Why does your regulator want you to know the difference between leased fee and fee simple?

By September 26, 2019 October 22nd, 2019 No Comments
fee simple

While the Appraisal Institute does publish The Dictionary of Real Estate Appraisal, we want to take the time to clarify terms that are important to regulatory compliance. Leased fee interest vs. fee simple interest are two of those terms. Not only should they be differentiated, but these two terms are ones that your regulator cares about.

What does leased fee mean?

Put simply; a leased fee interest is a landlord’s right of use of property and the right to lease to others. For example, let’s say your client owns an office building and is the landlord to several office tenants under standard office leases. The tenants occupy the building and the landlord, in general, does not. It might be common in real estate circles to say that your borrower owns the “fee” and that the handful of tenants that occupy the building own a “leasehold” interest. This is just another way to say that they rent space.

What does fee simple mean?

The fee simple interest, on the other hand, is unencumbered ownership right in a piece of property. Essentially, fee simple has the same definition as ownership. The fee simple interest is the most complete form of ownership in that the buyer owns the title for the property. In the example above, the landlord owns the fee simple interest.

When can the two terms get muddled?

The terms can become muddled when you order an appraisal. Let’s start with a pop quiz: When you are ordering an appraisal, what interest should you ask the appraiser to value? Should the appraiser give a value opinion of the fee simple or the leased fee interest? The answer may surprise you. You might be tempted to order an appraisal of the fee simple interest. After all, the landlord owns the property. However, requesting a value of opinion of the fee simple interest will give the appraiser the idea that they should research what the property would be leased for if it were leasing today. In valuing the property under the income approach, the appraiser will perform market research and use techniques and comparables to estimate the market rent. Then, the appraiser will use that market rent to value the building without considering the current leases.

Here’s where there can be some issues: Unless it’s a new property, chances are the office building’s tenants signed long-term leases with locked-in rental fees, and they probably signed their leases years ago. Regardless of the state of today’s real estate market, if the appraisal is completed with current market terms, the appraiser’s findings about the “market rent” may not bear a resemblance to the cash flow that’s actually coming in based on the specific terms of those leases. If you want the appraiser to dig through the terms of those leases and use actual numbers in the income approach, then you need to order your appraisal to give an opinion of the value of the leased fee interest.

 What if I order an appraisal the wrong way?

In most cases, ordering the incorrect appraisal is just a misunderstanding. However, keep in mind, getting this wrong can cost time and money to correct. If you order an appraisal that gives a value opinion of the fee simple interest, the appraiser may not think to ask you about leases and rent rolls. He or she may assume there isn’t a lease in place. The appraiser may have to go back and review leases and rework his income analysis. Save yourself time and money, and order the appraisal correctly the first time.

Why does your regulator care?

When you’re dealing with a property with below-market rents, it might be tempting to view this distinction as an opportunity to influence value. However, if you order an appraisal that gives a value opinion of the fee simple interest, you could take advantage of the market rents even though your borrower’s locked into below-market rents. While it might sound tempting, trust us when we recommend not to do that. Regulators require that appraisers report appropriate deductions and discounts, and that includes, specifically, for properties with below-market rents. Ultimately, your regulator is paying attention — and you should, too.

Avoid any mishaps with banking regulations by making a distinction between the leased fee and the fee simple interests from the start. Not only will you save yourself valuable time and money on the front end, but you’ll rest easy knowing you’re doing the right thing appraisal after appraisal. For more insider tips, news, and the scoop on all things appraisal management, sign up for our newsletter or contact us today.