Property Appraisals: Three Basic Indications of Value

1. Appraisals: Three Basic Indications of (or ways of approaching) Value (Text p. 387) 1. Sales Comparison Approach (recent sales of comparable properties) • Also known as “Market Data” Approach • The approach is less valid if there is an inactive market or if the property is unique 2. Replacement Cost • Cost of replacing a building (and the land under it) minus depreciation charges on the building 3. Capitalized Value of the Income a Property Generates Donald J. Weidner

2. Appraisals: Three Basic Indications of Value (cont’d) Reconciliation is the process of relating these three factors (recent sales, replacement cost and capitalized value of income) to determine a value-- it does not simply average them. A reconciliation may select one factor as the most important. Ultimately, valuation is a matter of definition and of judgment. Written appraisals of commercial properties can be voluminous. Donald J. Weidner

3. Three Ways of Looking at the Value of Property Through the Cash it Generates • Most rudimentary: estimate a value by multiplying the gross rent receipts by some factor. • Somewhat more refined: estimate a value of the property by applying a capitalization rate to its current net operating income. • More refined: estimate net operating income for each year well into the future and reduce each of those receipts to its present value. Donald J. Weidner

4. Method # 1: Use a GROSS MULTIPLIER to Derive A Value from Gross Rentals Sales Price of Comparable Properties = Multiplier Gross Rental Revenues of Comparable Properties Assume a Recent Sale of Comparable Property: 12 Million Sales Price = 6 [Gross Multiplier] 2 Million Gross Rental Revenue Applying this rough method, a comparable property with only $600,000 of Gross Rent receipts would therefore have a $3,600,000 value (six times gross rent receipts) ($600,000 X 6 = $3,600,000) Donald J. Weidner

5. Method #2: Determine the Capital Value of the Current Net Operating Income A. Determine Current Net Operating Income Begin by considering an owner’s net cash flow from a property she currently owns that is encumbered by financing. Net cash flow is simply the sum of all cash receipts from operations minus all cash spent (ignoring any capital improvements), including debt service. As we shall discuss more fully when we take up taxes, to derive taxable income or loss from net cash flow, simply start with net cash flow, then subtract the depreciation deduction and add back in amount that was paid to amortize debt. Donald J. Weidner

6. NCF versus NOI Net Cash Flow=Rent Receipts–Real Estate Taxes–Maintenance Expense– Insurance–(Principal + Interest) Assume you are a buyer valuing a property and you don’t yet know how you will finance your acquisition. You might want to ignore the debt service the owner has been paying and first look at the Net Operating Income from the property. Net Operating Income is NCF apart from the current owner’s debt service (principal and interest). NOI is “unique to the property, rather than the investor.”—Property Metrics. NOI = Rent Receipts – Real Estate Taxes – Maintenance Expense– Insurance Donald J. Weidner

7. B. Apply a Capitalization Rate to the current net operating income to determine a value for the property Basic idea: x 8% = $1,000 per year NOI  is how much an investor will pay for the right to receive $1,000 per year if the investor will insist on an 8% return on his or her investment. In this example, is $12,500 How Much Will Investor Pay for a Building with a $150,000 Net Operating Income? • If I expects an 8% cash return [stated in • fractions] • If I expects a 12% cash return [stated in • decimals]  The price x 8/100 return = $150,000 1) 1)  The price x .12 return = $150,000 2) Divide each side of the equation by 8/100 2) Divide each side of the equation by .12 • x .12/.12 = $150,000/.12 • = $1,250,000 ( x 8/100) x 100/8 = 150,000 x 100/8  = $1,875,000 This is NOT a course that requires you to make complicated calculations. On the other hand, you need to understand ways business people think about transactions. So let’s restate this all another way. Donald J. Weidner

8. Capitalizing Value of NOI A. Another Look at Net Operating Income. Another way of looking at Net Operating Income (NOI) is as the amount of cash flow that is available to service your acquisition debt. B. Another Look at the Capitalization Rate. • How much would you pay for an annual NOI of a certain amount? The answer depends on the rate of return you expect on your investment in a particular asset. That expected rate of return is your capitalization rate. It might be, for example, 5%. • To determine value, divide the net operating income by the Cap Rate you select, for example: NOI of $300,000 = $6,000,000 Value Cap Rate of .05 Donald J. Weidner

