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:

  1. 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.
  2. 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.
  3. 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.

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Florida’s Right to Medical Marijuana Initiative Amendment returns to the ballot in November, Amendment 2. If passed, Florida will join a growing number of states that have some form of legal marijuana. While recognized by these states, the sale and use of marijuana is still criminalized. As such, federal banks have not accepted reputable marijuana growers and dispensers as customers and the marijuana industry is a cash business.

             Increasingly, commercial real estate has become a favorite way for marijuana entrepreneurs to protect and grow their money. Colorado, perhaps the center of the legal marijuana industry, provides an interesting look at what could happen in Florida. In the Denver area, over 3.7 million square feet of industrial space is occupied by the industry. However, landlords generally don’t like to lease to grow houses and dispensaries for fear of potential issues with the federal government including tax issues and criminal liability. Landlords are also concerned about nuisance to other tenants from odors and strain on a building’s electric and water capacity and potential fire hazard. Marijuana related tenants are often charged 4 to 5 times the market rate for space. On the plus side for landlords, rent is paid in cash as tenants have no access to bank accounts.

             Many marijuana business people are investing in real estate for these reasons. With no access to bank accounts, storage of cash is a major concern. The business owners are finding that owning their own properties is a good entry into the real estate world. The value of marijuana related property in Colorado is appreciating rapidly. And, there is plenty of cash available to invest in other properties. In effect, marijuana business owners are legally “laundering” their cash and expanding their businesses.

             If Florida approves Amendment 2, will we see a mini real estate boom? It is possible. Certainly, the industry will be highly regulated, but the business owners will face the same problems that Colorado owners face; the biggest being that banks won’t take their money. The risk and cost of storing cash in a house or an office is high and many owners will look for safe, quick investments to park their cash. Real estate is the obvious choice.

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