Foundations of Real Estate 1

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Eleventh EDITION

REAL ESTATE PRINCIPLES

CHARLES F. FLOYD and MARCUS T. ALLEN

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This publication is designed to provide accurate and authoritative information in regard to the subject matter covered. It is sold with the understanding that the publisher is not engaged in rendering legal, accounting, or other professional advice. If legal advice or other expert assistance is required, the services of a competent professional should be sought.

President: Dr. Andrew Temte Chief Learning Officer: Dr. Tim Smaby Executive Director, Real Estate Education: Melissa Kleeman-Moy Development Editor: Julia Marti

Printed in the United States of America ISBN: 978-1-4754-2173-6 / 1-4754-2173-7 PPN: 1515-0111

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DEDICATION

This book is dedicated to R. W. Barber

a man of the land and

C. O. Floyd a man of business. —Charles F. Floyd

This book is dedicated to Rhonda, Melanie, and Issabella.

—Marcus T. Allen

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c o n t e n t s

p r e fa c e xi i i r e a l e s tat e t o d ay f e at u r e s xvi i

c h a p t e r 1

Why Study Real Estate? xx Chapter Preview 1

The Role of Real Estate Studies in Business Education 2

Personal and Business-Related Real Estate Decisions 2

Organization of This Book 3

Special Characteristics of Real Estate 4

The Economic Importance of Real Estate 9

The Real Estate Industry: Career Opportunities 10

Chapter Review 13

Key Terms 14

p a r t o n e

Real Estate Legal Analysis 15

c h a p t e r 2

Property Rights and Legal Descriptions 16 Chapter Preview 17

Real versus Personal Property 18

Fixtures 18

Mineral and Air Rights 20

Water Rights 20

Estates in Land 23

Concurrent Estates 29

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vi Contents

Condominium Ownership 31

Cooperative Ownership 32

Time-Shares 32

Legal Descriptions 32

Chapter Review 43

Key Terms 45

Study Exercises 46

Further Reading 412

g l o s s a ry 413 a p p e n d i x 431

i n d e x 437 c r e d i t s a n d a c k n o w l e d g m e n t s 447

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xiii

p r e f a c e

Welcome to the eleventh edition of Real Estate Principles! As one of the most popular and well-respected texts in college-level real estate education, this book has served as the framework for a practical and rigorous learning experience for intro- ductory real estate students at schools across the nation since its first edition was published in 1981. This edition continues that tradition by incorporating the latest industry advances and education technologies into a comprehensive, student-friendly presentation of the real estate “body of knowledge.” We are absolutely convinced that students who master the material presented in this text will become better-informed real estate market participants whether their primary real estate interests lie in con- sumption, investment, brokerage, appraisal, law, property and asset management, or any combination of these aspects of real estate.

| pedagogical devices ______________________________________

For students, the book contains the following pedagogical devices designed to enhance their learning experience:

■■ Each chapter begins with a Chapter Preview that clearly sets forth the learning objectives.

■■ The Key Terms discussed in each chapter appear in boldface for emphasis. These terms are succinctly defined in the end-of-book Glossary.

■■ Many tables, figures, and photographs are provided throughout the text to help readers visualize the topics and incorporate them in their knowledge base.

■■ Each chapter ends with a Chapter Review that concisely summarizes the key concepts.

■■ Thought-provoking review exercises are provided at the end of each chapter.

■■ Suggested reading lists for each chapter are included to direct students who wish to learn more about specific concepts to additional sources of information, including books, academic journals, practitioner journals, newspapers, magazines, and internet sites.

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xiv Preface

| instructor support _____________________________________

For instructors, we have developed an extensive collection of support materials that can be easily downloaded (with the proper password) from the publisher’s web- site at www.dearborn.com. The materials include

■■ detailed lecture notes in Microsoft PowerPoint and Microsoft Word format for each chapter (for use with a computer display projector or as transparency slides);

■■ assignment exercises for each chapter (with answers); and

■■ multiple-choice, true-false, and short-answer questions by chapter.

Readers familiar with previous editions of this text will be pleased to find that this edition continues to incorporate many of the special features from previous edi- tions that enhance the students’ learning experiences. Close-Ups, Legal Highlights, People Profiles, and Case Studies are liberally sprinkled throughout the book to dem- onstrate how real estate principles can be observed and applied in the “real world.”

| flexible pathways through the text ______________________

Because real estate is such a dynamic and diverse discipline, we have purpose- fully designed Real Estate Principles in such a way that instructors who wish to approach the material from their own preferred direction can do so with relative ease. Each chapter can be treated as a stand-alone learning module within the real estate body of knowledge. While we recommend presenting the material in the chapter order provided for general business students, an instructor who wishes to focus on finance and investment analysis issues can easily shift Chapters 16 through 20 to the beginning of the semester (after Chapter 1) to allow adequate time for in-depth cov- erage. Or an instructor who wishes to focus on real estate economics might consider following the first chapter with Chapters 11 through 15. We would be pleased to get feedback from instructors describing how they choose to sequence the chapters in their courses.

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Preface xv

| acknowledgments _______________________________________

No project of the magnitude of this book can be accomplished without a spirit of teamwork and mutual respect between all the parties involved. We wish to sincerely thank all of the people who provided comments, suggestions, and other invaluable forms of support in the research, writing, and production process, especially Jeffrey J. Rymaszewski, senior lecturer, University of Wisconsin at Milwaukee, Frank T. Cook, and Ron Williams.

In addition, special thanks are due to the students in our classrooms who served as guinea pigs for the new material.

Finally, we hope that everyone who reads this book will be able to use the lessons contained herein to improve their real estate decision-making skills and, ultimately, to enrich their lives with respect to real estate resources.

Charles F. Floyd, PhD University of Georgia

Marcus T. Allen, PhD Florida Gulf Coast University

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xvii

c h a p t e r 1

Case Study: The Importance of Location Case Study: The Gestation of Park Springs

c h a p t e r 2

Close-Up: Water Wars Legal Highlight: Who Can Use the Shore?

Close-Up: The Empire State Building Legal Highlight: How Did an Acre Get to Be an Acre?

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Close-Up: Meadow Brook Ranch Use Covenants Legal Highlight: Validity of Restrictive Covenants

Legal Highlight: Restrictive Covenant Disputes Legal Highlight: A Cautionary Tale on Mechanics’ Liens

Legal Highlight: Prescriptive Easement Legal Highlight: The Case of the Landlocked Parcel

Close-Up: Use of Conservation Easements Legal Highlight: Adverse Possession

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Legal Highlight: What Constitutes “Public Use”? Legal Highlight: Inverse Condemnation

Close-Up: The Smart Growth Controversy Legal Highlight: The Strange Case of the Incredible Shrinking Building

Legal Highlight: The Case of the Costly Permit Legal Highlight: The Takings Issue

c h a p t e r 5

Close-Up: Sleuthing for Transaction Price Legal Highlight: Title Examination through the Grantor and Grantee Indexes

r e a l e s t a t e t o d a y f e a t u r e s

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xviii Real Estate Today Features

c h a p t e r 6

Legal Highlight: Validity of an Oral Contract Legal Highlight: Necessity to Meet “Concurrent Conditions” by Date of Closing

c h a p t e r 7

Legal Highlight: Landlord’s Liability for Failure to Provide Adequate Maintenance Legal Highlight: Liability of Landlords for Injuries to Guests of Tenants

c h a p t e r 8

Legal Highlight: The Seller’s Agent’s Obligations to the Buyer Legal Highlight: Fair Housing

c h a p t e r 10

Close-Up: Green Acres Shopping Center—A Property Management Success Story

c h a p t e r 11

Close-Up: Civita: An Urban Green Village Close-Up: If You Build It Green, Will They Come? Yes!

Close-Up: Five Historic New Towns: Savannah, Riverside, Radburn, Levittown, and Reston Close-Up: Highlands Falls Country Club

Case Study: Milford Hills Saga

c h a p t e r 12

Close-Up: Atlantic Station: A Successful Brownfields Redevelopment Project Close-Up: The First Suburban Shopping Center: Country Club Plaza

Case Study: Birkdale Village Case Study: The Trump Building: 40 Wall Street Case Study: The Interstate North Industrial Park

Case Study: The Boiler Room Office Building: A Unique Adaptive Use

c h a p t e r 14

Close-Up: The Rise of the “Location-Neutral” Urban Migrant Case Study: A Tale of Two Cities: Flint and West Point

Case Study: Neighborhood Revitalization

c h a p t e r 15

Close-Up: Prequalified vs. Preapproved Case Study: The House That Came Off the Mountain

c h a p t e r 16

Close-Up: What Is Credit Scoring?

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Why Study Real Estate?

1c h a p t e r

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case study The Importance

of Location

case study The Gestation of Park Springs

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c h a p t e r p r e v i e w

Why study real estate? Why is it important? What are the characteristics that make real estate different from other types of assets? Fundamentally, people must have places to live and businesses must have locations for their activities. As a result, real estate is a vital resource that touches the economic lives of all people. A thorough understanding of the complexities of real estate resources and the markets in which they are traded enables us to make informed choices regarding real estate for either personal or business use. The objective of this book is to present the general principles necessary for effective real estate deci- sion making. The text also serves as a starting point for more advanced study of the concepts and issues facing real estate market participants.

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2 R E A L E STAT E P R I N C I P L E S

| the role of real estate studies in business education _____

When you first learned that your college or university offers a real estate prin- ciples course as part of its business school curriculum, you may have thought that the focus of the course would be to prepare for a career as a real estate broker. While real estate brokerage is an excellent career choice for many people, this book does not assume that a career in brokerage is your motivation for studying real estate issues. Instead, we present the principles of real estate from the perspective of the user of real estate resources. These principles provide a foundation for effective real estate decision making, whether you intend to make a career in the real estate industry or simply to become more knowledgeable about your personal real estate transactions.

In most universities and colleges, real estate is regarded as a specialty area under the general umbrella of business studies. As such, a real estate principles course cov- ers issues and topics unique to the real estate discipline that are much too specific for adequate coverage in other areas of academic study. Because of the special- ized knowledge required for effective real estate decision making, real estate issues deserve independent attention in a business school curriculum. The intricacies of real estate resources and markets can baffle the ill-prepared decision maker, but a solid foundation in real estate principles will help you make effective personal and business real estate decisions throughout your life and career. In addition, the topics covered in this text will serve as a springboard for those students who wish to pursue a more detailed study of real estate in subsequent courses.

| personal and business-related real estate decisions ______

A thorough understanding of real estate principles is extremely important for real estate decision making in both personal and business-related venues. As indi- viduals, all of us will probably face the following questions several times over the years:

■■ Should I buy a house or a condo or should I lease an apartment for my personal residence?

■■ In what neighborhood do I want to live?

■■ What type of financing should I use, and how do I arrange it?

■■ Should I use a broker to sell my property or try to sell it myself?

■■ How should I structure the sales contract to get the best deal?

■■ How do I decide which property I should invest in?

The same issues that face us as individuals also apply in the business environ- ment. Consider a company that requires additional office space to expand its opera- tions and compete effectively in its product market. Such a company faces many questions that can be addressed only with the knowledge of real estate principles. The following are examples:

■■ Should the company buy or lease additional space? If the company leases space, how should it structure the details of the lease agreement to best serve its objectives?

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C H A P T E R 1 Why Study Real Estate? 3

■■ If the company decides to buy more real estate, should it build a new property or purchase an existing one?

■■ How should the company finance the purchase or development?

■■ Should the company acquire a larger building than it currently requires and lease the additional spaced to tenants until the company needs it?

■■ Should the company consider relocating the corporate headquarters to a different location, either in its current city or in another city altogether?

Appropriate answers to these and other important questions require familiarity with the overall operation of real estate markets, as well as specific knowledge of legal issues, transaction details, and the financial framework of real estate resources. For this reason, real estate principles are a fundamental component of undergraduate business education, regardless of your chosen field of study.

| organization of this book ________________________________

Our goal is to present some of the basic principles of real estate in such a manner that you will be well prepared to anticipate and evaluate changing market conditions and make real estate decisions that best serve your personal and business objectives. We have divided the topics considered in the text into four categories:

1. Part One, Real Estate Legal Analysis (Chapters 2–7) consid- ers issues related to the legal concept of real estate ownership. We define various ownership interests one can obtain in real estate, deed and legal description methods, and private and public limitations on ownership.

2. Part Two, Real Estate Service Industries (Chapters 8–10) discusses the real estate services industry, including brokerage, property man- agement, and appraisal.

3. Part Three, Real Estate Market Analysis (Chapters 11–15) consid- ers the dynamics of real estate markets as a result of national, regional, and local influences on property values and uses. In addition, we review the classic models of urban growth and discuss various aspects of the land development process. We also examine the residential, commercial, and industrial development process.

4. Part Four, Real Estate Finance and Investment Analysis (Chapters 16–19) examines the financing of real estate investment and owner- ship, and real estate investment analysis.

The remainder of this introductory chapter sets the stage for the topics to be addressed throughout this text by describing the special economic characteristics of real estate, the economic importance of real estate, and various career opportunities in the real estate industry.

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4 R E A L E STAT E P R I N C I P L E S

| special characteristics of real estate ___________________

What is real estate? Simply defined, real estate is land and things attached to it such as buildings and other improvements to the land. Real property consists of the legal interests associated with ownership of the physical real estate. In practice, how- ever, the two terms are often used synonymously. All other movable property such as automobiles, furniture, boats, and clothing is known as personal property. As an economic resource, real estate has some distinct characteristics that distinguish it from other types of resources. These characteristics are

■■ fixed location;

■■ uniqueness;

■■ interdependence of land uses;

■■ long life;

■■ long-term commitments;

■■ large transactions; and

■■ long gestation period.

Fixed Location

The characteristic of real estate that distinguishes it from all other types of eco- nomic resources is its fixed location. If there is an oversupply of wheat in Kansas, or of automobiles in Michigan, they can be moved to areas of relative scarcity. This is not true of real estate resources. If there is an oversupply of condominiums in Miami, office space in Manhattan, or shopping centers in Minneapolis, they cannot be trans- ported to other communities where the demand is stronger. A tract of land, of course, cannot be moved a few feet up the street to help meet demand for space at that site. Thus, the success of real estate acquisition, development, and investment decisions is directly affected by the forces of supply and demand in a local area.

Uniqueness

Because real estate is fixed in location, every parcel is unique or, to use a fancy term, heterogeneous. Even subdivision lots located side by side are not perfect sub- stitutes for each other because of differences in such factors as topography, tree cover, and view. These factors often create large differences in property values. For example, lots fronting on a lake will probably sell for much more than lots just across the street; lots with a spectacular mountain view may sell for many times more than nearby ones without the view.

Interdependence of Land Uses

Real estate’s fixed location leads to another economic characteristic: interde- pendence of land uses. The use of real property depends greatly on the provision of

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C H A P T E R 1 Why Study Real Estate? 5

public services, the uses made of nearby land, and the general economic vitality of the neighborhood and community.

It is extremely difficult to use land to its full economic potential, particularly in an urban setting, unless adequate public services are provided and neighboring land is used in complementary ways. Even agricultural lands need to be served by roads, and such basic utilities as electricity and telephone service are necessary for prac- tical homestead use. As we move to denser residential development, public water and sewerage systems are essential as are such governmental services as education, police and fire protection, and various social services. Land must be converted to public use for parks, schools, and other governmental services, particularly trans- portation facilities. If adequate governmental services and public land uses are not available, it will be difficult or even impossible to develop land for residential, com- mercial, or industrial use.

The use of land is also affected greatly by nearby land use. If a large tract of vacant land is located near areas of expanding residential and commercial develop- ment, this location should increase both the land’s potential use and its value in the marketplace. Conversely, the value of land may be affected adversely by its proxim- ity to “undesirable” uses. It would probably be difficult, for example, to develop a single-family housing development next to a chemical plant or slaughterhouse. Such uses, however, particularly if served by transportation facilities and other public ser- vices, may make nearby land valuable for industrial purposes.

The economic vitality of a neighborhood, community, or region greatly affects the demand for real property and its value. If the economy of the area is expanding,

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c a s e s t u d y

The Importance of Location

How important is location to the value of real estate? Very important in the case of a 77-square-foot “studio apart- ment” in the exclusive Knights-

bridge neighborhood of London. The former storage closet, originally conceived as a maid’s room, is only slightly larger than a prison cell, but is priced at $335,000, or about $4,500 per square foot. Moreover, the room has no electricity or heat, which would cost an additional $59,000 to make it habitable. Rather pricey, but the tiny apartment is

located in one of the wealthiest neighborhoods in the world and is within walking distance to exclu- sive stores such as Harrod’s and the city’s iconic Hyde Park.

Almost unbelievably, other ultra high-end Lon- don properties have been selling for even higher prices, sometimes as much as $6,000 per square foot. By comparison, the closet-sized apartment is a bargain. The old real estate axiom that the three most important factors in real estate are location, location, and location certainly applies in this case.

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6 R E A L E STAT E P R I N C I P L E S

the population also will increase, bringing about a corresponding increase in the demand for residential, commercial, and industrial land. Conversely, if the economy of the area is in temporary or long-term decline, the demand for real estate and real estate value also will tend to decline.

It is the interdependence of land uses that leads to the existence of both private and public land-use controls, topics we will study in Chapters 3 and 4. The use of land affects the owners of other land more than the use of almost any other type of private property and may create costs to the public at large. For example, the fill- ing of floodplain lands (the low-lying land near streams) to make them suitable for high-density residential use may cause other owners of land on the floodplain to be affected adversely in periods of heavy rainfall. If other landowners also fill in their portion of the floodplain, a flood hazard may be created that will require large public expenditures to alleviate.

Long Life

Although its ability to generate income may change over time, land is virtu- ally indestructible. Additionally, real estate improvements—that is, buildings on the land—generally have very long lives. For example, a family would expect a new home to last as long as they wanted to live there and beyond, and many houses last for a century or more when maintained properly. Apartment houses, shopping cen- ters, and other types of income-producing property also have very long lives.

Long-Term Commitments

The long lives of real estate improvements mean that investment decisions are, by their very nature, long-term commitments. Although the immediate prospects for the production of income are very important in real estate investment analysis, the factors that influence income generation over the long term are equally critical. For example, the proximity of a hotel to a heavily traveled highway is a predominant fac- tor in the financial success of the hotel. If the hotel is built in a location that soon will be bypassed by a new freeway, it probably will not be a successful investment during much of its life. Conversely, shopping centers are often built somewhat ahead of the market to gain advantageous location in advance of expected population growth.

The characteristics of long life and long-term commitments force the real estate investor and developer to establish realistic, long-term outlooks if they want to make successful investment decisions. The real estate investor who merely assumes that favorable economic trends will continue will probably be unsuccessful. For exam- ple, most of the problems that arose during the recent decline in real estate prices occurred because investors and financial institutions regarded the future with unbri- dled optimism. Investors should analyze carefully the factors that have caused eco- nomic trends to be favorable in the past and try to ascertain what will happen to these factors for some years into the future.

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C H A P T E R 1 Why Study Real Estate? 7

Large Transactions

Another important economic characteristic is the relatively large size of real estate transactions. Because they involve large expenditures, real estate transactions are not entered into either lightly or frequently. A home is by far the average family’s largest single purchase. Investment in income-producing real estate requires even larger outlays.

The large size of real estate transactions means that buyers usually have to rely at least partially on some type of outside financing. This economic characteristic has led to the rise of the real estate finance industry. Both buyers and sellers generally need assistance to analyze the marketplace, evaluate long-term investment decisions, arrange financing and, in general, deal with the complexities of these transactions.

Long Gestation Period

A final economic characteristic of real estate is the long gestation period of real estate development projects. The time between the conception of a development project and its actual completion and subsequent entry into the available supply may be several years. Suppose a group of investors decides to develop an apartment com- plex. To complete this project, they first must acquire the land, then have engineer- ing and architectural plans drawn for the site and buildings, secure zoning and other regulatory approvals, arrange financing, and construct the improvements.

Long delays may occur at any of these steps. For example, it may be difficult to secure approval from the zoning board, or it may be necessary to wait several months for the completion of a new sewer line, or bad weather may delay construction.

The long gestation period makes the supply of real estate slow to respond to increases or decreases in demand. Because the supply cannot be increased quickly, increases in demand often result in rapid upward price movements unless an excess supply exists. Conversely, demand may decline during a project’s gestation period, making it less valuable upon completion than originally anticipated. This is yet another reason the real estate developer must analyze factors affecting future demand and supply. There may be a strong market for, say, office space in a certain area at present. This does not necessarily mean that the strong demand will continue. Many investors have discovered, to their immense sorrow, that by the time the project was completed, demand for the products had declined. Or they may not have fully considered the impact of other projects that were being built at the same time. Suc- cessful real estate investment requires a thorough, long-term economic perspective.

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8 R E A L E STAT E P R I N C I P L E S

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The Gestation of Park Springs

The development history of the Park Springs continuing care retirement community provides an excellent example of the long gestation period for real estate

development: 10 years from conception to generat- ing income.

In 1994, developers Andy and Kevin Isakson bought a 110-acre former private airport site that straddled two county lines in suburban Atlanta in order to obtain the two acres needed to complete the assemblage for a Super Target shopping center site. They then sold part of the remainder for a parking lot for the 1996 Atlanta Olympics but were left with 54 acres that had limited access and no utilities. In order to make the tract suitable for development they worked with the two counties involved and the state department of transportation to relocate an adjoining road to make the site more accessible. This also meant that the site would be surrounded on three sides by 3,500-acre Stone Mountain State Park. In order to gain utilities they had obtain water from one county and sewerage from the other. Finally, after four years of effort the site was ready for development. Now came the need to obtain zoning.

The plan was for a mixed-use development including apartments and retail space. This pro- posal was met with considerable community oppo- sition based on a fear of an influx of school children and an increase of traffic in the already congested area. Thus, the initial zoning proposal failed. Then one of the community leaders suggested an age- restricted senior retirement community. This was attractive to the community because there wouldn’t be additional local school children and the retired

residents would generate little traffic, particularly at busy hours. The developers responded with a proposal that included 398 residences restricted to persons 65 years of age and older. This proposal gained overwhelming community support and was approved after two more years of effort. This brings us to the year 2000, six years after purchase, with nothing but expense and no income from the property.

The developers saw the potential for success for a continuing care retirement community, one where seniors could purchase the right to occupy an independent living residence with the option of moving to assisted living or skilled care nursing facilities on the same site as their health needs changed. They offered a variety of units, ranging from an 800-square-foot one-bedroom apartment for $135,000 to a 2,400-square-foot detached two- to three-bedroom home for $600,000. For this entry fee the purchaser obtained the right to occupy the unit for his or her lifetime and the use of the development’s facilities, including a fitness center, library, woodworking shop, pottery shop, and three restaurants. A monthly fee covered all utilities, biweekly cleaning, all maintenance, and taxes. At owners’ death, 90% of the entry fee would be refunded to their estate.

The concept met with great market accep- tance, and finally in 2004, 10 years after the property was purchased, the first units were sold and the project began generating a cash flow—not yet a profit, but at least a cash flow. By 2007, all but 16 of the units had been sold, and entry fees had risen by 45%, generating a healthy profit for the developers upon resale of these units. Even

(continued)

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C H A P T E R 1 Why Study Real Estate? 9

| the economic importance of real estate ___________________

Real estate is a vital component of the national economy and constitutes a large portion of national wealth. As of the first quarter of 2014, land and structures com- prise about 21% of the total assets of households and about 33% of the total assets of businesses in the United States (the remainder consists of equipment and inven- tories). Real estate accounts for about 5% of the nation’s gross domestic product and about 36% of gross private domestic investment. In addition to tangible assets, individuals and businesses frequently borrow against real estate assets, which creates financial assets in the form of mortgages and mortgage-backed securities. In early 2014, the total outstanding mortgage debt in the United States was more than $13.3 trillion.

The economy of the United States is especially sensitive to changes in owner- occu pied residential real estate (housing) values. The most recent example was the overall negative economic impact the decrease in housing values in the 2000s had on the economy of the United States as well as impacts throughout the world. The shocking declines in overvalued housing stemmed from aggressive investment in mortgage-backed securities, which led to relaxed loan qualification standards and a variety of alternative mortgage loan products. These relaxed standards and so-called subprime loans enabled many people to obtain loans for which they would not have otherwise qualified. In some cases, borrowers did not have to provide any proof of their income or other assets (so-called liar loans). Some loan products allowed

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The Gestation of Park Springs

so, the development didn’t begin to really show an overall profit until 2009. Park Springs has been a resounding success, but only with developers who were able to surmount the many obstacles inherent in the site and absorb the large development costs during the more than 10-year gestation period.

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10 R E A L E STAT E P R I N C I P L E S

borrowers to pay only the interest due on the loan (instead of interest and princi- pal amortization, as in traditional loans) for the first few years of the loan. Some loans had reduced initial interest rates (so-called teaser rates) that lowered the initial monthly payments but required higher interest rates (and higher payments) after the first few years. Some loans allowed borrowers to borrow more than the value of the house being pledged as collateral for the loans.

Easy access to mortgages increased demand for housing and resulted in rapidly increasing housing values. According to the S&P/Case-Shiller Home Price Index, housing values increased by more than 47% between 2000 and 2006. By mid-2006, however, many subprime borrowers realized they could not afford their loan pay- ments (especially those with required interest rate adjustments), and the number of delinquent subprime loans started to rise dramatically. By the first quarter of 2007, more than 17% of subprime loans were delinquent, and foreclosures were rapidly increasing. Investor demand for mortgage-backed securities that relied on payments from subprime borrowers for their cash flows dried up very quickly. Lenders quickly instituted more prudent borrower qualification standards and returned to more tradi- tional types of mortgages.

With less mortgage capital available, the demand for housing quickly began to erode. Nationally, home values fell by 32% between mid-2006 and the end of 2009. Some areas experienced even more dramatic declines over this time period: Las Vegas, 55%; Phoenix, 51%; and Miami, 47%. Likewise, the value of mortgage- backed securities plummeted, severely affecting many major financial concerns that held these securities as investment assets. The general economic decline that fol- lowed has proven to be the worst economic crisis since the Great Depression of the 1930s. As of late 2014, housing prices in many markets around the nation are recov- ering but have still not reached the record highs of the mid-2000s.

| the real estate industry: career opportunities ___________

The real estate industry is diverse, offering many career opportunities. To some students a career in real estate means selling homes, and, indeed, this is a significant part of the real estate brokerage industry. But many other fascinating careers in real estate exist, and one of the purposes of this book is to introduce these career oppor- tunities, as well as to provide the basic knowledge needed to become a part of the real estate industry.

Real Estate Brokerage

In 2014, the largest real estate brokerage trade association, the National Associa- tion of REALTORS®, had over 1 million members, including brokers, salespersons, and other real estate professionals. The compensation earned by participants in the brokerage industry fluctuates with the ups and downs of the real estate market, but the U.S. Bureau of Labor Statistics estimated that in 2012 real estate brokers earned an annual average of $82,380, and salespersons $53,200.

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C H A P T E R 1 Why Study Real Estate? 11

Five principal classifications of real estate exist in the private marketplace: owner-occupied residential, renter-occupied residential, commercial, industrial, and farm and other open land. Because it is difficult to be an expert in all aspects of the real estate market, most brokers specialize in certain types of property. The extent of specialization depends on a number of factors, particularly the size of the local market. The real estate broker in a small city may deal in several or all types of prop- erties. In larger cities, brokers may sell one type of real estate or properties located in only one part of a city. Quite commonly, some brokers and salespersons sell only owner-occupied houses, while others deal only in the sale or leasing of income- producing properties.

Property Management

Many people who invest in income-producing real estate, such as apartments and shopping centers, have neither the inclination nor the expertise to personally handle the properties’ day-to-day operating activities, such as leasing, rent collection, build- ing repairs, and building services. These tasks—and, indeed, the general objective of maximizing the value of a property—are delegated to the property manager. Some brokerage firms manage real estate as a supplementary activity, while many larger firms have a separate property management department. Still other property man- agers may be hired directly by the firm that owns the properties. If the property manager does a good job, this function can add considerable value to a property. It can also earn a good income for the property manager. The average annual wage for property managers in 2009 was $52,610.

Real Estate Finance

Several characteristics of real property, principally the long-term nature of real estate investment and the consequent need for large amounts of money over a long period of time, make mortgage credit both necessary for most purchasers and attrac- tive to many lenders. In turn, this has given rise to the real estate finance industry.

Real estate loans are made by many types of institutions and even by individu- als, and major employment opportunities are found in savings associations, savings banks, commercial banks, mortgage banking firms, and life insurance companies. Savings associations and savings banks specialize in residential loans and do most of their lending locally. Commercial banks also lend money on real estate, particularly for relatively short-term construction loans, and they also purchase many mortgages for mortgage bankers.

The mortgage banking and mortgage brokerage industries also play large roles in the financing of real estate. Mortgage bankers do not collect deposits from savers and have only a small amount of their own capital to lend. After originating loans to borrowers, mortgage bankers sell the loans in the secondary mortgage market, but they often continue to service (collect payments, mail late notices, etc.) the loans for a fee. Mortgage brokers do not originate loans with their own funds but instead bring lenders and borrowers together in exchange for one-time fees. Both mortgage

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12 R E A L E STAT E P R I N C I P L E S

bankers and brokers are essential parts of the financial mechanism that makes debt capital available to real estate owners.

Appraisal

Estimates of value are needed in almost every aspect of real estate and develop- ment. Sellers need to know what their potential purchases are worth in comparison with other properties in the market. Mortgage lenders need estimates of value, an appraisal, before they make lending decisions. Appraisals also are essential for tax assessors, insurance adjusters, and right-of-way agents. Accordingly, some apprais- ers are employed by financial institutions, other private firms, and government orga- nizations, while many others work as independent fee appraisers—that is, they offer their services to the public for a fee. The average annual wage of appraisers was $57,040 in 2012.

Consulting

Closely related to real estate appraisal is real estate consulting. The real estate appraiser makes estimates of value, while the real estate consultant advises indi- viduals and firms regarding their real estate investments. Though the two specialties require similar kinds of knowledge, the consultant must have even more extensive knowledge than the appraiser of all phases of real estate, tax laws, and other aspects of investment.

Development and Construction

Real estate development certainly is one of the most fascinating aspects of real estate and one that offers greater potential return—and greater potential risk—than perhaps any other field within the industry. Real estate development involves the acquisition and subdivision of land, designing and planning the project, and the construction of improvements, such as roads, utilities, and buildings ranging from single-family homes to multi-million-dollar office building and shopping centers. Development is often described as the process of creating value by improving real estate for more productive use.

Corporate Asset Management

Although real estate makes up a large portion of corporate assets, most cor- porations have not placed adequate emphasis on managing these assets efficiently. Increasingly, however, firms are establishing corporate real estate departments, and this has led to many new opportunities in the real estate field. As might be expected, utilities and other firms with very large percentages of their assets in real estate have been leaders in the field, and other companies as well are realizing that efficient man- agement of their real estate can add significantly to corporate profits.

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C H A P T E R 1 Why Study Real Estate? 13

Legal Experts

The legal complexity of real estate transactions and development projects often requires the expertise of attorneys and other legal professionals. Many attorneys spe- cialize in real estate law and provide important services for real estate market par- ticipants such as title examination, contract drafting, and litigation. These attorneys often hire paralegals to assist them.

Land Planners

Land-use planning has grown in importance with the increase in both urbaniza- tion and concern for the environment. Planners are employed by local government planning agencies, regional planning districts, and state development offices.

| chapter review __________________________________________

■■ The five broad categories that comprise the real estate “body of knowl- edge” considered in this text include real estate market analysis, the legal framework of real estate, real estate services, the real estate transaction process, and investment analysis.

■■ Simply defined, real estate is land and things attached to it.

■■ The special economic characteristics of real estate are (1) fixed location, (2) uniqueness, (3) interdependence of land uses, (4) long life, (5) long- term commitments, (6) large transactions, and (7) long gestation period.

■■ The characteristic of real estate that distinguishes it from all other types of economic resources is its fixed location. Fixity of location means that every parcel of real estate is unique, and this factor can create large differ- ence in property values.

■■ Land is indestructible, and real estate improvements generally have long lives. Thus, investment decisions are by their very nature long-term decisions.

■■ Because real estate purchases involve large expenditures committed for long periods of time, outside financing is essential for most transactions.

■■ The use of land depends greatly on (1) the provision of public services, (2) nearby land uses, and (3) the general economic vitality of the neighbor- hood and community.

■■ The gestation period for real estate improvements—that is, the time between conception of a real estate project and its actual completion and subsequent entry into the available supply—may be several years. This long gestation period makes the supply of real estate slow to respond to increases in demand.

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14 R E A L E STAT E P R I N C I P L E S

p a r t o n e

■■ Five principal classifications of real estate exist in the private marketplace: (1) owner-occupied residential, (2) renter-occupied residential, (3) com- mercial, (4) industrial, and (5) farm and other open land.

■■ The general objective of the real estate property manager is to maximize the income flowing to the owners from income-producing property.

■■ Mortgage loans now total about $14.1 trillion and have led to the devel- opment of a major sector of the real estate and finance industries. Major employment opportunities related to real estate are found in savings banks, commercial banks, mortgage banking and mortgage brokerage firms, and life insurance companies.

■■ Real estate appraisers estimate the value of real property. Their services are used by buyers and sellers, financial institutions, tax assessors, and many others.

■■ Real estate counselors advise individuals and firms about their real estate investments. They must have extensive knowledge of all aspects of real estate, tax law, and investment.

■■ Real estate development offers greater potential return and greater poten- tial risk than perhaps any other field within the real estate industry.

■■ Land-use planners are engaged in physical design, economic and invest- ment aspects of development, and land-use policies and regulations.

■■ Many real estate specialists are employed at various levels of government in property acquisition, tax administration, land-use planning, and other operations of government.

| key terms _______________________________________________

appraisal

gestation period

personal property

real estate

real property

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p a r t o n e

Real Estate Legal Analysis

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2c h a p t e r Property Rights and Legal

Descriptions

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c h a p t e r p r e v i e w

Perhaps you own or lease some real estate. What exactly are the rights that come with owning or leasing this property? These can be difficult questions because real property rights associated with real estate can be quite complex. Real property rights can be divided in many ways. For example, one party may own the right to use the surface of the land, another may own the right to sub- surface minerals, gas, or oil, and yet another party may own the right to use the water that flows across or under the land. Or two or more owners may jointly own unique and specific rights to the same parcel of real estate. This chapter examines these and other property rights issues that every market participant should understand to ensure effective real estate decisions.

After reading this chapter, you should be familiar with how property rights are divided among various claimholders. The objectives of this chapter are to

■■ define the concepts of real property and personal property;

■■ demonstrate how property rights are physically divided;

■■ consider how property rights are bundled into “estates in land”;

■■ describe how properties can be jointly owned by two or more owners; and

■■ examine the three methods for legally and uniquely identifying individ- ual parcels of real estate.

close-up Water Wars

close-up The Empire State

Building

legal highlight How Did an Acre

Get to Be an Acre?

r e a l e s t a t e t o d a y

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18 PA RT O N E Real Estate Legal Analysis

| real versus personal property ___________________________

In the previous chapter, we defined real estate as land and things attached to the land. Another important term real estate market participants need to understand is property. Although the term property can be used in several ways, we gener- ally think of property as any objects that can be owned or possessed—real estate, vehicles, books, clothing, furniture, stocks, or bonds, for example. Legally, the con- cept of property can be divided into two broad classes: real property and personal property. Real property consists of legal interests in land and things attached to the land. Personal property includes legal interests in all other types of property. Stated more simply, real property refers to rights to real estate—land and things attached to that land—while personal property refers to rights to movable property such as automobiles, furniture, clothing, and business equipment. Personal property is also called chattel.

Generally speaking, the requirements to transfer real property from one owner to another are much more complex than are those for personal property. To buy a book at a store, for example, the purchaser simply tenders the funds and receives the book and perhaps (but not always) a written receipt or “bill of sale.” But when real property is transferred, a written document must be prepared with language that uniquely identifies the property being transferred, the specific rights and interests being transferred, the parties to the transfer, and any other important details involved in the transfer. There are a few exceptions to the rule requiring a written document as evidence of real property transfers (such as a lease for less than one year in some states), but it is always a good idea to specify the details of transactions involving real property in written form to prevent misunderstandings and disputes even if such a document is not absolutely required.

When ownership rights to real property (often called title) are transferred, the document normally used to convey the rights from one party to another is called a deed. When a tenant acquires property rights to leased property, the document used to convey the rights from the property owner to the tenant is called a lease. Leases convey the rights of use and possession of real property under the agreed-on terms, but leases do not transfer ownership rights to the property. Both deeds and leases are considered in detail later in this book.

| fixtures _________________________________________________

Whether a particular item of property is considered real or personal property cannot always be readily determined. For example, a central air-conditioning unit clearly is movable personal property at the time it is purchased. However, when it becomes attached to land as part of a building, it is treated as part of the real estate and considered real property. Personal property that becomes part of the real property when it is attached to the land or a building is termed a fixture.

For example, the antique chandelier you inherited from Aunt Matilda and hung in your dining room is a fixture and part of your house. Unless it is specifically excluded when the house is sold, the new buyer becomes the proud owner of the

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C H A P T E R 2 Property Rights and Legal Descriptions 19

chandelier along with the rest of the real estate. Other items generally considered fixtures include landscaping, automatic garage door openers, water heating or filter- ing systems, window treatments (such as blinds and drapes), and appliances installed in the house (such as built-in dishwashers and central air conditioners). It is impor- tant to remember that if you are selling a home and want to retain ownership of Aunt Matilda’s chandelier or your prized rose bushes, you must specifically exclude them from the transaction. Likewise, if you are purchasing a property, you should be careful to specify what items are to be included when negotiating the terms of the transaction.

Tests for Fixture Status

Whether an item of personal property has become a fixture can be critically important in determining (l) the value of real property, (2) whether a real estate transaction includes the item, (3) whether the item is part of the security given to the mortgagee (lender), and (4) whether the item remains with the landlord or can be removed by the tenant when the lease terminates. These issues are often resolved by through litigation when there are disputes over the status of the item in question.

Intent of the Parties

The most crucial test used to determine whether something is a fixture or per- sonal property is the test of intent of the parties. The best way to indicate intent, of course, is by a written agreement that states clearly which items are to be con- sidered part of the real estate and which are to be considered personal property. For instance, a sales contract for a house might specify that the range and refrigerator may be removed by the seller. Or a lease agreement for a factory or warehouse build- ing might state that the tenant may attach trade fixtures (personal property used in a trade or business) such as machinery, office equipment, and office cubicles to the building without losing the right to remove these items at the termination of the lease. (Notice that trade fixtures are, by definition, personal property, not real prop- erty.) As long as the intent of the parties is made clear, there should be no confusion about whether the item in question is considered a fixture or personal property.

Other Tests of Fixture Status

Unfortunately, the intent of the parties often is unclear, so other tests of fixture status are applied by courts in the event of disputes. If an item of personal property becomes attached to the real estate, it usually is considered a fixture, and the damage caused to the land or building by the item’s removal is a crucial element in the test of attachment. For example, while a portable window air conditioner would likely be considered personal property, a central air-conditioning system would be consid- ered a fixture because the building would be damaged if the system was removed. Another method for determining whether an item is a fixture is the test of adapt- ability. Under this test, items that have been specifically adapted to the real estate are

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20 PA RT O N E Real Estate Legal Analysis

generally considered fixtures. The issue considered in this test is whether removal of the item would substantially alter the usefulness of the remaining real estate. For example, kitchen cabinets and a built-in entertainment center would probably be considered fixtures, while free-standing, noncustom cabinets would be classified as personal property.

Because these last two tests for fixtures do not necessarily provide clear-cut distinctions between real and personal property, the parties involved always should indicate their clear intent by a written agreement. This, of course, helps avoid dis- putes in all business matters.

| mineral and air rights ___________________________________

Real property rights are not limited to the surface of the earth; they also include the space above the earth’s surface (air rights) and minerals or other useful materials that exist below the surface (collectively called mineral rights). Historically, a land- owner’s real property interests have been conceptualized as pie-shaped, beginning at the earth’s center and extending through the surface indefinitely into outer space. In modern thought, the property rights associated with the surface of the land, miner- als, or other useful material that may exist under the surface of the land and airspace above the land are often separated among several different owners. Similarly, the rights to water that may flow over the land or be adjacent to the land are sometimes owned separately from the land itself.

Ownership of airspace is limited to a reasonable distance above the earth’s sur- face. Obviously, an airplane flying over a property at an altitude of several thousand feet rarely interferes with the owner’s use or enjoyment of the land. But when aircraft fly so low that a reasonable use of the land is prevented (for example, near a length- ened airport runway), the owner of the land may be entitled to compensation on the basis that the plane is interfering with the owner’s property rights.

Mineral rights and air rights may be owned by someone other than the owner of the surface of the land. It is common, for example, for a surface owner to sell to a third party the rights to any oil, gas, coal, and other materials that may be located below the surface. The air rights, likewise, may be transferred to persons other than the owner of the surface. For example, office buildings and parking decks have been constructed over the tracks of railroads, with the owner of the building owning only the air rights.

| water rights ____________________________________________

Water rights—who has the right to withdraw water from the land—is a question of considerable importance, particularly in the more arid western states, and increas- ingly in the eastern states. These rights vary from state to state and depend primarily on what type of water the land touches.

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C H A P T E R 2 Property Rights and Legal Descriptions 21

Rights Relating to Navigable Bodies of Water

The owner whose land joins a navigable body of water, such as an ocean, a sea, or certain rivers, generally owns the land to the high-water mark (the government usually owns the land underneath the water). The owners of such adjoining lands are

r e a l e s t a t e t o d a y

c l o s e - u p

Water Wars

Water scarcity has always been an issue for much of the West, but in recent years, several issues, particularly urban population growth, have also brought it to the fore in the

eastern United States. One example is the long- running legal dispute between the state of Georgia and its southern neighbors, Alabama and Florida, over the allocation of water from Lake Lanier on the Chattahoochee River.

When the dam was completed in 1957, its purpose was to generate electric power and to provide for potential future water needs of the City of Atlanta. Since that time, however, the population of the Atlanta region has grown from about 1 mil- lion to almost 6 million with the resultant increase in the need for water consumption. The increased withdrawal of the lake’s water for Atlanta has left less for the states downstream. When the Corps of Engineers made the decision in 1989 to stop generating power and use that water to serve the needs of the Atlanta region, Alabama and Florida sued in federal court to stop the increased flow to Atlanta. They contended that if adequate water flow in the river was not maintained, both the envi- ronment and their economies would be severely harmed.

Despite decades of legal wrangling and negotiations, the issue still has not been resolved.

However, there is a growing realization that the current prolific water usage is not sustainable if the Atlanta region continues its growth and that increased conservation is essential.

In the West, drought conditions in the Colo- rado River basin, which supplies water to 25 mil- lion people and 1 million acres of farmland, has reached crisis proportions. Not only is the water supply for rapidly expanding Las Vegas threat- ened, agricultural needs in the Lower Colorado basin are in danger.

When Lake Mead was filled following the completion of the massive Hoover Dam in the 1930s, its water level stood at 1,200 feet. By 2014 it had dropped to 1,075 feet and the allocation for agricultural use in Arizona had to be reduced. It was feared that the water level would fall below the intakes for the Las Vegas water supply, and the city was rushing the completion of an $85 million tun- nel to draw water from the bottom of the lake. Las Vegas was also attempting to reduce water usage, but the increasing population created an even greater need. Of course, the city still was supply- ing water to 60 golf courses and landscaping used 70% of the total water usage.

These examples clearly illustrate that the availability of water, which in the past has been taken for granted in much of the country, will be of increasing importance to regional economic devel- opment in the future.

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22 PA RT O N E Real Estate Legal Analysis

called littoral proprietors. Disputes regarding the use of water from these waterways seldom occur because there usually is sufficient water to be shared. The principal issue involving navigable waters has been pollution. Laws exist at both the federal and state levels to hold polluters of such waters responsible for their actions.

Rights to Nonnavigable Bodies of Water

The rights of a landowner to use water from a nonnavigable lake or stream that flows across the land are more complex. If an upstream owner uses too much water, for example, there may be too little water left for landowners downstream to use as they wish. How should the water be allocated among the competing owners? The laws that answer this question have developed in a way that reflects the abundance or scarcity of water within the geographic area. The two dominant doctrines with regard to an owner’s rights to nonnavigable bodies of water are the riparian rights doc- trine and the prior appropriation doctrine. The dominant doctrine in the eastern United States is the riparian rights doctrine. Under this doctrine, all owners whose land underlies or borders the water have equal rights to the water. This concept allows all riparian landowners to use all the water desired as long as the use does not deprive other landowners who are also entitled to some of the water.

r e a l e s t a t e t o d a y

l e g a l h i g h l i g h t

Who Can Use the Shore?

Littoral rights affect the use of water, but they also relate to the use of land. For example, does a landowner’s right to control his land extend to the waterline of an

adjoining lake, or does the public have the right to walk along the shoreline?

This was the issue involved in a dispute between across-the-street neighbors on Lake Huron in Michigan. Richard and Kathleen Goeckel own property on the lake. Joan Glass owned the house across the street and had a fifteen-foot ease- ment on the Goeckel property that allowed her to go to the beach. The Goeckels objected to her use of the trail and walking the shoreline in front of their home. Glass’s right to use the trail on the easement

was easily established, but the issue of whether the public has a right to walk the shoreline went all the way to the Michigan Supreme Court. The appeals court had ruled that citizens have the right to walk along the beach as long as they remain in the water. Property owners, the court said, have exclusive right down to where dry land begins and may bar access to the beach.

The Michigan Supreme Court disagreed, ruling that although landowners may own to the water’s edge, under the public trust doctrine inherent in the common law, the public has a right to walk along the shore to the ordinary high water mark. Joan Glass can continue her strolls along the shore. [Glass v. Goeckel, 703 NW2d 1 (2005)]

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C H A P T E R 2 Property Rights and Legal Descriptions 23

In contrast, many states west of the Mississippi are extremely arid and, conse- quently, have rejected the riparian rights doctrine and adopted the prior appropriation doctrine. Under this concept, the first person to use a body of water for some ben- eficial economic purpose has a right to use all the water desired, even if landowners who later find a use for the water may be precluded from using it. This “first-come, first-served” concept is based on the premise that there is an insufficient supply of water to satisfy everyone’s desires; therefore, the first landowner(s) using the water for some worthwhile purpose should be allowed to use all of the water. Prior appro- priation states usually establish a permit system whereby a governing authority can control the water’s use.

Underground Water

There are two types of underground water. Water that flows in a defined channel is called an underground or subterranean stream, while water in pockets not clearly located is known as percolating water. Issues involving underground streams gener- ally are resolved by applying the same principles that would be used if the body of water existed on the earth’s surface. In the case of percolating waters, states gener- ally apply a reasonable use test: A landowner may use the water beneath the land for industrial, agricultural, or other purposes necessary to the beneficial use of the land. However, if withdrawing the water depletes the underground water supply of adjoin- ing landowners, the courts may restrict such action.

| estates in land ________________________________________

Collections or bundles of ownership interests in real property often are described as estates in land. These are divided into two basic types: freehold estates, or ownership, and leasehold estates, or the right to use and possess (but not own) property owned by someone else. Owners normally purchase a freehold estate; renters have a leasehold estate. Figure 2.1 summarizes the different types of estates. When discussing estates in land, the terms grantor, grantee, lessor, and lessee often are used. The grantor is the party who transfers (by sale or gift) a real property interest; the grantee is the party who receives the interest. In the case of leasehold estates, the landlord is known as the lessor, and the tenant is known as the lessee.

Freehold Estates

Freehold estates are separated into present interests and future interests. Pres- ently possessed interests are classified as fee simple absolute estates, qualified fee estates, or life estates. Future interests that accompany qualified fee estates and life estates include reversion and remainder interests. We discuss each of these owner- ship interests in the following.

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24 PA RT O N E Real Estate Legal Analysis

Fee Simple Absolute Estates The fee simple absolute estate is the fullest and most complete set of ownership

rights one can possess in real property. Also known as a fee estate or a fee simple estate, this estate is the one most commonly associated with “owning real estate” and is the type of estate acquired in a typical transaction.

The property owner receiving a fee simple absolute title has an unlimited right to transfer the property to another during his or her lifetime or at death. Legally stated, the fee simple absolute estate is alienable, devisable, and descend- ible. Alienable means the owner can transfer any interest in the property while living. Devisable means interests can be transferred by a will on the death of the owner.

f i g u r e 2.1 Types of Estates in Land

Estates in Land

Freehold Estates Leasehold Estates

Future Interests Present Interests

Tenancy for a stated period Tenancy from period to period Tenancy at will Tenancy at sufferance

Reversion Remainder (vested and contingent)

Noninheritable Estate Life estate

Inheritable Estates Fee simple absolute estate Qualified fee

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C H A P T E R 2 Property Rights and Legal Descriptions 25

Descendible means the interest passes to the owner’s legal heirs if he or she dies without a valid will.

In addition to the ability to transfer a fee simple absolute estate without restric- tion, the owner has the right of unlimited use and even abuse of the land, constrained only by liens and other encumbrances, public land-use controls, and restrictive cov- enants. These restrictions are discussed in Chapters 3 and 4.

Qualified Fee Estates In a qualified fee estate, the owner’s rights can be “defeased” or lost in the

future should a stated event or condition come to pass. For example, the University of Georgia holds a qualified estate in a historic rock house located on the campus in the midst of its modern buildings. Many years ago, the Lumpkin family donated a large tract of land to the university with the qualification in the deed that the family house had to be “forever maintained.” If the university were to destroy the building or let it fall to ruin, a large portion of the campus, both land and buildings added to the land by the university, would revert to the donor’s heirs.

Qualified fee estates are present interests in real property, but each qualified fee estate must also be accompanied by a future interest in the property. The future inter- ests that follow qualified fee estates are known as reversions. If the condition speci- fied is ever violated (for example, removal of the Lumpkin house), ownership in the property reverts to the grantor (or the grantor’s heirs). Depending on the language used to initially create the qualified fee estate, the reversion may happen automati- cally if the stated condition is violated or may require the holder of the reversion interest to initiate legal action to enforce the condition.

Many qualified fee estates are set up to protect a grantor’s personal preferences or wishes. A landowner once sold a parcel of land with the qualification that the property never be used for the distribution of alcoholic beverages (the grantor was a recovering alcoholic). If this condition were ever violated, the property would revert back to the grantor. The grantee accepted this condition because he had no intention of using the property in that fashion. After some years went by, the current owner decided to sell the land and was approached by a national convenience store chain about the property. Upon learning the condition the previous owner had placed on the land when he sold the land to the current owner, the convenience store chain quickly lost interest in the property. Had the chain bought the property, built a store, and sold a six-pack of beer or a bottle of chardonnay, the property rights purchased by the chain would have terminated immediately, and the original grantor or the grantor’s heirs would be the owner of the land and the store.

Life Estates A life estate is a type of freehold estate that terminates automatically and imme-

diately upon the death of a named person. The named person may or may not be the holder of the life estate. For example, a father may leave a last will and testament that creates a life estate in a property he owned at the time of his death for his daughter Sarah with the words “To Sarah, for her life” or “To Sarah, for Ann’s life.” In the first case, Sarah would be the owner of the property for as long as she lives. In the

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26 PA RT O N E Real Estate Legal Analysis

second case, Sarah would own the property as long as Ann lives. In both cases, Sarah is known as the life tenant. When the life tenant is someone other than the person whose life the life estate is tied to, the life estate is known as an estate pur autre vie (estate for the life of another).

Because it is impossible to know how long the named person will live, life estates have an indeterminate duration, but all life estates will eventually terminate (everyone dies sooner or later). Therefore, all life estates must have a future interest associated with them. If the grantor of the life estate does not specify to whom the property will belong on termination of the life estate, then the future interest is the reversion interest we described earlier in our discussion of qualified fee estates, and the property will revert back to the grantor (or the grantor’s heirs, if the grantor is dead) on the death of the named person. On the other hand, the grantor of the life estate may specify that a party other than the original grantee will become the owner of the property upon the termination of the life estate.

For example, the grantor could create a life estate with the words “To Sarah, for her life, and then to Robert.” In this situation, Robert holds the remainder interest in the property while Sarah is alive. The party who holds the remainder interest associ- ated with a life estate is known as the remainderman. Notice that on Sarah’s death, the life estate terminates, and Robert will own all of the rights to the property origi- nally held by the grantor of the life estate and the remainder interest. If the grantor had a fee simple absolute estate, then Robert will own a fee simple absolute estate upon Sarah’s death. If the grantor had a qualified fee estate, then Robert will own only a qualified fee estate upon Sarah’s death.

Remainder interests can take the form of a vested remainder or a contingent remainder. A vested remainder exists when the remainderman is guaranteed own- ership of the property at some time in the future, but a contingent remainder exists when there are conditions attached to the remainder interest that could prevent the remainderman from receiving a present interest in the property. For example, Alan could grant a life estate to “Nell for her life, then to Billy if he is married at the time of Nell’s death, otherwise to Clyde.” In this situation, both Billy and Clyde hold con- tingent remainder interests in the property. If Billy is married when Nell dies, then Billy will own the land on Nell’s death. If Billy is not married when Nell dies, then Clyde will own the land on Nell’s death.

The life estate is a very useful technique in estate planning. John might, for example, put the family home and farm in trust for his children Sue and Sally but give his wife Mary a life estate. Estate taxes have to be paid on John’s death. Mary may use the property during the remainder of her lifetime, but at her death, no addi- tional taxes are due because she possessed only a life estate. This often can reduce taxes greatly, particularly if the property has increased dramatically in value since John’s death.

Leasehold Estates

The term leasehold estate refers to the rights of use and possession (but not ownership) held by a tenant as a result of a lease agreement with a property owner.

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C H A P T E R 2 Property Rights and Legal Descriptions 27

The lease agreement may specify that the leasehold estate will last for a specific time period, or it may specify that the leasehold estate will last for as long as the lessor and lessee are willing to continue their relationship. In either case, the tenant pays rent and possesses and occupies the land or building for the duration of a lease with the understanding that the landlord retains full ownership of the real property. In other words, the landlord has a reversionary interest at the termination of the leasehold estate, often referred to as the right of reentry. While the tenant’s leasehold estate is in place, the landlord is said to hold a leased fee estate, meaning that the landlord is the owner of the property, but the property is currently leased to a tenant.

Leases, or tenancies, can be divided into the following four categories:

1. Tenancy for a stated period

2. Tenancy from period to period

3. Tenancy at will

4. Tenancy at sufferance

A tenancy for a stated period occurs when a landlord and a tenant enter into an agreement for a specified term. The stated period may be six months, a year, 10 years, or any mutually acceptable time period. In most states, leases that exceed one year must be written and signed by the parties. Of course, it is advisable always to have a written agreement even if the law does not require one.

A tenancy from period to period is created when landlord and tenant agree to continue their relationship from year to year or month to month, or some other period length. The agreement may establish an original term of one year, for example, with the provision that the lease is to continue yearly unless terminated at the end of a period with proper notice by either party. The method of giving proper notice should be set forth in the lease agreement. It is common to require notice of termination 30 to 60 days prior to the expiration of a period, depending on state law.

When parties enter into a lease agreement without specifying either a termi- nation date or a period length, the parties have created a tenancy at will. As the name implies, this lease lasts as long as both tenant and landlord desire and can be terminated at any time. Many states have statutes that specify the amount of time required in the termination notice for tenancies at will. A 30-day notice is most typi- cal for tenants; some states require, however, that the landlord give a 60-day notice of termination.

A tenancy at sufferance occurs when a tenant is in possession of a landlord’s property against the wishes of the landlord. Such a situation may occur when a ten- ant refuses to re-lease the premises at the termination of the lease but continues to possess the property until evicted by the landlord. A tenancy at sufferance also might occur when a property owner’s existing mortgage is foreclosed. The foreclosure ter- minates the borrower’s rights to the property, but the borrower may remain in pos- session of the property until evicted by the new owner. Eviction is the legal process used by lessors to terminate leasehold estates when lessees fail to abide by the lease terms or refuse to return possession of the property at the termination of a leasehold estate. Eviction laws vary from state to state, but the laws generally require that the

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28 PA RT O N E Real Estate Legal Analysis

r e a l e s t a t e t o d a y

c l o s e - u p

The Empire State Building

We can speak of a “bundle of rights” to describe the various elements of real estate owner- ship. The Empire State Building saga provides a vivid example of

how real estate ownership can be subdivided into leased fee and leasehold interests, how the terms of the lease can affect the division of value between the two elements of ownership, and how they can be recombined.

The Empire State Building is a legendary prop erty, for four decades the tallest building in the world, and celebrated in movies and legend. With its 2.24 million square feet housing 20,000 workers and its office space 95% occupied, the building is worth up to $1 billion. Then why did it sell in 2002 for only $57.5 million? Here’s a hint. Only the leased fee was sold. Almost all the value was in the lease hold interest.

In 1961 a partnership bought the building for $68 million. An insurance company provided $29 million in financing and was given ownership of the fee interest in order to receive tax advantages that reduced the cost of financing for the partner- ship. The other partners received a 114-year mas- ter lease that allowed them to control the building until the year 2075.

After the insurance company had exhausted the tax benefits, it sold the building, but the sale brought only $40 million because the fee owner received only $1.72 million in lease payments per year plus regain ing control of the building when it would be 123 years old. All the rental income went to the leasehold inter est.

Finally, the investor group that holds the lease purchased the building for $57.5 mil- lion, once again combining the leased fee and leasehold interests into a simple fee ownership. This accomplished, the owners embarked on a five-year, $600 million renovation to update the eight-decades-old building to provide state-of- the-art utilities and amenities to attract larger and better-paying tenants. In the first two years alone, the number of tenants was reduced from 550 to 320 with average rents increasing from under $30 per square foot to the mid-$50s. Included in the renovations are massive green renovations, which will reduce energy use by 38%, saving over $4 mil- lion annually and making the building much more attractive to potential tenants.

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C H A P T E R 2 Property Rights and Legal Descriptions 29

lessor notify the lessee of the violated lease terms and give the lessee a prescribed amount of time to remedy the violation or return possession of the property to the lessor. If the lessee fails to remedy the violation or return possession of the property, the lessor can seek the court system’s assistance to recover damages and/or have the tenant physically removed from the property.

| concurrent estates _____________________________________

The preceding discussion of property interests was based on the assumption that only one person or legal entity owns each interest. These interests are known as estates in severalty, that is, estates “standing alone.” Nevertheless, most of the real property interests discussed above may be owned simultaneously by more than one person or legal entity. Perhaps you want to buy a house with your spouse, another relative, or even an unrelated person; perhaps your Aunt Matilda left you and your sister Bess a farm to be owned jointly; perhaps you want to make a real estate invest- ment with business associates. All these situations involve the ownership of property simultaneously by two or more persons or entities and are examples of concurrent estates or, more simply, joint ownership. The most common types of concurrent estates are

■■ tenancy in common,

■■ joint tenancy,

■■ tenancy by the entirety, and

■■ community property.

Note that although the word tenancy is used here, it should not be confused with a tenant’s relationship with a landlord.

Tenancy in Common

The traditional form of concurrent ownership is tenancy in common. Each of the joint owners holds an undivided, proportional interest in the entire property. For example, if Jack and Bob own a warehouse as tenants in common, each owns a por- tion of the entire property, but neither knows which portion is his. Each owner can dispose of his or her portion of ownership through sale or will.

Tenants in common who become unhappy with the joint relationship can demand a partition of the property. Voluntary partitions result when cotenants agree how to divide the property. If they cannot agree, however, a court may order a compulsory partition.

Joint Tenancy

Joint tenancy is similar to tenancy in common except it carries with it the right of survivorship. If a co-owner should die, the other owner or owners automatically divide the share owned by the deceased. This type of ownership often is used to

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30 PA RT O N E Real Estate Legal Analysis

ensure the continued operation of an investment property should one of the owners die. The joint tenancy ends if any tenant sells his or her share of the property to a third party. The joint tenancy then converts to a tenancy in common.

Historically, to establish a valid joint tenancy, the four unities of time, title, interest, and possession had to be present. To satisfy the unity of time, the joint ten- ants’ ownership had to be created at the same time by the same conveyance. The unity of title exists when the owners have the same estate in the land, such as a fee simple estate, a life estate, or another estate discussed in this chapter.

Joint tenants meet the unity of interest requirement only when they have the same percentage interest in the real estate. For example, two joint tenants must each own 50% of the undivided property, three must own 33.33% each, four must own 25% each, and so forth. Finally, joint tenants have unity of possession only when each owner has the right to possess all of the real estate subject to the other owners’ rights of possession.

Originally, due to the unity of time requirement, a grantor who was the sole owner of real estate could not create a joint tenancy with the right of survivorship between himself and another person. To get around this problem, the grantor had to deed the property to a friendly third party, known as a “straw man,” who would then transfer that property to the grantor and the other party as joint tenants. Some states have abolished the need to use a straw man in the above situation and thus have relaxed the unity of time requirement under particular circumstances.

Tenancy by the Entirety

A tenancy by the entirety is a specialized type of joint tenancy that can be cre- ated only between husbands and wives. The spouses share ownership equally, shares automatically pass to the surviving spouse, and individual interests cannot be sold without the consent of the other spouse or without division by a court in case of divorce. Some states do not recognize tenancy by the entirety.

Community Property

Some states recognize a system of property rights between husbands and wives generally called community property. In these states, all property acquired during the marriage, whether real or personal, is considered property of the “marital com- munity.” In other words, property ownership is divided equally between husband and wife. This division may disregard the financial contribution each spouse actually made to the property’s acquisition.

It is possible for married couples in one of these community-property states to acquire property not subject to a spouse’s interest. Examples of this separate prop- erty include property owned prior to the marriage or property received by one of the spouses as a gift or an inheritance. Generally, any income derived from a spouse’s separate property also is separate income.

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C H A P T E R 2 Property Rights and Legal Descriptions 31

| condominium ownership __________________________________

In addition to the traditional forms of concurrent ownership, the condominium and cooperative are two other ways to own real estate jointly. In a condominium (condo) all owners typically have fee simple titles to their personal units, while com- mon areas such as sidewalks, yards, entrances, hallways, pools, tennis courts, and other recreational facilities are jointly owned in a tenancy in common or some other form of concurrent ownership. (If the condominium is built on land that is leased with a ground lease, the unit owners hold a leasehold interest in the land rather than a fee interest.) A condominium association handles the maintenance of the common areas, and each unit pays a mandatory fee to cover the expenses of the association. The officers or directors of the association are typically elected by majority vote from all of the unit owners. Condos are also common for commercial and industrial uses.

All states have laws governing the formation of condominiums. These stat- utes require that three basic documents be filed—the condominium declaration, the bylaws, and deeds conveying the individual units. The purchase of a condominium interest is legally more complex and potentially more demanding than the typical single-family home purchase. In most states, this complexity and past abuses have led to more rigorous disclosure of information to prospective buyers of condomin- ium homes. In Florida, for example, where condos abound, condo developers are required to give potential buyers 15 days to rescind a contract to purchase a new condo. Sales of existing condos require a rescission period of 3 days. The clock for these rescission periods starts ticking when the buyer is given copies of condo- minium documents to examine rather than the effective date of the contract, so most developers and sellers give such documents to potential buyers in advance of signing a contract.

Condominium Declaration

The condominium declaration identifies the individual units and all common areas, assigns a specific share of the common areas to each unit, creates an associa- tion to govern the project and maintain the common areas.

Bylaws

The bylaws represent a private contract among property owners regarding the operation of the condominium. They provide for the selection of the board of direc- tors, the powers and duties of the directors, meetings, regulations for the common areas, assessment and collection of association fees, and other relevant matters. The bylaws, which may be amended by the condominium association, are often quite extensive and often deal with such details as the color of curtains in the windows and whether or not unit owners may keep household pets.

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32 PA RT O N E Real Estate Legal Analysis

Individual Unit Deed

Deeds for condominium units are similar to other deeds conveying real property. These deeds are described in Chapter 5.

| cooperative ownership _________________________________

In the cooperative form of ownership (often abbreviated to co-op), the land and building usually are owned by a nonprofit corporation specifically created for the purpose of owning the property. Individual residents own stock in the corporation that owns the property and thus have the right to occupy a particular unit in the prop- erty. Rather than a fee simple ownership of real property, owners in a co-op have a proprietary lease for a specific unit. The lease period is typically indefinite because it is tied to the tenant’s interest in the cooperative corporation. The lease does not require the tenant to pay rent, but the tenant must pay a periodic fee to the co-op for the tenant’s proportionate share of maintenance, repairs, mortgage payments, taxes, and so on. The tenants vote for and elect a board of directors or officers for the coop- erative pursuant to the organization’s bylaws.

| time-shares _____________________________________________

Time-share, or interval ownership, is a type of concurrent estate that splits own- ership by time. Most of the activity in the time-share is vacation oriented, with sev- eral large companies such as Disney and Marriot expanding into this market. There are two basic categories of time-sharing interests, a fee interest time-share and a right-to-use time-share. A fee interest time-share divides the ownership of a unit, usually a resort condominium, into 52 separate, weekly intervals. Owners receive a fee simple title to their particular ownership period. A right to use time-share, on the other hand, basically is a lease arrangement with a leasehold interest for a spe- cific number of years.

Whether or not it is deserved, the time-share industry is sometimes regarded as having a less than stellar reputation because of the high-pressure sales tactics used by some developers and promoters. Potential buyers often are lured to the property on the pretense of a free vacation, only to find that the time they planned to lie in the sun by the pool is eaten up with relentless sales presentations and guilt-producing pitches from aggressive sales agents. The entry into the time-share market by larger, more stable companies may be a signal that the reputation of the time-share industry is poised for improvement.

| legal descriptions _____________________________________

A proper legal description of the property involved is essential in all documents that affect title to real estate. When it comes to the actual transfer of title to real estate through a deed, for example, a precise legal description is necessary. Speci- fication of the exact boundaries of the land being conveyed is essential for a valid

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C H A P T E R 2 Property Rights and Legal Descriptions 33

transfer. In the United States, three methods commonly are used to obtain a precise legal description of land—the metes-and-bounds system, the rectangular survey sys- tem, and reference to recorded plats. Each property has a unique legal description.

Preparing the Legal Description

For existing properties, a proper legal description of a property often can be obtained from the tax office or other public records. A new, original legal descrip- tion will be needed, however, for a property that is being subdivided from an exist- ing parcel or created by combining multiple existing parcels. New, original legal descriptions should be prepared by an attorney and a certified land surveyor. This avoids potential risks for buyer, seller, and real estate professional (broker, appraiser, etc.) that can result from an improperly drafted legal description. A correctly drafted legal description is important, particularly in deeds, mortgages, and other instru- ments directly affecting title to land.

Metes and Bounds

The original way to achieve a formal legal description of the exact boundaries of any piece of land was to refer to its corners and boundary lines in a metes-and- bounds description. Metes are the distances used in a description, and bounds are the directions of the boundaries that enclose a piece of land. A metes-and-bounds descrip- tion starts at a designated point of beginning and, through specific distances, directions,

f i g u r e 2.2 Angles in a Circle

N. 75o 0' 0" W.

S. 45o 0' 0" W.

N. 45o 0' 0" E.

S. 15o 0' 0" E.

N. 90o 0' 0" E. or “Due East”

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34 PA RT O N E Real Estate Legal Analysis

and reference points, locates the boundary lines and corners of the parcel of land. When a surveyor uses the legal description to identify the exact boundaries of a par- cel of land, he or she usually drives an iron pin or stake deep into the ground at each corner of the property to establish “monuments.” These pins serve as the reference points in the legal description and can easily be located (perhaps with a metal detec- tor) many years after they are placed in the ground.

In modern metes-and-bounds descriptions, distances are measured in feet to the near- est one-tenth or one-hundredth of a foot, and the angles are measured in degrees, minutes, and seconds. Recall that there are 360 degrees in a circle and that a circle can be divided into four quadrants: northeast, southeast, southwest, and northwest. Each quadrant con- tains 90 degrees (90°); each degree contains 60 minutes (60'); and each minute contains 60 seconds (60"). Figure 2.2 demonstrates various angles using this system.

The following metes-and-bounds description describes the property depicted in Figure 2.3.

Beginning at an iron pin on the northern side of Lava Street 95.0 feet due East of the northeastern corner of the intersection of Sixth Avenue and Lava Street, as

f i g u r e 2.3 Metes-and-Bounds Description N

. 8 o

0' 0

" E

. 20

0 fe

Iron Pin

100 feet

20 0

fe et

S . 1

5o 0

' 0 "

E .

S ix

th A

ve n

u e

Lava Street

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C H A P T E R 2 Property Rights and Legal Descriptions 35

measured along the northern side of Lava Street; running thence N. 8° 0' 0" E. 200.0 feet to an iron pin; running thence due East 100.0 feet to an iron pin; running thence S. 8° 0' 0" W. 200.0 feet to an iron pin; running thence due West 100.0 feet to the point of beginning.

While a metes-and-bounds description may look a bit cryptic at first glance, it simply describes the boundary lines and corners of the parcel of a particular parcel of land. Each metes-and-bounds description must start with a point of beginning (POB). Thereafter, each boundary is detailed—its length, its direction, and the points where it begins and ends. It is vital that the boundaries described actually enclose the property involved. In other words, each boundary must begin at the preceding boundary’s end and end at the next boundary’s beginning. The description of the last side always must conclude at the original POB.

The metes-and-bounds method easily addresses irregular shaped parcels of land, even those with curved boundary lines. Curved boundary lines are described by referring to the length of the curve and its radius. With this system, land surveyors can accurately identify the corners of a parcel of real estate and the boundary lines that connect them.

By now, it should be obvious that reference points are crucial to the metes- and-bounds description. Before developers began to use iron pins to mark these points, natural monuments often were used. Such a monument might be “the large oak tree,” “the spring-fed stream,” or “the old Indian rock mound.” Although refer- ence to such natural objects could cause some confusion because they are subject to change over time, they still are used today to describe some rural land. The following land description, found in an old deed in North Carolina, demonstrates an interest- ing use of natural monuments as reference points in a standard metes-and-bounds description.

Beginning at an ash bush on the North bank of Withrow’s Creek above the bridge, corner to the lands of R. N. Barber, and running thence North 14 degrees West 17.50 chains [one chain equals 66 feet] to a stone pile, in the line of Mrs. E. M. Summerell; running thence North 68 degrees East 6.56 chains to a post oak, corner to the lands of Elias Barber; running thence South 27 degrees East 8.80 chains to a hickory on the North bank of Withrow’s Creek, corner to the lands of Jane Barber; running thence Southwesterly up said creek 13.75 chains to the point of beginning, containing 12 acres, more or less.

Legal descriptions do not describe “the side of the hill”; they define a flat plane that may or may not have a mountain in it. In mountain states, many sellers will tell you they have, say, 20 fenced acres, thinking they are really selling 20 acres—not their actual larger number of surveyed acres. For example, suppose a tract of land measures 1,000 feet by 1,000 feet, or approximately 23 acres. If the property con- tains a steeply sloped hill within its boundaries, the actual ground area of this tract could be much more than 23 acres.

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36 PA RT O N E Real Estate Legal Analysis

Rectangular Survey System

Shortly after the end of the Revolutionary War, when the westward movement from the original states began, a method of describing wilderness land was required. The U.S. Congress approved a description method known as the rectangular survey system (also called the congressional survey system or government survey system). With the exception of Texas, land descriptions in all states west of the Mississippi, the five states formed from the Northwest Territory, and most of Alabama, Flor- ida, and Mississippi are based on this method.

Principal Meridians and Base Lines The rectangular survey system is based first on principal meridians running

north and south and base lines running east and west. Placement of these meridians and base lines generally coincides with an established landmark, such as the mouth of the Ohio River. The principal meridian was drawn north-south through the river’s mouth, and the base line was drawn east-west to intersect the meridian at the land- mark. The principal meridians and base lines around the United States are shown in Figure 2.4. Because the earth is round, lines that are drawn to run north and south eventually converge at the north and south poles. Surveyors use reference points cre- ated by “guide meridians” and “standard parallels” to account for this convergence when locating the corners of a property using the rectangular survey method.

r e a l e s t a t e t o d a y

l e g a l h i g h l i g h t

How Did an Acre Get to Be an Acre?