9. Capitalizing Value of NOI • Many of us who come to law school are uncomfortable using numbers at all, much less dividing by decimals (by the .05 Cap Rate). The following statement avoids dividing by decimals. • The assumption still is that NOI is $300,000 and the Cap Rate is .05% • The buyer expects a 5% return on an investment in this particular property. NOI x. 100 = Value Cap. Rate 300,000 X. 100 = $6,000,000 5 Donald J. Weidner

10. Capitalized Value of NOI (cont’d) • This simply substitutes multiplication coupled with a more simple division. • Suppose you expect a greater return on your investment, say, 8% rather than 5%. How much would you pay for that same $300,000 NOI? • $300,000 x. 100 = $3,750,000 8 The basic point: the higher the rate of return you expect, the less you will pay for the income stream (the NOI). Donald J. Weidner

11. Eyeballing Capitalized Value of NOI (cont’d) • Very simply (and rounded slightly) For 1% cap rate, the multiplier is:100 [100/1] x. $300,000 NOI = $30,000,000 For 2% cap rate, the multiplier is 50 [100/2] x. $300,000 NOI = $15,000,000 For 3% cap rate, the multiplier is 33.33 [100/3] x. $300,000 NOI =$ 9,999,000 For 4% cap rate, the multiplier is 25 [100/4] x. $300,000 NOI = $ 7,500,000 For 5% cap rate, the multiplier is 20 [100/5] x. $300,000 NOI = $ 6,000,000 For 6% cap rate, the multiplier is 16.67 [100/6] x. $300,000 NOI = $ 5,001,000 Why do so many domestic sellers like certain foreign investors? Because many of them are interested primarily in safety of principal rather than in a high return. Therefore, they may be more likely to settle for a lower return (apply a lower capitalization rate) and hence pay more for the property. Also, in a very general sense, does this help you see why the Fed Policy of driving down interest rates—and the rate of return people expect on their investments-- creates a “wealth effect” through increased asset prices? Donald J. Weidner

12. Method #3: Reduce the Future Stream of NOIs to its Present Value Values property by A) estimating the net operating income for each year into the future; and b) discounting those future flows of cash to their present value. Discounting is the obverse of compound interest. Assume you estimate NOI of $1,000 a year for each of 10 years. How much would you pay to purchase a 10-year position as landlord the right to receive $1,000 yr. rent for 10 years? Stated differently, what is the total present value of the right to receive $1,000 in cash at the end of each of the next ten years? The answer depends upon the rate of return you insist on. Assume the investor insists on a 20% rate of return. Because the 10, $1,000 payments are spread over the next 10 years, their total present value is the sum of the present value of each of the future payments. That is: • .833 x $1,000 = 833 • .694 x $1,000 = 694 • .579 • .482 • .402 • .335 • .279 • .233 • .194 • .162 x $1,000 = 162 • $4,193 Donald J. Weidner

13. 936 Second Ave. L.P. v. Second Corporate Dev. Co., Inc.(Text p. 681) • Long-term net lease of three adjoining buildings with mixed residential and retail spaces. • Lessee had option to renew for two, 20-year terms. • Renewal rent was to be 7% of the “value of the demised premises.” • “Demised” is here, and generally, synonymous with “leased” • Value was defined to include “the value of both the land and the buildings.” Donald J. Weidner

14. 936 Second Ave. (cont’d) • More specifically, the lease defined “value of the demised premises” to mean • “the value of the demised premises together with all buildings and improvements thereon including any and all additions and improvements erected by Tenant.” • Issue: Should the lease itself be taken into account in determining the “value of the demised premises?” • The lease was silent on the point. Donald J. Weidner

