Below-Market Leases in a Fee Simple Assessment Appeal
An appraiser is engaged by a county assessor to value the fee simple interest in a 12-unit apartment building for the 2025 assessment roll. Eight units rent for $1,450 per month; four units are under five-year leases signed in 2022 at $1,100 per month. Market rent for every unit is $1,450. Vacancy and collection loss is 5%, operating expenses are 35% of effective gross income, and the market capitalization rate is 6.25%. Three recent sales of unencumbered apartment buildings indicate values from $2.02 million to $2.14 million. The owner argues that the below-market leases reduce the property's value and should be deducted. The assessor's guidelines require fee simple valuation and state that below-market leases are not deducted unless they run with the land. The appraiser must decide the value to report and explain the treatment of the leases.
1. Which value interest is the appraiser engaged to appraise, and how should the four below-market leases be treated under the assessor's guidelines? Distinguish leased fee from fee simple.
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The engagement is for the fee simple interest, which assumes ownership of the entire bundle of rights and typical market rent, not the actual contract rents. A leased fee interest is the owner's interest encumbered by leases; its value reflects contract rent and lease terms.
Under the assessor's guideline, a below-market lease is deducted only if it runs with the land-for example, through a recorded covenant or an assignment that binds successors. Here the leases appear to be personal obligations of the owner. The appraiser should therefore value the property as if all 12 units were at market rent, disclose the four leases as an encumbrance, and note that a leased-fee analysis would produce a lower value.
2. Calculate the indicated value by the income approach for both the leased fee and fee simple interests. Show effective gross income, operating expenses, net operating income, and capitalization.
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Leased fee (contract rent):
- Potential gross income = (8 × $1,450 × 12) + (4 × $1,100 × 12) = $139,200 + $52,800 = $192,000
- Vacancy and collection loss = 5% × $192,000 = $9,600
- Effective gross income = $182,400
- Operating expenses = 35% × $182,400 = $63,840
- Net operating income = $118,560
- Value = $118,560 ÷ 0.0625 = $1,896,960
Fee simple (market rent):
- Potential gross income = 12 × $1,450 × 12 = $208,800
- Vacancy and collection loss = 5% × $208,800 = $10,440
- Effective gross income = $198,360
- Operating expenses = 35% × $198,360 = $69,426
- Net operating income = $128,934
- Value = $128,934 ÷ 0.0625 = $2,062,944
The difference of about $165,984 is the lease encumbrance.
3. Reconcile the income indications with the sales range. What value should the appraiser report, and what disclosures and adjustments are needed?
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The fee simple indication of about $2.06 million falls inside the $2.02 million–$2.14 million sales range. The leased fee indication of about $1.90 million is below that range, which is expected because the comparables were unencumbered.
The appraiser should report the fee simple value at about $2.06 million, rounded. The report should disclose that four units have below-market leases, that the assessor's guideline excludes them from fee simple value, and that a leased fee analysis would indicate about $1.90 million.
If the comparables differed in unit mix, condition, or lease status, adjust them. Do not subtract the lease difference from the fee simple conclusion; doing so would double-count the encumbrance and conflict with the stated interest.