Unlike the rational metric system, the English system of land measurement that the United States inherited does not seem to make much sense. It does,

however, but only if related to experience rather than to mathe matics. Village farmland in medieval England was laid out in long rows so that plows drawn by oxen would not have to turn around often. A strip of land a furrow long and wide enough to be plowed in a day was called an acre. Its actual size

varied from one part of the country to another, however, until a standard measure was introduced by one Edmond Gunter during the time of King James I. Gunter defined a chain as 66 feet and a furlong (the length of furrow for an ox-drawn plow) as 10 chains. An acre was defined as the length of a furlong by the width of one chain (660 feet by 66 feet), or 43,560 square feet). Eight furlongs stretch 5,280 feet, or one mile, and 640 rectangular acres fit in a square mile. It is all very logical, but only if your frame of ref erence is medieval England.

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C H A P T E R 2 Property Rights and Legal Descriptions 37

Townships The land on each side of the principal meridian is divided into six-mile-wide

strips by range lines, which run north and south and are numbered consecutively east or west of the principal meridian. For example, the first range line to the east of the principal meridian is numbered 1 East, the second is numbered 2 East, and so forth. Similarly, the land above and below the base line is divided into six-mile wide strips by township lines, which run east and west and are numbered consecutively north and south of the base line. For example, the first township line north of the base line is numbered 1 North, the second is numbered 2 North, and so forth. The range and township lines form the basic unit of the rectangular survey, the township, an area of land six miles square.

To identify a specific township, reference is made to the intersection of the town- ship and range lines. For example, the shaded township in Figure 2.5 is Township 3 North, Range 2 West, abbreviated as T3N, R2W. It’s often useful to count the spaces (the townships) rather than the township and range lines when locating townships on maps.

Townships are not only the basic unit of the rectangular survey system, they often are the basis of political subdivisions as well. Somewhat confusingly, however,

f i g u r e 2.4 Principal Meridians and Base Lines in the United States

= Meridians

= Base lines

= States using the rectangular survey system

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38 PA RT O N E Real Estate Legal Analysis

f i g u r e 2.5 Principal Meridians and Base Lines Numbering Method

Principal Meridian

T. 3N.

T. 2N.

T. 1N.

Township line 1S.

T. 2S.

T. 3S.

Base Line

R . 1E

R . 2E

R . 3E

R . 1W

R . 2W

R . 3W

T. 3N., R. 2W.

f i g u r e 2.6 A Township Divided into Sections

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C H A P T E R 2 Property Rights and Legal Descriptions 39

the term is also used to describe political subdivisions in states that were not sur- veyed under the rectangular system.

Sections The rectangular survey system divides each township into 36 equal-sized sec-

tions. Within any given township, sections are numbered beginning in the northeast corner, moving westerly, then southerly one section, and back easterly. The process continues until all sections are numbered. Figure 2.6 demonstrates this numbering process. Each section consists of one square mile, or 640 acres.

In the states covered by the rectangular survey, rural land is generally sold in patchwork pieces. Of course, farms in these states may be smaller than the sectional size of 640 acres. For example, farms claimed under the Homestead Act were one- quarter section, or 160 acres. As another example, a buyer might purchase the land indicated in Figure 2.7, the northwest quarter of the southeast quarter of the northeast quarter of the Section. How many acres did the buyer purchase? The answer is 10.

f i g u r e 2.7 Subdivision of a Section (640 Acres)

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40 PA RT O N E Real Estate Legal Analysis

Aerial photographs clearly show the effect a particular method of land survey has on rural areas. Under the metes-and-bounds survey system, farmlands are laid out in the random pattern illustrated in Figure 2.8, a photograph of farmland in the eastern United States. A comparable rural area that was surveyed under the rectangu- lar system, with its even patchwork pattern, is shown in Figure 2.9. This photograph of land in Kansas is typical of the midwestern and western United States.

Combined Use of Metes-and-Bounds and Rectangular Survey Systems

The rectangular survey system describes very accurately the extensive acre- age involved in farmland. It becomes difficult to use, however, when one wishes to describe the small, non-rectangular subdivision lots found in most communities. Sub- dividing a section of 640 acres into lots of one-half acre or less is an all but endless task. Therefore, metes-and-bounds descriptions become vital to clear legal descrip- tions. Many properties are described by some combination of the metes-and-bounds

f i g u r e 2.8 Aerial Photograph of Land Surveyed under the Metes-and-Bounds System

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C H A P T E R 2 Property Rights and Legal Descriptions 41

and rectangular survey methods. For example, a combined description might appear as follows:

Part of SW ¼ of the SE ¼ of Section 14, T43S,R34E., Tallahassee Principal Meridian, Hendry County, State of Florida, beginning at a point being 202 feet East of the SW corner of the SE ¼ of said Section 14; running thence North 8 degrees East 200 feet to an iron pin; running thence due East 100 feet to an iron pin; running thence South 8 degrees West 200 feet to an iron pin; running thence due West 100 feet to the point of beginning.

Figure 2.10 shows the parcel described previously. The parcel is located within the southwest quarter of the southeast quarter of Section 14 in Township 43 South, Range 34 East of the Tallahassee Principal Meridian.

Figure 2.11 shows a residential development that has grown up in and around farmland that was surveyed under the rectangular survey system. Here, we see the combined use of the metes-and-bounds system applied with the rectangular survey system. Notice that the undeveloped tracts still appear rectangular, but the newer subdivided tracts reflect irregularly shaped lots on curving streets.

f i g u r e 2.9 Aerial Photograph of Land Surveyed under the Rectangular Survey System

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42 PA RT O N E Real Estate Legal Analysis

References to Recorded Plats

A common alternative and supplement to these methods of legally describing real estate is to refer to engineers’ drawings of parcels of real estate called plats that have been recorded as part of the official public record. Plats show the streets, blocks, and lots as they actually exist. A plat of a subdivision appears in Figure 2.12. Notice that the plat contains the precise distances and directions (metes and bounds) of each property boundary. Once this document is part of the official public record, properties can be described simply by reference to the numbers of the lots as they appear in the plat of the block of the subdivision in which the lot is located. For example, we could identify the parcel highlighted in Figure 2.12 as “Lot 4 of Block G” of this subdivision as recorded in the public records of the county where the sub- division is located.

In the case of a condominium, each individual unit of the complex is described separately by referring to a previously recorded plat of the complex. In addition, a condominium description includes a reference to the fractional share (based on the number of units) of the common areas within the complex.

f i g u r e 2.10 Parcel Indicated by Combined Description

SE 1/4 of Section 14

Section

SW corner of the SE 1/4

202 ft

100 ft 200 ft

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C H A P T E R 2 Property Rights and Legal Descriptions 43

An interesting issue in legal description arises when the property involves an air lot, which means the property does not actually touch the ground. In these cases, ver- tical distances are measured from a point of known vertical height. The most com- mon vertical reference is mean sea level, but official benchmarks that can be used as reference points for both horizontal and vertical distances have been established throughout the United States by the Coast and Geodetic Survey. Thus, the air lot of a 32nd-floor condominium might be described by identifying the parcel of land under- neath and the vertical measurements of the airspace above the ground.

| chapter review __________________________________________

■■ Real estate refers to land and things attached to the land. Real property refers to the legal interests associated with real estate. Personal property

f i g u r e 2.11 Aerial Photograph of Land Surveyed by the Combined Metes-and-Bounds and Rectangular Survey System

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44 PA RT O N E Real Estate Legal Analysis

refers to all movable items (not real estate) and the rights associated with them.

■■ Items that were once considered personal property but have become part of the real property are called fixtures.

■■ Real estate can be physically divided into surface rights, mineral rights, air rights, and water rights.

■■ Real property can be divided into different bundles of property rights called estates in land.

■■ Estates in land can be divided into freehold (ownership) and leasehold estates.

■■ Freehold estates include the fee simple absolute estate, qualified fee estates, life estates, and reversion and remainder interests.

■■ Leasehold estates include tenancy for a stated period, tenancy from period to period, tenancy at will, and tenancy at sufferance.

f i g u r e 2.12 Plat of a Subdivision

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C H A P T E R 2 Property Rights and Legal Descriptions 45

■■ Freehold estates are generally transferred by a legal document called a deed. Leasehold estates are transferred by a legal document called a lease.

■■ When more than one owner has rights to the same real estate, the owner- ship is referred to as concurrent ownership.

■■ Examples of concurrent ownership include tenancy in common, joint ten- ancy, and tenancy by the entirety.

■■ Other ways the rights to real property can be divided among multiple own- ers include condominiums, cooperatives, and time-shares.

■■ Three different methods are used to describe individual parcels of real estate: metes and bounds, rectangular survey, and references to recorded plats.

| key terms _____________________________________________

air lot

air rights

base lines

chattel

community property

concurrent estates

condominium

contingent remainder

cooperative

deed

estate pur autre vie

estates in land

estates in severalty

eviction

fee interest time-share

fee simple absolute estate

fixture

freehold estates

grantee

grantor

joint tenancy

lease

leased fee estate

leasehold estates

lessee

lessor

life estate

life tenant

metes-and-bounds description

mineral rights

personal property

plats

principal meridians

prior appropriation doctrine

property

proprietary lease

qualified fee estate

range lines

real estate

real property

rectangular survey system

remainder

remainderman

reversions

right of first refusal

right of reentry

right of survivorship

right to use time-share

riparian rights doctrine

sections

tenancy at sufferance

tenancy at will

tenancy by the entirety

tenancy for a stated period

tenancy from period to period

tenancy in common

test of adaptability

test of attachment

test of intent of the parties

time-share

title

township

township lines

trade fixtures

vested remainder

water rights

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46 PA RT O N E Real Estate Legal Analysis

| study exercises _________________________________________

1. What is the difference between the terms real estate and real property?

2. What are fixtures and why is it important to be able to identify them?

3. What are the three general physical divisions of property rights?

4. Fred leases a building from George for his new restaurant. To increase his business, Fred installs an antique bar in the center of the restaurant, com- plete with water and drain lines. A year later, Fred’s business is so success- ful he decides to move to a larger building. He plans to remove the bar and take it to the new location, but George protests, claiming the bar is a fixture and cannot be removed. Does Fred have the right to remove the bar? Why or why not?

5. Distinguish between the riparian rights doctrine and the prior appropriation doctrine of water rights.

6. If Bob buys a parcel of land from Sarah, who is the grantor and who is the grantee?

7. Define each of the following terms with respect to the fee simple estate: alienable, devisable, descendible.

8. What is the primary difference between a fee simple absolute estate and a qualified fee estate?

9. What is the difference between a life estate and an estate pur autre vie?

10. Madeline has an opportunity to invest in either a cooperative or a condo- minium. What are the differences between these types of ownership?

11. Dick agrees to rent a two-bedroom house from Larry for a two-year period with monthly rent payments. What type of leasehold estate is involved in this transaction?

12. Charles rents a home from Woodley on a month-to-month basis. On June 1, Woodley gives proper notice to Charles that he wishes to terminate the ten- ancy on August 31. On September 2, Charles has still has not vacated the property. Under what kind of tenancy is Charles now holding possession?

13. According to the rectangular survey system, if a buyer purchases the south half of the northeast quarter of a section of land, how many acres has he or she purchased?

14. How many square feet are in an acre? How many acres are in a section? How many sections are in a township?

15. Use a simple sketch to show the location of T5S, R6E. Appropriately label the principal meridian, base line, and each of the range and township lines in the sketch.

16. Use a simple sketch to show the location of section 17 in a township.

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C H A P T E R 2 Property Rights and Legal Descriptions 47

17. Use a simple sketch to show the location of the parcel described as “the NW 1/4 of the NE 1/4 of the SE 1/4 of the SE 1/4” of a section. How many square feet does the parcel contain?

18. Use a simple sketch to show the boundaries and reference points of a prop- erty described as follows:

“Beginning at a point 200 feet due North of the southwest corner of Section 11; running thence 100 feet N. 45° E to an iron pin; running thence 100 feet S. 45° E. to an iron pin; running thence 100 feet S. 45° W. to an iron pin; running thence 100 N. 45° W. to the point of beginning.”

| further reading _________________________________________

Jennings, Marianne M. Real Estate Law, 9th ed. Mason, Ohio: West Thomson South- Western, 2011.

Karp, James, and Elliot Klayman. Real Estate Law, 8th ed. La Crosse, Wisconsin: Dearborn Real Estate Education, 2013.

McCormak, Jack C. Surveying, 6th ed. New York: John Wiley and Sons, 2012.

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3c h a p t e r Private Restrictions on Ownership

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c h a p t e r p r e v i e w

Even though someone may own the entire fee simple ownership rights in a parcel of real estate, this interest is often limited by certain restrictions placed on the property by public or private entities. These restrictions and limita- tions, known collectively as encumbrances, generally run with the land; in other words, they are binding on anyone who gains a subsequent interest in the property. In some cases, encumbrances may adversely affect both the use and the value of the property. In extreme cases, the land may be so encumbered that it would be valueless for a potential purchaser. Conversely, some public or private land-use restrictions may enhance the value of a property by protecting it from detrimental actions by others.

We consider several forms of private restrictions on ownership in this chap- ter, and we will consider public restrictions on ownership in the next chapter. The private restrictions we will consider in this chapter include

■■ covenants, conditions, and restrictions (CC&Rs);

■■ liens;

■■ easements;

■■ profit a prendre;

■■ adverse possession; and

■■ encroachments.

close-up Meadow Brook

Ranch Use Covenants

legal highlight Validity of Restrictive Covenants

legal highlight Restrictive

Covenant Disputes

legal highlight A Cautionary Tale

on Mechanics’ Liens

legal highlight Prescriptive Easement

legal highlight The Case of the

Landlocked Parcel

close-up Use of

Conservation Easements

legal highlight Adverse Possession

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| covenants, conditions, and restrictions __________________

Covenants, conditions, and restrictions, often abbreviated as CC&Rs, are private encumbrances that limit the way a property owner can use a property. The CC&Rs are essentially promises made by a landowner about how the property will or will not be used that are enforceable through the court system by the parties who expect to benefit from the promises. These promises are typically found in the deed or plat associated with the property and are recorded in the public record system. Once attached to a property, these covenants “run with the land” and are binding on successive owners of the property. For example, a developer who wants to limit the uses of the properties in the project may attach covenants to the deeds for each parcel that prohibit or require certain uses of the property. The developer’s goal is to increase the value of the property to prospective purchasers by assuring them that they will be protected from detrimental uses of the properties by their neighboring property owners. Of course, the use of CC&Rs is not limited to developers. Indi- vidual property owners may also attach limitations on how their properties can be used by subsequent owners. For example, the seller of a property may attach restric- tions that prohibit any commercial use of the property or that preserve a scenic view available to other properties.

It is increasingly common for developers to attach covenants that subject each parcel in the development project to the authority of a property owners’ association that is empowered by a majority vote of all property owners (with each parcel getting one vote) to adopt rules and restrictions that all property owners must adhere to. Because the developer owns all of the properties in the project when the association is first created, the developer will establish the initial rules and restrictions. As the parcels in the project are sold to individual property owners, the owners will eventually gain majority control of the property owners’ associa- tion and can change the rules as they collectively see fit. Such rules can be very specific. For example, the CC&Rs for a residential subdivision may restrict the use of the properties in the project to single-family uses only, may require that houses be a certain minimum size, and/or may prohibit business enterprises, nondomestic animals, or large antennas. The CC&Rs may also require the approval by the association of all buildings and landscaping plans, prohibit the use of certain building materials, and even mandate the painting of homes at regular intervals with approved paint colors. It is important to note that CC&Rs cannot create unreasonable or unlawful limitations on an owner’s use of land. For example, restrictions preventing the sale of property to a person of a particular ethnic or racial group clearly are unenforceable because they violate the laws and the Constitution of the United States.

The Real Estate Close-Up on the next page shows some of the CC&Rs in a rural subdivision called Meadow Brook Ranch.

CC&Rs are particularly important to the owners in residential communities. Sup- pose, for example, that the owners of one unit in a condominium project paint their unit in their college’s colors—a brilliant orange and green. Or suppose they decide that bright pink plastic flamingos would be just the thing for the front lawn. Not only might these actions have definite detrimental aesthetic impacts, they would have eco- nomic impacts on fellow property owners and, therefore, could be prevented through

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C H A P T E R 3 Private Restrictions on Ownership 51

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Meadow Brook Ranch Use Covenants

1. All lots in Meadow Brook Ranch are restricted to use for residential purposes only. No signs shall be placed on any part of these residential lots indicating a com mercial or nonresidential use thereof.

2. No animals or fowl shall be permitted other than those types of animals or fowl normally found on rural property that are raised for per sonal family use and/or plea- sure on a strictly noncommercial basis. Permitted types of animals shall include horses, chickens, and household pets. No swine shall be permitted. A maximum of two (2) dogs per lot shall be permit- ted. Exotic Game shall be allowed upon the property, with the exception of those that would affect the health, safety, and/or welfare of any of the land owners within the subdivision. Any and all ani mals, including household pets, require appropriate fenc- ing to confine them to their lot. No animal shall be permitted until this appropri ate fencing is completed.

3. No junk or junkyards of any kind or charac- ter shall be permitted, nor shall accumula- tion of scrap, used materials, inoperative automo biles, or machinery, or other unsightly storage of personal property be permitted.

4. No portion of the property shall be used in a manner that adversely affects adjoining property owners or creates an annoyance or nuisance to other property owners. This

shall include noise pollution such as bark- ing dogs, loud music, or any animal or fowl that causes a nuisance.

5. No hunting with firearms shall be permitted on any lot. Bow hunting shall be allowed on lots of at least 10 acres. No discharg- ing of any fire arms or fireworks shall be permitted on any lot.

6. No residence shall be erected on any part of said property or building site having less than 1,700 square feet of floor space livable area in the main building with one- half (½) thereof of masonry construction, with the exception of log homes, which will not require one-half (½) masonry construction.

7. All buildings erected on the premises shall be of new construction and materi- als. No buildings or portion of buildings of old material may be moved into said subdivision.

8. It is the intent of the undersigned that all dwellings and other structures have a neat and attractive appearance. No metal walls or walls of temporary sheeting will be allowed. The entire exterior walls of all dwelling units or other buildings hereafter constructed must be com pleted within one year after the commencement of work thereon or the placing of materials there- fore on said property, whichever occurs the earliest, and in connection therewith it is under stood that the use of the word “completed” also means the finishing of all such exterior walls.

(continued)

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52 PA RT O N E Real Estate Legal Analysis

CC&Rs (stating, for instance, that outside paint colors must meet the approval of a homeowners’ association and that no statuary or other furniture may be placed in front yards).

Because CC&Rs are a type of contractual agreement, parties to the agreement may enforce it through the court system. To recover damages or obtain an injunction, the nonbreaching party (usually the property owners’ association) must be able to show that some damage has been suffered. In other words, to be justified in enforc- ing the CC&Rs, the party must be able to show how the intended benefit has been denied.

Suppose, for example, that Mary violates the covenants in the deed to her home by erecting a 12-foot statue of her favorite sports celebrity in her front yard. Either the developer or other property owners could secure a court injunction to force the removal of the offending statue. If the covenant violation were even more severe, they could seek monetary damages.

Covenants generally run with the land, from owner to owner. They may exist only for a stated period of time—say, 20 years—or they can be terminated by the agreement of all affected parties should the right of enforcement be waived or aban- doned or if the restricted land is condemned for a public use. Alternatively, an owner

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Meadow Brook Ranch Use Covenants

9. No more than one residence shall be erected per each two and one-half (2.5) acres.

10. No outside toilets, privies, or cesspools will be permitted, and no installation of any type of sew age disposal device shall be allowed that would result in raw or untreated or unsanitary sewage being carried into any water body; all septic tanks must conform to the regulations of the State and County concerning septic systems.

11. No tents, campers, or trailers shall be used on any of the property for residential purposes, on a temporary or permanent basis. No premanu factured, modular,

trailer, or any other structure not built on the site shall be permitted.

12. All tracts shall be kept in a clean and orderly condition at all times, and all trash, garbage, and other waste shall be kept in sanitary con tainers.

13. No structures used for storage purposes shall be erected or placed upon any par- cel that will be vis ible from any roadway, unless placed within the most rear one- third (1/3) of the parcel, that being such portion farthest away from any roadway. All such structures shall be neatly maintained.

14. No resubdivision of any tract of less than two and one-half (2.5) acres shall be permitted.

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C H A P T E R 3 Private Restrictions on Ownership 53

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Validity of Restrictive Covenants

Salma Worthington purchased a home in the Mains Farm subdivi- sion near Sequim, Washington, for the purpose of establishing an adult-care facility. She knew

restrictive cove nants limited land use in the subdivision to “single-family residential purposes only,” but contended that the proposed use did not violate the covenants. She and her daughter moved into the home, along with four elderly residents. The home owners’ association sued to enforce the deed restric tions. The association won.

The court held that Worthington’s use of her home was not for “single-family residential pur- poses only” because of the business elements involved. Since Worthington provided 24-hour care for fees of $500 to $1,000 per person per month, the property’s use was essentially commer- cial, a use that was inconsistent with a residential purpose.

Worthington also contended that even if her use violated the restrictive covenants, the cov- enants could not prevent a home-care facility because the state legislature had adopted legisla- tion per mitting such facilities in all areas zoned for residential or commercial purposes, includ- ing areas zone for single-family dwellings. She contended that this enactment established the fact that maintaining disabled persons out side institu- tions is of greater value to the public than is the right to restrict the use of land through restrictive covenants.

Again, the court disagreed, holding that unlike covenants that might attempt to restrict ownership by race, creed, color, national origin, or handicap, the covenants in question served the legitimate pub lic purpose of protecting residential

neighborhoods from the effect of business uses. Although the legis lature has restricted local gov- ernments from zoning adult family homes out of residential areas, it did not limit the right of private homeowners to adopt restrictive covenants that prohibit certain uses of land in residential areas.

[Mains Farm Homeowners Association v. Wor- thington, 824 P.2d 495]

Does a State Growth Management Act Override the Provisions of a Restrictive Covenant? In 1932, a developer sold 13 lots in what is now the city of Shoreline, Washington, and included a restrictive covenant stating that the lots could not be “sold, conveyed, or leased to any person not of the White or Caucasian race.” Another provision of the covenants restricted density to one house per half-acre.

In 2002, Viking Properties bought a 1.46-acre lot in the subdivision with the intention of devel- oping it to a higher density than allowed by the covenants. When the subdivision homeowners refused to release the covenant, Viking Properties sued, contending (1) that the racial provision in the covenants made them unenforceable and (2) that the density restriction violated a policy of the state’s Growth Management Act favoring dense develop- ment in urban areas.

The court agreed that the racial provision was unenforceable, but this did not void the entire cov- enant. It ruled that the density restriction was totally separate from the racial issue. While the density restriction did impede some of the Growth Man- agements Act’s goals, it protected private property rights and preserved neighborhood open space. Thus, it did not violate public policy.

[Viking Properties, Inc. v. Holm, 118 P.3d 322]

(continued)

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54 PA RT O N E Real Estate Legal Analysis

could place a permanent restriction on the land. CC&Rs can supersede public land use regulations if they are more restrictive than the public regulations, as the Legal Highlight shown above illustrates.

| liens ___________________________________________________

A lien is a claim on a property as either security for a debt or fulfillment of some monetary obligation. For example, an owner might give a mortgage on a property in order to borrow money, thus creating a lien on the property. The lien does not represent right of ownership for the creditor; rather, it amounts to a financial secu- rity interest in the property, a claim the creditor holds against the property to help ensure the debt will be repaid. If the creditor is a private individual or business, the mortgage lien creates a private restriction on ownership. If the creditor is a govern- ment, the resulting encumbrance is a public restriction on ownership. The property tax lien is a common example of a public restriction and will be considered in the next chapter.

Real estate liens may be either voluntary or involuntary. Voluntary liens are those placed on property by the owner, usually in the form of a mortgage to secure repayment of long-term debt. Involuntary liens protect the interest of persons who have valid claims against the owner of real property—such as those resulting from a judgment in a lawsuit, from not being paid for some service, or from unpaid taxes.

Liens are also classified as specific or general. A specific lien is created to secure debts that are associated with a particular parcel of real estate. A general lien—for example, a judgment lien or an income tax lien—is placed on all of the property that might be owned by an individual, including any real estate.

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Validity of Restrictive Covenants

When Is a Fence a Fence? In 1978, Sophie Bubis bought property across the street from the beach in Loch Arbour, New Jer- sey, with a view of the ocean through a chain-link fence on the beachfront property across the street. Then, in 1995, Jack and Joyce Kassin bought the beachfront property across the street and built a landscaped berm approximately 18 feet in height, restricting Mrs. Bubis’s view of the beach. She sued, claiming that the berm violated both the

village’s zoning ordinance and an 1887 restrictive covenant prohibiting fences higher than four feet on beachfront property. She won.

The New Jersey Supreme Court ruled that a fence could made be made of any material, includ- ing earth, and that the Kassin’s berm violated the covenant’s restriction. They ruled it also violated the village ordinance’s six-foot limit for fences.

[Bubis v. Kassin, 878 A.2d 815]

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C H A P T E R 3 Private Restrictions on Ownership 55

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Restrictive Covenant Disputes

Protective restrictive covenants some times lead to controversy when they are enforced. As these examples illustrate, some of these controversies involve

very substan tive issues, while others reflect rather trite neighborhood disputes.

The Case of the Unapproved Garage After Don and Carolyn Colliver bought a house in the Stonewall Equestrian Estates, they wanted to build a detached two-car garage on their lot. Under the restrictive covenants this had to be approved by the community association, but it turned down the plans. Subsequently, the parties could not reach agreement, and the Collivers began con- structing the garage without approval. The asso- ciation took legal action to enforce the covenants. Even so, the Colliv ers continued the construction, which when finished cost almost $70,000.

In court, the Collivers challenged the validity of the covenants and the right of the community asso ciation to enforce them. Unfortunately for them, the court disagreed and ordered that the garage be removed:

“Despite the pending litigation and relief sought, the Collivers continued with the construc- tion of the garage at their own peril. They took an unwise risk and expended a large amount of money in spite of this litigation and the Associa- tion’s clear disapproval of their garage. We require the Collivers to remove the structure in its entirety immediately.”

[Colliver v. Stonewall Equestrian Estate Assoc., 134 SW3d 521, Court of Appeals of Kentucky]

Is a Church a Residential Use? Eddie Chan and Fat Fan Cheung bought adja- cent houses in the Kingsbridge Park subdivision. Cheung sought and received permission from the Architectural Control Committee to add a “game room” to his house. When it was constructed it became apparent the room was designed and furnished not as a game room, but for worship.

Chan and Cheung deeded their houses to the Tien Tao Association, a nonprofit reli gious corpora- tion. Tien Tao erected three 30-foot flagpoles in the backyard of one of the homes, paved the back lawn, and repainted the home’s shutters an unap- proved color. They did not seek advance approval for these changes as required in the restrictive covenants. Tien Tao housed Cheung and another priest in one of the houses and provided accom- modations for followers who gathered to worship. The unauthorized changes, plus the apparent use of the properties for other than single-family resi- dential use as required by the covenants, led the community association to sue for compliance.

The court ruled that the flagpole and other alter ations violated the covenants, as did the use of the properties for religious purposes. Tien Tao also argued that the purpose of the covenants was to restrict their members’ religious freedom in violation of the Fair Housing Act. The court disagreed, ruling that the association sought to abate a nuisance, not to exclude Taoist believers from the community: “That the nuisance stemmed from a gathering of a religious nature does not exclude it from coverage by the restrictions.”

[Tien Tao Association v. Kingsbridge Park Com munity Association, 953 SW2d 525, Texas Court of Appeals, 1st District]

(continued)

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56 PA RT O N E Real Estate Legal Analysis

Specific Liens

The two types of specific liens that are created to protect creditors using real estate as their security for repayment of debts are mortgages and mechanics’ liens.

Mortgages Because few people buy real estate without borrowing money, a mortgage is

the most common encumbrance on an owner’s title. In return for a loan to buy real property, purchasers often pledge the property as collateral for the debt. In other words, the borrower creates a lien in favor of the lender. The borrower who pledges real estate as security or collateral against a loan is the mortgagor; the lender that receives the benefits of this lien is the mortgagee. (A helpful hint for keeping the “ors” and “ees” straight in all real estate terms: the “ors” give property rights or interests in property and the “ees” receive them.) Although mortgage liens put a restriction on a mortgagor’s ownership interest, they make it possible for purchasers to obtain long-term financing for relatively large real estate purchases.

A mortgage lien acts as a private restriction on ownership. If the loan is not repaid on schedule, or if other requirements of the loan contract are not met, the mortgagee may instigate foreclosure proceedings. In some states, the foreclosure process results in the property being sold at public auction with the proceeds of the auction being used to satisfy the debt. In other states, foreclosure results in the

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Restrictive Covenant Disputes

The Case of the Too-Large Plaque When Sol and Renee Silberman bought their home in Lakewood Greens they hung a 45'' by 25'' terra- cotta plaque that depicted three cherubs pouring water from a pail. During a routine property inspec- tion the community association’s prop erty manager noticed the plaque and told the Silbermans that under the restrictive cove nants it required the approval of the architec tural control board. After their application was denied, the Silbermans still refused to remove the plaque, contending it was hung with only two screws and did not require any architectural changes or modifications, that the model home had three terra-cotta urns, and that

many other homeowners had similar plaques or hangings. The association then filed suit to force removal of the plaque.

The appeals court found that the Silber mans’ plaque was much larger than those hung by other homeowners, and that the other homeowners who had similar but smaller plaques complied with the cove nants. The Silbermans were ordered to remove the plaque, and the community was again safe from too-large terra-cotta cherubs.

[Lakewood Greens Homeowners Assoc. v. Sil berman, 765 So.2d 95, Florida Court of Appeals, 4th District]

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transfer of ownership from the mortgagor to the mortgagee. The mortgagee can then use or sell the property at it sees fit. Mortgage lending is discussed more fully in Chapter 16.

Mechanics’ Liens A mechanic’s lien (also known as a construction lien in some states) protects

those who provide labor or materials for real estate improvements, including sup- pliers, architects, engineers, landscapers, carpenters, plumbers, and similar workers. Any such suppliers of materials and labor who are not paid can file a mechanic’s lien on the property. If payment still is not made, foreclosure proceedings can result, with the property being sold to satisfy the debt.

Mechanics’ liens are not just a concern to persons who fail to pay for work done to their real property; they also can create problems for subsequent purchasers. Sup- pose, for example, that Marty and Carole Teem purchase a home from Potts Develop- ment. Some weeks after closing on the house, they are dismayed to learn that several subcontractors have filed mechanics’ liens on their home because they were not paid by the general contractor. Even though the Teems have already paid for the house, they may have to pay twice for the same work if the claims are valid. Needless to say,

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A Cautionary Tale on Mechanics’ Liens

Most homeowners have never heard of a mechanic’s lien, but every year some learn in a very painful way. Howard Krish had paid the final bill on his $9,600

roofing job, and he had the receipt. Even so, he was being sued by a building supply company for $3,100 to pay for the felt and shingles that were used on his Boynton Beach, Florida, home. Johnston Roofing had accepted his check but had not paid its suppli ers. Krish, along with 10 of his neighbors who had paid in full for new roofs, had to pay the building supply company to avoid having their homes sold to satisfy the mechanic’s lien.

Or consider the sad case of Maria Ghiran, a Chicago resident who decided to move to Florida.

She hired a contractor to build her house and paid him two installments totaling $57,000. When she flew down to inspect the work, she found a slab of concrete—and nothing more. The contractor had gone bankrupt after taking her money, and the subcontractors and suppliers placed mechanics’ liens on the property.

The moral of this story is clear. Homeown- ers need to check the mechanic’s lien law in their state before paying contractors for work on their property. In some states, homeowners can avoid paying twice if they can prove they paid the gen- eral contractor for the work. To avoid this painful surprise in other states, such as Florida in our sad tales, homeowners need to get signed lien releases before paying their general contractor.

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58 PA RT O N E Real Estate Legal Analysis

it is vital to see that all suppliers of material and labor are paid before the general contractor is fully paid or the house purchase completed.

General Liens

Like specific liens, general liens do not represent property ownership; they are, however, creditors’ claims against a property owner’s title. Unlike special liens, gen- eral liens normally may be filed on either personal or real property.

A common general lien is a judgment lien. The winner in a lawsuit who has not been paid may collect the debt by claiming an interest in the loser’s property, includ- ing any real estate. If the judgment debt still is not paid, the property can be sold to satisfy the creditor’s claim. Such a sale, commonly referred to as a judicial sale, is conducted as an auction by a sheriff or another legal authority. In some states, the debtor-owner of the real property may redeem ownership interest within a year of the sale by reimbursing the purchaser for the sales price and paying all costs of the sale.

Other general liens that could result in similar ownership limitations are public liens for delinquent taxes: federal income, federal estate, state income, and state estate or inheritance. As in a court-awarded judgment, such unpaid tax debts can be levied on real property. Ultimately, if the lien is not satisfied and removed, the land possibly could be sold at public auction through the foreclosure process.

| easements _______________________________________________

An easement is a right given to one party by a landowner to use the land in a specified manner. The landowner does not have to give up his or her land, but rather coexists with the holder of the easement. For example, property owners may grant a utility company the right to run a power line across their land, or one landowner may allow an adjoining owner to build a driveway across her property. From the perspective of the property that is subject to the easement, easements are restrictions on property rights.

f i g u r e 3.1 Easement Appurtenant Created by a Joint Driveway

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C H A P T E R 3 Private Restrictions on Ownership 59

Types of Easements

There are two types of traditional easements: an easement appurtenant and an easement in gross. An easement appurtenant exists when an easement is legally connected to an adjoining property. Suppose, for example, that Bill pays Susan to grant him an easement to run a sewer line from his house across her property to the city’s trunk sewer line. In this case, Bill’s land is being served or benefited by the easement and is known as the dominant estate. Susan’s land, on the other hand, is burdened by the easement and is known as the servient estate. Susan can continue to use her land, but she cannot do anything that would interfere with Bill’s use of the sewer line.

As with almost all encumbrances, this easement “runs with the land”; in other words, it continues when ownership of either the dominant or servient estate changes unless specifically terminated using one of the methods to be discussed below. Even though the new owners of Susan’s land may not want Bill’s sewer line to remain on their property, they have little choice in the matter.

In some cases, adjoining properties are both dominant and servient. Suppose that Ralph and Ed are neighbors, and each wants a paved driveway. To save money, they decide to share the building costs of one driveway that will serve both lots, as shown in Figure 3.1. Each grants the other an easement appurtenant to use the portion of the driveway on each other’s land. Both lots are simultaneously the servient estate and the dominant estate.

With an easement in gross there is no dominant estate, only a servient estate. For example, a utility company that acquires an easement to run its power line or pipeline across a property or the highway department that acquires an easement for a road right-of-way has acquired an easement in gross. The easements have been granted to the utility company or the highway department, not to parcels of land. The land over which the utility line or road crosses is the servient estate, and the ease- ment binds all future owners of the property.

f i g u r e 3.2 Easement Created by Express Grant

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60 PA RT O N E Real Estate Legal Analysis

Creation of Easements

Both appurtenant easements and easements in gross may be established in a number of ways. The most common method is by an express grant or reservation, but easements also may be established by implication and by prescription.

Express Grant or Reservation Most easements are created by either express grant or express reservation.

Suppose Scott sells half of his 10-acre lot to Darlene. If the property Darlene is pur- chasing has no road frontage, Scott may expressly grant her the right to use a portion of his remaining property for a driveway. In this case, Scott owns the servient estate, and Darlene owns the dominant estate. The deed Scott gives Darlene should specify the easement appurtenant that has been created. This easement is shown in Figure 3.2.

An easement also may be established by an express reservation. If Sam were to sell the front half of his land to Bob, the remainder of Sam’s property would be landlocked because it does not front on a public road. In the deed that transferred ownership of the frontage land to Bob, Sam could reserve a right of passageway through Bob’s newly acquired land. Sam owns the dominant estate, and Bob owns the burdened (servient) estate. By this express reservation in the sale of land, an easement appurtenant has been created, as shown in Figure 3.3.

Implication Sometimes, when one or more parcels are severed from a larger tract under com-

mon ownership, the right to use the land may be implied from the factual circum- stances even when an easement is not expressly created. The easement supposedly reflects the intentions of the parties and is called an easement by implication.

Suppose no mention of an easement was made in the previous examples. If Scott sold the land illustrated in Figure 3.2 to Darlene, and he allowed her to use the road on the property he retained, an easement by implied grant would be established.

f i g u r e 3.3 Easement Appurtenant Created by Implied Reservation

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C H A P T E R 3 Private Restrictions on Ownership 61

Likewise, as depicted in Figure 3.3, Sam’s continued use of the passageway over the land granted to Bob would create an easement by implied reservation.

In both of these situations, the implied easement arises from necessity. In the absence of the easements, the properties would have no access and virtually no value. Of course, even when an easement can be implied, it is best that all easements be stated expressly in writing.

Prescription An easement by prescription may be created when someone other than the

owner uses the land “openly, hostilely, and continuously” for a statutory time period. To use the land openly means that the user comes onto the land and acts entitled to be there. Such a user does not use the land secretly, as if to hide the use. Hostile use means the user treats the land as if he or she is the true owner of an easement. If the landowner has given specific permission for the use of land, hostility does not exist. To be continuous, the use must be uninterrupted for the time period provided by the applicable statute, usually between 7 and 20 years. These elements of prescription are very similar to those required for gaining title by adverse possession, a topic discussed later in this chapter.

Suppose, for example, that college students begin driving across kindly farmer Hodge’s land to reach a swimming hole on the river. Being a good fellow, he says nothing about it, and the use continues for many years. Later, when Mr. Hodge attempts to close the road, he is sued successfully to keep it open because of the prescriptive easement. This may seem to be unfair, but it is the law.

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Prescriptive Easement

After property has been used by another for a period of years, the owners may be forced to give up some of their property rights. This the Nicholsons discovered.

For more than 50 years two houses had shared a common driveway that provided access to each property’s carport. When bad blood developed between the two neighbors, one of the owners, the Nicholsons, started construction of a fence along a portion of the common driveway that would have

denied access to Dean Wells’s carport. Mr. Wells sued to stop them, and he won.

The court held that continuous use of the driveway for more than 50 years created a pre- scriptive easement through adverse possession. Mr. Wells had acquired a property interest to use the driveway, even though part of it was on the Nicholsons’ lot.

[Nicholson v. Wells, Ct. of Appeals of Arkan- sas, Div. 2, 2004]

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62 PA RT O N E Real Estate Legal Analysis

The lesson of all this for property owners is clear: They should not allow anyone to use their property without specific permission, and they should make certain the use is interrupted periodically. Otherwise, these property owners may find that a prescriptive easement has been created.

Nature of Easements

Easements are considered to be permanent in nature—that is, easements “run with the land” from owner to owner. Under an easement appurtenant, both the benefit to the dominant estate and the burden on the servient estate are transferred to the new owner if either of the properties is transferred. Owners Scott and Bob, represented in

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The Case of the Landlocked Parcel

It is an established principle of real estate property law that a parcel of land that has no access to a public road must be granted an easement across adjacent

lands to gain access. This does not mean, how- ever, that the easement must be provided wherever the land locked property owner desires.

Douglas Culpepper owned a 58-acre parcel of land in rural Louisiana that was landlocked, a fact he knew when he purchased the property. An old log ging trail had been used in the past for access, as well as a second logging road across land owned by a wood products company.

Two years before Culpepper bought his prop- erty, the adjacent property owner, John Davis, replanted his property, including the old logging trail, in pine seedlings. He also put up a fence where the logging trail started at the public road. Subsequently, Culpepper tore down the fence and bulldozed a new road across Davis’s land following the old trail. He destroyed the then seven-foot-high pines, and he also installed a water line down the

center of the new road. Davis re-erected the fence, but Culpep per promptly tore it down again.

Davis sued, seeking damages for tres pass, and Culpepper countersued, claiming ownership of the road. Culpepper lost.

The court held that although under Louisi ana law the owner of property that has no access to a public road may claim a right of passage over neighboring property, he may not demand an ease ment anywhere he chooses. The passage has to be along the shortest route from the enclosed estate to the public road at the location that is least injurious to the intervening lands unless this route is totally impractical due to adverse terrain. In this case, there was the second and shorter logging trail from the Culpepper property across land owned by the forest products company. The court ruled this road provided sufficient access for Cul- pepper and rejected his claim for right of passage across Davis’s land. Davis was awarded $21,845 in damages and attorney’s fees. Culpepper was also ordered to remove the water line.

[Davis v. Culpepper, La. App. 2 Cir. 794 SO2d 68]

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C H A P T E R 3 Private Restrictions on Ownership 63

Figures 3.2 and 3.3, own their respective lots subject to an easement of passageway over their land. If ownership of these lots were to change, the easement would still exist, as the passageway continues to be necessary for both Darlene and Sam to have access to the highway.

The burden on the servient estate also runs with the land in easements in gross. If Susan grants a utility company an easement to use her land for its electrical lines, then sells her land to Wilbur, the transfer does not destroy the utility company’s right to use the land. The easement, therefore, is just as valid under Wilbur’s ownership as it is under Susan’s. In some states, the utility company normally can pass this right to another organization as long as the burden on the servient estate is not increased. For example, an electric company could permit a cable television company to run its cable alongside those of the utility. In other states, additional users would have to negotiate their own easements with the landowner.

It is important to distinguish between the concepts of easement and license. A license is a revocable personal privilege to use land for a particular purpose. Whereas easements are permanent in nature, licenses are generally temporary and can be revoked at will. A landowner might, for example, allow a friend to park his car on her land anytime he wishes, as long as his doing so doesn’t inconvenience her. The benefits under a license and the burdens to the grantor’s land are temporary in nature and do not pass to successive owners.

Termination of Easements

Even though easements are considered permanent and pass from owner to owner, the rights and restrictions of an easement may be terminated under certain circumstances. Methods of terminating an easement include agreement, merger, and abandonment.

Agreement Parties affected by the easement may expressly agree to terminate their respec-

tive rights in the easement. Such an agreement should be written and recorded so that notice is given to everyone interested that a prior easement no longer exists. Because easements are valuable, convincing the owner of the dominant estate can be quite expensive. If an easement is created by an express grant or reservation that specifies it will last for a limited term only, the easement automatically ceases at the end of that term.

Merger An easement can also be terminated by the merger of the dominant and servient

estates. If Bill’s land is burdened by an easement that permits Sarah, the adjoining landowner, to travel across a portion of his property, Bill could persuade Sarah to sell him the land and thereby terminate the easement. Bill could then sell the land to another party without granting an easement, provided the property has another access route. Such a strategy is used when an agreement to terminate an easement cannot be reached.

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64 PA RT O N E Real Estate Legal Analysis

Abandonment A third method of terminating an easement is abandonment. If the benefited

party does not exercise his or her rights to use the servient estate over an extended period of time, the easement may be terminated. The length of time an easement may remain in effect without being used varies from state to state and from case to case. Some states require that the holder of a servient estate perform some act to block the easement’s use before any abandonment is possible. In essence, these states say that the easement must be terminated by the burdened owner’s prescriptive use or adverse possession.

| a relatively new type of easement ________________________

While the easements discussed so far are “affirmative easements” that allow specific uses of real estate by nonowners of the property, a conservation easement is a type of “negative easement” that prevents specific uses of the real estate by the owner. For example, suppose a property owner is seeking to gain approval for a new development project. Rather than clearing the trees and natural vegetation from the whole parcel and constructing buildings, the developer might elect to commit some portion of the property to a natural area by creating a conservation easement. Such a decision might improve the marketability of the development project (having a natu- ral area nearby might be pleasing to potential purchasers of the project), and it might also help persuade the development approval authorities to grant the development permit for the project. Conservation easements are an increasingly popular way for property owners to protect land from future development. Conservation easements are almost always created by express grant or reservation.

| profit a prendre _______________________________________

A profit, more correctly known as a profit a prendre, is a nonpossessory inter- est in real property that permits the holder to remove part of the soil or produce of the land. It is similar to an easement, although the holder of a profit has the right to remove specified resources, such as soil, produce, wild animals, coal or other miner- als, or timber, but the holder of an easement does not. A profit a prendre runs with the land unless terminated using one of the methods similar to those of terminating easements.

| encroachments _________________________________________

An encroachment is an unauthorized invasion or intrusion of a fixture, a build- ing, or other improvement onto another person’s property. Examples are a fence that strays across the property line and a driveway or patio that is constructed par- tially on the adjoining property. Although most of these intrusions are the result of carelessness or poor planning rather than intent, they should not be taken lightly. The owner of the property being encroached on has the right to force the removal of the encroachment; however, if that owner fails to force removal, the other party

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C H A P T E R 3 Private Restrictions on Ownership 65

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c l o s e - u p

Use of Conservation Easements

Those desiring to preserve historic build ings or open space often make use of restric tive covenants and easements. Historic buildings sometimes are

sold with covenants that limit the use of the building or the ways in which it can be altered. An owner may give a facade easement to a historic preservation organi zation to ensure that the facade of a building will remain. Conservation easements are often used to protect open space and farmland.

John and Faye McCune owned a 200-acre farm that had been in Faye’s family for more than 200 years. They wanted to preserve the farm rather than sell it for development, a fate that had befallen most farms in their area because the city was rapidly expanding in their direction. Property taxes, which were based on the developmental potential of the land in commercial use, were also increasing rap idly, and the McCunes were concerned that the increased tax burden might force them to sell the farm. A conservation easement on the land offered them many advantages.

The McCunes donated a conservation ease- ment on the farm to the Central Piedmont Land Trust. The easement restricted use of the land to agriculture and permitted the building of no more than three additional houses for family members. None of these could be built closer than 800 feet to the existing 200-year-old farmhouse and were required to be built in a style compatible with the old farmhouse.

Because the McCunes had given up the abil- ity to sell the land for commercial development, the conservation easement constituted a sizable charitable donation, the difference between the value of the land in its highest and best use and its value in agricultural and limited family residential use. Appraiser Steve Gault ney valued this donation at $800,000, or $4,000 per acre. This constituted a very sizable income tax deduction for the McCu- nes. They were able to take a deduction from their taxable income for federal income taxes up to 50% of their “adjusted gross income,” and they were able to spread this deduction over 15 years. They were also fortunate to live in a state that allows an income tax credit for a conservation easement donation, so, essentially, they did not have to pay any state income taxes for six years.

Because the potential use of the land was reduced from commercial to agricultural, the prop- erty tax assessment on the farm was also reduced to reflect this lower value. Given their taxable income level, the lowered value also ensured that the McCune children would not be facing a large estate tax burden on the farm. The easement in no way prevented the McCunes in giving the farm to their children or in selling the prop erty. It only restricted its potential use.

For this family in this situation, the conservation easement was clearly a “win-win” proposition. The community also gained because it was assured of continued open space.

(This case is a slightly fictionalized account of an actual event.)

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66 PA RT O N E Real Estate Legal Analysis

may claim the legal right to continue encroaching by adverse possession (discussed below). Encroachments can have a detrimental impact on property value.

The best way to detect encroachments is to have a boundary survey prepared for the property. The surveyor will locate the boundary lines and corners of the property as well as any encroachments onto the property from adjoining properties.

| adverse possession ______________________________________

Perhaps nothing in real estate law is so upsetting to property owners as adverse possession, which allows individuals to acquire title to land they do not own because they have openly possessed it for a statutory period of time, usually 7 to 20 years.

For title to be transferred by adverse possession, such possession must be “actual and exclusive, open and notorious, hostile, and continuous” for a statutory period of

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Adverse Possession

In 1986 Scott and Kathleen Walling bought a lot in Queens- bury, New York. The next year they built a house and land- scaped and installed drainage

adjacent to another building lot which Paul and Denise Przybylo bought in 1989. The Przybylos built a house on their lot in 1994, but because they didn’t obtain a mortgage and there was no require- ment to do so, they didn’t have the lot surveyed. That was a mistake.

The Wallings continued to improve the side yard, installing a buried-wire dog fence in 1998 and planting 10 willow saplings in 2003. About this time relations between the families deteriorated and they began to file counter-complaints against each other in town court about barking dogs and other matters.

Finally, in 2004 the Przybylos decided to plant a row of trees on the property line to shield themselves from the Wallings, which necessi- tated having the property surveyed. The survey showed that they actually owned 5,800 square feet, somewhat over 0.1 of an acre, of the side yard that

Walling had been using. The Wallings then claimed they had obtained title to the disputed land through adverse possession due to their open continu- ous and notorious (without permission) use of the property, under a claim of right, for longer than the 10-year statutory period required under New York law. The statutory period varies from state to state.

The Walling family won. New York’s highest court ruled that since the Przybylos had waited 15 years after purchasing the property, and almost 10 years after moving into their house, to assert their right over the disputed parcel, they had lost it to the Wallings.

Was this fair? Many would say no, but that is the law of adverse possession. Of course, the Przy- bylos could have avoided this problem if they had obtained a survey when they bought their lot.

The legendary poet Robert Frost wrote that “good fences make good neighbors.” So do good surveys, and one should never buy land without one.

[Walling v. Przybylos, 24 AD3d 1, NY Ct. of Appeals, 2006]

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C H A P T E R 3 Private Restrictions on Ownership 67

time. The phrase actual and exclusive does not require that the adverse possessor physically occupy the land at all times. Improving the land with a residence would constitute actual possession. So would clearing the land, building a fence along its boundaries, or farming it. Allowing other people to use the land without express permission would prove that the possession was not exclusive. The possessor must maintain possession in the manner of a reasonable owner. The terms open and noto- rious, hostile, and continuous have the same meaning in the case of adverse posses- sion as they do in the case of a prescriptive easement.

Another important prerequisite for adverse possession in some states is that the possession be under a “claim of right.” This means that the adverse possessor must have a basis for believing he or she owns the real estate claimed. A tenant who takes possession of a house while acknowledging the landlord’s ownership cannot adversely possess the leased property. If a claim of right is based on a written docu- ment, such as an invalid deed, the claim is said to be made under “color of title.” Some states require that the possessor have color of title to possess land adversely, while other states reduce the number of years required for continuous possession if written color of title is present. Still other states treat all claims of right in the same manner, whether or not they are based on documents.

At times, it is hard to imagine how anyone could become confused about land ownership unless a mistake has been made in the legal description in the deed. Adverse possession today is much more common in connection with boundary dis- putes than with possession of entire tracts. Boundary disputes involving adverse possession are of particular importance in residential areas, as can be seen in the previous Legal Highlight.

| chapter review __________________________________________

■■ Restrictions and limitations on ownership interests in real property take many forms. A private restriction is a limitation on the owner’s title by some private individual or business. An encumbrance created by a govern- ing body or public authority is a public restriction.

■■ Covenants, conditions, and restrictions—CC&Rs—are promises made by property owners that restrict how the property may be used. CC&Rs are intended to protect and enhance property values by preventing uses that would be incompatible with other properties.

■■ A lien is a security interest in a property held by a creditor as security for repayment of a debt or other obligation. It does not represent an ownership interest in the property. Mortgages and mechanics’ liens are examples of specific liens on real property. Other claims, such as judgment liens, are more general in that they can be attached to real or personal property. If a debtor fails to satisfy a specific or general lien, the property may eventu- ally be used to satisfy the debt.

■■ Easements are restrictions on a landowner’s title in which another person or entity has the ongoing right to use someone’s property for a specific

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purpose. When an easement exists, the property that is subject to the ease- ment is known as the servient estate. An easement appurtenant exists when the easement’s benefits are tied to another parcel of property—the domi- nant estate. If such benefits are held by an individual or a business without regard to the location of that individual or business, an easement in gross exists. A license is created by the landowner’s grant of permission to use his or her property. Generally, licenses can be revoked at the landowner’s whim; therefore, they are less permanent than easements.

■■ A profit a prendre is similar to an easement, but it specifically allows the holder to remove certain natural resources from the servient property.

■■ Adverse possession is the term used to describe a process by which own- ership of real property can be transferred from one party to another as a result of the second party’s ongoing possession of the land under certain conditions.

| key terms _______________________________________________

adverse possession

conservation easement

covenants, conditions, and restrictions (CC&Rs)

dominant estate

easement

easement appurtenant

easement by implication

easement by prescription

easement in gross

encroachment

encumbrance

express grant

express reservation

foreclosure

general lien

implied grant

implied reservation

judgment lien

license

lien

mechanic’s lien

mortgage

mortgagee

mortgagor

profit a prendre

servient estate

specific lien

| study exercises _________________________________________

1. What is the difference between a general lien and a specific lien?

2. Suppose that Charlie decides that he is going to cheat Harry out of the money he owes Harry for installing a new air-conditioning system in Charlie’s house. What steps might Harry take to collect the debt? (Do not include breaking Charlie’s legs.)

3. Why would someone voluntarily allow a mortgage lien on their property?

4. Define the following terms: easement, license, and encroachment.

5. What is the difference between an easement appurtenant and an easement in gross?

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C H A P T E R 3 Private Restrictions on Ownership 69

6. Suppose that David sells Joan an easement to run a water line across his property to her property. Who has the dominant estate and who has the servient estate? Explain your answer. Is this an easement appurtenant or an easement in gross?

7. Suppose that David sells the above property to Tamara. She tells Joan to remove the water line from her property. Can she force Joan to remove the line?

8. What is the difference in creating an easement by grant, by reservation, or by implication?

9. Describe an easement by necessity. Describe an easement by prescription.

10. List three methods for terminating an easement.

11. What is the difference between an easement and a license? Between an easement and a profit a prendre?

12. Suppose that Cindy purchases a house and discovers that her neighbor Eleanor has several rose bushes that encroach on her lot. When Cindy asks Eleanor to move the bushes, Eleanor becomes indignant and accuses Cindy of being unfriendly and a poor neighbor. May Cindy legally insist that the bushes be moved? Why or why not?

13. Suppose that Jack inherits his grandmother’s house. He finds that the deed granted many years ago contains a restriction that the property may be sold only to someone of the Caucasian race. Could this restriction be enforced? Why or why not?

14. When Claudia decides to sell her house, she discovers that there is a restriction in her deed that prohibits putting up a For Sale sign on her lawn. “This violates my free speech,” she fumes. “I’m going to sue the commu- nity association.” Will she win? Why or why not?

15. Tim makes the following argument: “Even though CC&Rs limit what a property owner can do with his land, they may increase his property value.” Is Tim right? Why or why not?

16. Suppose a new homeowner in the Meadow Brook Ranch development is upset because his neighbor is keeping a horse on her property. Based on the covenants for this development discussed in the Real Estate Close-Up on pages 51–52, may the upset owner demand that the horse be removed?

17. Internet Exercise: Do a Google search at www.google.com on the term “CC&Rs” and locate the CC&Rs for a residential development project near you. Read over the CC&Rs and comment on some of the restrictions that you think have a positive impact on the value of the homes in the develop- ment. Do any of the restrictions make owning a home in this development less appealing to you?

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Public Restrictions on Ownership

4c h a p t e r

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legal highlight What Constitutes

“Public Use”?

legal highlight Inverse

Condemnation

close-up The Smart Growth

Controversy

legal highlight The Strange Case of the Incredible

Shrinking Building

legal highlight The Case of the

Costly Permit

legal highlight The Takings Issue

c h a p t e r p r e v i e w

In addition to the private restrictions on property rights discussed in the previous chapter, governments also create limitations on the ownership of real estate. These limitations arise from governments’ powers of

■■ taxation;

■■ eminent domain;

■■ police power; and

■■ escheat.

After reviewing the four powers governments have over real property, this chapter discusses some of the techniques and tools of public land-use control and examines a few of the controversies surrounding land-use policy issues. The specific topics covered are

■■ the history of land-use controls;

■■ the public land-use planning process;

■■ zoning and other land-use control methods; and

■■ the takings issue.

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| the property tax ________________________________________

The first power of government over private property to be considered is the power of taxation. The government exercises this power by levying both property taxes and income taxes. We will consider the impact of income taxes later in this text and focus our attention on the property tax in this chapter.

Although declining in importance, the property tax is still a critical source of rev- enue for local governments. On average, property taxes account for approximately 30% of general revenues and 75% of tax revenues. These revenues are used to fund schools, police and fire protection, and other local government services. Property taxation provides a stable source of revenue that is not greatly affected by short- term fluctuations in business activity, and because it is tied to property that is largely immobile, the property tax is relatively easy to administer and very difficult to evade.

The Property Taxation Process

The property tax is an ad valorem tax; that is, it is levied as a percentage of value. It is a tax on the value of the property, as opposed to a tax on the income earned from the property. Property taxes are often expressed in millage rates rather than percentage rates. One mill is equal to one dollar of tax for every one thousand dollars of value. One percent is equal to one dollar of tax for every one hundred dol- lars of value. Stated another way, one mill equals $0.001, or 1/1,000 of $1. In some jurisdictions, only a portion of the market value of the property is subject to taxa- tion, where market value is generally defined as the price that the property prob- ably would bring in the market, given knowledgeable and willing buyers and sellers who act under no unusual pressures and who have a reasonable time to complete the transaction. The portion of market value subject to taxation is called the assessed value. The fraction used to determine assessed value from market value is called the assessment ratio. (Some states, such as Florida, use an assessment ratio of 1.00, which means 100% of the market value of property is subject to tax. Other states, such as Georgia, use an assessment ratio of 0.40, which means that only 40% of the market value of property is subject to tax.) Furthermore, some jurisdictions exempt certain amounts of a property’s assessed value to provide tax relief for certain types of property owners (full-time residents, disabled persons, the elderly, etc.). These exemptions effectively shift some of the tax burden away from the properties that qualify for the special treatment toward properties that do not qualify. Subtracting the amounts of exemptions from assessed value gives the property’s taxable value.

To see how property taxes are calculated, consider a property with a market value of $120,000 in a jurisdiction that applies an assessment ratio of 40%. For this property, the assessed value is $48,000 ($120,000 × 0.40 = $48,000). Suppose the property qualifies for a tax exemption of $2,500 because it is the owner’s homestead. The taxable value of this property is thus $45,500 ($48,000 – $2,500 = $45,500). If the tax rate in this jurisdiction is 25 mills (or 2.5%), then the property tax amount is $1,137.50 (45,500 ÷ 1,000 × 25 = $1,137.50).

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The following framework shows how the property tax bill for this property is calculated:

Market Value $120,000 multiplied by Assessment Ratio × 0.40 equals Assessed Value $48,000 minus Exemptions (if any) $ –2,500 equals Taxable Value $45,500 divided by 1,000 ÷ 1,000 multiplied by Millage Rate × 25 equals Property Tax $1,137.50

Administering the Property Tax

From the government’s perspective, the steps involved in administering the property tax are

1. property value assessment,

2. development of the budget and tax rate, and

3. tax billing and collection.

Property Value Assessment The first step in the property taxation process is to estimate the market value for

all properties within the jurisdiction, a process known as assessment. The govern- ment official responsible for doing so, usually called the assessor, property asses- sor, or property appraiser, must identify, list, and value all taxable properties in the jurisdiction. An efficient assessor maintains a complete set of maps that show each parcel of real estate and its features, as well as a system of continuing inspection of deeds and building permits in order to keep up with new construction and changes in property ownership.

After all properties have been identified, the assessor must accomplish the most difficult part of the job, that of estimating the market value of the properties within the jurisdiction. Many states use mass appraisal techniques, or statistical models, to assess the value of all properties in a jurisdiction each year. After estimating the property’s market value and applying the assessment ratio and any exemptions, the assessor arrives at the property’s taxable value. This value is subject to review, and the results of the review process may be appealed by the taxpayer before an appeal board or court.

Development of a Budget and Tax Rate The next step in the property taxation process is the development of a budget

and tax rate by the city council, the county commission, or other government body. The amount of revenue coming from other taxes and from nontax sources is sub- tracted from the total budget; the remainder must be collected in property taxes. This amount then is divided by the total of the taxable values of all properties in the jurisdiction to determine the tax rate.

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For example, suppose that the local government needs to raise $10 million in property taxes, and the total taxable value of all properties in the jurisdiction, known as the tax digest, is $500 million. The tax rate needed to raise these revenues is $10,000,000 ÷ $500,000,000 = 0.02.

The tax rate usually is expressed as the rate per thousand dollars of assessed val- ue—the millage rate, where one mill equals $0.001, or 1/1,000 of $1. In the example above, 20 mills equal $20 tax per $1,000 of assessed valuation, or 2%.

As a matter of practice, of course, the local governing body does not merely decide what it would like to spend and then set a corresponding tax rate. It may feel constrained not to raise the present tax rate at all, to raise it only slightly, or even to lower it. In many areas, tax rate adjustments require a vote on the issue by the people in the jurisdiction.

After the tax rate is set, the taxable values are multiplied by the tax rate to obtain individual tax bills. If a house in our hypothetical locality has a taxable value of $50,000, for example, the property tax would be $1,000 (20 mills × $50,000).

Tax Billing and Collection Tax billing and collection procedures vary widely among the states. In some,

property tax bills are payable annually; in others, taxes are payable semiannually or quarterly. Some states have special taxing districts that send their tax bills at differ- ent times of the year.

If property taxes are not paid when due, the government to which the taxes are owed can place a lien on the real estate for the unpaid taxes, plus a penalty and inter- est. If the taxes remain unpaid for a certain period of time, which varies from state to state, the property may ultimately be sold at public auction to satisfy the tax lien. In essence, the tax sale is similar to a foreclosure sale that follows default on either a mortgage or a mechanic’s lien.

| power of eminent domain _________________________________

Under the power of eminent domain, a government can acquire property for a public use, even if the owner doesn’t want to sell, as long as the owner receives just compensation. This power comes from the Fifth Amendment to the U.S. Con- stitution, which, among other things, states that property shall not be taken from any person for public uses without the payment of just compensation. Although this provision applies specifically to the federal government, it has been extended to the states through the due process clause of the Constitution’s Fourteenth Amendment. In addition, state constitutions have similar provisions.

In an eminent domain proceeding, also known as a condemnation proceeding, the government must establish that the land is needed for a public use or benefit and that the amount of money offered to the landowner is the reasonable value of the land being taken. The concept of public use is quite broad, going beyond the taking of land for public facilities such as roads and schools. It has been extended to include the condemnation of private land for resale to other private individuals or firms for urban renewal, as well as the enforced breakup of old Hawaiian estates to extend

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land ownership more widely. The concept also has been extended to include quasi- public organizations such as utility companies, railroads, and pipelines.

Most of the controversy surrounding the taking of private property rights by condemnation centers on the question of whether compensation was adequate. If the condemning authority and the owner fail to agree on the property’s value, the owner can request a trial to determine the amount of just compensation.

Inverse condemnation occurs when a property owner, seeking to force payment for taking of property rights, starts condemnation proceedings against the govern- ment, contending that a government action has destroyed or reduced the value of the property to such an extent that the government has effectively taken the prop- erty away from the owner. For example, suppose a highway department announces plans for a new road but delays purchasing the necessary rights-of-way. A property owner in the path of the proposed road could sue to force the highway department to purchase the land, contending that the announced plans have made it impossible to sell the land for private purposes. Or a property owner near an airport might bring legal action to force a condemnation and collect payment for reduced property value caused by the noise of low-flying aircraft.

| police power ____________________________________________

Under police power, governments have the power of regulation, which gives them the ability to protect the public health, safety, morals, and general welfare. In addition to obvious actions such as protecting against crime and health hazards, gov- ernments have also relied on these police powers to enact a variety of controls over the way landowners can use their properties.

The use of a particular parcel of land is affected greatly by other nearby land uses and depends heavily on public investments and the economic vitality of the surrounding neighborhood and community. It is this interdependence of land uses that creates the need for public land-use controls. Generally speaking, the use of land affects the owners of other nearby properties more than the use of any other type of private property. Conversely, financial returns for the real estate developer or investor may be greatly affected by the land uses that are permitted by governments or by the allowable intensity of land use. Consequently, the issue of public land-use controls is of vital importance to all who are concerned with real property.

The concept of planning and control of land use is not new. In fact, in this country, it dates back to the colonial era. Many early American cities were carefully planned and developed under a variety of land-use controls. One of the early controls still valid today is the English common-law concept of nuisance law, laws relating to the use of property in such a way as to harm the property of others. Most of the prohibited land uses were hazardous or noxious practices, such as the operation of a slaughterhouse or the manufacture of bricks near a residential area. In these cases, the offending activity might be declared a nuisance. The injured parties could seek an injunction to force the polluter to stop the offending activity, or they could seek monetary damages.

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Nuisance laws provided some relief to individual property owners from the worst types of injurious land uses, but they were not well suited for public land- use control because a substantial injury had to be proved before any relief could be given. As the United States rapidly urbanized around the turn of the 20th century, municipalities increasingly turned to police power to regulate land uses. Most cities have found that a comprehensive general plan is necessary to effectively implement land-use controls.

| the comprehensive general plan _________________________

To ensure that urban areas develop in an orderly fashion, most local govern- ments have formulated and adopted a comprehensive general plan that serves as a statement of policies for the future development of the community. These poli- cies provide a basis for the land-use control methods employed by the municipality. The policies should reflect a long-range plan that examines closely the community’s predicted physical needs for 15 to 25 years in the future. It usually contains the fol- lowing elements:

■■ An analysis of projected economic development and population change

■■ A transportation plan to provide for necessary circulation

■■ A public-facilities plan that identifies such needed facilities as schools, parks, civic centers, and water and sewage-disposal plants

■■ A land-use plan

■■ An official map

The comprehensive plan may also include other elements such as housing, rede- velopment, and historic preservation. It should not be a static document but must be revised continually as conditions change.

Implementing the Comprehensive Plan

The comprehensive plan and its land-use component are implemented through several tools of land-use control. The most prominent of these is comprehensive zon- ing, but they also include building codes, mandatory dedication, impact fees, zoning for planned unit development, performance or impact zoning, incentive zoning, and transfer of development rights. We will consider each of these methods in turn.

| zoning __________________________________________________

Zoning refers to the process of dividing a community’s land into districts in which only certain uses of the land are allowed. For example, an area might be zoned to allow only single-family residences on lots of at least one-half acre in size, another area might be zoned to allow only commercial uses, and yet another area might allow only industrial uses of the land. The first comprehensive zoning ordi- nance was passed in New York City in 1916 to restrict the use and height of buildings

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What Constitutes “Public Use”?

As governments have moved beyond their traditional use of the power of eminent domain to acquire land for public projects such as schools and roads to

include objectives such as economic development, an extended controversy has arisen as to what constitutes “public use.”

In 1946, the United States Congress estab- lished a District of Columbia Redevelopment Land Agency to redevelop blighted areas of the city. The agency began to acquire land within the desig- nated area, including a department store owned by Berman. Berman sued, contending that condemn- ing his property for redevelopment was not a “public use.” The U.S. Supreme Court disagreed, ruling that economic redevelopment of blighted areas was a legitimate use of the power of eminent domain. [Berman v. Parker, 348 US 26, (1954)]

While the concept of governments acquir- ing property in blighted areas for redevelopment has been generally accepted, what about taking nonblighted properties to transfer land from one property owner to another to further economic development? In the early 1990s the City of Detroit took about 1,000 homes and 600 businesses in the Poletown neighborhood to make room for a General Motors plant. Although this project was bitterly contested, it was upheld in the courts. More recently, however, Wayne County, Michigan, desired to construct a business and technology park near the Detroit airport to spur economic development. It acquired all but 40 acres of the 1,300 acre site, and it sought to condemn the remainder under eminent domain. One of these

property owners was Edward Hathcock, who owned a 12-employee millwork and kitchen cabinet factory that sat in the middle of the proposed proj- ect. Although the county offered him $360,000 for the one-acre site, he declined to sell, saying that it would cost him far more to relocate. He fought the taking, contending that taking private property in order to turn it over to other private interests was not a “public use.” The Michigan Supreme Court agreed, overturning the Poletown decision, and rejecting the principle that “a private entity’s pursuit of profit was a ‘public use’ for constitutional taking proposed simply because one entity’s profit maxi- mization contributed to the health of the general economy.” [County of Wayne v. Edward Hathcock, 684 MW2d 765, Michigan Supreme Court, (2004)]

This issue came to the U.S. Supreme Court when New London, Connecticut, attempted to take Susette Kelo’s house in the Fort Trumbull neigh- borhood as part of a plan to redevelop some 90 acres containing 115 properties. All but 15 own- ers agreed to sell, and the city condemned the other homes, including Kelo’s. She challenged the taking, and the case went to the U.S. Supreme Court. In a 5-4 decision, the Court ruled for the City, holding that economic development fits within the definition of public use, and thus justifies the condemnation of private property. [Kelo v. the City of New London, 545 US 469 (2005)]

The Kelo decision sparked a virtual firestorm of adverse public opinion, and, subsequently, a majority of state legislatures have passed laws restricting the use of eminent domain for develop- ment purposes. This is an issue that will be a lively one for many years to come.

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in various districts of Manhattan. Zoning gained increasing acceptance during the 1920s, and after the constitutionality of the concept was upheld in 1926, zoning ordinances and related land-use controls were adopted in most urban areas and many rural communities of the United States.

Type of Use

The three main kinds of zoning districts classified by use are residential, com- mercial, and industrial. Each such district usually is divided into several subcatego- ries. For example, there generally are several single-family districts with varying minimum sizes of lot and house. Other residential districts may permit multifamily housing. Similarly, commercial and industrial districts usually are subcategorized as neighborhood shopping districts, highway commercial districts, light industrial

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Inverse Condemnation

The Thomas A. McElwee & Sons printing company had been located on Philadelphia’s Market Street since 1954. In 2000 the Southeastern Pennsylvania

Transportation Authority (SEPTA) began construc- tion of a new rail line in the area. The Authority’s vehicles and construction debris blocked McEl- wee’s driveway so it could not be used either to receive shipments or to send out deliveries. Trucks had to park some distance away, greatly reducing productivity. Then, in September 2002 the block in which the firm was located was closed during business hours for nine months. This effectively shut down any walk-in traffic, which had consti- tuted over 20% of their business. Finally, in May 2005 McElwee gave up and closed the business, with $20,000 in unpaid bills.

Thereafter, McElwee sued SEPTA in inverse condemnation, claiming a de facto taking of their property rights. They claimed that blocking their driveway and closing the street during business

hours reduced their productivity and ability to attract business and caused severe financial harm to the business. The Pennsylvania Commonwealth Court agreed, ruling that McElwee was entitled to compensation.

The court said that a de facto taking occurs when an entity having the power of eminent domain essentially deprives the owner of a property of “beneficial use” and enjoyment of his property. This, the court said, included reasonable access to the property. In this case there was extremely limited access to the firm’s driveway for the three- year construction period, and virtually no access for the time when the Authority closed the street during business hours. Extreme deprivation of use for such a lengthy period constituted more than a “temporary inconvenience” and, in fact, constituted a taking of the property rights for which compensa- tion from SEPTA was required.

[Thomas A. McElwee v. Southeastern Penn- sylvania Transportation Authority, Commonwealth Court of Pennsylvania, 2006]

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districts, and so on. Most zoning ordinances contain, in addition to the three main categories, such special-purpose districts as agricultural, and historic preservation.

Intensity of Use

Within each zone, governments may specify the intensity of use, or the extent to which land in the zone may be used for its permitted purposes. The government can regulate intensity of use, also known as developmental density, in several ways, including placing restrictions on building height and bulk, specifying minimum lot sizes, and establishing setback requirements.

Height and Bulk Limitations Height limitations regulate the maximum height of buildings in feet or stories.

Bulk limitations control the percentage of the lot area that may be occupied by buildings. Both serve to control the volume of a structure on the land and, therefore, the intensity of use.

Floor-Area Ratio Another measure by which building volume may be controlled is the floor-area

ratio (FAR). The FAR is the relationship between the total floor area of a building and the total land area of the site. For example, an allowable ratio of 4 to 1 would permit a 4-story building to occupy the entire area of its lot; an 8-story building would be permitted to occupy only half of the site’s surface area; while a 16-story building could occupy only one-fourth of the land area. Other FARs are illustrated in Figure 4.1.

Minimum Lot Size and Setback Requirements The most common method of regulating development density is through provi-

sions for a minimum lot size. Relatively large lots may be necessary for public health reasons if public sewer and water systems are not provided. However, requirements of very large minimum lot sizes may run into court challenges on the basis that they deprive the owner of reasonable use or are designed to exclude various groups.

