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Fee (Not So) Simple: Property Rights & Market Value

By:  Jack Pasternacki, CAE & Timothy Vergin, MAI

Presented: IAAO International Conference Sacramento, California

The concept of the fee simple estate is often referenced in matters of ad valorem taxation, especially in property tax appeals. The concept of a specified set of ownership rights described by the phrase fee simple is generally understood by trained valuation professionals as the full set of property rights. The general concept of the fee simple estate is a central component of appraisal and often the mandated market value for property tax purposes in some jurisdictions.  Transactional data from the commercial real estate marketplace is the foundation for valuation in mass appraisal, and it is with those transactions that the complexities of property rights issues for assessors and appraisers begin.  

This paper will review the definitions behind the concept of property rights, examine the connection to the theory of market value, and discuss applications within the three approaches to value. The recent publication of the Appraisal Institute’s The Appraisal of Real Estate, 14th Edition in 2013 gives fresh guidance on property rights and will be referred to as a helpful guide for seminar attendees in their day to day work.  The IAAO’s Property Assessment Valuation published in 2010 will also be referenced, as will the 2014-2015 USPAP for guidance on the issue.

Property Rights

A starting point in this discussion is the fundamental distinction between real estate, and real property in appraisal. The following definitions are stated in the 2012-2013 Uniform Standards of Professional Appraisal Practice(USPAP) promulgated by The Appraisal Foundation:

  • Real Estate: an identified parcel or tract of land including improvements, if any.
  • Real Property: the interests, benefits, and rights inherent in the ownership of real    estate.                      

Real estate represents the physical land and appurtenances, which are tangible and immobile. Real property represents the interests, benefits and rights inherent in real estate ownership.  An estate in real estate ownership is the degree, nature or extent of interest that a person has in it.

Appraisal literature refers to the analogy of real property ownership to a “bundle of sticks” in which each stick in the bundle represents a separate right or interest inherent in the ownership. The complete bundle of ownership rights and interests can include the following:

  • The right of possession (Ownership)
  • The right to sell an interest (Disposition)
  • The right to lease an interest
  • The right of control
  • The right to use the property (Enjoyment)
  • The right of exclusion

Thus, the most complete form of ownership is title in fee, which establishes an interest in real property known as fee simple interest. This 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. These public restrictions on ownership are known as the four powers of government.

Partial Interests in Real Property

Anything less than the fee simple interest is referred to as a partial interest or a fractional interest, which are “cut out” of the fee simple interest. These interests are discussed in Chapter 7 “Indentifying the Rights to be Appraised, The Appraisal of Real Estate, 14th Ed. Partial or fractional interests that can be created can include the following:

Economic Interests - The common example is a lease, which divides the fee simple interest between the lessor (leased fee interest) and the lessee (leasehold interest).  Additional economic interests would be sub-leasehold interests.

Legal Interests - Real property may be subject to legal interests such as easements, life estates, or transferable development rights.

Physical Interests - Examples of physical interests in real property include “horizontal” divisions of ownership such as subdivision or assemblage. “Vertical” divisions of ownership include subsurface rights and air rights.

Financial Interests - Equity and debt positions may create financial subdivisions of the fee simple, leased fee and leasehold estates.  Other financial interests include sale-leaseback, senior and subordinated debt, and equity syndication.

Thus the concept of a fee simple estate envisions complete property ownership rights with no divisions by any kind of possible interests- in other words, no leases, no mortgages, and no easements. In reality, very few properties would have this type of non-divided ownership interest, especially commercial properties whose very value is based on their income stream via leases. The concept of a pure fee simple estate, without any encumbrances, is something that rarely exists in the real marketplace due to all the typical encumbrances of real property; leases, easements, mortgages, etc.  Yet the concept of the fee simple estate dictates how appraisers analyze rents and how comparables are adjusted in a market value appraisal for that set of property rights, with often profound impact on the final value opined for the property. This creates a situation where the vast majority of comparables which form the basis for valuation are encumbered in a manner different that the fee simple estate that is the goal of many assessment jurisdictions.  

Economic Interests created by a Lease:

The most common economic interests created in commercial real property are created by a lease.

