You Can’t Just Tell an Appraiser to Find The Fair Market Rental Value

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In a lot of deals, especially for long term leases, rent will be reset to “Fair Market Rent.” Following the convention, we’ll call that FMR. This could happen at renewal time or, typically with a long-term ground lease, every 10 or 20 years. Rightly concerned that crystal balls aren’t very good at knowing what the market will look like 10 years or more down the road, landlords and tenants, each for their own reason, often resort to resetting what would otherwise have been a continuation of some stream of fixed annual rent increases, say 3% a year or 10% every 5 years (yes, those aren’t the same increases). Effectively, the lease would say (and we paraphrase, not suggest usable lease language): “on the 10th (or 15th or 20th or 25th, etc.) anniversary of the Rent Commencement Date, Base Rent shall change to FMR. If by the 180th day before that anniversary, the parties have not agreed as to such a FMR, then each party shall designate a Qualified Appraiser, who shall [opine as to FMR]. If they don’t agree, then they shall jointly choose a third Qualified Appraiser… .”

In the made up example above, the parties recognized that not all appraisers are created equal, so they will call for certain levels of experience, accreditation, geographic familiarity, and similar things. We’ve all seen that. But, how often do we see a lease giving the appraisers any guidelines for their assignment? After the following simple, but classic, example we’ll start a list and invite Ruminations readers to nominate additional appraisal factors or to comment on those already listed or even to challenge the whole darn concept.

Let’s say a tenant leases two entire, absolutely empty floors in an office tower and installs its own elaborate offices with rare wood flooring, comprehensive communications wiring, movable walls, deluxe rest rooms, and to top it off, a truly breathtaking spiral staircase to connect the floors. That’s right. The landlord did nothing other than to turn the space over in less than “vanilla box” condition. The initial rent was a tightly negotiated fixed sum for two “fresh canvases (floors)” in the building. Commensurate with the initial first class, perhaps deluxe, fit-up, the tenant, still using to use its own money, continues to maintain and even upgrade its offices. Now, 20 years later, the lease calls for the rent to be reset to FMR. The parties can’t agree on that figure, so it gets tossed to the appraisers, only instructing them to find the FMR for the premises. Essentially, “how much would an unrelated party pay to lease these premises?” Obviously, an unrelated party would be leasing two floors of absolutely beautiful, offices in pristine condition. And, if a new tenant were really going to take the space, it certainly would expect to pay for such offices. But, what should the existing tenant pay? So, looming above all other questions would be: do you price the space for the continuing tenant “fully outfitted” just as you see it, or as if they were “gutted,” just as they were when first leased by the existing tenant? Big difference, don’t you think?

At the end of this posting, we’ll point you to a real situation involving a ground lease where the tenant added its own building, as described in an unpublished U.S. District Court decision in New Jersey.

So, what are the kinds of factors that a lease or other real estate contract might consider including in its “instructions” to appraisers? Here’s the start of a list. Should the appraisal be affected by:

● the improvements made by the tenant at the tenant’s expense (and what about any reimbursement the tenant received by way of a construction allowance)? Keep in mind that if the tenant left the space, the next tenant would be leasing fully built out space.

● the fact that the tenant is already a tenant of the premises? Should the FMR be determined as if the space were empty? For example, what if the tenant is a retailer whose very presence at the property brings enhanced consumer traffic and thus raises the value of the space at the shopping center? Should that tenant pay “enhanced” rent based on the very traffic that it, itself, brings?

● the base year(s) used in this lease?

● any allowances in the marketplace being given to new tenants on account of tenant improvements, rent concessions, moving allowances, existing lease buy-outs, and concessions?

● the presence of “special” features of the existing lease, such as its exclusive use provisions which might be of no value to anyone other than the existing tenant?

● whether brokerage fees are payable in connection with the lease in question or the “comparable” lease?

● whether parking privileges are factored into the lease or are outside of the lease? See this case: a Summary or the Actual Opinion.

● measured by recent history within the same project or in a broader area (and, if so, what geographic area)?

● creditworthiness of tenant compared to “average” tenant?

● for a ground lease, should the FMR (ground rent) be based on the land encumbered by the very building sitting there or should it be based on the highest and best development value? If you hadn’t thought about that, take a look at this recent, unpublished court decision: Summary – or the Actual Opinion .

So, it’s not so simple. Yet, most of the leases we see just blow right past the question. Do yours? If you don’t deal with this issue at the outset, you may face a big surprise when the “numbers” come back or even when you find yourself in unwanted litigation and exposed to an even bigger surprise.


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