Fair Market Rental Value (FMRV) in Commercially Leased Spaces: Considerations for Landlords and Tenants (Part 3/3) 

Part One covered the basics of Fair Market Rental Value. In Part Two, we outlined the process of choosing an appraiser - and why that matters so much. This final installment in our series will cover other important considerations for landlords and tenants undergoing the FMRV process.


Considerations for both landlords and tenants


Our investigation of the Fair Market Rental Value (FMRV) process has highlighted the basic theory behind the practice, as well as the most common methods of arriving on a mutually agreeable rental value for the renewal of a lease.


There are, however, a number of considerations that both landlords and tenants should bear in mind. Ideally, one will take these into account when drawing up the language of the original lease, as it will be much more difficult to insert them into the process later. Let’s examine a few possible scenarios.

Recall our hypothetical tenant, Meredith, with her 1300 sq. ft. bakery/cafe. Let’s imagine that when she took over the space, she had to make a number of improvements in order for it to be a functional space.


Tenant Improvements


Should Meredith’s improvements be factored into the FMRV? If Meredith were to leave, the landlord would be able to lease out a fully improved space at a much higher rate than he would have been able to let the space Meredith originally inhabited.


Did Meredith receive any reimbursement for her improvements, or did she get a reduction in her rent along the way? What about Meredith’s presence in the location? She could argue that her business anchors (for example) a small strip mall, which would decrease in value if she were to leave. Her bakery cafe brings foot traffic and more consumers, raising the value of the space at the entire shopping center. Should she have to pay more rent now because she’s built a successful business?


The answers to these questions should ideally be written into the original lease, specifying how each will be handled when the renewal process begins. Structuring these considerations well in advance will also allow Meredith and her landlord to foresee their expenses, investments, and potential returns before embarking on major projects.


Right to Arbitrate = Right to Renew


In Part Two, we covered the Baseball Arbitration method. It is not uncommon to confuse “mediation,” “arbitration,” and “appraisal,” in casual language, but these are in fact three very different things. In mediation, the two parties (e.g. Meredith and her landlord) meet with a neutral mediator and try to come to an agreement without binding determinations by a judge or arbitrator.


In arbitration, by contrast, a neutral party acts like a judge and makes binding decisions (as in the Baseball Arbitration method). Whichever party loses cannot decide that they do not want to abide by the agreement - they are bound by the decision of the arbitrator. This process almost always involves legal representation.


Finally, an appraiser may be involved in all of these processes, but is not resolving disputes or making judgements. The appraiser is only making a determination of value according to the terms specifically provided in the lease. He or she cannot tell Meredith or her landlord what the lease means, whether it is fair, unfair, whether it has been breached, or make any other determination other than a valuation of the commercial property.


It is critical to note that not every lease includes an automatic right for a tenant to renew. Many leases do include a renewal right, and good ones specify the FMRV determination method. But without a right to arbitrate, there is effectively no right to renew.


For example, let us imagine that Meredith’s lease doesn’t include a right to arbitrate. Perhaps her landlord has discovered that he can charge another tenant with a similar business a much higher rent, and he quotes Meredith an extremely high renewal rate. Without a right to arbitrate, there is no guarantee that Meredith’s landlord has to accept a reasonable renewal rate from her. It is an obvious ploy to force her out, but one that could have been avoided had the lease included a right to arbitration clause.


Again, good advance planning and appropriate expert advice (whether from a real estate attorney, or an appraisal expert) could help forestall many difficulties down the line.


It’s All In the Timing


As is doubtless apparent, the negotiation process over FMRV can in some cases be a protracted one. What happens in the interim?


Does Meredith, for example, pay her old rent until a new rental value is established? Or is she required to pay the new rental rate from the beginning of the new lease period retroactively once a figure has been agreed upon?


It is wisest to include deadlines in the original lease specifying that the new rental rate be determined before the end of the old lease. That way, if neither party is satisfied, they both have time to make other arrangements, and there is no confusion about the rates for the new leasing period.


Fair Market Rental Value, when handled well and with foresight, can help both landlords and tenants continue in a mutually profitable business relationship for many years.


However, it is a complex negotiation that can trip up the unwary, the unprepared, or the uninformed, so securing expert appraisal services and advice is a smart investment for all parties at every stage of the commercial leasing process.