Leased Fee Interest

The right held by the lessor, or landlord, including the right of use and occupancy conveyed by lease to others.

Leasehold interest             

The right held by the lessee to use and occupy the real estate for a stated term and under the conditions specified in the lease.

Sub-leasehold interest

Created by an agreement in which the lessee in the prior lease conveys the right of use and occupancy of the property to another, the sub-lessee, for a specified period of time.

Identification of Property Rights in Appraisal

The description of property in an appraisal is a fundamental part of the appraisal process. It tells the intended user of the report what rights in the property are being appraised. USPAP Standards Rule 1-2 requires an appraiser to identify the real property interest to be valued and any known easements, restrictions, encumbrances, leases, reservations, covenants, contracts, declarations, special assessments, ordinances or other items of a similar nature. Depending on the property rights described in an appraisal assignment, the appraiser will consider any impact to value caused by such encumbrances.  An appraiser has to identify and value a variety of different rights regarding real property ownership, and analyze any effect such limitations of those rights have on the value of the property.

The Uniform Standards of Professional Appraisal Practice (USPAP) state that value and property rights must be defined and specified in the development of a real property appraisal as the following excerpt indicates:

  • USPAP- Standard 1-2- In developing a real property appraisal, an appraiser must:

(c) Identify the type and definition of value, and if the value opinion to be developed is market value, ascertain whether the value is to be the most probable price:

(i) in terms of cash

(ii) in terms equivalent to cash

(iii) if value opinion based on non-market financing or with unusual conditions/incentives, terms must be indentified and their contributions to or negative influence on value must be developed by analysis of relevant market data.

  • USPAP- Standard 1-2- In developing a real property appraisal, an appraiser must, (cont’d.):

(d) identify the effective date of appraisal

(e) identify characteristics of property relevant to the type and definition of value and intended use, inc.:

(i) location, physical legal and economic attributes;

(ii) the real property interest to be valued;

(iii) any personal property, fixtures, intangibles included;

(iv) any easements, restrictions, encumbrances, leases, covenants, contracts, special assessments, or other

Thus USPAP refers to a definition of value is linked to a specified set of property rights in appraisal.  For the purposes of appraisal, they are integrated concepts, as it would be impossible to define a type of market value for purposes of appraisal development without stating the real property interest to be valued.  This is also evident in the commons definitions of market value in the appraisal industry.

Definitions of Market Value

The use of the term “value” alone is usually not used by professional appraisers, as it can lead to misunderstanding as it is incomplete as to the type of value.  Typical definitions of market value in appraisals can vary, but often resemble the one stated in the Appraisal of Real Estate, 14th Edition;

The most probable price, as of a specified date, in cash, or in terms equivalent to cash, or in other precisely revealed terms, for which the specified property rights should sell after reasonable exposure in a competitive market under all conditions requisite to a fair sale, with the buyer and the seller each acting prudently, knowledgeably, and for self-interest, and assuming the neither is under undue duress.”  The Appraisal of Real Estate, 14th Ed., The Appraisal Institute, 2013.

USPAP also refers to a market value definition that includes property rights;

A type of value, stated as an opinion, that presumes the transfer of a property (i.e., a right of ownership or a bundle of such rights), as of a certain date, under specific conditions set forth in the definition of the term by the appraiser as applicable in an appraisal.” USPAP 2014-2015 Edition, The Appraisal Foundation.

This points to the important and direct link between the concept of “market value” and specified property rights.  It is the “transfer” (the hypothetical sale, the foundation of an opinion of value by an appraiser) where property rights intersect with the concept of market value, because every sale will have a transfer of some rights. So to appraise a subject property we hypothetically create the situation of a “transfer” or sale, and with that hypothetical sale we have to specify which set of property rights are transferred so that the type of value we are opining is clear. Accordingly, every sale comparable that has transferred did so with a specified set of property rights, and thus has to either match the property rights stated in the appraisal of the subject property or be adjusted appropriately.