Zoning ordinances generally provide for setback of buildings from the street and minimum size of side yards in residential districts. Such restrictions also may be applied to commercial and industrial districts, but this is less common.

Some Innovative Zoning Issues

Traditional zoning has been criticized for being inefficient, for being subject to poor administration and even corruption, and for having little relationship to plan- ning goals. Some attack it for its flexibility, charging that true separation of uses seldom is achieved because zoning boards submit to developer pressure to grant extensive rezonings. Others attack zoning for its rigidity, charging that its inflexible requirements stifle good design and foster inefficiency and rising costs. A few have come to the conclusion that zoning controls should be abolished, while others have

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attempted to improve the zoning process. The latter movement has led to some inno- vative techniques, including zoning for planned unit development, performance or impact zoning, incentive zoning, and transferable development rights.

Planned Unit Development Zoning for planned unit developments (PUDs) can avoid some of the failings

of traditional zoning practices. Generally, many bulk and use regulations may be waived to permit greater flexibility of design. For example, lot sizes may be reduced to permit greater densities, and setback and side-yard requirements may be waived to permit attached housing. Convenience shopping also may be permitted within the development. In return, the community should receive the advantages of pres- ervation of natural features, community recreation and open space, greater housing choice, safer streets and pedestrian ways, reduced need for automobile travel, and lower costs.

Performance Zoning Performance zoning, often known as impact zoning, is a technique to relate

permitted uses of land to certain performance standards, usually to protect the envi- ronment. Such performance standards, particularly industrial-use standards related to noise, smoke, smell, and the like, sometimes are quite detailed.

Adoption of performance zoning generally results in simplified land-use con- trols. The performance standards relate land-use demands to land-use capacity, and they can be used to achieve better design and to reduce the cost of regulation as well as to protect the environment. The standards used are often related to density; open-space ratio; impervious-surface ratio (surface-water runoff); and the number of vehicle trips generated by the site.

A number of municipalities in Bucks County, Pennsylvania, have performance zoning ordinances that reduce the number of residential zoning districts to only one or two. A variety of housing densities is possible, however, because the number of units permitted is related to the environmental carrying capacity of each site.

f i g u r e 4.1 Examples of Floor-Area Ratios

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Although at first glance these rules seem somewhat complex, developers generally have favored them because the performance standards are not subject to varying administrative interpretation and permit much greater variety in design.

Breckenridge, Colorado regulates all development through a comprehensive permit system based on performance standards. A small Victorian-era mining com- munity in the Rocky Mountains, Breckenridge is a major ski area with attendant development pressure. The performance standards establish architectural guidelines to ensure that new development is compatible with the existing Victorian character of the town, prohibit certain features in a development and require others, and assign positive or negative scores for other features related to environmental impact. The development must achieve a total score of zero or better to receive a permit, but it can receive significant density bonuses if it achieves higher scores. As in Bucks County, developers generally have been pleased with the permit system because its structured nature reduces uncertainty and processing time.

Performance zoning also can aid redevelopment of an area. For example, South Pointe, a deteriorated, 250-acre, multifamily residential district on the southern tip of Miami Beach, was originally platted in small, 50-by-100-foot lots sold to indi- vidual buyers in the 1920s. Attempts to redevelop the area had met with little success until a new performance zoning ordinance was enacted that increased the minimum lot size and minimum width of lots, required 60% to 70% open space, yet increased the allowable FAR. These changes have encouraged the aggregation of the small lots and have led to substantial development.

Incentive Zoning Closely related to performance zoning is incentive zoning, which encourages

developers to provide certain publicly desired features in return for various incen- tives. For example, the San Francisco City Planning Code permits increased floor area if the developer provides a pedestrian plaza or arcade, and New York City has provided similar incentives. Other communities permit higher densities for residen- tial developments that provide such features as open space.

Transferable Development Rights Another creative technique of land-use regulation that has received increasing

attention involves transferable development rights. Under a transfer system, in order to develop their property, landowners can sell part of their bundle of rights to other landowners, who then can use their own land more intensively. For example, suppose that Mrs. Johnson owns a 10-acre wooded tract that she wishes to preserve as it is. Nearby, Mr. Hite owns another 10-acre tract that he wishes to develop. Exist- ing regulations require minimum one-acre lots in the area, so Mr. Hite could build only 10 houses on his land. Mrs. Johnson, having no interest in developing her prop- erty, could sell her development rights to Mr. Hite, who then could build 20 houses on his 10 acres, while Mrs. Johnson’s land remained in its wooded state. Proponents of this system contend that it is more equitable than one that does not permit such transferable development rights; it enables communities to preserve floodplains, open space, and historic structures without wiping out their property values because development rights can be sold to other property owners.

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The use of transferable development rights still is limited but is growing in application. Several communities in New Jersey and California are experimenting with the system in their efforts to preserve open space. A number of cities, including New York, Chicago, Denver, and Washington, are using the transfer mechanism as a means to preserve historic landmarks. FARs on such properties can be transferred to other properties to allow denser development on those sites. For example, Tiffany sold development rights over its Fifth Avenue building to Donald Trump to enable him to add more space to his Trump Tower development.

Zoning Changes

For various reasons, a property owner may seek a change in zoning or relief from some provision of the zoning ordinance. This can be accomplished through legisla- tive, administrative, or judicial means.

Legislative Relief If a property owner seeks a change in the property’s use, he or she can request a

change in zoning use classification from the local zoning authority, usually the city council or county commission. Zoning amendments generally require review by a planning commission, an advertised public hearing, and some type of justification from the applicant demonstrating that changed conditions justify the zoning change. Because zoning changes often are quite controversial, so are the hearings, with spir- ited and sometimes acrimonious public debate.

Administrative Relief If a property owner seeks a relatively minor change, it sometimes can be accom-

plished administratively through a variance or special-use permit granted by a board of adjustments, a zoning appeals board, or some similar body. A zoning variance permits use to deviate slightly from a strict interpretation of the zoning ordinance to avoid placing undue hardship on an owner. For example, for a house to be con- structed on an oddly shaped lot, some relief from minimum side-yard requirements may be needed.

Zoning ordinances often permit special uses within certain districts if certain conditions are met. For example, a public utility substation, church, school, or recre- ational facility may be permitted in a residential district if the board determines that the required conditions have been satisfied.

Variances and special-use permits can make a zoning ordinance much more reasonable and less burdensome to property owners. If not carefully controlled, however, these permits also can completely undermine the community’s land-use planning efforts. Variances that change the essential character of land use within a district often are granted with little justification. The powers of the board must be spelled out carefully to prevent such happenings.

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The Smart Growth Controversy

Smart Growth . . . Sprawl . . . New Urbanism . . . Property Rights . . . Housing Density . . . Light Rail. These are some of the bywords tossed around in the

“Smart Growth” controversy, perhaps the most con tentious issue in land use today.

In earlier years, American cities were mostly pedestrian oriented, with relatively high population densities. They were limited in geographic reach to the footpower of people or horses. Then in the early years of the past century the trolley and other pub- lic transportation enabled cities to spread out, and the age of the streetcar suburb arrived. With the coming of the automobile age, this trend toward decentrali zation and lower-density development speeded up. Within the past few decades it has accelerated at an ever-increasing pace, leading to the cries of “Sprawl!” The question: Is sprawl an evil, or is sprawl the inevitable result of an expand- ing popula tion and an essential element in “the American Dream”?

Sprawl has been blamed for a multitude of problems: traffic congestion, diminished air quality, loss of farmland, urban decay, increased cost of public infrastructure, loss of neighborliness—even the obe sity crisis. The prescription according to “smart growth” advocates is to increase urban densities, restrict rural development through the imposition of urban growth boundaries, and limit road improve ments in favor of public transporta- tion, particularly light rail.

Although some elements in the smart growth agenda are widely supported, particularly redevelop ing inner-core urban areas and develop- ing infill sites, reusing “brownfields,” preserving open space and farmland, and encouraging new

forms of “new urbanist” design, increasingly the smart growth advo cates have been defending themselves against accusations that it is an elitist, anti-opportunity move ment that raises housing prices, destroys property rights, and deprives low- income households of an opportunity to pursue the American dream of home ownership. The oppo- nents also point out that despite the claims of the smart growth advocates, such policies increase traffic congestion and air pollution. Spending on light rail transit is attacked as wasteful and inefficient.

In a practical sense, however, the smart growth movement has little power to reshape Amer- ica’s urban landscape in any significant way. The biggest factor influencing future land-use decisions is the nation’s need to accommodate a projected 23% increase in population by 2020—some 64 mil- lion people. Thus, continued dispersal of the urban population appears inevitable, particularly given people’s demonstrated preference for the subur- ban lifestyle.

Portland: The Smart Growth City Nowhere has the smart growth model been embraced more fully than in the Portland, Oregon, metropolitan region. In 1992 Portland area voters created Metro, a “supergovernment” regional plan- ning authority with vast powers over land use and transportation planning in three counties and 24 cit ies. An urban growth boundary was established that encloses 365 square miles. This boundary is not just symbolic. Growth outside the boundary is virtually nonexistent. It is common to observe high-density development on one side of a road that marks the urban growth boundary, while on the other side land use is limited to agriculture.

(continued)

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Judicial Relief If property owners are unhappy because the legislative or administrative relief

they sought is not granted, they may appeal to the courts. An appeal is based on a contention that the zoning regulations are in some way unconstitutional or that own- ers were deprived of the property without due process of law because a decision was arbitrary, unreasonable, or capricious. Even with the increased aggressiveness of the judicial branch, courts are generally reluctant to substitute their judgment for that of legislative bodies, and zoning ordinances usually are upheld unless they involve clear abuses of power or are unduly restrictive.

Zoning restrictions are of great importance to real estate developers. Those who disregard them do so at their peril, as the developer in the Legal Highlight shown above found to his chagrin and financial loss.

Nonconforming Uses A nonconforming use is a continuing use that was legal before a zoning ordi-

nance was passed but that no longer complies with the current zoning regulation. Such a use generally is allowed to continue for some period of time unless the non- conforming structure is substantially destroyed or abandoned. Regulations concern- ing nonconforming use usually do not permit the existing structure to be enlarged or substantially changed in use. They also may require that the nonconforming use be discontinued after a stated period of time, a process that is known as amortization.

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The Smart Growth Controversy

Although Metro estimates that Portland’s popula tion will increase by 80% by 2040, the planned expansion of the urban growth boundary is only 6%. Thus, to accommodate the population increase localities within the region have been assigned mandatory population targets requiring high-density, mixed-use developments. The impact on housing costs is predictable. With restricted supply the price has increased greatly, making Port land one of the least affordable cities for home ownership in the United States.

Portland is attempting to accommodate the increasing need for transportation through the

development of a 125-mile light rail network, while limiting road improvements. More than half the region’s transportation dollars are being spent on this network, even though public transit accounts for only 1% of travel. Traffic congestion is pre- dicted to quadruple by 2020, which Metro says will increase smog by 10%.

So, does Portland’s “smart growth” model pro- duce a more livable city, as its pro ponents claim, or is it a planning disaster, as its opponents claim? The jury is still out, but obviously “smart growth” in Portland is not producing an urban utopia.

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Most amortization periods for buildings are relatively long, perhaps 50 years. Most controversy has centered around more minor uses, such as nonconforming signs and billboards.

Although the courts have not been unanimous in their approval of the amortiza- tion concept, most have regarded relatively long phase-out periods, such as three to seven years, as reasonable compensation for nonconforming signs.

Building Codes

Another tool used in implementing a comprehensive land-use plan is the set of ordinances known as building codes. Such codes establish detailed standards for the construction of new buildings and the alteration of existing ones. Their primary purpose is to protect health and provide safety, and they are related primarily to fire prevention, quality and safety of construction, and public health safeguards.

Building codes also may be used to promote energy conservation and other pub- lic purposes. A building permit is required before construction can begin, followed by inspections at various stages of the construction process to ensure compliance. This

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The Strange Case of the Incredible Shrinking Building

In New York City, developer Laurence Ginsberg applied for a building permit to con struct a 31-story apartment building on Park Avenue at 96th Street. The

city had estab lished a special zoning district 150 feet on each side of Park Avenue that limited new buildings to 210 feet (18 floors), but Ginsberg based his application on a zoning map that errone ously showed the special district to extend only 100 feet from Park Avenue. He received the building permit and began construction. Later, however, the city discovered the error, canceled the permit, and issued a stop-work order on the top 12 floors. Gins berg appealed the order and kept on building—all the way to the 31st floor. New York’s highest court turned down Gins berg’s appeal, ruling that “reasonable diligence would

have readily uncovered for a good-faith inquirer the existence of the unequivocal limi tations of 150 feet in the original binding metes and bounds descrip- tion of the enabling legislation, and that this boundary has never been changed by the [City].” The court ordered the top 12 floors removed. Gins berg then applied, after the fact, to the city for a variance for the additional height, but this was also denied.

Finally, eight years after construction began, a 7,000-pound, hammer-wielding robot began pound ing away, reducing the 31-story apartment building to 18 stories, at an estimated cost of $1 million. The developer’s total losses were approxi- mately $14 mil lion.

[Parkview Associates v. City of New York, 519 N.E.2d 1372]

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procedure enables local officials to ascertain that the site plan has been approved and that the construction complies with applicable building codes, zoning regulations, and subdivision regulations.

Subdivision Regulations

Subdivision regulations, another tool for implementing the community plan- ning process, establish the standards and procedures for regulating the subdivision of land for development and sale. Their purpose is to protect both the community and future residents from poorly planned and executed developments.

The local planning board or another planning agency determines the standards that must be met for subdivision approval. Standards are provided for the design and construction of new streets, utilities, and drainage systems. The planning board also establishes an approval procedure, usually consisting of three distinct steps: a preap- plication conference, approval of the preliminary plat, and approval of the final plat.

Preapplication Conference The purpose of the preapplication conference is to allow the developer to meet

informally with the planning board before going to the expense of preparing a formal

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The Case of the Costly Permit

In 1990, the Boynton Beach, Florida, building code inspector observed Mr. Andre St. Juste performing extensive repairs to the roof of a residential rental

house he owned. The inspector ordered Mr. St. Juste to stop work until he obtained a permit, and later sent him an official notice that he was violating city codes.

Mr. St. Juste ignored the notice, and several weeks later the Code Enforcement Board began fin ing him $200 per day. Four months later St. Juste finally applied for a building permit, but when he told the building department that the repairs would cost only $21.80, they told him he didn’t need a permit because the repairs cost less than $500.

When the code inspectors learned that the repairs would actu ally cover more than 25% of the roof and cost more than $500, they again ordered St. Juste to get a permit. Again, he ignored them.

In 1992, the city made Mr. St. Juste an offer: get a permit, fix the roof, and ask the Code Enforcement Board to reduce the fines. He refused.

In 1994, the circuit court ruled that the city had made every effort to help Mr. St. Juste pass the building code, and that he owed $316,000 in fines and $20,000 in court costs. St. Juste attempted to declare bankruptcy to avoid the fines, but the judge refused to approve the bankruptcy.

Finally, in 1995 the city commissioners voted unanimously to auction off the St. Juste house to pay the fines. It was sold on the courthouse steps.

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plat. Working with a sketch plan, the planning staff can review the proposal with the developer and make suggestions for changes that may be necessary to meet the sub- division regulations. The developer also may benefit from general planning efforts of the board that may affect the development.

Approval of the Preliminary Plat The next step is for the developer to prepare and submit a preliminary plat of

the subdivision for approval. The term preliminary plat is misleading because all construction and mapping of the lots will be done on the basis of this plat. Detailed information is required, therefore, usually including topographic data regarding existing boundary lines, utilities, and ground elevations. Also required is the layout of the proposed subdivision, including streets, other rights-of-way or easements, lot lines and numbers, sites of special uses, and minimum building setback lines. A preliminary plat is shown in Figure 4.2.

Approval of the Final Plat After receiving approval of the preliminary plat, the developer can stake the lots

and construct streets and other required improvements. After these tasks are com- pleted, or with the posting of a certified check or bond to guarantee completion, the developer can prepare a final plat and related documents.

The final plat is intended to be filed in the registry of deeds and must contain all information necessary for land titles, such as exact lot lines, street rights-of-way, utility easements, and surveying monuments. A final plat is shown in Figure 4.3. The required accompanying documents usually include a certification by a licensed engi- neer or surveyor regarding the accuracy of the details of the plat, plans concerning utility improvements within the subdivision, and certification that the improvements have been constructed in accordance with the approved plans.

After approval by the planning board, the final plat will be recorded, and the developer then will be permitted to sell the lots in the subdivision.

Mandatory Dedication

Another method used to shape city growth is referred to as mandatory dedica- tion. To obtain approval for a project, the developer often is required to dedicate parts of the property to such public purposes as rights-of-way for streets, utilities, and drainage. In some communities, developers also may be required to dedicate land for parks, open space, and schools. If the development is small, payments in lieu of dedication sometimes are required.

The mandatory dedication of land for parks and schools understandably is con- troversial. One view is that the need for such facilities is created by the new subdivi- sion, while the opposing view holds that parks and schools are a general government responsibility that should be borne by the public at large. The courts are divided on the issue as well. In some cases they have upheld mandatory dedication of land for such purposes, and in other cases they have held that the denial of the right to sub- divide land on the condition that the developer donate land for parks and schools is a

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f i g u r e 4.2 A Preliminary Plat

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f i g u r e 4.3 A Final Plat

and so on

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violation of due process. In some jurisdictions, the developer is required to reserve the land for only a stated period of time, during which the municipality may purchase the property. If the land has not been purchased by the end of the period, the developer no longer is bound by the reservation.

Impact Fees

In addition to mandatory dedications, a community may also enact impact fees on new development to help raise the funds necessary for the expansion of public facilities. These fees are specific assessments on development; for example, $2,500 per dwelling unit or $2,000 for each 1,000 square feet of new commercial or office space. As might be expected, these fees are quite controversial, but their use by local governments is widespread.

Recent court decisions and legislation in many states have made it a necessity for governments that impose impact fees to tie them directly to the need created by the development. Otherwise, the fees may be regarded as extortion.

Takings

If a governmental unit acquires property for public use under the power of emi- nent domain, this action is a taking, which requires the payment of compensation, whether it involves acquisition in fee simple or only partial property rights, such as an easement. Regulation of land use under police power, on the other hand, normally does not constitute a taking. The courts have ruled, however, that if the regulation is so severe that it deprives owners of any beneficial use of their property, it may then constitute a taking and, thus, be invalid. The problem is that the courts have never defined the exact point at which regulation goes too far and becomes a taking. The increasing magnitude of land-use regulation has made this a very real issue for many property owners.

Escheat

The final power governments have over private property is known as the power of escheat. In the very unlikely event that a landowner dies intestate (i.e., with- out leaving a valid will and without legal heirs) the state government becomes the new owner of the property. This power prevents real estate from simply “becoming unowned.” The right of the government to the land under these limited circumstances is called escheat, a concept that dates back to the medieval feudal system. The king gave land to his barons, but if they died without surviving sons, the king would reclaim the land. If a knight or servant had no male heirs, that person’s land would escheat to the next higher tier in the feudal order. Today, of course, the presence of any heir, even if not a relative or the deceased landowner, will prevent the state from asserting its right of escheat.

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The Takings Issue

Land-use regulations under the police power can have a great impact on the value of private property. The question as to how far these regulations can go in

controlling the use of land is a very contentious one, an issue that has been fought in both legisla- tures and the courts.

Although the general rule is that actual or potential losses resulting from police power regulations do not require compensation, the U.S. Supreme Court has ruled that if a restriction goes “too far,” it will be considered a taking. Unfortu- nately, in many cases the court has provided little guidance as to how far is “too far.”

The Euclid Decision Sometimes, the U.S. Supreme Court issues a deci- sion that is truly momentous to a particular issue. Village of Euclid v. Ambler Realty Company (1926) was such a case, upholding the constitutionality of comprehensive zoning regulations.

Euclid, a suburb of Cleveland, adopted a comprehensive zoning ordinance in 1922. The Ambler Realty Company owned a 68-acre tract of land that it hoped to sell for industrial develop- ment. Because industrial use was precluded by the ordinance, which zoned part of the tract for single- family residential use only, Ambler Realty attacked the ordinance on the ground that it was a taking of the company’s property without compensation. The district court agreed and declared the ordinance null and void.

The village appealed to the U.S. Supreme Court, which reversed the lower court by a five-to- four decision. The victory was a narrow one, with one justice changing his mind in favor of upholding the ordinance after an opinion striking down the

principle of zoning had been written but not made public. In its final decision, the court ruled that the community was not taking or destroying Ambler Realty’s property for public use but was invok- ing a general power over private property, which was necessary for the orderly development of the community.

For better or worse, the Euclid decision changed the course of urban development in the United States. The zoning ordinances of more than 400 municipalities were upheld, and hundreds of others were soon passed. Now, almost every city with a population over 10,000 has enacted a comprehensive zoning ordinance, as have many smaller municipalities and counties. It is interest- ing to speculate what might have happened to the course of urban development in the United States if the one justice had not changed his vote. [Village of Euclid v. Ambler Realty, 272 US 365 (1926)]

Can Regulation Constitute a Taking? In 1922 the Supreme Court ruled that a Pennsylva- nia law regulating the mining of coal went “too far” because it mandated that pillars of coal be left to support the ground above, and constituted a taking of the mining company’s property. This has led to a series of decisions over the years attempting to define just how far is “too far.”

[Pennsylvania Coal Company v. Mahon, 260 US 393 (1922)]

Physical Invasion Compensation is required when the government appropriates private property. But regulation can also go so far as to result in a physical occupa- tion of the land that calls for compensation. For example, Mrs. Jean Loretto bought a New York City apartment building that was served by a television

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The Takings Issue

cable company. A state law forced apartment building owners to provide a place on their prop- erty for TV and telephone cables. When the cable company attempted to install additional cables on Mrs. Loretto’s building, however, she sued. She won, the Supreme Court ruling that this regulation constituted a physical invasion of Mrs. Loretto’s property [Loretto v. Teleprompter Manhattan CATV Corp. 458 US 419 (1982)]

In another case, low-flying planes landing at a nearby airport passed over Mr. Causby’s chicken ranch, scaring the chickens so that they flew into walls, often killing themselves. Mr. Causby was ruled eligible for compensation. [U.S. v. Causby, 328 US 256 (1946)]

Loss of Beneficial Use Lucas had bought two residential lots on the Isle of Palms, a South Carolina barrier island, for $975,000. He intended to build single-family homes on the lots, as the owners of adjacent lots had done. To his dismay, however, the South Carolina legislature passed the Beachfront Management Act, which prohibited building on Lucas’s lots. He sued, contending that regulation had taken his property because he was left with no economically viable use of his land. The U.S. Supreme Court agreed:

Total deprivation of beneficial use, is, from the landowner’s point of view, the equiva- lent of a physical appropriation . . . We think, in short that there are good reasons for our frequently expressed belief that when the owner of real property has been called upon to sacrifice all economically beneficial uses in the name of the com- mon good, that is to leave his property economically idle, he has suffered a

taking. [Lucas v. South Carolina Coastal Council, 505 US 1003 (1992)]

How Far Is “Too Far?” When governmental regulation results in a com- plete deprivation of the landowner’s viable use of the property, as in the Lucas case, there is a taking requiring compensation. But what of regulation that reduces the economic value of a property, but still leaves the owner with an economically viable use?

In 1980, the Supreme Court upheld Tiburon, California’s open-space zoning ordinance against a taking claim. The Agins family owned five acres of unimproved land overlooking San Francisco Bay that they considered “the most valuable land in California.” The city subsequently enacted a zon- ing ordinance that restricted density on the tract to between one and five single-family residences, and the Agins sued, asserting that the city had effec- tively taken the property, preventing its develop- ment for residential use and completely destroying “the value of the property for any purpose or use whatever.” They also sought $2 million in dam- ages for inverse condemnation. In other words, the Agins felt the rezoning was a taking that required compensation. The Supreme Court did not agree.

In upholding the ordinance, the Court held that a zoning ordinance would constitute an unconsti- tutional taking only if the landowner is denied any economically viable use of the property. The Court considered the preservation of open space and the promotion of orderly development to be legitimate state interests and noted that the effects of the ordinance fell on numerous property owners, not just on the Agins. It also found that although the ordinance restricted the density of development, it did not deny the Agins “economically viable use” of the land because it could still be developed for

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The Takings Issue

residential purposes, though perhaps not at the density they desired. [Agins v. City of Tiburon, 447 US 255 (1980)]

Similarly, the Supreme Court upheld New York’s historic preservation law against a takings challenge. The City enacted a landmarks preserva- tion law in 1965 to establish a citywide program of identification and preservation of historic structures and sites. Designation barred any construction or alteration of a building’s exterior appearance without the approval of the Landmarks Preservation Commission. Grand Central Terminal, a monumen- tal building in the beaux-arts style that was com- pleted in 1913, was designated as landmark under the law. Later, the Penn Central Railroad leased air rights over the terminal for a proposed skyscraper. The Landmarks Preservation Commission rejected the plan, reasoning: “To balance a 55-story office tower above a flamboyant Beaux-Arts façade seems nothing more than an aesthetic joke which would reduce the Landmark itself to the status of a curiosity.”

Penn Central challenged the constitutionality of the landmarks law, contending it resulted in the taking of private property without compensation. The Court disagreed, concluding that:

The submission that appellants may establish a “taking” simply by showing that they have been denied the ability to exploit a property interest that they heretofore had believed was available for development is quite simply untenable.

Even so, the Court made it clear that preserva- tion laws could not deprive the owner of a reason- able return from the property, but that the return need not be the highest possible return.

[Penn Central Transportation Co. v. New York City, 438 US 104 (1978)]

Limits on Mandatory Dedications As noted in the text, property owners are often required to dedicated land or make infrastructure improvements as a condition to obtaining develop- mental approvals. Here also, the Court has ruled these can go “too far.”

The Nollans wanted to replace a small bunga- low on their beachfront lot with a larger house. As a condition to granting a building permit, the Califor- nia Coastal Commission required the donation of a 10-foot walkway easement along the beach in front of the Nollan property. The commission contended that the easement was necessary to offset the reduced “visual access” caused by the construc- tion and to help prevent congestion of the public beaches. The Nollans contended the exaction was not related to any need to which their project con- tributed directly and was therefore a taking.

The Supreme Court reaffirmed the constitu- tionality of developmental controls and exactions, stating that the commission could have legitimately imposed conditions to protect the public’s ability to see the beach, such as height and width restric- tions or a ban on fences, could have required the dedication of a “public viewing spot” on the Nol- lans’s property, or even could have prohibited the new construction altogether. However, the Court agreed with the Nollans that the requirement to dedicate the public walkway easement was not sufficiently related to the problems supposedly cre- ated by the new construction:

The lack of nexus between the condition and the original purpose of the building restriction converts that purpose to some- thing other than what it was. The purpose then becomes, quite simply, the obtain- ing of an easement to serve some valid governmental purpose, but without

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| chapter review __________________________________________

■■ Government has four basic powers that affect real estate owners. These powers are (1) the power of taxation, (2) the power of eminent domain, (3) police power, and (4) escheat.

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The Takings Issue

payment of compensation . . . Unless the permit condition serves the same gov- ernmental purpose as the development ban, the building restriction is not a valid regulation of land use but an out-and-out plan of extortion.

This need to tie any dedication requirements more closely to actual impact of the proposed development was made clearer in the Supreme Court’s decision Dolan v. Tigard. The Dolans owned a plumbing and electrical supply store in the city of Tigard, Oregon. They wanted to double the size of their building and add parking spaces. The planning commission approved the plans with requirement that the Dolans dedicate about a tenth of their land for flood control for the adjacent creek and about an additional 15 feet for a bike path.

The Dolans challenged the dedication requirement. In 1994 the Supreme Court decided by a five-to-four vote that requiring a dedicated easement as a condition of permission to build or expand is an unconstitutional taking unless the government can show a “rough proportionality” between the regulation and impact of the develop- ment. Do these decisions mean that local govern- ment can no longer require mandatory dedications from developers? No, but the Court has made it clear that any required dedications must be closely related to the regulatory objective. [Dolan v. Tigard, 114 US 2309 (1994)]

The Regulatory Takings Issue In recent years, there has been a growing move- ment by conservative groups to seek legislation to require compensation for any potential loss of value resulting from environmental or land use regula- tion. Oregon’s Measure 37 provides a prominent example.

Oregon passed statewide land use regula- tions in the early 1970s. While most Oregonians took pride in this effort, others felt themselves victimized by restrictions on land use. Their efforts to change the law culminated in the passage of Measure 37 in 2004, which required the payment of compensation for any regulation that potentially reduced the value of property. Major land develop- ers immediately began filing claims affecting more than 750,000 acres. These included mobile home parks in sacred native burial grounds, shopping malls in farmland, and gravel pit mines in residen- tial neighborhoods. Recognizing that Measure 37 had gone too far in protecting property rights, three years later the state’s voters overwhelmingly passed Measure 49, which essentially repealed the earlier law.

The takings controversy boils down to the basic question of the nature of private property rights. Do private parties own property subject to regulations, or do they have the unlimited right to use their property as they choose? Where is the proper middle ground? This is an issue that prom- ises to be a lively one for many years to come.

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■■ Property taxes are an important source of revenues for state and local governments. They provide a relatively stable source of revenue that is not subject to wide fluctuations in short-term business activity, and they are very difficult to evade because they are tied to property that is largely immobile.

■■ The steps involved in the property taxation process are (1) property value assessment, (2) development of the budget and a tax rate, and (3) tax bill- ing and collection.

■■ The government’s right to condemn land is founded on the power of eminent domain, as granted by the Fifth Amendment to the U.S. Constitu- tion. Once the government establishes the right to take title to or place an easement on property for society’s needs, the major issue of concern is the determination of just compensation.

■■ The police power is the power of government to regulate activities to pro- mote the public health, safety, and general welfare.

■■ In the event that a landowner dies without heirs or a valid will, the govern- ment, through the power of escheat, becomes the owner of the property.

■■ The interdependence of land uses—that is, the impact that the use of land has on other property and on the public as a whole—leads to land-use controls.

■■ A comprehensive general plan is a statement of a community’s long-range policies covering its predicted physical needs for 15 to 25 years in the future. It usually contains the following five elements: (1) an analysis of projected economic and population developments, (2) a transportation plan, (3) a public facilities plan, (4) a land-use plan, and (5) an official map.

■■ The most widely employed method of regulating the use of land is com- prehensive zoning. This divides land into zones and prescribes regulations relating to the type and intensity of use. Relief from zoning regulations can be sought through legislative rezoning, through administrative variance or special-use permit, or through the courts.

■■ Under a system of planned unit development (PUD), many regulations are waived to permit greater flexibility of design. Lot sizes may be reduced, for example, if community open spaces are provided.

■■ Performance zoning is a technique that relates permitted uses of land to certain performance standards. Such standards usually are intended to protect the environment.

■■ Incentive zoning, which is closely related to performance zoning, is any type of zoning provision that encourages developers to provide certain publicly desired features in return for such incentives as increased density of land use.

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■■ Under the concept of transferable development rights, a landowner is able to sell part of his or her bundle of rights to another landowner, who then can use his or her own land more intensively.

■■ Developers often are required to dedicate rights-of-way for public streets, utility, and drainage, and in some communities, they also may be required to dedicate land for parks, open space, and schools.

■■ Building codes establish detailed standards for the construction of new buildings and the alteration of existing ones.

| key terms _______________________________________________

ad valorem tax

assessed value

assessment

assessment ratio

building codes

bulk limitations

comprehensive general plan

eminent domain

escheat

exemptions

floor-area ratio

height limitations

impact fees

impact zoning

incentive zoning

intensity of use

inverse condemnation

just compensation

mandatory dedication

market value

millage rates

minimum lot sizes

nonconforming use

performance zoning

planned unit developments

police power

setback requirements

subdivision regulation

taxable value

transferable development rights

zoning

zoning variance

| study exercises _________________________________________

1. What are the desirable features of the property tax for local governments?

2. What is the tax digest?

3. Suppose a local government has a tax digest of $500 million and feels it must raise $15 million for the operation of its schools and general govern- ment. What would be the millage rate?

4. Why is the government’s power of escheat so seldom used?

5. By what authority does the government have the power of eminent domain?

6. What is meant by public use?

7. What characteristic of real estate leads to the need for public land-use controls?

8. Contrast police power and the power of eminent domain.

9. Discuss the history of the takings issue.

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10. Describe the elements usually contained in a comprehensive general plan.

11. How is zoning used to control land use and intensity of use?

12. What are mandatory dedications?

13. What is incentive zoning? Performance zoning?

14. Describe the transferable development rights concept.

15. Mack owns 25 acres of land on the edge of town on a major road that is now zoned for residential use. He decides he would like to develop this land as an office park and shopping center. What steps would he have to take to secure approval of his project?

16. Mary owns a lot on which she wishes to build her dream house. To her consternation, she finds that if the house is placed on her rather narrow lot, it will fail to meet the sideyard setback requirements by three feet. What can she do?

17. Internet Exercise: While the concept of private property rights was near and dear to the heart of America’s founding fathers, there seems to be an ongo- ing attack on those rights by people who want more government control over property owned by individuals. Do a Google search at www.google.com on the words “private property rights” and look for examples of the battle around the nation. Summarize the facts of one of these battles near your location and state your personal position on this issue.

| further reading _________________________________________

Thomas, R. H. (2013). Recent Developments in Regulatory Takings. Urban Lawyer, 45(3), 769–807.

Underkuffler, L. S. (2013). Property and Change: The Constitutional Conundrum. Texas Law Review, 91(7), 2015–2037.

Callies, D. L., ed. Takings: Land-Development Conditions and Regulatory Takings after Dolan and Lucas. Chicago: American Bar Association, Section of State and Local Gov- ernment Law, 1996.

Dowling, Timothy, Douglas Kendall, and Jennifer Bradley. The Good News about Takings. Chicago: American Planning Association, 2006.

Meltz, Robert, Dwight H. Merriam, and Richard M. Frank. The Takings Issue: Constitu- tional Limits on Land Use Control and Environmental Regulation. Washington, D.C.: Island Press, 1998.

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5c h a p t e r Deeds and Title Examination

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c h a p t e r p r e v i e w

The previous chapters in this section have described the concept of real estate ownership, including the legal rights held by real estate owners and the public and private limitations on those ownership rights. In this chapter, we first consider deeds, which are the legal documents used to convey title, or owner- ship, from one party to another. We then discuss the process by which parties evaluate the quality of title to a property and how grantees can protect them- selves from potential defects in the title to a property.

Under the topic of deeds, we examine the necessary elements of a deed and various types of deeds, including the warranty deed, special warranty deed, bar- gain and sale deed, and quitclaim deed.

Under the topic of title examination, we examine the concepts of

■■ good and marketable title;

■■ insurable title;

■■ title perfect of record;

■■ chain of title;

■■ title search;

■■ title abstract;

■■ title opinion;

■■ title insurance; and finally,

■■ the Torrens system.

close-up Sleuthing for

Transaction Price

legal highlight Title Examination

through the Grantor and Grantee

Indexes

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100 PA RT O N E Real Estate Legal Analysis

| deeds ___________________________________________________

Centuries ago in England, any person who possessed land generally was con- sidered to be the legal owner, as possession and ownership essentially were synony- mous. An owner could transfer his title, or legal ownership, to another person simply by going on the land in the presence of witnesses and handing the new owner a clod of earth while announcing that title was transferred. This symbolic transfer of title by delivery caused great confusion because there were no written records. The potential for fraud or forcible seizure was limitless. Therefore, in 1677, Parliament enacted a statute of frauds, which, among other things, required that all title transfers of real property be in writing. This provision has been adopted by every state in the United States with the goal of limiting the opportunities for fraudulent transactions. Thus, when title to real estate is to be transferred today, a written document called a deed must be given by the grantor to the new owner, the grantee.

Once the deed is written, title to real property is transferred by delivery of the deed to and its acceptance by the buyer. The delivery can be made by the seller or a person acting on behalf of the seller. Delivery of a signed deed can even be made after the seller’s death if that was the seller’s intent. When ownership is to be trans- ferred, a deed must be drafted, signed by the grantor, and delivered to and accepted by the new owner.

Several elements are necessary for a deed to be valid. In addition to the basic requirement that a deed must be in writing, a valid deed must include

■■ identification of the parties,

■■ consideration given for the conveyed interest,

■■ legal description of the property,

■■ specification of the interests conveyed, and

■■ signatures of the proper parties.

The deed in Figure 5.1 is an example of one that was retrieved over the internet from a county public records system (names and locations have been changed for our purposes). It will serve as a useful example in the following discussion of the neces- sary elements of a valid deed.

Necessary Elements of a Deed

All valid deeds must identify the parties involved in the transfer of title. The parties involved are usually, but not always, the buyer and the seller. (Sometimes property is given as a gift from one party to another.) The seller, or giver, is the grantor and the buyer, or receiver, is the grantee. In the example deed shown in Figure 5.1, the grantors are Joseph Nowak and Deborah Williamson, and the grantees are Michael Rodriguez and Nina Rodriguez.

A valid deed must involve consideration, something of economic value given by the grantee to the grantor in return for the property ownership. Usually, the con- sideration is the transaction price. Sometimes the exact amount of this consideration

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C H A P T E R 5 Deeds and Title Examination 101

is stated on the deed, but often a nominal amount (such as “$10 and other good and valuable considerations”) is mentioned in the deed as the consideration paid. This practice tends to keep the actual purchase price a secret known only to the parties involved in the transaction, but a little detective work can often reveal the transaction price. (See the Real Estate Today feature: Sleuthing for Transaction Price.)

A valid deed must include a unique description of the real estate involved in the transaction. The property must be described accurately so that there is no question about what parcel of real estate is being conveyed. A mere street address is an insufficient description in the deed because the address does not define the exact property boundar- ies and is subject to change. Buyers frequently discover that the street number by which their new property is known (and where mail is delivered) is not the number stated in other documents; at some time in the past, the number was changed. To describe the real property’s precise location, the metes-and-bounds method, the rect- angular survey method, and/or a reference to plats should be used. We considered each of these methods in Chapter 2. The legal description for the property being transferred by the deed in Figure 5.1 uses the “reference to recorded plat” method:

Lots 1 through 4, inclusive, the East 25 feet Lot 5, the East 25 feet of Lot 18, and Lots 19 through 22, inclusive, all in Block 27 of the Grand Plan of Cam- den, Massachusetts, as revised September 7, 1937, according to the plat thereof recorded in Plat Book 2, Pages 71–78, inclusive, of the Public Records of Dearborn County, Massachusetts.

The legal description is accompanied by the words that actually convey the prop- erty interest. The words of conveyance should make it clear what rights are being transferred. In this example, the words of conveyance specify that the grantor has “granted, bargained, and sold . . .” the property to the grantee “. . . to have and to hold in fee simple forever.”

The deed may also include promises (covenants and warranties) that the grantor is making to the grantee. These promises are the defining features of the different types of deeds we will consider in the next section of this chapter. Notice that several promises appear at the bottom of the first page of the sample deed.

As shown on the second page of the sample deed, the grantor then must sign the deed. Before a deed can be recorded, most states require that the grantor sign in the presence of one or more witnesses (who also sign the document). Notice that the grantee’s signature is not required on the deed in some states. The grantors sign this deed along with two witnesses, one of whom is a public notary. Once the deed is properly signed, it can be said to have been executed, or subjected to all require- ments that establish its validity.

Finally, the deed must be delivered to the grantee. Title to the property is not actu- ally transferred from the grantor to the grantee until delivery has been completed. Of course, it is assumed for the purposes of this discussion that the grantee accepts the deed. Refusal to accept the deed results in an ineffective delivery. Although a transfer of title need not be recorded in the public records to be valid, the grantee must record the new deed in the county’s record or deed office to be assured of protection against claims that the grantor later transferred his or her title to someone else. The public records system will be discussed in more detail later in this chapter.

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Additional Elements

Although the elements just described are essential to a valid deed, the most common types of deeds contain additional elements called covenants and warran- ties. A covenant is any agreement or promise, and a warranty is a guarantee that the statements made are true. Traditionally, there are four covenants and one warranty: (1) covenant against encumbrances, (2) covenant of seisin or ownership, (3) cove- nant of quiet enjoyment, (4) covenant of further assurances, and (5) warranty forever. Whether all, some, or none of these items exist in a deed depends on the type of deed the grantor is required to give. In some states the five items are not expressly stated in the deed but are incorporated by common law or reference to statute.

Degree of Protection

It is important to understand the degree of protection each type of deed gives to the grantee. The order in which these types of deeds will be discussed is also the order of the amount of protection provided. The warranty deed contains the greatest assurances by the grantor that the grantee will have security from nearly all potential claims. The special warranty deed limits the grantor’s liability to title defects that occurred during the grantor’s ownership. The bargain and sale deed simply states that the grantor has the right to convey the title involved, but all other assurances are missing. Finally, the grantor who gives a quitclaim deed does not even promise that he or she has any rights in the real estate, but conveys whatever rights the grantor does have to the grantee.

Types of Deeds

There are many kinds of deeds, each having its own special characteristics. The more common types are warranty deeds, special warranty deeds, bargain and sale deeds, and quitclaim deeds.

Warranty Deed The warranty deed is the broadest type of all deeds. In a warranty deed, the

grantor makes promises that cover the traditional covenants and warranty. The grantor assures the grantee that no liens or encumbrances other than those on public record exist against the property (covenant against encumbrances), that the grantor has a fee simple interest in the property, and that he or she is in full possession of the interest being conveyed and, thus, has the right to convey it (covenant of seisin). (The covenant against encumbrances does not mean that there are no encumbrances on the property but rather that if there are encumbrances, they will be listed in the deed or in public records. In many states, encumbrances that are open and visible and that benefit the land are also excluded.) The grantor also promises that the grantee’s enjoy- ment of the property will not be disturbed by some party claiming to own or to have a lien on it (covenant of quiet enjoyment). These covenants relate to the present condition of the grantor’s title.

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A warranty deed further assures the grantee that the grantor will execute any future documents needed to perfect the grantor’s title (covenant of further assur- ances). Finally, the grantor promises to always defend the title conveyed (warranty forever). These latter two items relate to the grantor’s duties as they might arise in the future.

In the typical residential sales transaction, the buyer should insist that the sales contract require that the seller transfer title by warranty deed. The language at the bottom of the first page of Figure 5.1 demonstrates how these covenants and war- ranty are spelled out in a typical warranty deed.

A warranty deed provides some protection to the purchaser concerning the acquisition of “good title” to real estate. This protection, however, may not extend to “marketability” of the title. If, for example, a neighbor has obtained an unrecorded easement by prescription (as described in Chapter 3) across the property being trans- ferred, the grantee under a warranty deed can successfully sue the grantor for the amount by which this encumbrance has diminished the property. In this situation, the grantor would have breached the covenant of quiet enjoyment and the covenant against encumbrances. Some states have interpreted the covenants and warranties of a deed as being breached only if the grantee loses possession to another party. Obvi- ously, under this interpretation, the existence of a prescriptive easement would not be a breach of the covenant of quiet enjoyment or the covenant against encumbrances.

Special Warranty Deed A special warranty deed is similar to a warranty deed except the special war-

ranty deed limits the extent of the grantor’s warranties to events that occurred during the grantor’s period of ownership. It does not protect the grantee against encum- brances that may have arisen before the grantor took title. The grantor’s warrants cover only title defects that occurred during the grantor’s ownership. For example, a corporation might give a special warranty deed to protect itself against any potential liabilities resulting from a foreclosure that happened before it owned the property.

Bargain and Sale Deed A deed that implies the grantor has title to the property and the right to convey

it but does not contain any express covenants as to the title’s validity is called a bar- gain and sale deed. This deed is also called a warranty deed without covenants or a grant deed.

In essence, the bargain and sale deed simply specifies that the grantor “does hereby grant, sell, and convey” some interest in real property to the grantee. Notice the lack of covenants in this type of deed in comparison to the warranty deed and special warranty deed discussed above. If the sales contract fails to specify what type of deed must be delivered, the bargain and sale deed may be the only one required. If the buyers want to make certain they receive a warranty deed, this must be clearly stated in the sales contract.

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f i g u r e 5.1 Warranty Deed

Prepared by and return to: Stephanie A. McGuire, Esq.

Stephanie A. McGuire Attorney at Law 417 East Woodland Hwy. Camden, MA 33440 369 – 983 – 0547 File number: 07.7990.01 Will Call No.:

WARRANTY DEED

This Warranty Deed made this 23rd day of February, 2015 between Joseph Nowak and Deborah Williamson, husband and wife whose post office address is 125 W. Dobson Avenue, Camden, MA 33440, grantor, and Michael Rodriguez and Nina Rodriguez, husband and wife whose post office address is 16700 N. Sangamon Dr., Lovington, MA 33470, grantee:

(Whenever used herein the terms “grantor” and “grantee” include all the parties to this instrument and the heirs, legal representatives, and assigns of individuals, and the successors and assigns of corporations, trusts and trustees)

Witnesseth, that said grantor, for and in consideration of the sum of TEN AND NO/100 DOLLARS ($10.00) and other good and valuable considerations to said grantor in hand paid by said grantee, the receipt whereof is hereby acknowledged, has granted, bargained, and sold to the said grantee, and grantee’s heirs and assigns forever, the following described land, situate, lying and being in Dearborn County, Massachusetts to-wit:

Lots 1 through 4, inclusive, the East 25 feet Lot 5, the East 25 feet of Lot 18, and Lots 19 through 22, inclusive, all in Block 27 of the Grand Plan of Camden, Massachusetts, as revised September 7, 1937, according to the plat thereof recorded in Plat Book 2, Pages 71–78, inclusive, of the Public Records of Dearborn County, Massachusetts.

Parcel Identification Number: 3-34-43-01-010-0027-001.0

Subject to covenants, conditions, restrictions, easements, reservations and limitations of record, if any. Reference to these restrictions and reservations shall not operate to reimpose same.

Together with all the tenements, hereditaments and appurtenances thereto belonging or in anywise appertaining.

To Have and to Hold, the same in fee simple forever.

And the grantor hereby covenants with said grantee that the grantor is lawfully seized of said land in fee simple; that the grantor has good right and lawful authority to sell and convey said land; that the grantor hereby fully warrants the title to said land and will defend the same against the lawful claims of all persons whomsoever; and that said land is free of all encumbrances, except taxes accruing subsequent to December 31, 2014.

B K 7 6 0 P G 4 4 9 D O C S T A M P S $ 4 0 0 7 . 5 0 D K T # 2 0 0 7 0 3 0 8 2 1 o f 2

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Quitclaim Deed A quitclaim deed transfers any interest that the grantor may have in the property

described but does not imply that the grantor has any valid interest in it. (Some people mistakenly say “quickclaim” instead of “quitclaim.”) The quitclaim deed is most commonly used to clear defects in the title to property. For example, suppose Bob wished to sell land he allegedly owned to David, but Clare, Bob’s sister, claimed to own a one-fourth interest in the land. Before David would be willing to purchase the land, he would want Clare to give Bob a quitclaim deed that would extinguish any claim she might have had on the property. Then, David can accept a deed from Bob knowing that Clare has no claim on the property. The quitclaim deed would indicate that Clare had relinquished any claim she might have had in the property, but she

f i g u r e 5.1 Warranty Deed (continued)

In Witness Whereof, grantor has hereunto set grantor’s hand and seal the day and year first above written.

Signed, sealed and delivered in our presence:

____________________________________ ____________________________________ (Seal)

Witness Name: ______________________ Joseph Nowak

____________________________________ ____________________________________ (Seal)

Witness Name: ______________________ Deborah Willliamson

____________________________________

Witness Name: ______________________

State of Massachusetts County of Dearborn

The foregoing instrument was acknowledged before me this 23rd day of February, 2010 by Deborah Williamson and Joseph Nowak, who [_] are personally known or [_] have produced a driver’s license as identification.

_________________________________________

Notary Public

[Notary Seal]

Printed Name: ____________________________

My Commission Expires: ___________________B K 7 6 0 P G 4 5 0 F I L E D A N D R E C O R D E D 2 / 2 8 / 2 0 0 7 1 1 : 4 5 : 0 0 A M 2 O F 2

K E V I N C R E N S H A W C L E R K O F C I R C U I T C O U R T D E A R B O R N C O U N T Y M A .

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106 PA RT O N E Real Estate Legal Analysis

would not be liable for any defects in the title. If David wished to get full clear title to the land, he typically would insist on receiving a general warranty deed from Bob, as well as the quitclaim deed from Clare.

Similarly, a quitclaim deed is sometimes used to release marital interests in a property. If Bob and Jane divorce and Jane is awarded ownership of the family home, Bob may be required to sign a quitclaim deed that releases any interest he may have in the property to Jane. The quitclaim deed would serve as evidence that Bob no longer held an interest in the property after the divorce.

The grantee who takes property under a quitclaim deed must understand that he may be receiving nothing at all of value. A person could give a quitclaim deed describing a neighbor’s land, or even a university’s football stadium for that mat- ter. Under a quitclaim deed, the grantor conveys all the interests possessed without any assurances that any rights of ownership exist. If the grantor has no rights in the

r e a l e s t a t e t o d a y

c l o s e - u p

Sleuthing for Transaction Price

Sometimes a little detective work is necessary to determine the transaction price from a recorded deed. The transaction price can often be discovered by closely

examining the fee paid to the records office to record the document. In most counties in Florida, for example, the fee for recording a deed in the public records system is $0.70 per $100 of the transaction amount. The amount of this fee, called a documentary stamp tax or simply doc stamp tax, is stamped onto the first page of the recorded document. The party recording the deed is required to provide a sworn affidavit of the transac- tion amount. Thus, anyone who knows the amount of the tax and the way it is calculated can, with a little bit of algebra, determine the transaction amount for any transaction even if the deed does not specify the full amount.

The example deed shown in Figure 5.1 has a computer-generated “stamp” in the top left hand corner of each page that shows the Official Record Book and Page in which the document was recorded. The stamp also shows the amount of deed documentary tax paid when the document was recorded: $4,007.50. Using the explanation of doc stamps in the previous paragraph, the documentary stamp tax for a deed recorded in this county is calculated as:

Tax = $0.70 × Transaction Price $100

Rearranging terms gives:

Transaction Price = Documentary Stamp Tax × $100 $0.70

For this property transfer, therefore, the trans- action price is:

Transaction Price = $4,007.50 × $100 $0.70

= $572,500.

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C H A P T E R 5 Deeds and Title Examination 107

property, then nothing is transferred. Of course, the grantor might be guilty of fraud if he or she falsely claims ownership of the football stadium!

An example of a quitclaim deed is shown in Figure 5.2. The readability of some deeds can be sorely lacking. Handwritten deeds that contain all the necessary ele- ments are just as valid as a nicely printed deed and accomplish the purpose of trans- ferring property rights from the grantor to the grantee.

Deeds for Special Uses There are several other kinds of deeds that have specific purposes. Each of these

specialized deeds is named for the signer, and the warranties given, if any, depend on that signer’s capacity. An executor’s deed is an example. An executor of an estate seldom will be willing to promise that the title being transferred is free of all defects. Therefore, the executor covenants only that he or she is conveying the title held by the deceased person and that he or she has not encumbered the property in his or her capacity as executor. A grantee taking property under any such special deed must be aware that the grantor’s covenants and warranties are very limited or nonexistent.

| title examination _______________________________________

From previous discussion we now understand that deeds are documents that convey title, or legal ownership, from one party to another. In the typical real estate transaction, the buyer’s chief desire is to acquire “good” title from the seller. More specifically a good title is one that is marketable, insurable, perfect of record, or some combination of these attributes.

A marketable title is one that is free and clear of all past, present, or future claims that would cause a reasonable purchaser to reject such title. An insurable title is one that a reputable title insurance company is willing to insure. And title perfect of record means that the public records related to the particular title involved show no defects whatsoever. This last condition usually provides the buyer with the most protection. Suppose, for example, that inspection of the seller’s title reveals that years ago a deed was signed improperly by a previous title holder. Perhaps the signor left out her middle initial in her signature. A reasonable buyer might not hesitate to accept the title and a title insurance company might be willing to insure it, but the seller’s title still is not perfect of record.

Any prospective grantee of real estate must take steps to discover all possible defects in the seller’s title. This responsibility generally is satisfied by means of a lawyer’s title opinion or by title insurance. A title opinion is a statement by a lawyer that summarizes the findings disclosed by a search through all public documents that may relate to the title. Title insurance is a policy that insures the title received by the grantee against any deficiencies that may have been in existence at the time title was transferred. Before a title insurance policy or title opinion can be given concerning a particular property, a search of the title will be performed.

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f i g u r e 5.2 Quitclaim Deed

Name:

Address:

This Instrument Prepared By:

Address:

Property Appraisers Parcel Identification:

Folio Number(s):

Grantee(s): S. S. # (s)

_______________________________________Space above This Line for Processing Data________________________________________

This Quit Claim Deed, Executed the _____________ day of _______________ ___________ , by __________________________________________________________________________________________________________, first party, to ___________________________________________________________________________________________________________________, whose post office address is ________________________________________________________________________________, second party. (Wherever used herein the terms “first party” and “second party” include all the parties to this instrument and the heirs, legal representatives, and assigns of individuals, and the successors and assigns of corporations, wherever the context so admits or requires.)

Witnesseth, That the first party, for and in consideration of the sum of $ ____________________,

in hand paid by the said second party, the receipt whereof is hereby acknowledged, does hereby remise, release, and quit claim unto the second party forever, all the right, title, interest, claim and demand which the said first party has in and to the following described lot, piece or parcel of land, situate, lying and being in the County of ____________________________, state of _________________________, to-wit:

To Have and to Hold The same together with all and singular the appurtenances thereunto belonging or in anywise appertaining, and all the estate, right, title, interest, lien, equity and claim whatsoever of the said first party, either in law or equity to the only proper use, benefit and behoof of the said second party forever.

In Witness Whereof, the said first party has signed and sealed these presents the day and year first above written.

Signed, sealed and delivered in presence of:

_______________________________________ _______________________________________ Witness Signature (as to first Grantor) Grantor Signature

_______________________________________ _______________________________________ Printed Name Printed Name

_______________________________________ _______________________________________ Witness Signature (as to Co-grantor, if any) Post Office Address

_______________________________________ _______________________________________ Printed Name Co-Grantor Signature, (if any)

_______________________________________ Post Office Address

STATE OF _______________________________________ )

COUNTY OF _____________________________________ )

I hereby Certify that on this day, before me, an officer duly authorized to administer oaths and take acknowledgments, personally appeared _______________________ known to me to be the person ______ described in and who executed the foregoing instrument, who acknowledged before me that _________________________ executed the same, and an oath was not taken. (Check one) ❑ Said person(s) is/are personally known to me. ❑■Said person(s) provided the following type of identification: __________________________.

NOTARY RUBBER STAMP SEAL Witness my hand and official seal in the County and State last aforesaid this ______ day of ____________, _________

_______________________________________ Notary Signature

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C H A P T E R 5 Deeds and Title Examination 109

Title Search

A title search reveals the ownership history, or chain of title, of a property. An examination of the chain of title might show that the seller has good title, or it could show that the seller is only one of several parties claiming to own the real estate being sold. The title search is made possible by the recording system provided by each state.

Recording System Each state’s recording statute provides that any document affecting title to real

estate must be recorded. Although recording systems vary from state to state, the purpose of all such systems is to protect the potential interest holder, including the fee simple owner, the tenant, and the mortgagee. The documents related to those interests are, of course, the deed, the lease, and the mortgage. As a result of the recording requirement, anyone concerned with the validity of a real estate title can determine that validity by means of a title search.

Most states require that the recorded document be signed by the grantor. To be filed in the public record, the instrument must be witnessed and acknowledged by a notary public or another person authorized to acknowledge such documents. If this formality is not satisfied, the document cannot be recorded.

The location for the recording of real estate documents varies from state to state. State law generally creates a recorder’s office in the local courthouse. The official in charge of that office may be called the clerk of the court, county clerk, recorder, or registrar of deeds.

Because the public has constructive notice of all interests that are properly recorded, any buyer or lender can determine easily whether the seller or borrower has title to the real estate he or she claims. Failure to record an interest may cause the holder to lose that interest to a subsequent good-faith purchaser because that purchaser would have no notice of unrecorded interests.

The recording requirement is the key element that creates an efficient method of transferring title to real estate. Without public records, the confusion that existed in England centuries ago still would occur. Prospective buyers or mortgagees can gain near certainty as to their predecessors’ titles because of public records. To reach any level of certainty about the validity of a real estate title, the method of conducting a title search must be understood.

Although real estate title records are public and open to inspection by any inter- ested person, real estate title searches normally should be conducted by an attorney or title examiner (sometimes called an abstractor) who is trained specifically in this field. A title examiner must trace the grantor’s chain of title to be sure that no defects exist from previous transactions. For example, in a previous transaction involving the property, a spouse may not have signed the deed, even though both the husband and wife jointly owned the property. This type of title defect raises the possibility that the spouse who did not sign still has a legal interest in the property. This defect should be corrected before the new buyer accepts the current grantor’s deed.

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Assume, for example, that Otis had good and marketable title to a parcel of land. Assume further that Otis sold the parcel to Bill, but Bill failed to record the deed he received. Between the two, Bill has the superior title to the property. Assume, however, that Otis has wrongfully deeded the lot to George, who is unaware of Bill’s interest. When George searches Otis’s title, he will find no record that Otis previ- ously sold the lot to Bill. Therefore, as far as George can ascertain, Bill has no right to the lot. Because George had no notice of Bill’s interest and because George recorded his deed before Bill did, all states would say that George, as a good-faith purchaser, has title to the property.

Grantor and Grantee Indexes The chain of title can be followed through grantor and grantee indexes. Each

county in the United States maintains indexes of people or entities (grantors) who have given any interest in real estate to another and people or entities who have received such interests (grantees). For a particular property, the current owner will be listed in the grantee index. When ownership of the property is transferred, the previ- ous owner’s name will be added to the grantor index, and the new owner’s name will be entered into the grantee index. The title examiner begins by tracing the property involved back through the grantee indexes to verify that the seller is, in fact, the cur- rent owner of record. Then the examiner searches the applicable grantor indexes to verify that the current owner has not granted any interest in the property to another person. Generally, a title search covers a period of 40 to 60 years.

Completing the Records Search Merely examining the grantor and grantee indexes is not enough to ensure an

accurate title search. The examiner also must check the tax records to discover whether any tax payments are delinquent. Furthermore, the examiner must search the local court records to determine whether any judgment has been awarded or any lien has been filed against the property. Only after these additional factors have been researched can the title be considered insurable or marketable. Of course, any recorded document that appears to relate to the property at issue must be checked for its legal description. Only if a tax lien or an attempted transfer by an owner concerns part or all of the property under contract does that record have to be examined.

Title Abstract

In some states, a title examination is made much easier by the use of title abstracts. A title abstract is a written summary of the chain of title for a given parcel of real estate. Generally, such abstracts are prepared by employees of an abstract company who are not licensed lawyers but are trained specifically to search titles. When an abstract is readily available, the buyer’s attorney does not have to go through the detailed search of the grantor and grantee indexes. The attorney obtains the proper abstract, studies it, and issues a title opinion, an opinion to the buyer on the validity or defectiveness of the title. When abstracts are used widely, the attorney’s fees in a real estate transaction may be much lower than they are when the attorney must

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perform the entire title examination. Title abstracting is declining in popularity, par- tially due to the costs of storing and maintaining the documents involved. Title insur- ance has supplanted the title opinion as a means of title examination in most areas of the country.

Title Insurance

The lawyer’s title opinion is not the only type of protection a buyer can obtain to ensure that the seller can deliver marketable title. In many parts of the country, title insurance, which grew out of the expanded function of abstract companies or a group of lawyers, is purchased to provide protection in case the acquired title is defective. In addition to preparing abstracts or writing opinion letters, these compa- nies or associations began to issue insurance that the title to a parcel of real estate was “good and marketable.”

On receiving a request for title insurance, the title insurance company conducts its own search of the grantor’s title, using public records. The company then evalu- ates the validity of this title and determines the risk it must take to ensure the title’s marketability. The title insurance policy includes a schedule of exceptions, which might list liens, easements, or other encumbrances that appear in an examination of the public record. Often, the policy will state that all restrictions of record are excluded from coverage. In addition, the policy can exclude those defects created by any party who possesses the property at the time the policy is delivered. Other risks excluded might include defects revealed by an accurate survey of the property or defects not recorded as required. The insured party under a title insurance policy must be certain what defects are excepted from the policy and either have the seller- grantor clear the title of these defects or encumbrances before purchasing the prop- erty or protect themselves by receiving credit from the seller for existing financial liens and paying off such liens after the purchase.

In a real estate transaction, title insurance may be purchased for the buyer- grantee or for the institution (mortgagee) financing the transaction and taking a security interest in the real estate. In the typical transaction, the policy is paid for by the buyer, or mortgagor, as a condition of obtaining financing. Title insurance differs from liability, life, or property-hazard insurance in several important ways. First, the insured is charged a premium only once, and it is payable when the policy is delivered. Second, a title insurance policy protects only the named insured; there- fore, when the insured transfers the title that is covered, the insurance does not pro- tect the new owner. Third, in contrast with most types of insurance (which protect against future events), title insurance protects against past events only. The schedule of exceptions normally exempts from coverage any liens, encumbrances, or other defects that arise after the title is insured.

A title insurance policy may act as a substitute for the lawyer’s title opinion let- ter. Indeed, the practice in many states is to purchase a title policy rather than obtain a title opinion because some people feel the title policy provides more protection at

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a better price. Alternatively, a title policy may be purchased as supplemental pro- tection to the lawyer’s opinion, although most would consider this redundant and a waste of money.

In essence, a title insurance company provides protection to the insured to the extent that the title was free from unknown defects when the insured acquired title. Primarily, this protection covers the possibility that the recording system has failed to disclose a proper claim to the property. For example, if a previous owner received title through a forged deed and later the true owner appeared, the title insurance company would be obligated to defend the insured’s title in court, reach a monetary settlement with the lawful owner, or make good the insured’s loss. In such a situa- tion, title insurance can provide very valuable protection.

Mortgage companies usually require a title insurance policy before they will lend money to purchase the property. Although the buyer will normally have to pay for this policy as part of the costs of obtaining the loan, the policy protects only the lender. If the property owners also want title insurance to protect their interest, they must purchase a separate policy. In any case, the buyer can file suit against the seller for breach of warranty if the title turns out to be defective. The seller, however, may be insolvent and unable to pay any judgment the buyer might obtain. Legal action also involves attorney’s and other expenses, as well as considerable time and inconvenience.

If a lawyer for a title abstract company has given an opinion on a title that later turns out to be defective and the defect was overlooked because of the negligence of the abstractor or the attorney, the title holder has a cause of action against the negli- gent party. Here again, however, recovering from a title insurance company normally will be much cheaper and less time-consuming than having to pursue a lawsuit for negligence.

The Legal Highlight on the next page demonstrates the use of the grantor and grantee indexes in title searches.

The Torrens System

The Torrens system of land registration provides the landowner with a title cer- tificate similar to that used to show title to a car. To obtain the Torrens certificate of title, the purported owner must be willing to go through a legal registration proceed- ing. After reviewing all potential interests in the land, the judge issues a decree nam- ing the true owner of the land and any valid claims, such as mortgages, easements, or other restrictions, against the land. The judge’s decree is entered on the court’s records, an original certificate of title is recorded, and a duplicate certificate is given to the landowner. To transfer title under the Torrens system, the old certificate of title is returned to the registrar, who then issues a new certificate to the new owner.

Although the Torrens system simplifies the real estate transfer process, it is per- mitted as an optional method of land transfer in only 12 states (Colorado, Georgia, Hawaii, Iowa, Illinois, Massachusetts, Minnesota, New York, North Carolina, Ohio, Oregon, and Washington), and even in those areas, it has been applied on a very limited basis.

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C H A P T E R 5 Deeds and Title Examination 113

There are two main reasons for this. First, the high initial cost of the proceeding discourages owners from having their land registered. Second, and perhaps more important, lawyers, abstractors, and title insurance companies have fought against the use of the Torrens system because land transfers under this system eliminate or greatly diminish the need for their services.

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Title Examination through the Grantor and Grantee Indexes

Suppose you are thinking of buying a house from the current owner, Sarah Howell. You or your representative will want to examine the title to be sure Sarah

is the true owner of the property. By using the grantor and grantee indexes, the

title examiner finds the following information. First, by looking through the grantee index, the examiner discovers that the seller, Sarah Howell, bought the house now being sold on March 28, 1984, from Charles Edwards. Again via the grantee index, the examiner finds that Edwards purchased the land on which the house sits on June 17, 1965, from J. William Martin. The examiner learns that Martin had owned the property since November 12, 1916, after inheriting it from his mother, Edith Martin. Hav- ing determined that the chain of title can be traced back more than 80 years (some states require only a 30-year root of title, the time period that must be examined to ensure full legal protection), the examiner must “come forward” with the title to make sure that each grantor had the right and power to transfer title. Beginning with the grantor index, the examiner searches the grantor index to see whether Mrs. Martin’s executor deeded the

land involved to anyone other than J. William Martin on November 12, 1916. The examiner must take similar measures to learn what Martin did with the property between November 12, 1916, and June 17, 1965.

When the examiner is satisfied that Charles Edwards received good title on June 17, 1965, she finds next that Edwards mortgaged the land to finance the construction of the house you now want to buy. A satisfaction of that mortgage—that is, a discharge of the obligation—was filed when Edwards sold the house and lot to Sarah Howell in 1984. Therefore, it appears that as of the date of her purchase, Sarah Howell had good, clear, marketable title. To complete the job, the exam- iner must check the grantor index under the name Sarah Howell from March 28, 1984, to the present. Again, the land and house were mortgaged when Sarah bought the property. Because she has not yet paid off that mortgage, at the closing the buyer will insist that a document be recorded showing that the seller has totally paid the mortgage. A mortgage satisfac tion generally is filed at the same time as the deed conveying the property from the seller to the buyer.

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| chapter review __________________________________________

■■ A deed is a legal document that conveys title, or ownership, from one party to another. A valid deed must be written formally to include (1) identifica- tion of the parties, (2) a legal description of the property, (3) language of conveyance in return for the consideration named, and (4) signature of the grantor. It then must be (5) delivered to and accepted by the grantee.

■■ Deeds are differentiated by the covenants and warranties that the grantor makes regarding the title being transferred. Such assurances may include (1) covenant against encumbrances, (2) covenant of seisin, (3) covenant of quiet enjoyment, (4) covenant of further assurances, and (5) warranty forever. The general warranty deed, special warranty deed, bargain and sale deed (also called warranty deed without covenants or grant deed), and quit- claim deed are the most common deeds used in real estate transactions. Each has a special purpose, with which the parties involved should be familiar.

■■ Title to land signifies the legal right to ownership. A buyer of real estate is concerned fundamentally with acquiring “good title.” Good title is title that is specified as marketable, insurable, perfect of record, or any combination thereof. To protect themselves against inadvertent acceptance of defec- tive titles, all buyers should obtain a title opinion or title insurance. Title opinions are written by lawyers after they have searched the applicable title or examined the title abstracts. Title insurance provides protection from defects in title that might be discovered after the grantee receives the property from the grantor.

■■ A title search is conducted by trained personnel who examine the grantor and grantee indexes, the tax records, and the judgment records to deter- mine whether the grantor has the right and power to grant the stated inter- est. An abstractor searches a title and compiles all records applicable to a piece of real estate; the resulting compilation is called an abstract.

■■ Title insurance can be beneficial in conjunction with or in lieu of a title opinion. In essence, a title policy insures the title against any defects or claims that exist as of the date title is acquired. Title insurance does not cover potential defects or claims that come into existence after the policy is issued. Although title insurance is important in some situations, it should not be purchased automatically when a title opinion is obtained because that opinion may provide sufficient protection.

■■ The Torrens system of land registration provides an alternative to the more traditional method of exchanging title to real estate by delivery of a deed. Through a legal action to register the land, the judge determines the true owner of the land and the valid claims that exist. A certificate of title is issued then, and new certificates are issued when the property is sold in the future. This registration system has not gained wide acceptance in the United States because of the high cost of the required legal proceeding and the opposition of lawyers and abstractors. Title being conveyed in a deed should be examined to determine its quality.

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| key terms _______________________________________________

bargain and sale deed

chain of title

consideration

covenant against encumbrances

covenant of further assurances

covenant of seisin

deed

documentary stamp tax

executed

grant deed

grantee

grantor

grantor and grantee indexes

insurable title

legal description

marketable title

quitclaim deed

special warranty deed

title

title abstract

title insurance

title opinion

title perfect of record

title search

Torrens system

warranty deed

warranty deed without covenants

warranty forever

| study exercises _________________________________________

1. What are the essential elements of a deed?

2. Describe the covenants and warranty contained in a warranty deed.

3. What are the differences between

a. a warranty deed and a special warranty deed?

b. a warranty deed and a bargain and sale deed?

4. Evaluate the following statement: Quitclaim deeds are useful for removing “clouds” on real estate titles.

5. How should you respond to a dear friend who says, “I’m buying a new house in a new subdivision, so I don’t need to worry about a title search. No one has owned this house before.”

6. What is the difference between insurable title and marketable title?

7. Discuss whether or not you think the Torrens System would be an improve- ment over the deed system used in most parts of the United States.

8. Internet Exercise: Visit the website for the public records system in your area (usually the county clerk’s office) and view a few recently recorded warranty deeds and quitclaim deeds. Compare the language of these two types of deeds and explain how the warranty deed provides better protec- tion to the grantee than does the quitclaim deed. If you can’t find the web- site for your local public records system, try http://hendryclerk.org/official records.htm to access the records for a county in Florida.

| further reading _________________________________________

Karp, James, and Elliot Klayman. Real Estate Law, 8th ed. La Crosse, Wisconsin: Dearborn Real Estate Education, 2013.

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6c h a p t e r Contracts and Title Closings

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117

c h a p t e r p r e v i e w

This chapter focuses on three specific types of contracts that define the agree- ment between parties to eventually transfer ownership in real property: sales contracts, option-to-buy contracts, and contracts for deed. Each of these types of contracts provides the rules governing the parties’ rights and duties during the time between the agreement to transfer real property and the actual transfer of title using a deed.

The transfer of title occurs at the title closing or settlement of the transaction. We consider the responsibilities of the parties to the transaction to bring the transaction to a close. We also demonstrate how the funds are accounted for in a typical residential real estate closing.

Under the topic of topic of contracts, we examine

■■ the necessary elements of a contract;

■■ performance and breach of contract;

■■ the purpose and structure of the real estate sales contract;

■■ the purpose and structure of option-to-buy contracts;

■■ the purpose and structure of contracts for deed; and

■■ some contract negotiation tips and strategies.

Under the topic of title closing, we study

■■ the buyer’s responsibilities;

■■ the seller’s responsibilities;

■■ closing costs;

■■ events at closing; and

■■ escrow closing.

legal highlight Validity of an Oral

Contract

legal highlight Necessity to

Meet “Concurrent Conditions” by Date

of Closing

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| necessary elements of a contract ________________________

The required elements of any valid contract consist of (1) an offer, (2) an accep- tance, (3) consideration, (4) parties with capacity, and (5) a lawful purpose. When contracts involve real estate, there is an additional requirement that the agreement be expressed in writing to be enforceable by the court system (one exception is a lease for one year or less).

Offer and Acceptance

Before any contract can be created, one person must make an offer to another. In essence, an offer is a statement that specifies the position of the maker of the offer (who is called the offeror). The offeror states implicitly in an offer that he or she is willing to be bound by the stated position. An offer becomes a valid contract when it is accepted by the party who receives it. The receiving party is called an offeree, and his or her acceptance should create a contract.

An acceptance, which expresses satisfaction with an offer, must mirror the pre- cise terms and conditions stated in the offer. If the terms in the purported acceptance differ from those of the offer, no contract is formed. Indeed, such an attempted accep- tance becomes a counteroffer. With a counteroffer, the original offeror and offeree switch legal positions, and a contract may result when a counteroffer is accepted. Acceptance of a contract involving real estate is indicated by the signatures of the parties on the written document that spells out their agreement.

Consideration

The law requires that an exchange of consideration occur before a contract is enforceable. Consideration often is described as anything that incurs a legal detri- ment or the forgoing of a legal benefit. What that means, in simple terms, is that each party to a contract must give up something. In a typical real estate contract, the seller promises to give up title to the land in return for money; the buyer promises to give up money in return for title to the land.

