Leased Fee or Fee Simple?

Just yesterday a lender client called me with a question, should he bid an appraisal out for the leased fee or fee simple estate? I thought that was a great question, and would make for an interesting post — so here we go.

First things first: all properties have a fee simple value. For the purpose of this post, the fee simple estate is the value of the property unencumbered by a tenant’s rights. That said, any property that is leased should also have a leased fee value; however, the difference from a lender’s perspective is a) what is the difference in value between these two estates and b) how does a lease affect my collateral?

Being a pragmatist, the answer to the lender’s question: if the remaining lease term is less than an anticipated marketing period for a distressed asset, then the fee simple value should be sufficient for collateral underwriting. Of course, this assumes that there is no option to renew in place that is favorable to the tenant.

For example: assuming a 12 month lease term remaining (with no options to renew), if the lender has to foreclose on the subject property one month after loan closing and it is projected to take 12 months to liquidate the asset then the lender should be able to disregard the leased fee interest and rely on the fee simple estate for underwriting purposes.

That said, if market rent is currently $10/SF and the tenant is paying $5/SF with an option to renew, with only a modest rental rate increase, then the lease encumbrance may extend into the future past the projected marketing time — since the tenant is likely to exercise this option given its below-market lease rate. In this instance, the lender would certainly want to know the value of the leased fee estate as this positive leasehold would diminish the property’s value below its value “fee simple”.

Generally as the lease term shortens the difference between a property’s fee simple and leased fee estates converge. So assuming no options to renew, we are usually much less concerned about a two year lease to a local tenant than a nine year lease to a regional one, where the present value of a leasehold may have a much more dramatic impact on the property’s underlying collateral value.

I am often called by lenders as they draft the scope of an RFP, please feel free to contact me to chat about your commercial appraisal needs here in southeast Michigan.