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March 3, 2014

Life Estate - An Approach to Valuation

Filed under: Uncategorized — Tags: , , — marc @ 5:45 am

Life Estates and an Approach to Valuation

By Marc P. Nadeau, SRA

Inherent in the fee simple ownership of real estate is something that is commonly referred to as the “Bundle of Rights”. The Bundle of Rights is in effect the exclusive right, use and disposition of the property that belong to the property owner. Inherent within the Bundle of Rights can be the right to sell, the right to mortgage, the right to occupy, the right to lease and the right to enter. The owner of the Bundle of Rights typically has the ability to convey all or some of those rights to another. The conveyance of the right to another person that enables them to occupy a property for the duration of their life is commonly known as a Life Estate. The beneficiary of the Life Estate is referred to as the Tenant. The person or entity that actually has the ownership in the real property is referred to as the Remainderman.

The life estate interest is an estate in real property that ends upon the death of the holder of life estate, (the tenant). The property may then revert back to the original owner of the property or some other designated person (the remainderman).

Uses of a Life Estate

The life estate is typically used as a tool for estate planning. A life estate can avoid probate and insure that the intended heir will receive title to the real property. For example let’s say that an aging parent would like to see to it that their son or daughter receive the full benefit of the value of the parent’s property, without the potential hassle of the property passing through probate or term care or perhaps Medicare costs eroding the value of the estate, a life estate is a likely vehicle for planning.

The Appraiser’s Role

There are multiple scenarios where an appraiser is needed to evaluate a life estate. Sometimes the role of the appraiser is to estimate the value of the interest for the Tenant and sometimes the role is to estimate the value of the Remainderman.

Valuation Scenario – Remainderman’s Interest

The following is an example where the appraiser’s role is to value the interest of the Remainderman. The property is encumbered by a Life Use that has been granted to a 70-year-old person.

There are a series of steps that must be taken in this valuation scenario which are summarized as follows:

q Estimate the fee simple market value of the property assuming it is unencumbered as of the date of conveyance. The scenario presented assumes a fee simple market value of $500,000.

q Estimate the term of the life estate. This element is based upon the age of the beneficiary (The Tenant) of the life estate and their life expectancy. Life expectancy can be estimated from a variety of published tables including that of the tables included in IRS publication 590, which contains a table of life expectancies based upon age. In the case of this valuation scenario, the beneficiary is 70 years old and has a life expectancy of 17 years. The following is an excerpt from the Life-Expectancy table that is included in IRS publication 590:

Table - Expectancy of Life in Years

Age

Life Expectancy

Age

Life Expectancy

60

25.2

69

17.8

61

24.4

70

17.0

62

23.5

71

16.3

63

22.7

72

15.5

64

21.8

73

14.8

65

21.0

74

14.1

66

20.2

75

13.4

67

19.4

76

12.7

68

18.6

77

12.1

Source: IRS Publication 590, published 2013

q Estimate the expected rate of appreciation over the life expectancy. There are a variety of statistical references that an appraiser can utilize to estimate the expected rate of appreciation. That expected rate of appreciation should be rooted in fact and takes into consideration the kind of property that is being valued. For example if that property is located in an area that historically has seen better than average appreciation, then it is likely warranted that a better than average rate of appreciation be projected. If that property is located in an area or is the type of property where decline in property value is expected for some time then a below average rate of appreciation should be projected.

For this valuation scenario let’s assume that the property will achieve a rate of appreciation that is typical of the general market.

In this case your appraiser might utilize an institutional or nationally recognized benchmark such as the Consumer Price Index (all items). The benchmark chosen in this case was the twenty-year average of the Consumer Price Index (CPI), “All items”. The twenty-year average mirrors the term of the life expectancy of the tenant with CPI being one of most reliable and least subjective measurements of anticipated appreciation. A review of the CPI index, as published by the Bureau of Labor Statistics between 1993 and 2013 revealed an average rate of inflation of 3.1%. Inflation over the past ten years has averaged less than 3.0%. Your appraiser has chosen a rate of 3.0% for the anticipated annual rate of appreciation.

q Discount the forecasted future value of the property over the remaining duration of the Life Estate at an appropriate discount rate. Discount rate is synonymous with what would be an expected rate of return for a like property.

Expected Rate of Return/Discount Rate is essentially synonymous with the rate that an investor would expect over the anticipated holding period. There of course is the option of polling individual investors in real estate in order to establish what the expected rate of return should be. This however, is typically not a feasible method and would likely be flawed, depending upon the size of the sampling. Your appraiser in this case has consulted the Price Waterhouse Coopers Investor Survey that was published for the second quarter of 2013. Discount Rates for residential apartment properties ranged from 5.00% to 14.00% with an average of 8.04%. The subject property being a residential single family home would generally result in a rate at the lower end of the scale simply because it is not exclusively viewed as an investment vehicle. Your appraiser has estimated a rate of 7.00% for the subject property.