If you or your clients might need appraisal services related to fair market rental value, or any other kind of commercial real estate valuation, please email us at [email protected]or call us at (626) 486-9327.


SOURCES/FURTHER READING:



Fair Market Rental Value (FMRV) in Commercially Leased Spaces (Part 2/3): Choosing an Appraiser

Part One focused on the basics. In Part Two, we’ll cover the common appraisal methods to arrive at a new rental value. Getting this right is key to a FMRV that is fair and equitable for both parties, so selecting the correct method is vital!


Part Two: Choosing an Appraiser?


Part One discussed the basics of a Fair Market Rental Value (FMRV) process - what it is, when it arises, and who might need one. We are examining these concepts through a hypothetical case of a small commercial bakery on a ten-year lease. Our tenant, Meredith, has leased a 1300 sq. ft. space to house her commercial bakery and coffee shop on a 10-year lease, which is due for renewal. Both the landlord and Meredith want to re-up, but both also want to ensure that the rent paid is fair and equitable. Naturally, Meredith wants the rent to be as low as possible, while the landlord wants to obtain a good return on his or her investment. Recall that FMRV is based on an analysis of comparable properties with comparable leases.


So who chooses comparable leases of comparable spaces? That’s the job of an appraiser. That appraiser can be hired by the landlord or the tenant, or negotiated between them according to a prearranged system. Sometimes this will have been specified in the initial agreement, and sometimes not. If you’re in the process of writing a lease or considering signing one, taking this into account at the beginning of the process can save a lot of trouble and negotiation down the line.


There are three common methods of choosing an appraiser and/or agreeing on a valuation: the Average Method, the Three Broker Method, and the Baseball Method.



The Average Method


This is probably the simplest method, but also the one most prone to poor outcomes. The landlord and the tenant each hire an appraiser to determine fair market rental value based on a set of common criteria. If the two appraisers’ valuations don’t match (which is likely), the amounts are averaged, and the resulting figure is declared the fair market value rent.


This method is fairly unsophisticated, and also prone to manipulation. Either party, for example, could game the system by submitting an abnormally high or low valuation. Maybe Meredith hires an appraiser who deliberately turns in a valuation well below average, which, when combined with her landlord’s fair appraisal, results in a rental value that is a veritable steal for Meredith. Conversely, her landlord could employ an appraiser whom he knows will return an astronomical valuation. Moreover, it is entirely possible that an average of two appraisals could result in a rent that is not at all consistent with comparable leases of comparable properties. For that reason, many experts warn against adopting the Average Method.

 


The Three Broker Method


Because the Average Method is inherently problematic, some leases opt instead for a slightly adapted version. In the Three Broker Method, Meredith and her landlord each hire an appraiser. If the two appraisers agree on a fair market rent, the process is at an end. If, however, they cannot agree, then the two appraisers will instead agree on a third, impartial appraiser, who will independently calculate fair market rental value. (In some variations of the Three Broker Method, an average of the three valuations is used instead of the third appraiser’s valuation.)


This is a popular option, as it incentivizes both the landlord and the tenant to choose reasonable appraisers in the first place to avoid further cost. However, it can be more expensive if a third appraiser is needed, and certainly it is possible that disputes might arise surrounding the third party’s valuation. Furthermore, there is no guarantee that the third appraiser will not make an unreasonable valuation or an arbitrary decision.


Certainly the Three Broker Method is preferable to the Average Method, and it is very common in commercial leases, but if either party can foresee that the negotiation process might become contentious, they might be best served by the final method.



The Baseball Method


Few organizations are better at complex negotiations around value than Major League Baseball, and this final method is based in their player arbitration system. In the Baseball Method, the landlord and Meredith would each submit an estimate of fair market value to a neutral arbitrator whom they have mutually selected: what does Meredith think a fair rent would be, and what does her landlord think is fair?


The arbitrator must select one of the two proposals. He or she cannot average them or suggest an alternative, but is required to accept one option on the table, which then becomes binding.


Choosing a good arbitrator can mean that this method is most likely to produce an equitable and reasonable result, but it is also by far the most likely to be expensive, lengthy, and difficult. Because it is a binding arbitration process, each party typically hires an attorney, and has legal fees, arbitration costs, and potentially appraisal costs as well to consider.


