Property Rights Brought to Light: Principles and Misconceptions.

Author:Heiland, Gary E., II
 
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Abstract

One of the most important components of any real property appraisal is a solid understanding of property rights. The root of inconsistent valuation methodologies often is found in differing understandings and misconceptions regarding property rights. Does an appraiser value real estate or real property? Does the market value of the leased fee interest plus the market value of the leasehold interest equal the market value of the fee simple estate? What is "dark store theory"? This article addresses the basics of property rights, the relationship of partial rights and the fee simple estate, proper application of the approaches to value, and common misconceptions relating to property rights.

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A solid understanding of property rights and the application of appropriate valuation techniques are paramount to developing a credible real estate/real property appraisal. Property rights are one of the most important aspects of every appraisal assignment--but unfortunately, many misconceptions exist. These misconceptions can lead to erroneous appraisals. This article discusses principles related to property rights, and common issues and misconceptions related to the understanding of property rights and appraisal terminology. (1)

Real Estate versus Real Property

Do appraisers appraise real estate or real property? Real estate is defined as "an identified parcel or tract of land, including improvements, if any." (2) Real estate is tangible. It is the soil, rocks, trees, bricks, etc. The term real estate appraiser is commonly used by both practitioners and users of appraisal services. The Appraisal Institute's predecessor organizations were the American Institute of Real Estate Appraisers and the Society of Real Estate Appraisers. The Appraisal Institute's authoritative texts are entitled The Appraisal of Real Estate and The Dictionary of Real Estate Appraisal. Additionally, all of the forty-one individual appraisal regulatory agencies in the United States and Puerto Rico have "real estate" in their names.

In The Dictionary of Real Estate Appraisal, sixth edition, real property is defined as follows:

  1. An interest or interests in real estate.

  2. The interests, benefits, and rights inherent in the ownership of real estate. (USPAP, 2016-2017 ed.)

  3. All rights, interests, and benefits related to the ownership of real estate. (IVS) (3)

    The Uniform Standards of Professional Appraisal Practice (USPAP) points out, "In some jurisdictions, the terms real estate and real property have the same legal meaning. The separate definitions recognize the traditional distinction between the two concepts in appraisal theory." (4) It is important that appraisers understand this distinction. But which term is more applicable: Do appraisers appraise "bricks and sticks" (real estate) or interests and rights (real property)?

    To understand these terms better and to answer these questions, the concept of market value must be examined. Market value is a value-in-exchange concept and reflects the market's perception of something's worth. In order for an item to have value to the typical market participant, it must have the potential to transfer to another party with rights that the market desires. As it relates to the ownership of real estate, this concept of rights is best described by the term real property. It is the rights in and to real estate that cause the market to recognize value in the tangible real estate. Real estate without any rights (rights of use, occupancy, etc.) has no market value; The Appraisal of Real Estate, fourteenth edition, states, "Real estate in and of itself has no value; the rights, or interests, in real estate are what have value." (5)

    Consider, for example, what a buyer would pay for a vacant one-acre lot that the buyer could not use, could not sell, could not rent to someone else, could not mortgage, could not physically enter, could not give away, could not enjoy, etc. As a typical market participant, the buyer would pay nothing. Hence, real estate void of rights has no market value. Now consider that same lot with the potential to build a public park, but zoning that will not allow any other use. How much would the buyer pay? What if zoning allowed a parking lot? What if zoning allowed development of a dwelling? What about development of four dwellings or an office building or a retail store? With each of these different rights, a buyer would likely pay a different price, yet the tangible real estate has not changed.

    Next, consider a residential dwelling. Suppose similar dwellings typically sell for $250,000 to owner-occupants; however, this particular dwelling is encumbered by a lease for 10 years with the tenant paying only $100 per month. Now consider what a buyer would pay for this property. By generating a gross income of only $1,200 per year over the next 10 years, a buyer is not likely to pay $250,000 but instead something considerably less. Again, the real estate may be identical to others on the same street, yet its market value is different due to the rights that would transfer with it upon a sale.