Capacity of Parties

To have a valid contract, all parties involved must have contractual capacity. The law insists that all parties have the mental capability to know what the contract represents and to understand its terms. Most commonly, two categories of people are said to lack contractual capacity. First, those who have been declared mentally incompetent are protected from people who attempt to take advantage of their mental condition. Because the law often cannot distinguish people with unjust intent from those with good intentions, insane persons cannot be held to the terms and conditions of a contract. Therefore, such contracts, although binding on the competent party, are voidable, or can be rescinded, at the election of the incompetent party’s guardian.

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The second category of people who lack contractual capacity consists of minors—that is, those who have not reached the age of majority, usually 18 or 21. Although some minors (typically defined as persons younger than 18) have the intel- ligence to comprehend even the most complex transactions, the law provides them with protection.

Any time before a person reaches the age of majority and within a reasonable period thereafter, nearly all contracts that the minor has entered into may be voided by the minor. Certain types of contracts involving a minor’s purchase of necessi- ties—such items as food, clothing, and medical care, essential for the preservation and reasonable enjoyment of life—cannot be voided. Because real estate is seldom considered a necessity, however, minors generally lack the capacity to purchase or sell it. Therefore, when one party to a contract involving the transfer of real estate is a minor, that contract is voidable at the minor’s (or his guardian’s) option.

If a contract is voided, the minor and adult parties must return any consideration that was previously exchanged. Therefore, an adult must beware of buying real estate from or selling it to a minor, as such a transaction subsequently may be undone.

Lawful Purpose

A valid contract must have as its ultimate purpose some legal act or function. For example, a contract for the delivery of illegal drugs is not enforceable—at least not in the courts. Although people sometimes subsequently put real estate to an illegal use, the sale or lease of real estate seldom directly involves illegal intentions; there- fore, this element of a valid contract generally is less troublesome than the other elements.

Even so, both buyers and sellers should be aware that any illegal purpose in the contract may make it void. For example, suppose a sales contract specifies the buyer’s intent to utilize the property in violation of current zoning provisions. This clause may give the buyer an “out” that the seller may not recognize.

Writing Requirement

Contracts may be either implied or expressed, and expressed contracts may be oral or written. All contracts involving land or items attached to it, however, must be in writing before a court will enforce them. Contracts involving the sale of timber and crops may be oral and remain binding. The rules governing contracts for per- sonal property are found in each state’s version of the Uniform Commercial Code, a collection of laws that govern business transactions. Each state’s law should be consulted regarding the requisites of such contracts.

The requirement that real estate contracts be in writing to be enforceable by the legal system is found in each state’s statute of frauds, a law designed to prevent fraudulent practices by requiring that certain contracts, including those involving real property, be in writing and signed. We discussed this statute briefly in the pre- vious chapter. Real estate contracts must be written to reduce the possibility that a court may be defrauded or tricked into ruling improperly when the subject matter

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is valuable real estate. The required writing does not have to be a formally drafted document. Indeed, any written words that indicate the parties’ positions and that are signed by the parties involved satisfy the statute of frauds. For example, the words “I agree to sell my farm to Robert Harris for $50,000,” written on a paper napkin, are enforceable by Harris if they are signed by the farm owner. Of course, it is assumed that the owner has only one farm; otherwise, the property designated as “my farm” is not adequately described. An adequate written description of the real property being sold is essential. Methods of legal description were discussed in Chapter 2.

Although the statute of frauds requires that contracts involving real estate be in writing, there are exceptions to this rule. Courts may, for instance, enforce an oral contract if the parties have partially performed their agreement. Partial performance is the fulfillment of the terms of an agreement to such an extent that the existence of the agreement may be reasonably inferred, even though no written contract exists. If a court can determine from the parties’ actions what their intentions were, it may hold that a contract exists despite the lack of a written document. Generally, mere payment of some money by the buyer is not sufficient to replace a written contract.

Payment plus possession by the buyer and physical improvements made to the property, however, point to the existence of some kind of contractual understanding, and the courts often will rule in favor of such a buyer—but not always, as the buyers found in the Connecticut case described in the Legal Highlight on the next page.

| breach of contract _____________________________________

Failure to perform a required contractual obligation is called a breach of con- tract. If a party to an agreement breaches its terms, the other party has a choice of remedies, either outlined in the contract or provided by law. Let’s assume the seller, who has signed a valid real estate sales contract, refuses to transfer title to the buyer. The buyer may then sue for specific performance; that is, ask the court to order the breaching party to perform the terms of the contract.

A suit for specific performance is possible only if the contract concerns a unique item. Because land and improvements on land are considered one-of-a-kind items, a buyer probably will be successful in obtaining an order of specific performance. As an alternative, a buyer may seek payment for any damages that result from the seller’s breach. Such damages could include compensation for the buyer’s loss of time and the buyer’s expenses related to the sale, such as legal fees for a title search, a land survey, and a building inspection.

If the buyer refuses to perform the duties under a valid contract, the seller also has the right to sue. In many states, however, the seller’s rights are limited to recover- ing monetary damages, including any earnest money that may have been paid by the buyer. Usually, a seller cannot seek specific performance because courts do not feel that a ready, willing, and able buyer is a unique commodity. Eventually, the courts presume, some other purchaser will be found.

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| contract contingencies _________________________________

The preceding discussion of remedies for a breached contract is based on the presumption that the party’s nonperformance is not excused. A well-drafted contract provides that the parties will be discharged from performance in the event of certain conditions. These conditions are called contingencies. A common clause in residen- tial real estate sales contracts is a financing contingency that allows a buyer who is not able to arrange the necessary financing within a certain time period to cancel the contract and recover any earnest money paid without further obligation. Similarly, real estate sales contracts often contain a title contingency that allows either party

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Validity of an Oral Contract

The statute of frauds requires that con tracts for the sale of real estate be written in order to be enforceable. Richard and Mary Kelly learned this to their sorrow.

The Kellys reached an oral agreement with William Ryan to purchase his residential waterfront property in Greenwich, Connecticut, for $2,125,000 in cash. The sale was subject to securing approval from the Coastal Area Manage ment Commission for construction on the property that would double the size of the existing house and add a tennis court. The Kellys had a wetlands survey made and site plans prepared for submis sion of the applica- tion. A few days later, their attor ney submitted a contract to Ryan’s attorney, which essentially put the oral agreement into writing. Ryan refused to sign, and the next day, he con tracted to sell the property to a third party. The Kellys sued, seeking specific performance by Ryan of the oral contract. They lost.

The court ruled that:

However plain and complete the terms of an oral contract for the sale and purchase

of real estate, it cannot be enforced against a party thereto unless he, or his agent, has signed a written memoran dum which recited the essential elements of the contract with rea sonable certainty.

Even though the Kellys had a definite oral agree ment with Ryan, as the Hollywood producer Sam Goldwyn used to say, “An oral agreement isn’t worth the paper it’s written on.” The Kellys also argued that they had made “substantial improve- ments” to the property on the basis of the oral agreement, thus defeating the written requirement in the statute of frauds. The court did not agree, holding that the survey and site plans, at a cost of less than $5,000, were not “substantial” to a prop- erty with a value of more than $2 million. The les son is clear: Never, never, never rely on an oral contract in the sale or purchase of anything of value, par- ticularly not in the sale or purchase of real estate.

[Kelly v. Ryan, Nos. CV 91 011 53 81, DV 91 011 54 38 S., Connecticut Superior Court, 1991]

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to cancel a contract if the title search reveals a problem with the seller’s legal title to the property that cannot be resolved within a certain time period. Another common component of real estate sales contracts is the inspection and repair contingency. This clause permits the buyer to have a qualified inspector examine the property for any physical defects. If defects are found, the seller may be obligated to make repairs up to an agreed-on amount. If the cost of repairs exceeds this amount, the buyer may elect to cancel the contract. Almost any condition can be added to an agreement, as long as it does not create a contract for an unlawful purpose. Also, most courts would consider a contract that included an unconscionable condition (one that is shock- ingly unfair) to be invalid.

| real estate sales contracts _____________________________

Now that we understand the fundamental concepts behind the theory of con- tracts, let’s consider some specific examples of contracts used in real estate trans- actions. Frequently encountered contracts in real estate transactions include sales contracts, option-to-buy contracts, contracts for deed, leases, listing agreements, buyer representation agreements, and property management agreements. Our focus in this section is on the real estate sales contract. Sales contracts provide for the eventual transfer of title to real property. Title, or the legal right to ownership of land, is passed by use of a deed and does not change hands until the transaction actually is closed, or brought to a successful conclusion. The sales contract’s purpose is to provide the rules governing the parties’ rights and duties during the time between the agreement to transfer real property and the actual transfer of title. A reasonable time period generally is necessary to allow the buyer to secure financing, check the seller’s title, and obtain property insurance.

Negotiating a Sales Contract

In most real estate markets, property owners who wish to sell their properties will advertise them at a specified price through a local real estate broker or as a for-sale-by-owner deal (FSBO, sometimes pronounced “fizbo”). Potential buyers examine the property and decide if they are interested in purchasing it. Preliminary negotiations between buyers and sellers are very often oral, but because the ultimate agreement must be in written form, sincere negotiations usually begin with one party (either the buyer or the seller) writing his or her offer, signing it, and presenting it to the other party for review. If the other party accepts the offer and signs it, then a contract is formed as specified in the document. If the other party, however, suggests a change to the first party’s offer, then the second party has essentially rejected the offer and presented a counteroffer. Perhaps the first party will accept this change and thus a deal is struck, or the other party may choose to make yet another counteroffer to the second party’s counteroffer. The negotiations continue in this fashion until the parties either reach an agreement or discontinue negotiations. Keep in mind that one party must make an offer, or a counteroffer, that the other party accepts in the exact form in which it was offered before a final agreement is reached. Offers and

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C H A P T E R 6 Contracts and Title Closings 123

counteroffers can be withdrawn by the offeror at any point prior to acceptance by the offeree.

Sales Contract Example

Let’s consider the real estate sales contract shown in Figure 6.1 to better under- stand the details of such a contract. The property in question is a small office building (2,750 square feet) that is currently owned by an investor through a holding company. The building is currently leased to an accounting firm for $4,200 per month ($18 per square foot per year) with four years remaining on the lease. The property has been on the market for several months with an asking price of $879,000. Another invest- ment holding company is interested in buying the property at a price of $800,000. The principals of the two holding companies have negotiated extensively and have finally reached an agreement that their attorneys have put into written form as shown in “Purchase Agreement and Deposit Receipt” (Figure 6.1).

The first section of the document identifies the buyer, the seller, the property, and the purchase price, and states that an agreement has been reached. The remainder of the document is divided into numbered paragraphs that can be referred to by the parties. There is nothing special about the ordering or naming of these paragraphs— the attorneys merely included them for easy reference. We will talk about the most interesting paragraphs here.

The purpose of paragraph 1 is to specify how the buyer will pay for the prop- erty. This paragraph is linked to paragraph 2 by the reference to a new first loan in clause 1.B. From these paragraphs, we know that the buyer made an initial deposit of $20,000 at the time the parties signed the document. (An escrow agent is holding the initial deposit in trust until one of three things happens: the contract closes, the con- tract terminates due to a contingency, or one of the parties defaults on the contract. If the contract closes, the escrow agent will release the deposit to the seller at the clos- ing as part of the purchase price. In the event of termination of the contract due to a contingency or a default, the relevant language in the document will determine who gets the deposit money.) Additionally, the buyer will apply for a loan of $450,000 as specified in paragraph 2. If the buyer does not make a timely, good-faith effort to obtain the loan or refuses to accept a loan with the specified interest rate and other terms, the deposit will be forfeited to the seller. (The borrower can, of course, accept a loan with more favorable terms but cannot refuse to accept a loan with the specified terms.) If the loan application is denied, the deposit will be refunded to the buyer. Upon obtaining a loan commitment, the buyer will make an additional deposit to the escrow agent of $50,000. The balance of the purchase price, $60,000 ($580,000 –$20,000 – $50,000 – $450,000), must be paid by the buyer at closing.

Paragraph 3 specifies the date by which the contract will close. If all of the con- tingencies are satisfied, the seller will convey title by warranty deed, pay the deed recording fees, and give possession to the buyer on or before this date. Of course, the buyer must give the seller the full purchase price at the closing. The escrow agent will release the deposits, the lender will release the loan funds, and the buyer will pay the balance of the purchase price.

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f i g u r e 6.1 Sales Contract Example

PURCHASE AGREEMENT AND DEPOSIT RECEIPT

MTA Investment LLC, hereinafter designated as “SELLER”, has agreed to sell and Barber Junction Enterprises LLC, hereinafter designated as “BUYER”, has agreed to buy the real property identified below and all fixtures permanently attached thereto for the PURCHASE PRICE of $580,000. Legal Description: Lot J, Block 12, Winwood Farms Subdivision Address: 5635 Dirkson St., North Charleston, SC, 29406 Description: 2,750 sq. ft. office building with parking built in 2002 on 1.25 +/- acres. 1. FINANCING TERMS AND LOAN PROVISIONS. A. Initial deposit received and currently held in trust by escrow agent: $20,000.

B. Additional deposit to be placed in trust with escrow agent within ten (10) days of receipt of loan commitment per Item 2: $50,000. C. New first loan per Item 2 with a fixed interest rate of 7% or less, an amortization period of twenty (20) years, term of not less than five (5) years, and points/origination fees not to exceed 1% of the loan amount: $450,000. D. Balance of purchase price in cash or cashier’s check due at closing: $60,000.

2. LOAN PROCESSING AND APPLICATION. BUYER’s obligation is contingent upon BUYER obtaining a commitment for a new first loan from Third Bank of the Pacific, hereinafter designated as “LENDER”, within thirty (30) days of acceptance of this Agreement. BUYER shall apply for said loan within five (5) days from acceptance of this Agreement. BUYER shall provide all documents or information requested by LENDER in a prompt and timely manner. BUYER shall take any action that is needed or requested by LENDER to process the loan application. 3. CLOSING DATE. On or before June 1, 2011, SELLER agrees to convey the property to the BUYER by warranty deed free of encumbrances, except as herein stated. SELLER agrees to pay all statutory deed recording fees. At closing, BUYER agrees to have cash, cashier’s check or certified funds drawn on a local bank in the amount of the balance of the purchase price plus all costs payable to the closing attorney or escrow agent. Physical possession of the property shall be delivered to BUYER at closing. 4. TITLE. BUYER shall take title to the property subject to: (1) real estate taxes not yet due, and (2) covenants, conditions, restrictions, rights of way, and easements of record, if any, which do not materially affect the value or intended use of the property. Within three (3) days of acceptance of this Agreement, BUYER shall order a preliminary title report for title insurance at BUYER’s expense. BUYER shall, in writing, notify the SELLER of any defects identified in the preliminary title report within ten (10) days of receipt thereof. SELLER shall use due diligence to remove such defects at SELLER’s expense before closing. If SELLER is unwilling or unable to remove such defects before closing, BUYER may elect to purchase the property subject to such defects or to terminate this Agreement. In the event of such termination, all deposits plus actual expenses incurred by BUYER to the date of cancellation shall be returned to the BUYER.

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f i g u r e 6.1 Sales Contract Example (continued)

5. ADJUSTMENTS. The purchase price shall be appropriately adjusted as of the date of closing for taxes, water, sewer assessments, sewer charges, fuel oil, property owner’s association fees, rents, and any other income and expenses. Annual expenses or income shall be apportioned using 365 days. Monthly property expenses or income shall be apportioned by the number of days in the month of closing. Prorations at closing shall be final. 6. DESTRUCTION OF IMPROVEMENTS. If the improvements of the property are destroyed or damaged by fire, wind, water, or other insurable or non-insurable event prior to closing. BUYER shall have the option of proceeding hereunder or of terminating this Agreement. In the event BUYER elects to terminate this Agreement, BUYER shall provide written notice to SELLER within thirty (30) days of the event and all deposits shall be returned to BUYER. In the event BUYER does not elect to terminate the Agreement, BUYER shall be entitled to receive the property and any and all insurance proceeds payable on account of the damage or destruction. 7. CHANGES DURING TRANSACTION. During the pendency of this transaction, SELLER agrees that no changes in the existing leases or rental agreements shall be made, nor new leases or rental agreements entered into, nor shall any substantial alterations or repairs be made or undertaken without written consent of the BUYER. 8. EXISTING LEASES. Within seven (7) days of acceptance of this Agreement, SELLER shall deliver to BUYER for BUYER’s approval copies of all existing leases and rental agreements, copies of all outstanding notices sent to tenants, a written statement of all oral agreements with tenants, and a written statement of all tenants’ deposits held by SELLER, all of which SELLER warrants to be true and complete. BUYER’s obligations are conditioned upon approval of said documents. BUYER shall be deemed to have approved said documents unless written notice to the contrary is delivered to SELLER within seven (7) days of receipt of said documents, in which case BUYER may have all deposits returned and both parties shall be relieved of all obligations hereunder. SELLER shall, at closing, provide estoppel certificates executed by each tenant acknowledging that the lease or rental agreement is in effect, that no lessor default exists, and stating the amount of any prepaid rent or security deposit. 9. INCOME AND EXPENSE STATEMENT. SELLER shall, within seven (7) days of acceptance of this Agreement, deliver to BUYER a true and complete statement of monthly rental income and expenses for the past twelve months for BUYER’s approval. BUYER’s obligations are conditioned upon approval of said statement. BUYER shall be deemed to have approved said statement unless written notice to the contrary is delivered to SELLER within seven (7) days of receipt of said statement by BUYER, in which case BUYER may have all deposits returned and both parties shall be relieved of all obligations hereunder. 10. ACCESS TO PROPERTY. SELLER agrees to provide reasonable access to the property to BUYER and inspectors representing BUYER as provided in this Agreement and to representatives of lending institutions for appraisal purposes.

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f i g u r e 6.1 Sales Contract Example (continued)

11. INSPECTION OF PHYSICAL CONDITION OF PROPERTY. BUYER at BUYER’s expense, within thirty (30) days of acceptance of this Agreement, shall have the privilege and responsibility of selecting licensed contractors or other qualified professionals to prepare inspection reports listing physical defects that have a material impact on the property’s value. BUYER shall, within ten (10) days of receiving inspection reports, furnish copies to SELLER of all inspection reports identifying such defects. SELLER shall use due diligence to correct such defects at SELLER’s expense before closing. If SELLER is unwilling or unable to correct such defects before closing, BUYER may elect to purchase the property subject to such defects or to terminate this Agreement. In the event of such termination, all deposits plus actual expenses incurred by BUYER to the date of cancellation shall be returned to the BUYER. 12. MAINTENANCE. SELLER covenants that the heating, air-conditioning, electrical, sewer, septic system, drainage, sprinkler (if any), plumbing systems, water heaters, built-in appliances and other mechanical apparatus shall be in normal working order on the date possession is delivered. 13. DEFAULT. If the BUYER defaults under this Agreement, the SELLER shall have the option of suing for damages and specific performance or rescinding this Agreement. If the SELLER defaults under this Agreement, the BUYER shall have the option of suing for damages and specific performance, or rescinding this Agreement. Upon default by the SELLER, if the BUYER elects to rescind this Agreement, BUYER will be refunded all sums paid hereunder and in addition, shall be reimbursed by the SELLER for actual costs incurred, including but not limited to costs of inspection, appraisal, surveying, and title examination. 14. ATTORNEY FEES. In any action or proceeding involving a dispute between BUYER and SELLER regarding this Agreement, the prevailing party shall be entitled to receive from the other party a reasonable attorney fee to be determined by a court of competent jurisdiction. 20. ENTIRE BINDING AGREEMENT: This written instrument expresses the entire agreement and all promises, covenants, and warranties between the BUYER and SELLER. It can be changed only by a subsequently written instrument signed by both parties. The benefits and obligations shall inure to and bind the parties hereto and their heirs, assigns, successors, executors, or administrators. Time is of the essence for this agreement. IN WITNESS WHEREOF, this Agreement has been accepted and duly executed by the parties. BUYER: ______________________________________________________________________ Date Time SELLER: _____________________________________________________________________ Date Time ESCROW AGENT: _____________________________________________________________ Date Time

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The buyer will likely have to bring more than just the balance of the purchase price to the closing, and the seller will likely receive less than the purchase price at the closing. Because the seller is obligated to convey “clear” title (free of encum- brances other than those noted in paragraph 4), any existing loans on the property must be satisfied at the closing and will thus reduce the seller’s proceeds from the transaction by the balance of those loans. Both parties may owe fees to third parties that, for the seller, will be deducted from the purchase price and, for the buyer, must be paid with additional funds at the closing.

Paragraph 4 creates a “title contingency.” The buyer must order and pay for an examination of the title to the property. The seller must correct any title defects iden- tified in that examination or, if the seller cannot or will not correct the defects, return all deposits to the buyer. Note that even if the buyer is willing to accept certain title defects, the lender may not be willing to accept them, and thus, the deal would likely terminate due to withdrawal of the loan commitment by the lender.

Paragraph 5 specifies that any property expenses that have been paid in advance by the seller for the current month or year will be prorated so that the buyer bears the expenses for the remaining time period related to these expenses. Similarly, any income received in advance by the seller will be prorated for the remaining time related to the income to the benefit of the buyer. (Though not addressed in this agree- ment between the buyer and seller, the lender may also require the buyer to pay loan fees and to “prepay” interest for the remainder of the month and a portion of the coming year’s property taxes and insurance. These costs will increase the amount of money the buyer must bring to the closing.)

Paragraph 6 contains language that protects the buyer from potential damage to the property between the date of this agreement and the closing. If the property is damaged, the buyer can elect to be released of all obligations and be refunded all deposits. Or, the buyer can elect to proceed with the transaction and receive any insurance proceeds that are due to the seller.

Because the buyer is acquiring the property for investment purposes, the buyer is keen to know the details of existing leases and the property’s net income history. Paragraphs 8 and 9 require the seller to make extensive disclosures about any agree- ments with tenants and to provide an accurate accounting of the property’s income and expenses during the previous 12 months. The buyer can walk away from the deal (with a refund of deposits) if the buyer finds any of the information provided to be unsuitable. Notice that there are tight time requirements on both the seller and the buyer in these paragraphs. In short, the buyer has a maximum of 14 days to withdraw from the deal without losing the deposits based on information in the leases or the property’s net income.

The physical condition of the property is also an important concern of the buyer, as evidenced by the language in paragraphs 10, 11, and 12. While the buyer has undoubtedly made a cursory examination of the property and found it acceptable, the buyer prudently wants to have the land and the improvements further inspected by qualified professionals to identify any physical defects. The seller must give such inspectors access to the property and must correct any defects they identify. If the seller does not or will not correct the defects, the buyer can elect to terminate the

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contract and receive a refund of deposits, plus expenses incurred through the date of termination.

Note that the language in paragraph 11 essentially creates a 30-day “due dili- gence period” for the buyer to further examine the property and make a decision to proceed or withdraw from the deal if the physical condition of the property is unacceptable. Real estate sales contracts, especially those for investment properties, frequently define a due diligence period during which the buyer can evaluate the physical condition of the property, current land-use regulations affecting the prop- erty, current market conditions that affect the property’s income and value, and many other issues the buyer wishes to consider in more detail. Evaluating issues of this type may be costly, and the buyer may not be willing to spend the money to conduct such evaluations until a contract is in place. Also note that in some situations sellers and buyers may agree that the property is being purchased in “as is” condition. That means that the seller is under no obligation whatsoever to make any repairs to the property. But, in that situation, a prudent buyer would certainly want to include lan- guage in the contract that creates a due diligence period that gives the buyer adequate time to inspect the property and to consider other issues that may affect the buyer’s decision to move forward in the deal.

Finally, paragraph 20 makes it clear that everything the buyer and seller have agreed to regarding this transaction is specified in the contract document. Neither party can hold the other party accountable for anything said or unsaid before or after the date of the contract that does not appear in this document. It also says that time is of the essence, meaning that the parties must precisely comply with the time periods defined in the document.

| option-to-buy contracts _________________________________

Another type of contract that is often useful in real estate transactions is the option-to-buy contract. Sometimes a party is interested in buying a specific prop- erty but is not yet ready to sign a sales contract. The option-to-buy contract is one way to ensure that the property will not be sold to another party before the person who holds the option to buy has made a final decision.

The option-to-buy contract is an agreement between a property owner and a potential buyer that states that the property owner agrees to keep an offer open for acceptance during a stated period of time. If the buyer decides to exercise the option before it expires, the owner must sell the property at the specified price. For example, an owner may state that he or she will sell the property to the option holder for $75,000 and will allow the holder to accept this offer at any time within the next six months. To ensure that the option is binding, it must be in writing and contain all of the necessary elements of a valid contract: offer, acceptance, consideration, parties with capacity, and lawful purpose.

The amount of consideration for the option depends on the circumstances. Sup- pose, for example, that Broker Judy Michaud is trying to assemble six properties as a tract for a shopping center. She offers Blanche, the owner of one of the six proper- ties, an option-to-buy contract to purchase her house for $110,000, even though the

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property is worth only $90,000 as a residence. Blanche’s property is worth the larger amount only if it can be used for the shopping center, and to achieve this, Judy must both obtain contracts from the other property owners and secure rezoning of the entire tract.

Thus, Judy offers Blanche an option contract that gives Judy the right to pur- chase the property for $110,000 any time in the next six months. Blanche might be happy to accept consideration of $1,000 or even less for agreeing to this arrangement because she will receive a very good price for her house if Judy is successful in put- ting the deal together. The consideration received by Blanche for the option granted to Judy is hers to keep, regardless of whether Judy exercises her option to buy. Thus, the consideration received by Blanche is her compensation for giving up the right to sell the property to anyone other than Judy for the next six months.

| contract for deed ______________________________________

In addition to the contracts discussed thus far, real estate transactions are some- times arranged as “installment sales,” using a contract for deed. This arrangement stretches out the payments to the seller over time, but it allows the seller to retain legal title to the property until the agreed-on amount is paid. While making payments to the seller, the buyer typically has possession of the property as the “equitable” owner. Contracts for deed are sometimes called land contracts or agreements for deed.

The obvious question you might be asking is: How does a contract for deed dif- fer from a mortgage? The answer is that the seller’s collateral interest in the property is better protected in the event the buyer defaults on the agreement. If the buyer stops making payments, the seller is already (still) the legal owner of the property and thus can simply assert his or her ownership rights and sell the property to another buyer or keep it. Most states, however, recognize the possibility of a buyer’s losing any equity he or she might have acquired in the property while making payments over time. In these states, buyers who breach a contract for deed are entitled to a refund of their equity (if any) in the property, but not interest paid. This requirement makes the contract for deed even more similar to a mortgage in these states. Regardless of whether default on the contract for deed requires that the seller refund any of the buyer’s equity, buyers should realize that the seller is the legal owner of the property while a contract for deed is in place and could possibly cause other liens to be placed on the property prior to transferring title to the buyer.

| some basic negotiation strategies ________________________

Many novice negotiators mistakenly approach a negotiation as if there were one pie that had to be somehow divided among the parties involved, and that every bite one party got was one less bite another party could get. In other words, some nego- tiators approach a negotiation as if it were a “zero-sum” game with the parties being classified as either “winner” or “loser” when the game is over. In most situations,

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however, the size of the pie, so to speak, is not nearly as fixed as we might assume, and all parties can ultimately benefit if the right solution can be found.

There is an old saying in real estate: “You can name the price if I can name the terms.” This saying goes to the heart of what good negotiation is all about. Be willing to let the people who are most concerned about certain slices of the pie grab what they think they want, but look for creative ways to make the total pie bigger, thus ensuring yourself a sufficient slice, too!

In a typical real estate transaction, price is often viewed as the single most impor- tant factor to be resolved. Suppose a seller wants to get $1 million for the property and adamantly refuses to take one cent less. While some buyers might be discour- aged by the seller’s stubbornness, an astute buyer might think of another issue that can be added to the negotiation to “sweeten the deal.” Perhaps the buyer will agree to the full asking price if the seller will agree to allow the buyer to pay only $850,000 immediately and make annual payments of $50,000 each for the next three years (a total of $1 million, but an interest-free loan for part of this amount). Or perhaps the seller will agree to take part of the $1 million in the form of another parcel of real estate the buyer owns and the remainder in cash or cash and a note. The potential for finding a creative solution is limitless in real estate negotiations, and those who seek solutions that make “winners” out of all parties to the negotiation are more likely to enjoy sustained success.

An important step in becoming a successful negotiator is to keep an open mind so you can better understand the other party’s position. Find out what is important to the parties and try to ensure that they get what they want, while you get something you want (which may not be the same something you thought you wanted when the negotiation began). Search for common ground early in the negotiation process. With this accomplished, the remaining contentious issues may not appear nearly so large, and both parties may ultimately benefit. One of the worst mistakes a novice negotia- tor can make is to ignore the possibility of other ways to structure a deal that would benefit all parties involved.

| title closings ___________________________________________

When all the conditions of the sales contract have been met, the last step in the transaction process is to “close” or “settle” the transaction. In fact, a real estate transaction may involve several types of closings. The borrower and the lending institution must close the loan; the escrow agent, if one is employed, must close the escrow arrangement; and the grantor and grantee must close or transfer the title to the property involved. Generally, but not always, the various closings occur at the same meeting. Therefore, the word closing or settlement can refer to the conclusion to several different relationships. Remember that the ultimate purpose of the real estate sales process is to transfer title from the seller to the buyer. To look at closing properly, we must first examine each party’s prior responsibilities.

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Buyer’s Responsibilities

Once the negotiations between a buyer and seller are completed and a sales contract is signed, the real estate transaction begins. Indeed, during the time period (usually 60 days) between the signing of a contract and the closing of the transaction, buyers often take on many new responsibilities, including

■■ obtaining financing,

■■ examining the title evidence,

■■ having the property surveyed,

■■ obtaining property insurance, and

■■ having the property inspected.

Financing the Purchase Buyers’ reliance on borrowed money requires that they insist on a financing

contingency. A buyer who, after a good-faith effort, is unable to secure the specified financing may cancel the sales contract and have the earnest money refunded.

Under a clause conditioning the sale on the buyers’ ability to obtain adequate financing, the buyers must use good faith and honesty in all attempts to borrow the required amount. They must apply for the loan within a short time after the contract is signed. They cannot delay such an attempt until there is not enough time for the lending institution to approve the loan before the closing date. If the buyers’ failure to secure adequate financing is a result of their lack of good faith, the sellers can sue for damages as a consequence of the buyers’ inability to close the transaction. If the money market is exceedingly tight, however, or if lenders are unwilling to risk the loan because they doubt the buyers’ ability to pay, or if the loan is not approved for some reason over which the potential borrowers have no direct control, the buyers are relieved of their contractual obligation.

Failure to include in the sales contract the clause conditioning the sale on the buyers’ ability to obtain financing can cause great hardship to the buyers. In that case, failure to secure adequate financing does not relieve the buyers of their con- tractual duties; therefore, buyers who cannot pay the purchase price at closing have breached the contract and are liable for the sellers’ damages and may be required to forfeit any deposit money.

Examining the Title Evidence Another principal responsibility of the buyer before closing is to examine the

title evidence. Even though a seller may agree to pass title by warranty deed, the buyer must check on the state of the seller’s title for at least two important reasons. First, the seller’s deed usually promises that there are no encumbrances other than “restrictions of record.” It then becomes the buyer’s responsibility to learn of any restrictions of record. Second, the sales contract normally requires that the buyer inform the seller of any defects found in the seller’s title and give the seller the opportunity to correct them. As discussed in Chapter 5, title defects are discovered through a title examination.

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Having the Property Surveyed An actual survey of the property’s boundaries is not always required before title

can be transferred, particularly in subdivisions that have been platted. The plat in the public records normally will suffice in lieu of a survey. If there is some confusion as to the actual property lines, however, or if the lending institution requires that a survey be made to determine if any encroachments exist, the buyer usually must pay for it. Of course, the sales contract can provide that the seller bear the cost of any survey if the buyer and seller agree to this arrangement.

Obtaining Property Insurance Again, because of the magnitude of real estate costs, most people cannot bear

the risk of losing the property’s value as a result of fire, vandalism, or other potential hazards. When a buyer is borrowing money to purchase real estate, the lender will require that the buyer purchase property insurance. Indeed, the lending institution will refuse to close the loan unless the borrower has provided proof that the property is insured for at least the amount of the loan.

Such proof typically is provided by a letter from the insurance company to the lender, a document often referred to as an insurance binder. Property insurance is indirectly vital to the title closing because the property insurance must be obtained before the loan can be completed, and the loan is crucial to the overall performance of the sales contract.

Inspecting the Property Except in the most unusual circumstances, a buyer will have visited the real

estate once or twice, or perhaps many times, before the sales contract is signed. Despite numerous visits to view the property, the prospective buyer seldom investi- gates thoroughly the property’s mechanical systems such as the plumbing, wiring, or heating systems. At times, a buyer feels great pressure to sign a sales contract so that he or she will not lose the opportunity to buy a particular property. The major utilities and appliances, if included, often remain uninspected as well.

The high cost associated with repairing any structural problems, mechanical systems, or appliances makes it extremely important that these items be in good working order. If any of these components of the property are damaged or not work- ing properly, the buyer should know so that the offer to purchase can be adjusted accordingly.

The real estate sales contract we reviewed earlier in this chapter included an inspection and repair clause. The buyer should inspect the premises during the time period before the closing. The seller must cooperate in allowing access to the buyer for this purpose. Although it does cost money to have someone knowledgeable inspect the major items of concern, the expense is far smaller than that of replacing the heating unit two weeks after the transaction is closed.

Other Responsibilities A buyer who is purchasing land for development purposes should investigate

the zoning restrictions on the parcel involved. A sales contract for commercial land

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should contain a provision permitting the buyer to cancel the contract if the zoning regulations do not permit the intended use or cannot be changed to permit it by the stipulated closing date. A buyer of rental property should study the current lease’s terms and conditions, as well as the schedule of rental payments. Of course, because the parties are the masters of their contracts, a sales agreement may include other duties owed by the buyer before the closing of the transaction.

Seller’s Responsibilities

A seller’s work, like a buyer’s, really begins when a sales contract is signed. Before actually going to the closing, a seller must typically do the following:

■■ Prepare the required deed

■■ Remove all encumbrances

■■ Prepare papers with respect to the seller’s loan

■■ Cooperate with inspectors

Preparing the Deed As we discussed previously, various types of deeds can be used to transfer title,

depending on the circumstances of the transaction. The sales contract always should specify the kind of deed that is to be delivered by the seller. The typical sales transac- tion involves a warranty deed or special warranty deed.

Removing Encumbrances Assuming that a seller is required to present a warranty deed, he or she will

covenant that the real estate is free of encumbrances other than those specified in the deed. Encumbrances that the seller may have to remove could include unrecorded claims of ownership, easements, covenants, and liens. One of the most frequently filed liens is the tax lien, resulting from the owner’s failure to pay state, county, or city property taxes. Therefore, before the closing, a seller must have paid all taxes that are then due on the property.

Paying the Seller’s Loan Mortgage loans usually are to be paid back over a period of 25 to 30 years.

Because of the longevity of such loans, most owners do not complete their mortgage payments before they sell the property. Therefore, a major encumbrance on the real estate being purchased is the seller’s mortgage.

One of two things can happen with respect to the seller’s loan at closing: It will be satisfied out of the sale’s proceeds, or it will be taken over by the buyer. Which- ever event occurs, the seller must have the proper papers ready at the closing. With the aid of the seller’s lender and lawyer, either a certificate of satisfaction or the loan assumption papers must be prepared. (Mortgage assumptions are quite rare.)

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Cooperating with Inspectors As mentioned earlier, the seller may be obligated to cooperate with the various

inspectors a buyer may hire to inspect the property for termite damage or structural/ functional defects in the property. Cooperation includes making the property available to the inspector and having utilities available to fully test the mechanical systems.

Other Responsibilities If the property being sold is for a development project, the seller may have con-

tractual duties to assist the buyer in changing the zoning restrictions. On closing a transaction involving rental property, the seller must turn over all valid leases to the buyer. In addition, the rent schedules and copies of letters to all tenants informing them of the change of ownership must be provided.

Once again, a sales contract can place special duties on both the buyer and seller, and generally, these contractual obligations must be performed before the transac- tion is closed. Failure to do so may void the contract, as the buyer in the Legal High- light on the following page discovered.

Costs at Closing

A prospective purchaser of real estate may save up money for the down payment only to learn that he or she needs more cash to cover the closing costs. The elements of closing costs vary from time to time and from location to location, but generally the buyer must pay for the following items in cash:

■■ Loan origination fee

■■ Loan discounts, or points

■■ Appraisal fee

■■ Credit report fee

■■ Lender’s inspection fee

■■ Mortgage insurance premium

■■ Attorney or closing agent’s fees

■■ Hazard insurance premium

■■ Recording fees for the mortgage he or she gives (yes, the borrower gives a mortgage in exchange for the loan)

The loan origination fee, the points, and the mortgage-guarantee insurance pre- mium usually are based on a percentage of the loan. For example, the loan origina- tion fee—the fee charged by the bank to process the loan—may be 1% to 3% of the amount of the loan. Points are an extra charge made by the bank; each point is 1% of the amount of the loan. (Points and other financing charges are discussed in Chapter 18.) The typical mortgage insurance premium is 2% of the amount of the loan, of which 0.5% is due at the closing. The other 1.5% is paid over a 10-year period. These types of closing costs generally total 2% to 6% of the money borrowed.

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The seller also has to pay closing costs, which may include the

■■ real estate brokerage commission;

■■ attorney or closing agent’s fees for preparing the deed or other documents;

■■ documentary stamp taxes, where required; and

■■ recording fees for the certificate of satisfaction of the seller’s mortgage.

r e a l e s t a t e t o d a y

l e g a l h i g h l i g h t

Necessity to Meet “Concurrent Conditions” by Date of Closing

Real estate sales contracts usually cre ate conditions that both parties must fulfill by the closing date. These are called concur rent conditions. Failure to

do so can void the contract, as one purchaser found to his sorrow.

On November 24, 85-year-old Lily Canham agreed to sell a 56-acre parcel of land in San Luis Obispo County, California, to real estate broker Jef frey Pittman for $250,000. The contract called for an initial deposit of $1,000 and a further deposit of $24,000 before closing. The balance of the pur chase price was to be paid by a note secured by a deed of trust on the property. The closing of escrow was to be within 30 days, and the contract provided that “time is of the essence.”

About the second week of December, Canham sent a signed copy of the deed to the escrow agent, which—he pointed out—had not been notarized. When broker Pittman contacted Canham, she told him she would have the deed notarized at an escrow agent near her home. By the closing date of Decem ber 24, Canham still had not sent the signed deed to the escrow agent, nor

had Pittman tendered the $24,000, promissory note or deed of trust. There the matter rested until the following May, when Canham told Pittman she had entered into a contract with other purchasers to buy her property for $600,000. Pittman wrote her a letter demanding she sell the prop erty to him as agreed in the earlier contract, but she refused and sold it to the other buyers. Pittman sued for breach of contract. He lost.

Under the contract, Canham was supposed to tender a signed and notarized deed by the closing date of December 24; Pittman was supposed to ten der a $24,000 deposit, note, and deed of trust. The court ruled that neither party had fulfilled the concur rent conditions called for in the contract by the clos ing date, resulting in a “discharge of both parties’ duty to perform.”

“We appreciate the reluctance of a buyer to act first by placing money into escrow. But in a contract with concurrent conditions, the buyer and seller can not keep saying to one another, ‘No, you first.’ Ulti mately, in such a case the buyer seeking enforcement comes in second; he loses.”

[Pittman v. Canham, 3 Cal. Rptr. 2d 340]

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A seller, however, generally does not have to worry about coming up with the cash to pay for these items. Such costs simply are subtracted from the proceeds of the sale.

Proration of Property Expenses

Certain property expenses must be prorated or shared by the buyer and seller. Such costs normally include state and local taxes, the hazard-insurance premium if that insurance policy is to be assigned to the buyer, and the monthly mortgage pay- ment, should the buyer assume the seller’s loan.

The costs of any other contracts that exist during the seller’s and buyer’s own- ership should be prorated. For example, the cost of a pest extermination contract purchased by the seller and not canceled by the buyer must be shared. Whether this proration will appear as a credit to the seller or to the buyer depends on which party pays the amount owed. In commercial sales, the collection or payment of rents also must be prorated equitably. If the property is heated by oil, the buyer must pay the seller for the oil remaining in the storage tank, usually at the current price per gallon.

Parties Present at the Closing

Although closings can be handled through the mail without ever having a group meeting of interested parties, the closing of a real estate sale normally is held at the offices of one of the people involved in the transaction: the real estate broker, the lending institution, the title insurance company, the seller’s attorney, or the buyer’s attorney. Obviously, the seller wants to be there to get his or her money, the buyer wants the deed and the keys to the doors, the broker wants the commission, the lender’s representative (who may be the title company) wants signatures on the mort- gage documents, and the title company and attorneys want to be paid. Usually, the appraiser, pest inspector, and surveyor are content to get their money from the clos- ing agent after the deal is closed.

Escrow Closing

Instead of the conventional closing described above, escrow closings are prac- ticed in some communities in the eastern United States and in the majority of west- ern states. Instead of the buyer and seller coming face to face, a third party called an escrow agent acts as an intermediary to facilitate the closing. The escrow agent is usually an attorney, a title company, a trust company, an escrow company, or the escrow department of a lending institution.

The seller deposits a fully executed deed with the escrow agent, who then deliv- ers the deed to the purchaser after the receipt of the purchase price. The agent then delivers the deed to the purchaser and the purchase price to the seller.

Some of the advantages of the escrow closing are (1) the seller is assured of receiving the buyer’s money before title passes because the check must clear before

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this occurs, (2) the buyer’s money will not be paid until the seller’s title is acceptable and free from liens, and (3) the parties need not be present. The last is particularly advantageous if one or both of the parties reside in other areas.

| chapter review __________________________________________

■■ A contract is a legal document that represents an agreement between two or more parties. The essential elements required before any contract is binding include (1) an offer, (2) an acceptance, (3) consideration, (4) par- ties with legal capacity, and (5) a lawful purpose. In addition, all states require that contracts involving any interest in land must be in writing and signed by the party against whom enforcement is sought.

■■ Failure to perform contractual duties is a breach of contract. Remedies available to a buyer for the seller’s breach include an order for specific performance, monetary damages, or the return of the earnest money. A seller generally cannot seek the specific performance of a buyer who has breached the contract, but will probably be able to retain any earnest money paid by the buyer and may be able to seek additional damage com- pensation through the courts.

■■ Most contracts include various contingency clauses that specify that the contract may be voided in the event of certain conditions. Common examples in real estate contracts include financing contingencies, title con- tingencies, and inspection and repair contingencies.

■■ Real estate sales contracts are, in essence, gap fillers. Such contracts must govern the parties’ rights between the time an agreement is reached to transfer property from one party to another and the time the transaction is formally completed, or closed.

■■ Several kinds of contracts may be used in a real estate transaction. Among the common types are the sales contract, the option-to-buy contract, and the contract for deed.

■■ The traditional real estate sales contract should consist of provisions speci- fying (1) the property description, (2) the purchase price and the way it is to be paid, (3) the escrow arrangement, (4) the effect on the contract of the destruction of improvements, and (5) the closing date.

■■ The option-to-buy contract gives the holder the right, but not an obliga- tion, to purchase the property at an agreed-on price on or before a speci- fied date. While the optionee is not obligated to perform, the optionor is obligated to honor the contract terms.

■■ Contracts for deed are a combination of a sales contract and a financing arrangement: The seller holds title to the property while the buyer makes payments over time. On paying the agreed-on amount, the seller will trans- fer title to the buyer.

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138 PA RT O N E Real Estate Legal Analysis

■■ Skilled negotiators realize that successful negotiations are not “zero-sum” games in which the parties attempt to capture all they can grab of the same pie. Keeping an open mind and looking for ways to create win-win situa- tions are important keys for becoming a better negotiator.

■■ The real estate transaction is “closed” when title to real property passes from the seller to the buyer. In essence, a closing—or settlement, as it is sometimes called—includes the closing of the loan, of the escrow arrange- ment, and of the title.

■■ Between the signing of the sales contract and the closing of the deal, both seller and buyer have certain responsibilities that must be completed. The buyer must obtain an opinion about the status of the title and attempt in good faith to secure the needed financing. Among other obligations, the seller must make sure that all encumbrances are removed and obtain the type of written deed the contract requires.

■■ Closing costs are the charges incurred by the buyer and seller at the close of the transaction. Such costs to the buyer include the loan origination fee, the loan discount points, and attorney’s fees. Costs to the seller may consist of the real estate brokerage commission and various recording fees. The buyer’s closing costs and the down payment often must be paid in cash. The seller’s closing costs are deducted from the amount due to the seller.

■■ At the closing, many papers are examined, signed, and exchanged by the parties. A successful closing of the transaction results in the transfer of the seller’s title to the buyer.

| key terms _______________________________________________

acceptance

agreements for deed

breach of contract

closing

consideration

contingencies

contract

contract for deed

contractual capacity

counteroffer

escrow agent

escrow closings

financing contingency

inspection and repair contingency

land contracts

offer

offeree

offeror

option-to-buy contract

partial performance

sales contracts

settlement

specific performance

statute of frauds

title contingency

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C H A P T E R 6 Contracts and Title Closings 139

| study exercises _________________________________________

1. List and explain the six essential elements of a valid real estate sales contract.

2. In a contract, what is meant by capacity? By consideration?

3. Mark offered to buy Charlie’s four-acre tract for $200,000, and they shook hands on the deal. Both men went to an attorney to draft the formal con- tract. The next day, Mark signed the written contract, but Charlie refused to do so because he had received a higher offer. What recourse, if any, does Mark have against Charlie for failing to abide by their oral agreement?

4. Suppose instead that Mark and Charlie had agreed on the deal and Mark wrote the terms of the sale on the back of an envelope, which both signed. They planned on hiring an attorney to “flesh out” the agreement and draft a more formal contract. Charlie refused to sign the formal contract, having received a higher offer. Could Mark force Charlie to carry out the contract?

5. Nell and Edward agreed that Nell would purchase Edward’s house and lot. Because both parties wanted to avoid the expense of having a formal contract drafted, they signed their names below the following handwrit- ten statement: “Nell hereby agrees to buy from Edward the house at 1023 Washington Avenue for $65,000. Closing to be within 60 days from today: September 13, 2007.” Nell had planned to borrow 90% of the purchase price but failed to qualify for this loan. Does Nell’s inability to obtain a loan excuse her from performance of the agreement as written?

6. After Kristy finished college and started working, she found a small house that she wanted to buy but could not afford. As an alternative, she agreed to lease the house with an option to buy it. To be valid, what must the option agreement include?

7. Answer the following questions based on the real estate sales contract depicted in Figure 6.1.

a. When does the buyer get occupancy of the premises?

b. What actions can the buyer take if the seller’s title proves to be unmarketable?

c. Whose responsibility is it to obtain and pay for a survey to detect any encroachments?

d. If an encroachment is detected in the survey, what happens?

e. Who must pay for the various closing costs associated with the deed?

f. What happens to this agreement if the property is destroyed by fire or other casualty before the closing?

g. What actions can the parties take if the other party breaches the contract?

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140 PA RT O N E Real Estate Legal Analysis

8. From the buyer’s perspective, what advantage does traditional mortgage financing offer in comparison to agreement for deed financing, even in states that treat these arrangements similarly?

9. Why might a buyer elect to use agreement for deed financing instead of traditional mortgage financing?

10. The Hoods and the Wakeleys entered into a formal contract whereby the Hoods agreed to buy the Wakeleys’ partially restored 80-year-old house. During the time period between the signing of the contract and the closing of the transaction, what things should the Hoods accomplish? What respon- sibilities do the Wakeleys have?

11. Internet Exercise: Visit the website www.hud.gov and search for a document called “Buying Your Home: Settlement Costs and Helpful Information.” Read the document and answer the following questions based on it.

a. How soon after applying for a mortgage loan should the lender provide a written “good-faith estimate” of the settlement charges you will likely have to pay in association with the loan?

b. Are you entitled to a copy of the appraisal report prepared in association with your loan application?

c. Does federal law dictate whether the buyer or seller must pay for certain settlement charges in a real estate sales contract or can the parties nego- tiate this issue?

| further reading _________________________________________

Nierenberg, Gerald I. The Art of Negotiating. New York: The Negotiation Institute, 1988.

Siedel, George, and Robert J. Aalberts. Real Estate Law, 8th ed. Mason, Ohio: South- Western, 2012.

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Real Estate Leases

7c h a p t e r

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143

c h a p t e r p r e v i e w

The previous chapter introduced the general requirements of real estate contracts with a focus on the sales contract. In this chapter, we consider another type of contract that is common in real estate markets: the lease. Real estate leases are contracts that transfer the rights of use and possession, but not owner- ship, of real estate between a landlord and tenant. Leases are the documents that create the leasehold estates discussed in Chapter 2.

We will consider

■■ the recommended elements of a lease;

■■ specific clauses in lease agreements; and

■■ duties of the lessor and lessee.

legal highlight Landlord’s Liability

for Failure to Provide Adequate

Maintenance

legal highlight Liability of

Landlords for Injuries to Guests of

Tenants

r e a l e s t a t e t o d a y

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144 PA RT O N E Real Estate Legal Analysis

| leases __________________________________________________

When a property owner agrees to transfer rights of use and possession (but not ownership) of the property to a tenant in exchange for rent or lease payments, the agreement is called a lease or rental agreement. Leases divide estates in land into two components: a leased fee estate and a leasehold estate.

Although some leases need not be put into written form (short-term residential leases, for example), most prudent real estate market participants know the impor- tance of making sure the agreement between parties is clearly stated in writing to minimize misunderstandings and disputes.

A lease is a type of contract, and its basic requirements are the same as the gen- eral requirements for contracts. Through the lease contract, the landlord conveys use and possession of the property in return for the tenant’s agreement to pay rent. The lease also defines the rights, duties, and liabilities of both landlord and tenant and should contain, at a minimum, the following elements:

■■ Names of the lessor (landlord) and lessee (tenant), both of whom must have contractual capacity to enter into the lease agreement

■■ Identification of the premises

■■ Conveyance of the premises

■■ Term or duration of the lease

■■ Amount of rent and manner of payment

■■ Duties and obligations of the parties

■■ Signatures of the parties

As in all contracts, a lease becomes valid when it is delivered and accepted. If the lease is for a term of one year or longer, it must be in writing to be enforceable in court.

Classification of Leases

Leases can be classified in several ways. Generally, they are classified by dura- tion of term, type of use, and method of rental payment.

Duration of Term The duration of the term of a leasehold estate determines whether it is a tenancy

for a stated period, a tenancy from period to period, a tenancy at will, or a tenancy at sufferance.

A tenancy for a stated period conveys the property to the tenant for a stated period of time, sometimes called the term. The term may be for any length of time from one month to many years, although in most states a lease for longer than 99 years is regarded as a fee simple transaction. Possession of the property reverts to the landlord at the end of the term, subject to any right of renewal set forth in the lease. Some states require that long-term leases, usually for more than five years, be recorded in the public record to be enforceable as a contract.

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C H A P T E R 7 Real Estate Leases 145

A tenancy from period to period is of indefinite duration. The tenancy does not terminate until proper notice is given by either party. It commonly exists from month to month and is renewed automatically at the end of each month, provided the tenant has paid the rent.

A tenancy at will may be terminated by either party at any time. Tenant- protection statutes, however, generally require reasonable notice on the part of the landlord—usually 30 days.

A tenancy at sufferance is created when a tenant continues to occupy property after the expiration of the lease period. The tenant has no right to the property and remains there at the sufferance of the landlord. Even so, many states require that the tenant be given notice to quit the premises before eviction proceedings can be instituted.

Type of Use Leases are often distinguished by the type of use to which the property will be

put. For example, a lease involving property that will be used for commercial pur- poses may be very different from a lease involving property that will be used for residential purposes. The laws regulating the relationship between parties to leases in some states differ significantly for commercial and residential leases. Many resi- dential leases specifically prohibit the tenant from using the property in a commer- cial capacity.

A ground lease is a long-term (usually 50 years or longer) lease involving unimproved land. The leased land is usually developed by the tenant for commer- cial, residential, or agricultural purposes. At the end of the lease, the land and any improvements revert to the landowner. Because such a lease makes it possible to separate the ownership of the land from the ownership of the improvements, the ground lease frequently is used as a financing device in the development of major office buildings.

For example, many Manhattan office buildings are built on leased land. Because the land often constitutes 30% to 40% of the cost of such projects, a ground lease can greatly reduce the amount of money the developer must raise. The ground lease can also offer substantial tax advantages to the lessee because lease payments are fully deductible from taxable income as an ordinary expense, whereas the cost of land cannot be depreciated—that is, the owners cannot reduce their taxes by stating on their tax return an amount by which the value of the land has decreased with age, as one can do in the case of buildings.

Methods of Rent Payment or Adjustment Arrangements for rental payments between tenant and landlord can take many

forms, and rental arrangements are far from uniform. Two factors that determine the form of the lease are the degree of overhead cost that is assumed by the tenant and whether the amount of rent is fixed or variable.

Under a gross lease, the landlord agrees to pay the real estate taxes, utilities, insurance, and all other operating expenses in connection with use of the premises.

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Under a net lease, the tenant pays the operating expenses in addition to rent. Such a lease transfers uncertainty regarding the future cost of operating expenses to the tenant and leaves the landlord with a more definite net return. Occasionally, the tenant assumes responsibility for other costs as well, so there are net-net leases and net-net-net leases. Under a net-net lease, the lessee pays not only operating expenses but insurance premiums as well. Under a net-net-net lease, also known as the triple-net lease, the lessee pays operating expenses, insurance premiums, and real estate taxes.

Under a fixed-rent lease, the amount of the rental payment is fixed for the term of the lease. This type of rental payment is most common for short-term residential leases. In the graduated-rent lease, or step-up rent lease, the rental payment is fixed for the initial term of the lease and then is increased by specified percentages at designated intervals. This type of lease provides some protection against inflation for the landlord and also may be used for a new business or property whose income- producing ability is expected to increase in the future.

The reappraisal lease is similar to the graduated-rent lease except that the level of each rent increase is determined by a reappraisal of the property. Such leases are used most often for the long-term rental of entire buildings. For example, if a tenant leases an entire warehouse for $10 per square foot, and the property value increases by 10%, the rent in the following year would be $11 per square foot.

The percentage lease is a lease of a property used for commercial purposes under which the rent payments are based on some percentage of sales made on the premises. Usually, the stated percentage of gross sales is combined with a flat mini- mum rent. Such leases are found predominantly in shopping centers, particularly in the larger malls. For example, a toy store in a mall may be charged a base rent of $1,500 per month, plus 2% of gross sales over $50,000. If the store’s December sales are $90,000, the rent will be $1,500 plus 2% of $40,000, for a total of $2,300. If January’s sales are only $25,000, the store will pay only the base rent of $1,500.

The percentage of gross sales charged as rent will vary, depending on whether the store is a low-margin/high-volume or high-margin/low-volume outlet and on its relative importance to the shopping center. For example, an “anchor” department store almost always can negotiate lower rent (on a per square foot basis) than can a small merchant.

Another type of lease is known as the index lease. In this arrangement, lease payments are “indexed” to some measure of the cost of living, such as the Consumer Price Index. Rents are adjusted periodically to account for changes in the value of the dollar. The adjustments provide protection for the landlord against inflation and rapidly changing prices in the economy.

| the landlord-tenant relationship ________________________

The purpose of the lease agreement is to define the relationship between the landlord and the tenant. Thus, a well-drafted lease should address such issues as the term of the lease, rent amount, rent adjustment process (if any), limitations on use, and responsibility for maintenance, expenses, renewal provisions, and so forth.

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C H A P T E R 7 Real Estate Leases 147

Renewal Options

Many leases contain a renewal option, a provision that protects the tenant against large increases in rent at the end of the initial lease term. The renewal option specifies what the rent will be if the lease is renewed, usually at a higher level to protect the landlord against rising costs. Without the renewal option, the landlord can raise the rent to any level desired. The tenant then has the option of paying the higher rent or moving out.

Expenses

The lease should state clearly who pays for expenses in connection with the property, including maintenance, property taxes, insurance, and utilities. In residen- tial leases, the landlord is usually responsible for normal maintenance to the building and for taxes and insurance on the real estate. Utilities usually are the responsibil- ity of the tenant, as is breakage or other damage caused by the actions of the ten- ant. In commercial leases, it is quite common for tenants to be held responsible for some portion of the landlord’s operating expenses of the property. Commercial leases often specify that tenants must pay common area maintenance fees (CAM fees) in addition to rent. Such leases often specify an expense stop that sets the maximum amount of operating expenses the landlord will pay. Above the stop, the tenants will be charged for all operating expenses that exceed the stop in proportion to the amount of space each tenant has as a percentage of the total space available in the property. Obviously, the language relating to responsibility for expenses can be a crucial part of commercial lease negotiations.

Assignment and Subleasing

It often is desirable to a tenant to be able to assign a lease or sublease to another tenant if plans change before the end of the lease term. Assignment means that all of the tenant’s rights under a lease are transferred to the new tenant, although the lessee still is liable unless released by the landlord. Subleasing means transferring a portion of rights under a lease. For example, a tenant could sublease an apartment for only six months of a two-year lease term. Under a sublease clause, the landlord may reserve the right to approve of any sublessee, generally for reasons of creditworthi- ness. Unless the landlord consents, the tenant is not relieved of his or her obligation to pay the rent.

If rents are rising, it may be possible to sublease to another tenant at a profit, receiving rent from the sublessee and then paying the required rent under the original lease to the landlord. In a long-term commercial lease, this “leasehold interest” may be worth literally millions of dollars. If the lease contains a clause against subleas- ing, then subleasing is a violation of the lease agreement and can result in eviction.

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148 PA RT O N E Real Estate Legal Analysis

Security Deposits

The lease may require that the tenant provide a security deposit prior to occu- pancy. Security deposits are intended to give the landlord protection if the tenant damages the property, moves out early, or fails to pay the rent. The landlord may also require that the tenant pay a cleaning fee at the termination of the lease, which is usually withheld from the security deposit owed to the tenant. Deposits make it essential that both landlord and tenant inspect the property before occupancy and note any damages that may exist.

Improvements

If a tenant makes improvements to a rented property, the tenant must recognize that unless they can be removed easily, these improvements normally become part of the real estate (fixtures) and remain with the property when the lease expires. If built- in bookcases were added to a residential property, for example, these would become a fixture and part of the property. But, added shelving to a commercial property would normally be considered a trade fixture and would remain the property of the tenant at the end of the lease. We discussed fixtures and trade fixtures in Chapter 2. Before making any improvements or adding any items to the real estate, it is wise to reach a written agreement with the landlord regarding who will own them at the termination of the lease.

Let’s consider the commercial real estate lease agreement shown in Figure 7.1 to better understand the details of such agreements. Keep in mind that an important purpose of any lease agreement is to define the relationship between the landlord and the tenant, including each party’s obligations and any limitations placed on either party by the other. The property being leased is a storefront in a strip shopping cen- ter owned by an investment holding company. The tenant will use the storefront as a neighborhood bar and grill called “The Astor Pub.”

The first portion of the lease identifies the landlord, the tenant, and the property and specifies the starting and ending dates of the lease term. The remainder of the document is divided into numbered paragraphs that can be referred to by the par- ties. There is nothing special about the ordering or naming of these paragraphs—the attorney who crafted the document merely included them for easy reference. We will talk about the most interesting paragraphs here.

The purpose of paragraph 1 is to specify the rent to be paid by the tenant. This lease requires the tenant to pay a monthly base rent (which will be increased each year by a fixed percentage) in advance by the first day of each month. The tenant must also pay additional rent that includes a common-area maintenance fee (subject to adjustments each year based on changes in actual maintenance cost), a prorated share of the increases in property tax and insurance (based on the square footage of the leased space as a proportion of the space in entire shopping center), and a per- centage of the tenant’s gross sales in excess of a specified amount. Should the tenant not pay any month’s rent within the first five days of the month, the tenant must also pay late rent.

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C H A P T E R 7 Real Estate Leases 149

f i g u r e 7.1 Lease Example

COMMERCIAL REAL ESTATE LEASE AGREEMENT

In consideration of the covenants herein contained, Astor Pub, Inc., hereinafter called “Tenant” and MTA Investments LLC, hereinafter called “Landlord”, agree as follows:

For the period of time beginning on July 1, 2011, and ending at midnight on June 30, 2016, Landlord hereby grants to Tenant the sole and exclusive right to lease the real property known as Suite A-112 of The Shoppes of Elan Center, 3853 Palomar Drive, Charleston, SC 29406.

1. RENT. Tenant shall pay Monthly Base Rent and Additional Rent to the Landlord as follows: (a) MONTHLY BASE RENT. Tenant shall pay a Monthly Base Rent to the Landlord for

each month during the term of this lease or any renewal thereof, in advance on or before the day of each month during the term of this Agreement. The amount of the Monthly Base Rent for the first year of this Agreement shall be THREE THOUSAND EIGHT HUNDERED EIGHTY Dollars ($3,880.00).

(b) The rental for the first month of this lease shall be paid at the date of execution thereof. The Monthly Base Rental shall be increased as follows: 3% annually.

(c) ADDITIONAL RENT. In addition to the Monthly Base Rent and any accumulative adjustments, Tenant shall pay Additional Rent as indicated herein. 1. PROPERTY TAXES: Tenant shall pay annually a sum equal to any increase in

real estate taxes (ad valorem, special assessments and any other government charges to include any solid waste disposal user fees) over those assessed for the year of 2011, on a pro rata basis.

2. PERCENTAGE OF GROSS SALES. Tenant shall pay annually a sum equal to 3% of gross sales in excess of FIVE HUNDERED THOUSAND Dollars ($500,000), in any lease year. Tenant shall deliver to Landlord within 15 days following the end of each lease year a written statement signed and certified by Tenant to be a true and correct statement of the amount of gross sales during the proceeding lease year. Tenant shall at the same time pay the amount of Additional Rent due (if any) as a percentage of the excess over the amount herein stated.

3. COMMON AREA MAINTENANCE. Tenant shall pay on the first day of each month, in advance, a fee equal to the Tenant’s pro rata share of the cost of maintaining common areas. Tenant’s common area maintenance fee for the remaining portion of the calendar year in which this lease became effective shall be SEVEN HUNDRED Dollars ($700) per month. Said fee shall be adjusted at the end of each calendar year to reflect any increase in cost during said year.

4. INSURANCE. Tenant shall pay annually a sum equal to any increase in insurance premium for the year of 2011, on a pro rata basis. Presentation of copies of insurance bills shall constitute sufficient evidence of additional rent due and shall be payable within fifteen (15) days after receipt thereof.

5. LATE RENT. If rent is not paid within five (5) days after due date, the Tenant is subject to a one-time late fee of THREE HUNDRED Dollars ($300).

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150 PA RT O N E Real Estate Legal Analysis

f i g u r e 7.1 Lease Example (continued)

2. SECURITY DEPOSIT. Upon execution of the lease by the Tenant, the Tenant shall pay to Landlord a Security Deposit in the amount of THREE THOUSAND Dollars ($3,000). Any security deposit required by Landlord and paid by Tenant shall be retained as security (interest free) for the faithful performance by Tenant of all terms, covenants and conditions herein. The Security Deposit, less any unpaid amounts due to the landlord by the tenant under the covenants of this Agreement, shall be returned to the Tenant within 30 days of the end of the lease term.

3. TENANT'S UTILITIES. Tenant shall pay all charges or bills for the utility and services used by the Tenant.

4. USE OF PREMISES. Tenant agrees not to abandon or vacate the Premises and to use entire leased Property for a neighborhood style bar and grill and for no other purposes without the express written consent of the Landlord.

5. EXAMINATION OF PREMISES. Tenant has examined the Premises and is familiar with their present condition. Tenant, relying solely on said examination, agrees to accept Premises in their present “as is” condition.

6. LIABILITY INSURANCE. Tenant shall not carry any stock of goods or do anything in or about the Premises which will in any way restrict or invalidate any insurance coverage of the Premises.

7. MAINTENANCE AND REPAIRS. Landlord shall repair and maintain the foundation, roof, outer walls and structural members of the Premises. Tenant shall, at Tenant’s sole expense, make all other repairs necessary to maintain the Premises, both interior and exterior.

8. SANITATION. Tenant shall keep the Premises clean, safe, sanitary, and in compliance with laws, ordinances and requirements of any legally constituted public authority.

9. ALTERATIONS. Tenant shall make no alterations, additions, improvements, or rewiring in or to the Premises without the written consent of Landlord.

10. ASSIGNMENT OR SUBLEASE. Tenant shall not, without written consent of Landlord, in each case, assign, transfer, mortgage, pledge or otherwise encumber or dispose of this lease, or sublet the Premises or any part thereof.

11. SIGNAGE. Tenant shall place no signs, notices, pictures, or advertising matter upon the exterior of the lease Premises except with the written consent of the Landlord.

12. RULES AND REGULATIONS. Landlord reserves the right at any time to make further rules and regulations as in Landlord’s judgment that may be necessary for the safety, care, appearance, and cleanliness of the Premises and the entire property, and the preservation of good order herein, and such other rules and regulations shall be binding upon the parties hereto with the same force and effect as if they had been contained herein at the time of execution hereof.

13. RIGHT OF ENTRY. Landlord, without being liable for trespass or damages, shall have the right to enter Premises during reasonable hours, with reasonable prior notice, to examine same or make repairs, additions, or alterations as Landlord may deem necessary for the safety, comfort, appearance, or preservation thereof or to exhibit said Premises.

14. DAMAGE OR DESTRUCTION OF PREMISES. If Premises are totally destroyed by fire or other casualty, this lease shall terminate as of the date of such destruction. If Premises are damaged but not wholly destroyed by the fire or other casualty, rent shall abate in such proportion as use of Premises has been lost to the Tenant. Landlord shall

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C H A P T E R 7 Real Estate Leases 151

f i g u r e 7.1 Lease Example (continued)

restore Premises to substantially the same condition as prior to damage as speedily as practicable, whereupon full rent shall commence.

15. DAMAGE TO PERSONAL PROPERTY. All personal property, merchandise, fixtures and equipment placed or moved into the Premises shall be at the risk of Tenant or the owners thereof and Landlord shall not be liable for any damages, loss or theft of said personal property, merchandise, fixtures, or equipment, from any cause whatsoever.

16. ESTOPPEL. Tenant shall from time to time, within ten days following written notice from Landlord, execute, acknowledge, and deliver to the Landlord a written statement certifying that this Agreement is in full force and effect.

17. DEFAULT. If Tenant fails to comply with any covenant of this Agreement, including failure to pay Monthly Base Rent including Additional Rent on or before the due dates as herein stated, Tenant shall be in default.

18. ATTORNEY’S FEE. In the event Landlord successfully defends any action by the Tenant, or if it is necessary for Landlord to employ an attorney for the collection of rent or any other sum due hereunder, or to enforce any covenant of this lease, or the termination of this lease, or for the possession of the Premises or any part thereof the Tenant shall pay all costs, including reasonable attorney’s fees.

19. SUBORDINATION. Tenant agrees that this Agreement shall be subject and subordinate to any mortgages, deeds of trust or any ground lease now or hereafter placed upon the Premises and to all modifications thereto, and to all present and future advances made with respect to any such mortgage or deed of trust.

20. ENVIRONMENTAL MATTERS. Tenant represents, warrants and covenants to Landlord throughout the Term of this Agreement as follows that Tenant is and agrees to remain in compliance with all applicable federal, state and local laws relating to protection of the public health, welfare, and the environment (“Environmental Law”) with respect to Tenant’s use and occupancy of the Premises.

21. AMERICANS WITH DISABILITIES ACT. Any other provision of this Agreement notwithstanding, the parties hereby agree that the Premises may be subject to the terms and conditions of the Americans with Disabilities Act of 1990 (hereinafter the “ADA”). The parties further agree and acknowledge that it shall be the sole responsibility of Tenant to comply with any and all provisions of the ADA, as such compliance may be required to operate the Premises.

22. ENTIRE AGREEMENT. This lease contains the entire agreement between the parties hereto and it may be modified only by a dated written agreement signed by both Landlord and Tenant. TIME IS OF THE ESSENCE WITH REGARD TO ALL TERMS AND CONDITIONS IN THIS AGREEMENT.

IN WITNESS WHEREOF, this Agreement has been accepted and duly executed by the parties.

Tenant: ______________________________________________________________________ Date Landlord: ____________________________________________________________________ Date

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Paragraph 2 specifies the amount of a security deposit to be paid by the tenant to the landlord. This deposit protects the landlord against potential losses associated with the tenant defaulting on the agreement. The landlord must return the deposit to the tenant at the end of the lease term if the tenant does not default on the agree- ment. Paragraph 17 specifies the potential tenant actions and inactions that constitute default.

In this lease, the tenant must pay for utilities, such as water and electricity (para- graph 3). The tenant may only use the property as a bar and grill (paragraph 4). The tenant accepts the property in its present “as is” condition as of the starting date of the lease term (paragraph 5). The tenant may not stock any goods or conduct any activities in the leased space that would increase the landlord’s cost of insuring the property (paragraph 6). The landlord must repair and maintain the four main parts of the building (foundation, roof, outer walls, and structural supports), but the tenant is responsible for repairs and maintenance to all other building components in both the interior and exterior of the leased space (paragraph 7).

The lease requires the tenant to maintain the leased space in a sanitary condition (paragraph 8). The tenant is prohibited from making alterations to the property with- out the landlord’s consent (paragraph 9). Likewise, the landlord’s consent is neces- sary for assigning or subletting the space and for placing any signs on the exterior of the property (paragraphs 10 and 11). The landlord, at the landlord’s discretion, has the right to impose additional rules and regulations beyond those already contained in the lease agreement. The tenant must observe these rules as if they are part of the lease agreement (paragraph 12). The landlord retains the right to enter the leased space for specific purposes with prior notice to the tenant (paragraph 13).

Paragraph 14 addresses the possibility that the leased space might be destroyed or damaged by fire or other events. In the event of total destruction, the lease agree- ment terminates immediately. In the event of damage that prevents the tenant from using the space, the tenant is not required to pay rent until the landlord repairs the damage and the space becomes usable again. Paragraph 15 specifies that the landlord is not liable for damages or losses to the tenant’s personal property within the leased space.

Paragraph 16 requires that the tenant comply with requests for estoppel cer- tificates: a written statement from the tenant that acknowledges the existence of the lease agreement. Lenders and potential buyers often require such acknowledgements (as we saw in the sales contract example in Chapter 6) as part of their lending and purchase decisions.

Paragraph 18 specifies that the tenant is responsible for any attorney fees or other costs that may be incurred by the landlord as a result of the tenant’s actions or inactions. Paragraph 19 specifies that the lease agreement is subordinate to any exist- ing or future mortgages, deeds of trust, or ground leases. As such, any foreclosure on the property will either automatically terminate the lease or entitle the lender, at its option, to terminate the lease. Paragraph 20 requires that the tenant comply with all environmental regulations during the tenant’s use and occupancy of the leased space. Similarly, paragraph 21 requires the tenant to comply with all applicable require- ments of the Americans with Disabilities Act of 1990.

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Lastly, paragraph 22 makes it clear that everything the landlord and tenant have agreed to is specified in the lease agreement document. Neither party can hold the other party accountable for anything said or unsaid before or after the date of the agreement that does not appear in this document. It also says that time is of the essence, meaning that the parties must precisely comply with the time periods defined in the document.

The Rights and Obligations of Tenant and Landlord

The fundamental right of the landlord is to receive rents, while that of the ten- ant is to use, enjoy, occupy, and possess the leasehold premises. The tenant has the right of exclusive possession of the property during the period of the lease, known as the covenant of quiet enjoyment, and can use the property in any legal manner that is agreed to in the lease document. Unless exceptions are made in the lease, the landlord cannot enter the property except to abate some nuisance or prevent destruction of the property. For example, a landlord could enter a tenant’s premises without securing permission to repair a burst water pipe but not to make alterations or improvements without the tenant’s prior consent. Conversely, the tenant cannot alter the leasehold premises without the permission of the landlord. The tenant has the obligation to pay the rent when due and not violate any of the lease provisions. If the tenant fails to pay the rent or violates other provisions of the lease, the landlord can move to have the tenant evicted from the premises.