15. 936 Second Ave. (cont’d) • Lessor’s appraiser said value was $ 7.1 million. • Lessor’s appraiser, in effect, treated the real property to be “free and clear” of the lease. • Lessor’s appraiser employed both the comparable sales and income capitalization approaches • Lessee’s appraiser said value was $ 3.4 million. • Lessee’s appraisal is lower because Lessee’s appraiser considered the effect of the net lease itself on the value of the premises. • The Lessee’s appraiser treated the lease itself as an encumbrance. • Lessee’s appraiser used only the income capitalization method. Donald J. Weidner

16. 936 Second Ave. (cont’d) • N.Y.Ct.App. reversed two lower courts and held that the lease itself must be considered in determining the “value” of the demised property. • Cites Plaza Hotel: “the market value . . . is the amount which one desiring but not compelled to purchase will pay under ordinary conditions to a seller who desires but is not compelled to sell.” • Standard definition of fair market value • The “highest and best use” of the property is also a standard referent. Donald J. Weidner

17. 936 Second Ave. (cont’d) • Unless the lease provides otherwise, appraisers generally consider highest and best use, but they “necessarily must examine any restrictions . . . that may impact the highest and best use for which the property may be utilized.” • Then: “valuations of land must take into consideration all encumbrances thereon, including reasonable restrictions as to its use, unless there is a clear provision to the contrary.” • “Special attention must be given to limitations on ownership rights, which include easements, encroachments, leases and the disposition of air or subsurface rights and an appraiser must ‘analyze all of the economic benefits or disadvantages created by the lease.’” Donald J. Weidner

18. Plaza Hotel Associates 340 N.Y.S.2d 796 (N. Y. Sup. 1973) • PLAZA OWNS THE BUILDING Operating  HOTEL CP Agreement BUILDING ½  PLAZA ½  LAND LEASE SUBLEASE OF  ½ FEE INTEREST LEASE OF  ½ FEE INTEREST Donald J. Weidner

19. Plaza Hotel Facts • Lease provided for rent to increase to 3% of the “value” of “all of the land,” exclusive of the building and improvements. • It also provided that, if LL and T could not agree on value, appraisers would determine value. • An appraisal valued the land alone at $28,000,000. • Tenant sued to set appraisal aside on ground that it was too high because it was based on the assumption that the land was vacant and available for its highest and best use. Donald J. Weidner

20. Plaza Hotel Highlights • Court set aside the appraiser’s valuation, stating that the appraiser “erroneously valued the land as available for its highest and best use, and not as already encumbered by the long term lease which restricts the use of the land to hotel purposes only.” • Consider: since the fee and the building on it were separately owned, the fee could be sold separately. Hence, it is possible to ask: how much would someone pay for the fee. • How would you value the fee? Discount the cash flow? • Having set aside the appraiser’s determination of value, the court undertook to determine value. Donald J. Weidner

21. Plaza Hotel Highlights • The court distinguished price from value: • “Price is determined by short term factors and by the caprices of the market.” • “Value . . . is dependent upon long term factors and is directly related to the intrinsic worth of the property that resists the impact of temporary and abnormal conditions.” • “[V]alue, even more than price, is a matter of judgment.” Donald J. Weidner

22. More from Plaza Hotel • “The concept of a fluid market such as that existing in regard to corporate securities, where one sale can indicate the value at the time, is just not true with respect to real estate.” • The lessee’s 3 appraisals of the land alone ranged from $8.5 million to $11.5 million. • The lessor’s 3 appraisals of the land alone ranged from $33.3 million to $34.5 million. Donald J. Weidner

23. Plaza Hotel (cont’d) • Plaza Hotel noted: • “In considering the opinions of the experts, the court is not unmindful that ‘the appraisal of rental property necessarily involves the discretionary application of one or more accepted methods of computation’ and we must recognize that appraisers retained in litigated matters, within the limits of professional integrity, tend to adopt those formulae which favor their employer’s position.” Donald J. Weidner