Perhaps a healthy dose of practicality is needed in the day to day application of the valuation of the fee simple estate.  There is a disconnection with mass appraisal expediency, most probably from its genesis in residential mass appraisal methodology which lacks the property rights complexity of fractional interests created via a lease.  This methodology is based on the study of comparable sales and the resultant sales ratio analysis, but is complicated by the income-producing element so common in commercial real property.  Commercial real property is bought and sold every day based on the income approach, unlike residential. Many comparables are bought and sold on the leased-fee position of the landlord which triggers the need for various adjustments to sold properties.  The adjustment process is very much a non-standardized set of calculations which can be dependent on the training and experience of the appraiser. The private sector appraisal industry certainly differs on the process of adjustments for property rights, and the mass appraisal industry is no different.  The legacy methodologies of mass appraisal stem from the origins of residential appraisal which bypasses some of the complexities of commercial real estate.  Combine this legacy with the various relationships that occur in jurisdictions between oversight entities (such as Departments of Revenue, etc) and the various assessment authorities (State, County, Province, City, etc) and subjective property rights adjustments become difficult to administer. And this is before we get to the valuation appeal process (Tax Courts, Boards of Review, Tribunals, etc.) and the various governmental definitions of value for the purposes of property tax (fees simple, leased fee, various versions of “market value”, etc.) which may not be as straightforward as those found in a textbook.  A review of property rights issues that arise in the application of the three approaches to value can assist valuation professionals in accurate applications of appraisal methodology.

Sales Comparison Approach & Property Rights

In the sales comparison approach property rights may trigger the need for adjustment when sales comparables have a different set of property rights than the type of market value being developed for the subject property. According to the Appraisal of Real Estate, 14th Edition, adjustments in the sales comparison approach are divided into two types of adjustments; transactional adjustments having to do with the transfer, and property characteristics adjustments that focus on differences between properties. In the first set of adjustments, a specific sequence is suggested with property rights being the first adjustment made, as follows:

The Transactional Adjustments:

1. Real property rights conveyed

2. Financing terms

3. Conditions of sale

4. Expenditures made immediately after purchase

5. Market conditions

Remaining adjustments are referred to as the Property Adjustments:

6. Location

7. Physical Characteristics

8. Economic Characteristics

9. Legal Characteristics

10. Non-realty components of value

The adjustment methodology for rights transferred upon sale is not entirely consistent in general appraisal practice.  This topic is not completely covered in authoritative texts or courses in enough detail to handle all appraisal situations that arise in commercial property, and adjustments can differ from appraiser to appraiser.  Also, there are many, many types of appraisal assignments that do not put a focus on adjustments for property rights as a fee simple value may not be the main emphasis of the appraisal assignment.

An additional challenge for mass appraisal is that transactions in the jurisdiction’s ratio study may have included sales that transferred with various sets of property rights without the benefit of adjustment. Depending on the definition of value required in that jurisdiction for purposes of assessment, this may present a disconnection between the mass appraisal value and a single-property appraisal for tax appeal purposes.  Mass appraisal, in its attempt to follow current market trends for a very large number of properties, may include sold properties with a varying set of transferred property rights. Yet appraisal of a fee simple market value requires that adjustments be made:

“In a ratio study, market values are usually represented by individual market transactions or sales prices.  These prices may not reflect market value because the transactions may not meet the assumptions in the definition of market value. Actual prices should be adjusted for changing market conditions, financing, personal property, or other considerations.” Property Assessment Valuation, IAAO, 2010, Chapter 15, Mass Appraisal, page 430.

Thus it is the concept of market change that result in the need for adjustment to sales from a different market cycle, or with non-market elements when compared to the market for that type of property as of the appraisal or assessment date in question.

“Changing market conditions may reduce the validity or applicability of older sales that do not reflect the market’s changes.” The Appraisal of Real Estate, 14th Ed., Chapter 18: The Sales Comparison Approach, p. 382.

It is this concept of market change that drives the need for adjustment in a fee simple appraisal.