Other benchmarks for expected rate of return could be long-term treasuries, bonds, equities or some type of index fund as these investment vehicles could all be alternatives to investing in real estate. The following chart depicts some of the other investment vehicles that an appraiser might reference:

Investment Alternative

Yield

Characteristics

20-Year Treasury Bills

3.42%

Generally liquid asset, easily traded on market, guaranteed yield by Federal Government

20-Year AAA Rated Bond

3.55%

Generally liquid asset, could be corporate or municipality issued

1-Year Return, S & P 500 Index

22.22%

Liquid asset, volatile, short-term performance over the past 52 weeks no guaranteed return

Poll Date: February 24, 2014

The above chart illustrates what might be considered extreme ends of the investment spectrum yet also illuminate options that a prospective investor might consider.

Summary of Life Estate Valuation ~ Remainderman Interest

Current Value Estimate of Subject Property

$500,000

Projected Value of Property 17 years hence utilizing a 3% annual rate of appreciation

$826,424

Present Value of Reversion of Property

(utilizing a discount rate of 7.0%)

$261,625

say

$262,000

The Remainderman’s interest is valued at $262,000, much lower than the fee simple market value of $500,000.

Valuing the Tenant’s Interest

Consider the same information given in the previous example but now the appraisal problem is to estimate the value of the life estate for the tenant. Assume that a survey of comparable rents reveals that the rental market value of the property is $1,000 per month and that the tenant is responsible for maintenance, insurance and taxes. Therefore, as a result of the Life Estate granted, the tenant is enjoying the benefit of $1,000 per month.

Other Assumptions:

v The market value of rents will continue to increase at the rate of 3% annually.

v The expected rate of return over the balance of anticipated life is 7%.

The benefit (or value) to the tenant is best illustrated in the following table:

Year

Monthly Rent Savings

Annual Rent Savings

Present Value Factor @ 7.0%

Present Value of Rental Savings

1

$1,000

$12,000

.9346

$11,215

2

$1,030

$12,360

.8734

$10,795

3

$1,061

$12,731

.8163

$10,392

4

$1,093

$13,113

.7629

$10,004

5

$1,126

$13,506

.7130

$ 9,630

6

$1,159

$13,911

.6663

$ 9,269

7

$1,194

$14,329

.6227

$ 8,923

8

$1,230

$14,759

.5820

$ 8,590

9

$1,267

$15,201

.5439

$ 8,268

10

$1,305

$15,657

.5083

$ 7,958

11

$1,344

$16,127

.4751

$ 7,662

12

$1,384

$16,611

.4440

$ 7,375

13

$1,426

$17,109

.4150

$ 7,100

14

$1,469

$17,622

.3878

$ 6,834

15

$1,513

$18,151

.3624

$ 6,578

16

$1,558

$18,696

.3387

$ 6,332

17

$1,605

$19,256

.3166

$ 6,096

Total

$142,921

The total present value of this Life Estate in this example (for the tenant) is $142,921 or $143,000 (rounded)

Author Bio

Marc Nadeau is a designated appraiser with 30 years experience based in Guilford, Connecticut. His specialties include: appraising historic properties, appraisals for tax planning and litigation. Marc Nadeau is currently authoring the book for the Appraisal Institute, Identifying and Appraising Historic Properties.

December 8, 2011

Partial Interest Valuation - A Case Study

Filed under: Uncategorized — Tags: — marc @ 6:15 am

Partial Interest Valuation of Real Estate

~ A Case Study by Marc P. Nadeau, SRA

Partial Interest Value ~ The Concept

Partial interest valuation is a technique used by appraisers and other valuation professionals to estimate the value of a fractional interest in real estate. Fractional interests in real estate result from the owner’s ownership of less than 100% of a given property. The technique involves the valuing of a fractional interest in real property with a discount factor being applied to that fractional interest. Reflective of what could be a number of factors including, but not limited to the nature of the property, the percentage or ownership and the management structure in place an appropriate “discount factor” is chosen by a valuation professional. Ownership of a partial interest in real property ownership can manifest itself in a number of forms. Those ownership forms include, but are not limited to: general partnerships, limited partnerships, REITs, joint tenancy, tenants in common, tenancy by entirety, family trusts and ownership of shares in a limited liability corporation.

The transfer or conveyance of a partial interest can arise from any number of events including: divorce, partnership dissolution, estate planning, donation or sale of a partial interest to an unrelated party and so on. In theory, partial interests are almost always worth less than their fractional value. For example, a $1 million dollar property owned by five different owners, each with a 20% interest, would in pure mathematical terms have a value of $200,000 for each interest. That 20% interest, were it to be marketed or sold to another party would be considered a minority interest.

The nature of a minority interest is that it typically has the following characteristics:

  • Lack of Marketability
  • Longer than typical Marketing time
  • Lack of Control
  • Limited or no ability to refinance the property
  • Limited ability to influence decision-making policies

Discounts associated with a partial interest can typically range from 20% to 60% of the proportionate value of the interest as it relates to the entire property. In the case of the $200,000 fractional interest above, a discount factor would be applied to the fractional value.