24. A Different [Florida] View on “Free and Clear” Appraisal • In Taylor v. Fusco Management, 593 So.2d 1045 (Fla. 1992), the issue was to determine value within the meaning of a tenant’s option to purchase contained in the lease. • The lease was a 99-year lease. The price of the option to purchase, in the tenant’s view, was the present value of the rents (economically, a prepayment of the rent). • That is, the future cash cash flows discounted to their present value • The court held for the landlord: • “[T]he market value of leased property at the time a lessee exercises an option to purchase the property should be computed as if the property were unencumbered by the lease. Any intent to value the property otherwise should be clearly stated in the lease.” • Correctly decided? Donald J. Weidner

25. Florida Statute on Balloon Mortgages(Supplement p. 39) • Fla. Stat. sec. 697.05(2)(a)1 has its own definition of balloon mortgage. • “Every mortgage in which the final payment or the principal balance due and payable upon maturity is greater than twice the amount of the regular monthly or periodic payment of the mortgage shall be deemed a balloon mortgage.” Donald J. Weidner

26. Florida Statute on Balloon Mortgages(Cont’d) • With certain exceptions, “there shall be printed or clearly stamped on such mortgage a legend in substantially the following form: • THIS IS A BALLOON MORTGAGE AND THE FINAL PRINCIPAL PAYMENT OR THE PRINCIPAL BALANCE DUE UPON MATURITY IS $-----, TOGETHER WITH ACCRUED INTEREST, IF ANY, AND ALL ADVANCEMENTS MADE BY THE MORTGAGEE UNDER THE TERMS OF THIS MORTGAGE.” Donald J. Weidner

27. Florida Statute on Balloon Mortgages(Cont’d) • The statute also has special provisions concerning “the case of any balloon mortgage securing the payment of an obligation the rate of interest on which is variableor is to be adjusted or renegotiated periodically, where the principal balance due on maturity cannot be calculated with any certainty.” • Failure of a mortgagee to comply with these provisions “shall automatically extend the maturity date of such mortgage.” Donald J. Weidner

28. Florida Statute on Balloon Mortgages(Cont’d) • Note that the Florida Statute on Balloon Mortgages has several exceptions important for commercial real estate purposes: • “Any mortgage, the periodic payments on which are to consist of interest payment only, with the entire original principal sum to be payable upon maturity;” • “Any mortgage securing an extension of credit in excess of $500,000;” and • “Any mortgage granted by a purchaser to a seller pursuant to a written agreement to buy and sell real property which provides that the final payment . . . will exceed the periodic payments thereon.” Donald J. Weidner

29. Provisions in Mortgages • The typical “mortgage” transaction involves two separate documents: • 1. A note • 2. A mortgage. • We have been considering some of the variables in notes. • We now turn to consider the variables among and within mortgages and mortgage substitutes. • We’ll then take up more of the law of notes. Donald J. Weidner

30. DRAGNET CLAUSE IN MORTGAGE(Text p. 380) • A dragnet clause in a mortgage uses a single property to secure the original debt and any other debt owed, or to be owed, by the mortgagor to the mortgagee. • The clause “drags” other debts into the protection of the mortgage • Courts vary in approach to dragnet clauses • Some “interpret” dragnet clauses narrowly, holding, ex., that dragnet clauses will only secure subsequent debts directly related to the property. • Some “presume” that a future advances clause only covers advances of the same quality or relating to the same transaction, • perhaps unless the documentation concerning the subsequent advance refers to the original mortgage as providing security. Donald J. Weidner

31. State Bank of Albany v.Fioravanti(Text p. 381) • 1966: Fee Owner executed $2,500 Note #1 and Mortgage #1 on Lot 1. • Mortgage #1 had a dragnet clauseproviding that additional subsequent debt up to $2,500 would be secured by Mortgage #1. • Lender recorded Mortgage #1. • 1973: Fee Owner executed $6,800 Note #2 & Mortgage #2 on Lot 2 to same Lender. • No reference was made to Lot 1. • Fee Owner conveyed Lot 1 to Grantee who assumed “the payment” of Mortgage #1 on Lot 1. Donald J. Weidner