Adjustment Issues:

One method of adjustment for property rights that the textbook references is the capitalization of income differences.  This method is based on the capitalization of a difference in income to arrive at an adjustment amount.  The example on page 406 of the Appraisal of Real Estate, 14th Edition is of an office property comparable that sells as a leased fee interest, and needs adjustment to be applicable to the fee simple appraisal of the subject property.  The difference between market rent and contract rent in the comparable is $5 per SF on a net basis, and could be capitalized at an appropriate cap rate to come up with the adjustment. This type of example is often used in textbooks- a single tenant situation with a long term lease- as it lends itself to a readily understandable adjustment; the difference between market rent and contract rent is capitalized into the amount of the adjustment.  If the lease term is of more typical shorter duration, a present value calculation could be utilized so not to overstate the adjustment.

Chapter 20, Applications of the Sales Comparison Approach of the Appraisal of Real Estate, 14th Ed, includes an example of the adjustment for property rights in the appraisal of an industrial building on page 433.  The example includes present value calculations of rent differences between contract and market leases on leases with 7 and 10 years of remaining term at time of sale.  Adjustments for specific lease terms require knowledge of the various provisions of the leases at time of transfer, which may not be available to the assessment jurisdiction at time of sale, further complicating the mass appraisal situation.

Capitalization of rent differences may also be used to address physical characteristics of a building (i.e. lack of an elevator) or economic characteristics.  Care should be taken to avoid “double-counting” this type of adjustment. The term “multi-co-linearity” is used to describe the situation where an adjustment for one factor is duplicative or related to the adjustment for another factor. An example would be a property rights adjustment made for non-market rent, with an adjustment for economic characteristics of a property that could also be based on rent levels, potentially resulting in a “double counting”.  Another example would be an adjustment for market conditions, say a deflation of real estate prices caused by a recession, which also causes reductions in rents and increases in vacancy.  Appraisers should take care to keep the adjustments separate and accurate.   

One of the challenges in mass appraisal is that tax appeal timelines often create retrospective appraisal situations where multiple adjustments may be appropriate to a comparable that sold some years before the assessment date in question. Of the transactional adjustments, some would be viewed in the context of the transaction date (property rights conveyed, financing terms, conditions of sale, expenditures made immediately after purchase), while the adjustment for market conditions would imply that the comparable property is being used in an appraisal report that is distant in time from the sale.  

Income Approach & Property Rights

Most practitioners in the valuation industry are in relative agreement that a fee simple valuation is based on market rent, as stated in appraisal literature.  Furthermore, market occupancy is often utilized, as the amount of market rent an owner could receive would be tempered by market occupancy.  Fee Simple valuation requires the appraiser to estimate market rent for the property to be applied in the income approach.

“When the fee simple interest is valued, the presumption is that the property is available to be leased at market rates….A lease never increases the market value of real property rights to the fee simple estate.  Any potential value increment in excess of a fee simple estate is attributable to the particular lease contract”.  The Appraisal of Real Estate, 14th Ed., Chapter 21: The Income Capitalization Approach, p. 441

“To a certain extent, the interest being appraised determines how rents are analyzed and estimated.  The valuation of fee simple interests in income-producing real estate is based on the market rent the property is capable of generating.  The Appraisal of Real Estate, 14th Ed., Chapter 21: Income and Expense Analysis, p. 467

In fee simple valuation disagreements can certainly arise on what are market rents, appropriate market vacancy rates and market capitalization rates to be applied to the subject income stream. However, these inputs may come from the information observed in the market, so in theory they originate at least in part from the sales comparison approach.  There are perhaps more areas of disagreement on the market data derived from sold properties that on the application of the data to arrive at a fee simple value for the subject property. In mass appraisal, the sale ratio is a central focus, so it is understandable that the sales prices of sold properties are perhaps the attribute that receives the most weight in setting an assessment. But a focus on transactional sale prices can limit consideration of adjustments that are needed, and may lead to inaccurate indications of value in times of significant market change.  Leased fee transactions may be based on contractual rent and occupancy from a different market cycle, and thus may need adjustment to current market levels as of the date of appraisal.

“Leases negotiated several years earlier may not accurately reflect current prevailing conditions, and the rents paid may not be indicative of current market rent.”  Property Assessment Valuation, IAAO, 2010, Chapter 12, The Income Approach: Income and Expense Analysis, page 321.