On the other hand, baseball arbitration incentivizes both parties to submit reasonable estimates. If, for example, Meredith submits an estimate of fair market rental value that is largely reasonable, if a little on the low side, while her landlord is sky-high, the arbitrator is almost certain to select Meredith’s estimate. The lack of compromise in this method is what drives both parties to be less partisan in their estimates.



Specify the method in the lease


No matter which method of establishing FMRV is chosen, the best method to avoid future conflict is to specify it in the original lease. Language like this, for example, would ensure that Meredith and her landlord undergo the Baseball Method when it comes time to re-negotiate her rent:


  • “Each party shall submit to the arbitrator and exchange with the other, in accordance with a procedure to be established by the arbitrator, its best offer. The arbitrator shall be limited to awarding only one or the other of the two positions submitted.”
  • “The parties agree that they will exchange and provide to the arbitrator a copy of written proposals for the value of market rent.  In rendering a decision, the arbitrator(s) shall be limited to selecting only one of the two proposals submitted by the parties.”


Understanding the various methods, their pros and cons, and specifying one preferred method in the original leasing language can save both parties a tremendous amount of money, time, and trouble down the line.

In Part Three of this series, we’ll examine some specific concerns landlords and tenants might have surrounding Fair Market Rental Value, and what to do about them.




If you or your clients might need appraisal services related to fair market rental value, or any other kind of commercial real estate valuation, please email us at [email protected] or call us at (626) 486-9327.


SOURCES/FURTHER READING:


Fair Market Rental Value (FMRV) in Commercially Leased Spaces (Part 1/3)

Determining fair market rental value is critical for both landlords and tenants. This three part series will explore important issues that will help you and your clients make better choices.

What is Fair Market Rental Value and How Does It Work?


In many areas of California - and in many other rapidly developing areas across the country - real estate values are rising sharply year over year. If a space is leased for a number of years, how can both landlord and tenant ensure that  it is a fair and sustainable rate? This is exactly the point that fair market rental value (FMRV) appraisals seek to answer. In this article, we’ll examine the FMRV process through a hypothetical case study. Sometimes the concepts can seem rather abstract, but by placing them into a real-world scenario, it’s easier to understand how they might impact the concerns of both landlords and tenants.


Concerns about fair market rental value arises most commonly in two scenarios. First, it comes into play when there is the option to extend a lease beyond its current terms. Should the rent go up, go down, or remain the same? A FMRV appraisal can help create a fair outcome for both parties.

FMRV appraisals are also often ordered when a new landlord inherits a building, perhaps from the terms of a will or trust. Are the rents that are currently charged fair? An FMRV appraisal can help establish that.


Meet Meredith. Let’s imagine that Meredith wants to turn her small home-based bakery into a larger commercial space, converting a successful pastry line into a limited-service cafe. She envisions a comfortable, neighborhood space where customers can enjoy a cup of coffee and a delicious pastry, and where she can also feature local jams, artisanal food products, and occasional live music or cooking demonstrations. But Meredith doesn’t have a lot of money, so she’s looking at leasing a restaurant space in a less desirable area and hoping that, over time, she can grow with the neighborhood.


Meredith finds her ideal space - it’s 1300 sq ft, available for an initial 10 year lease. Meredith signs a modified gross lease. That means that she pays her rent in one lump sum, which can include property taxes, insurance, and common area maintenance. In Meredith’s case, trash is included but all other utilities and janitorial services are her responsibility. Modified gross leases tend to be more tenant-friendly, since they are easier to set up and manage.


This also allows Meredith to predict her expenses. If, for example, property taxes or insurance rates change, the landlord absorbs the difference and Meredith’s rent stays steady. She’s paying $30/sqft, or $3250/month, in 2018. Meredith and her landlord agree that she will have the option to renew her lease in 10 years, in 2028. Because neither of them want to set a specific dollar amount given the unpredictability of the California real estate market, they agree that the renewal rate will be mutually determined in the future based on fair market rental value (FMRV) – a very standard provision in many commercial leases.


But what does that actually mean? Here is the first critical element to understand: fair market rental value is established based on comparable leases of comparable spaces. Let’s explore that concept in more depth.

 

Comparable leases of comparable spaces


Fair market rental values are established by looking at similar commercial spaces that are leased in the same area, in the same way that one establishes the value of a property before selling it by comparing similar properties in the area. So if Meredith is located in North Hollywood, comparable leases of comparable spaces would include commercial leases on similar square footage, for similar uses, with roughly similar features and agreements. That means that a 1500 sq ft Chinese takeout two blocks away on a 3 year modified gross lease would be a useful property to consider, while a 1300 sq ft bakery located in Santa Monica would not.


