the three options, having the greatest amount and level of information. Such reports are utilized when the user(s) includes parties who are not the client.

    Summary reports are also used when intended users are those other than the client. While not as detailed as self-contained reports, summary reports nonetheless have a considerable amount of information and analyses.

    Restricted use reports are permitted only when the intended user is the client and the client is familiar with the property. The content of restricted reports is typically quite limited. It is most important that the appraiser determine in advance what the client's knowledge of the property is and what the report will be used for. By doing so, misunderstandings will be avoided.

    Clients sometimes ask that appraisers provide "just a letter appraisal," stating that they do not need a lengthy report. The appraiser cannot accommodate such requests, given the strictures of USPAP. Rather, the above-described report types are the only options available.

    Appraisers are often asked to provide updates of prior appraisals. Such requests constitute a new assignment, even though the appraiser had prepared the prior valuation. The content of such an update does not have to be in the same type of report as the prior version. It can be in the form of any of the three reporting options but must "contain sufficient information to be meaningful and not misleading to the intended users."

    In short, the choice of reporting option is dictated by the user's level of understanding of the property and by the intended use of the report. Avoiding confusion and misleading content is of paramount importance.

    Functional Obsolescence

    Depreciation is "the difference between the market value of an improvement and its reproduction or replacement cost at the time of the appraisal. The depreciated cost of the improvement can be considered an indication of the improvement's contribution to the property's market value" (The Appraisal of Real Estate, 12th Edition).

    Functional obsolescence is distinctly different from depreciation, as reflected in cost-based financial statements. Within the overall category of depreciation, there are three sub-categories: physical deterioration, functional obsolescence and external obsolescence.

    The following addresses functional obsolescence, defined by the above source as "a flaw in the structure, materials, or design that diminishes the function, utility, and value of the improvement." Functional obsolescence is intrinsic to the property (as distinguished from external obsolescence, which is extrinsic to the property). The definition of functional obsolescence also applies to improvements. Land does not become obsolete, although its value may rise or fall due to many factors.

    Functional obsolescence may be either curable or incurable. In the case of the former, the cost to cure will result in a value increase equal to or greater than said cost. Incurable obsolescence cannot be economically cured. Further, this type of obsolescence may be due to a deficiency or a superadequacy.

    Functional obsolescence is best described by type of property. Examples of functional obsolescence in office buildings are as follows:

    • Poor energy efficiency;
    • Inefficient floor plans (low ratio of usable area);
    • Inadequate parking; and
    • Inadequate number of elevators.
    Examples in shopping centers are:

    • High maintenance finish materials;
    • Dated design and appearance;
    • Inappropriate bay depths; and
    • Shortage of on-site parking.
    Functional obsolescence in industrial improvements includes:

    • Inadequate loading docks;
    • Limited clear height;
    • Lack of adequate electrical power; and
    • Limited size of truck courts.
    Functional obsolescence may thus take the following forms:

    1 Curable:
        Deficiency requiring an addition; deficiency requiring substitution or modernization; or superadequacy.

    2 Incurable:
        Deficiency or superadequacy.

    The quantification of functional obsolescence is beyond the scope of this article. The specifics of a particular improvement dictate the proper treatment of the obsolescence. Nonetheless, the model for addressing functional obsolescence (per the above-cited source) involves the following:

    • Identify the problem;
    • Identify the component(s) in the facility or lack of component(s);
    • Identify possible corrective measure(s) and the related cost to cure;
    • Select the most appropriate corrective measure;
    • Quantify the loss caused by the functional problem, which results in added value if the problem is corrected;
    • Determine if the item is curable or incurable. (If the value added is greater than the cost to cure, the functional problem is curable.); and
    • Apply the functional obsolescence procedure.
    The proper treatment of this form of obsolescence is important to the accuracy of the resulting value opinions.

    Principle of Substitution

    The principle of substitution is both basic and extremely important in real estate valuation. The term is defined as, "The appraisal principle that states that when several similar or commensurate commodities, goods, or services are available, the one with the lowest price will attract the greatest demand and widest distribution. This is the primary principle upon which the cost and sales comparison approaches are based" (The Appraisal of Real Estate, 12th Edition).

    The principle is intuitively valid, given that real estate buyers in most instances have various options. For example, an investor may purchase an existing property or construct a new building. The option to purchase an existing building will likely involve several alternative properties. Assuming that all such properties offer equally desirable qualities, that which is available at the lowest price will, in all probability, be selected. Construction of a new building represents another alternative, assuming no inordinate delay.

    In all cases, the principle of substitution is based upon the rationality of the decision-makers, as well as the assumption that no undue delay is involved in achieving successful outcomes. The principle of substitution also applies to market rent estimation. Specifically, a rational lessee would not pay a greater rental rate than that available for equally desirable alternative space.

    The elements considered in evaluating alternatives are numerous. They include use, design and appeal, quality and condition, location, availability and cost of parking, among others. For investors, the essential concern is the relationship between returns and risk among alternative properties.

    From the foregoing, it should be apparent that the principle of substitution permeates many aspects of the real estate decision-making process. To be sure, there are instances whereby either the specific needs of the investor/occupant or the characteristics of a property are so unusual as to be "unique," i.e., for which equally desirable alternatives do not exist. In such cases, the role of this principle is likely to be minimized.

    Investors utilize this principle in evaluating the share prices of publicly traded real estate investment trusts (REITs). If the aggregate value of REIT shares significantly exceeds the aggregate value of the underlying real estate assets, one would anticipate a correction in share prices. Alternatively, if share prices in the aggregate are materially less than the value of owned real estate, an increase in share prices may be likely. The decisions of value-driven investors are frequently based upon such relationships.

    The principle of substitution is of prime significance. For the real estate valuation professional, this principle is implicit in the proper application of all three approaches to value.

    Next Issue:

  • Market value in the absence of buyers
  • Treatment of concessions and inducements
  • Sources of market data
  • Liquidation and "go dark" values

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