Under the implied warranty of habitability principle, the landlord also has the obligation to maintain the premises in reasonable condition. Should a landlord fail to do so, many states have granted tenants of residential property the right to repair minor defects and deduct the cost of such repairs from rent payments. Local ordinances also require that landlords meet city and county health and safety codes.

Landlords also have the obligation to maintain common areas, such as elevators, hallways, and grounds, in a safe condition. If they do not, they may be liable for injuries that result from any defects or lapses in security.

The landlord’s responsibility to protect tenants against criminal acts committed by third parties is still a murky area; nevertheless, courts are increasingly awarding tenants damages when landlords are held partially responsible because of some type of negligence (such as not repairing locks, etc.).

Many leases contain provisions giving the tenant the option of renewing the lease before its expiration. As mentioned above, this does not necessarily mean, however, that the lease can be renewed with the same terms as in the old lease, and rental rates often are raised at this time.

A lease may contain one or two distinct types of renewal clauses. If, by its terms, a lease is renewed automatically if neither party gives notice of termination, a negative renewal clause is involved. A lease that provides for renewal only when the tenant gives notice to the landlord that renewal is desired contains a positive renewal clause. In accordance with this latter provision, if no notice of renewal is given properly, the landlord-tenant relationship terminates at the end of the original lease period.

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Most leases have a specific time period within which notice to terminate (under a negative renewal clause) or notice to renew (under a positive renewal clause) must be given. Although the landlord and tenant always may agree to whatever time period they desire, one to two months prior to the expiration of the lease is very common.

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Landlord’s Liability for Failure to Provide Adequate Maintenance

Landlords have the duty to provide ade quate maintenance on their properties, and when they do not, a tenant may collect dam ages for any harm that

results. This the Hav erford Place Apartments discovered.

Shortly after Elizabeth Stroot moved into the Haverford Place Apartments she noticed mold around the windows and in the bathroom. She attempted to remove the mold with bleach, but it kept returning. There were also leaks in Stroot’s bathroom ceiling; within a few months the leaks had caused holes in the drywall, and the edges of these holes were covered with a black substance. When ever the tenants above Stroot showered, black water ran out of the holes.

Stroot complained to the management, but she was told that the problem was caused by the upstairs tenants taking “sloppy” showers. The lessors did nothing to fix the problem, even after Stroot made an emergency call to the maintenance department com plaining that the hole in the ceil- ing was so large that it was not just leaking, but “raining.” The manage ment still did not attempt to fix the problem, and finally the bathroom ceiling collapsed, flooding the bathroom floor. The drywall debris and the exposed ceiling area were covered with black, green, orange, and white mold, which emitted a strong, nauseating odor. When Stroot

called maintenance, she was told they could do nothing until the following day.

By the next morning Stroot, who had suffered from allergies and asthma since childhood, could not breathe and was rushed to the hospital by ambulance. During the 21 months she had lived at Haverford Place, her medical problems had increased significantly, forcing her to go to the emergency room 7 times for asthma attacks, spend 9 days as an inpatient and receive intravenous steroids 12 times.

Stroot sued for damages, and at trial several experts testified there was excessive and atypi- cal mold growth in the apartment buildings, that it was caused by the landlord’s failure to maintain the buildings, and that the high concentration of toxic mold significantly and permanently increased the severity of Stroot’s asthma. The jury agreed, award ing Stroot $5,000 for property damage and $1,000,000 for personal injuries. The landlord appealed, claiming that the jury award “was so excessive as to shock the conscience.” The land- lord lost, the court ruling that “given the permanent nature of Stroot’s injuries as well as the physical and emotional pain and suffering Stroot will have to endure for the remainder of her life,” the verdict was not excessive.

[New Haverford Partnership v. Stroot and Wat- son, 772. A.2d 792, Supreme Court of Delaware]

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State Statutes Affecting the Landlord-Tenant Relationship

In addition to the agreed-on lease terms, the relationship between a landlord and tenant may be further defined by state laws that regulate the relationship. For exam- ple, state laws dictate the eviction process that landlords must follow for removing tenants who have violated the lease agreement, including the nonpayment of rent. Similarly, state laws may specify how long the landlord has to return any security deposit at the end of a lease, assuming the tenant has not damaged the landlord’s property. Laws such as these vary dramatically from state to state. To view the actual statutes, visit the website at www.nolo.com and follow the links to your state.

| chapter review __________________________________________

■■ A lease is a contract that conveys use and possession of a property from the landlord to the tenant in return for the tenant’s agreement to pay rent.

■■ The four types of leasehold estates in regard to duration of term are (1) tenancy for a stated period, (2) tenancy from period to period, (3) ten- ancy at will, and (4) tenancy at sufferance.

■■ A ground lease is a lease of land to the exclusion of any improvements. Such leases frequently are used as a financial device in the development of major office buildings.

■■ In a gross lease, the landlord agrees to pay the overhead expenses that arise in connection with the use of the premises. In a net lease, the tenant pays the operating expenses.

■■ Rental payments can be fixed or variable under a lease. In a graduated-rent lease, the payment is increased by specified percentages at stated intervals, while under a reappraisal lease, the level of each rent increase is deter- mined by a reappraisal of the property. A percentage lease is a lease of property used for commercial purposes under which the rental payments are based on some percentage of sales made on the premises.

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Liability of Landlords for Injuries to Guests of Tenants

Dr. Thomas Luck (his real name) was attending a medical meeting in Winston-Salem, North Caro- lina. After the conference had ended for the day he spent the

evening and night with his daughter at the Hill Top Ridge apartment complex.

During the night it began to snow, and another tenant noticed that the frozen precipitation had made the outside stairs that provided access to the apartment quite slippery, but she did not inform the management. Early the next morning, the apart- ment’s site manager checked the weather, and find ing only slush on the steps outside his own apartment, believed there was no need to clear snow or ice from the property.

Later that morning, Dr. Luck left his daugh- ter’s apartment, carrying a small bag in his left hand and a clothes bag over his shoulder. The lighting was dim and there was a light fog. When he reached the second step from the top of the exposed stairway, he hit the ice and slipped. He grabbed at the slick, ice-coated handrails, but to no avail. Dr. Luck fell down the staircase all the

way to the bottom, suffer ing permanent injuries. He sued the apartment own ers and managers, alleging that their negligence caused him to be permanently paralyzed, lose his medical practice, and suf fer great financial loss.

Dr. Luck’s ability to gain compensation for his losses hinged on whether he was an “invi tee” or a “licensee” under North Carolina law. An invitee is someone who is invited to be on the property, such as a customer in a store, and the law affords them considerable protection against negli gence by the landlord. A licensee, on the other hand, is a social guest of the owner or the tenant, and under North Carolina law only “willful or wanton conduct” on the part of the landlord will result in liability. The court ruled that although the apartment complex perhaps should have made sure that the steps were clear of ice, they were not guilty of willful or wanton conduct. As a social guest of his daughter, Dr. Luck was not entitled to recover for any alleged damages. Dr. Luck was out of luck.

[Luck v. GWWS L. P., 1997 U.S. App. LEXIS 39011, U.S. 4th Circuit]

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| key terms _______________________________________________

assignment

common area mainte- nance fees

covenant of quiet enjoyment

expense stop

fixed-rent lease

graduated-rent lease

gross lease

ground lease

index lease

lease

lessee

lessor

net lease

net-net lease

net-net-net lease

percentage lease

reappraisal lease

renewal option

rental agreement

security deposit

step-up rent lease

subleasing

tenancy at sufferance

tenancy at will

tenancy for a stated period

tenancy from period to period

term

warranty of habitability

| study exercises _________________________________________

1. Define the following terms: lease, lessor, lessee, tenancy for a stated period, tenancy from period to period, tenancy at will, tenancy at sufferance.

2. What is the difference between a gross lease and a net lease?

3. Define the following terms: percentage lease, graduated-rent lease, ground lease, reappraisal lease, and index lease.

4. What is the difference between subleasing and assignment? When is sub- leasing desirable for the existing tenant?

5. What do the terms covenant of quiet enjoyment and warranty of habitability mean?

6. Do expense stops limit the expenses paid by the landlord or the tenant?

7. Based on the Legal Highlight involving Dr. Luck on page 156, are land- lords liable for injuries suffered by guests of tenants?

8. What purpose do security deposits serve from the lessor’s perspective?

9. What is the difference between a negative renewal clause and a positive renewal clause?

10. Al’s Shoe Store has a percentage lease that requires a base rent of $2,000 per month, plus 2% of monthly gross sales over $10,000. What will the rent be when the monthly gross sales are $18,000?

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| further reading _________________________________________

Bogart, Daniel, and Celeste Hammond. Commercial Leasing: A Transactional Primer. Dur- ham, N.C.: Carolina Academic Press, 2007.

Stewart, Marcia, and Ralph Warner. Leases and Rental Agreements. Berkeley, Calif.: Nolo Press, 2013.

p a r t t w o

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p a r t t w o

Real Estate Service Industries

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8c h a p t e r Real Estate Brokerage

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161

c h a p t e r p r e v i e w

Real estate brokers are trained specialists who assist individuals, firms, and other entities in their real estate transactions for compensation. A real estate broker’s specialized knowledge is extremely valuable to those who purchase and sell real property infrequently and may not be familiar with the complexities of real estate transactions. To ensure that those who call themselves real estate brokers are competent to perform the task, each state has adopted professional licensing laws that regulate the real estate brokerage profession.

The objective of this chapter is to describe the typical real estate sales process, then consider numerous aspects of the real estate brokerage business, including

■■ the difference between real estate brokers and sales associates;

■■ state licensing and regulation of brokers and sale associates;

■■ the legal nature of agency relationships;

■■ the role of real estate brokers in real estate transactions;

■■ types of listing agreements, namely the (1) exclusive-brokerage listing, (2) exclusive-right-to-sell listing, (3) open listing, (4) net listing, and (5) limited service listing;

■■ the buyer representation agreement;

■■ duties and rights of brokers, sellers, and buyers;

■■ termination of agency relationships;

■■ types of real estate brokerage firms and their characteristics; and

■■ issues relating to broker and sales associate compensation.

legal highlight The Seller’s Agent’s Obligations to the

Buyer

legal highlight Fair Housing

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| the real estate sales process ___________________________

When a property owner decides to sell a property or a potential buyer decides to purchase one, real estate brokers can often provide useful assistance. The primary functions of the real estate brokerage industry are to match properties and customers and guide the buyer and seller through the complexities of real estate transactions. Both buyers and sellers of real estate need to understand the sales process, which typically involves the following steps: (1) listing, (2) marketing the property and qualifying buyers, (3) presentation and negotiations, (4) contracts, and (5) settlement or closing.

Listing Agreement

The listing agreement is the contract that defines the relationship between the property owner and the real estate broker. This agreement authorizes the broker to begin searching for a buyer for the specified property. Perhaps the most critical point in the listing agreement is the determination of an offering (or listing) price. Most sellers do not have adequate market information to determine the value of their prop- erty. If the offering price is priced too high, the property probably will not sell within a reasonable period of time, if at all; if it is too low, the owners will not receive as much as they should. In addition to specifying the offering price, the listing agree- ment usually defines the amount of compensation due to the broker for finding a buyer, how long the broker has to search for a buyer before the relationship ends, and any other details of the relationship between the property owner and the broker.

Marketing the Property and Qualifying Buyers

With the listing agreement in place, the broker will then begin marketing the property to potential buyers. Marketing techniques include a For Sale sign on the lawn, newspaper advertisements, special television advertisements, open houses, and internet-based advertising. As responses to these advertisements are received, the broker will then deal with potential prospects directly.

In the process of searching for a buyer, the broker provides an important service for the seller: separating true prospects from casual shoppers or those who really do not have adequate financial resources to buy the property. For example, a couple earning $30,000 a year and having little available equity may be quite ready and willing to buy a $175,000 house, but they probably will be unable to pay for it. The process of examining buyers’ ability to purchase the property is known as qualifying the buyer. Mortgage lenders also use this phrase when they determine a borrower’s creditworthiness.

Presentation and Negotiations

After the broker has found a qualified and interested buyer, a period of presenta- tion and negotiation begins. This period can last for a few hours or many months,

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depending on such factors as the complexity of the transaction, the extent to which the property actually meets the potential buyer’s perceived needs, and, of course, price. The buyer should remember that in these negotiations the broker generally is employed by the seller and is obligated to represent the seller’s interests. Accord- ingly, in any complicated transaction, buyers may want to employ the services of a broker to represent their interests.

Contracts and Closing

If the parties agree, a contract that spells out the details of the agreement is drawn up and signed by both seller and buyer, a process discussed in Chapter 6. Though the broker cannot provide legal advice unless he or she is a licensed attorney, the broker can assist the parties in negotiating an agreement and committing that agreement to paper. After insurance is obtained, financing is arranged, and the deed and other necessary legal papers are prepared, the transaction can be closed. At the closing, or settlement of the transaction, ownership is formally transferred to the buyer. Real estate closings were also discussed in Chapter 6. With this general discussion of the real estate sales process in mind, we now turn our attention to more specific aspects of the real estate brokerage business.

| real estate brokers and sales associates ________________

In general terms, a broker is an intermediary who brings together buyers and sellers, assists in negotiating agreements between them, executes their orders, and receives a commission (or brokerage) in compensation for services rendered. The broker does not take ownership of the item being transferred from seller to buyer but merely negotiates a transaction between the parties to the transaction. A real estate broker is a specialized type of broker—an intermediary licensed by the state in which he or she operates—who arranges real estate sale or lease transactions for a fee or commission. A real estate associate is also a broker in the general sense but, under the laws of the state, is authorized to act only under the direction of a licensed real estate broker. In other words, sales associates can carry out only those responsi- bilities assigned to them by their supervising broker.

| licensing of sales associates and brokers ________________

Although you need not hold a real estate license to conduct real estate transac- tions on your own behalf, a license is required if you engage in real estate activities on behalf of someone else. The license and educational requirements imposed by states generally do not constitute serious obstacles to most people who want to enter the field, and the number of brokers and sales associates in the industry tends to expand or contract with swings in demand for real estate. Most states have a website where the licensing requirements and application materials for various real estate professions (brokerage, appraisal, property management, etc.) can be found.

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All states and the District of Columbia require that real estate sales associates and brokers obtain a license. (Some states do not distinguish between sales associ- ates and brokers and only issue one type of license.) The license requirements vary from state to state and also depend on whether the applicant wishes to become a sales associate or a broker. Typically, an applicant for a sales associate’s license must have completed high school and a minimum number of hours in approved real estate courses. In addition, the applicant must pass a written test given by the state real estate licensing authority. The prospective sales associate usually needs no pre- vious experience if educational requirements have been satisfactorily met. To obtain a brokerage license, however, the applicant usually must work for a specified period of time (usually one year or more) as a licensed sales associate, complete additional real estate educational courses, and pass a more comprehensive written test.

States now have continuing education requirements for both sales associates and brokers. The intent of these requirements is to ensure that those involved in real estate brokerage keep abreast of current developments in the field. Successful completion of the required course is a prerequisite for license renewal.

Because real estate licensing laws and regulations change from time to time, readers interested in obtaining a real estate license should contact their state real estate licensing authority for full details on current licensing requirements.

| real estate brokerage regulation ________________________

In addition to licensing sales associates and brokers, the state real estate licens- ing authority or a similar body is responsible for ensuring that licensees obey laws designed to protect the public from unscrupulous business practices. These include misrepresentation, fraud, and failure to comply with fair housing laws. If the licens- ing authority finds a licensee guilty of an infraction, it may revoke or suspend that person’s license or invoke similar penalties.

In more severe cases, a legal judgment may be brought through a lawsuit by the injured party against a licensee or firm. Because these judgments sometimes are uncollectible due to the defendant’s poor financial status, roughly 40 states either require that real estate brokers be bonded or, more commonly, maintain a state- sponsored recovery fund. A portion of each real estate license fee goes into the recovery fund, available to pay uncollectible judgments against licensees.

| legal aspects of the broker-client relationship __________

Because people have neither the time nor the knowledge to accomplish every- thing they want or need to do, they hire other people to assist them. This certainly is true in real estate transactions, where a specialized knowledge of markets, law, and financing is vital to the success of the transaction.

The law recognizes the relationship between an employer and an employee as that of principal and agent. The principal (employer) is the person who authorizes the agent (employee) to act on his or her behalf. The agent is a fiduciary of the principal, which means the agent is in a position of confidence and must perform

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his or her duties in the best interest of the principal. In addition to fair dealings, the principal owes the agent compensation for services, and the agent owes the principal the duties of good faith, diligence, and loyalty.

The legal relationship known as agency is applicable to real estate transactions in several ways. First, a seller of real estate may authorize a broker to help locate a buyer. Second, a potential buyer may engage the services of a broker to search for available properties. Third, many brokers hire sales associates to assist in locating buyers and properties. These three relationships are created from written or oral con- tracts. In each case, one party is the principal, and the other is the agent. The broker is the agent in the relationship with the client (either seller or buyer), and the broker is the principal in the relationship with a sales associate. The sales associate is an agent of the broker and a subagent of the broker’s principal.

| the role of real estate brokers _________________________

Real estate brokers and sales associates play an important role in many real estate transactions. Traditionally, real estate brokers have been hired by property owners to help locate buyers for their property. The broker’s role is to advertise and market the property and assist the seller in finalizing the transaction once a buyer is found. In this situation, the broker is an agent of the seller. Brokers may also repre- sent property owners who wish to lease their properties to tenants. Property manage- ment and leasing are discussed in Chapter 15.

Many real estate transactions involve more than one broker. Frequently, one bro- ker (called the listing broker) obtains a listing agreement with the property owner, while another broker (called the selling broker) actually locates a buyer. The selling broker in such a transaction may represent either the buyer or the seller. If the selling broker represents the seller, he or she is an agent (subagent) of the seller. If the sell- ing broker represents the buyer, the broker is an agent of the buyer.

Increasingly, potential buyers are hiring brokers to assist them in locating a property for purchase. As a buyer’s agent, the broker’s role is to identify properties that meet the buy- er’s specifications, then assist the buyer in negotiating a transaction for the desired property.

In some cases, a single broker is employed by both the seller and the buyer to assist in the completion of a transaction. When this broker has fiduciary duties to both parties simultaneously, the broker is known as a dual agent. Many states rec- ognize the problems inherent in this type of agency relationship and have declared it illegal for a broker to attempt to work as a dual agent. To overcome this situation, some states recognize that brokers may act as a transaction broker and provide limited representation to both parties to a negotiation to help them close their deal without working to the detriment of either of the parties.

Most states’ laws require that the broker disclose the nature of his or her agency relationship to all parties involved in the negotiations prior to entering into meaning- ful negotiations to avoid confusion and possible violations of the fiduciary respon- sibilities. The next section examines the creation of agency relationships between (1) sellers and brokers and (2) buyers and brokers.

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| the creation of agency relationships ____________________

Before a principal is bound by the acts of an agent, the agent must have actual or apparent authority to transact business on the principal’s behalf. In other words, there must be evidence that the principal has authorized the agent to perform in some capacity on behalf of the principal. Real estate brokers can act as agents for either sellers or buyers because a broker may be employed by either. Listing agreements refer to the agreement between the seller and the broker when the broker is a seller’s agent. Buyer representation agreements define the agency relationship between the buyer and the broker when the broker is a buyer’s agent. We will examine each of these agency relationships in turn.

The Broker-Seller Relationship (Seller’s Agent)

Property owners generally give real estate brokers authority to sell their property using a written document called a listing agreement. Because listing agreements are contractual in nature, the essential elements of a binding contract must be present. These elements are discussed more fully in Chapter 6. Only about 20 states actually require listing agreements to be in writing, but as in any transaction, a written con- tract always is preferable to an oral agreement to clarify the relationship established and the duties owed.

A listing agreement describes the property and states the asking price, the duties of the broker, the extent of authority granted, the duration of the agreement, and the rights of the broker to a commission. There are various forms of listing agreements and each has its own legal impact. The more common types of agreements are the exclusive-brokerage listing, the exclusive-right-to-sell listing, and the open listing. These listing agreements create certain obligations between the broker and the seller, and the extent of the obligation depends on the type of agreement.

Suppose, for example, that Sarah Howell is being transferred by her job and wants to sell her house in Fort Lauderdale, Florida. She has decided to hire Julio Rodriguez to assist her in finding a buyer and accomplishing the sale. The follow- ing paragraphs outline how the various types of listing agreements would affect the terms of this agency relationship.

Open Listing Sarah may choose to grant an open listing to Julio Rodriguez of Rodriguez

Realty. In this type of listing, the broker is only entitled to a commission if he suc- cessfully arranges a transaction. At the same time Julio is trying to find a buyer, other brokers may also have entered into open listing with the seller. The document used to create open listing agreements is often called a commission agreement. The document identifies the parties to the agreement, the location of the property, and the broker’s compensation should he successfully close the deal.

By entering into an open listing, the seller is authorizing the broker to attempt to find a willing buyer. Nevertheless, the owner reserves the right to authorize other brokers to locate a potential buyer. In addition, the seller may sell her property

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without the aid of any broker. Under this commission agreement, Julio Rodriquez is entitled to the stated commission only if he successfully brings a buyer to Sarah. Julio will not receive any commission if either another broker or Sarah herself sells the property.

The open listing has both advantages and disadvantages for the sellers. Because they are not limited to one broker, they have greater flexibility. On the other hand, the broker does not have as much incentive to concentrate on selling the property because there is no assurance of actually earning a commission if another broker beats him to the punch. For this reason, open listings are seldom encouraged by brokers.

Exclusive-Brokerage Listing Sarah may choose to enter into an exclusive-brokerage listing, also called an

exclusive-agency listing, with Julio. This listing agreement differs from the open listing in that the seller cannot authorize another broker to find a buyer without becoming obligated to pay the original broker a commission even if another broker finds a buyer for the property. Despite the limit placed on the seller’s use of multiple brokers, she retains the right to sell her property on her own without becoming liable to pay Julio a commission. This type of agreement may seem most beneficial to sell- ers because they have one broker acting as their exclusive agent and can sell their property themselves without becoming liable for the commission. The broker may not be totally dedicated to marketing the property, however, because he or she could lose all rights to the commission on a sale-by-owner transaction.

Exclusive-Right-to-Sell Listing Another popular type of listing agreement that is probably the most preferred

type of listing agreement from the broker’s perspective is called an exclusive-right- to-sell listing. In an exclusive-right-to-sell listing agreement, the owner authorizes the broker to search for a buyer for the property and agrees to pay the broker a com- mission even if property is sold by anyone while the listing agreement is active, including the owner. This agreement gives the broker the best guarantee of ulti- mately receiving a commission on the sale of the property.

Net Listing A type of listing used very infrequently today, and illegal in many states, is the

net listing. In this agreement, the seller is guaranteed a specified amount of money, while the broker receives the remainder of the sales price. This type of listing obvi- ously invites fraud because there is an incentive for the broker to deceive the seller about the fair-market value of the property and thus obtain a larger commission.

Limited-Service Listing A relatively new type of listing agree is starting to become more popular in many

markets around the United States. In a limited-service listing the broker agrees to place the property on the multiple listing service (MLS), an arrangement in which participating brokers make their listings available to other members. The broker

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provides minimal support to the seller, but this type of listing allows property owners to advertise their properties for sale on the MLS, which is only available to paying members.

The Broker-Buyer Relationship (Buyer’s Agent)

When a potential buyer hires a broker to assist in locating a property for pur- chase, the relationship between the broker and the potential buyer should be clearly specified in a written document referred to as a buyer representation agreement. As in the case of listing agreements, buyer representation agreements must contain the essential elements of a contract. In addition, the document should specify the type of property desired, the duties and obligations of the buyer and seller, and the terms by which the broker will be paid for services rendered.

Types of Buyer Representation Agreements Similar to the different types of listing agreements discussed earlier, buyer repre-

sentation agreements may specify that the broker has an exclusive-right-to-represent or that the arrangement is an “open” one. Under an exclusive right to represent, the broker is entitled to a commission if the potential buyer purchases a property with or without the assistance of the broker. In an open arrangement, the broker is entitled to a commission only if the buyer purchases a property identified and suggested by the broker. If the buyer finds a property without the broker’s assistance, no commission is due.

Compensating the Buyer’s Broker Structuring the compensation to a buyer’s broker properly is an important aspect

of the buyer representation agreement. In many cases, the agreement calls for a retainer fee at the time the contract is signed, with a commission due if a property is purchased. The commission is either a fixed fee or is calculated as a percentage of the transaction amount. If the property is identified through the MLS, the buyer’s broker will receive a “commission split” from the listing agent. Typically, the com- pensation due from the buyer is reduced by this amount. Because the compensation due the broker is calculated as a percentage of the purchase price, one might question whether the broker will negotiate aggressively for the lowest price possible on behalf of the buyer. Fortunately, the fiduciary responsibility owed to the principal precludes the agent from engaging in this type of behavior.

| duties and rights under agency relationships _____________

Once any principal-agent relationship is established, each party owes the other the duties of loyalty, good faith, and diligence in fulfilling the conditions promised. These duties are not a matter of choice but are created by state laws that govern the agency relationship. In addition to their legal responsibilities, successful real estate brokers and sales associates know that ethical business practices are critical to con- tinued professional success. For example, the National Association of REALTORS®,

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the largest trade organization for real estate brokers and sales associates, holds its members to high ethical standards. In general, these standards require fair dealings with clients, customers, and the public. The National Association of REALTORS® has state and local associations in many areas of the country and is the largest mem- bership organization in the real estate industry, with more than 1 million members. The website for this organization (www.realtor.org) provides a wealth of information for real estate practitioners, consumers, and students. The following sections exam- ine the broker’s, seller’s, and buyer’s legal duties to one another in detail.

The Broker’s Duties

Real estate brokers and sales associates assume a fiduciary role when they are hired by either a seller or a buyer. A fiduciary is a person who occupies a position of trust and confidence in relation to another person or his or her property. Therefore, brokers must protect their clients’ best interests at all times. A breach of a fiduciary’s duties may occur as a result of negligence, fraud, misrepresentation, or failure to

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The Seller’s Agent’s Obligations to the Buyer

The Strassburgers owned a 3,000-square-foot home in Diablo, California, located on a one-acre lot and complete with a swimming pool and large guest

house. They listed their home with Valley Realty, which sold the property to the Eastons for $170,000. Unfortunately for the Eastons, how ever, they were not aware that part of the property was on filled land that already had been subject to earth slides.

Shortly after moving in, the Eastons became painfully aware of this fact when massive earth move ment cost them a portion of their driveway and caused the foundation of the house to settle, the walls to crack, and the doorways to warp. Esti- mates to repair the damage and avoid recurrence ranged as high as $213,000. The Eastons sued the Strassburg ers and Valley Realty for damages,

charging misrep resentation. In a landmark decision that has had lasting implications for the real estate bro kerage industry, they won.

The court held that although there was no evidence that the broker intentionally misled the buyers by deliberately giving false informa tion, he had an “affirmative duty” to the buyers to conduct “a reasonably competent and diligent inspec tion of the property listed for sale and to disclose to prospective purchasers all facts materially affecting the value or desirability of the property that such an investigation would reveal.” Because the broker did not do this, he was liable for part of the assessed damages of $197,000. As a result of this case, bro- kers are held responsible for disclosing information about the condition of the property to buyers.

[Easton v. Strassburger, 199 Cal. Rptr. 383, Cal. App. 1 Dist., 1984]

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follow instructions. Fraud is present if a broker, (1) with the intention to mislead, (2) makes a false statement material to a transaction that (3) is justifiably relied on by a client, resulting in (4) injury to the client. The elements of misrepresentation are the same as for fraud except that the intention to mislead need not be present.

Seller’s Agent’s Duties to Seller After a listing agreement is signed, the broker’s job is to locate a willing and able

buyer. Of course, the broker must do so honestly, diligently, and in good faith while following any instructions given by the owner and looking out for the owner’s inter- ests. The broker must also keep the seller informed at all times and communicate any and all offers received to the seller.

Seller’s Agent’s Duties to Buyers When the broker is an agent of the seller, the broker must look out for the seller’s

best interests. Even so, the broker must be careful not to misrepresent the property to a potential buyer. Courts are increasingly holding that the broker must go farther, having a responsibility to disclose any negative factors that might adversely affect the property’s value. Suppose, for example, that the foundation of the house has settled, necessitating repairs. In addition, the basement has been subject to flooding in extremely wet weather. The broker has the responsibility to inform any interested buyer that these problems exist and that additional repairs to correct them may be necessary in the future. The Legal Highlight above illustrates the liability brokers may face if they do not furnish adequate information to a prospective buyer.

If a buyer gives a broker any money as deposit on a potential purchase, these funds must be kept separate from the broker’s personal and other business funds and cannot be used for the broker’s benefit. For example, any use of “earnest money” by the broker for anything other than the buyer’s instructed purposes is improper and illegal. The money must be deposited in an escrow account and must not be “com- mingled” with the broker’s personal or other business funds.

Buyer’s Agent’s Duties to Buyers When a buyer representation agreement is in place, the broker is a fiduciary of

the buyer. The broker must act diligently and in good faith to find a property that matches the buyer’s criteria. Failure to attempt to locate a property for the buyer would violate the terms of the buyer representation agreement. Although normally still splitting a commission paid by the seller, the buyer’s broker’s loyalties must lie with the buyer. The broker has the responsibility of advising the buyer, negotiating the lowest price, and otherwise assisting the buyer in closing the transaction.

Buyer’s Agent’s Duties to Sellers Even though a buyer’s broker is a fiduciary of the buyer, the broker must treat

sellers fairly, honestly, and with due care. Failure to do so is a violation of the “fair dealings” requirement imposed on state-licensed real estate agents.

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Fair Housing

In all situations, the broker also must be careful not to violate federal fair hous- ing laws, which prohibit housing discrimination based on sex, race, color, religion, national origin, disabilities, or familial status. In the past, some brokers have engaged in the practice of steering—that is, channeling minority prospects only to minority neighborhoods. Other unscrupulous brokers have engaged in blockbusting—using scare tactics to drive down home prices when minority owners begin moving into an area.

The Civil Rights Act of 1866 provides that “All citizens of the United States shall have the same right, in every State and Territory, as is enjoyed by white citizens thereof to inherit, purchase, lease, sell, hold and convey real and personal property.” In 1968, the U.S. Supreme Court ruled that this law prohibits “all racial discrimina- tion, private as well as public, in the sale or rental of property.” The Fair Housing Act of 1988, enforced by the U.S. Department of Housing and Urban Development, was enacted to, among other things, provide civil penalties (now ranging from $16,000 to $70,000) plus actual and compensatory damages against individuals who engage in discriminatory practices. Americans who feel their rights have been violated should file a complaint immediately with the Office of Fair Housing and Equal Opportunity at HUD. The law means what it says, as the broker in the Legal Highlight on the next page discovered. Most states have similar laws.

Disclosure of Agency Relationship

Most states have enacted laws and regulations that require that real estate bro- kers and sales associates disclose the nature of any agency relationships at the first substantive contact with clients and customers. In many states, this disclosure must be made in writing and acknowledged by the parties involved. In the past, many buyers have purchased property with the mistaken belief that one of the brokers involved in the transaction represented their best interests. Unless a buyer represen- tation agreement is executed, buyers should not assume that the broker is working exclusively to benefit them.

| termination of agency relationships______________________

In the typical agency relationship in real estate, the relationship ends when a transaction occurs as specified in the listing agreement or buyer representation agreement. For example, if an open listing created the relationship, the relationship terminates on a sale, whether that sale is completed by the listing broker, another broker, or the owner. In an exclusive-brokerage listing agreement, it is understood that the agreement ends with the sale, whether the real estate is sold by the listing broker or by the owner.

If a transaction does not occur, the time period provided in the listing agreement governs the duration of the agency relationship. At the expiration of that term, the relationship terminates. Some states do not require a stated termination date for a

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Fair Housing

Landlords may wish to remove a tenant for some reason, but they must be very care ful they do not violate the fair housing laws. This the owners of the Boulder

Meadows mobile home park and the Sabre Village apartments learned to their sorrow.

Barbara Saville had lived in Boulder Mead ows for eight years when she received a notice of evic- tion, asserting that she had failed to maintain her home and lot site as required in her ground lease agreement. She responded with a letter explain- ing that she had a medical condition resulting in dizziness and seizures when performing physical labor. Boulder Meadows then commenced another attempt to evict Ms. Saville.

Because she was unable to maintain the prop- erty, Saville then arranged to provide free rent to a caretaker to live in her home in return for per- forming the required maintenance work. Boulder Meadows responded by issuing another notice of eviction for violation of a covenant requirement that prohibited anyone other than persons listed on the lease agreement from living on the premises. Saville responded to this demand by delivering a letter to Boulder Meadows requesting a reason- able accom modation for her disability under state and federal fair housing laws. Boulder Meadows refused, and this case went to court.

The court ruled that Boulder Meadows was required to provide reasonable accommodation for Saville’s disability, noting that allowing the care- taker to remain would have provided this. They

ordered Boulder Meadows to provide mainte nance of Saville’s lot without any charge, given the com- pany was receiving revenue in excess of $3 million per year from the park. They also awarded Saville $150,000 in dam ages for increased stress and humiliation caused by the park’s failure to provide reasonable accommo dation as required by the fair housing laws. [Boulder Meadows v. Saville, Colo- rado Court of Appeals]

When Elmo Green moved into the Sabre Vil- lage apartments he was the only African Ameri- can tenant. Racial discrimination appeared to be evident from the outset: Green was forced to pay a double deposit and was placed in a unit that was isolated from other buildings in the complex. Later, the apart ment management laid sod in every other yard but his. One day Green came home to find police and management in and around his apart- ment, manag ers saying they saw someone in the unit they didn’t recognize. The man was Green’s brother, who was baby-sitting his five-year-old son. Shortly after that the management removed Green’s air-conditioning and screen doors. At trial, a former employee testi fied that management had told him at the time, “We’re going to let that n_____ sweat in that box.”

The jury awarded Green $715,000 in dam- ages, finding that the owners of Sabre Village were guilty of racial discrimination in housing practices, forcible entry, and trespassing. [Green v. Sabre Village, Callaway County, Mis souri Circuit Court, 2004]

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listing agreement. In such cases, the agency relationship lasts for a reasonable time. A “reasonable” time is generally considered to be three months for residential prop- erty and six months for commercial property. The determination of a reasonable time period often must be made by a court; therefore, absence of a specific term in the agency agreement may result in expensive litigation.

A third way the agency relationship between a broker and owner ends is by mutual agreement. Some circumstances make it more beneficial to all parties to relieve the broker of his or her duties to locate a buyer and to relieve the owner of his or her duties to the broker. Such an agreement may occur before the expiration of the agency agreement’s term. Provisions for early termination should be specified in the agreement.

Even without the consent of the agent, many states allow the principal to revoke at any time the listing agreement that established the agency relationship. Revoca- tion of an open or exclusive-brokerage listing is looked upon less harshly than revo- cation of an exclusive-right-to-sell listing. Of course, the principal who breaches the agreement is liable to the broker for damages, although the determination of an agent’s damages may be difficult.

Of course, if either party to the agency relationship breaches his or her duties, the other party is relieved of further liability under the listing agreement. For exam- ple, if a broker fails to keep the seller fully informed of negotiations, the seller can list the property with another broker or sell it without a broker even if the original listing agreement was an exclusive-right-to-sell listing. The owner’s revocation of the listing agreement releases the broker from all duties to locate a buyer.

Because the agreement that created the principal-agent relationship is a contract between the parties, loss of contractual capacity by either party terminates the rela- tionship. Such loss of capacity may occur as the result of the death or insanity of either the principal or the agent. Destruction of improvements on the listed property or the property’s seizure by the government under the power of eminent domain also terminates the agency relationship. A broker is under no obligation to seek a buyer for a house that has been destroyed in a hurricane, for example, and a seller is not obligated to pay a commission for one that has been condemned for a highway right-of-way.

In summary, there are at least seven means by which the broker-owner agency relationship can be terminated:

1. A transaction occurs.

2. The term of the agreement expires.

3. The parties agree to termination.

4. One party breaches his or her duties.

5. One party becomes contractually incapacitated.

6. A listed property’s improvements are destroyed.

7. A listed property is taken by the government under the power of emi- nent domain.

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| types of brokerage firms ________________________________

Real estate markets, particularly markets for single-family homes, are local in nature, and real estate brokerage firms traditionally have been small, one-office busi- nesses that operated only in their local markets. For the most part, the real estate brokerage industry is still made up of small firms. Increasingly, however, the real estate brokerage market in most larger communities is dominated by large, multi- office firms, often part of regional or national organizations.

Many real estate brokers and brokerage firms specialize in one type of real estate transaction. Some brokers, for example, act only as buyer’s brokers, while others serve only as seller’s brokers. Many brokers limit their activities to the owner- occupied residential market; apartment leasing; vacant land sales; or commercial, industrial, or retail properties. Concentrating one’s efforts on a smaller market seg- ment allows some brokers to finely tune their skills to the needs of their clients and customers and ultimately increase their productivity.

Franchises

One way the smaller real estate brokers compete with the large regional and national firms is by becoming part of a franchise chain, such as Century 21 or Better Homes & Gardens. Franchisees pay an initial fee plus a percentage of their annual gross. For this, they receive the advantages of sales and management training pro- grams, a referral network, and, perhaps of most importance, name recognition. Just as families moving to an area recognize McDonald’s and Domino’s Pizza, they also often recognize real estate franchise chains. Consumers should recognize, however, that most of these firms are independently owned and operated, and the quality of service can vary.

Desk Fee Arrangements

Increasingly, brokerage firms are organizing the brokers and sales associates who work in the firm in a “desk fee” arrangement. Brokers or sales associates who wish to work with other members of the firm pay a monthly fee for the right to occupy space in the office. The firm provides phone service, cooperative advertising, and other resources that are shared by the members of the firm. Agents in this type of firm keep 100% of the commissions they generate after paying the required desk fee.

Multiple Listing Services

Multiple-Listing-Service Clause Another way the smaller broker is able to compete with larger firms is by becom-

ing part of a multiple listing service (MLS). If another broker sells the property, the listing broker still receives a portion of the commission. While the MLS is particu- larly valuable to the small broker, who otherwise might not have enough properties

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to sell, the service is also usually an advantage to the seller because all members of the MLS offer the property for sale and may reach many more potential buyers.

The MLS is an arrangement in which participating brokers make their listings available to all other members. The members agree that they will share information about properties they are trying to sell and agree to share (not necessarily equally) the commission being paid by the seller if another member finds a buyer for the property.

Suppose a seller has agreed to pay the listing broker a 6% commission. If the broker is a member of the MLS and offers to split the commission on a 50-50 basis with any other member broker who locates a buyer, each broker will receive 3% of the transaction price. If the listing broker finds a buyer without the assistance of another broker, of course, the listing broker would receive the full 6% commission.

| broker and sales associate compensation ________________

As discussed above, a real estate broker or sales associate receives a commission for services rendered in connection with the transaction. Normally, the commission is determined by a percentage of the gross transaction amount, though it can also be a flat fee. Usually, no commission is paid until the transaction is completed. In some cases, however, the broker may receive an advance fee, or a fee may be paid for performance of specific services, such as consultation and advice or appraisal of property. The commission amount varies with the type of property sold. Commis- sions on single-family homes typically range from 2 to 6%. Large commercial prop- erties usually carry a lower percentage commission, in the range of 1 to 5%, while commissions on unimproved land generally range from 6 to 10%.

Of course, real estate brokerage commissions cannot be set by agreement among brokers without violating antitrust statutes but must be negotiated between broker and client. Even discussion between brokers concerning the level of commissions is an antitrust violation and a criminal offense. Nevertheless, like other prices, com- mission rates tend to be relatively uniform, although lower rates can be negotiated, particularly in a “sellers’ market.”

When more than one broker is involved in a transaction, the commission usually will be split among the selling broker, the listing broker, and the firms that employ the brokers. The amount of commission to be split between firms is determined by agreement between the firms involved in the transaction. Typically, the listing bro- ker who represents the seller will specify in the multiple listing service posting the amount of commission to be paid to the selling broker. The brokers may then be obligated to split their commissions with their respective firms and, possibly, their sales associates. Of course, if the selling and listing broker were the same person, he or she would collect all of the commission.

Compensation for Sales Associates

State laws require that sales associates must work under the direction of a broker. Compensation for sales associates is often based on a percentage of the commissions

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earned for the broker. The actual percentage will vary from firm to firm and from sales associate to sales associate on the basis of such factors as the prevailing prac- tice in the area, the degree of advertising and other support provided by the broker, and the sales record of the associate. In general, the portion of the total commission going to the sales associate will increase with his or her level of sales.

| chapter review __________________________________________

■■ Two characteristics of real estate markets—the complexity of transactions and buyers’ limited knowledge of the markets—have led to the establish- ment of various real estate service activities, including real estate broker- age, property management, and appraisal.

■■ The steps in the real estate sales process are (1) listing, (2) marketing the property and qualifying buyers, (3) presentation and negotiations, (4) con- tracts, and (5) settlement or closing.

■■ A real estate broker is an intermediary who arranges real estate sale or lease transactions for a fee or commission. A real estate sales associate must work through a broker and can carry out only those responsibilities assigned by the broker.

■■ All states and the District of Columbia require that brokers and sales asso- ciates be licensed and meet mandatory education or experience require- ments. Failure to obtain the proper license prohibits the collection of any commission.

■■ The primary functions of the real estate brokerage industry are to match properties with buyers and to guide the buyer and seller through the com- plexities of real estate transactions.

■■ Real estate brokers’ relationships with sellers and buyers are governed by the law of agency. The broker or sales associate serves as an agent for either the seller or the buyer, who is the principal. A principal authorizes his or her agent to perform certain functions on behalf of the principal. In a typical real estate transaction, the principal (seller) grants the agent (bro- ker) express authority as stated in the listing agreement.

■■ The broker-seller relationship is created on the establishment of a list- ing agreement, usually written. Such an agreement specifies the parties, describes the property, states the asking price, and provides the govern- ing terms. The traditional types of listing agreements include (a) the open listing, (b) the exclusive-brokerage listing, (c) the exclusive-right-to-sell listing, and (d) the limited-service listing. Net listing agreements are used infrequently today because of the possibility of fraud.

■■ The broker-buyer relationship is created on the establishment of a buyer representation agreement, usually written. Such an agreement identifies the parties, describes the property desired, and establishes the broker’s right to compensation. These agreements can be open or exclusive.

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■■ A broker or sales associate has the duty to act honestly and diligently on the principal’s behalf. Complete loyalty is owed to the party the agent represents.

■■ Federal fair housing laws prohibit housing discrimination based on a buyer’s or (lessee’s) sex, race, color, religion, national origin, disabilities, or familial status.

■■ A commission is earned when the conditions of the agreement have been satisfied. In a listing agreement, the commission is due when the broker procures a ready, willing, and able buyer or when the transaction is actu- ally completed. In a buyer representation agreement, the commission is due when the buyer contracts to purchase a property.

■■ The agency relationship terminates when a transaction occurs, when the term provided in the agreement expires, when both parties consent to termination, when either party breaches its conditions, when either party becomes incapacitated, when the property is destroyed or heavily dam- aged, or when the property is condemned by the government under the power of eminent domain.

■■ A real estate broker or sales associate normally receives a commission when the transaction is completed successfully but no salary or other fee until that time. The commission normally is stated as a percentage of the gross sales price, and it varies with the type of property sold.

| key terms _______________________________________________

agency

agent

blockbusting

broker

buyer representation agreement

buyer’s agent

commission

commission agreement

dual agent

exclusive-brokerage listing

exclusive-right-to-sell listing

fair housing laws

fiduciary

fraud

limited-service listing

listing agreement

listing broker

misrepresentation

multiple listing service

net listing

open listing

principal

real estate broker

seller’s agent

selling broker

steering

subagent

transaction broker

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| study exercises _________________________________________

1. What characteristics of real estate have led to the establishment of the real estate brokerage industry?

2. Discuss the difference between the function of a real estate broker and that of a real estate sales associate.

3. What is the difference between an open listing and exclusive-brokerage listing? How does an exclusive-brokerage listing differ from an exclusive- right-to-sell listing?

4. What is a net listing? Why is it illegal in most states?

5. What is the difference between fraud and misrepresentation?

6. What are blockbusting and steering? Why are these practices illegal?

7. What impact do you think the internet has had on the real estate brokerage business? Take a look at Realtor.com and Loopnet.com for insights.

8. What document is used to create a relationship between a broker and a buyer who wishes to have the broker work in his or her best interest?

9. Would the compensation to a broker be the same if he or she assists a seller using a limited-service listing agreement as opposed to an exclusive-right- to-sell listing agreement? Why or why not?

10. Joe desires to sell his house. He lists the property with Johnny White, a real estate broker. In this case, who is “principal” and who is the “agent”? What duties does Johnny owe to Joe? What duties does he owe to any potential buyer?

11. Suppose that Johnny shows the house to Janice, who asks him to negotiate on her behalf with Joe. If he does so, what is he guilty of? What must he do to protect his right to a commission on this sale if he grants her request?

12. Sylvia listed her house for sale at $105,000 with the Keg Realty Company, and Keg began to show the property. A prospective buyer looked at Sylvia’s house, liked it, and gave a written offer for her asking price—$105,000. Having some second thoughts about selling, Sylvia claimed that this par- ticular buyer could not afford her house and refused to accept the offer. If there is no evidence that the buyer is in financial difficulty, does Keg Realty have any claim against Sylvia?

13. Real estate broker Molly Smith has listed a house for sale that is located in a floodplain and has been flooded on several occasions. Does Molly have an obligation to make these facts known to prospective buyers?

14. Suppose that Molly knows about the potential floodplain problem but tells a potential purchaser that the house is not in the floodplain. Of what is she guilty? Would the buyer have a claim against her?

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15. Suppose that Molly fully informs the potential buyer about the floodplain problem, but he still buys the house. Later his house is flooded, and he sues Molly for not telling him that houses in floodplains can be flooded. Does he have a legitimate claim?

16. Visit the website for the National Association of REALTORS® at www.realtor.org and explore the many resources there that are available to help members of the organization do their jobs better. Summarize one of the resources there and offer any ideas you have about how the resource could be improved.

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9c h a p t e r Real Estate Appraisal

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181

c h a p t e r p r e v i e w

What is the property worth? This question is central to decision making in almost every aspect of real estate. Sellers want to know what their properties should bring in the marketplace, and buyers want to know what their potential purchases are worth in comparison with other properties in the market. Mortgage lenders want to know that the value of a property being pledged as security for a debt is at least as much as the loan amount. Tax assessors, insurance adjusters, and right-of-way agents also must obtain estimates of value in order to collect property taxes, pay insurance claims, and compensate landowners for eminent domain takings.

Arriving at reliable estimates of property values requires an in-depth under- standing of the factors that influence value, as well as the methods available for estimating value. A thorough understanding of the process appraisers use to esti- mate value is beneficial to all real estate market participants, and it is absolutely necessary for anyone who hopes to make a career in the appraisal profession. The objectives of this chapter are to

■■ discuss the regulatory environment surrounding the appraisal profession;

■■ define the concept of value;

■■ define some of the basic principles underlying the appraisal process;

■■ describe the steps in the appraisal process;

■■ review the basic techniques appraisers use to arrive at value estimates; and

■■ demonstrate the appraisal process for a single-family home.

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| appraisal regulatory environment ________________________

Even though almost all individuals, businesses, and other organizations use real estate in their normal activities, few have the expertise necessary to evaluate real estate market conditions and arrive at sound estimates of property value. As a result, many real estate decision makers often must seek the services of real estate apprais- ers who possess the skills and knowledge necessary to accurately estimate property value. To ensure that people engaged in appraisal services do so in a competent and professional manner, all states have established minimum education and experience requirements for obtaining an appraisal license or certification.

Prior to 1989, few states regulated the appraisal industry and no specific license was required to perform appraisals. In that year, Congress passed the Financial Institutions Reform, Recovery, and Enforcement Act (FIRREA). Among other things, FIRREA established a federal regulatory hierarchy for the appraisal industry in an attempt to improve the reliability of appraisals in the loan approval process. Under FIRREA, appraisals for properties involved in “federally related” transac- tions must be performed by state-licensed or state-certified appraisers. Federally related transactions include those involving certain federal government agencies, as well as those involving institutions that are regulated or insured by federal agencies. Because most banks, savings institutions, and credit unions are federally regulated, virtually all appraisal assignments must be completed by a state-licensed or state- certified appraiser.

The Appraisal Foundation is a nonprofit educational organization formed by the appraisal profession in 1987. Its members consist solely of other organizations that have an interest in the promotion of professionalism in the appraisal industry. The Appraisal Foundation structure includes the Appraisal Qualifications Board (AQB) and the Appraisal Standards Board (ASB). Under FIRREA, the AQB estab- lished minimum education and experience guidelines that states must use to issue appraisal licenses and certifications (some states set even higher standards than the federal minimums). The ASB has established Uniform Standards of Professional Appraisal Practice (USPAP) that must be followed in federally related transactions. Many states require that all appraisals (even those not involved in federally related transactions) be performed in accordance with USPAP.

Appraiser License and Certification Guidelines from the AQB

The guidelines adopted by the AQB establish four different appraiser categories that permit the license or certificate holder to perform appraisal services in federally related transactions. These categories distinguish between residential and nonresi- dential assignments and the complexity of the transactions.

The first category is called trainee appraiser. A trainee appraiser must work under the supervision of a licensed or certified appraiser who is ultimately respon- sible for the work performed by the trainee. Becoming a trainee appraiser requires at least 75 hours of classroom instruction in appraisal topics. There is no experi- ence requirement for becoming a trainee appraiser, nor is there an examination that

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must be passed in order to become a trainee appraiser. Generally, trainee appraisers remain in this category for no more than two years. As they gain experience, they can apply for a more advanced license or certificate.

The second category of appraisers recognized by the Appraisal Foundation is called licensed residential real property appraiser. Licensed appraisers are autho- rized to perform appraisals involving complex one- to four-unit residential properties in transactions of less than $250,000 and to perform appraisals for noncomplex one- to four-unit residential properties for transactions of less than $1 million. Licensed appraisers must have an associates degree or higher from an accredited college or university (or at least 30 semester hours of college-level education), completed 150 hours of classroom instruction, must have passed a written examination on appraisal topics, and must have completed 2,000 hours of appraisal experience.

The Appraisal Foundation’s third category of appraisers is called certified resi- dential real property appraiser. Appraisers who hold this certification can appraise residential properties of one to four units without regard to transaction amount or complexity. These appraisers must hold a bachelor’s degree or higher from an accred- ited college or university, have completed at least 200 hours of appraisal education (inclusive of the 150 hours required for becoming a licensed appraiser), must have passed an examination, and must have completed at least 2,500 hours of appraisal experience.

The most advanced category of real estate appraiser established by the Appraisal Foundation is the certified general real property appraiser. Appraisers who hold this certification can appraise any type of property. Certified general appraisers must hold a bachelor’s degree from an accredited college or university, complete a mini- mum of 300 hours of classroom instruction (inclusive of the 200 hours required for becoming a certified residential appraiser), must have passed an examination, and must have completed at least 3,000 hours of appraisal experience, including at least 1,500 hours in non-residential appraisal work.

Uniform Standards of Professional Appraisal Practice from the ASB

The standards of practice adopted by the ASB set forth the rules appraisers must follow when developing an appraisal and reporting its results. There are 10 Stan- dards and each one has various “rules” associated with it. For example, Standard 1 requires that appraisers carefully identify the appraisal problem to be solved and the tasks necessary to reach a solution to the problem in a credible manner. The rules that accompany Standard 1 require that appraisers use recognized appraisal methods and techniques and that they apply these techniques appropriately. Furthermore, the rules stipulate what it means to “identify the appraisal problem” by specifically iden- tifying the real estate involved and the definition of value that will be investigated. For readers who are interested in the specific rules that appraisers must follow, the current edition of the Uniform Standards of Professional Appraisal Practice can be viewed on the internet at www.appraisalfoundation.org.

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| what is value? __________________________________________

The concept of value is a topic that has been dear to philosophers and econo- mists for centuries, and the debate over a proper definition of value is frequently revisited in the real estate appraisal literature. Some of the questions considered by researchers include the following: What constitutes value? Is it the worth of a prop- erty to society in general or to an individual investor? Is it priced in terms of money or some intrinsic characteristic of the property? Is it value in exchange, value in use, or perhaps the cost to produce? For our purposes, we limit our concern to this ques- tion: What is it that real estate appraisers are trying to estimate? As we will see, the answer to this question is carefully defined.

Market Value

The type of value that real estate appraisers generally attempt to estimate is market value. The following definition, taken from the FIRREA legislation, is the most widely accepted definition of market value and is the basis for most appraisal reports.

Market value: The most probable price which a property should bring in a competitive and open market under all conditions requisite to a fair sale, the buyer and seller each acting prudently and knowledgeably, and assuming the price is not affected by undue stimulus. Implicit in this definition is the consummation of a sale as of a specified date and the passing of title from seller to buyer under five condi- tions whereby

1. buyer and seller are typically motivated;

2. both parties are well informed or well advised, and acting in what they consider their best interests;

3. a reasonable time is allowed for exposure in the open market;

4. payment is made in terms of cash in U.S. dollars or in terms of finan- cial arrangements comparable thereto; and

5. the price represents the normal consideration for the property sold unaffected by special or creative financing or sales concessions by anyone associated with the sale.

Though lengthy, each portion of this definition is important to the appraiser’s estimate of value. For example, the price for which one family member might sell a particular property to another could be very different from the price that could be received if the property were offered to all prospective buyers. Similarly, because the financing terms of a transaction may affect the price, the definition of market value refers to the most probable cash or cash equivalent price. Furthermore, this definition assumes that all market participants have an opportunity to consider the property and make an informed and voluntary decision about whether to purchase it. While the implications of the above definition should be always kept in mind, we will simply refer to a property’s market value as its most probable selling price.

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Investment Value

Market value is what the classical economists called value in exchange, that is, the consensus price that would be reached in a market with many buyers and sellers. Another classical value concept is “value in use,” which has a modern real estate application in the concept of investment value. Investment value is defined as the worth of a property to a particular investor, based on that investor’s personal stan- dards of investment acceptability. Investment value refers to the value of a property to a specific buyer, while market value refers to the value of a property to the typi- cal, but unspecified, buyer in the market. We will consider the topic of investment analysis in Chapter 19.

Price versus Market Value

As opposed to market value, which is an estimate of the most probable selling price, price is the amount actually paid for a property in a particular transaction. It is a historical fact, not a prospective concept. Because the buyer or seller may not be well informed, may not be acting prudently or may not be free from undue pressure, or may not be engaged in an “arm’s-length” transaction, the price actually paid for a property may not be the same as the market value estimated by an appraiser. On the other hand, price is an accurate indicator of market value if the transaction matches the conditions described in the definition of market value.

Market Value versus Cost of Production

One of the factors influencing market value is cost of production. No rational entrepreneur will keep producing a product unless it is expected to sell for a price that is high enough to cover costs and provide a profit. Unfortunately, however, this does not mean that an entrepreneur will not make a mistake and produce a product that the market will value at less than the cost of production. Real estate developers occasionally make mistakes by misjudging markets and developing projects that will not sell at their desired price. Although costs are one indication of value, market value actually may be higher or lower than cost of production.

Other Types of Value

Although appraisers usually estimate market value, they may be asked to esti- mate other measures of value as well. Among these are assessed value and insurable value. Assessed value is the value placed on a property for property tax assessment purposes. Property taxation is considered in Chapter 4.

Insurable value represents the amount of insurance that should be carried on the destructible portion of the real estate to compensate the owner adequately in case of loss. Because insurable value is measured using the concepts of actual cash value and replacement cost, it often differs from current market value.

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| some key appraisal principles ____________________________

A number of basic principles drawn primarily from economic thought are essential to the practice of appraisal, and they apply to every type of real estate appraisal assign- ment. Among them are the principles of anticipation, change, substitution, and contribution.

Anticipation

The current value of a property depends on the anticipated utility or income that will accrue to the property owner in the future. This is the principle of anticipa- tion. Because the present value of a property depends on the expected future benefits of ownership, the appraiser must be skilled in analyzing national, regional, local, and neighborhood trends that will influence future income or utility. For example, a motel may have been very profitable in the past, but changing road patterns and other neighborhood factors may considerably reduce the property’s income and, hence, its value in the future.

Change

The principle of anticipation is closely related to the principle of change, the notion that economic, social, political, and environmental forces are constantly caus- ing changes that affect the value of real property. Real estate markets are dynamic rather than static, and appraisers must carefully analyze the direction and degree of change in factors affecting market values. For this reason, every value estimate must be made as of a specified date.

Substitution

The principle of substitution holds that a prudent buyer will pay no more for a property than the cost of acquiring an equally desirable substitute in the open market. This principle is fundamental to all three traditional approaches to real estate valua- tion, the sales comparison, income, and cost approaches. It supports the premise that a buyer will not pay any more for a home or other real estate improvement than the cost of reproducing the improvement on a similar site. Suppose, for example, that a lot can be purchased in a particular subdivision and a certain size and type of house constructed for a total cost of $300,000. This will tend to set the upper limit of value for existing houses of similar size and type in the subdivision unless they have some distinguishing locational feature such as an exceptional view or nearness to a golf course or lake.

Contribution

The principles of diminishing marginal utility and diminishing returns as factors of production are fundamental to economic theory. Their application in real estate appraisal is closely related to the principle of contribution, which states that the

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value of a component part of a property depends on the amount it contributes to the value of the whole. For example, tasteful landscaping may increase the value of a home much more than the cost of the improvement. An expenditure for extensive plantings of exotic shrubs, however, probably will not be recovered if the property is sold. In fact, certain improvements to a property can actually have a negative effect on value.

Suppose a homeowner builds an elaborate shrine in the dining room honoring a major league baseball team. Because the typical buyer prefers that such an item not be a part of the property, the “value” of the shrine is negative and equal to the cost of removing it, less any salvage value. The principle of contribution is an especially important consideration for real estate appraisers. Even though a property may have an expensive feature or characteristic, the contribution to market value is often less than the cost of the feature (or perhaps even negative) because the typical buyer in the market does not desire that feature in the property.

| the appraisal process ___________________________________

Over the years, appraisers have developed a formal process to collect data, analyze the data to arrive at an estimate of value, and present their findings. The appraisal process is a systematic procedure employed to arrive at an estimate of value and convey that estimate to the appraisal user. Although we present the steps of this process in their general chronological order, it is important to realize that in practice, the order of consideration of these steps may need to be adjusted to match the conditions of a specific appraisal assignment. Careful consideration of each of the following six steps will lead to sound estimates of value:

1. Definition of the problem

2. Data selection and collection

3. Highest and best use analysis

4. Application of the three approaches to value

5. Reconciliation of value indications into a final value estimate

6. Report of defined value

Step 1: Definition of the Problem

The first step in the appraisal process is to define the problem at hand. The accu- racy of the value estimate provided by the appraiser depends on careful specification of the appraisal assignment. The appraiser and the client must be in accord as to the

■■ type of value to be estimated,

■■ property involved,

■■ specific property rights being appraised,

■■ use of the appraisal, and

■■ effective date of the appraisal.

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The most common purpose of an appraisal is to estimate market value, but appraisers may be asked to estimate rental value, insurable value, assessed value, or investment value. The type of value to be estimated will largely dictate the type of data that must be collected and the way they should be analyzed. It is essential, there- fore, that the purpose of the appraisal and the definition of value be stated clearly.

The identification of the property to be appraised must include the location of the property, usually provided by both its street address and legal description. This description must also include any easements or encroachments that might affect value. Obviously, the physical characteristics of the property must be identified, including buildings and other improvements, the size of the parcel, its topography, soil conditions, elevation, and other physical features.

Not only the physical property but the specific property rights to be appraised must be clearly identified. These rights may be complete, as in a fee simple estate, or partial, including only such interests as air rights, the reversionary right in a leased fee, an easement, or some other type of limited property interest. The description should include limitations on these property rights, such as restrictive covenants and land-use controls.

The appraiser usually is called on to make an estimate of the current value of the property, although in some cases an appraisal is required for some date in the past or for some date in the future. Retrospective appraisals may be required for many reasons, including a determination of inheritance taxes and insurance claims. Prospective appraisals may also be required, especially in the case of evaluating proposed real property improvements before construction begins. Because the value of property changes over time, specification of an effective date for an appraisal is a necessary part of defining the problem.

Step 2: Data Selection and Collection

After defining the problem, the appraiser must identify and collect data that will permit an accurate estimate of property value. In addition to general information regarding economic, social, political, and environmental factors that may affect the value of the property being appraised, the appraiser must collect specific informa- tion regarding recent sales prices of similar properties, construction cost data, and income and expense information for the subject property and comparable properties in the market. As we will see in the remaining steps of the appraisal process, the accuracy and appropriateness of data collected for analysis are critical to the validity of the value estimate. Estimates of value based on inaccurate or inappropriate data are not reliable.

Step 3: Highest and Best Use Analysis

After determining the data requirements for an appraisal assignment and collect- ing the data for analysis, the next step is to analyze the property’s highest and best use. Highest and best use is defined as that use that is found to be legally permissi- ble, physically possible, financially feasible, and maximally productive. As we noted

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earlier, market value refers to the most probable price a property would bring in an open market transaction. Because the typical buyer in such a transaction would most probably use the property in its highest and best use, value estimates are based on the assumption that the highest and best use of the property has been identified. This follows from the recognition that competition among market participants will result in the most efficient and appropriate use of a property, even if that means changing its current use. Any estimate of market value must include a determination of the property’s highest and best use.

The determination of the highest and best use of a property is of primary impor- tance in any appraisal, although in many cases it is readily apparent. For example, if the property to be appraised is a five-year-old house in an established single-family neighborhood, the highest and best use of the property is most likely a single-family home. In other cases, however, the highest and best use of a property may be dra- matically different from its current use.

Highest and best use of a property is affected by many factors, including its past and present use, land-use controls, nearby land uses, the availability or absence of utilities and transportation facilities, and recent or anticipated economic growth in the area. Analysis of highest and best use generally is easier for vacant land than for land with improvements that might require removal, so we will consider each in turn.

Highest and Best Use of Vacant Land Suppose that a 50-acre tract of land has been planted in soybeans for some years.

The value of the land in this agricultural use is $2,500 per acre. In the past, farming represented the highest and best use of the tract because the site was located sev- eral miles from a small city. More recently, the city has begun expanding because increased business and manufacturing activity there has led to population growth. These factors, combined with road improvements and the extension of water and sewer lines, have led to a change in the highest and best use of the site. In fact, there may be several legally permissible and financially feasible uses for it. One developer believes there is sufficient demand for a low-density, single-family residential subdi- vision and is willing to pay $30,000 per acre. Another developer wishes to build an apartment complex and is willing to pay $120,000 per acre. The second developer must believe that using the land for an apartment complex is more profitable than using it for single-family homes. Assuming both of these uses are legally permissible and physically possible, the highest and best use of this parcel is for an apartment complex because it results in the highest land value.

Highest and Best Use of Land with Improvements In the example above, the determination of highest and best use was simplified

by the fact that the land was vacant. Suppose, however, that a one-acre lot and the house on it are worth $175,000 as a single-family home. Under the current zoning ordinances, if the land were vacant, it could be sold for $80,000 as a single-family home site, or for $150,000 for a commercial activity. If vacant, the highest and best use of the site is clearly commercial, but because the property is worth more in its

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current use, its highest and best use still is residential. If the value of the site for commercial use increases above its value in residential use (plus the cost of demoli- tion), however, it would be advantageous to tear down the existing house and change the use to commercial. The highest and best use of this property may change quickly if the existing improvements begin to deteriorate rapidly as a result of age or other factors. Although identifying a property’s highest and best use can be a difficult task, appraisers must understand the manner in which the property would be used by the typical buyer in order to estimate its most probable selling price.

Step 4: Application of the Three Approaches to Value

In the traditional appraisal process, the appraiser normally considers three approaches to value. Each of these approaches is intended to replicate the thought processes of the typical buyer in order to estimate a property’s most probable selling price in an open market transaction. Because we will consider the details of each of these approaches in the following sections of this chapter, we provide only brief descriptions here.

In the sales comparison approach, appraisers compare similar properties that have been sold recently in open market transactions with the subject property. The prices of these comparable properties provide an indication of the value of the sub- ject property. Of course, every property is unique, and any differences between the comparable properties and the subject property must be taken into consideration.

In the cost approach, appraisers arrive at an estimate of the market value of a property by estimating its cost of production. Estimating value using this approach involves (1) estimating the value of the site as though it were vacant, (2) estimating the cost to produce the improvements, (3) subtracting depreciation, and (4) adding site value. There are numerous techniques for estimating the value of vacant land, with the most preferred method being the sales comparison approach. Estimating production cost requires knowledge of construction methods and current prices of materials and labor. The estimate of production cost is based on constructing a new structure, so the appraiser must subtract any depreciation that exists in the subject property. Adding the site value to the depreciated cost of the improvements provides an indication of market value.

In the income approach, appraisers estimate market value by estimating the income that the property is expected to generate, then converting the income stream into a present value estimate. The techniques used to relate income expectations to market value estimates include gross income multiplier analysis, net income capital- ization, and discounted cash-flow analysis.

Step 5: Reconciliation of Value Indications into a Final Value Estimate

Although the three approaches described previously should theoretically lead to identical value estimates, the realities of real estate markets usually result in a different estimate of value from each approach. Large differences between the value

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indications suggest that one or more of the approaches may not be appropriate for estimating a particular property’s market value. To arrive at a final estimate of value, appraisers must reconcile the estimates obtained from each approach. Reconciliation of the three approaches requires considerable judgment on the part of the appraiser.

In most appraisal situations, the appraiser may feel that one of the approaches provides a better indication of value than the others and will therefore give more emphasis to that approach in the reconciliation step. For example, if an appraiser is estimating the market value of a church building, the sales comparison approach might not be appropriate if sales of church buildings are infrequent in the market. Similarly, the income approach may not be appropriate because such properties are not considered income producing. The lack of data required to implement these approaches in this situation may lead the appraiser to place more emphasis on the value estimate provided by the cost approach. In all cases, the appraiser must deter- mine the weight given to the value indicated by each approach using his or her pro- fessional judgment. The appropriate weight depends on the amount and quality of available data, as well as the relevance of the approach to the problem at hand. When all of the approaches are relevant to some degree, appraisers often use a weighted average of the three value estimates to arrive at a final value estimate.

Step 6: Report of Defined Value

After reaching an estimate of value, the appraiser must convey the information to the client, normally in a written report. This report describes the data considered as well as the methods and reasoning used in arriving at the final value estimate. Any assumptions used in the analysis must be clearly stated and defended.

When the property involved is a single-family home and the function of the appraiser is to verify property value for loan approval purposes, the appraiser’s anal- ysis and conclusion must be reported in a format acceptable to the lender. Because lenders often sell their loans in the secondary mortgage market, the secondary mar- ket participants dictate the format of the appraisal report. Fannie Mae and Freddie Mac have jointly approved a Uniform Residential Appraisal Report (URAR) form for loans sold in the secondary mortgage market. (An example of the URAR form is shown in the case study at the end of this chapter.) Similar forms are used for other types of property, including vacant land and small income properties. For more complex appraisal assignments, the analysis and conclusions are usually presented in a narrative report format. Narrative appraisal reports may exceed several hundred pages for large-scale income properties.

Now that we understand the general process appraisers use to estimate prop- erty value, we can take a closer look at the specific techniques used in each of the three approaches to value: the sales comparison approach, the cost approach, and the income approach.

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| the sales comparison approach __________________________

Perhaps the best single indication of the value of any good is the price that simi- lar goods are selling for in the marketplace. This is the basis of the sales comparison approach to the valuation of real property. This technique has tremendous intuitive appeal because it closely resembles the process most buyers go through when select- ing a property for purchase. The procedure involves comparing the subject property with similar properties that have sold relatively recently or are currently offered for sale, then using the sale prices of these properties to gain insight into the market value of the subject property.

Because individual parcels of real estate all have unique characteristics, close comparisons are difficult. In addition, sales data may be very sketchy or nonexistent for specialized properties. Nevertheless, when data are available, the sales compari- son approach generally is considered the best method for estimating the value of real property. It is particularly valuable in appraising single-family homes in active markets.

The sales comparison approach involves two steps: (1) collection of data on sales of similar properties and (2) adjustment of the sales data to make them reflect the subject property as accurately as possible in regard to physical and locational characteristics, financing arrangements, conditions of the sale, and market condi- tions at the time of the sale.

Comparable Sales Data

The selection of “comparables,” recently sold of properties that are roughly similar to the subject property, is critical to the market value estimate. The appraiser must take great care that the sales selected are truly representative and not distorted in some way. For example, the price that results from a sale from one family member to another probably would not be representative of the property’s market value.

Generally, three to six comparable sales are considered adequate. The infor- mation on each transaction should include the date of sale, price, financing terms, location of the property, and a description of its physical characteristics and improve- ments. Deed records can provide information regarding location and date of sale, and where available, deed tax stamps may also give some indication of sales price. More definitive price and property characteristics may be provided by the buyer or seller, brokers, title and abstract companies, multiple listing services, or specialized finan- cial reporting services.

Adjustment of Sales Data

After data on comparable sales have been gathered, adjustments may be required to make them reflect the subject property as accurately as possible. The appraiser may make lump-sum adjustments by evaluating all of the differences between the comparable sale and the subject property that are considered important. For example, the appraiser may conclude that on the basis of a comparable sale of $75,000, the

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subject property should sell for $80,000 because of its more desirable location and better quality construction. A refinement of this lump-sum approach is to evaluate the individual elements that may affect value. In any case, the following elements of comparison must be evaluated for potential differences between the subject property and the comparable properties.

Elements of Comparison Six different elements of comparison must be considered in the sales comparison

approach. The first two elements of comparison are property rights conveyed and conditions of sale. If analysis of these two elements identifies significant differences between the subject property and any potentially comparable property, the sale price of such a comparable provides little insight into the market value of the subject prop- erty and it should be eliminated from further consideration.

For example, if the subject property involves a fee simple absolute estate and a comparable property was sold as a life estate, the subject property is almost certainly worth more than the comparable. Therefore, the sale price of the comparable prop- erty will not give a reliable indication of the value of the subject property. In most cases, appraisers prefer to eliminate properties with inconsistent property rights from further analysis. Similarly, if a potentially comparable property’s transaction price is not the result of arm’s-length negotiation between informed parties, the sale price of the comparable property will not provide a valid indication of the market value of the subject property. The definition of market value is explicit in defining the conditions of sale for the subject property. In general, appraisers assume that the subject property will be sold in a competitive and open market under all conditions necessary for a fair sale.

Another element of comparison addresses the financing terms in a comparable sale. As required by the definition of market value, the market value of the sub- ject property is estimated in terms of cash or financial arrangements comparable to cash. If the transaction of a comparable property involves unique financial arrange- ments that may have affected the sale price, the sale price of the comparable must be adjusted to reflect this difference. For example, if a seller provides a mortgage loan with a below-market interest rate to the buyer, it is likely that the buyer would pay a higher price for the property. Because the financing terms in this transaction are more favorable than those generally available in the market, the price of the compa- rable must be adjusted downward to accurately reflect the value of the subject prop- erty. The amount of adjustment primarily depends on the interest savings provided to the buyer by the below-market financing.

Another important consideration is the fact that local market conditions are sub- ject to change over time as a result of changing economic, political, social, and envi- ronmental factors. This element of comparison is frequently referred to as market conditions. A property that sold four months ago or even a week ago may sell for more or less today as a result of changing market conditions. Therefore, appraisers must adjust the sales prices of comparable properties to reflect differences in market conditions between the time of sale and the effective date of the appraisal. If con- ditions have improved such that a sale of a comparable property in today’s market

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would result in a higher price, then the price of the comparable should be adjusted upward to provide a valid indication of the subject property’s current market value.