    Appraisers have historically been taught that they appraise real property rights, not real estate itself. In answer to the question, "Precisely what does a real estate appraiser value?" The Appraisal of Real Estate responds, "In simplest terms, the real property rights, not the real estate itself." (6) It is further stated that "in an appraisal, a particular set of real property interests--not the real estate--is what is valued." (7) However, is it true that appraisers only appraise property rights?

    USPAP requires appraisers to identify the real property interest to be valued. (8) This is necessary so the context of the appraisal can be understood. The appraiser must understand whether the appraisal is of real estate subject to rights held as a fee simple estate (ownership interest in real estate that is not leased), a leased fee interest (ownership in leased real estate), or a leasehold interest (a tenant's interest in the real estate). Does this mean that real estate is not what is appraised? To answer this question, consider typical appraisal requests. Appraisal clients generally want to know what particular real estate is worth, subject to rights that would transfer with it under a hypothetical sale. The client may ask, "What is 123 Main Street worth?" or "What is the value of the industrial property at Market and Penn Streets?" A market value opinion should reflect what the typical buyer would pay for the real estate that would transfer to a typical buyer in a hypothetical sale along with all applicable rights. Consummating the typical transaction involves payment for the tangible real estate, generally in cash or its equivalent, and transfer of legal title of the real estate to the buyer via deed. Important here is that the tangible real estate is transferred, not just the rights. However, the market value of the real estate is dependent on the rights that would transfer with it.

    USPAP Advisory Opinion 23 clarifies that not only are rights appraised but also the real estate. "The subject of a real property appraisal has both physical and legal characteristics.... Appraisers and property owners often discuss a subject property in physical terms, such as my home, the residence, my land, or the building. However, a physical object, alone, is not what is being appraised." (9) As such, and as is explained herein, when an appraisal addresses a fee simple estate or a leased fee interest, it is real estate that is appraised, subject to transferable rights.

    Appraisers commonly make statements in appraisals such as "this is an appraisal of the fee simple estate in 123 Main Street," or "this is an appraisal of the leased fee interest in 123 Main Street." While this is commonplace, appraisers and users of appraisals should remember that the tangible real estate is also appraised. As such, both "real estate appraiser" and "real property appraiser" are accurate descriptions for appraisal professionals. Conversely, as is explained later, when appraisals address leasehold interests, appraisers are only appraising rights to real estate, not real estate subject to rights. This is because in a leasehold transaction, only the interest in the real estate is transferred; the real estate is not transferred. In a leasehold valuation appraisers are only acting as real property appraisers as they are only appraising a tenant's rights to real estate. To further unpack the idea of property rights, the bundle of rights concept is reviewed next.

    Bundle of Rights Theory

    Property rights can best be understood by an examination of the bundle of rights concept. Under this concept, which is familiar to most appraisers, the various property rights in the real estate are represented as sticks in a bundle, with each stick representing a separate right. These "sticks" include, but are not limited to, the following:

    * The right to use the real estate

    * The right to sell it

    * The right to lease it

    * The right to mortgage it

    * The right to enter it

    * The right to give it away

    Note that these are things that can be done to or with the real estate.

    When an owner holds the entire bundle of sticks (all rights in the real estate except the governmental powers), then the owner's interest is known as a fee simple estate. The appraisal profession defines fee simple estate as follows:

    Absolute ownership unencumbered by any other interest or estate, subject only to the limitations imposed by the governmental powers of taxation, eminent domain, police power, and escheat. (10) Once an owner conveys rights to a tenant for use and occupancy via a lease, the fee simple estate becomes bifurcated: the owner's interest becomes a leased fee interest, while the tenant, who holds the rights of use and occupancy, has a leasehold interest.

    Fee Simple Estate

    Confusion exists as to definitions and interpretations of the term fee simple...

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