Meredith’s landlord wants to charge a higher rent than he’s currently getting. After all, he could (presumably) find a new tenant who would pay much more than Meredith is paying. But Meredith points out that her cafe and its success and attractiveness to customers is an integral part of why the area is more desirable than it was ten years ago. She also doesn’t think that she should have to pay a higher rent because she’s made improvements to the space  - after all, that would be like paying for those upgrades twice!


Selecting comparable leases of comparable value is a critical part of establishing FMRV; it’s easy to imagine how cherry-picking properties could lead to a fair market value that would be heavily biased in one direction or the other. It is obvious, then, that establishing an impartial appraisal is critical to an equitable FMRV.


So who chooses comparable leases of comparable spaces? That’s the job of an appraiser. That appraiser can be hired by the landlord or the tenant, or negotiated between them according to a prearranged system.


In Part Two of this series, we’ll investigate the primary methods by which an appraiser can be chosen. Part Three will outline other considerations that landlords and tenants should bear in mind when establishing agreements, leases, and negotiating new rental rates.


If you or your clients might need appraisal services related to fair market rental value, or any other kind of commercial real estate valuation, please email us at [email protected] or call us at (626) 486-9327.


SOURCES/FURTHER READING:



Give Now! 2018 Tax Changes on Lifetime Gift & Estate Provisions

There’s never been a better time to give: with the provisions in the 2017 tax bill, estate planners and real estate investors are looking at lifetime gifting as a way to maximize their long-term strategies.

As  you’ll remember from the debates surrounding the new tax code, in addition to many business-positive changes, the 2018 law temporarily (and controversially) doubled the exemption amount for estate, gift and generation-skipping taxes from the $5 million base (set in 2011) to a new $10 million base, for tax years 2018-2025.


The exemption is indexed for inflation, so an individual could realistically shelter $11.2 million in assets. With proper planning to take advantage of portability, a couple could exclude $22.4 million for 2018. The law is set to sunset in 2025, and opinions remain divided on whether or not it will do so.

In the meantime, everyone agrees on one thing: whether this is a temporary measure or a permanent one, there’s no question that this is the moment to do some very serious estate planning.


“One does not need to die before 2026 to take advantage of this increased exemption, since it can be used for lifetime gifts,” said Beth Kaufman, an estate tax lawyer at Caplin & Drysdale and former associate tax legislative counsel at the Treasury Department.


So if, for example, you expected to live for at least another twenty years, you would presently have an $11.2 million (or $22.4 million if married) exemption level, which in seven years might or might not fall back to $6 million. But if you were to gift your children, heirs, or charity $11 million today instead of at your death, you would in essence be able to give them an extra $5 million dollars tax free.


Thus, many estate planners are encouraging that families, trusts, and individuals take advantage of strategies based in gifting, like:


  • Making gifts to existing or new irrevocable trusts, including generation-skipping trusts;
  • Leveraging gifts to support the funding of life insurance or existing sales to trusts; and
  • Pairing gifts with philanthropy (such as a charitable lead trust).


It is also worth noting that the new tax bill creates a  new 20% deduction for pass-through businesses, which is especially relevant for estates and trusts. For taxpayers with incomes above certain thresholds, the 20% deduction is limited to the greater of: (a) 50% of the W-2 wages paid by the business, or (b) 25% of the W-2 wages paid by the business, plus 2.5% of the unadjusted basis, immediately after acquisition, of depreciable property (which includes structures, but not land).  REIT dividends and distributions from publicly traded partnerships are not be subject to the wage restriction.


Also noteworthy for those with real estate investments is the fact that the bill preserves the 20% tax credit for the rehabilitation of historically certified structures, but taxpayers must claim the credit ratably over a 5-year period.  The bill does, however, repeal the 10% credit for the rehabilitation of pre-1936 structures.


“Many of the provisions passed will have a positive impact on investors by putting more money back into their pockets in terms of tax savings,” said Michael Episcope, co-founder and principal at Origin Investments, a real estate investment firm that acquires primarily office and multifamily properties.


“Some of the changes to the tax treatment of capital expenditures, for example, will shield a tremendous amount of income for property owners that are making capital investments and improvements in properties,” he says.