Yet another element of comparison involves differences in the locational charac- teristics of the subject and comparable properties. Most people are familiar with the old saying among real estate investors that the three most important factors affecting real estate values are “location, location, and location.” Though simplistic, this state- ment embodies a certain amount of wisdom. Because real estate values are dramati- cally influenced by local market factors, properties located in the same neighborhood are considered the most comparable to each other. A neighborhood can be defined as a geographic area containing complementary land uses. For some properties, the boundaries that define a neighborhood are quite expansive, while others are more compact. Even within the same neighborhood, one site may be preferable to another due to access and proximity to shopping and schools, traffic volume on the surround- ing streets, and numerous other factors. Consideration of locational characteristics is a critical step in the adjustment process.

The final element of comparison reflects differences in physical characteristics between the subject property and the comparable properties. Though the possibili- ties are endless, some commonly encountered differences include the size of the property (land area and improvements), number and size of the rooms, type of con- struction, quality of construction, interior design, architectural style, and numerous special features. If the comparable properties possess physical characteristics that differ from the subject property, appropriate adjustments must be made to the sale prices of the comparable properties to ensure that the price is indicative of the sub- ject property’s market value.

When the adjustments for each of these elements of comparison are complete, the adjusted sales prices for the comparables give an indication of the value of the subject property. Again, the steps involved in this approach mirror the steps a poten- tial buyer might go through when comparing alternative properties and making a purchase decision. The example presented below demonstrates the logic behind the sales comparison approach using “matched pair analysis” to determine the appropri- ate adjustment amounts.

Applying the Sales Comparison Approach Consider the problem of estimating the value of a vacant lakefront lot in a resi-

dential subdivision. The lot under consideration measures 80 by 120 feet. Three sim- ilar vacant lots in this subdivision have sold recently in transactions resulting from arm’s-length negotiations for the transfer of fee simple absolute estates, and all sale prices reflect cash-equivalent financing terms. The significant differences between these properties are date of sale, lot size, and location of the lot relative to the lake. Comparable number one measures 85 by 120 feet and is also located on the lake. It sold for $30,100 two weeks ago. Comparable number two is a lakefront lot measur- ing 85 by 140 feet. This lot sold one year ago for $32,500. Comparable number three sold six months ago for $21,600. It is an interior lot measuring 80 by 120 feet.

A good way to organize and analyze sales comparison data is through a market data grid such as the one shown in Table 9.1. Because the lots differ in terms of size,

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we can simplify our analysis by first calculating the sale price per square foot. After adjusting the sale prices of each comparable for differences in market conditions since the sale date, we can then multiply the adjusted price per square foot by the size of the subject property to arrive at an estimate of value for the subject property.

To determine the adjustment necessary to account for changing market condi- tions, notice that comparables 1 and 2 are both lakefront properties, but comparable 2 sold approximately one year later than comparable 1. Because we eliminated the size difference by calculating price per square foot, the only difference between comparables 1 and 2 is the date of sale. The difference in price for these properties suggests that property values have increased by approximately $0.22 per square foot over the past year. Because the effective date of the appraisal is today, we must esti- mate the price the comparables would bring if offered for sale under current market conditions. Thus, we adjust the price per square foot of comparable 2 upward by $0.22. Assuming the change in property values has been constant over the past year, we can also adjust the sale price of comparable 3 upward by half of this amount, or $0.11, to account for changing market conditions over the past six months.

After adjusting for changing market conditions, the only remaining difference between the subject property and any of the comparables is location of the lots rela- tive to the lake. Our subject property is a lakefront lot, as are comparables 1 and 2. Comparable 3, however, is an interior lot. Just as we determined the adjustment for

ta b l e 9.1 Sales Comparison Market Data Grid

Comparables

Subject #1 #2 #3

Sales price — $30,100 $32,500 $21,600

Size in square feet 9,600 10,200 11,900 9,600

Price per square foot — $2.95 $2.73 $2.25

Date of sale Current – 2 weeks – 1 year – 6 months

Adjustment for changing market conditions

— + $0 + $0.22 + $0.11

Adjusted price per square foot — $2.95 $2.95 $2.36

Location Lake Lake Lake Interior

Adjustment for location — + $0 + $0 + $0.59

Adjusted price per square foot — $2.95 $2.95 $2.95

Indicated value of subject property: 9,600 square feet × $2.95 = $28,320

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changing market conditions by comparing the sale prices of two of the comparables that differed only in terms of their sale date, we can determine the appropriate adjust- ment for location by comparing the sale price of comparable 3 with the sale prices of the other comparables. The higher sale prices of the first two comparables suggest that lake frontage adds approximately $0.59 per square foot to property values in this neighborhood. Adding this amount to the price per square foot of comparable 3 results in a value indication from each of the comparables of $2.95. Multiplying this amount by 9,600 square feet yields $28,320. Thus, we conclude that this amount is an estimate of the current market value of the subject property, after adjustments for differences in market conditions, lot size, and location.

Although this example refers to vacant land, the same procedure can be applied to improved residential and nonresidential properties. We will apply this approach to a single-family home in the case study at the end of the chapter. Of course, it is unlikely that all of the comparable properties will provide an identical indication of value. Also, the appropriate unit of comparison is not always price per square foot. The primary consideration in this approach to value is to correctly determine the appropriate amount and direction of adjustments for each element of comparison. In most situations, the adjustments are much more detailed than those described here. Furthermore, the data available from sales of comparable properties may be insuf- ficient to provide a valid value estimate. Without adequate data, the sales comparison approach is not reliable.

| the cost approach _______________________________________

In addition to having existing properties to choose from, a potential buyer of a home or other real property improvement usually has the alternative of buying a similar site and constructing similar improvements. Generally, therefore, site value plus production costs of the improvements tend to set the upper limit to value. In this sense, the principle of substitution is the basis of the cost approach to value. There are four key steps in the cost approach, including (1) estimating the value of the site as though it were vacant, (2) estimating the cost to produce the improvements, (3) subtracting depreciation, and (4) adding site value.

The indicated value of the property is the cost to produce the building, less the estimated accrued depreciation, plus the value of the site and site improvements. Subtracting accrued depreciation is necessary because the cost estimate is based on constructing a new, identically designed building using current prices for materials and labor. The subject property is most likely not new, and if it were constructed new, any design flaws would be corrected. Estimating the accrued depreciation for a property is often the most difficult step of the cost approach.

Estimating Site Value

The first step in the cost approach is to estimate the value of the site. Land val- ues are usually estimated by the sales comparison approach, as demonstrated above,

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though other techniques are sometimes used. The cost of site improvements such as grading, landscaping, and paving must be added to arrive at a total value for the site.

Estimating Production Cost

The second step in the cost approach is to estimate the production cost of the improvements. Production cost estimates are based on either reproduction cost or replacement cost. Reproduction cost refers to the cost of constructing an exact rep- lica of the subject property’s improvements, while replacement cost refers to the cost of constructing an equally functional improvement, rather than an exact duplicate. Using replacement cost as the basis for this approach simplifies the cost-estimating procedure when the property being appraised contains design elements or materials that are out-of-date and would, therefore, not be included if the building was con- structed today.

Estimating production cost requires specialized knowledge regarding construc- tion methods, so appraisers frequently rely on engineering and architectural experts for accurate cost estimates. Professional cost-estimating companies publish cost manuals or provide computerized cost programs that assist appraisers in this task. In practice, construction costs can be estimated by obtaining actual expenditure data on the subject property, by collecting data on other similar projects in the area, or through data services that collect and distribute cost data on various types of con- struction. Methods used in estimating production costs include the comparative-unit method, the segregated-cost method, and the quantity-survey method. Of these meth- ods, the quantity-survey method is the most detailed.

The comparative-unit method employs the known costs of similar structures, typically measured in dollars per square foot, to derive an estimate of the cost to produce a subject property’s improvements. For example, a typical warehouse might cost $32.15 per square foot to construct. If the subject property contains 50,000 square feet, its cost is estimated at $1,607,500. This approach does not separately identify the individual components that make up the building, but it can be fairly accurate for properties with uniform construction.

In the segregated-cost method, the unit costs for various building components are used to arrive at a cost estimate. If the cost of building finished exterior walls on a warehouse is $5.52 per square foot, and the subject property has 10,700 square feet of exterior walls, then the cost of this component would be approximately $59,000. The cost of each major component of the building (walls, roof, flooring, plumbing, etc.) is estimated separately, then all costs are added together for a final cost esti- mate. This method is more comprehensive than the comparative-unit method, but less detailed than the quantity-survey method.

The quantity-survey method is the most comprehensive method, and is therefore more accurate when correctly applied. In this method, the quantity and quality of all materials and all categories of labor are identified separately, then costs for each of these items are totaled to arrive at a final cost estimate. For example, the num- ber of sheets of plywood, gallons of paint, the amount of piping, hours of electri- cians’ labor, and all other materials or labor needed to construct the building must

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be identified and the costs of each estimated. The quantity-survey method provides the most detailed cost estimate, but it is time-consuming and not used frequently in the appraisal process.

Estimating Accrued Depreciation

Structures wear out over time. They also may become obsolete or unprofit- able because of technological innovation or economic change. Therefore, unless the subject property’s improvements are new, appraisers must estimate deprecia- tion—the amount by which the value of a building has declined since it was built, as a consequence of physical deterioration, functional obsolescence, and economic obsolescence.

Physical deterioration may result from ordinary wear and tear, weathering from the elements, vandalism, or neglect. Physical deterioration should be minimal in new buildings and can be prevented or minimized by proper maintenance and quality construction. Appraisers often estimate the effective age of the improvements, then use the ratio of effective age to useful life to measure physical deterioration. For example, a 15-year-old house with normal maintenance might exhibit 25% physical deterioration if its useful life is 60 years.

Many properties suffer their greatest loss in value from the effects of obsoles- cence, both functional and economic. Functional obsolescence is a loss in value that occurs because the property has less utility or ability to generate income than a new property designed for the same use. This sort of depreciation results from fac- tors inherent in the property itself. It may occur because of changes in technology or in tastes, which would cause a new building to be constructed quite differently from the way the existing structure was built. For example, buildings using asbestos insulation now suffer a large penalty. To a lesser extent, so do outmoded, multistory factory buildings and poorly designed houses with small, dark rooms. An increas- ingly important issue faced by appraisers is the difficulty of estimating the value of environmentally contaminated parcels.

Economic (or external) obsolescence is a loss in value resulting from factors outside the property that affect its income-producing ability or other degree of use. For example, suppose that a well-designed and well-constructed motel in good phys- ical condition is located in an area that is bypassed by a new highway. The resulting decline in traffic may greatly decrease the income-producing ability of the property and hence its value. Economic obsolescence also may occur because of changes in consumer expenditure patterns, population movements, adverse legislation, or neighborhood change.

Applying the Cost Approach

To demonstrate the steps involved in the cost approach, consider a two-year-old apartment building. To estimate its value by this approach, we must estimate the value of the site, the production cost of the improvements, and the accrued deprecia- tion resulting from physical deterioration and economic and functional obsolescence.

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Suppose the appraiser estimates these items as shown in Table 9.2. The land value is estimated as $150,000 using the sales comparison approach. Estimated production cost for the two-year-old building is $594,000.

Even though the buildings are almost new, the appraiser still determines that there should be some allowance for depreciation. A minor roof repair is necessary ($4,680), and there is some miscellaneous physical deterioration that requires atten- tion ($17,820). In addition, the appraiser judges that the swimming pool has been placed too close to apartment number 11, resulting in some minor functional obso- lescence that could be eliminated by building an appropriate screening wall ($4,000). Because the property is relatively new, the appraiser determines that no allowance is necessary for economic obsolescence. Depreciation from all causes in the amount of $26,500 is subtracted from the estimated reproduction costs to yield a depreci- ated building value of $567,500. Adding this amount to the site value provides an indication of value by the cost approach of $717,500, which the appraiser rounds to $718,000.

| the income approach ____________________________________

The income approach to value is based on the principle of anticipation, which implies that purchasers buy properties in expectation of receiving future benefits. In general, the value of any income-earning asset can be thought of as the sum of the present value of the expected future returns to the owner, including both periodic cash flows from operations and cash flows from the eventual sale of the asset. The

ta b l e 9.2 Summary of Cost Valuation of an Apartment Property

Estimated production cost $594,000

Depreciation

Physical deterioration: cost of repairs (roof repair, painting, exterior caulking)

$4,680

Miscellaneous physical deterioration (3% of reproduction costs)

17,820

Functional obsolescence (screen between swimming pool and apartment to reduce noise from pool)

4,000

Economic obsolescence 0

Production cost less depreciation 567,500

Estimated site value 150,000

Total value indicated by cost approach $717,500

Rounded $718,000

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same logic is valid for any income-producing asset, whether it be the goose that lays golden eggs, a savings certificate from a financial institution, common stock, or income-producing real estate such as an apartment complex, a shopping mall, an office complex, or an industrial building. The income approach in real estate appraisal involves two basic steps: (1) estimating future income and (2) converting the income estimate into a present value estimate.

Appraisers employ many different techniques to convert future income into pres- ent value estimates. Each of these techniques has been developed to replicate the thought processes of the typical buyer in a market. We consider two these techniques here: gross income multiplier analysis and net income capitalization.

Gross Income Multiplier

All techniques used in the income approach to value are based on the idea that market participants demand investment returns in exchange for purchasing income properties. Furthermore, competition between market participants results in a rela- tively stable relationship between income and value in most real estate markets. When this relationship can be measured or quantified, appraisers can use it to esti- mate market values. One “rule-of-thumb” measure of the relationship between gross income and market value is the gross income multiplier, or GIM.

Gross Income Multiplier = Value Gross Income

The GIM is an estimate of the prevailing relationship between prices investors are willing to pay for properties and the gross income the properties are expected to produce. To calculate the GIM for a market, appraisers collect information about properties that have recently sold in the market, then divide the price of each prop- erty by its gross income. Of course, the properties used to estimate the GIM for a market must truly be comparable to the subject property. Gross income is defined as the total amount of revenue the property is expected to generate annually.

For example, consider a property that is expected to generate $10,000 per year in gross income. If that property is sold in an arm’s-length transaction for $100,000, the GIM for this property is 10: 100,000 ÷ 10,000. To use this measure to esti- mate the value of a similar property that is expected to generate $9,000 per year in gross income, we multiply $9,000 by 10 to get a market value estimate of $90,000. By observing market transactions, appraisers can measure the relationship between income and value using GIM, then use the multiplier to estimate market value of the subject property.

Because the GIM technique ignores the expenses of operating an income prop- erty, it is most appropriate when the expenses of the comparable sales are similar to the expenses of the subject property. When expenses differ across properties, a more detailed technique is required. The net income capitalization technique described below is an alternative technique that recognizes the variability in operating expenses across similar properties.

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C H A P T E R 9 Real Estate Appraisal 201

Net Income Capitalization

The net income capitalization technique recognizes that the value of an income property depends on “net” rather than “gross” income, as discussed above. In this technique, net income is converted into a present value estimate using a capitaliza- tion rate rather than a multiplier. The relationship between value and net income is measured as shown below:

Capitalization Rate = Net Income Value

For example, consider a property that recently sold in an arm’s-length transac- tion for $1 million. If this property is expected to generate net income of $100,000 annually, the implied capitalization rate for this property is 10%. To estimate the value of a similar property that is expected to generate $105,000 in net income (gross income minus expenses), we can rearrange the capitalization rate formula as follows:

Value = Net Income Capitalization Rate

Value = $105,000 0.10

Dividing net income by 10% provides a market value estimate of $1,050,000 for this property. By observing market transactions, appraisers can determine the capi- talization rate that best represents the relationship between net income and value, then use this measure to estimate the value of a subject property based on its net income. The accuracy of this technique, of course, depends on accurate estimates of the subject property’s net income and the capitalization rate.

| chapter review __________________________________________

■■ Real estate appraisers are specialists who possess the skills and knowledge necessary to estimate property value. The appraisal industry is subject to state regulation as a result of the Financial Institutions Reform, Recovery, and Enforcement Act of 1989, which requires that appraisals for property involved in “federally related” transactions be performed by state-licensed or certified appraisers.

■■ The Appraisal Foundation, through its Appraiser Qualifications Board and Appraisal Standards Board, implements the minimum guidelines for the four different appraiser categories and the professional standards of prac- tice appraisers must follow when performing appraisal tasks.

■■ The type of value that appraisers most often estimate is market value, or a property’s most probable selling price in well-defined situations.

■■ Four key principles underlying appraisal practice are

1. anticipation,

2. change,

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3. substitution, and

4. contribution.

■■ The six steps in the appraisal process include

1. definition of the problem,

2. data selection and collection,

3. highest and best use analysis,

4. application of the three approaches to value,

5. reconciliation, and

6. reporting the defined value.

■■ In the sales comparison approach to value, appraisers compare the subject property with similar properties that have sold recently. After adjusting for differences in the appropriate elements of comparison, the prices of these “comparables” provide an indication of the value of the subject property.

■■ In the cost approach, appraisers estimate value by estimating a property’s cost of production. The four steps in the cost approach are

1. estimate the value of the site,

2. estimate the cost to produce the improvements,

3. estimate accrued depreciation and subtract depreciation from produc- tion cost, and

4. add site value.

■■ In the income approach, appraisers estimate value by forecasting the future income that is expected to be generated by the property, then convert- ing that forecast into a present value. Techniques include gross income multiplier analysis, net income capitalization, and discounted cash-flow analysis.

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| key terms _______________________________________________

Appraisal Foundation

appraisal process

Appraisal Qualifications Board

Appraisal Standards Board

assessed value

capitalization rate

certified general appraiser

certified residential appraiser

cost approach

depreciation

economic obsolescence

Financial Institutions Reform, Recovery, and Enforcement Act

functional obsolescence

gross income multiplier

highest and best use

income approach

insurable value

investment value

licensed real property appraiser

market value

physical deterioration

price

principle of anticipation

principle of change

principle of contribution

principle of substitution

sales comparison approach

trainee appraiser

| study exercises _________________________________________

1. Provide a justification for the federal government’s decision to establish minimum education requirements and standards of practice for appraisers.

2. How many hours of experience are required for each of the categories of appraisers under the AQB criteria?

3. Based on the most widely accepted definition, what is market value?

4. Define the following concepts: value in exchange, value in use, investment value.

5. Does the concept of market value reflect the perceptions of the typical buyer in a market or a specific buyer? What is the difference?

6. Under what conditions is price equivalent to market value?

7. In what circumstances is it possible for the production cost of a property to exceed its market value?

8. Define the following terms: assessed value, insurable value.

9. List and define the four key appraisal principles discussed in the chapter.

10. Outline the steps in the appraisal process.

11. What issues must be considered in step 1 of the appraisal process?

12. Define the concept of highest and best use. Why is this an important step in the appraisal process?

13. Consider a property that is worth $45,000 as a vacant commercial site. The property is improved with a single-family residence. As such, the property is worth $35,000. If it costs $5,000 to demolish the structure, what is the

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value of the site? What is the value of the structure? What is the highest and best use of this property?

14. List the steps involved in each of the three approaches to value.

15. Why is reconciliation a necessary step in the appraisal process?

16. List the six elements of comparison in the sales comparison approach.

17. Consider a vacant lakefront lot measuring 90 by 120 feet in a residential subdivision. Three similar vacant lots have sold recently. Comparable number one measures 85 by 120 feet and is also located on the lake. It sold for $35,000 one week ago. Comparable number two is also on the lake, and it measures 85 by 120. It sold one year ago for $30,000. Comparable number three sold six months ago for $31,000. It is a hillside lot that offers an exceptional view. The lot measures 80 by 120 feet. Complete the market data grid provided to estimate the value of the subject property.

Sales Comparison Market Data Grid

Comparables

Subject #1 #2 #3

Sales price — $35,000 $30,000 $31,000

Size in square feet 10,800 10,200 10,200 9,600

Price per square foot —

Date of sale Current – 1 week – 1 year – 6 months

Adjustment for changing market conditions

—

Adjusted price per square foot —

Location Lake Lake Lake Hillside

Adjustment for location —

Adjusted price per square foot —

Indicated value of subject property:

18. Define the following terms:

a. accrued depreciation,

b. physical deterioration,

c. functional obsolescence, and

d. economic obsolescence.

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19. Consider the example discussed in Table 9.2. If the actual market value of the land was $190,000, and the cost to reproduce the structures was $610,000, what market value would be indicated by the cost approach?

20. Define the following concepts: gross income multiplier, capitalization rate.

21. An investor is considering the purchase of a 11,000-sq. ft. warehouse that is expected (based on comparable properties) to command $8.40 per square foot in annual rents. The two comparable warehouses have recently sold in the market. Comparable 1 measures 12,000 sq. ft. and sold recently for $450,000. Comparable 2 measures 8,600 sq. ft. and sold recently for $322,500. Compute the gross income multiplier that is implied by these transactions and estimate the value of the subject property.

22. Suppose the investor in the previous problem is concerned that the subject property may be more expensive to operate than the comparable properties. Analysis of the operating expenses for each of the properties reveals the following net income estimates:

Subject Property $52,400

Comparable 1 $65,600

Comparable 2 $47,000

Compute the capitalization rate implied by these transactions to estimate the value of the subject property by the net income capitalization technique.

| further reading _________________________________________

The Appraisal of Real Estate, 14th ed. Chicago: The Appraisal Institute, 2013.

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10c h a p t e r Property and Asset Management

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207

c h a p t e r p r e v i e w

As discussed throughout this text, the characteristics of real estate resources and transactions imply that specialized knowledge is needed for successful deci- sion making regarding real estate. Just as real estate brokers, salespersons, and appraisers provide a valuable service to buyers and sellers, property managers and asset managers also provide an important service to property owners. This chapter explores several issues related to the business of property management, including

■■ the role of the property manager in investment real estate;

■■ the property management agreement and the manager’s compensation;

■■ the functions of the property manager, including

■■ administration,

■■ marketing and advertising,

■■ tenant selection,

■■ lease negotiation,

■■ move-in inspections,

■■ property maintenance,

■■ rent collection,

■■ move-out inspections, and

■■ security deposit returns;

■■ and the role and function of asset managers.

close-up Green Acres

Shopping Center— A Property

Management Success Story

r e a l e s t a t e t o d a y

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| the role of the property manager ________________________

While many property owners are quite capable of managing their own proper- ties, others may find they have neither the ability nor the desire to cope with the complexities of managing rental properties. Day-to-day operating decisions for most income-producing properties require specialized skills that many real estate inves- tors do not have. Whether the owner chooses to wear the hat of the property manager or to hire a professional, the goal of the property manager is unchanged: to manage properties efficiently with the objective of maximizing the value of the property. When an owner hires a professional, the property manager acts as an agent for the property owner with respect to the leasing, marketing, and overall operation of the property. In many cases, the property manager is also a licensed real estate broker, though some states issue a separate license to property managers.

Consider an investor who purchases a small shopping center. Unless that inves- tor is experienced in shopping center management, a property manager may be required to handle the center’s operations. For example, the property manager will be responsible for marketing space in the center to potential tenants, negotiating the lease agreement, collecting rents, addressing tenant concerns, coordinating the prop- erty maintenance program, bookkeeping, and paying the property expenses such as utilities, property insurance, property taxes, and employee salaries. Having a trained professional to handle these tasks improves the likelihood that the investment will prove successful.

Property managers may be hired by the property owner as employees or inde- pendent contractors, or they may work for a property management firm that has con- tracted with the property owner to provide management services. Many successful property managers hold designations such as the Institute of Real Estate Manage- ment’s Certified Property Manager (CPM) or Accredited Resident Manager (ARM). Managers can be awarded these designations only after meeting the education and experience requirements established by the awarding organization. Membership in organizations such as the Institute of Real Estate Management (IREM) or the Build- ing Owners and Managers Association International (BOMA) benefits property man- agers through education, research, information, and more. Some states regulate the property management profession by requiring that managers obtain a license from the state after completing educational and experience requirements.

| the management agreement ______________________________

The management agreement establishes an agency relationship between the owner of a property and the property manager. To clarify each party’s duties and responsibilities, this agreement should be written. The document should specify the powers, obligations, and compensation of the manager, and it should set the term of the agreement.

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C H A P T E R 10 Property and Asset Management 209

Powers of the Manager

As the agent of the owner, the property manager has the power to set rents; to execute, extend, and cancel leases; to make settlements with tenants; to collect rents; to spend money on behalf of the property (a power generally limited to some maxi- mum dollar amount beyond which the owner’s approval is necessary); and to hire, fire, and supervise personnel to operate the property.

Just as the manager has the power to act on behalf of the owner, he or she also has the obligation to carry out those functions in a professional manner. Because the manager has a fiduciary relationship with the owner, many management agreements require that the agent and his or her employees be bonded.

Compensation

If the property manager is employed directly by the property owner, the most common form of compensation is a fee based on a percentage of the property’s gross income. The fee ranges from approximately 4% to 10%, depending on such factors as the size of the project, the responsibilities of the manager, and the competitiveness of the local market. If the property manager is an employee of a property manage- ment firm, the manager’s compensation is usually a fixed salary. The management company contracts with the property owner to provide management services for a fee negotiated between the property owner and the manager.

When a property owner hires a property manager, the parties should carefully outline their agreement to avoid confusion and disputes. Because property manag- ers serve as a fiduciary of the property owner, the relationship between owners and managers is an agency relationship. We saw the legal issues involved with agency in Chapter 8 concerning real estate brokerage. Being a fiduciary means that the man- ager must always work in the best interest of the principal in the agency relationship. Though some states allow oral management agreements, we recommend, as always, that such an important contract be put into written form.

| functions of a property manager _________________________

The property manager may be involved in virtually all aspects of the operation of a rental property. Whether the property manager is the owner of the property or an agent of the owner, the functions of a property manager include

■■ administration,

■■ marketing and advertising,

■■ tenant selection,

■■ lease negotiation,

■■ move-in inspections,

■■ property maintenance,

■■ rent collection,

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■■ move-out inspections, and

■■ security deposit returns.

We will consider each of these functions in turn.

Administration

Part of a property manager’s function is to handle the day-to-day administrative concerns of the property. Administration refers to record keeping, report genera- tion, paying the property’s bills, monitoring the employees, and generally overseeing the property’s operations. The exact administrative activities of the property man- ager vary with the type of property and the breadth of the property management agreement.

Marketing and Advertising

Leases are perishable commodities: They expire. Rental space, therefore, must be marketed continually so new tenants can be found to take the place of those who leave. Lease periods range from one day for hotel and motel rooms to several years for commercial property. (Residential apartments may be leased for perhaps six months or a few years.) The general objective of marketing is to maximize property value. This usually means to maximize occupancy rates and rental price schedules. The two obviously are in conflict, however, and a balance must be found in order to maximize income. One can ensure a rental unit’s occupancy for three years, for example, by granting a three-year lease, but the income derived from the unit may be greater if it is rented to three successive tenants for one year each—if, at the end of each year, market conditions provide a tenant willing and able to pay a higher rent. The property manager must understand the market in which he or she is operating in order to make the right decision.

Choosing the correct marketing strategy is important to the success of any rental project. This is an area where the property manager’s experience and expertise can be of tremendous value to the owners. A clear marketing strategy is essential. What types of tenants are sought? Will the project attempt to stress some price advantage, location, design, or other marketing feature? Unless a clear strategy is carried over into tenant selection, rent schedules, and the physical character of the project, it will be impossible for the property to reach its maximum potential.

The purpose of advertising a rental property is to find a tenant, and the type of advertising that is appropriate varies from market segment to market segment. For example, a property manager seeking a tenant for a vacant unit in a trailer park might use very different advertising methods from those secured by a manager seek- ing a tenant in a Class A office building. The key to “good” advertising is using the

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C H A P T E R 10 Property and Asset Management 211

advertising tool that will attract the best tenants to that particular property type. Examples of advertising tools include

■■ signs on the property,

■■ neighborhood flyers,

■■ bulletin boards,

■■ internet sites,

■■ listing the property with leasing companies,

■■ newspaper ads, and

■■ “open house” days or weekends.

Tenant Selection

If the advertising campaign is effective, potential tenants will respond and express an interest in leasing the property. Property managers must carefully evalu- ate each tenant to ensure that accepting this tenant is consistent with the overall objective of the manager: maximizing the return to the property owner. Of course, no property manager should discriminate against potential tenants in any way that violates anti-discrimination laws, but other tenant characteristics should certainly be considered in the tenant selection process.

In the case of residential property, for example, the 1988 Fair Housing Act pro- hibits anyone from refusing to rent to someone because of their race, color, national origin, religion, sex, familial status (including children younger than 18 living with parents or legal custodians, pregnant women, and people securing custody of chil- dren younger than 18), or physical disability. Discrimination charges under this act are investigated by the U.S. Department of Housing and Urban Development. In addition to this federal requirement, many states and some counties and cities impose additional restrictions on how residential landlords can screen potential ten- ants. Various state- and city-level antidiscrimination laws address educational status, sexual preference, occupation, medical status, and age.

The tenant mix is also important for nonresidential properties. The objective usually is to achieve a variety of tenants that will complement and enhance the image the project is seeking. For example, a coin-operated laundry would not be a desirable tenant in an upscale shopping center where relatively expensive goods were sold in boutiques, but it might be quite complementary to other stores in a small neighbor- hood center.

To evaluate prospective tenants on valid grounds, property managers should request from each tenant a completed tenant application that collects information regarding the applicant’s financial resources (including employment and income sta- tus), credit history, and references from prior landlords. In his book The Landlord’s Troubleshooter, Robert Irwin strongly recommends that more emphasis be placed on the reference (or lack thereof) provided by the applicant’s landlord before the cur- rent one. The current landlord may be anxious for the tenant to leave and may give

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a glowing recommendation to speed the tenant’s departure. The landlord prior to the present one is likely to give a more honest recommendation.

Lease Negotiation

Even before the advertising and tenant selection processes begin, the property manager should decide the acceptable conditions of the lease agreement. Obviously, the rent amount is a key issue, but there are many other factors that should be resolved in a well-written lease. Examples of issues to be addressed include the following:

■■ What is the amount of the security deposit?

■■ What day will rent be due each month?

■■ What day will the rent be considered late each month?

■■ What is the nature of the tenancy (tenancy for a stated period, tenancy from period to period, or tenancy at will, as discussed in a previous chapter)?

■■ Is the lease renewable? At what rent level?

■■ What items will the tenant be responsible for maintaining?

■■ What is the permitted use of the property?

■■ How many people may occupy the property?

■■ Who is responsible for maintaining insurance on the property?

■■ Can the tenant sublease the property to others?

■■ Do local laws require that the landlord make any safety or health dis- closures to the tenant (asbestos, lead-based paint, radon, etc.)?

■■ Are pets allowed? How many? What kind? How big?

As we discussed in Chapter 6 on contracts, being a good negotiator requires being open to new ways of structuring a deal to benefit all parties. Of course, there are some issues that managers must hold firm to or risk violating their overall objec- tive: maximizing value to the property owner.

Move-in Inspections

When a lease agreement is in place, the next step before turning over the keys to the property is for the manager and tenant to perform a move-in inspection. This inspection is critical because it will be the basis for any claim the manager may make against the tenant’s security deposit at the end of the lease. Any existing damage to the property should be carefully documented, and both the manager and the tenant should sign the document. With this strategy, the tenant can be held responsible for any additional damages (beyond normal wear and tear) that might be discovered during the lease period or on termination of the agreement. Some property managers use photographs and videos to document property condition at the start and finish of a lease agreement.

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C H A P T E R 10 Property and Asset Management 213

Property Maintenance

Though some leases require that the tenant take care of any property repairs, the manager is usually responsible for ensuring that the repairs are done promptly and correctly. Some larger properties may have a property maintenance staff, while smaller properties will use local repair contractors (plumbers, roofers, electricians,

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Green Acres Shopping Center—A Property Management Success Story

When Frank Brookins took over the man agement of the Green Acres Shopping Cen ter, it was in real trouble. Built 20 years earlier in typical neighborhood strip-

shopping-center style, two-thirds of its approxi- mately 60,000 square feet were vacant. The center was showing its age, and the main tenant, a grocery store, had moved out, leaving its 16,000- square-foot space empty. The tenant mix was less than desir able. For example, a “game” room had become well known to local police for the drug activity that alleg edly occurred there. The center obviously was not generating an acceptable return for its owners, and its marketability was low.

Frank’s first task was to improve the appear- ance of the center. He was helped by a storm and the local government. The storm tore the outdated turquoise facade off the building, and the insur- ance settlement provided the monies to replace it and repaint the center. The local government bought right-of-way for widening the road in front of the cen ter, and these monies paid for a new sign with a time and temperature display to give the center some identity. The ugliness of the black- top parking lot was broken by the construction of islands filled with shrubs and trees. Although these improvements were relatively inexpensive, they vastly improved the attractiveness of the center.

The next task was to improve the tenant mix and to fill the empty spaces. The key was secur- ing a tenant for the black hole formerly occupied by the supermarket. Mr. Brookins learned that the state’s nursing school was unhappy with its current location. Although this would be a some- what unconventional tenant for a neighborhood shopping center, the 100 students would provide a ready market for restaurants and other potential tenants. The catch was that the state required that the owner provide building improve ments equal to about three years’ rent, although it would sign only a one-year lease. Even so, the owner took the plunge.

With the nursing school as an anchor, two restau rants and other stores soon followed, one replacing the game room whose lease was not renewed. Cur rently the center is fully leased, and it is generating three times the gross income it did just five years ear lier, with consequent increase in value.

“Successful property management depends on constant attention to detail,” explains Mr. Brookins. “Every morning I am there making sure the parking lot is clean, the plants maintained, and that the cen ter is ready for customers. That’s what keeps ten ants happy, creates value for the owners, and provides good commissions for me.”

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214 PA RT T WO Real Estate Service Industries

etc.) on an as-needed basis. The manager must shop for the needed professionals carefully to get the best price and performance for the property owner. Failure to address minor repairs may lead to even more costly repairs in the future.

Physical management is divided into two categories: (1) maintenance designed to conserve the property and (2) rehabilitation and renovation designed to make the project more competitive in a changing market.

A program of continuing maintenance is essential to continued economic viabil- ity. Owners and managers who fail to give proper attention to landscaping, redeco- rating, and other items of general maintenance will soon find their project no longer competitive in the marketplace. Even if a project is well maintained, it may be nec- essary, after a time, to conduct extensive renovations to keep it viable. For instance, an older shopping center may benefit greatly from a new facade and redesigned landscaping and parking areas.

Rent Collection

One of the most arduous tasks facing a property manager is rent collection. Sooner or later, every manager must deal with a tenant who is “late with the rent.” If a tenant does not pay the rent on the due date stated in the lease agreement, the manager should take the following actions simultaneously:

■■ Discuss the issue with the tenant and determine when the rent will be paid

■■ Begin the eviction process

In most cases, tenants will offer an excuse for why they have not paid their rent as required. A “tough” manager will respond that the rent always must be paid on time and that there are no acceptable excuses for late rent. The manager will explain that if the tenant cannot afford to pay the rent on time, then the tenant cannot afford to occupy these premises. What does a “reasonable” manager do? Exactly the same things. If the tenant is persistent in paying rent late, the manager should either rene- gotiate the lease agreement to change the date rent is due or should evict the tenant for violating the original lease agreement. Of course, if a tenant refuses to pay the rent, the manager has no choice but to evict the tenant.

Most states have landlord-tenant laws that regulate the eviction process. Manag- ers must follow these laws precisely to avoid denying a tenant “due process.” Most states require that landlords give tenants a written notice stating that eviction will begin in a certain number of days (usually three to seven) if the rent is not paid in full before the time expires. After the time period expires, the landlord must file a lawsuit asking a court for possession of the premises from the tenant. If the landlord prevails in the suit, the tenant is evicted. Eviction means the tenant’s rights of use and possession are terminated by the court, and the tenant will be forcibly removed (if necessary) from the property by a court officer (sheriff). Managers may not use threats or intimidation tactics to encourage tenants to vacate a property. Managers must follow the process for eviction prescribed by state and local laws.

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C H A P T E R 10 Property and Asset Management 215

Move-Out Inspections

On termination of the lease agreement, the manager should inspect the prem- ises with the tenant to determine if the tenant is responsible for any damage to the property. As mentioned earlier, having a carefully documented “move-in inspection” makes the “move-out inspection” go more smoothly.

Security Deposit Returns

After the inspection is completed, the manager is legally obligated to return any unused security deposit to the tenant. The security deposit is money collected from the tenant prior to granting occupancy that protects the landlord from damages the tenant may cause or from failure to pay rent as agreed. If any of the deposit is retained for damages or unpaid rent, most states require that the landlord give the tenant a written explanation of all charges. Most states set a time limit on how long the landlord has after the lease terminates to return any deposits due to the tenant.

| the role and function of asset managers _________________

The preceding discussion has focused on the role of the property manager when the property is operated as income-producing real estate. Another type of property manager, known as the asset manager, is increasingly becoming common in the real estate market.

Almost every business firm must own or lease real estate as a part of its opera- tion, even if the firm’s primary line of business is not real estate–related. Often, the company’s exposure to the real estate market is quite substantial, and a professional real estate manager is needed to manage the company’s real estate assets. In this situation, persons assigned to this task are known as corporate real estate asset managers. The tasks of an asset manager are often more complicated than those of a traditional property manager because the asset manager must operate within the framework of meeting the company’s overall objective in its primary line of busi- ness. Corporate real estate asset managers are real estate specialists who provide a wide range of real estate services for their companies, even though the company may not be “in the real estate business.”

The asset manager has four major functions, including (1) management, (2) acquisition, (3) financing, and (4) disposition of corporate real estate assets.

Management

The management function of the real estate asset manager goes beyond facility management to include the strategic decisions involving the real estate needs of the firm. The asset manager can aid operating units in planning, acquiring and financing facilities, often improving the return on the firm’s real estate that might otherwise be underutilized.

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216 PA RT T WO Real Estate Service Industries

Acquisition

Few top business executives in industries that are not directly related to real estate possess the specialized skills needed in planning for their real estate needs or in site selection. A professional real estate asset manager can assist in targeting space requirements and design features. He or she can also aid the site selection process, considering the complex factors involved with locating various types of facilities. The asset manager also serves as the firm’s negotiator in reaching a final agreement when it comes to leasing or buying additional space.

Financing

The first issue in financing a new facility is the question of whether it is in the company’s best interest to lease or purchase the property. This decision involves many factors, including the general financial status of the firm and whether the facil- ity required is a special-purpose building. The firm might decide to build the struc- ture needed, then immediately sell it to an investor and simultaneously lease it back. This strategy, known as sale-and-leaseback, frees up the firm’s capital for use in its primary line of business. If ownership is the chosen alternative, the asset manager assists in deciding what type of financing will best fit the objectives of the firm.

Disposition

Another important part of the corporate asset manager’s job is to redeploy or divest property that is no longer needed by the firm. This may occur because of reduced operations and consolidations or because the facilities have become surplus owing to the acquisition of new ones. Disposition may involve the property’s sale or lease to another firm, renovation for another use, or exchange for another property.

| chapter review __________________________________________

■■ Professional property managers are trained to manage properties efficiently with the objective of securing the highest net return for the property owner over the property’s useful life. The property manager acts as an agent for the property owner with respect to the leasing, marketing, and overall operation of the property.

■■ Property management encompasses three functions: (1) administrative management (the collection of rents, the keeping of records, and the prepa- ration of reports), (2) marketing (the leasing of rental space in the manner most profitable for the owner in the long term), and (3) physical manage- ment (maintenance designed to conserve the property and rehabilitation and renovation designed to make the project more competitive in a chang- ing market).

■■ The management agreement identifies the powers and obligations of the property manager and the compensation he or she is to be paid. The

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C H A P T E R 10 Property and Asset Management 217

agreement also specifies the time period for which the relationship will exist.

■■ The usual form of compensation for property managers is a fee based on a percentage of gross income from the property.

■■ Corporate real estate asset managers are real estate specialists who pro- vide a wide range of real estate services for their company, even though the company may not be “in the real estate business.” The asset manager has four major functions, including (1) management, (2) acquisition, (3) financing, and (4) disposition of corporate real estate assets.

| key terms _______________________________________________

asset manager

eviction

management agreement

property manager

sale-and-leaseback

security deposit

| study exercises _________________________________________

1. What is the primary objective of a property manager?

2. What are the general functions of a property manager?

3. What is the legal relationship between the property manager and the owner? What document creates this relationship?

4. What purpose do security deposits serve from the lessor’s perspective? What does an asset manager do? How do these tasks differ from the tradi- tional property manager’s?

5. Describe the strategy known as sale-and-leaseback.

6. If a tenant fails to pay the rent on time, can the manager or landlord discon- nect the utilities to encourage the tenant to cough up the dough?

7. Under what circumstances can a private property owner refuse to accept a tenant because of his or her gender, or race, or religion?

8. Why should a property manager carefully document the physical condition of the property at the beginning of a lease?

9. Define the concept of eviction.

| further reading _________________________________________

Kyle, Robert C. Property Management, 9th ed. La Crosse, Wisconsin: Dearborn Real Estate Education, 2013.

O’Mara, Martha A. Strategy and Place: Managing Corporate Real Estate and Facilities for Competitive Advantage. New York: The Free Press, 1999.

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Real Estate Market Analysis

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Residential Land Uses

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221

c h a p t e r p r e v i e w

The objective of real estate development is to create value by converting land from one use to a higher and better use. The process of real estate develop- ment is one that requires extensive knowledge and practice of all aspects of real estate: legal, financial, and markets. Because of the special characteristics of real estate improvements—large size, long life, and long gestation period—success in real estate development is in large part determined by the accuracy of fore- casts of long-term market potential for the project.

This chapter and Chapter 12 examine the real estate development process. In this chapter, we focus on residential land development, while Chapter 12 deals with various types of commercial development.

Residential development takes various forms: single-family and multifamily dwellings, primary and secondary homes, custom-built and factory-built houses. Whatever form a development is to take, successful developers must study care- fully the market for the type of housing they contemplate and analyze carefully the financial feasibility of the proposed project.

The topics to be covered in this chapter are

■■ types of residential development, including (1) single-family detached houses, (2) single-family attached houses, (3) multifamily residences, (4) manufactured homes, and (5) second homes;

■■ time-sharing;

■■ market and feasibility analysis; and

■■ financial feasibility analysis.

close-up Civita: An Urban

Green Village

close-up If You Build It

Green, Will They Come? Yes!

close-up Five Historic New Towns: Savannah,

Riverside, Radburn, Levittown, and

Reston

close-up Highlands Falls Country Club

close-up Milford Hills Saga

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222 PA RT T H R E E Real Estate Market Analysis

| types of residential development ________________________

Although the single-family home on its own lot remains the ideal of most Ameri- can families, other forms of single-family dwellings are becoming increasingly pop- ular. Multifamily residences, too, take various forms. The five principal types of residential development are

1. single-family detached houses,

2. single-family attached houses,

3. multifamily residences,

4. manufactured homes, and

5. second homes.

Single-Family Detached Houses

The single-family house separated from any adjoining house with at least some open land on all four sides remains the dwelling type most sought after by American families. Many will accept a very basic house on a very small lot simply to attain this goal. The reason often given is that the detached house provides more privacy than an attached dwelling, though this is not always the case, especially if lots are small. Nevertheless, because of this perception, detached houses often have the best resale value.

Patio or Zero-Lot-Line Houses The patio house, or zero-lot-line house, is very similar to the detached house

except that construction is from lot line to lot line, with an outdoor living area in an interior garden court.

The garden court is normally enclosed by the house or by the house and walls. Although small compared to the yard of the usual single-family detached house, the secluded area provides a great deal of privacy. The houses are usually one story, are often L-shaped, and may have one small side yard to provide passage to the rear court area.

Single-Family Attached Houses

The attached row house is a form of housing that goes back to colonial times. This type of dwelling, on its own fee simple lot but sharing common walls with its neighbors, was quite common in cities of the East and in San Francisco.

The first association of homeowners who owned streets and parkland in common was founded in Boston in 1826. Louisburg Square, which contains 18 row houses and a common park on a 2.3-acre site on Beacon Hill, remains a very desirable resi- dential area even today.

The rise of the suburbs shortly after the turn of the 20th century led to the domi- nation of the detached house. The suburban form of the row house, the town house, was a rarity until the 1960s; the overwhelming majority of such dwellings have been

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C H A P T E R 11 Residential Land Uses 223

built since 1970. For projects that are owner-occupied, almost all have used the condominium form of ownership, with a community association managing common areas.

The single-family attached dwelling has several advantages over the detached project. Clustering requires less road frontage and shorter utility lines, resulting in lower development costs per unit. The higher density of houses also permits lower land costs, further reducing cost per unit. This type of development also can result in less adverse ecological impact, with more of the site being left in its natural state and with more useful open space. A frequent complaint in conventional subdivisions is “I have to spend my weekends cutting all that grass, but there’s no place for the kids to play.” In a well-designed single-family attached project, yard maintenance by the homeowner is reduced greatly or eliminated, and there is a place for the children to play.

Single-family attached housing can be of several types, including the town house, the plex, and the patio house.

Town Houses The town house is similar to the old row house. Each unit has its own front door

that opens to the outdoors, but it shares one or both side walls with adjacent houses. Although the town house has no side yards, it may have front and rear yards. Town houses may front on the street or may be built in a series of five to 10 units fronting on a common area.

Plexes The plex shares the characteristics of the town house and the single-family

detached house. Each building in a plex contains two or more units, each with its own outside entrance. A duplex is for two families; a triplex, for three families; a quadruplex, for four families; and so on.

Multifamily Residences

Although the single-family home is still preferred by most families, it is too expensive for an increasing portion of the population. Multifamily housing may be the best alternative for such families, as well as for young couples who lack the down payments necessary to purchase their own homes, “empty nesters” who no longer need or desire as large a home as they did when their children lived with them, and single-person households. Where land prices are extremely high, rental or owner- occupied apartments may be the only feasible type of new housing available.

Ownership Alternatives: Condominiums and Cooperatives As noted in Chapter 2, many potential homeowners look to condominiums and

cooperatives as ownership alternatives. To review these concepts very briefly, the owner of a condominium (condo) holds title in fee simple to the particular unit

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224 PA RT T H R E E Real Estate Market Analysis

occupied and shares ownership in common areas such as recreational facilities, lob- bies, and parking lots. The owner of a cooperative (co-op) owns stock in a corpora- tion that actually holds title to the property, but the individual has the right to live in a particular apartment. Almost all condos and co-ops are attached or multifamily units.

Condominiums and cooperatives offer several economic advantages to the buyer when contrasted with renting. Like other homeowners, the owner of a condo or co-op can deduct property taxes and mortgage interest from taxable income for income tax purposes. Second, and perhaps of even greater importance, condominium or cooperative ownership serves as a hedge against potential inflation, enabling the owner to accumulate an equity position. Conversely, of course, it also exposes the owner to potential declines in housing prices.

An aging home-buying demographic and economic factors affecting the once- overbuilt rental market helped increase the popularity of condos and co-ops. Operat- ing costs for apartments in many cit ies increased far more rapidly than rents, and in

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Civita: An Urban Green Village

In the 1920s, the Grant family started a quarry and concrete business that produced stone and concrete for many of the major construction projects in

San Diego for over 70 years. Finally, the quarry was entering the end of its life cycle, leaving a 230-acre developable site in the heart of the Mission Valley district. It presented quite a challenge both to potential developers and to the city.

Sudberry Properties, a San Diego-based com- mercial real estate developer, proposed a mixed- use, walkable, transit-oriented, infill community called Quarry Falls, which included 4,500 diversely priced residences and more than 1 million square feet of office and retail space for shops and res- taurants. The project was designed to follow an urban master plan endorsed by the city called the

City of Villages that envisions mixed-use, sustain- able communities. The plan placed almost 50% of its land area in some type of open space and was designed to be walkable with easy access to public transit facilities. The plan received Gold Certification from the Leadership in Energy and Environmental Design (LEED) neighborhood devel- opment pilot program.

Despite depressed economic conditions, the first phase of the project, renamed Civita, broke ground late in 2010. One factor that made this possible was the land-owning Grant family’s willingness to remain in the development, greatly reducing the need for developer financing. It is scheduled to be built in four phases over 12 to 15 years and require a total investment of approxi- mately $1.5 billion.

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C H A P T E R 11 Residential Land Uses 225

cities with rent controls, the squeeze was much worse. That led to a large number of conversions from rental units to condominiums and cooperatives. That trend began in Chi cago and spread to other metro areas across the country.

Condos continue to be a part of the home-buying landscape with most in major metro areas and larger suburbs.

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If You Build It Green, Will They Come? Yes!

Over the past several years, energy efficiency and environ- mental awareness have moved tocenter stage in the commercial building industry. The Depart-

ment of Energy estimates that 58% of all commer- cial construction in 2015 includes “green” components, and in building projects costing $50 million or more, 71% specifically reference Leadership in Energy and Environmental Design (LEED) certification as a primary goal.

What’s driving energy efficiency is the rising cost of fossil fuels used to heat, cool, light, and secure the nation’s 5 million commercial and indus- trial buildings. The Department of Energy says those buildings account for more than 20% of the nation’s annual energy consumption – at a cost of $200 billion per year—while producing 45% of the nation’s greenhouse gases. The U.S. Energy Infor- mation Administration (EIA) estimates that more efficient buildings will save American consumers more than $4.61 trillion through 2030.

Equally important to the real estate sector is that energy efficient buildings are proving to be magnets for tenants.

The Institute for Building Efficiency, using sta- tistics from McGraw-Hill’s annual U.S. construction analysis, found that energy is the highest operat- ing cost in most office buildings and that green

buildings reduce that operating cost now and offer additional building valuation in the future.

Looking at both LEED-certified and ENERGY STAR-certified space, approximately 4 billion square feet in total, the study found:

• Green properties had rental premiums of 7 to 9% in 2010, or more than $2.60 per square foot.

• ENERGY STAR buildings had 13.5% higher market values compared to non- ENERGY STAR buildings.

• In 2010, occupancy rates for LEED-certi- fied buildings were 16 to 18% higher than conventional buildings of the same style and quality; occupancy rates for ENERGY STAR buildings were 10 to 11% higher.

• Operating expenses were 30% lower in ENERGY STAR buildings than non- ENERGY STAR building and utility expenses were 9.8% lower.

• For ENERGY STAR buildings, net operat- ing income per square foot was $0.25 higher (5.9%) than non-ENERGY STAR properties.

The study also suggested there were non- calculable co-benefits to energy efficient spaces, including building designs that allowed more daylight that improved the customer and employee experience and worker productivity.

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Manufactured Homes

A manufactured home, or mobile home, is a dwelling that is manufactured in a factory and then moved to a particular site. The traditional image of mobile homes has been that of cheap, tacky, and high-density housing in sleazy “shantytown” trailer parks. Unfortunately, in the past, much of this reputation was richly deserved. In contrast to the resale value of conventional site-built houses, which has generally appreciated, the value of a mobile home generally fell each year. This caused many lenders to treat mobile homes as personal property, much like automobiles, and to provide only relatively short-term, high-interest installment loans. In many areas, it was impossible to obtain a single mortgage that would cover the purchase of both a mobile home and its site. Opposition to mobile-home developments led many com- munities either to zone them out completely or to limit them to generally undesirable or rural areas.

The image is changing, however, because the design and construction of manu- factured homes has been greatly improved. With the introduction of new materials and designs, the “oversized aluminum shoebox” has been replaced by a structure much closer to a conventional house in appearance. Part of this process has been the trend toward wider units and the double-wide and triple-wide units that are assembled on site into 24-foot-wide to 36-foot-wide homes. Construction quality also has improved tremendously with the introduction of required national or state construction standards. Some states have even formed organizations to address con- cerns regarding manufactured housing. For instance, in Virginia, the Virginia Manu- factured Housing Board operates within the Department of Housing and Community Development. The board is composed of nine members appointed by the governor. The members must include two manufactured home manufacturers, two manufac- tured home dealers, the director, and four members representing the public who have knowledge of the industry.

The economies of scale and the controlled construction environment give manufactured homes a definite price advantage over conventional site-built homes. Although direct comparisons are difficult because conventional homes usually con- tain more luxury features, U.S. Department of Commerce data show that the average price of a multisection manufactured home is about $40 per square foot, compared to over $90 for the average site-built home.

These factors, plus the trend toward owner-occupied manufactured-home sub- divisions instead of rental parks, have led lenders to liberalize financing and make it more comparable to that for conventional homes. In the past, mobile homes were considered personal property and were financed with 10-year to 15-year consumer installment loans that generally carried an interest rate approximately 2 percentage points above conventional mortgage rates. Today, however, owners of manufactured homes located permanently on their lots can obtain 30-year, FHA-insured mortgages.

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Five Historic New Towns: Savannah, Riverside, Radburn, Levittown, and Reston

Although we tend to think of large-scale planned develop- ments and “new towns” as being relatively recent developments, they are not. This Close-Up

examines five historic examples: Savannah, Georgia, a new town from the colonial era; River- side, Illinois, a railroad suburb begun in the 1870s; Radburn, New Jersey, a 1920s “city for the motor age”; Levittown, New York, which introduced mass home building; and Reston, Virginia, one of the most successful of recent years.

Savannah, Georgia Quite a few cities in this country were planned communities, including New Haven, Philadelphia, Detroit, Williamsburg, Mobile, New Orleans, and, of course, Washington, D.C. One of the most innova- tive was Savannah, Georgia, planned in 1730s by James Oglethorpe. His basic unit was a ward, con- sisting of 48 lots grouped around public squares. For over 100 years the city expanded by adding such cellular units until there were 26 squares.

Savannah became an economic backwater when the cotton economy collapsed, protecting most of the old plan from redevelopment until its historic and economic potential was realized. Two of the squares were destroyed to make way for a road, and one was covered over by a hideous parking garage. The remainder, with their homes restored, make Savannah one of the unique cities of the United States.

Riverside, Illinois Adoption of the rectangular survey system for the western lands stretched the grid system across the country, and almost all new communities were

laid out in this fashion. A notable exception was Chicago’s most famous suburb, Riverside. River- side was designed in 1869 by the nation’s leading landscape architect, Fredrick Law Olmsted, who rejected the conventional grid pattern and devel- oped a curvilinear street system. Open parkland straddled the Des Plaines River, and a park sur- rounding the railroad station provided a focus for the town government and business activities. The railroad made commuting the 10 miles to Chicago feasible and allowed the town to develop as a bedroom community.

Over 130 years after it was first developed, Riverside is still an outstanding town that contains the best features of “modern” planning. It also remains an economically viable community in which property values bring a premium.

Radburn, New Jersey Radburn, New Jersey, was designed as a “city for the motor age.” It was originally conceived as a town for 25,000 residents located on 1,300 acres in then-rural Bergen County. Ten miles from mid- Manhattan, Radburn was designed as a series of “superblocks.” Traffic was routed around these neighborhoods, and houses were located on cul- de-sacs, oriented toward interior parks of four to six acres. A system of pedestrian walkways and underpasses achieved complete separation of vehicular and pedestrian traffic.

The Great Depression, which hit only five months after the first houses were completed in May 1929, aborted Radburn’s growth, and only 150 acres, containing two superblocks, were devel- oped according to the original plan. Even so, Rad- burn is a viable community today and has served

(continued)

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Five Historic New Towns: Savannah, Riverside, Radburn, Levittown, and Reston

as a planning example for developments in many countries, particularly in recent years.

Levittown, New York Following World War II, there was tremendous pent-up demand for housing, particularly among the returning veterans. William Levitt, who was already an experience mass builder of war-time housing, bought 1,000 acres of potato farms on Long Island and set out to build a new town, Levittown.

Levitt’s homes won no awards for architectural excellence. They were 750 square foot, two- bedroom Cape Cods on 60 by 100 foot lots. The houses were built in assembly line fashion, with specialized crews for each step of the process. For example, one man’s sole job was to bolt washing machines to the floor. Using these techniques, Lev- itt was able to turn out 30 to 40 houses a day, and sell them for only $7,990. Even in 1951, this was a very attractive price, and he ended up selling 17,400 homes in Levittown.

Many predicted that Levittown would turn into instant slum, but the town has since surprised many of its critics. The modest standardized houses have been modified over the years to reduce the sameness, and the saplings that were set out fifty years ago are now mature large trees. The homes, which sold for about $8,000, now sell for an average of near $155,000, some reaching more than $200,000.

Reston, Virginia Reston was the first of the modern new towns in the United States and owed much of its inspiration to Radburn. The town was begun in the early 1960s by Robert E. Simon, who used his initials in naming the town. Simon purchased 6,750 acres of Virginia countryside near Washington, D.C., and planned a complete city for approximately 70,000 residents.

Reston was officially dedicated in May, 1966, just in time to have its sales severely affected by the tight-money conditions accompanying the Vietnam War buildup. Land development requires relatively large up-front investment before sales generate adequate cash flow. In a large under- taking such as Reston the up-front costs were massive, and the sales slowdown forced Simon to sell Reston to Gulf Oil Company, which already had made an investment in Reston and had the finan- cial resources to sustain a long-term development.

Reston has met Simon’s original vision and has been a financial success, even if not for him. The town now has a population of about 60,000. Six of the village centers have been completed, along with the town center which serves as Reston’s “downtown.” Reston straddles the Dulles Technol- ogy Corridor and is the home of three Fortune 500 companies, the National Wildlife Association, a regional governmental center, and the U.S. Geo- logical Survey.

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C H A P T E R 11 Residential Land Uses 229

Second Homes

By their very nature, second homes are very different from primary homes, and second-home markets are quite different from primary-home markets. The principal reason for owning a second home is the desire to use it for leisure-time enjoyment, and certain amenities are ordinarily the main factors in its location: beaches, moun- tains, golf courses, tennis courts, ski lifts, and so on.

Most second-home owners occupy their dwellings for only a small portion of the year, often because of the seasonal nature of many resorts but also because the owners are unable to get away from their jobs or other responsibilities for extended periods. Hence, many units are bought at least partially for their investment potential and rented for much of the year. As landlords, owners enjoy various tax benefits, including depreciation allowances and deduction of maintenance costs, but changes in tax laws and regulations have greatly reduced potential tax advantages in recent years. For example, there are limits on the time the owner can occupy the dwelling and still claim it as rental property.

Because ownership of a second home is so expensive, many buyers in recent years have turned to resort time-sharing, a concept discussed in Chapter 2. Under time-sharing, a single dwelling is sold to a number of buyers, each of whom receives exclusive ownership of the dwelling for a specified time period each year. Like other forms of fee simple ownership, this ownership interest can be willed, leased, or sold.

The time-sharing concept of vacation property first appeared in the 1960s, and today there are about 1,600 timeshare resorts in the United States. Over three million consumers own time-share units.

| market and feasibility analysis __________________________

Many factors determine the demand for housing at the national, regional, and neighborhood levels. All such factors must be considered when analyzing the market for a particular project. Both developers and lenders need to know what the market will be for a project in order to determine its feasibility. Essentially, they must deter- mine what market conditions have been in the recent past and which factors that would affect the market for the project are likely to change in the near future. The steps in such a market analysis are

1. delineation of the market area;

2. analysis of recent economic trends in the local market area;

3. determination of possible changes in demand factors, such as employ- ment, disposable income, population, household characteristics, and the absorption rate (the number of units that are being absorbed by the market); and

4. analysis of the potential supply, including other possible competing projects.

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Highlands Falls Country Club

It was not an outstanding golf club com munity or real estate development. In fact, the Highlands Falls Country Club was a failure. Located near the

western North Carolina mountain resort town of Highlands, the club was first opened as the nine-hole Skylake golf course in the 1960s. It was a shoestring operation, with golfers depositing their greens fees in an honor box, where the money was picked up at the end of the day. Several develop- ers worked on the project, the last adding nine more holes and a clubhouse. By 1980, there were about 85 homes, but the sales were slow and the project’s mortgage was foreclosed.

The mortgage on the Highlands Falls Country Club was held by two real estate investment trusts. They had to decide whether the development could be made economically viable.

Not only was Highlands Falls Country Club a failed project with a poor reputation, it also came with about 85 very disgruntled and suspi cious existing homeowners. Thus, the new development firm was faced with the daunt ing task of not only developing a high-quality golf club that could yield a development profit but also handling a near revolt of existing club members. It was no small task.

Noted golf architect Joe Lee completely rede- signed the golf course, building several new holes and combining others to create longer ones, and the entire course was refurbished. While this made Highlands Falls a much better and more chal- lenging golf course, it also made some of the old club mem bers unhappy because they preferred the shorter course. A tennis and swim center was added, and extensive additions and renovations were made to the clubhouse.

The developer worked very hard to upgrade the image of Highlands Falls, but this was a slow, uphill process. Both the members and the

community had seen too much mediocre devel- opment and failure in the past. Rumors persisted that the club would soon be foreclosed again. Gradually, how ever, the sweeping physical facility improvements, increasing lot and home sales, and small but impor tant touches such as extensive landscaping and masses of flowers turned the country club’s image around.

Today, Highlands Falls Country Club has a deserved reputation as one of the premier clubs in an area of very exclusive golf courses. Lots, which in 1980 ranged in price from $10,000 to $15,000, now range from $80,000 to $300,000, with one exceptional view lot selling for $650,000. There are now more than 375 homes in the development. Club memberships, which in 1984 sold for only $1,100, now sell for $45,000. Home prices range from about $340,000 for some of the older homes to $2 million for some of the newer ones.

The story of the Highlands Falls Country Club shows that even a failed development can be turned into an outstanding and profitable one if the basic ele ments for success are present and the project is man aged by a knowledgeable developer with sufficient resources and a sincere desire to create a quality development.

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C H A P T E R 11 Residential Land Uses 231

Delineation of the Market Area

To begin with, the project’s market area—that is, the extent of the housing sub- market in which it will compete—must be described. The market area is determined largely by employment opportunities and commuting ranges. In smaller communi- ties, of course, all of the local employers will be within the market area, but local workers also may commute to jobs in nearby communities.

In larger urban areas, the analyst must determine the extent of employment avail- able within relevant commuting ranges. Public transportation facilities can extend the commuting range and expand the market area.

Analysis of Recent Trends

What has been the demand for housing within the market area during the past few years, and what economic factors lie behind recent trends? What are the vacancy rates for local rental housing and the absorption rates for new owner-occupied units? Such data usually are available and are essential for an analysis of the market poten- tial of a new project.

Determination of Future Demand

After past and present housing market conditions have been determined, the most important part of the analysis remains—the estimation of future demand. How much unfulfilled demand remains in the market? What changes in the economic base or in national or regional economic conditions will affect demand in the local area? Are new transportation facilities or other public facilities being completed that will influence demand? The developer must analyze such factors carefully to make a rea- sonably accurate estimation of potential demand for the project.

Of course, not even the most keen and careful analyst can always accurately prophesy the future. Indeed, one would need almost supernatural powers to totally forecast the impact on real estate of the interactions of international political and economic intrigues, tax changes coming from Congress or state and local govern- ments, the expansion or contraction plans of large corporations, and the complexity of business locational decisions.

Analysis of Future Supply

Many developers correctly analyze demand factors but then court disaster by ignoring competitive projects. One of the primary characteristics of real estate improvements is their long gestation period, and developers must estimate both demand and supply conditions during that period.

Suppose, for example, there is a potential demand for 500 new apartment units in a community within the next two years. If three developers respond to this potential demand by constructing three 500-unit complexes, it is impossible that each will be successful in the short run unless the market expands more than anticipated. At best, vacancy rates in the local market probably will rise to a high level, and the general

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Milford Hills Saga

The Milford Hills saga is an interesting tale, and one that incorporates many of the varied aspects of real estate develop- ment. (This example is based on

a true case.) When Charles and Becky Barr moved to

Lower Nowhere they wanted privacy and place for their dog Puddy to run. They were able to achieve these objectives by buying 56 acres on the edge of town and building their home in the middle of it. After enjoying the land for 35 years, however, they wanted to retire, sell the land, and spend their retirement years elsewhere.

Charles and Becky’s economic objective, of course, was to get the maximum value for their house and land. This was a much more complex problem than merely selling a house in a subdivi- sion. It involved determining the highest and best use of the property, possibly securing a zoning change to enable them to sell the property for this use, and then finding a developer-buyer.

Although the area was undeveloped when the Barrs built their house, in the intervening years their land had become an island of greenspace sur rounded by residential subdivisions, a school, and a church. As might be expected, the residents of these new subdivisions had come to enjoy the Barrs’ open space and didn’t want to see it devel- oped, particularly at a higher density than the two units per acre permitted by the Rowan County zon- ing ordinance.

The Land Planning Process Much of the Barr land was heavily wooded, with steep slopes and two small rocky-bottom streams.

Not only did these features create natural beauty for the property, they also made the land unfeasible for a half-acre, “cookie-cutter” subdivision. In fact, Mr. Barr’s preliminary investigations convinced him that it would not be feasible to develop more than 75 conventional lots on the property. Both good devel opment practices and practical economics called for a conservation subdivision on the prop- erty. In other words, the homes would be clustered on relatively small lots, with large areas left in permanent open space.

Because Rowan County did not have provi- sions for conservation subdivisions in its zoning code, it was necessary for the Barrs to apply for a Planned Development. Because this type of zon- ing required specific plans, the Barrs hired land planner Ron Meislar. After going through several iterations, he and the Barrs agreed on a plan that clustered 125 homes within a 22.5 acre “building envelope.” The remainder of the land, 34 acres, approximately 60% of the total land, would be left in permanent open space. Mr. Barr named the development after the area where he grew up, Mil- ford Hills.

Dealing with the Neighborhoods The Barrs knew their land would be much more valuable if they could secure a zoning change to permit their proposed development. They were also realistic enough to know that the plan had little chance of approval without neighborhood support. Accordingly, they held a number of meetings over a 12-month period with small groups of neighbor- hood leaders to explain details of the plan and to gain their input.

(continued)

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C H A P T E R 11 Residential Land Uses 233

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Milford Hills Saga

The Conservation Easement At one of the meetings the view was expressed that although the open space was desirable, there was no guarantee it would not be disturbed and pos sibly developed in the future. When Mr. Barr pro posed putting a large portion of the open space in a conservation easement, this gained immedi- ate neighborhood support. Thus, working with the Yad kin River Land Trust, the Barrs agreed to place 24 acres in a conservation easement. The terms of the easement limited use of this area to walking trails and prohibited cutting any of its large hard- wood trees. The agreement did permit an ease- ment for a sewer line, as this was the only way to tie in with the county’s sewerage system.

The conservation easement gave the adjoining homeowners significant benefits, providing them with open space area they knew would remain undisturbed forever. The con servation easement also provided significant bene fits for the Barrs. Not only did it gain vital neighborhood support for their rezoning effort, it improved the marketability of the property and also provided tax benefits.

The Rezoning Process After two years of formulating the land plan and gaining neighborhood support, and spending more than $20,000 on the planning effort, the Barrs applied to Rowan County for a Planned Develop- ment. The planning staff suggested a few changes, and these were incorporated into the plan. They then recommended to the Planning Commission that the plan be approved. At the public meeting, a number of nearby neighbors spoke in favor of the plan, expressing the view that although they would natu rally prefer the land to remain undeveloped,

they felt the conservation subdivision was a “best- case” alter native. Only two people spoke in oppo- sition. The Planning Commission praised the plan and voted unanimously to recommend approval by the County Commission.

At this point the Barrs were introduced to the ugly side of land planning politics. One of the county com missioners who was aspiring to be elected mayor decided to oppose the plan for perceived political advantage. He organized a public meeting to try to organize neighborhood opposition. Happily for the Barrs, however, this effort backfired and helped solid ify support from residents who felt the plan was as good as they were likely to get and who wanted to secure the benefits of the proposed conservation easement. They worked to inform other residents, and Mr. Barr hand-delivered a copy of the plan to 185 nearby neighbors so they would know exactly what was being proposed.

These efforts bore fruit. At the public hear ing, another commissioner who was opposed to any new development joined in trying to defeat the plan. Despite this, in a close vote the County Com- mission voted to approve it.

Selling the Land With approval of the Planned Develop ment zoning, the Barrs were no longer simply selling a house and 56 acres. Now they were selling 56 acres and the right to develop a 125-unit conserva tion sub- division. It was no longer necessary for a potential developer to spend a year or more in the uncertain process of trying to secure a rezoning while interest and other costs kept accumulating.

(continued)

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The Barrs signed a six-month exclusive-listing agreement with broker Frank Glover to sell the prop erty for $900,000. This worked out at $5,600 per unit plus $200,000 for the existing house. The house could be used as a clubhouse for the devel- opment, or sold as a residence.

Mr. Glover prepared a comprehensive sales package that included the developmental plan, a copy of a letter from the county engineer stat- ing that water and sewer capacity was adequate to serve the development, and other supporting documents. He sent this package to commercial brokers in the area, as well as potential developers. He also placed an advertisement in an area busi- ness maga zine to try to attract buyers from outside the immedi ate Lower Nowhere locale.

The old adage that “real estate is easy to buy but hard to sell” proved true for the Milford Hills project. Unlike stocks, bonds, or other financial instruments, real estate markets can grind very slowly, particularly for complex properties. Ten months after placing the property on the market the Barrs had received several serious expres- sions of interest, but nothing that resulted in a sales contract. They did receive three “letters of intent,” but quickly learned these meant little or nothing. The potential buyer was merely expressing interest, but this expression of interest was not binding in any way.

Then a local developer, Mr. Mayer, presented a sales contract to Mr. Glover. He offered $562,500, or $4,500 per unit for the land but did not want to buy the house. The Barrs would be forced to sell this separately. Mr. Mayer also wanted five months to close on the property, and his contract provided him the opportunity to with draw if he did not secure

what he considered to be adequate financing. The Barrs rejected this offer.

Mr. Tom White, a developer in a nearby area, was seeking to find suitable land for a residential development in Rowan County. His broker earlier had received a sales package on the Milford Hills development from Mr. Glover. He presented this to Mr. White, and he felt Milford Hills might be what he was looking for.

After conducting market and financial feasibil- ity studies, Mr. White offered the Barrs $800,000 for the property, with a 120-day closing date. This offer was contingent on the Barrs’s securing an updated letter from Rowan County verifying that adequate water and sewer capacity was available for the develop ment and providing a Phase 1 Environmen- tal report certifying there were no environmentally hazardous materials on the property. It was also contingent upon Mr. White’s being able to secure a develop ment loan.

The Barrs countered with a price of $850,000 and a deposit of $15,000 earnest money that would go to them in the event that Mr. White did not close on the property for any reason other than the contin gency factors. Mr. White came back with a revised offer of $825,000, and the Barrs accepted. The closing took place in late December in the office of attorney Bill Berry field.

Market Analysis To determine the feasibility of the Milford Hills proj- ect, and before he made his offer to the Barrs, Mr. White conducted a market analysis study. Although Milford Hills would be the first conservation subdivi- sion in the Lower Nowhere area, he deter mined there was a strong market for single-family houses

(continued)

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profitability of all complexes will be reduced, or perhaps will be nonexistent, result- ing in foreclosure and failure.

The second step in the analysis—determining what lies behind recent trends— sometimes is not given enough emphasis, much to the subsequent regret of the devel- oper. Suppose that housing markets in a particular community have been very tight during the past five years; that is, there has been excess demand. Without proper analysis, this might indicate a continuing strong demand for housing in the next few years.

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in the $160,000–$185,000 range. From this study he felt it would be feasible to sell 40 homes a year at an average price of $175,000. From this sales price he felt that the value of each lot was $30,000.

Developmental Analysis Mr. White then had his engineer, Bevan Barrin ger, make an estimate of the expenditures that would be necessary to develop the Milford Hills project. (See Table 11.1.) Assuming that land and house could be purchased for $825,000, the following

table shows that total developmental expenses would be $2,287,050, compared to an assumed lot sales yield of $3,750,000. In addition, there would be interest expense on the develop ment loan.