32. Fioravanti (cont’d) • Fee Owner paid in full the 1966 Lot 1 Note #1 in connection with which Mortgage #1 (with the dragnet clause) was issued and recorded on Lot 1. • Fee Owner defaulted on the 1973 Note #2, causing Lender to foreclose Mortgage #2 on Lot 2. • Lender got a $3000 deficiency judgment in the foreclosure of Mortgage #2. • Lender sued Grantee of Lot 1 to foreclose Mortgage #1 (the payment of which Grantee had assumed) on Lot 1 to recover $2,500 of the $3,000 deficiency from the foreclosure of Mortgage #2 on Lot 2. • Recall, the dragnet clause in Mortgage #1 had a $2,500 limit on the additional debt that could be dragged in. Donald J. Weidner

33. Fioravanti (cont’d) • HELD: “payment of the 1966 note [secured by Mortgage #1 on Lot 1] could not terminate the bank’s right to foreclose the mortgage [#1].” • To decide otherwise would defeat intent. • TO EMPHASIZE: The note and mortgage are two separate instruments. One can survive the other. • Dissent: Lender’s document did not specify that the Lot 1 Mortgage would survive the payment of the Lot 1 Note • Construe a document that is at best ambiguous against the person that drafted it. Donald J. Weidner

34. Note 1 to Fioravanti • In particular, pre-existing debt must be specifically included (or they will be deemed excluded). • In Florida, dragnet clauses are construed against the drafter. • United Nat’l Bank v. Tellam, 644 So.2d 97 (FL 3d DCA 1994) (invalidated attempt to drag in pre-existing debt rather than future debt). Existing debts must be specified and future debts may not be dragged in if they were not anticipated at making of the Mortgage. Donald J. Weidner

35. Note 2 to Fioravanti(p. 416) • The Restatement of Mortgages permits dragnet clauses only if (a) the future debt is incurred in a transaction similar to the original mortgage; [or] (b) the original mortgage described with adequate specificity the additional types of loans that will be secured by the mortgage; or (c) the parties expressly agreedat the time of the future advance that it would be secured by the original mortgage. Donald J. Weidner

36. AFTER ACQUIRED PROPERTY CLAUSE(Text p. 381) • Secures a single debt with a mortgage that purports to encumber both the property originally mortgaged and all future property the borrower will acquire. • Attempts to bring future property under the mortgage rather than future debt. • However, real estate lenders receive only limited benefit from after acquired property clauses in mortgages. Donald J. Weidner

37. AFTER ACQUIRED PROPERTY (Cont’d) • The reason: A mortgage with an After Acquired Property clause will be outside the chain of title of the after-acquired property. • Subsequent purchasers or mortgagees of a second parcel will not find the After Acquired Property clause in the mortgage on the first parcel in the recorded chain of title of the second parcel. • Hence they will not be bound by that clause. • The purpose of the recording acts is to allow buyers and lenders to rely on the instruments properly recorded in a particular parcel’s chain of title. Donald J. Weidner

38. AFTER ACQUIRED PROPERTY (Cont’d) • In sum: a subsequent purchaser (or mortgagee) of the second parcel will defeat the lender-mortgagee of the first parcel who is trying to rely on the After Acquired Property clause in the mortgage on the first parcel. • This is true whether a tract or a grantor-grantee index is used. Donald J. Weidner

39. EVOLUTION OF PROTECTION OF MORTGAGORS(Text p. 337) The “mortgage deed,” says the legal historian Maitland, “is one long suppressio veri and suggestio falsi.” Donald J. Weidner

40. Borrower Deed Lender’s estate ends ONLY if borrower pays everything off exactly on time. Lender Fee simple subject to condition subsequent Stages in Evolution of Mortgage Law • Defeasible fee enforced according to its terms • Equity relieved Borrower in special circumstances • Special circumstances were always found • The equity of redemption came to be called an estate in land. Donald J. Weidner

41. Stages in Evolution of Mortgage Law (cont’d) • Lenders were required to foreclose the borrower’s equity of redemptionbut it could be strict. • Lenders were permitted to end the borrower’s right to redeem the land from the mortgage • Strict foreclosure decree states: pay up now or be barred (foreclosed) from asserting any interest in the future. • Lenders were required to foreclose by sale (generally by judicial sale, in some states, by nonjudicial sale) • The proceeds of a foreclosure sale are distributed: • First, to the lender, to pay what is due to the lender (principal, interest and costs) • Second, any surplus is paid to the borrower. • Thus, the lender gets what was promised to the lender, repayment, interest and no more. Donald J. Weidner