The concept of applying an estimate of current market rent to a subject property is neither difficult nor disputed in appraisal methodology.  However, the process of estimating current market in times of changing market conditions can be complicated by many factors. Assessors need access to detailed lease and sale information to understand changing rents, sales motivations and cap rates derived from market activity, and that information may not be forthcoming in a timely manner relative to assessment deadlines.  Published asking rents may be an inaccurate reflection of achievable market rent in times of market downturns, and information from published sources can lag the actual market cycle. Concessions and tenant improvement provisions may impact market rents and this information may not be available until complete lease details are available to be examined.

“Concessions are provided by landlords when demand is weak and there is increased competition among landlords to attract new tenants. It is not unusual for free rent concessions to be given outside of the lease term so that the concessions do not appear on the written lease contract.  In these situations appraisers must still consider the lease concessions when calculating the effective rent being paid.  Concessions together with tenant installation allowances influence market rent estimates.” The Appraisal of Real Estate, 14th Ed., Chapter 21: Income and Expense Analysis, p. 471

Capitalization rates are derived from leased fee sales in the market and used in the fee simple valuation of the subject property.  If contractual rent levels in the sold property are not at market rent, then the capitalization rate may not be applicable to a fee simple value of a subject property.

“If the objective of the appraisal is to value the fee simple interest, income streams for the comparable properties must be at or around the level of market rent, or adjustments will be necessary.” The Appraisal of Real Estate, 14th Ed., Chapter 23: Direct Capitalization, p. 493.

Again, detailed information on leases, future rollover of tenants, credit worthiness of tenants, buyer & seller motivations, as well as other specific information is important in understanding if the resultant capitalization rate is appropriate to be used in the fee simple valuation of the subject property.  The IAAO’s textbook Property Assessment Valuation has a fairly extensive discussion regarding the derivation of overall capitalization rates from market sale transactions, and is referenced as follows;

“To derive an overall capitalization rate (Ro) from market sales transactions for use in direct capitalization, the sales transactions must be highly comparable to the subject property.  The disadvantage of using direct capitalization is that frequently the necessary data on comparability of properties are not available. If any significant adjustments must be made, then the technique becomes inapplicable.  The requirements for comparability are as follows:

  • Comparable types of property, with the same remaining economic lives, operating expense ratios, physical condition, and ratios of land-to-improvements as proportions of total property value.
  • Comparable income streams with the same characteristics of risk, timing, stability, and income projection pattern.
  • Comparable terms of sale and types of financing
  • Comparable type of buyers with buying motivations the same as those of the most probable buyer.
  • Comparable market conditions at the time of sale and the time of appraisal.

Unless these conditions can be met, the overall capitalization rate cannot correctly be estimated directly from market sales transactions.”  Property Assessment Valuation, IAAO, 2010, Chapter 13, The Income Approach: Capitalization Formulas and Rates, page 348.

The overall investment profile of a leased fee transaction may not be reflective of current market conditions if significant market change is occurring or if the transaction has non-market attributes.  Such issues as 100% occupancy via a long term lease by a credit tenant can represent an investment which can result in cap rates which may not be indicative of current market rents, occupancy and risk.

“The overall level of risk associated with each comparable should be similar to that of the subject property. Risk can be analyzed by investigating the credit rating of the property’s tenants, market conditions for the particular property, the stability of the property’s income stream, the level of investment in the property by the tenant, the property’s net income ratio, and the property’s upside or downside potential.” The Appraisal of Real Estate, 14th Ed., Chapter 23: Direct Capitalization, p. 493.

Often times direct capitalization rate derived from a sale are hard to find, and it is difficult to find those that are a perfect fit for a fee simple investment. In times of market downturns, leased fee investments with low risk may attract very low cap rates that may not be applicable to a fee simple valuation with market rent and market occupancy.  

The Cost Approach & Property Rights

The cost approach to value is where the appraiser compares the costs of the subject improvements with the cost to develop similar improvements with similar utility. The development cost estimate is then adjusted for market extracted losses in value due to the various types of depreciation.  The term “cost” is either a fact, or an estimate of a fact.