So whether it’s considering how to restructure a trust or making a gift now instead of in the future, the options are wide open in a way that they have never been before.


If you or your clients might need appraisal services related to the tax code’s updated provisions surrounding gift and estate taxes, date of death appraisals, or any other kind of commercial real estate valuation need, please email us today at [email protected] or call us at (626) 486-9327.



SOURCES/FURTHER READING:

  • “Final Tax Bill Includes Huge Estate Tax Win For The Rich: The $22.4 Million Exemption,” Forbes.com (Dec. 21 2017)
  • New estate tax law gives an enormous gift to rich families,” CNN Money (Jan. 9, 2018)
  • “The Effect of the New Tax Reform Bill on Real Estate,” IPX1031 (Dec. 18, 2017)
  • “How CRE Investors Could Cash In on the Tax Bill,” National Real Estate Investor (Dec. 27, 2017)
  • “The Tax Cuts and Jobs Acts - What it Means for Homeowners and Real Estate Professionals,” National Association of Realtors
  • “New Tax Law ‘Holds Favorable Prospects’ for Commercial Real Estate,” rebusiness (Jan. 16, 2018)



Two recent housing ordinances seek to address LA’s homeless crisis

More than 34,000 citizens of LA are homeless, and an estimated 25,000 are living without any shelter at all.

Last year, the city passed Measure HHH, a $1.2 billion measure to build 10,000 units of housing for homeless people over the next decade. That project — a long-term strategy for combatting homelessness — is underway. However, in the interim, the city is proposing two additional ordinances to ease the transition into permanent housing and to address the immediate need for shelter.


One ordinance, the Proposed Permanent Supportive Housing Ordinance (or PSH), is designed to streamline the process of getting to those 10,000 units. Under the PSH, normal zoning laws and parking regulations would be relaxed to allow construction to proceed more rapidly. The ordinance is also proposing allowing by-right construction of multifamily units on land that is currently already zoned for public facility (providing that there are other existing multifamily developments already in existence nearby). Each permanent supportive housing project could receive up to four zoning concessions, including:


  • Decreases in setback requirements
  • Decreases in required open space
  • Increases in lot coverage limits
  • Increases in allowed height & floor ratios


While the PSH seeks to streamline the construction process, the second ordinance is designed to address the immediate and urgent needs of those who lack shelter. The Interim Motel Conversion Ordinance would allow existing residential structures, like hotels, motels, and hostels, to undergo interior renovations and repurpose themselves as transitional housing for homeless people.


According to an article by Urbanize.LA, 2016 data from the LA County Assessor’s office shows that LA currently has about 10,000 total guest rooms. The majority of motels (about 83%) have fewer than fifty rooms, with the average being 26. The IMC ordinance would permit these buildings to serve as transitional housing over a half year to two year period for people who are moving off the street or out of shelters and into permanent supportive housing.

Both of these ordinances are especially timely, as Mayor Eric Garcetti reported this year that LA’s homeless population had swelled by 23%. The largest increases were in younger people, between the ages of 25 and 54. The population of veterans who are now homeless also jumped substantially, up 57% from the previous year.


According to the Homeless Services Authority, the major culprit for the dramatic rise has been the economic stress on renters in the LA area. As the LA Times reported:


More than 2 million households in LA & Orange counties have housing costs that exceed 30% of income, according to data from Harvard University’s Joint Center for Housing Studies…[while] according to the nonprofit California Housing Partnership Corp., median rent, adjusted for inflation, increased more than 30% from 2000 to 2015, while the median income was flat.


And as housing prices continue to rise in Southern California, the problem of homelessness motivated by economic distress and the inaccessibility of affordable housing seems likely to only intensify. While the first multifamily dwelling funded by Measure HHH is going up in Rampart Village, more will need to happen to substantively address the housing crisis that is affecting all of Southern California’s residents, both those on the margins and those who have already moved to the streets.


If you or your clients might need appraisal services related to the City of Los Angeles’ homelessness ordinances, or any other kind of commercial real estate need, please email us today at [email protected] or call (626) 486-9327.



SOURCES & FURTHER READING:








Valbridge Property Advisors has been proudly serving the greater Los Angeles and Inland Empire markets since 2002.


Calvin Cummings, MAI

Senior Managing Director

(626) 486-9327

[email protected]

www.Valbridge.com

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