Applying the concepts of net present value and internal rate of return discussed in Chapter 17 from the developer’s perspective, we can calculate that Mr. White estimates at NPV of just more than $170,500 at a required annualized return of 25% and and an annualized IRR of just more than 31%.

ta b l e 11.1 Milford Hills Project—Projected Development Expenses

Purchase of Land and House $825,000

Clearing, Grubbing, Grading, and Drainage 368,550

Curb, Gutter, and Paving 516,900

Water Mains and Sanitary Sewer 357,500

Landscaping, Entrance Signs, and Nature Trail 86,100

Engineering, Permits, and Survey 133,000

Total $2,287,050

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ta b l e 11.2 Milford Hills Development—Pro Forma Cash Flow Statement

Quarter

1 2 3 4 5 6

Sale of Lots $300,000 $300,000 $300,000 $300,000

Use of Funds:

Land and House $825,000

Clearing, Grading, etc. $275,000 93,880

Curb, Gutter, Paving 350,000 166,900

Water and Sanitary Sewer 268,125 89,375

Landscaping, Entrance 50,000 36,100

Engineering, Surveying 65,000 68,000

Interest Expense 22,250 46,841 41,762 35,306 28,688

Net Cash Flow (890,000) (983,625) 203,159 258,238 264,694 (114,913)

Cumulative Cash Flow (890,000) (1,873,625) (1,670,466) (1,412,228) (1,147,534) (1,262,447)

Quarter

7 8 9 10 11 12

Sale of Lots $300,000 $450,000 $450,000 $450,000 $450,000 $450,000

Use of Funds:

Land and House

Clearing, Grading, etc.

Curb, Gutter, Paving

Water and Sanitary Sewer

Landscaping, Entrance

Engineering, Surveying

Interest Expense 31,561 24,850 14,221 3,327

Net Cash Flow 268,439 425,150 435,779 446,673 450,000 450,000

Cumulative Cash Flow (994,008) (569,858) (133,079) 313,594 763,594 1,213,594

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C H A P T E R 11 Residential Land Uses 237

On more thorough investigation, however, the developer might determine that the tight market conditions resulted from an influx of workers to a major new manu- facturing plant, which now operates at its designed level. Unless growth occurs in either the plant or some other part of the community’s economic base, the absorption rate—and, therefore, absolute demand for new housing—will decline.

The analyst also must carefully evaluate potential demand in the particular sub- market at which the project is aimed. For example, it may be that the new plant mentioned above caused a significant expansion in demand for rental housing. The future demand for this segment of the market may decline, even though demand in other segments may expand, if the new workers move out of the rental units to owner-occupied houses.

Bank financing, which is usually essential, also helps to reduce the devel- oper’s risk because a large amount of the developer’s own or company funds are not involved. On the other hand, any delays can be quite expensive when the interest-rate meter is running. For example, if the site improvements cannot be constructed as rapidly as the developer anticipates or if the houses do not sell as rapidly as expected, the result could be a greatly reduced profit or even default on the loan.

| financial feasibility analysis ____________________________

In addition to a market analysis, the developer should conduct a financial feasi- bility analysis of the proposed project. Such an analysis may be quite sophisticated in the case of a large and complicated development or relatively simple for a small one. In either case, the purpose is to determine—on paper, at least—the probable success of the project. The financial decision rules (net present value and internal rate of return) used to assess the decision to move forward with a project are dis- cussed in Chapter 17.

| the importance of market analysis _______________________

If the three most important factors in real estate are “location, location, and location,” it should be clear to the readers of this book that the three most important factors in real estate development are “the market, the market, and the market.” Real estate developers who forget this lesson usually fail; those who carefully and cor- rectly analyze the market usually succeed.

| chapter review __________________________________________

■■ The five principal types of residential development are (1) single-family detached houses, (2) single-family attached houses, (3) multifamily resi- dences, (4) manufactured homes, and (5) second homes.

■■ The single-family detached home has dominated the housing markets for the past 50 years and remains the most sought after type of dwelling.

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Escalating land costs and growing environmental and energy concerns have made this type of housing less attractive than it once was, however.

■■ Types of attached housing include (1) the town house, (2) the plex, and (3) the patio house.

■■ Condominium and cooperative ownership of multifamily and attached housing is increasing because of the economic benefits of such ownership, favorable demographic trends, and the declining profitability of rental housing.

■■ Manufactured or mobile homes gradually are moving toward greater acceptance by consumers, financial institutions, and communities. As a result of improvements in design and quality, the availability of financing, and the rising cost of conventional housing, manufactured homes probably will capture an increasing share of the single-family market.

■■ Amenities are the primary factors leading to the purchase of a second home. Because most buyers cannot occupy their units for much of the year, many units are purchased for their investment potential.

■■ Time-sharing enables buyers to purchase the use of a second home for a specific time period each year. Buyers thus protect a large portion of their future vacation costs from inflation and benefit from any appreciation in the value of their interest.

■■ The steps in analyzing the market for a residential project are (1) delinea- tion of the market area, (2) analysis of recent trends in the local market area, (3) determination of possible changes in the demand factor of the project, and (4) analysis of the potential supply, including other possible competing projects.

■■ The market area is determined largely by employment opportunities within the relevant commuting range.

■■ The market analyst essentially determines what market conditions have been in the recent past and which factors that would affect the market for the project are likely to change in the near future.

■■ The developer should conduct a financial feasibility analysis that projects the probable cash flow and profit or loss of a proposed project.

| key terms _______________________________________________

absorption rate

manufactured home

patio house

plex

time-sharing

town house

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| study exercises _________________________________________

1. What are the five principal types of residential developments?

2. What are the differences between condominium and cooperative owner- ship? What are some of the advantages of these types of ownership over renting?

3. What are the three types of single-family attached housing? What are the differences among the three?

4. What are the three types of multifamily residential housing? What are the differences among the three?

5. Discuss some of the factors that are leading to greater acceptance of manu- factured or mobile homes.

6. What are the principal reasons for owning a vacation home, and how do they differ from the reasons for owning a principal residence?

7. Discuss the use of time-sharing in the marketing of vacation homes.

8. Describe the steps in analyzing the market for a residential project.

9. What factors determine the market for a residential project?

10. Describe the process of financial feasibility analysis for a proposed residen- tial project.

| further reading _________________________________________

Brett, Deborah L., and Adrienne Schmitz. Real Estate Market Analysis: Methods and Case Studies, 2nd Edition. Washington, D.C.: Urban Land Institute, 2009.

Long, Charles. Finance for Real Estate Development. Washington, D.C.: Urban Land Insti- tute, 2011.

Miles, Mike E., Gayle L. Berens, Mark J. Eppli, and Marc A. Weiss. Real Estate Develop- ment: Principles and Process, 4th Edition. Washington, D.C.: Urban Land Institute, 2007.

Peiser, Richard, and David Hamilton. Professional Real Estate Development: The ULI Guide to the Business, 3rd Edition. Washington, D.C.: Urban Land Institute, 2012.

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Commercial and Industrial Land Uses

12c h a p t e r

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241

close-up Atlantic Station: A Successful Brownfields

Redevelopment

close-up The First Suburban Shopping Center:

Country Club Plaza

case study Birkdale Village

case study The Trump Building:

40 Wall Street

case study The Interstate North

Industrial Park

case study The Boiler Room Office Building: A Unique Adaptive

Use

c h a p t e r p r e v i e w

Shopping centers and other buildings for retail trade, office buildings, hotels and motels, and restaurants are examples of income-producing commercial properties. Industrial property includes factory buildings and warehouses. The development of these types of properties is the focus of this chapter.

Specific topics to be discussed are

■■ shopping center development;

■■ evolution of the shopping center;

■■ the development process of commercial properties, including (1) mar- ket and feasibility analysis, (2) site location, (3) tenant selection, and (4) financial feasibility analysis;

■■ office buildings;

■■ industrial parks and distribution facilities; and

■■ hotels and motels.

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| shopping center development ____________________________

The suburban shopping center is a creature of the automobile and is both a result and a cause of the suburban explosion that has taken place since World War II. As shopping centers have proliferated in suburban areas, the older central business districts of many cities have become economic backwaters. Others have been rede- veloped, some as specialized shopping areas.

The traditional American shopping area was the central business district, an unplanned series of buildings constructed along major streets in the center of town. The modern shopping center is distinguished from the traditional commercial district by the following characteristics:

■■ One or more structures of unified architecture housing firms that are selected and managed as a unit for the benefit of all tenants

■■ A site that serves a particular trade area

■■ On-site parking

■■ Facilities for deliveries separated from the shopping area

■■ Single ownership and management

Although all shopping centers share these characteristics, not all shopping cen- ters are alike. In fact, there are four major types, classified on the basis of type of tenants, size, and function: the neighborhood center, the community center, the

f i g u r e 12.1 Types of Shopping Centers

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C H A P T E R 12 Commercial and Industrial Land Uses 243

regional center, and the super-regional center. The types of shopping centers and their characteristics are shown in Figure 12.1 and listed in Table 12.1.

The neighborhood shopping center, sometimes called a convenience center, is designed to serve an area within a radius of approximately 1.5 miles and a popula- tion of 2,500 to 40,000. Its principal tenant usually is a supermarket, while the other stores largely provide convenience and shopping goods, such as pharmaceuticals, housewares, and personal services. Its gross leasable area—that is, the total floor area designed for the tenants’ use—ranges from 30,000 to 100,000 square feet, with 50,000 square feet typical. It usually is located on about three acres of land. Gener- ally, the neighborhood center is built in the strip style—that is, in basically a straight line, with stores tied together by a canopy over a pedestrian walk. Parking space is provided adjacent to the stores and off the public street.

The community shopping center provides a wider range of merchandise and usu- ally is built around a junior department store, variety store, or discount store. It is

ta b l e 12.1 Characteristics of Shopping Center, by Type

Type

Leasing Tenant

Typical

Leasable Area

(Square Feet)

Range of Gross Leasable Area (Square Feet)

Typical Site Area

(Acres)

Minimum Support Required (Number

of People)

Neighborhood or convenience center

Supermarket or drugstore

50,000 30,000–100,000 3 2,500–40,000

Community center

Variety, discount, or junior department store

150,000 100,000–300,000 10–30 40,000–100,000

Regional center

One or more full-line department stores

400,000 300,000–750,000 30–50 150,000 or more

Super-regional center

Three or more full-line department stores

1,000,000 750,000–1,500,000 100 or more 200,000 or more

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244 PA RT T H R E E Real Estate Market Analysis

designed to serve an area with a radius of approximately three to five miles and has a gross leasable area of 100,000 to 300,000 square feet located on from 10 to 30 acres.

When a discount store is the main tenant, the community shopping center some- times is known as a discount shopping center.

The regional shopping center offers a full range of goods and services, usually has between 300,000 and 750,000 square feet of gross leasable area, and occupies between 30 and 50 acres. It is anchored by at least one full-line department store but usually has two or more.

A super-regional shopping center exceeds 750,000 square feet in gross leasable area, occupies 100 acres or more, and includes at least three department stores. Most centers exceed 1 million square feet and may draw customers from more than 50 miles. Most super-regional centers are built with multiple levels to reduce walking distances for shoppers.

Variations on the major types of shopping centers include the superstore, the power center, the specialty shopping center, and the factory outlet center. The super- store is a very large discount store with between 60,000 and 200,000 square feet under one roof. Such stores are typified by the Wal-Mart and Target Superstores.

The power center is a large strip type shopping center that contains several “big box” retailers that are of a certain type: “category killers,” discount department stores, and warehouse clubs. They usually have a trade area that goes far beyond the typical shopping center. Sometimes large retailers such as Wal-Mart, Target, Lowe’s, and Home Depot will build very large stand-alone stores.

The specialty shopping center focuses on unusual market segments, usually offering high-quality and high-priced merchandise in boutique-type stores, although a number of new specialty centers focus only on discount stores.

Another type of specialty center is the factory outlet center, which consists of manufacturers’ retail outlet facilities, where goods are sold directly to the public in stores owned and operated by manufacturers. These centers began when manufac- turers opened factory-owned stores near their plants to sell off seconds, outdated, or overproduced goods, or goods sent back unsold by retailers. Then, in the 1980s, developers began constructing shopping malls catering specifically to outlet stores.

| evolution of the shopping center ________________________

The tremendous rise in automobile ownership during the 1920s put a strain on downtown shopping areas designed for pedestrians and public transportation. Con- gested streets, parking meters, and the limited curbside areas available for parking in most cities encouraged a shift to new concentrations of shopping facilities with adequate provisions for parking.

The automobile also encouraged population movement to the suburbs, and these areas on the outskirts of cities became the logical sites for the new shopping facilities. A few developers built the first true suburban shopping centers with uni- fied architecture, a planned mix of tenants, and the essential ingredient—off-street

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C H A P T E R 12 Commercial and Industrial Land Uses 245

parking. The surge in the number of centers came after World War II, with the explo- sion of residential suburbs.

The first suburban shopping center was Country Club Plaza in Kansas City, pro- filed on page 250. The first regional shopping center to contain a major full-line department store as the leading tenant was the Northgate Shopping Center in Seattle,

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Atlantic Station: A Successful Brownfields Redevelopment Project

There are an estimated 40,000 former industrial or other sites in the United States where pollution from their former use inhibits their reuse and redevelopment. While

this presents many challenges to potential devel- opers, the sites often also offer great potential. The developers of Atlantic Station have overcome the problems of its 138-acre site at the edge of downtown Atlanta to produce a massive and thriving project that when completed will include 6 million square feet of Class A office space, 5,000 residential units (from luxury condo lofts to more affordable town houses and apartments), 2 million square feet of retail and entertainment space including restaurants and movie theaters, 1,000 hotel rooms, and 11 acres of public parks.

When construction of the Atlantic Steel Mill began in 1901, the site was on the outskirts of Atlanta. It produced steel products, such as nails, barbed wire, plough shears, and galvanized steel, and at the height of its production in the 1950s, the facility employed more than 2,300 people and pro- duced approximately 750,000 tons of steel annu- ally. By the 1970s, however, it was virtually closed, retaining nominal operations until 1998, primarily to avoid the tremendous cleanup costs of the site.

Developer Jim Jacoby began the Atlantic Station project in 1997, relying mostly on private investment, but heavily supplemented by a special

tax district to pay for city tax bonds for public utili- ties on the site. The Georgia Department of Trans- portation also built a large bridge over the adjacent interstate freeway to connect the development to mid-town Atlanta.

Environmental remediation of the contami- nated site required the excavation of 180,000 cubic yards of soil contaminated with lead. In addition, at least two feet of clean fill was placed over all the slag that still remained, and a groundwater collec- tion and treatment system was also constructed in order to prevent the migration of contaminants to other nearby areas. As part of the cleanup, around 150,000 cubic yards of concrete from the steel mill’s foundations and support structures were recycled.

At this writing, the project is over half finished and will require a total investment of over $2 billion. In addition to the increased jobs and sales taxes from establishments located in the development, the city and county are already benefiting through greatly increased property taxes. Before redevel- opment, the site contributed $300,000 a year in property taxes. Atlantic Station is now generating over $30 million in property taxes.

Although its final completion has been slowed by the so-called “Great Recession,” Atlantic Station has already proved a great success to a tremen- dous environmental and development challenge.

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246 PA RT T H R E E Real Estate Market Analysis

constructed in 1950. The center contains several features that soon became familiar, including a central pedestrian mall, a truck tunnel to separate deliveries from the shopping areas, and vast seas of parking spaces surrounding the central building.

In the late 1950s, a design breakthrough was achieved when developers began to construct completely enclosed malls so that the interior climate could be controlled with air-conditioning and heating. Developers also began to expand centers verti- cally instead of horizontally to conserve land and protect the environment. The first enclosed mall, which also initiated the multilevel concept, was the Southdale Center near Minneapolis, opened in 1956. In the 1960s and 1970s, the enclosed multilevel mall became the dominant form of regional shopping center. There also was a trend toward larger complexes, with three or more full-line department stores.

The building of large, multilevel regional shopping centers has continued in recent years, but at a reduced pace. Major activity has centered on the expansion, redesign, and refurbishment of earlier centers, along with the building of power centers.

One other development of note is the megamall, as typified by the Mall of America in Minneapolis-St. Paul, a 4.2-million-square-foot center containing a 2.5- million-square-foot shopping mall with more than 525 specialty stores, 4 national department stores, more than 50 restaurants, 7 nightclubs, 14 movie theaters, an 18-hole miniature golf course, a roller coaster, a 7-acre theme park, a NASCAR Sili- con Motor Speedway, and parking for 20,000 cars. The Mall of America attracts more than 42 million visitors a year and claims to be the nation’s most visited attraction.

| the shopping center development process ________________

A developer who contemplates the construction of a shopping center must under- take several exhaustive studies if the proposed project is to have any hope of succeed- ing. The first task is to analyze the market to determine whether the proposed project is economically feasible. If it is, the developer then must determine the precise site that will be most likely to ensure the project’s success. Having settled on a site, the developer must secure the commitments of the key anchor tenants and the proper supplementary tenants to ensure a complementary mix of shopping facilities.

Market and Feasibility Analysis

Before a developer will build a shopping center, before a lender will make a mortgage loan, and before potential anchor tenants will consider signing leases, several questions need to be answered regarding the proposed center’s market and economic feasibility. Can the proposed center generate enough sales volume—and, therefore, rental income—to justify its development? Can the community absorb the proposed new retailing space? Are the population and purchasing power of the potential trade area expanding? If the market is not expanding, can the proposed center and its particular merchandising mix succeed in taking business away from existing stores or shopping centers?

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C H A P T E R 12 Commercial and Industrial Land Uses 247

A new center can do little to create business; basically, it must take business away from other retailers or capture expanded trade in a growing area. It is essential, therefore, that the developer also carefully analyze the status of the competition and the future prospects of the trade area.

Defining the Trade Area The first step in a feasibility and market analysis is to define the trade area—

that is, the geographic area from which the major portion of the patronage necessary to support the shopping center is to be drawn. This area will vary with the types and quality of merchandise offered. For example, families generally purchase food and sundries close to their homes, but for more expensive items, such as clothing, furniture, and major appliances, they often will drive long distances to secure a bet- ter selection or lower prices. Similarly, those seeking specialty items, such as sports equipment or high-quality cameras, also will travel longer distances to shop.

These factors are reflected in the trade areas for the various types of centers. The primary trade area—that is, the area that accounts for 60 to 70% of the center’s sales—will have a radius of approximately 1.5 miles for a neighborhood shopping center, 3 to 5 miles for a community shopping center, and 8 to 10 miles for a regional shopping center. Additional shoppers may come from the secondary trade area— the area for a regional center that is 15 to 20 minutes’ driving time from the primary trade area and that normally accounts for 15 to 20% of sales.

Besides the types of goods desired, the main factors that determine the size and shape of the trade area are the nature and location of competitive centers, the loca- tion of major transportation facilities, and natural barriers. For example, the defined trade area for the proposed center shown in Figure 12.2 is skewed toward the east and north because there is little or no competition in those directions. A lake forms a natural barrier in the southeast, and competitive facilities in the south and particularly the west greatly reduce the radius of the trade area in those directions.

Determining the Size of the Market After the extent of the trade area has been determined, the next step is to calcu-

late the size of the potential market within the trade area. Basic data can be obtained from the Census of Population and Housing and the Census of Retail Trade. They can be supplemented by other public and private data sources, such as the annual estimates of personal income by county supplied by the Bureau of Economic Analy- sis and the Survey of Buying Power, published annually by Sales and Marketing Management magazine.

Analyzing the Competition After determining the current size and characteristics of the trade area’s popu-

lation, these data must be projected into the future. Projections are critical to the center’s potential success because it is in the future that the center must compete in the marketplace.

It often is tempting simply to extrapolate recent trends into the future, but this method will provide a very poor basis for decision making unless the best evidence

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248 PA RT T H R E E Real Estate Market Analysis

indicates that a recent trend will continue. The experienced analyst or investor goes behind recent trends to find their causes and then attempts to project those trends on the basis of his or her findings.

Competitive Survey Once the probable future purchasing power and retail purchases of the defined

trade area have been estimated, the analyst must estimate the percentage of the total that can be captured by the proposed development.

One obvious step is to make a competitive survey to determine the extent and strength of existing centers in the market. It also is essential to find out what other potential competitors are planned. A market study that indicates a potential demand sufficient to support a new shopping center probably will lead to a very unsuccessful project if the developer fails to take into account another proposed new center.

Site Location The market and feasibility analysis can substantiate the practicability of a center

within the defined trade area, but it does not pinpoint the exact site, and site selection is a crucial factor in the success of a shopping center.

Several factors are important in the selection of the shopping center site, including size, shape, topography, drainage, utilities, and zoning. The most important consid- erations by far, however, are location and access. The neighborhood or convenience shopping center requires easy access from the supporting residential area. It usually is located on a connector street; in a planned community, it also may be located to encourage pedestrian access. The community center normally is located along a major

f i g u r e 12.2 Primary Trade Area of a Proposed Shopping Center, Skewed by a Natural Barrier and Competitive Facilities

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C H A P T E R 12 Commercial and Industrial Land Uses 249

thoroughfare, while the principal location requirement for regional and super-regional centers is easy access to major freeways and, increasingly, mass-transit facilities.

It is not necessary for shopping centers to be located far from other centers; in fact, centers located across the street from or adjacent to each other may be comple- mentary. For example, a specialty fashion center may draw customers to an adjacent regional shopping center from competing centers in the area because the specialty center enhances the general location for shoppers. Alternatively, one center may not compete with another nearby because it handles different types of goods. For exam- ple, a convenience or neighborhood shopping center may be located near a regional center and actually benefit from this location.

Again, there is a saying among developers that there are only three important considerations in real estate development: “location, location, and location.” The maxim is especially applicable in choosing a shopping center site. Selection of any but the best site not only will mean a less successful center initially; it usually will mean that a competing center eventually will be built on the best site and will use this advantage to secure the lion’s share of the business.

Tenant Selection

The success of most shopping centers is contingent on the securing of key anchor tenants. For regional and super-regional centers, the anchors are major department stores; for community centers, they are junior department stores or discount stores; and for neighborhood centers, they are supermarkets or drugstores. Consequently, the negotiating strength of such firms is great, and they usually secure very favor- able lease terms. Often, the major tenants in a regional center purchase land from the developer and construct their own buildings.

The major tenants are expected to attract shoppers to the supplementary ten- ants. These tenants must be chosen carefully to be complementary to each other and to the anchor stores. For example, men’s stores—shoes, clothing, and sporting goods—tend to reinforce each other. The same principle holds for women’s clothing and related shops, including food products and personal services. To yield the high- est return, continuing careful attention is also crucial to ensure that the tenant mix changes when necessary to reflect new trends.

| office buildings _________________________________________

The demand for office space in a community depends on the level of certain types of business activity and government employment. Nationally, the increasing percentage of the work force in white-collar occupations and the growth in service industries have added to the demand for more office space. Increased business activ- ity in expanding areas also affects the demand for additional office space. Within cities, the growth of suburban office parks has greatly expanded the supply of office buildings in these locations.

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250 PA RT T H R E E Real Estate Market Analysis

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The First Suburban Shopping Center: Country Club Plaza

The first suburban shopping center gen erally is considered to be Country Club Plaza in Kansas City, although strictly speaking, it is a shopping district rather than

a shopping center. At any rate, it was the first suburban shopping area to incorporate unified archi tecture, common management, tenant selection, and off-street parking. It remains one of the premier urban spaces in the coun try, although its tenant mix has changed greatly over the years.

The J. C. Nichols Com pany began to develop the Country Club district shortly after the turn of the past century, when it was the extreme southern suburb of Kansas City. To the north of this area and between it and the developed portion of the city was Brush Creek Valley, a largely overgrown area that was occupied by a brick kiln, several trash dumps, and an old goat farm. In these unpromising surroundings, Nichols devel oped a new shopping center that featured off-street parking in what he termed “parking stations” and architecture reminis- cent of that of Seville, Spain.

The first building was completed in 1923, and the center has been under almost continu- ous devel opment and redevelopment since that time. It expanded greatly after World War II into a prestige shopping area containing more than 180 retail and service shops. Over the years the center has changed from a shopping center catering to general needs to a specialty cen ter catering to high-income shoppers. For example, the last drug- store closed in 1996.

In order to remain competitive, the Plaza com pleted a $240 million expansion and renova- tion project that added 780,000 square feet of new retail and office space to the 2.8 million square feet of exist ing space. It was partially financed with $55 million in tax increment financing extended by the city. Under this arrangement, 100% of property taxes on the new buildings and 50% of sales and other taxes generated by the expansion will be rebated to the developer until the total reaches $55 million.

Country Club Plaza pioneered many of the con cepts that are commonplace in suburban shop- ping centers today. Because of the high quality of its design and architecture and continuing good man agement that has successfully adapted the center’s facilities to keep abreast of evolving mar- keting trends, Country Club Plaza has retained its rank as a prestige shopping center for more than 80 years.

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C H A P T E R 12 Commercial and Industrial Land Uses 251

Location of Office Activity

Office buildings traditionally have been located in downtown business districts, and in recent years, they have become the dominant form of land use in many city cen- ters. Downtown office buildings most likely are to be used as main offices of financial institutions, corporate headquarters, attorneys’ offices, and government facilities.

Most cities also have at least one secondary “uptown” office node, usually located along a major thoroughfare leading to the suburbs. Other specialized nodes may develop near government installations, shopping centers, hospitals, and universities.

Another type of development is the office park, a community of office struc- tures under central management and administration, usually located in the suburbs and adjacent to a major freeway. Such parks generally consist of lowrise buildings in a campuslike setting. They attract tenants in sales, manufacturing, and similar

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Birkdale Village

Where separation of uses was long the rule in land-use planning and zoning, recent years have seen the rise of the mixed-use development. Birkdale Village is

an outstand ing example of this type. Birkdale Village is located in the affluent and

rapidly growing Lake Norman area of the Char lotte, North Carolina, region. The site has a popula tion of approximately 55,000 within a 5-mile radius and average household income of around $110,000. Even so, to go out and essentially build a down- town on a 52-acre bare ground site was an auda- cious move on the part of the developers, but a very suc cessful one.

The village is anchored at one end of a linear park with a 16-screen movie theater. On each side of the parkway are three-story buildings with retail at street level and 320 apartments above. About 60 shops and offices occupy the 285,000 square feet of retail space, along with six restaurants. Large retailers Barnes and Noble, Gap, Pier One,

and Dick’s Sporting Goods are located on a back street, providing this type of shopping without the typical “big box” look.

Birkdale Village has been an almost instant success. Its high-quality shops, restaurants, and community activities have attracted shoppers far beyond the usual reach of a shopping center. The Village has received a number of awards for its inno vative design.

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252 PA RT T H R E E Real Estate Market Analysis

activities that do not need downtown locations. The office park’s advantages are its location near suburban residential areas, with resultant reduction in commuting time, ease of parking, and a pleasant environment.

Types of Office Products

Office buildings can be classified in several ways. Building location, discussed above, is one way. Another is by number of tenants. Single-tenant buildings are very common. They range in size from a 1,000-square-foot suburban structure for a small firm or up to a one-million-square-foot skyscraper for a large corporation. They may be owner-occupied or leased from an investor.

Many office buildings, particularly the larger ones, are built by investors on a speculative basis for lease to multiple tenants. Sometimes a large company will lease a major portion of the building, which then will be named for the firm. In other cases, ownership is organized on a condominium basis, with the individual firms owning their office space and sharing ownership of the common areas.

Future Office Building Usage

With economic hardship or downturn, businesses often consolidate offices or no longer need the space they used during peak times. This can have an impact on the availability of office space, leaving buildings empty and driving prices down. Along with consolidation and downsizing, the “virtual office” or telecommuting culture has become popular in many industries.

Telecommuting allows an employer to save space in the office or stay in an under- sized office that has a growing staff. Costs can be lower for the employer because no infrastructure needs are required along with no parking or permanent elements, such as a work station. Employees benefit from diminished commute costs and decreased wear and tear on their vehicles. In some cases, telecommuting allows a parent to stay home with children instead of having to pay for the expenses of childcare.

These developments should be considered by both developers of office space as well as employers who see either staff growth or reduction as a possibility for their future.

| industrial parks and distribution facilities _______________

Early industrial facilities were located wherever transportation facilities, water, power, and other such features were adequate. Around the turn of the previous cen- tury, however, industrial parks—controlled, parklike developments designed to accommodate specific types of industry and providing all necessary utilities—came into existence. These parks provided location advantages and also avoided conflicts with other land uses.

Several planned industrial districts were pioneered in Chicago, beginning with the Original East District in 1902. These districts were served by railroads, and their success led to the establishment of other railroad-sponsored industrial districts

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C H A P T E R 12 Commercial and Industrial Land Uses 253

in other parts of the country. Following World War II, the industrial-park concept spread widely. Most recent parks depend primarily on road access, but most also are served by rail facilities.

Some industrial parks contain manufacturing plants, but many allow only light manufacturing activities. Others are devoted exclusively to warehousing and distri- bution activities.

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The Trump Building: 40 Wall Street

Large profits in real estate investing come to those who can visualize uses or reuses that others cannot see. That was the case with flamboyant developer

Donald Trump’s rehabilitation of the 40 Wall Street Building.

Known as the Manhattan Company Building when it opened in May 1930, the 72-story building was briefly the tallest in the world. With its golden pyramid-shaped roof crowned by a spire, the 1.2- million-square-foot building was considered one of the most prestigious addresses in the market for more than 50 years.

In late 1982 the building and its ground lease- hold was acquired by a company controlled by Phil ippines dictator Ferdinand Marcos and his wife Imelda. When he was driven from office, his assets in the United States were frozen, and the building was virtually ignored. Tenants began to leave, and combined with the decline in downtown Manhat- tan real estate following the stock market crash in 1987, the 40 Wall Street building started a long slide to being virtually worthless.

In 1989 the building and ground leasehold were auctioned off for $77 million, but the buyers soon realized their mistake and turned the build- ing back to their lender. In 1993 another company

bought the leasehold for only $8 million, but the contin ued depressed market convinced them that money invested in renovations would be throwing good money after bad. With ground lease pay- ments, taxes, and operating costs continuing, the building suffered from a nega tive net worth. It sat virtually empty for several years.

Enter Donald Trump, who, seeing a market for a completely renovated building, purchased 40 Wall Street for $1 million. He then poured $65 million into enlarging the lobby, completely gutting the interior, lifting the ceilings, rewiring the build- ing (including state-of-the-art telecommunication services), and providing new mechanical systems. The building was transformed from a virtually der- elict property to a highly desirable Class A office building. When the market picked up in 1996, 40 Wall Street, renamed The Trump Building, quickly was leased to almost total capacity.

In 1998 Trump was able to secure a $125- million mortgage, which repaid all his renova- tion costs with many millions left over. Trump then attempted to sell the building for $400 million, but he was unsuccessful. At this writing, he still retains ownership but has been successful in leasing its space despite a depressed rental market in lower Manhattan.

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| analysis of industrial sites ______________________________

The task of determining the feasibility of developing a site for industrial use is much like that of analyzing other types of property. The basic technique is to

■■ determine the amount of existing or potential supply,

■■ forecast the demand for additional developed industrial acreage or building space in the general area,

■■ estimate the absorption rate during the analysis period, and

■■ compare the competitiveness of the subject site with that of other properties.

| hotel, motel, and resort developments ___________________

The demand for lodging services comes from several sources, including pleasure travelers, business travelers, and conventioneers. The various types of lodging cus- tomers necessitate different types of facilities, although there often is considerable

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The Interstate North Industrial Park

Perhaps no aspect of real estate devel opment has changed more in recent years than warehousing and distribution facilities. Although bulk warehouse

buildings still make up a large part of the market, a new type of industrial facility has evolved, the office and distribution facility.

Interstate North, located in the northeastern part of the Atlanta metropolitan region, is an excel- lent example of this new type of facility. Many firms need not only to store goods for distribution but also to have office space and even showrooms in their warehouse facilities. Interstate North caters to this need, and quite successfully.

In addition to being in a major market, a distri- bution facility needs to be located near an Inter- state highway interchange, and visibility from the

highway is also an important asset. The 120-acre Interstate North site offered all these advan tages, and enabled McDonald Development to convince Panasonic to build a 350,000-square-foot facil- ity expandable to 500,000 square feet as the first firm to locate in its new industrial park. Not only did this help to provide the financing necessary to complete the park’s infra structure, it gave Interstate North prestige in attract ing tenants for other build- ings in the development.

The park is extensively landscaped, a neces- sary amenity in securing tenants who desire Class A office and showroom space in addition to their distri bution facilities. The fronts of the buildings don’t look like warehouses; they look like office buildings. No—these are not your father’s ware- house buildings.

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C H A P T E R 12 Commercial and Industrial Land Uses 255

overlap. For example, many pleasure travelers seek easy access to and from major highways, and so do many business travelers. Pleasure travelers seek resort loca- tions, and so do many convention groups.

The distinction between motels and hotels was quite marked in the early days of the motel. Motels usually were small structures of one or two stories offering parking space adjacent to rooms and a minimum of services. Today, many motels are almost indistinguishable from hotels, the primary distinction being that hotels generally offer a wider range of services.

Lodging facilities usually are classified as commercial hotels, highway or airport hotels, and resort hotels.

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The Boiler Room Office Building: A Unique Adaptive Use

The Round Hill shopping center, a 1960s era strip center in Lake Tahoe, Nevada, was looking very tired and out of date. The main anchor, a Safeway grocery store,

needed a larger and more modern building, and the entire center was simply no longer competitive. Because new commercial build ing sites in the environmentally sensitive Lake Tahoe area are difficult to find and the center’s loca tion was a good one, the decision was made to com pletely rebuild it.

The original center was heated by steam boil- ers located in a 3,000-square foot building from which heat was then piped to the various stores. In the rebuilt center this outdated sys tem was replaced by package heating and air- conditioning units in the individual stores, mak ing the boiler room building superfluous. It sat unused and unloved for about three years, its boilers and pumps slowly rusting away.

The Johnson-Perkins real estate appraisal firm needed more office space, and they were looking for a building site. Because Lake Tahoe has some of the toughest land-use regulations in the nation,

in order to build a new building, Johnson-Perkings would have had to buy transfer of development rights at a cost of about $45 per square foot for a building and $10 per square foot for the site. Not only was the old boiler room building basically quite sound, it came with the necessary develop- ment rights. The Johnson-Per kins firm decided it made economic sense to make the rather unique and unlikely conversion of the old boiler room building to first-class office space.

The first step in remodeling the building was to remove the six 12,000-pound boilers and their asso ciated pumps and plumbing. The firm then demolished an incinerator tower, gutted the interior of the building, and cut new windows. In keeping with the rustic nature of the area, the exterior of the building featured river rock, stucco, and cedar siding. The interior included peeled-log support columns, 18-foot-tall vaulted ceilings, and cedar- finished ceilings.

The result was an office building with unique features that actually cost less than a conventional new building. The project received the South Tahoe Chamber of Commerce’s award for Best Overall Remodel.

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Commercial hotels cater primarily to business people and conventioneers. Their occupancy is usually relatively stable throughout the year but often drops to low levels on weekends. Many depend heavily on convention trade and have exten- sive facilities to attract this type of business.

A highway hotel, also called an airport hotel, caters primarily to businesspeople or vacationers who are in transit. Such facilities range from the small highway motel that offers little more than a sparsely furnished room to elaborate facilities with extensive amenities.

Resort hotels, which are also known as destination hotels or seasonal hotels, cater to individuals or families on vacation. By definition, the hotels must be located near scenic, historic, or other attractions that appeal to pleasure travelers. To enhance their appeal further, most offer extensive facilities—golf courses, tennis courts, swimming pools, and the like. Many are seasonal, often closing completely in the off-season or staying open to cater to convention groups.

Lodging facilities differ in several ways from other types of real estate. Their revenues are very susceptible to changes in business activity or pleasure travel, as rentals usually are from night to night rather than on the basis of the long-term leases used for other types of rental property. Conversely, rates can be adjusted quickly in periods of rapid inflation, a desirable characteristic for investors. Management is of critical importance to the success of such facilities, usually making the difference between a successful and an unsuccessful project. Even a well-designed and well- located lodging facility will have difficulty overcoming inadequate management.

| chapter review __________________________________________

■■ The shopping center is distinguished from the traditional commercial district by the following five characteristics: (1) one or more structures of unified architecture housing firms that are selected and managed as a unit, (2) a site that serves a particular trade area, (3) on-site parking, (4) facili- ties for deliveries separated from the shopping area, and (5) single owner- ship and management.

■■ There are four major types of shopping centers, classified on the basis of type of tenants and functions: (1) the neighborhood or convenience center, with a typical gross leasable area of 50,000 square feet and a supermarket or drugstore as leading tenant; (2) the community center, with a typical gross leasable area of 150,000 square feet and a variety, discount, or junior department store as leading tenant; (3) the regional center, with one or more full-line department stores and 400,000 square feet of gross leasable area; and (4) the super-regional center, with three or more full-line depart- ment stores and 1 million square feet or more of gross leasable area.

■■ The factory outlet center was a development of the 1980s. These centers contain stores where goods are sold directly to the public by manufacturers.

■■ So-called power centers contain a number of “big box” stores.

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C H A P T E R 12 Commercial and Industrial Land Uses 257

■■ The steps involved in a feasibility and market analysis for a shopping cen- ter are (1) define the trade area—that is, the geographic area from which the major portion of the center’s patronage will be drawn; the primary trade area (the area from which 60 to 70% of sales are expected to come) will have a radius of approximately 1.5 miles for a neighborhood shopping center, 3 to 5 miles for a community shopping center, and 8 to 10 miles for a regional shopping center; (2) determine the size of the market in terms of population, purchasing power, and expected sales; (3) analyze existing and potential competition; and (4) estimate the percentage of sales of the total trade area that can be captured by the proposed center.

■■ Several factors are important in the selection of the shopping center site, including size, shape, topography, drainage, utilities, and zoning. Most important is location.

■■ The demand for office space in a community depends on business activity and government employment.

■■ Office buildings generally are located in downtown business districts, in office nodes along major thoroughfares leading to the suburbs, and in office parks.

■■ A firm’s selection of an industrial site is influenced by many factors, including (1) the availability of land, (2) the availability of utilities, and (3) access to major transportation facilities.

■■ The steps in determining the feasibility of developing a site for industrial use are (1) determining the amount of existing or potential supply, (2) fore- casting the demand for additional developed industrial acreage or build- ing space in the general area, (3) estimating the absorption rate during the analysis period, and (4) comparing the competitiveness of the subject site with that of other properties.

■■ Demand for lodging services comes from several sources, including plea- sure travelers, business travelers, and conventioneers.

■■ Transient hotels and motels usually are classified as (1) commercial hotels, which cater primarily to businesspeople and conventioneers; (2) highway or airport hotels, which cater primarily to businesspeople and vacation- ers who are in transit; and (3) resort hotels, which cater to individuals or families on vacation.

| key terms _______________________________________________

central business districts

commercial hotels

discount shopping center

factory outlet center

gross leasable area

highway hotel

industrial parks

office park

power center

primary trade area

resort hotels

secondary trade area

specialty shopping center

superstore

trade area

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258 PA RT T H R E E Real Estate Market Analysis

| study exercises _________________________________________

1. What characteristics distinguish a shopping center from the traditional commercial district?

2. What are the four major types of shopping centers?

3. Describe the characteristics of (1) the neighborhood center, (2) the commu- nity center, (3) the regional center, and (4) the super-regional center.

4. Discuss the steps involved in a feasibility and market analysis for a pro- posed shopping center.

5. Define the primary trade area. What is its typical size for each of the major types of centers?

6. What factors are most important in the selection of a successful shopping center site?

7. What is a specialty shopping center? What is a discount shopping center?

8. What factors determine the demand for office space in a community?

9. What types of firms tend to lease space in downtown office locations? Why do financial institutions and attorneys often choose downtown locations?

10. Where are “office nodes” likely to develop?

11. What factors have led to the growing popularity of the suburban office park?

12. What factors determine a firm’s selection of a specific industrial site?

| further reading _________________________________________

Baltin, B., et al. Hotel Development. Washington, D.C.: Urban Land Institute, 1996.

O’Mara, W. P., M. D. Deyard, and D. M. Casey. Developing Power Centers. Washington, D.C.: Urban Land Institute, 1996.

Sabbagh, K. Skyscraper: The Making of a Building. New York: Penguin Books, 1989.

Schwanke, D. Resort Development Handbook, 2nd ed. Washington, D.C.: Urban Land Insti- tute, 2008.

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Understanding Real Estate Market Dynamics

13c h a p t e r

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261

c h a p t e r p r e v i e w

A key requirement for making effective real estate decisions is having a clear understanding of how real estate prices (values) are determined in real estate markets. This understanding is central to all aspects of real estate, including con- sumption and investment decisions, mortgage lending and borrowing, appraisal, brokerage, land-use policy, and, of course, development.

This chapter discusses the dynamics of owner-occupied residential real estate markets and commercial real estate markets. We will use a simple supply/demand equilibrium model to discuss how prices are determined in these two major real estate market categories. In our discussion of commercial real estate markets, we will consider the important distinction between real estate space markets (transactions between landlords and tenants regarding the use of space in exchange for rent) and the real estate asset market (transactions between developers and investors or inves- tors and investors regarding ownership of real estate and the rights to rental income).

The objectives of this chapter are to

■■ use the supply and demand equilibrium model to consider how prices are determined in owner-occupied residential real estate markets;

■■ distinguish between real estate space markets and the real estate asset market as components of the commercial real estate market;

■■ examine how rents are determined in commercial real estate space mar- kets and how prices are determined in the commercial real estate asset market;

■■ consider how the development industry ties commercial real estate space and asset markets together; and

■■ review the procedures for conducting a formal real estate market analysis.

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262 PA RT T H R E E Real Estate Market Analysis

| owner-occupied residential real estate markets ___________

By definition, a market is the mechanism or arrangements through which goods and services are traded between market participants. An owner-occupied residential real estate market involves transactions of new and existing dwelling units that will be occupied by the new owners (not tenants). These markets can be further cat- egorized by type of dwelling units and geographic location (condos in downtown Atlanta, single-family houses in a suburb of Los Angeles, townhouses in Washing- ton, D.C., or even manufactured houses in rural Kansas).

Developers/builders/investors construct new dwelling units or renovate existing dwelling units when they believe they can sell those units to consumers at prices equal to or greater than the cost of constructing them (including reasonable profit). Existing dwelling units are typically offered for sale in this market by owners who no longer wish to own them due to employment changes, change in family size, change in financial circumstances, or even death of the owner. The dynamics of such markets are often quite complex, but they can be simplified using the familiar supply/demand equilibrium model.

Demand conditions in owner-occupied residential real estate markets can be dra- matically affected by changes in total population, the number of households, individ- ual and household income levels, changes in taste and preferences for dwelling unit designs, and the mortgage loan interest rate level. Supply conditions are sensitive to the price of developable land, the prices of construction materials and labor, and the interest rates on construction loans. The combined effects of supply and demand determine price levels in owner-occupied residential real estate markets.

The Basic Supply/Demand Equilibrium Model

In the basic supply/demand equilibrium model developed by economists, sup- ply is defined as the amount or quantity of the good or service that will be offered at various prices. Demand is defined as the amount or quantity of the good or ser- vice that will be desired at various prices. For most goods and services, the supply increases with price, meaning that more of the good or service will be offered at higher prices. But the demand for most goods and services decreases with price, meaning that less of the good or service will be desired at higher prices. A market is said to be in equilibrium when the price negotiated between suppliers and demand- ers results in the quantity of the good or service offered by the suppliers equaling the quantity of the good or service desired by the demanders. When supply or demand conditions change, the market seeks a new equilibrium—a balanced price/quantity combination that reflects the new conditions. Economists have long used this simple model to analyze market dynamics for many different goods and services, including owner-occupied residential real estate. Let’s consider a hypothetical housing market to demonstrate the model’s ability to explain and predict market dynamics.

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C H A P T E R 13 Understanding Real Estate Market Dynamics 263

Demonstrating Market Dynamics

Suppose we interview all of the participants in a hypothetical housing market and discover the number of dwelling units offered by suppliers (builders and exist- ing-unit owners) at various prices and the number of units desired by demanders (owner-occupants) at various prices. The results of our interviews are shown graphi- cally in Figure 13.1. Notice that the demand curve is downward sloping, implying that participants in this market desire fewer dwelling units at higher prices than they do at lower prices. Also, notice that the supply curve is upward sloping, implying that participants in this market offer more dwelling units at higher prices than they do at lower prices. Note that the market is in equilibrium (E) at the price of P

0 : the

number of units offered equals the number of units desired. By altering the supply and demand information, we can understand how equilibrium prices will change as supply and demand conditions change in this market.

How do changes in demand affect prices in this market? Suppose that the demand for dwelling units in this market increases instantaneously from D

0 to D

1 , but the

supply (S 0 ) remains unchanged. The new demand curve (D

1 ) intersects with the sup-

ply curve at the new, higher price of P 1, as shown in Figure 13.2. Or suppose that the

demand for dwelling units in this market decreases instantaneously from D 0 to D

2 ,

but that the supply (S 0 ) remains unchanged. The new demand curve (D

2 ) intersects

with the supply curve at the new, lower price of P 2 . Thus, we can say that equilibrium

prices are directly related to changes in demand. (If demand goes up, price goes up;

f i g u r e 13.1 Supply/Demand Equilibrium Model

Price

Supply

Demand

Quantity

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264 PA RT T H R E E Real Estate Market Analysis

and if demand goes down, price goes down.) From this result, we know that factors that lead to increased demand in housing markets will result in price increases, other things held constant.

How do changes in supply affect prices in this market? Suppose that the supply of dwelling units in this market increases instantaneously from S

0 to S

1, as shown

in Figure 13.3, but that the demand remains unchanged. The new supply curve (S 1 )

intersects with the demand curve (D 0 ) at the new, lower price of P

1 . Or suppose that

the supply of dwelling units in this market decreases instantaneously from S 0 to S

2 ,

but that the demand remains unchanged. The new supply curve (S 2 ) intersects with

the demand curve at the new, higher price of P 2 . Thus, we can say that equilibrium

prices are inversely related to changes in supply. (If supply goes up, price goes down; and if supply goes down price goes up). From this result, we know that factors that lead to increased supply in housing markets will lead to price decreases, other things held constant.

How do prices change when both supply and demand change simultaneously in this market? The answer depends on the relative magnitudes of the supply and demand changes. If both supply and demand change by the same proportionate amounts and

f i g u r e 13.2 Demand Changes Price

Price

Quantity

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C H A P T E R 13 Understanding Real Estate Market Dynamics 265

in the opposite directions, equilibrium prices will not be affected. But, if the changes in supply and demand are not equal or are in the same direction, the impact on price can be quite dramatic. Figure 13.4 shows how a small supply increase (from S

0 to S

1 )

and a large demand increase (from D 0 to D

1 ) that occur simultaneously can lead to

much higher equilibrium prices (from P 0 to P

1 ).

| example: fort lauderdale, florida ________________________

Let’s apply the supply/demand equilibrium model to a specific housing market to see how the model explains current prices and predicts future prices.

Fort Lauderdale, Florida, is an internationally renowned tourist destination. Miles of sandy beaches along the Atlantic Ocean and perpetual sunshine make this city a favorite spot for beach lovers. In addition, much of the eastern portion of the city is crisscrossed by a series of ocean-accessible canals that connect to the Intra coastal Waterway and make it possible to dock oceangoing motor yachts and sailboats in the backyards of many single-family homes. For this reason, Fort Lau- derdale is often called the “Venice of America.”

f i g u r e 13.3 Supply Changes Price

Price

Quantity

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266 PA RT T H R E E Real Estate Market Analysis

To apply the supply and demand model discussed above to the market for new, luxury homes on ocean-accessible lots in Fort Lauderdale, let’s first consider the supply side of the market. The city’s amenities have long been popular with wealthy retirees who were willing to pay top dollar to enjoy the Florida sun, and the city has experienced persistent population growth for most of the last 50 years. Thus, almost all ocean-accessible lots have an existing home on them, with almost no vacant lots available. The supply side consists of mostly older single-family homes that are smaller than the luxury homes of today’s standards and are approaching the end of their useful lives (the houses, not the owners).

Because there are no new canals anticipated in this market, the long-run mar- ginal cost of adding homes is upward sloping because the cost of each new, ocean- accessible luxury home includes the cost of demolition of an existing home. As more and more ocean-accessible luxury homes are built to replace the existing homes, the cost of building the next home increases even more. Over the long run, this market has a steeply sloping supply curve because the amount of land with ocean access cannot be increased.

f i g u r e 13.4 Simultaneous Supply and Demand Changes

Price

Quantity

S0 S1

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C H A P T E R 13 Understanding Real Estate Market Dynamics 267

On the demand side of this market are full- and part-time residents who have high disposable income levels or significant wealth portfolios and wish to maintain a permanent residence or vacation home in the area. Many of these full- and part-time residents are quite willing to spend several million dollars for an existing older home that they will demolish and replace with an even more luxurious home where they can dock their multi-million-dollar motor yacht or sailboat in the backyard.

The City of Fort Lauderdale recognizes the importance of attracting these big spenders and works hard to maintain the “Venice of America” image with infra- structure improvements and international marketing campaigns. The price of luxury, ocean-accessible homes in this market depends, at least to some degree, on the suc- cess of the city’s efforts to maintain this image. When the number of wealthy resi- dents (full- and part-time) increases, the demand for such homes increases. Given the shape of the supply curve, the prices of such homes increase as demand increases. As the value of the homes increases, the city’s property tax base increases, enabling the city to spend even more money to attract more wealthy residents to the area (see Figure 13.4).

| commercial real estate markets _________________________

Whereas the preceding discussion focused on owner-occupied residential real estate, we now turn our attention to commercial real estate markets in which the properties generally are intended to generate rental income for the owners. We can further divide commercial real estate markets into real estate space markets (where landlords and tenants engage in transactions over the use of space) and the real estate asset market (where investors/developers engage in transactions over the ownership of real estate and the rights to receive the rents from tenants).

Real Estate Space Markets

Real estate space markets involve transactions for the rights to use land and buildings. On the demand side of this market are people, firms, and other entities that are willing to pay to use space for consumption or production purposes. The supply side of this market consists of property owners who are willing to sell such space to users. The price of use in space markets is often called rent, even if the user is the owner/occupant of the space.

Users of space often have specific requirements for the type of space they demand and the locations of that space. A family, for example, wants comfortable, attractive living space near shopping, education, and entertainment resources, but a manufacturing firm is likely to be more concerned with functionality and proximity to its customers or raw materials suppliers. Suppliers in the space market have build- ings that were designed for specific uses and are fixed in their locations.

Because supply and demand are location and type-specific, real estate space markets are highly segmented. Office space in Los Angeles is clearly a different mar- ket from the warehouse space market in Texas. Prices (rents) for one type of space

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268 PA RT T H R E E Real Estate Market Analysis

may be very different from rents for a different type of space in the same geographic area, and prices for the same type of space in two different geographic areas may differ dramatically.

Categories of the Real Estate Space Market Real estate space markets can be categorized by property usage and by geo-

graphic boundaries. The major segments of the real estate space market include residential, industrial, retail, office, agricultural, and lodging. Adding geographic dimensions to these categories allows us to discuss the “highway motel market in the southeastern United States,” the “warehouse market in Chicago,” the “class B office market in San Antonio,” or almost any other reasonable combination of location and use. Accurate analysis of a real estate space market requires an accurate market definition. Let’s consider how each of the major market segments can be further subdivided in terms of property usage. As you read through these categories, keep in mind that the objective for identifying the specific market segment is to be able to analyze the factors that affect activity in that market segment.

Office Space Market

The office market is commonly divided into four subcategories: Class A, Class B, Class C, and Class D. The following distinctions are common:

■■ Class A—Buildings that will generate the highest rents per square foot due to their high quality and/or superior location.

■■ Class B—Buildings that most tenants would find desirable but are lacking certain attributes that would permit owners to charge top dollar.

■■ Class C—Buildings that offer few amenities but are otherwise in physically acceptable condition and provide cost-effective space to ten- ants who are not particularly image-conscious.

■■ Class D—Buildings with few amenities and poor locations and/or physical condition.

Retail Space Market

Retail space is commonly divided into five subcategories: (1) freestanding retail, (2) neighborhood centers, (3) community centers, (4) regional centers, and (5) super- regional centers. These subcategories are generally defined as follows:

■■ Freestanding retail—Single tenant buildings.

■■ Neighborhood center—Sometimes called a convenience center, designed to serve a relatively small trade area (1.5-mile radius) with a population of between 2,500 and 40,000 people. Its anchor tenant (primary tenant) often is a supermarket, with other stores providing convenience goods and personal services (hardware, pharmacy, hair salon, etc.). These centers usually are built in strip style—that is, stores

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C H A P T E R 13 Understanding Real Estate Market Dynamics 269

placed side-by-side in a straight line or an L-shape with a covered walkway along the front for pedestrians. The neighborhood center usu- ally is separated from the street by a customer parking area.

■■ Community center—Designed to serve a larger trade area than a neighborhood center (3- to 5-mile radius), it includes a wider variety of merchandise. Its anchor tenant is usually a discount store or junior department store. When the anchor tenant is a discount store, the center is sometimes called a Discount Center. These centers are usually built in strip style with large customer parking areas in front.

■■ Regional center—Designed to serve a primary trade area within a radius of 7 to 12 miles, these centers offer a full range of goods and services. Regional centers are usually designed as enclosed malls with at least one, and sometimes several, full-line department stores serving as the anchor tenants.

■■ Super-regional center—Designed to serve trade areas with a radius of more than 50 miles, these centers often exceed 1 million square feet of space and offer a tremendous range of products and services. One example of a super-regional center is the Sawgrass Mills Mall in South Florida. This mall attracts customers from all over southern Florida and also from Latin America, the Caribbean, and parts of Europe. Billed as one of the world’s most popular shopping destinations and Florida’s largest retail and entertainment center, Sawgrass Mills Mall features almost two miles of enclosed shopping space with more than 400 name-brand stores, pushcarts and kiosks, more than 30 restaurants, several entertainment clubs, and more than 20 movie screens.

Industrial Space Market

Industrial space is commonly divided into three categories: (1) warehouse, (2) manufacturing/production, and (3) materials processing.

Agricultural Space Market

Agricultural space (mostly land) is commonly divided into three categories: (1) annual (seasonal) cropland, (2) perennial cropland, and (3) livestock facilities and grazing land.

Lodging Space Market

Lodging space can be divided into the following five categories: (1) highway motels, (2) convention/business hotels, (3) luxury hotels, (4) resort (destination) hotels, and (5) extended stay hotels/motels.

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270 PA RT T H R E E Real Estate Market Analysis

Residential Space Market

Residential space can be divided into (1) single-family detached homes, (2) sin- gle-family attached homes (condos, co-ops, town houses, etc.), (3) manufactured homes, and (4) multifamily apartments.

| real estate asset markets _______________________________

Whereas the real estate space market reflects transactions involving the use of space, the real estate asset market reflects transactions involving cash-flow rights to real estate. The term cash-flow rights refers to the claims to the future cash flows that the buildings and land are expected to generate. The participants in this market are concerned with the amount and timing of the cash flows a building is capable of producing rather than the building’s configuration for a particular use. These market participants make their decisions about buying and selling by comparing real estate assets with other capital market assets such as stocks and bonds. As such, the real estate asset market must be regarded as part of the larger capital market, the market for capital assets of all types.

To understand how real estate assets compete with other capital assets, consider the chart provided in Figure 13.5. This chart divides the capital asset market into four broad categories: publicly traded equity assets, publicly traded debt assets, privately traded equity assets, and privately traded debt assets.

Public markets transactions typically involve relatively small portions of owner- ship rights to various capital assets. The stock market is the most obvious example of a public market. Shares of public corporations trade in huge volume on any given trading day, and observed prices reflect all currently available information about the assets.

Private markets involve transactions between individual buyers and sellers with- out the aid of a formal market mechanism. Private markets usually involve the sale of whole assets rather than shares of assets. Because such transactions happen less frequently than public market transactions and because the parties to the transaction may keep information private, it is generally more difficult for private market par- ticipants to determine the value of assets traded in these markets. Furthermore, the transaction costs of trading these assets are likely to be much higher than the costs of trading in the public markets.

The chart also divides the capital market into debt and equity categories. Debt assets can be thought of as rights to the future cash flows paid by a borrower on a loan. These cash flows are contractually specified according to the details of the loan agreement. As such, the debt holder is entitled to be paid before the borrower gets any cash flow from the underlying asset (the source of the cash flow). Debt assets typically have a specified maturity date.

Equity assets refer to assets that entitle their owners to the residual cash flow generated by an underlying asset (after the debt holders have been paid). Equity assets are more risky than debt assets, in general, because of their “second” priority behind debt assets. Of course, the riskier the asset, the higher the expected return.

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C H A P T E R 13 Understanding Real Estate Market Dynamics 271

Capital asset vehicles based on real estate as the underlying asset take a variety of forms. In the public equity market, shares of publicly traded real estate investment trusts (REITs, pronounced “reets”) trade with a volume comparable to that of shares of industrial corporations. REITs raise money from the sale of shares to investors and then use the proceeds to acquire properties and mortgages. They then manage the portfolios to maximize the return to their shareholders.

In the public debt market, investors can purchase derivative products such as mortgage-backed securities (MBSs), whose underlying assets are pools of mortgages on residential and commercial properties. As mortgage payments are made to the pool by borrowers, the money is distributed to the various investors according to the type of security they bought from the pool. In the private debt market, investors and institutions buy and sell mortgage loans that are secured by individual buildings.

Most people who think of the real estate asset market think about the private equity market that involves ownership of whole properties. The lack of complete information and infrequency of trades in the private equity real estate market make this market one of the most dynamic and interesting capital markets. Even so, the different categories of real estate asset markets are well integrated with each other and the markets for other capital assets. The prices of real estate assets in the pri- vate equity market reflect the integration of all capital markets and the competition between asset markets for investors’ dollars.

Price Determinants in the Real Estate Assets Market Real estate asset market prices are determined by three main factors: opportunity

cost of capital, growth expectations, and risk. Investors make their buy/sell decisions about real estate assets by comparing the return they expect to get from real estate assets with alternative rates of return they could earn from other capital assets in the capital market. As the opportunity cost of capital goes down, investors are generally willing to put more money into real estate assets, thus driving up their prices.

f i g u r e 13.5 Major Types of Capital Asset Markets and Investment Products

Public Markets Private Markets

Equity Assets Stocks REITs Mutual Funds

Real Property Private Firms Oil and Gas Partnerships

Debt Assets Bonds MBS Money Instruments

Bank Loans Whole Mortgages Venture Debt

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272 PA RT T H R E E Real Estate Market Analysis

Investors are also concerned with the likely amount of growth (or decline) they expect from a property’s cash flow. The cash flow a property can generate is, of course, determined in the real estate space market, as we previously discussed. The higher the expected growth rate in the space market, the more money investors will be willing to pay for property in the asset market.

Finally, the third determinant of prices in the real estate asset market is risk. Investors will evaluate how certain (or uncertain) they feel about a property’s future cash flows and will prefer to pay less for a property with higher risk. Paying lower prices allows the investor to have a higher expected return for a given level of risk.

| tying together the space and asset markets ______________

Now that we understand the distinctions real estate analysts make between the real estate space market and the real estate asset market, our current task is to show how these markets are interrelated. Figure 13.6 shows a simple model of “the real estate system” in terms of the development industry, the real estate asset market, and the real estate space market.

In this visual model of the real estate system, activity in the space market, the asset market, and the development industry are simultaneously determined. Influ- enced primarily by local economic conditions, owners/users and landlords/tenants negotiate over price (rent) levels in the space market. When demand conditions warrant, the owners/users and landlords purchase additional properties from the development industry and make them part of the available supply. At the same time, landlords and the owners/users negotiate in the capital market with potential tenants/ buyers who are attracted to real estate assets by attractive risk-return combinations relative to other assets in the national or even international capital market. Potential buyers who become owners then enter the space market as landlords or owners/users, thus completing the “system.”

Visualizing the real estate system in this manner can help us see how the three major components of the real estate system (development, space market, asset mar- ket) are tied together. Relatively small changes in any one component may flow through the system to the other components and can have dramatic impacts on them. A prudent commercial real estate market participant is well advised to keep this visual image in mind, especially when analyzing a real estate deal that looks much too good to be true!

| preparing a commercial real estate market analysis _______

While all of the preceding theoretical discussion is crucial to the understand- ing of real estate markets, how can we apply these theories to real world situations? This section of the chapter describes how to prepare a structural analysis of a real estate market. By definition, a market analysis is an examination of the supply and demand sides of a real estate space market segment and the balance (equilibrium) between these two sides. The goal of market analysis is to assist real estate market

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C H A P T E R 13 Understanding Real Estate Market Dynamics 273

participants in making effective real estate decisions. Market analysis can be used to answer such questions as the following:

■■ How much rent should I charge tenants in this building?

■■ How many new units should I build this year?

■■ Where should I locate a new branch office for my business?

■■ What type of building should I build on this site?

■■ What are the growth prospects for this market segment?

Basic Inputs to Market Analysis The typical real estate market analysis focuses on a few carefully chosen vari-

ables that are designed to characterize the supply and demand sides of the market segment as well as the balance between these two sides. Five of the most common inputs to a real estate market analysis are

1. vacancy rate,

2. rent or price level,

3. quantity of new construction started,

4. quantity of new construction completed, and

5. absorption of new space.

f i g u r e 13.6 The Real Estate System

Rents/Occupancy

SPACE MARKET

Supply (Landlord)

Demand (Tenant)

Economic Conditions

Capital Markets

DEVELOPMENT INDUSTRY

ASSET MARKET

Values Returns

Demand (Potential Buyers)

Supply (Owners)

Add new space when development

is profitable

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274 PA RT T H R E E Real Estate Market Analysis

We will consider each of these variables in turn. Vacancy rate is the measure of the amount of unoccupied space as a percent-

age of the total amount of space in the market. For example, a community with 50 empty rental apartments and 1,500 total rental apartments has a vacancy rate of about 3.3 percent (50 ÷ 1,500). The vacancy rate is an indicator of the balance between the supply and demand sides of the market segment. The unit of measurement used in calculating vacancy rates varies by market segment. For apartments, the typical unit of measure is “number of units,” as we just demonstrated. For commercial and industrial space, the typical unit of measure is “square feet of space.”

Another important indicator of the balance between supply and demand in a market segment is the rent or price level. Changes in the market rent or market price of space indicates changes in the balance between supply and demand. In residential markets, rents are often expressed as monthly rents per dwelling unit. In commercial and industrial markets, the unit of measure is more commonly the annual rent per square foot of space.

Two good indicators of the supply side conditions of a real estate space market include construction starts and completions. In residential markets, these variables are measured by the number of new homes or apartments. In commercial and industrial markets, these variables are measured in square feet of space. Construction starts and completions indicate the amount of new supply “in the pipeline” and the amount of new supply “flowing out of the pipeline,” respectively. In some markets, a thorough market analysis would also need to address the amount of space being demolished to make room for new construction and the renovation of existing space.

Finally, one of the best indicators of the demand side conditions of a real estate space market is the absorption rate. Gross absorption refers to the total amount of new space that became occupied during a specified time period. Net absorption is defined as the net change in the amount of occupied space in the market segment during a specified time period.

Using Market Analysis to Look Forward These five indicators of a space market give a good overview of the supply and

demand conditions in a market and the direction of change for both the supply and demand. These five variables can be combined in some creative ways to develop a forecast for future market conditions. For example, many real estate market analysts use the concept of “months supply” to look into the future of a real estate space mar- ket. Months supply is calculated by the following formula:

Months Supply = (Vacant Space + Space in Construction) ÷ Net Absorption per Month

The months supply indicator tells us how long it will take (in months) for all the vacant space in the market to be absorbed at the current rate of absorption. A housing developer, for example, can use this measure along with an estimate of the average time it takes to complete new units to determine whether the market can support another project. In a market that is absorbing 30 housing units per month and has 30 currently vacant units and 90 units under construction, the “months supply” is four.

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C H A P T E R 13 Understanding Real Estate Market Dynamics 275

If the developer’s construction time is two months, it is likely that a new project will hit the market at a time when there is excess supply. The months supply indicator is a simple measure for looking forward in a real estate space market segment.

Professional Market Analysis Reports Performing a thorough market analysis can be very expensive and time consum-

ing and may require the skills of a professional market analyst. Numerous market research firms around the world offer their services to investors and consumers for a fee. Some of the big names in real estate market research include Torto Wheaton Research, LaSalle Investment Advisors, and RREEF Research. To formulate their market analysis reports, research firms examine the key “drivers” for each market segment. Examples of these drivers for various segments are described below:

■■ Office: employment in office occupations

■■ Lodging: air passenger volume, highway traffic counts, tourism receipts, number of visitors

■■ Retail: per capita income, aggregate income, wealth measures

■■ Industrial: manufacturing employment, transportation employment, shipping volume

■■ Apartments: population, household formation, local housing affordabil- ity, employment growth (blue and white collar)

■■ Owner-occupied residential: population, household formation, interest rates, employment growth, income growth

Combining the information on these key drivers with the previously described indicators allows these firms to predict future market conditions and identify invest- ment opportunities for their clients.

| chapter review __________________________________________

■■ By definition, a market is the mechanism or arrangements through which goods and services are traded between market participants. The combined effects of supply and demand in markets determine equilibrium prices.

■■ Prices are generally said to be directly related to changes in demand and inversely related to changes in supply. Events that increase demand lead to increased prices, and events that decrease demand lead to decreased prices. Events that increase supply lead to decreased prices, and events that decrease supply lead to increased prices. When supply and demand change simultaneously, the resulting price depends on the relative magnitudes of the supply and demand changes.

■■ Commercial real estate can be divided into two types of real estate mar- kets: the real estate space market and the real estate asset market.

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276 PA RT T H R E E Real Estate Market Analysis

■■ The real estate space market is concerned with transactions that involve owners/users and landlords/tenants. This market is highly segmented along lines governed by use and location.

■■ The real estate asset market involves transactions regarding rights to the cash flows generated by real estate assets. Participants in this market are primarily concerned with cash-flow generating ability of a property rather than its configuration for a particular use.

■■ The real estate asset market is a component in the larger market for all capital assets.

■■ Prices in the real estate asset market are primarily determined by the opportunity cost of capital, growth expectations, and risk.

■■ The space and asset markets are tied together by the development industry. When participants in the asset market expect high returns from real estate assets relative to other capital assets, they will purchase new construc- tion from the development industry. The new buildings become part of the available supply in the space market. Together, the real estate space market, the real estate asset market, and the development industry form a “real estate system.”

| key terms _______________________________________________

absorption rate

capital market

community center

demand

equilibrium

freestanding retail

gross absorption

market

market analysis

months supply

neighborhood center

net absorption

real estate asset market

real estate space market

regional center

super-regional center

supply

vacancy rate

| study exercises _________________________________________

1. Use a simple graph of the supply/demand equilibrium model to show how an increase in mortgage loan interest rates might affect owner-occupied residential real estate prices (other things held constant).

2. Use a simple graph of the supply/demand equilibrium model to show how a population increase accompanied by a decrease in construction costs might affect owner-occupied residential real estate prices (other things held constant).

3. If demand in the space market declines, what is the predicted impact on prices?

4. What are the three main determinants of prices in the real estate asset market?

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C H A P T E R 13 Understanding Real Estate Market Dynamics 277

5. If price levels in the space market increase significantly, will that entice investors to purchase more real estate in the asset market?

6. How will the asset market and the development industry respond to an increase in demand in a space market?

7. What are the three major components of the “real estate system”?

8. Define the terms net absorption and gross absorption.

9. Calculate the months supply of warehouse space in a market that absorbed 10,000 square feet last year, has 6,000 vacant square feet, and has 3,000 square feet under construction. Would this be a good time to start a new warehouse project in this market? Why or why not?

10. Internet exercise: Visit the website of a major real estate research firm and compare the multifamily apartment market in your community with the national multifamily apartment market. Does the outlook for this market segment in your community look brighter or dimmer than the national outlook? Why?

| further reading _________________________________________

Geltner, David M., Norman G. Miller, Jim Clayton, and Piet Eichholtz. Commercial Real Estate Analysis and Investments, 2nd ed. Mason, Ohio: Thomson South-Western, 2007.

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14c h a p t e r Urban and Regional Economics

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279

c h a p t e r p r e v i e w

As we discussed in the previous chapter, an understanding of real estate market dynamics is crucial to effective real estate decision making. The disci- pline of studying real estate markets at the urban and regional level is called urban and regional economics. In this chapter we consider some of the con- cepts and tools that urban and regional economists have developed for evaluat- ing real estate markets. These tools help explain how cities grow and change and how land uses and values vary within and among urban areas. Because real estate markets are an integral component of the overall real estate system, the better we understand market dynamics, the better we can understand the overall system.

The objectives of this chapter are to define various theories and concepts from the urban economics discipline, including

■■ the concept of comparative advantage;

■■ economic base theory;

■■ the bid-rent curve and the concept of highest and best use;

■■ the concentric circle model of urban form;

■■ the sector growth model;

■■ the axial growth model;

■■ the multiple-nuclei growth model; and

■■ the neighborhood life cycle model.

close-up The Rise of the

“Location-Neutral” Urban Migrant

case study A Tale of Two Cities: Flint and West Point

case study Neighborhood Revitalization

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280 PA RT T H R E E Real Estate Market Analysis

| economic factors influencing the growth and decline of cities _____________________________________

Why does one region or locality develop into a center of trade or industry while others do not? Why does the economy and population of a city or region grow or decline? What factors determine the economic growth rate of an area? The answers to these questions are closely linked to the concepts of comparative advantage and economic base.

Determinants of a Community’s Comparative Advantage

Rapid economic and population growth generally results because one locale has a comparative advantage over another. This advantage may result from sev- eral factors. A city may grow because it has advantages in transportation facilities; advantages in the quality or quantity of other factors in the created environment; or because of natural resources, a favorable climate, or the quality or quantity of its labor force.

Transportation Facilities Perhaps the most important factor that gives a community comparative advan-

tage is transportation facilities. Almost all colonial cities in the United States devel- oped around ports, either on natural harbors or along rivers. Most of the latter ports were located at important river junctions or at the fall line, the point at which the rivers cease to be navigable because their waters, descending from the uplands to the lowlands, form rapids and falls.

These initial natural advantages often were aided by further transportation improvements. For example, New York became the dominant port on the eastern seaboard and a world city largely because of the initial advantage it enjoyed after the completion of the Erie Canal in 1825, which provided easy access to the developing West.

Later, the advent of the railroad led to the “railroad town.” A community located on a railroad enjoyed a distinct economic advantage over a town that was not, and communities at important rail junctions gained an even greater comparative advan- tage. The best example is Chicago, which developed into one of the nation’s largest cities primarily because of its dominance as a rail center between East and West.

Because major highways have tended to follow the paths of major railroads, rail centers have also become highway centers. Similarly, many have become major air- traffic transfer points. Two of the busiest airports in the United States are those in Chicago and Atlanta, two cities that serve as transfer points, one between East and West and the other for the Southeast.

Educational Facilities In today’s technological and service-oriented economy, the quality of educa-

tional facilities is of great importance, both in providing centers for technological

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C H A P T E R 14 Urban and Regional Economics 281

development and in increasing the educational quality of the labor force. These fac- tors undoubtedly will become even more important in future years.

Created Environment The created environment consists of such things as utilities, public services and

tax levels, housing, cultural activities, and transportation and educational facilities. The quality and quantity of such factors may give a region or community a compara- tive advantage or disadvantage. If a community has an industrial park, for instance, it may attract additional industrial employment. Conversely, an industrial firm will not locate where adequate utilities and other services are not available.

Natural Resources Another important factor in the location of cities is the existence of various

natural resources. Denver owes its origins to the discovery of gold and silver in the nearby mountains; ample deposits of coal and iron ore greatly aided the development of Birmingham and Pittsburgh. After the resources that led to its formation have been depleted or become less of a comparative advantage, and if it is to continue to prosper, a resource-based city must develop other advantages as a center of trade and industry.

Climate Other cities and regions owe much of their comparative advantage to their favor-

able climate; for those whose economy is based on tourism, this factor may be domi- nant. Climate has been an extremely important factor in the development of cities in Florida and California and is cited as one of the major comparative advantages of the Sunbelt. As a greater percentage of the population reaches retirement age over the coming decades, the advantage of these communities as retirement locations will also rise in significance.

Labor Force Another important factor that may give an area a comparative advantage is the

quality or quantity of the labor force. For example, the textile industry, for the most part, deserted the cities of New England for those of the Southeast following World War II, largely because the Southeast offered an ample supply of labor that was will- ing to work for relatively low wages. Conversely, New England cities—particularly those in Massachusetts—were able to attract a substantial portion of the expanding electronics industry because their labor forces possessed a relatively high level of education and skill.

Leadership An intangible but critical factor in community growth and in a community’s

becoming a quality place to live is community leadership. In fact, many feel this is the most important factor in regional and area growth and quality development.