“The term cost is used by appraisers in relation to production, not exchange. Costs may be either an accomplished fact or an estimate.” The Appraisal of Real Estate, 14th Ed., Chapter 3: The Nature of Value, p. 26

Depreciation falls into the three general categories of physical depreciation, functional obsolescence and external (economic) obsolescence.  It is perhaps this last form of depreciation that is so crucial in times of dramatic market change, and is the link between the cost approach and the indications of the income and the sales comparison approaches. The irony of the cost approach is that it relies on a depreciation estimate that is extracted from the market in the other two approaches, yet it is often used to value properties when very limited sales or income market data is available.  This approach can be less reliable in times of significant market change with limited market sales and income data to assist in the calculation of depreciation.

The facts of actual development costs of a project do not result in a value without market derived deductions for the various types of depreciation.  These adjustments are often complex and subjective, yet are essential to reliability the approach.

“The usefulness of cost as a representation of value must be kept in its proper context.  The assessor/appraiser should remember that the objective is market value, not cost.  Cost estimating is not appraising; it is only one step in the appraisal process.  Appraising is an orderly and disciplined method of estimating the most probable selling price of a property.  Cost estimation, although it states the development cost of a new property, does not indicate the ultimate value of a property.  Other factors (general economy, market, supply and demand, and location) influence value and must be accounted for…”  Property Assessment Valuation, IAAO, 2010, Chapter 10, The Cost Approach to Value: Cost Estimation, page 238.

In appraisal methodology the cost approach is often stated to result in an indication of the fee simple interest.  At first glance, the cost approach seems to be the most straightforward of the three approaches as they relate to a fee simple value conclusion.  Simply value the land, and add the depreciated cost of the buildings and site improvements.

“Typically the cost approach provides an indication of the value of the fee simple interest.  The value indicated may need to be adjusted accordingly if a leased fee or other partial interest is being valued.” The Appraisal of Real Estate, 14th Ed., Chapter 4, The Valuation Process, p. 47.

Property rights are mentioned here primarily in regard to a partial interest being valued, since it is stated that the cost approach typically results in fee simple value so a property rights adjustment is applicable to adjust the fee simple indication if the assignment is a leased fee estate:

“If the purpose of the appraisal is to estimate the value of an interest other than fee simple, an adjustment will be required.  For example, a property rights adjustment could be made as a lump-sum adjustment at the end of the cost approach.  This would be particularly important when the interest appraised is the leased fee encumbered by a long-term lease.” The Appraisal of Real Estate, 14th Ed., Chapter 27: The Cost Approach, p. 562.

However, the cost approach is linked to feasibility, and when the interest appraised is fee simple and the other approaches to value are coming significantly lower, then project feasibility may come into question. In times of market change, the development timeline may result in a project nearing completion in a market very different that when it was originally conceived.   

“A higher value indication from the application of the cost approach than from the sale comparison or income capitalization approaches may suggest that the real estate development is not economically feasible.” The Appraisal of Real Estate, 14th Ed., Chapter 27: The Cost Approach, p. 567

The issue of project financial feasibility is tied to the highest and best use analysis, and appraisers should check to see that indications of the various approaches are consistent with that analysis.  The cost approach is dependent on accurate deprecation estimates, and in times of changing market conditions the calculation of depreciation (including external obsolescence) is crucial.

“In the income and sales comparison approaches external obsolescence is self-measured; for example, the income stream would be reduced for depreciation that is evident in the subject property. Likewise, the sale price of a property would reflect the loss in value to depreciation”.  Property Assessment Valuation, IAAO, 2010, Chapter 10, The Cost Approach to Value: Cost Estimation, page 228.

Appraisers should remember that a project is financially feasible when market value exceeds the total developmental and building costs plus a market-supported entrepreneurial incentive.  If either the income approach or the sale comparison approach is suggesting a market value that would not satisfy development costs, the feasibility of the development could be questioned, as well as the reliability of the approach.


Market value is always linked to specified property rights, and if the fee simple interest is being appraised it may require adjustments and considerations within the three approaches to value. Whether the assignment is mass appraisal or single-property appraisal, a review of the definitional foundations of market value and property rights is a solid starting point that can assist in the development of accurate valuations in today’s complex commercial marketplace.

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