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.

Selecting the right property to buy or lease can be tricky. Every one knows the old adage “location, location, location”.  Clearly, location is crucial to every one involved in a real estate project from brokerage to development to construction; from lending to investment; from management to leasing, location will be a crucial factor in everyone’s return on the investment in real estate.  However, a corollary to location is zoning, zoning, zoning.  A property that does not have the proper zoning and land use designation for the proposed use, and one that can not be appropriately re-zoned, or variances obtained, will have no value to a buyer, developer, tenant or investor and location will add no value.

This rule applies to properties that are being purchased or that are being leased. A retail location might be the best spot in town for your client’s hot new night club.  But zoning might not allow any business which serves alcohol to be located in that location because a church is located within 1000 feet.  Or, noise regulations prohibit music after 10:00 because of the hospital across the street.   These are some of the things that should be considered even before entering into a contract or a lease.  They can save time and money.

When purchasing a property, it is a good idea to have preliminary, exploratory conversations with city planning and zoning staff to discuss the site. This is a good way to learn what the city would be comfortable with.  The meeting will help the buyer understand what approvals will be necessary for the project and will assist in formulating a timeline for obtaining approvals.

Upon preparing the contract, the buyer should make the obligation to close contingent upon obtaining the necessary approvals. The approvals can be specific, but I like to keep them as generic as possible.  For example, I define “Approvals” as all approvals necessary to enable buyer to obtain building permits to construct the Intended Improvements.  When pushed, I will list approvals to include, without limitation, zoning, land use, platting, site plan, and I will expand as necessary.

Many times, going into the contract, the parties know precisely what zoning is going to be required, or the seller has already begun the process of re-zoning in anticipation of a sale for such a use. This should not affect buyer’s contingency as the use drives the value of the property and must be in place prior to closing.

Zoning diligence before contract can make negotiations smoother and faster. It can also help buyers and sellers set a realistic price for a property, particularly because with proper approval contingencies, buyers won’t have to close if the zoning is not sufficient for the intended use.  But patient sellers will be more likely to get their desired price.

Tenants shopping for new space should understand how the cost of Landlord funded Tenant Improvement affects rent. When negotiating for space, one of the first questions a Tenant should ask is whether the advertised rent includes any TI allowance because after negotiating a comfortable rent, Tenants who then turn attempts to negotiate a TI allowance as an incentive to lease will find that rent will increase as TI dollars increase.  However, Tenants should be careful to assure that the increase in rent is limited to the actual cost of the TI allowance and that the Landlord is not adding a profit, unless the profit was specifically negotiated.

 

The formula for adding Landlord funded TI to rent is simple:

TI =     {(X/Initial Lease Term in Years)}

________________________                      add result to per square foot Rent

{Premises Square Feet    }

 

For example, if the Landlord has agreed to a $180,000 TI Allowance and the initial lease term is 5-years on a 4,000 square foot lease, $9.00 per square foot would be added to the quoted rent [(180,000/5)/4000].  If rent was originally quoted at $18 per square foot, with the TI added, rent would now be $27 per square foot.  Of course CAM would be a separate issue.  If the Landlord quotes rent higher than $27, Tenant should be aware that landlord is charging overhead or is not providing all of the improvements for which Tenant is being charged.  Additional negotiations might be necessary.

Another point Tenant should consider is rent increases following the initial term.  While annual increases during the initial term are, and should be adjusted, on the gross amount (including the adjustment for TI), following the initial term, rent at the commencement of the first renewal term should be adjusted back to the base rent without the amortization for TI.  Most Landlords and Tenants over look this in negotiations and negotiations begin with the same percentage increase on the rent from the end of the initial lease term.  Other times, Landlords attempt to re-set rent based on “market rent” then existing, but with a floor, limiting the ability to lower rent below the rent of the prior year or even adding a percentage above the prior lease year.  Tenants who have paid the fully amortized cost of TI should insist that, at the beginning of the first renewal term, that rent be adjusted to deduct the cost of the TI.  Increases going forward would then be based on the adjusted amount.

If Tenants are aware of how TI allowance affects rent, there should be cost savings down the road.  Be savvy!

 

Contract Agreement on the Office Desk

Every buyer of real property wants representations and warranties from its seller in the purchase contract. Every seller knows that the buyer is going to request that the seller make representations and warranties as to everything under the sun and the seller will do its best to eliminate as many of the requested reps and warranties as possible. Then, the seller will do whatever is possible to water down the remaining reps and warranties so that they have as little meaning as possible and the exposure to the seller is as minimal as possible.

In a recent contract negotiation, my client was assembling two parcels of property for development. The first parcel seller was actually going to flip the property to my buyer client. Having just acquired the property from the local government, the seller was very unwilling to provide any meaningful representations or warranties. What reps and warranties the seller was willing to provide, seller strictly qualified to “the best of Seller’s knowledge”. My client, understanding how the seller acquired the property and that the seller did not every operate a business on the property or have any plans to develop the property, was willing to rely on its own due diligence with respect to this parcel.

The second parcel, owned by a different seller, was owned by the seller for a number of years. There was not a lot of discussion concerning the warranties and we were able to get nearly all of the reps and warranties we requested, without much qualification and without much discussion. Together with the due diligence my client would do on this property and given the fact that the parcels were adjacent, my client had a great deal of comfort that there would be no issues with either parcel.

The trouble, however, began in negotiating the second contract on a similar issue as to representations from my client, the buyer. As part of the consideration for the acquisition for the second parcel, upon the closing, my client agreed to convey, or cause the first seller to convey, a 75 foot by 300 foot piece of the first parcel to the second seller. This strip (the “Conveyance Parcel”) would allow the second seller to “square off” property he was retaining adjacent to the total parcel my client was purchasing and would provide a better access point for his property. The second seller asked my client to provide all of the same reps and warranties for the Conveyance Parcel that seller was providing to the buyer for the main parcel. The second seller was adamant and would not listen to our logic that because we did not own the Conveyance Parcel, we could not make any reps or warranties about the Conveyance Parcel. And, in fact, because the first seller would be conveying directly to the second seller, we would never actually own the Conveyance Parcel.

Notwithstanding, the second seller insisted. We went so far as to show the second seller the provisions in the first contract that were the toothless representations and warranties from first seller, again explaining that we could not provide the same reps. A compromise was reached. My client was willing to provide the exact same reps and warranties that he received from the first contract seller, but these reps and warranties would be “to the best of Buyer’s knowledge” which was further diluted to mean solely as to the seller’s knowledge as set forth in the underlying contract. In essence, we were getting two layers of insulation in providing these reps. But the comfort factor meant enough to second seller to proceed with the transaction and that alone, provided enough teeth necessary to make the reps and warranties worthwhile. Sometimes, toothless representations and warranties are better than no representations and warranties at all.

 

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