42. Stages in Evolution of Mortgage Law (cont’d) • Legislatures in roughly half the states supplement the equity of redemption with an additional Statutory Right of the Borrower to Redeem from a Foreclosure Sale • In short, the mortgagor (and, often, a junior lienor) is permitted, for a specific period of time, to redeem “from the sale” by paying, to the foreclosure sale purchaser, the foreclosure sale price plus, in some cases, certain additional amounts. • There are many approaches to the consequences of nullifying the foreclosure sale. Donald J. Weidner

43. Stages in Evolution of Mortgage Law (conclusion) Where that leaves us. • Leading Rule today: There may be no contemporaneous (with the loan origination) waiver of the equity of redemption. • No matter how clearly stated, understood and agreed to, a contemporaneous waiver of the equity of redemption is unenforceable. • However, in many states: Powers of sale, authorizing a non-judicial foreclosure sale, whether they are contained in mortgages or in deeds of trust, are enforceable (and popular). • In these states, the only two necessary steps to foreclose are notice and sale. Donald J. Weidner

44. THE PRACTICAL REALITY OF CHOICE OF SECURITY INTEREST • A Mortgage • A Deed of Trust • An Absolute Deed Standing by Itself • An Absolute Deed with Collateral (accompanying) Documents • Collateral documents such as a lease back or an option to repurchase • An Installment Land Contract • Also called “contract for deed” or “bond for title” • A Negative Pledge • A Lease • A Proprietary Lease in an Cooperative Donald J. Weidner

45. Sample Balloon Mortgage(Supplement p. 34) • “This Mortgage Deed” • “Mortgagor hereby grants, bargains, sells, conveys and confirms unto Mortgagee, in fee simple” • Legal description of the land conveyed • Mortgagor covenants that it “is indefeasibly seized of the Premises in fee simple and has full power and right to convey . . . And does hereby fully warrant title and will defend the same” Donald J. Weidner

46. Sample Balloon Mortgage(Cont’d) • “CONDITIONED, HOWEVER, that . . . If Mortgagor shall fully perform all the covenants, conditions and terms of this Mortgage, then these presents shall be void, otherwise to remain in full force and effect.” • The mortgagor also covenants • To pay the principal and interest “according to the terms of the Note and this Mortgage.” • To pay all taxes and assessments. • To keep the buildings and improvements insured Donald J. Weidner

47. Sample Balloon Mortgage(Cont’d) • The mortgagor also covenants to give the mortgagee • the right to spend money to cure defaults by the mortgagor [ex., to pay real estate taxes if the mortgagor does not] and add the amount to the mortgage • the right, on default, to declare the “whole of the indebtedness . . . due and payable” and proceed to foreclosure [the “acceleration” clause] Donald J. Weidner

48. Sample Balloon Mortgage(Cont’d) The mortgagor also covenants that • “all rents, profits, incomes . . . are hereby assigned and pledged as further security for payment of the indebtedness hereby secured with the right on the part of the Mortgagee at any time after default hereunder . . . to demand and receive the same and apply the same on the indebtedness hereby secured.” Donald J. Weidner

49. Sample Balloon Mortgage(Cont’d) • The Mortgagor also covenants • “Receiver. In the event suit is instituted to foreclose this Mortgage or enforce the payment of the Note . . . Mortgagee shall be entitled to the appointment of a receiver to take charge of the Premises, to collect the rents, issues and profits . . . and to . . . care for the premises, and such appointment shall be . . . as a matter of right to the Mortgagee.” Donald J. Weidner

50. Sample Balloon Mortgage(Cont’d) The mortgagor also covenants • “Subordination. This mortgage” shall be “subject and subordinate to the lien of any and all institutional mortgages that may now or hereafter affect the premises,” provide they are in connection with the property and not more than $500,000. Donald J. Weidner