Many contracts and leases leave the parties to determine a future purchase price or rent between themselves as set by the then “Fair Market Value” (FMV). The crafty draftsperson will often try to sneak in language “as determined by seller (or landlord)”. But smart buyers and tenants won’t stand for that unilateral determination. A more concrete method of determining the FMV needs to be added to the document to set the future purchase price, option price or renewal rent. FMV is then usually determined by an appraisal. Sometimes the seller or landlord will obtain the initial appraisal, with the buyer/tenant having the right to challenge the initial appraisal by obtaining its own appraisal. If the 2 appraisals don’t agree, the appraisers choose a 3rd appraiser whose appraisal would then be binding. This process can be time consuming and costly. Other times, the buyer and seller or landlord and tenant agree in advance as to who the appraiser will be and jointly pay for the appraisal prior to the time the purchase price, option price or rent is to be set. The appraiser’s determination of FMV would be binding and the purchase price or rent is set based on such determination.
It is important to understand what you are getting when you add this appraisal language to a contract or lease. Otherwise, when the time comes, the appraisal you obtain might not fit your needs and the FMV could cause you to overpay, as tenant or buyer, or receive, as seller or landlord, less than FMV.
The Uniform Standards of Professional Appraisal Practice, as developed by the
Appraisal Standards Board of the Appraisal Foundation, has 3 approaches in determining a property’s value:
- Cost Approach: Under this approach, a property’s value is determined by adding the estimated value of the land to the current cost of construction of the replacement for the improvements on the land and subtracting depreciation (land value + construction cost – depreciation). The appraiser must obtain cost estimates from builders and contractors. Appraisers must do research as to depreciation. Land value is established separately.
- Sales Comparison Approach: this approach is useful when several similar properties have sold or are for sale in the subject market. The value of the subject property is determined by comparing comparable sale and a price range is given.
- Income Capitalization Approach: Value under this approach is reached as the present value of future benefits of property ownership. There are 2 methods, direct capitalization and yield capitalization. Direct capitalization is the relationship between 1 year’s income and the value of the property that equals a cap rate or income multiplier. Yield capitalization is the relationship between several years of stabilized income and a reversionary value at the end of a defined term.
Most appraisals determine value using at least 2 of the methods. Income producing property will almost always use an Income Capitalization Approach. Where 2 of the approaches conclude virtually the same value, it is safe to assume that the appraisal is fairly accurate. However, it is important to review the appraiser’s assumption. How old are the comps used? What is the supply of like properties currently for sale? What is the absorption rate? What are area cap rates? What is the condition of the subject property and what was the condition of the comps? What is the vacancy rate and what vacancy rates were used? There are many other assumptions to consider that could affect the appraiser’s conclusions as to FMV.
At contract/lease drafting time, sellers and landlords want as much flexibility as possible to raise the purchase price or rent in the future. At this point, FMV is a very loose term. Buyers and tenants want caps. Efforts to cap an increase are sometimes futile, especially following a lengthy initial lease term with small rent increases. That is why it is essential that the parties work to ensure that FMV actually be fair at the adjustment time.