The IRS perspective

The perspective or position of the IRS has frequently been that the discount applied to the fractional interest be limited to the actual cost of partitioning a property. The courts fortunately, have generally recognized that this is both unreasonable and illogical. The fact is that fractional interests for the most part have a very limited market appeal to the general marketplace with the range of appeal varying by the type of property and the percentage of ownership.

The IRS Training Manual for Appeals Officers in fact recognizes and cites several factors that could influence the size of the discount. The following factors are listed in the manual:

  • The number of owners
  • The size of the fractional interest
  • The size of the tract
  • The use of the land
  • The availability of financing and finally,
  • The cost of partitioning (dividing) the land

Valuation Methodology

The following steps would be involved in valuing a partial interest:

1. Value the property in its entirety;

2. Calculate the value of the proportionate share in the property by taking the 100% value of the property times the percentage of property owned;

3. Determine an appropriate discount for the partial interest;

4. Calculate the value of the fractional interest by multiplying the value of the “proportionate share” times the discount rate.

Discount Rates ~ what are appropriate rates?

Reflective of the fact that partial interests have very limited marketability there is certainly a lack of empirical market data that appraiser’s can draw from. One of the best benchmarks for determining an appropriate discount would be court cases.

The following is a summary of relevant court cases that involve partial interest valuations:

In the case of Lefrak vs. Commissioner the court did not consider fractional discounts as compelling evidence because security owners do not have the right to force partition (the shares were part of a corporate entity). However, the Court did allow a 30% discount for a minority interest and a lack of marketability.

In the case of the Estate of Cervin vs. Commissioner the Court allowed a 20% discount for a 50% undivided interest in a homestead and farm. The legal costs along with the time delays and discounts required by a prospective buyer were reasons for the granted discount.

The case of Williams vs. Commissioner involved the transfer of a 50% interest in 2,360 acres of rural land and its timber in Putnam County, Florida. The court found a discount of 44% to be reasonable. The discount factored in the cost of partitioning, the longer than typical anticipated marketing time and the lack of

control.

The case of the Estate of Baird vs. Commissioner involved minority interests of timberland located in Louisiana. The plaintiffs specifically in this case were that of the Estate of John L. Baird and the Estate of Sarah W. Baird who were married at all pertinent times. John died on December 18, 1994 while Sarah died less than 1 year later on November 2, 1995. At times of death, John held a 14/65 interest while Sarah held a 17/65 interest in a trust that owned 16 noncontiguous tracts of timberland comprising 2,957 acres.

Both estates claimed a 60% discount on the tax returns with the plaintiffs mounting an impressive case that involved the testimony of two real estate appraisers that had extensive experience in valuing timberland as well as a third expert witness that had the experience of actually purchasing partial interests of like timberland. The appraisers, by product of analyzing actual partial interest sales of timberland arrived at discounts of 55% and 36% respectively while the timberland expert claimed that the discount should be 90%, while the written report prepared by the same expert claimed “at least a 55% discount”. The Court found that a 60% discount was reasonable and supported.

Empirical Market Data ~ Partial Interest Sale

Locating actual sales of a partial interest is like finding a needle in a haystack. Given the lack of marketability combined with the difficulty of verifying such a transaction can leave appraisers very little to work with. Presented below is a recent example of a partial interest sale that the readers of this article may find useful in their own analysis of a partial interest:

Case Study ~ Sale of Partial Interest

This study involves the sale of a 1/5 interest in a property identified as Uncas Point Road located in Guilford, Connecticut. The parcel is a vacant, non-buildable waterfront parcel that contains .67 acres and was owned by 5 separate owners, each with an undivided 1/5 interest in the land. The value of the parcel is that is provides access to and has frontage along the harbor.

Established factual information of Case Study

Grantor: Jonathan Wallace

Grantee: Carolyn Matthes

Sale Date: July 1, 2010

Sale Price: $ 3,750 plus $1,000 in assumed property taxes

Volume/Page: 801/340, Warranty Deed

Interest Purchased: 1/5 fee simple interest

Additional Facts for this Case

An independent appraiser appraised the property on September 24th, 2007 for $75,000. With documented time adjustments the value of the property as of July 1, 2010 (the conveyance date) would have been $52,500. $52,500 divided by 5 = $10,500. $10,500 would be the value of a 1/5 interest before factoring in any discount. The discount factor derived from this sale would be 55%.

This appraiser interviewed both parties, both of who indicated that they were each acting in their own best interest. Ms. Matthes is a neighboring property owner who lives across the street from the parcel and is attempting to purchase the entire parcel in pieces in order to have a full, undivided fee simple interest in the parcel.

Bio of the author

Marc Nadeau is a designated appraiser which extensive experience in appraising and consulting on properties with tax implications. Additional information regarding Mr. Nadeau’s services is available at: www.marcnadeau.com