My late partner Michael “Mad Dog” Cannon used to preach what he called “the law of real estate appraisal.” Mad Dog used to say “Real estate appraisers don’t appraise real estate, we appraise real property interests.”
The idea that appraisers are not appraising the physical real estate flies in the face of convention, because many real estate appraisers spend a lot of time measuring and quantifying the physical aspects of the real estate, the size of the land, the size, age, and the quality of the physical buildings. Even experienced real estate owners think that real estate is made up of land and buildings. We tend to think of real estate as a physical asset, which it is in fact.
But the legal ownership of real estate conveys six principal rights, which we call the bundle of rights. The right to sell, lease, occupy, mortgage, devise (transfer by will upon death), and subdivide form the six principal rights. Property interests are called estates, and when you retain all of the unencumbered rights to exercise any or all of the six basic rights, you hold a property interest known as the fee simple estate. That is why we call it “Real estate” — it is your interest (estate) in physical (real) property.
When you lease the real estate to another entity, you have traded your right of occupancy (possessory estate) and conveyed by lease the rights to occupy to someone else. Owners of real estate that is leased own a leased fee estate (the fee simple estate is subject to leases, i.e., the rights of others to occupy). If you are the Tenant, you hold what is known as a leasehold estate because you “hold” the exclusive rights of occupancy by lease.
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When you place a mortgage on the property, you encumber your estate in realty offering it as collateral to repay a note. Your estate does not change, but whatever estate you hold is referred to as “encumbered” by the mortgage.
So when you buy a house with financing, you hold the fee simple estate subject to the mortgage. The mortgage note is recorded to evidence its claim against your property rights; it is an encumbrance to property title, and title cannot be sold (or devised-gifted-willed) until the mortgage is satisfied, and the property title is released. Most mortgages will also restrict your ability to subdivide until the mortgage is paid off.
But by far, the most interesting of all the six fundamental rights in real property is the right to subdivide.
Many think of subdivision in a conventional sense where one takes a large tract of land, and subdivides it into smaller lots. But there are other forms of subdivision as well.
For example, a condominium building is a vertical subdivision of the building (not the land), and the land in fact is not subdivided, but rather owned in common ownership pro-rata among all of the condominium unit owners.
You can also subdivide your ownership in the property by ownership applying different percentage ownership of the real property, or its component parts. You can transfer (sell) 50 percent of the property to your sister, or you can hold 100 percent of the title, but convey the right to occupy the property to your mom for the duration of her life (known as a Life Estate).
The creation of a lease is also a form of subdivision, but in this case you are subdividing the right of occupancy (conveyed to another by lease) from the right to sell, mortgage, or gift. You still retain all of these other property rights, subject to the rights of the leaseholder to occupy during the term of the lease.
So why does your estate in real property matter? When you are seeking to understand the value of real property (in exchange), the rights you hold represent the interest you are valuing.
Let’s take a fairly common example in South Florida.
In the 1950s, your grandfather owned a parcel of real estate and entered into a 99-year land lease with a developer, who constructed a little retail building and sub-leased the building to a shoe store (sub-leaseholder). Your grandfather was smart, and got paid top dollar on the ground lease, receiving $10,000 per year for property he bought in 1947 for $50,000. Grandma was very happy with this arrangement.
However, grandpa didn’t count on real estate appreciating so quickly, and never built into the lease a re-valuation clause to occasionally reset the rent based on updated real estate values. So today, in 2017, you are still collecting $10,000 per year, but now your little retail property on Lincoln Road is worth $10 Million (even without the building).
The problem is, investors will generally not pay $10 million for the right to receive $10,000 per year for the next 32 years. Also, a new user for the property cannot have access for another 32 years unless they also buy out the land lease and the current building sublease (which subtracts from the value of your interest).
So, the value of your leased fee estate at $10,000 per year is dramatically different than the value of your fee simple interest if unencumbered. Understanding the property rights you hold is fundamental to understanding the economic value of the asset.
There are many reasons why you might enter into agreements which subdivide your property interests. One of the principal reasons owners subdivide their interest is to eliminate risk.
For example, when you ground-lease real estate, the ground rent payments are due no matter what happens to the building. When grandpa leased the land on Lincoln Road, he didn’t want to take on the risk of constructing the shoe store, and he didn’t know any shoe store owners at the time to lease the building. The developer invested to construct the building, so grandpa felt pretty confident that his $10,000 per year was definitely going to be collected because if the developer didn’t pay the ground lease, grandpa would terminate the ground lease and get back a brand new building.
The ground-lease tenant (developer) is responsible for upkeep of the building, natural disasters that may damage the building, and for all other matters (and usually costs) associated with their occupancy. This is much less risky than investing to build a building. Investors also pay a premium for property with ground leases where the tenant builds and manages their own building because the rental income (while lower than building rent) is more predictable and less risky, and you don’t have to recapture the capital invested in constructing the building (less upfront cost).
Land leasing also allows owners to convey the future income (and rights to reclaim the property at the end of the lease, called the “reversion”) for tax and estate planning, and sequentially gift smaller portions of the property (and its ground rent income) over time to minimize inheritance tax.
Experienced real estate appraisers understand and are prepared to evaluate these various property interests, and value them according to their risk profile, duration and other important rights and conditions of a lease that affect the value. And that is why the Mad Dog preached to us all: We don’t appraise real estate, we appraise real property interests. You can’t get the value right if you don’t understand the real property interests.
▪ Graziano is a monthly contributor to the ‘Broker’s View’ space in Business Monday. This piece reflects the view of the writer and not necessarily of the newspaper. Got a ‘Broker’s View’? Realtors may submit columns for Broker’s View of 700 words to to rclarke@MiamiHerald.com. This feature is intended primarily for residential brokers, who will be given preference, but pieces about commercial real estate will also be accepted as space allows.