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282 PA RT T H R E E Real Estate Market Analysis

Some communities have many comparative advantages, but languish; others prosper, though they possess few natural advantages. The difference, in most cases, is the caliber of local leadership.

The Concept of an Economic Base

Specialization is both a fundamental economic concept and the primary rea- son for the existence of cities. In a developed economy, and even in most primitive societies, neither the individual nor the family nor the community can be wholly self-sufficient. Even solitary trappers occasionally must emerge from the wilds to sell pelts and purchase necessary supplies. Similarly, a community or region is not self-sufficient but must sell goods and services outside its borders to pay for the imports it needs.

The pelts Trapper Joe sells are “exports” for his economy, and the proceeds can be used to purchase needed supplies, “imports”. Similarly, a community tends to specialize in certain activities in which it has a comparative advantage and to sell those goods and services to the rest of the world. The income from those exports can be used to import goods and services from outside the community.

In examining local economies, analysts often classify employment into two general categories: (1) export activities, also called basic activities, which pro- duce goods and services for sale or consumption outside the area’s borders, and (2) population-serving activities, also called nonbasic activities, which produce goods and services for sale or consumption within the community itself. Although it is difficult to determine with any exactness which of a community’s activities are for export, they usually include most of those in the fields of agriculture, mining, manufacturing, and wholesale trade.

The population-serving activities generally include those undertaken by the con- struction industry, public utilities, the retail trade, finance, service industries, and government. Sometimes, however, population-serving activities are also export in nature. A regional shopping center may draw customers from far beyond the local area, a city may serve as headquarters for financial institutions serving a large region, and a large university usually attracts students far from the local area.

If export activity in a region or city expands, so will employment in the pop- ulation-serving industries. Suppose that Amalgamated Whitzadidle opens a new manufacturing plant in Lower Swampville that employs 500 workers. The economic impact of the new plant will go far beyond this direct employment increase. Con- struction workers will be needed to build the facility and homes and apartments for individuals and families who may move to the area. Purchases of various goods and services by the manufacturing workers will give rise to additional employment in the trade and service industries. The new residents also will be purchasing and financing homes and buying insurance, thereby creating new jobs in those fields. In the same fashion, the impact of the new plant will spread throughout the local economy so that the total employment and income created will be far greater than the direct impact.

In the past, many regional analysts, planners, and appraisers have tried to quan- tify the relationship between changes in employment in industries that bring income

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C H A P T E R 14 Urban and Regional Economics 283

into a region from beyond its borders—that is, changes in the economic base—and changes in total employment, income, and population. To understand the potential market for real property in a community, it is essential to understand the commu- nity’s industrial structure and the probable changes that will occur. If the economic base is likely to expand, demand for real property also is likely to expand. Con- versely, of course, if the economic base is expected to contract, the demand for real estate also is likely to contract.

| the location of people __________________________________

Cities tend to develop in places that offer firms a comparative advantage, and exploitation of that advantage leads to growth of the economic base. People also tend to locate where they can achieve a comparative advantage, and although there are exceptions, most people live where they do because of economic opportunities. When jobs are plentiful, other factors come into play as well—personal preferences for a particular type of climate or landscape, big-city attractions or small-town tranquility,

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c l o s e - u p

The Rise of the “Location-Neutral” Urban Migrant

We know that except for retirees and the few with independent incomes, people normally must work within commuting distance of their employment. However,

with modern communications and data networks a small but increasing number of workers are employed in jobs that can be referred to as “location-neutral,” not tied to any particular location. Thus, these people can choose where they want to live without regard to employment needs.

Take, for example, Greg and Kristin Shields. Greg is sales engineer and expert on the com- munication needs of the financial industry with telecommunications company SAVVIS. He assists sales representatives around the country, primar- ily through conference calls. Kristin is a program

manager with a consulting firm, doing environ- mental impact studies for the Corps of Engineers. Neither of these jobs requires them to be in a particular location, so they decided to move away from their suburban Washington home to a less fast-paced life in Salisbury, North Carolina. Instead of his former 45-minute commute, Greg now walks the seven blocks to his office, an office that is much less costly for his company than his former urban location. They live in a 100-year-old home in a historic district that they never would have been able to afford in their former location, where hous- ing was much more expensive. They also benefit from other less costly small-town amenities such as membership in the local country club and boating on nearby lakes. Having location-neutral jobs has definitely enabled Greg and Kristin to enjoy a more relaxed and better lifestyle.

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284 PA RT T H R E E Real Estate Market Analysis

and closeness to or distance from relatives. When jobs become more scarce, such considerations tend to lose their force; people go where they can find work.

Demand for housing in a locality is very closely related to employment demand— that is, to the community’s economic base. Indeed, most real estate activity occurs as a result of changes in the economic base. For example, industrial construction is a direct result of such changes. And indirectly—through increases in the demand for population-related activities—changes in the economic base lead to the development of shopping centers, construction of schools, and the like.

| analyzing local real estate demand ______________________

How do these regional and community growth factors influence the local demand for real estate? The real estate analyst must have an understanding of both the current changes in the industrial structure of the community and the factors that might lead to economic changes that attract new people or cause residents to leave. Demand for existing properties is tied to the current industry mix and expected short-run changes. Long-term demand for existing properties and for new developments is related to the long-run vitality of the community’s economy, which can be assessed only by an analysis of potential change.

Analysis of Short-Run Demand

Previously, we saw that although completion of new construction may add to the supply of real property improvements, the supply is largely fixed in the short run. Changes in demand in the short run most often affect vacancy rates, sales of existing properties, prices, and lease rates.

The real estate analyst attempting to ascertain possible short-term changes in local real estate markets must ask the following questions:

■■ What is the current supply of various types of real estate improvements?

■■ What is the industrial structure of the community?

■■ What changes have occurred in the local economy in the recent past?

■■ What is likely to happen to the economy in the near future?

Suppose, as in the following case study, that a city’s economy is heavily depen- dent on the automotive industry. A decrease in demand for automobiles would have an immediate impact on employment, which would lead in turn to a decrease in con- sumer spending. If these conditions persist, and particularly if a major firm closes its local manufacturing facility, then housing and other real estate markets would be quite adversely affected.

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C H A P T E R 14 Urban and Regional Economics 285

Analysis of Long-Run Demand

Suppose a potential investor is considering building a new resort facility in a community or that a developer is considering building a shopping center in a city whose dominant manufacturing employer has been forced to begin massive layoffs. In these situations, the prospects obviously would be poor in the short run. But the proposed improvements would not actually come onto the market for some time, and demand could then be quite different and favorable for the new project. In this situ- ation, the analyst must examine additional questions:

■■ What are the long-run prospects for the economy of the community?

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c a s e s t u d y

A Tale of Two Cities: Flint, Michigan and West Point, Georgia

The 21st century has not been kind to the automobile manufac- turing industry in the United States, with industry employment falling by about half. The

Detroit-based “Big Three” were hit particularly hard, with General Motors and Chrysler falling into bankruptcy.

As we would expect, the communities where the automotive industry constituted a major part of the economic base suffered large losses in employment and population. The population of Detroit, which had reached 1,800,000 in 1950, fell to only 800,000 by 2010, with a large number of abandoned houses and large swaths of the city reverted to open space.

Flint, Michigan, the birthplace of General Motors (GM), had virtually been a “company town,” but with the loss of 60,000 GM jobs, its economy nearly collapsed. The city’s population, which was 125,000 in 2000, fell 11 percent by 2010 to around 111,000. As in Detroit, the housing market experi- enced falling prices, numerous foreclosures, and abandonments.

West Point, Georgia, also has a history as a one-industry town, with textiles accounting for most of its economic base. When the textiles firms closed in the 1990s, the town became practically a ghost town.

In contrast to the old American automobile manufacturing firms located primarily in the so- called “Rust Belt” north-central states, the Asian automotive firms have located their new plants in the Sunbelt states. Aided by large state incentives, in 2005 the Korean firm Kia Motors began building a $1.2 billion manufacturing facility in West Point. The plant, which began producing vehicles in late 2009, has a capacity of 300,000 vehicles a year and will employ between 2,500 and 3,000 workers when fully operational. Related parts suppliers will employ several thousand more workers.

The impact on the economy of the town of 3,500 has been dramatic, with many new busi- nesses opening and old ones expanding. New residential subdivisions are being built, and the housing market is vigorous. The town has also experienced definite cultural change. For example, the local Pizza Hut is now a Korean barbecue restaurant.

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286 PA RT T H R E E Real Estate Market Analysis

■■ What national or regional trends are likely to affect employment in the area?

■■ Are new firms likely to locate in the area, bringing additional employment?

Projecting and forecasting future employment trends is an interesting exercise that often involves sophisticated modeling techniques. In the final analysis, however, the real estate investor must carefully evaluate the assumptions that lie behind popu- lation and employment projections. While most of our discussion thus far has been targeted at how entire urban areas grow and change, the next several sections of this chapter examine land-use patterns within urban areas.

| the bid-rent curve and the concept of highest and best use ____________________________________________

Why is a certain parcel of land used for a particular purpose? Why are certain parcels of land worth more than others? The answer to these questions lies in the concept of land rent. The classical economists included land as one of the three elements of production (land, labor, and capital), and rent is the return on or price of land. In theory, a particular parcel will be used in the way that yields the highest return to the owner. Land rent is the return that a particular parcel of land will bring in the open market.

Land rent, of course, differs from one parcel to another because the highest and best use of each parcel differs. By definition, highest and best use is that use of a parcel that will produce the highest return or price to the owner. Highest and best use is constrained by legal restrictions and the physical characteristics of the parcel. Over time, the highest and best use of a parcel of land may change, but the process by which one land use gives way to another is not rapid. Rather, the existing improve- ments will be converted to a new use over a period of time; the final conversion occurs only when the value of the land in an alternate use is great enough to pay for the site, the existing building, and its demolition.

To understand how location and use affect price, let’s examine one of the classic concepts from the urban economic discipline: the bid-rent curve. Bid-rent refers to the maximum rent that a potential real estate space user would be willing to pay, or “bid,” for a specified location.

Consider a simple community that consists of three different types of space users: commercial, residential, and agricultural. Each of these potential users in this community space market has its own bid-rent function that can be expressed as the relationship between the price they would be willing to pay for locations as the dis- tance from the center of the community increases.

Figure 14.1 shows the bid-rent functions for each of the three space users in our community. Notice that the commercial users are willing to pay the highest prices for locations closest to the center of the city. But the commercial users are not willing to pay any price for locations at distances greater than point B from the community center. Similarly, we see that residential users are willing to pay the second highest

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C H A P T E R 14 Urban and Regional Economics 287

prices for locations at the center of the community, but not as much as the commer- cial users are willing to pay. At distances beyond the first vertical dashed line, how- ever, the residential users are the high bidders for space. Beyond the second vertical dashed line, agricultural users are the high bidders. Looking at the “outer edge” of the curve formed by the combination of the three users’ bid-rent functions gives the bid-rent curve for this community. We can see the land prices fall as distance from the city center increases, quickly at first, but more slowly as the distance increases more and more.

This model shows that each location has a highest and best use that is deter- mined by its land rent. We also see this concept in the appraisal chapter of this text.

| models of urban growth patterns ________________________

A city may grow in several ways: vertically, by replacement of smaller structures with taller ones and by use of air rights to construct new buildings over existing ones;

f i g u r e 14.1 Theoretical Price-Distance Relationships

Price

Distance

B D F H

Commercial use Residential use

Intensive agricultural use Nonintense agricultural use

Legend

Line AB: Commercial users

Line CD: Residential users

Line EF: Intensive agricultural users Line GH: Nonintensive agricultural users

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288 PA RT T H R E E Real Estate Market Analysis

by in-filling of open spaces between existing structures; and horizontally, by exten- sion of settled areas.

Of these forms of growth, the first two are applicable to already established urban areas, while the last describes the process of urban expansion. Several models have been used to explain these growth patterns, including the concentric-circle, axial, sector, and multiple-nuclei models of growth. Each model describes aspects of modern urban growth in simplified model form, and most observed growth patterns contain elements from several models.

Concentric-Circle Growth

One model of urban growth patterns resulted from the 1920s study of land uses by Ernest Burgess in Chicago. The concentric-circle model postulates that from a central business district, several concentric zones radiate outward. (See Fig- ure 14.2.) In this model, zone 2, immediately bordering the central business district, was one of transition, consisting primarily of slums occupied by recent immigrants, who remained there until they were financially and socially prepared to move to better- quality residences farther from the center. The study found that this zone also contained widely contrasting development, including luxury apartment buildings, elegant restaurants, nightclubs, and theaters. Light-manufacturing facilities were located at its outer edge.

The next zone was occupied mostly by workers employed in the manufacturing activities located in zone 2. Most housing consisted of older single-family dwellings converted into multifamily use. The passage of older housing to less affluent families as it ages is referred to as filtering, and it is an important element in neighborhood change.

f i g u r e 14.2 Concentric-Circle Growth

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C H A P T E R 14 Urban and Regional Economics 289

Higher-income families who could afford better housing on larger lots occupied zone 4. This zone also contained specialized commercial activities serving the afflu- ent group. Still farther out was the limit of the commuter zone, consisting of satellite cities and suburban developments. The area beyond was given over to agricultural activities.

The concentric-circle model basically follows bid-rent theory. Users who are able to pay higher rents are located closer to the center. When considering the real- ism of the concentric model, we must remember that it was developed in the 1920s, when the central business district was the business district because the automobile had not yet influenced the creation of alternate shopping nodes. The model is also more realistic when its assumption of uniform topography is dropped.

Rivers, lakes, mountains, and other geographic features may constrain growth or make it impossible in certain directions. For example, Chicago cannot grow to the east because of Lake Michigan; and the growth of Colorado Springs to the west is constrained by Pikes Peak. Growth in the San Francisco area has been southward, down the peninsula, and largely restricted to the east because of the coastal mountain range. Urban development in the East Bay area is constrained by San Francisco Bay on the west and the Diablo Range on the east. Similarly, the form of most other urban areas has been shaped by geographic features and barriers.

Axial Growth

Transportation is a critical factor not only in the location of cities but also in the way they develop. We know that cities are often located at transportation nodes— that is, at the junctions of major transportation routes. They may originate near ocean or river ports, at junctions of major railroads or highways, or where various modes of transportation interconnect. These cities have a competitive edge over communities that do not enjoy such transportation advantages.

Similarly, land within an urban area that is well served by transportation facilities has a comparative advantage over land that is not. Thus, land tends to develop along major transportation routes. The result, according to the axial model of growth, is a star-shaped city with growth extending outward along transportation lines. (See Figure 14.3.)

The axial growth model was developed in the 1930s, before most workers had automobiles to commute to work and before trucks freed industrial facilities from dependence on railroads. These factors, plus the construction of major beltway high- ways, have reduced the impact of radial transportation routes on urbanization, but they are still an important factor in urban development.

Sector Growth

Extensive studies in the 1930s of residential neighborhood change also led to the development of the sector model theory of urban growth by a famous geogra- pher and real estate investor named Homer Hoyt. Hoyt found that particular types of development tended to extend in wedge-shaped sectors from the center of the city,

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290 PA RT T H R E E Real Estate Market Analysis

as illustrated in Figure 14.4. For example, if expensive homes were first built in the western sector of a city, their development tended to continue outward in the same direction. The older houses in the sector would be occupied by successively lower- income groups through the filtering process and eventually might be converted into multifamily dwellings. Lower-income groups were not able to commute long dis- tances and tended to live near their work. Thus, lower-income housing usually was located near manufacturing activities but also tended to develop in wedge-shaped patterns.

Most people’s experience verifies the sector model. Consider your own home- town and how it has developed. While it won’t follow the model precisely, you prob- ably will be able to identify a number of sectors that conform to this model of urban growth.

Multiple-Nuclei Growth

The multiple-nuclei model of city growth takes the sector theory another step toward describing the actual growth process. It emphasizes that many commercial activities occur in clusters and that, in most cities, there is more than one center of commercial activity (see Figure 14.5). This theory of urban growth was formulated in the 1940s by researchers Harris and Ullman, after the automobile’s impact on land-use dispersion had more fully developed. This theory maintains that these clus- ters developed because (1) certain activities require specialized facilities, (2) many

f i g u r e 14.3 Axial Growth

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C H A P T E R 14 Urban and Regional Economics 291

similar activities benefit from close proximity to one another, (3) certain dissimilar activities are detrimental to each other, and (4) some activities must seek less desir- able, lower-priced sites.

Many factors, particularly highway and communications improvement, have led to the further fragmentation of most cities’ commercial activities in recent decades. Generally, the importance of the central business district has greatly declined with the growth of major suburban shopping centers and office parks. The development of such subcenters has led to a serious deterioration in the central business districts of many communities, and the question “What can we do to save downtown?” has occupied the attention of many planners and public officials.

Some downtowns, however, have experienced a revival recently as a result of concern with urban sprawl, a lessening of inner-city tensions, and public policies designed to encourage such development.

| the importance of public facilities in the growth process _

Investments in public facilities, often called infrastructure, play a critical role in the local development process. Transportation improvements figure prominently in the theories of urban form, but other public investments in such facilities as sew- erage and water lines also are important in the local development process. Infra- structure development or the lack of it is often used as a policy tool to encourage or discourage growth.

f i g u r e 14.4 Sector Growth

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292 PA RT T H R E E Real Estate Market Analysis

Transportation Facilities

Until about 1870, urbanized areas were almost exclusively pedestrian cities, with commuting limited to the distance one could travel on foot or in a horse-drawn vehicle. The introduction of the streetcar and electric rail transit greatly extended commuting ranges during the next 50 years and led to axial-type development along the transit lines. The automobile era (which began around 1920), when cheap, mass- produced cars became available, expanded the size of the city even more. The auto- mobile tended to bring more concentric-type growth, for it was not limited to a few axial routes. Freeways and other highways, however, did promote development along their routes.

Figure 14.6 illustrates the process of development that often occurs when a major freeway is constructed at the rural fringe of an urban area. In the first drawing, the land is used primarily for farming, but there are scattered residences and some minor commercial activity at one road junction. In the second stage, the highway is under construction, and developers have recognized the area’s heightened potential. Much of the farming activity has ceased, and this land has been purchased for pos- sible future development. In the third picture, intense development is occurring.

In addition to several subdivisions, commercial strips have formed along the road near the freeway interchange. Some apartments have been constructed, and still another tract awaits development.

f i g u r e 14.5 Multiple-Nuclei Growth

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C H A P T E R 14 Urban and Regional Economics 293

The beltways constructed around many large cities as part of the interstate high- way program have also had a great effect on urban form. Beltways have reduced the star-shaped growth tendencies of their cities, making many areas more accessible, and have encouraged large amounts of residential and industrial development. They have also served as the sites of many shopping malls and office parks, thereby fur- thering the development of multiple nuclei and greatly weakening the importance of the central business district.

Water and Sewer Facilities

Water and sewer facilities are not glamorous, but they are essential to urban growth. Even in areas that have ample water, access to a municipal water system is still necessary for any type of concentrated growth. In the more arid regions, where wells are often impractical, almost any type of urban development is impossible without access to a municipal water system. Similarly, if soil and other conditions are adequate, it may be possible to serve low-density developments with septic tanks, but public sewerage is essential to high-density developments. The growth potential of a particular parcel can be influenced dramatically by its access to such facilities.

Figure 14.7 shows how the construction of a major sewer line can enhance the development potential of a particular site. The first drawing shows scattered resi- dences along rural roads in the watershed of a creek at the edge of an urban region. The building of the sewerage system paralleling the stream enables subdivisions to be built within this area. Because there are no sewers in the adjoining areas, intensive development cannot occur there.

| the dynamics of neighborhood change ____________________

Thus far, we have seen that the value of individual parcels of real estate depends, to a large extent, on national changes in demand, regional and community growth,

f i g u r e 14.6 The Impact of Freeway Construction on Urban Development

First Stage Second Stage Third Stage

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294 PA RT T H R E E Real Estate Market Analysis

and urban growth patterns. Let’s narrow our focus a bit and consider the importance of local neighborhood changes on property values.

What Is a Neighborhood?

Location is perhaps the most important single factor in determining the value of real property. The selling prices of identical houses built in different locations within an urban area almost always vary with the character of the surrounding neighborhood.

A neighborhood can be defined in several ways: As an area in which types of property are similar; as a distinct geographic area or one distinguished by a conspic- uous physical feature; as a social unit—that is, a community with religious or ethnic ties; and as a group of people with the same general level of income. All these factors work to create housing submarkets in which the values of properties are influenced by the same general set of outside influences.

Neighborhood Change

As do humans, neighborhoods go through a life cycle consisting of seven stages: (1) gestation, (2) youth, (3) maturity, (4) incipient decline, (5) clear decline, (6) accelerating decline, and (7) death or abandonment. Unlike the human situation,

f i g u r e 14.7 The Impact of a Major Sewer Line on Urban Development

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C H A P T E R 14 Urban and Regional Economics 295

however, the process of change in neighborhoods is not inevitable. It can be arrested or reversed, and a declining neighborhood can be restored to vigorous health.

Gestation, Youth, and Maturity In the early stages of a neighborhood’s life cycle, both property values and

residents’ incomes generally are rising. Turnover usually is relatively low, and new residents are economically and socially similar to those already living in the neighborhood.

Incipient Decline At some point in the process of neighborhood change, those who leave the

neighborhood are replaced by less affluent families and individuals, and over time, the housing may filter down to still less affluent groups. In this stage of the life cycle, housing prices and rentals decline as more affluent families leave the neighborhood.

The process of decline may be caused by several factors. The houses simply may have reached an age where the costs of maintenance are greater than the residents can afford. There may be outside influences, such as construction of a new freeway, which make living conditions in the area less desirable and competing areas more accessible. The decline of the neighborhood may be caused by various changes in the socioeconomic characteristics of its residents or by their aging and death. Likewise, construction of more desirable dwellings in other neighborhoods may lead to a drop in demand for property in a certain area.

Clear Decline As the housing in a neighborhood ceases to provide a reasonable return to the

owners and becomes substandard by most definitions, the neighborhood enters a period of clear decline. Owners make only minimal repairs, and properties deterio- rate noticeably. Financial institutions may avoid investing in the area, making reha- bilitation and the introduction of new owners even more difficult. As owners try to squeeze additional income from their declining investments, housing densities and the consequent need for public services increase dramatically, though those services (schools, police protection, sanitation) may not be provided.

Accelerating Decline and Abandonment The demise of a neighborhood often occurs quickly. Those who are able to move

elsewhere do so. Only the lowest-income residents remain, and unemployment rates and the percentage of families on welfare are high. Landlords cease making repairs and often abandon their buildings when they are no longer profitable. At the terminal stage, the neighborhood may be virtually abandoned—as are portions of the South Bronx in New York City—or the buildings may be demolished, allowing the neigh- borhood to enter a new cycle.

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Neighborhood Stabilization and Rehabilitation

It must be emphasized that the process of neighborhood deterioration and decline is not inevitable. Values in many mature neighborhoods remain strong over long

r e a l e s t a t e t o d a y

c a s e s t u d y

Neighborhood Revitalization

Declining or even virtually abandoned neighborhoods can be revitalized and once again be valuable assets to their communi ties. The Edenton

Cotton Mill Village is an outstanding example. The textile industry was a vital element in the

industrialization of the southeastern United States, and many of these firms built mill villages to house their workers. With the obsolescence of many of the old mills and the general decline of the indus try in the United States, most have closed, with the mill villages often being abandoned. Such was the case with the Edenton Cotton Mill in Edenton, North Carolina.

The mill, which opened in 1898, constructed more than 70 homes adjoining the mill for its work- ers and supervisors. When it finally closed in 1995, the 44-acre village, with 57 remaining houses and the mill building, was donated to Preserva- tion North Carolina, which sought to restore it as a viable com munity and a living example of a histori- cal southern mill village. They have succeeded.

Some of the houses had been boarded up, and the remainders were sorely in need of rehabilitation. Preservation North Carolina made some infrastruc ture improvements such as plac- ing the utili ties underground, and restored one of the houses as a model. A few of the houses were purchased by the former tenants, but the remain- der were sold at favorable prices to others who

agreed to rehabilitate them according to restrictive covenants that ensured that the historical integrity of the village would be main tained. Because the Edenton Cotton Mill Village has been placed on the National Register of Historic Places, the buyers could receive a tax credit on their state income taxes for a portion of the rehabilitation expenses. With the success of the houses, attention then turned to the old brick cotton mill building, with its two-story windows lining all sides, a clerestory run- ning the length of the rooftop, and a tower oversee- ing the entrance. The mill building was converted into 33 condominium residences.

Today, taxable property values in the old mill village have increased from $610,000 before to $12.4 million today. In addition to preserving its heritage, the community has gained an economi- cally prosperous neighborhood.

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C H A P T E R 14 Urban and Regional Economics 297

periods of time if the area remains competitive in housing markets. Other neighbor- hoods may, as a result of a conscious public policy effort or natural market forces, reverse their decline and become healthy once again.

The first people who attempt to renovate deteriorated dwellings often are young, middle-income individuals or families who desire to live in town; cannot afford housing in the established, higher-income neighborhoods; and are willing to spend the time and effort to rebuild the dwellings and social fabric of the declining neigh- borhood. If the process is successful, values may rise dramatically as the neighbor- hood becomes a desirable location for middle- or upper-income groups. This process is known as gentrification.

A negative aspect of gentrification is the displacement of low-income families, who often can no longer afford to live in their neighborhood.

| urban form: a synthesis _________________________________

The development of urban form may, at first, appear of interest only to city planners and public officials. To the contrary, the real estate investor or analyst must understand the factors that direct city growth in order to assess the potential develop- ment of a certain piece of real estate. The various theories of urban growth describe particular aspects of the growth process. Let us synthesize and summarize some of the critical growth factors so we can better understand the impact of potential urban change on the economics of the individual parcel.

Commercial Growth

Because access is so important to commercial developments, major commercial projects such as regional shopping centers are usually located near freeway inter- change nodes or other major road junctions. Smaller commercial developments are also dependent on transportation access and the customer traffic it brings; therefore, they usually are located along heavily traveled roads and streets.

Due to improvements in transportation, particularly the development of the automobile and the attendant growth of highways, cities have spread out, and many commercial subcenters have been created. As a result, the central business district has declined in importance and, in many communities, has become a blighted area. Office buildings have also been moving from the central city to outlying subcenters, often in suburban office parks.

Industrial Growth

Like commercial development, industrial growth has tended to move away from the central city to the suburbs or to rural areas. Most small- and medium-sized plants, along with warehousing and other distribution facilities, are often found in industrial parks where transportation and other necessary public facilities are avail- able. Major manufacturing facilities often locate in more rural areas, where land for

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298 PA RT T H R E E Real Estate Market Analysis

expansion is more readily available and major highways or railroads provide acces- sible transportation.

Residential Growth

Residential development is also strongly influenced by the location of public facilities. High-density development is impossible without the provision of public water and sewerage facilities. Commuting access is important, but individuals have demonstrated that they will endure long commutes to enjoy a suburban or rural life- style and to escape some of the central city problems. In addition, the dispersion of employment to suburban locations in recent years has also encouraged the dispersion of residential development to these areas.

| chapter review __________________________________________

■■ The reason why one locality rather than another will develop into a center of trade or industry is because that community enjoys a comparative advantage, which can result from transportation facilities or other factors of the created environment, natural resources, climate, or the quality and quantity of the local labor force.

■■ A community’s export activity produces goods and services for sale out- side its borders. Population-serving activities produce goods and services sold within the community itself.

■■ Almost all real estate market activity and development depends directly or indirectly on the location of people, and the location of people depends largely on the location of employment.

■■ Because the supply of real estate is largely fixed in the short run, changes in demand most often influence vacancy rates, sales of existing property, prices, and lease rates. Over the long run, the supply can, of course, be increased, and the potential investor in a new development must carefully analyze the long-run prospects for the community’s economic base.

■■ Nothing is more essential to the determination of real estate values than the process of community development and neighborhood change.

■■ A city may grow in several ways: (1) vertically, by replacement of smaller structures with taller ones and by use of air rights to construct new build- ings over existing ones; (2) by in-filling of open spaces between existing structures; and (3) by extension of settled areas.

■■ Some models that have been used to explain the peripheral growth patterns of urban areas are (1) concentric-circle growth, (2) axial growth, (3) sector growth, and (4) multiple-nuclei growth.

■■ Investments in public facilities, often called the infrastructure, play a criti- cal role in local development. The infrastructure includes transportation improvements, sewer systems, and water lines.

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C H A P T E R 14 Urban and Regional Economics 299

■■ Because access is so important, major commercial growth tends to occur near transportation nodes, such as freeway interchanges and junctions of other major roads.

■■ Industrial growth tends to occur along major highways, railroads, or both.

■■ A neighborhood can be defined in several ways: (1) as an area in which types of property are similar; (2) as a distinct geographic area or one that is distinguished by a conspicuous physical feature; (3) as a social unit— that is, as a community with religious or ethnic ties; and (4) as a group of people with the same general level of income.

■■ Neighborhoods tend to go through a life cycle, from gestation to maturity to decline, but this process can be arrested or reversed, and a declining neighborhood may be restored to economic health.

| key terms _______________________________________________

axial model

bid-rent curve

comparative advantage

concentric-circle model

economic base

export activities

filtering

gentrification

highest and best use

in-filling

infrastructure

land rent

multiple-nuclei model

neighborhood

population-serving activities

sector model

urban and regional economics

| study exercises _________________________________________

1. What is meant by the concept of comparative advantage?

2. What are some of the factors that may give a community a comparative advantage in attracting new employment?

3. Why do people locate where they do?

4. Discuss the concept of an economic base. What are export activities, and what are population-serving activities?

5. How do local real estate markets react to changes in short-run demand? To changes in long-run demand?

6. What steps might a community take when faced with declining industry or a plant that closes?

7. Discuss the concept of land rent, and explain how it tends to allocate land resources.

8. Why would we not expect to find someone growing corn on a lot in mid- town Manhattan in New York City?

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300 PA RT T H R E E Real Estate Market Analysis

9. Discuss some of the models that have been used to explain growth patterns in urban areas.

10. What is meant by infrastructure?

11. Suppose a new freeway is completed in a relatively undeveloped suburban area. What would be some of the probable developmental impacts?

12. A new interceptor sewerage line is completed in an area that previously could be served only by septic tanks. How would this likely change resi- dential development?

13. Discuss how improvements in public facilities influence the local develop- ment process.

14. Why have American cities tended to develop in a more multinucleated form during the past several decades?

15. Where does major commercial growth tend to occur within a community?

16. Where does industrial growth tend to occur within a community?

17. Describe the life cycle of neighborhoods.

| futher reading __________________________________________

Arthur O’Sullivan, Urban Economics, 7th Edition, McGraw-Hill/Irwin, 2008

Deborah L. Brett, Real Estate Market Analysis, 2nd Edition, Urban Land Institute, 2009

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Home Purchase Decisions

15c h a p t e r

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303

c h a p t e r p r e v i e w

Buying a home is the most important investment decision that the aver- age U.S. family ever makes. Too often, however, it is made with the buyer at a distinct disadvantage and without the complete information needed to make the best choice at the most favorable terms. By now, you should be far better informed about real estate transactions than the usual homebuyer because you already know the basic principles of real estate. This chapter covers four topics specifically related to buying a home:

1. The rent-or-buy decision

2. How much home you can afford

3. Choosing the right property

4. The negotiation, purchase, and closing process

close-up Prequalified vs. Preapproved

case study The House That

Came Off the Mountain

r e a l e s t a t e t o d a y

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304 PA RT T H R E E Real Estate Market Analysis

| the rent-or-buy decision _________________________________

Everyone needs a place to live, and housing expense is a dominant portion of most families’ budgets. A major question facing these families is the rent-or-buy decision.

Should you rent, or should you buy? That depends on a great number of factors, many of which are not economic ones. For example, many families derive great sat- isfaction from owning their own homes; to others, the responsibility of home owner- ship is a psychological burden.

To make the correct economic decision, you really need an all-seeing crystal ball that accurately reveals the future. What will happen to home prices in the future? Will they rise, making your investment in a home more valuable? How much will they rise? Or will home prices fall, making your investment an unwise decision? What will happen to income tax laws that affect the deductions you can take for mortgage interest and property taxes? If these deductions are reduced or eliminated, home ownership will be relatively less desirable than renting. How long will you live in the home? Will your work require that you move within a relatively short time, or will you remain in the home for many years? Will you and your spouse continue to live in marital bliss, or will you split, making your home just one more thing to fight over?

In earlier chapters, we discussed the financial euphoria that swept the United States in the early years of this century and the subsequent collapse that led to the worst recession in eight decades. This collapse was especially severe in the housing markets.

For decades, housing prices had generally experienced a gradual increase, usu- ally in line with the general rate of inflation. In 1970, for example, the median house price was $25,000. By 1990, this had increased to $90,000, an annual rate of increase of 6.6%. The real rate of increase, that is, inflation adjusted, was only 1.1%. Of course, real estate markets are local, and price changes in particular markets varied depending upon changes in a community’s economic base. For individual home- owners, the value of their home was also influenced by neighborhood change and whether they had purchased wisely.

When financial institutions relaxed their lending standards and plunged into “subprime” home loans that were made seemingly without regard to the borrow- er’s ability to repay, this artificially influenced increase in demand led to greatly increased home prices. Between 2000 and 2006, the median home price increased at an annual rate of 11.1%. When the bubble burst, house prices plunged, leaving many homeowners “under water,” that is, with mortgages that were larger than the value of their homes. Foreclosures greatly increased, and between 2006 and 2010, median home prices declined at an annual rate of 9.2%. As noted earlier, price declines in some markets—mostly those that had experienced rapid increases during the boom years—were far more severe.

Irrational periods of financial euphoria are not a new phenomenon. In the 1630s, for example, Holland experienced the “Tulipomania.” Several years earlier, tulips had been introduced from their native eastern Mediterranean areas. Some bulbs became

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C H A P T E R 15 Home Purchase Decisions 305

prized for their beauty and brought high prices. Soon, however, prices increased, not because of true demand but because they were expected to go higher. It was reported, that an individual bulb might be worth “a new carriage, two grey horses, and a com- plete harness.” However, when some became nervous and began to sell, forcing prices lower, the market collapsed, and along with it, the economy of Holland.

Similar periods of boom and bust have occurred throughout the history of the United States. For example, there was the Florida land boom of the mid-1920s. Improved transportation made the state, with its favorable climate, more accessible and desirable. Lots could be purchased for a cash payment of about 10%, meaning that even a small increase in prices could result in large profits to buyers—as long as there was an ever increasing number of new buyers. At the height of the boom, prices could be expected to double in a matter of weeks, but when the supply of new buyers needed to sustain the upward thrust dried up, there was a futile rush to get out. The market collapsed.

This story should be familiar to students of the recent irrational speculation in Florida, Nevada, California, and certain other markets. But what will happen in the coming years? We don’t know, but let us say that market rationality will return and we can analyze the rent-or-buy decision based on some reasonable assumptions regarding the future.

Suppose that Carlos and Mary Mallory, a financially successful young couple, are pondering the purchase of a home. They currently live in an apartment, which costs them $1,000 per month plus utilities, but they have found a $180,000 house they like. They can finance the home with a down payment of $36,000 and a 30-year, 7.5%, $144,000 mortgage. In addition to the down payment, closing costs on the loan will add $3,800 to the required investment.

Monthly payments for principal and interest on the mortgage will be $1,006.87, plus another $230 per month for property taxes and $80 for property insurance—a total of $1,316.87. The first year’s interest charges will be approximately $10,755, and property taxes will total $2,760. These two items are deductible from taxable income, and for their analysis, Carlos and Mary assume a marginal federal and state tax rate of 30%. This means they can save $4,055 in income taxes during the coming year, or $337.88 per month, if they purchase the house. This reduces their after-tax monthly payment on the new home to $978.99, approximately the amount they cur- rently pay in rent.

Of course, home ownership also entails additional maintenance expenses, but because the house is new, Carlos and Mary believe these will be relatively minor during the analysis period.

(The amount of income tax savings depends on many factors. With their assumed income of $79,200, the Mallorys are entitled to a standard deduction of $6,000. Until their itemized deductions exceed this amount, they gain no tax advantage. Let us assume that the Mallorys pay $4,000 in state income taxes, but they have no addi- tional deductions other than the $2,760 in property taxes and $10,755 in mortgage interest. Under these assumptions, the tax savings would be only $3,245 annually, not $4,055, as assumed above. If they live in a state with no state income tax, the tax savings would be even less; however, if they have other allowable deductions,

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306 PA RT T H R E E Real Estate Market Analysis

such as charitable contributions or unreimbursed employee expenses, their income tax savings from buying the house could equal or exceed the assumed $4,055. Life is not simple!)

Their jobs may require that the Mallorys move sometime in the next several years, but they do not know when that might occur or whether it will be necessary or desirable at all. This is one of the uncertainties that make the rent-or-buy decision difficult. For this analysis, however, the Mallorys assume they will move after five years.

The next question is what will happen to home prices. This, of course, is a critical assumption. Carlos and Mary initially assume a 3% annual growth rate, but recognize that they must also analyze other possibilities.

Given these assumptions, the Mallorys arrive at the analysis summarized in Table 15.1. At a 3% annual rate of appreciation, the home can be sold for $208,669 in five years, or $196,149 after deducting a 6% real estate sales commission. From the mortgage loan repayment schedule in Table 15.2, we find that the principal of the mortgage has been reduced by only 5.4%, leaving a balance of $136,249.

After paying off the loan, the Mallorys would be left with $59,900, which would represent a 8.6% annual return on their $39,800 initial investment.

The Mallorys also would benefit from another federal income tax break for hom- eowners. Profit on the sale of a principal residence up to $250,000 for individuals and $500,000 for married couples filing jointly is excluded from taxable income, and a taxpayer can claim this exemption every two years. In our example, Carlos and Mary would have a profit on the sale of their home of $16,149, but no income taxes would be due.

ta b l e 15.1 The Mallorys’ Home Ownership Analysis

Assumptions 1. House will cost $180,000. It will appreciate 3% annually over five years. House will sell for $208,669 in five years. 2. Real estate sales commission will be 6% of sales price. 3. House will be financed by a down payment of $36,000 and a 30-year, 7.5%, $144,000 mortgage. Financing costs will be

$3,800. Sales price after five years $208,669 Sales commission –12,520 Net sales receipts 196,140 Loan repayment –136,249 Cash to Mallorys 59,900 Cash after taxes $55,055 Return on investment of $39,800 = 8.6% annually After-tax return on alternative investment = 4.3% annually

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C H A P T E R 15 Home Purchase Decisions 307

Alternative Investment

We must not forget that if Carlos and Mary do not buy the home, they can invest the $39,800 elsewhere. They might buy Amalgamated Whitzadiddle stock, which could be worth 100 times their initial investment. But Amalgamated Whitzadiddle might also go bankrupt, leaving their investment worthless. For simplicity, let’s sup- pose the Mallorys invest the money very conservatively in U.S. government savings bonds, an investment that pays 6% annually, with income taxes on the interest not due until the bonds are cashed. This investment yields a 4.3% after-tax annual rate of return on the Mallorys’ $39,800 investment—considerably less than the yield on the investment in the home.

Impact of Inflation or Deflation on Home Prices

Suppose, however, that Carlos and Mary purchase the home just before a period of rapid inflation, during which home prices rise 10% annually. Under this assump- tion, the Mallorys’ house could be sold for $289,892 at the end of five years, yield- ing a profit of $92,498 after the sales commission and giving the Mallorys $136,249 in cash after they repay the loan. This would yield a 27.9% annual return on their investment of $39,800.

In this type of inflationary situation, it would be extremely likely that the cost of renting an apartment would also rise rapidly. If the cost of renting their apartment should rise at this assumed 10% annual rate, the Mallorys’ $1,000-per-month apart- ment would cost $1,600 per month in five years. On the other hand, if they buy the house and finance the purchase with a fixed-rate mortgage, the mortgage payment would not rise. This is another factor that makes home ownership more advantageous in inflationary times.

Now, let’s make the pessimistic but often realistic assumption that home prices decline by 3% annually during the five-year analysis period. Under this grim sce- nario, the Mallorys could sell their house for only $154,572 in five years, leav- ing them with $9,049 after paying a real estate brokerage commission and repaying the mortgage. This means they would lose $30,751 of their $39,800 investment—a decidedly negative return.

Are Carlos and Mary likely to experience a 10% annual increase in the value of their home during the analysis period? Probably not. Are they likely to experience a 3% annual decline? Probably not. But these extremes set realistic parameters for their analysis.

Impact of Mortgage Interest Rates

In this evaluation of the rent-or-buy decision, the Mallorys have a mortgage interest rate of 7.5%. Suppose, however, that their interest rate is 9%. This would affect the analysis in two principal ways. First, of course, the Mallorys would face much higher monthly payments for principal and interest—$1,158.66 compared with $1,006.87. This would make the total monthly payment $1,468.66, or $1,062 after

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308 PA RT T H R E E Real Estate Market Analysis

taxes the first year assuming they benefit from the entire mortgage interest and prop- erty tax deduction.

In addition, as indicated in Table 15.2, the mortgage payback is much slower with the higher interest rate. If we assume our initial 3% annual rate of apprecia- tion in home prices, the Mallorys will receive a lower cash return because they have a larger mortgage repayment—$138,067 compared with $136,249 with the 7.5% mortgage. This reduces their rate of return to only 5.9% annually. It is important to understand the difference even a half of a percentage point on a mortgage rate can make. To give a historic view of where the industry has been, Table 15.3 reflects rates and payments for recent loans that are contrasted with historical rates. Notice the huge impact rising interest rates can have not only on total payments of interest but on the monthly principal and interest payment as well. For historical perspective, the 8% rate was average for 2000, and the 10% rate was average for 1990.

Period of Ownership

Generally, because of the inflation in home prices, the longer the period of ownership, the greater the relative advantage of home ownership over renting. For

ta b l e 15.2 Mortgage Loan Repayment Schedule

Year 6% 7.5% 9%

1 1.2 0.9 0.7

2 2.5 1.9 1.4

3 3.9 3.0 2.2

4 5.4 4.1 3.1

5 6.9 5.4 4.1

6 8.6 6.7 5.2

7 10.4 8.3 6.4

8 12.2 9.7 7.6

9 14.2 11.4 9.0

10 16.3 13.2 10.6

15 28.9 24.6 20.7

20 46.0 41.1 36.5

25 69.0 65.1 61.2

30 100.0 100.0 100.0

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C H A P T E R 15 Home Purchase Decisions 309

example, let’s return to our original assumptions for the Mallorys’ rent-versus-buy analysis, with one exception.

Let’s now assume that Carlos and Mary will own the home for 10 years rather than five. The results of this analysis are shown in Table 15.4. The sales price of the house would increase to $241,905, leaving the Mallorys with $88,189 in cash after paying the brokerage commission and repaying the mortgage.

This represents a 10% after-tax annual rate of return on their original $39,800 investment. We might also note that if apartment rents increase at the same 3% annual rate, in 10 years, the Mallorys will pay more than $1,345 a month if they stay in their apartment.

Some Conclusions

After all this, should Carlos and Mary rent, or should they buy? That depends on what assumptions they make regarding these future imponderables. However, at least we now know the parameters for the decision. Given the history of the past several decades, homeowners have done well compared to renters because their homes have

ta b l e 15.4 The Mallorys’ Rent-versus-Buy Analysis—10-Year Ownership Period

Assumptions 1. House will cost $180,000. It will appreciate 3% annually over 10 years. House will sell for $241,905 in 10 years. 2. Real estate sales commission will be 6% of sales price. 3. House will be financed by a down payment of $36,000 and a 30-year, 7.5%, $144,000 mortgage. Financing costs will be

$3,800. Sales price after 10 years $241,905 Sales commission –14,514 Net sales receipts 227,391 Loan repayment –124,985 Cash to Mallorys $102,406 Return on investment of $39,800 = 10% annually After-tax return on alternative investment = 4.3% annually

ta b l e 15.3 Impact of Interest Rates on a 30-Year loan (Principal and Interest only)

Rate PI Payment Principal Interest 30 Year Total Loan Paid Interest Paid

4% $954.83 $288.66 $666.17 $343,739.01 $200,000.00 $143,739.01

4.5% $1013.37 $263.37 $750.00 $364,813.42 $200,000.00 $164,813.42

5% $1073.64 $240.31 $833.33 $386,511.57 $200,000.00 $186,511.57

7% $1330.60 $163.94 $1166.67 $479,017.80 $200,000.00 $279,017.80

8% $1467.53 $134.20 $1333.33 $528,310.49 $200,000.00 $328,310.49

10% $1755.14 $88.48 $1666.57 $631,851.53 $200,000.00 $431,851.53

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served as hedges against inflation. Although it appears that rates of inflation will be lower in future years, don’t count on it.

And what will happen to present income tax breaks enjoyed by homeowners? Will proponents of a flat tax remove the deductions for mortgage interest and prop- erty taxes? Will the tax forgiveness on the profit on the sale of a principal residence be done away with? We don’t know, although these tax breaks have broad support.

Of course, the Mallorys’ decision may well rest on noneconomic factors. Per- haps the intangibles of owning a home are very important to the Mallorys. Perhaps they love to garden and will enjoy working on their home. If so, they may want to buy even if they feel the investment probably will not be economically profitable. Or perhaps they hate yard work and all forms of home maintenance. They might want to be able to simply call the landlord when the heating system conks out, rather than having to deal with it themselves. If so, they may even be willing to pay a premium to live in a rental unit.

| how much can you afford? _______________________________

After working through the rent-or-buy analysis, Carlos and Mary decide that they want to further explore the option of buying a house. The next question is how much house can they afford? In other words, how big a mortgage can they expect a lender to extend, given their income and financial obligations? First, the Mallorys need to estimate their income, including gross salary, self-employment income, wages from a second job, dividends, interest, pensions, Social Security, rental income, and child support or alimony received, but excluding one-time events, such as inheritances, insurance settlements, and capital gains.

Carlos and Mary have combined gross monthly salaries of $6,200. In addition, Carlos earns an average of $500 monthly in tax work for outside clients and has done so for several years. Mary receives an average of $300 in dividends on some Amal- gamated Whitzadiddle stock that she inherited from her uncle. They also receive $100 in monthly interest on $60,000 of savings and Mary’s additional inheritance they have in a bank, but they would need to use almost $40,000 of this money for the down payment and closing costs if they buy the home they are considering. See Table 15.5 for a breakdown of the Mallorys’ monthly income.

ta b l e 15.5 The Mallorys’ Estimated Monthly Income

Salary (gross) $6,200 Self-employment income 500 Dividends 300 Interest on $20,000 100 Total $7,100

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Next, the Mallorys calculate their monthly payments. These include items such as payments on loans for automobiles, furniture, appliances, boats or recreational vehicles, revolving credit, and student loans. Carlos and Mary’s monthly payments, shown in Table 15.6, are $1,100: $450 for a car, $200 for furniture, $300 for revolv- ing credit, and $150 for a student loan.

Lenders often use qualifying ratios as rules of thumb to estimate maximum mortgage payments. Generally, these ratios range between 25/33 and 28/36. The first figure of both ratios is the percentage of gross income a lender will allow as a maxi- mum monthly mortgage payment. For the Mallorys’ $7,100 monthly gross income, this amount would range from the conservative 25% ($1,775) to the more generous 28% ($1,988).

ta b l e 15.6 The Mallorys’ Monthly Payments

Car $450 Furniture 200 Appliances 0 Boat or recreational vehicle 0 Revolving credit 300 Student Loan 150 Other 0 Total $1,100

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Prequalified vs. Preapproved

The concepts of prequalification and preapproval cause confu- sion for buyers in the process of obtaining a loan to purchase a home. Prequalification and

preapproval are two very different levels of review- ing a borrower’s capacity to purchase a home. Prequalifying is a simple process of a lender sitting with a borrower, asking basic questions about the borrower’s income and debts, and coming up with an estimate of the borrower’s purchasing power. Preapproval, on the other hand, is a process of

documenting the borrower’s information including credit scores, debt, income, and savings with collected materials including pay stubs, bank statements, and retirement savings statements. Most preapprovals are also reviewed by an underwriter or run through automated underwriting to give the strongest opinion of the borrower’s ability to buy. Once a borrower is preapproved, the lender will be willing to issue a preapproval letter indicating their confidence in the borrower’s ability to buy, a letter that many sellers require to accom- pany a purchase agreement.

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The second calculation reduces this amount to account for payments on other indebtedness. Using the 33% conservative figure, a lender would calculate the Mal- lorys’ maximum monthly payment as follows:

Monthly gross income $7,100 Times 33% (one-third) 2,367 Less other monthly payments 1,100 Amount available for payment $1,267

Using the more liberal 36% ratio, the maximum monthly payment could be $1,456. In other words, the Mallorys’ maximum monthly payment would be reduced significantly to reflect the impact of their existing debts.

In addition to principal and interest, the typical house payment includes one- twelfth of yearly property taxes and property insurance. Thus, the $1,267 to $1,456 that Carlos and Mary have available for a monthly house payment must be reduced to reflect these items before the Mallorys can estimate the maximum mortgage they can afford. The amount of property taxes depends on several factors, including the value of the home and the community in which it is located. Property taxes for the house the Mallorys are considering would be $280 each month, with another $80 for property insurance. This means they are left with $957 to $1,146 for the actual mortgage payment.

Because the monthly payment for principal and interest on the 7.5%, 30-year, $144,000 loan they need to buy the house is $1,007, the Mallorys have adequate income to qualify for this loan. The fact that Mary owns the Amalgamated Whitza- diddle stock and they would still have $20,000 in the bank after expending $39,800 for the down payment and closing costs also makes them a more favorable credit risk.

| choosing a property _____________________________________

Now that Carlos and Mary know the price range of the home they can afford, they need to decide whether their chosen house is really their best buy. The search for a home has two aspects. First, they must decide on a general area in which to look, and second, they must decide on a particular property. While the decision is very important, it is not one they will have to live with forever—the average first-time homebuyer moves after five years—and the decision must be based partly on the Mallorys’ desires and preferences and what will appeal to prospective future buyers.

Choosing an Area

If the Mallorys buy in a small or medium-sized town, choosing an area may be quite uncomplicated. But if they live in a large metropolitan area, the choice can be quite complex. Let’s suppose the latter is the case. Not only do Carlos and Mary have to decide what type of home they would like and what development they might like to live in, they must also choose a community.

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The Mallorys begin their search by deciding how far they want to commute to work. Some people do not like commuting and choose residences that are close to their employment. Others will endure longer commutes to enjoy the suburban life- style they prefer. Carlos and Mary decide they will limit their hunt to a maximum commuting distance of 60 minutes during rush hour. Within this area, they concen- trate on six basic criteria for choosing one community over another:

1. Property tax base

2. Quality of general public services

3. Available recreational facilities

4. Quality of public school system

5. Crime statistics

6. Overall quality of community

Property Tax Base and Quality of Public Services In a metropolitan area, property tax rates and the quality of public services can

vary considerably from one community to another. Other things equal, a low tax rate is desirable if it is not achieved by cutting necessary services. Both factors are important.

Available Recreational Facilities Good public recreational facilities and established sports programs may be very

important factors in locational decisions for some families. For others, they may not be important at all. Carlos and Mary, who have no children, are much more interested in access to cultural events and good shopping.

Quality of Public School System Having no children, the Mallorys are not concerned significantly about the local

school system, although they know it may be quite important in the future. In addi- tion, they realize that quality of schools probably will be a vital consideration for potential future buyers of their home.

Crime Statistics Carlos and Mary, like most homebuyers today, are very concerned about their

security. Thus, crime statistics and the quality of the local police force are extremely important considerations in their locational decision.

Overall Quality of Community In the final analysis, the locational decision may come down to what the Mallo-

rys perceive as the overall quality of the community. Is it attractive? Does it control signage, or are its thoroughfares visual litter boxes? Are homes in the community well maintained? And, finally, does the community control its growth and require quality real estate development, or does mediocrity abound? The answers to these

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questions may be based partly on fact and partly on perception, but the quality of a community is vital to property values.

Many sources of information are available on these community factors, includ- ing real estate agents, building and real estate publications, and bankers or lend- ers. Another extremely good source of information is people in a neighborhood. If they respond favorably to inquiries about their area, this almost certainly indicates a desirable community.

Evaluating the Individual Home

Even more than the selection of a community or housing area, selection of an individual property is governed by personal preferences. Carlos and Mary prefer a

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c a s e s t u d y

The House That Came Off the Mountain

Why should you obtain a professional home inspection before you purchase a home? Let’s look at a dramatic example.

Philip and Phyllis McDonald (not their real names) bought a mountainside house with a spectacular view in an exclusive resort area of western North Carolina. Even though the house had a 40-foot-high concrete block foundation wall on the downhill side, the McDonalds did not have the house inspected before they purchased it for $375,000. They should have!

Less than six years later, the McDonalds came up from Florida to open their summer moun- tain home. That night, Philip awoke to hear loud cracking noises. The next day, he had the house inspected by a local contractor and later by an engineer. Both informed him that the structure was very unsafe and could collapse at any time. They noted separated and bulging foundation walls, twisted and leaning deck supports, separation of roof sections and walls, and separation of concrete

blocks throughout the basement area. The house was in such danger ous and deteriorated condition that the only practical course of action was to move out immediately and have the house demolished. The demolition cost $25,000.

The McDonalds, sadder but wiser, suf fered a loss of more than $400,000. They could not recover anything from their homeowner’s insurance policy because no “occurrence” caused the loss. For the same reason, they could not claim a casualty loss on their income tax return. The con tractor who built the home had gone out of business, so the McDon- alds were advised that legal action against him was not practical. The loss fell on them alone.

This financial tragedy could have been avoided if the McDonalds had only spent perhaps $200 to have the house inspected before they bought it, as any qualified inspector could have spotted the inad equate construction methods and the potential for disaster. This sad tale also points out the need for adequate government building codes to protect consumers.

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C H A P T E R 15 Home Purchase Decisions 315

home with traditional architecture, for example, and want large, open rooms that are good for entertaining.

If a house has a swimming pool, they will not even consider buying it because neither likes to swim, and they don’t want the maintenance burden that goes with a pool. To others, a pool would be a very desirable feature.

Despite these individual preference items, all homebuyers should consider cer- tain basic factors. The first rule is to buy a home that is less expensive than the aver- age for the neighborhood. The more expensive homes will tend to raise its value. Conversely, never buy the most expensive home in a neighborhood. The others will drag down its value.

Also, look carefully at other factors that affect a home’s investment potential. Does it have a good exterior design? Is the floor plan well arranged? Does it have convenient traffic flow? Is the home well placed on the lot? Is the lot well drained, with good landscaping?

Finally, the structural integrity of the home is extremely important, as the Case Study on the next page shows. In fact, even if the home is new, but particularly if it is not, it may be very prudent to have the home inspected by a professional. But there are many items that anyone armed with a flashlight and a bit of common sense can examine. Carlos and Mary did this with several houses they considered, covering the items discussed in the following paragraphs.

Attic Does inspection of the attic reveal water leaks or signs of rodent infestation? Are

insulation and ventilation adequate?

Walls and Ceilings Are there cracks in plaster walls or ceilings? Are seams in wallboard smooth and

invisible?

Floors What is the condition of the floors? Do they show signs of buckling or sagging?

What is the condition of any carpets?

Roof Does the roof show signs of wear? An asphalt roof usually lasts only 15 to 20

years, for example, and bare spots can mean it will have to be replaced soon.

Basement or Crawlspace Are there signs of water damage under the house? If so, a professional should

evaluate the problem. Is there evidence of rot or termites? Almost all lenders require an inspection by a professional from a pest control firm.

Electrical System A professional should inspect the electrical system, but the potential buyer can

check some important things on his or her own. For example, does the home have

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adequate electrical capacity? A modern home should have at least a 150-ampere entrance. Are there enough outlets throughout the home?

Heating and Cooling System How old is the heating and air-conditioning system? Older units are less effi-

cient and may need to be replaced soon. Again, the services of a professional may be necessary.

Water Supply and Waste Disposal If the home is connected to a municipal water and sewerage system, the potential

buyer need worry about only the adequacy of the household plumbing. If the home depends on a well, the water should be tested before purchase. Is the supply adequate throughout the year? How old is the pump? If the home uses a septic tank waste disposal system, this also needs to be checked by a professional. In many states, inspection by the state health department is required before the property can be sold.

Two Final Thoughts

Following these guidelines can help you make an informed decision regarding where and what home to buy. And remember—you can always find a buyer for a good home in a good location. Take the time and effort to do the job right.

Finally, remember that this home is probably not your last. Consider your future needs, but unless you are an extremely unusual buyer, you will move in a few years.

| making and closing the deal _____________________________

Carlos and Mary have now completed the preliminary steps to buying a home. They have determined how much home they can afford. They have researched com- munities and specific neighborhoods and developments to determine where they might like to be located. They also have learned some of the factors they should look for in a home and have thought carefully about what features are important to them.

Now they are ready to choose a property, negotiate its purchase, obtain financ- ing, and close the deal.

In this process, always remember one thing: In the normal sales transaction, no one works for you. The real estate broker works for the seller (unless you have hired a buyer’s broker); the lender works for the mortgage company; even the closing attorney, whose fee you pay, does not really look out for your interests. This does not mean that these people are dishonest or out to cheat you, but they do not work for you. It is not their job to look out for your interests.

The Real Estate Agent

A real estate broker or salesperson can be a valuable source of information on neighborhoods and homes for sale. He or she can also save you considerable time

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C H A P T E R 15 Home Purchase Decisions 317

by narrowing your search to properties that might really fit your needs and desires. But remember, unless you hire an agent specifically to represent you, the real estate broker does not work for you. The broker works for the seller and is legally bound to represent the seller’s interests, not yours. Even though the salesperson spends long hours showing you around town, taking you to lunch, and, in general, being a won- derful person, don’t forget that simple fact. For example, you certainly shouldn’t tell the agent that you probably would be willing to make a higher offer on a particular house. The agent is duty bound to take that information to the seller, thereby weaken- ing your position.

As discussed earlier in Chapter 8, buyers are increasingly being represented by buyer’s brokers. This may be a very good idea, particularly when you move to a com- munity that you do not know thoroughly.

The Negotiating Process

Suppose you have found a home that fits your needs. Now comes the tricky part—negotiating a price and terms. In this process, there are two rules:

1. Set a top limit above which you will not go

2. Be prepared to walk away from the deal

If you fall in love with a home and just have to have it, you are in a very poor bargaining position. Be prepared to walk away. On the other hand, if you really have found the home of your dreams, it may be worth spending a little more to get it, rather than going through the time-consuming process of extending the search. But be certain it really is the home you want. Don’t fall in love with the first thing you see.

Not everyone, and particularly not a first-time homebuyer, is an experienced and shrewd negotiator. This may be one more reason to engage an agent to represent your interests. For one thing, the buyer’s broker probably knows conditions in the market better than you do. Your agent may know that the house you are considering has been on the market for some time, and the owners are eager to sell. This information may place you in position to obtain a much better deal, which may more than pay for your representative’s fee.

Finally, don’t forget a fundamental rule of contracts: Oral agreements are not worth the paper they are written on. Unless something is written down as part of a contract, it is not part of the contract. If promises or agreements are made, be certain they are contained in the written contract. If not, they are worthless.

Dealing with the Lender

Lenders sell money, and, naturally, they want to get the highest price (the inter- est rate) they can. You should shop as carefully for a mortgage loan as you do for a home. Don’t take the first offer, and check with several lenders to find the best deal.

Also, remember that any appraisal and inspections required by the lender are to protect the lender, not necessarily you. For example, the purpose of the appraisal,

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which you normally pay for, is to ensure that the home has value high enough to enable the lender to be able to recover its money in case of foreclosure. The appraisal does not tell you whether the home is a good investment for you, although it certainly should help in this determination. (It is amazing how many appraisals for lending purposes arrive at values that are almost exactly the selling prices.)

The Closing Attorney or Escrow Agent

The closing attorney’s or escrow agent’s job is to prepare the necessary docu- ments relating to the sale and loan and to make sure the title is in order, the require- ments of the lender and the title insurance company have been met, all funds have been collected and properly disbursed, and the necessary documents have been recorded. All of this is important to the buyer, but, again, the closing agent is not paid to look after the buyer’s interests. The agent does not negotiate for you, draft a purchase contract favorable to you, make certain the contract has no clauses that are unfavorable to your interests, help arrange favorable financing, or make sure that the seller fully honors his or her agreement with you. To the contrary, the closing agent’s job is to see that the transaction meets legal requirements and is closed.

Perhaps we have been too forceful in warning you of the pitfalls in the sales, lending, and closing transactions when buying a home. Certainly, the intention is not to convey that real estate brokers, lenders, and attorneys are dishonest or unethical. But do remember whom they work for. If you feel you need someone to represent your interests, don’t depend on these individuals; hire your own representative.

| selling the home ________________________________________

After six years, Carlos and Mary decided to move to another city, so they needed to sell their home. They learned that preparing the home properly for sale, setting the right asking price, and choosing the right real estate agent can make a large difference in determining how much they can gain from the sale. They also learned that while real estate is easy to buy, it sometimes is hard to sell. It is not a liquid asset, and sales involve significant transaction fees.

Preparing the House for Sale

In preparing their house for sale, Carlos and Mary had to step back and take a hard look as a potential buyer would do. Most of us tend to overlook minor things— burned out light bulbs, dingy paint, cluttered garages, the door that doesn’t close just right, the leaking faucet, dirty carpets—that may turn off a prospective buyer. A “well-polished” house will normally sell much faster and for a higher price than its shabby neighbor, even though both are structurally well-maintained.

So, it makes sense to spend money on cleaning, painting, and cosmetic repairs. In particular, the kitchen and bathrooms should receive special attention, making them clean, bright, and odor free. A fresh coat of paint will probably be a wise investment, perhaps both inside and out.

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C H A P T E R 15 Home Purchase Decisions 319

Major repairs do not make economic sense, however, unless they are absolutely necessary. For example, a new roof may impress a potential buyer, but usually this won’t increase the selling price enough to cover the cost.

When it comes time to actually show the house, it needs to present its best appearance. The lawn should be cut and neatly trimmed, as well as the shrubbery and flowerbeds. Clear out the clutter to make the house look more spacious.

Setting the Asking Price

Setting the right price is perhaps the most important factor in selling a home. Set it too high, and the house won’t sell. Set it too low, and the house won’t bring what it should in the marketplace.

A real estate agent who knows the market can be of great assistance in setting an appropriate asking price. Even so, the sellers also need to find out the sale prices of similar houses, partly to reduce their own unrealistic expectations.

One important thing to be considered is how quickly the house needs to be sold and whether the sellers are anxious to sell. Obviously, a lower price will help the house sell quicker. If time is not a critical factor, sellers can afford to be patient and perhaps get a higher price.

Choosing a Real Estate Agent

Selling a house is not a simple process, and most homeowners do not have the knowledge or experience to manage it successfully. A competent broker will help set a realistic asking price based on his or her extensive market knowledge, and will have access to many more potential buyers. Of course, this also comes at a price, typ- ically 6% of the selling price, but the rate can sometimes be negotiated downward.

The Sale

How the Mallorys fared in their house sale is hard to say. Perhaps they set a realistic market price, engaged a very competent real estate broker, enjoyed a strong market, and sold their home quickly. Or perhaps they had difficulty, setting the price too high, listing with a broker who did not market the house effectively, and failing to sell as quickly and for not as much as they had hoped. Real estate home sales involve many factors.

| chapter review __________________________________________

■■ Important factors in the rent-or-buy decision are (1) the future of home prices, (2) the probable period of ownership, (3) the mortgage interest rate, and (4) noneconomic factors.

■■ Lenders will normally make a mortgage loan with a monthly payment equal to between 25 and 28% of monthly gross income or, if the payment

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is less, an amount equal to 33 to 36% of monthly gross income reduced by the amount of existing monthly debt payments.

■■ Important factors in choosing a community in which to buy a home are (1) commuting distance to work, (2) property tax base, (3) quality of general public services, (4) available recreational facilities, (5) quality of the public school system, (6) crime statistics, and (7) overall quality of the community.

■■ In choosing a home, it is a good rule to buy one priced lower than the aver- age for the neighborhood. Also, the buyer should consider a home that has a good design and should carefully check the home’s structural integrity.

■■ In the negotiating, lending, and closing process, always remember that in the normal sales transaction, no one works for the buyer, and therefore, no one really looks out for the buyer’s interests.

| study exercises _________________________________________

1. What are some of the important factors to consider in the rent-or-buy decision?

2. Jack and Jill Jolly are thinking about buying a home. Their combined monthly income is $5,000, and they have $30,000 savings in a bank. They also have existing debt that requires monthly payments of $350 for a car, $200 for furniture, and $250 for revolving credit. How large a mortgage loan could they expect to get if the current interest rate is 8.5%? How expensive a home could they buy?

3. In choosing a location and home, what factors should Jack and Jill consider?

4. Is the assertion really true that in the negotiating, lending, and closing pro- cess, no one works for the buyer? Why or why not?

p a r t f o u r

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Real Estate Finance and Investment Analysis

p a r t f o u r

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Residential and Commercial Property Financing

16c h a p t e r

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c h a p t e r p r e v i e w

The economic characteristics of real estate make mortgage credit both necessary for most real estate purchasers and attractive to many lenders. As we saw in a previ- ous chapter, a specialized legal framework for real estate financing exists whereby real estate assets can be pledged as security for a debt and, if the borrower should default on the loan, the value of the property can be used to satisfy the debt.

The objectives of this chapter are to describe the processes of obtaining financing for residential and commercial property. With respect to owner-occupied residential properties, we

■■ discuss the mortgage concept and U.S. mortgage practice,

■■ review the structure of the U.S. housing finance system and its most prominent participants,

■■ examine the loan origination process by considering the residential loan application procedure,

■■ discuss several federal regulations designed to protect residential mortgage consumers, and

■■ outline the underwriting guidelines used by lenders to evaluate residential loan applications.

The commercial property financing system relies on the concept of secured debt just as the housing finance system does, but there are some important dif- ferences in the way these two financing systems work. We address the following topics in the commercial property financing system:

■■ Sources of debt and equity capital in commercial property markets

■■ Underwriting criteria used by lenders to evaluate commercial property loan applications

close-up What Is Credit

Scoring?

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| understanding the mortgage concept _____________________

The basic factor that differentiates real estate credit from most other loans is the concept of collateral. A borrower’s promise to repay an unsecured loan is not backed by a lien or an encumbrance on a specific asset, and if a borrower defaults, the lender’s only recourse is to make a claim against the borrower’s general assets. The lender’s ability to collect on the defaulted debt depends on the amount and quality of those assets and the debtor’s income-earning ability. It is hard to imagine financial institutions making many real estate loans on such a basis because the size of such loans is relatively large, and their duration is so long that the borrower’s financial condition could change drastically before the loan is repaid.

In most cases, therefore, borrowers acquire financing for real estate purchases using secured loans. In this type of loan, the property being purchased is pledged as collateral for the debt, and a lien or other encumbrance is created on the title to the property. If the borrower is unable or unwilling to repay the debt as scheduled, the lender can take legal action to sell the specified property to recover the loan funds. This type of credit instrument makes it feasible for lenders to make relatively large, long-term loans for the purchase of real estate.

History of the Mortgage Concept

A mortgage is a pledge of property to secure a debt. The concept dates back to early Egyptian, Greek, and Roman times. Under early Roman law, nonpayment of a mortgage loan entitled lenders to make borrowers their slaves. Eventually, Roman law was changed to permit the unpaid debt to be satisfied by the sale of the mort- gaged property.

These early mortgages provided that if the borrower met all the terms of the loan and completely repaid the debt, the mortgage was then terminated, and the title was returned to the borrower. If any condition was not met, however, the borrower lost all rights to the property, including all money previously paid, and the property was sold to repay the debt. Gradually, a system developed to more equitably protect the rights of the parties to a loan secured by real estate, and many of these concepts serve as the basis for modern mortgage laws in the United States.

Modern Mortgage Concepts

U.S. courts typically consider a mortgage as a voluntary lien on real estate given to secure the payment of a debt. Borrowers remain in possession of the property, but some states recognize the lender as the owner of the mortgaged property, while oth- ers interpret a mortgage purely as a lien on the property. States that have adopted the concept of title theory recognize that the mortgagee (lender) has the right to posses- sion of the mortgaged property immediately on default by the mortgagor (borrower). The property can be sold at this point, with the sale proceeds used to satisfy the debt. In lien theory states, however, if the mortgagor defaults, the lender must foreclose on the lien through a court action to enforce the lender’s right of using the property

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to satisfy the debt. The property will then be sold (usually by the court) and the funds received from the sale will be used to extinguish the debt. In both title and lien theory states, any proceeds from a foreclosure sale in excess of the loan amount and any costs of sale must be returned to the borrower. In the normal course of a mortgage, the question of title versus lien theory is irrelevant. Only if the borrower defaults will the property be sold to satisfy the debt.

| u.s. mortgage practice __________________________________

Although practice varies somewhat from state to state, the obligation secured by a mortgage generally is acknowledged by a promissory note—that is, a written promise to pay money owed. The promissory note document contains the names of the borrower and lender, the amount of the debt, the interest rate and repayment terms, reference to the security instrument, and other details of the loan agreement. The promissory note makes the borrower personally liable for the debt. If the bor- rower violates the terms of the promissory note, the lender can then take steps to foreclose on the debt. Figure 16.1 contains an example of a promissory note.

| typical provisions of a promissory note __________________

While much of the language in this sample promissory note is self-explanatory, a few items deserve special emphasis. Section 4 of the note is a prepayment clause. The borrower in this note has the right to prepay any or all of the principal any time before it is due without penalty. Section 5 specifies a late charge for overdue pay- ments, classifies any late payment as a default on the terms of the agreement and, in the event of default, permits the lender to accelerate the full amount of principal that has not been paid and any interest that is owed on that amount. This last item is known as an acceleration clause. Section 6 makes all those who sign this note “jointly and severally liable” for the debt. Thus, the lender can demand payment from one or all of the borrowers at its option. Section 7 of this note contains a due- on-sale clause. In the event the borrower sells or transfers all or any part of the prop- erty secured by the mortgage associated with this note, the lender may, at its option, require immediate payment of all amounts owed.

The promise to repay the debt is secured by a pledge of property as specified in the mortgage document or other security instrument, which typically contains the names of the mortgagor and mortgagee, a description of the property involved, reference to the promissory note, and various provisions common to the mortgage arrangement. Figure 16.2 contains an example of a mortgage document.

Typical Provisions of a Security Instrument

The language of the security instrument, in this case a mortgage, is intended to pro- vide the mortgagee with protection against financial losses resulting from default on the promissory note. The covenants referred to in the security instrument represent prom- ises between the borrower and lender regarding the repayment of the debt, provisions for

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f i g u r e 16.1 Promissory Note

February 5 , 2011 St. Joseph , Missouri (City) (State)

1097 Timbers Crossing (Property Address)

1. Borrower’s Promise To Pay In return for a loan that I have received, I promise to pay U.S. $ 108,000 (this amount is called “principal”), plus interest, to the order of the Lender. The Lender is First Savings Bank .

I understand that the Lender may transfer this Note. The lender or anyone who takes this Note by transfer and who is entitled to receive payments under this Note is called the “Note Holder.”

2. Interest Interest will be charged on unpaid principal until the full amount of principal has been paid. I will pay interest at a yearly rate of 8.00 %.

3. Payments (A) Time and Place of Payments

I will pay principal and interest by making payments every month. I will make my monthly payments on the 1st day of each month beginning on April 1, 2011. I will make these payments every month until I have paid all of the principal and interest and any other charges described below that I may owe under this Note. My monthly payments will be applied to interest before principal. If, on April 1, 2041 , I still owe amounts under this Note, I will pay those amounts in full on that date, which is called the maturity date.

(B) Amount of Monthly Payments My monthly payment will be in the amount of U.S. $ 792.47 .

4. Borrower’s Right To Prepay I have the right to make payments of principal at any time before they are due. A payment of principal only is known as a “prepayment.” When I make a prepayment, I will tell the Note Holder in writing that I am doing so. I may make a full prepayment or partial prepayments without paying any prepayment charge. The Note Holder will use all of my prepayment to reduce the amount of principal that I owe under this Note. If I make a partial prepayment, there will be no changes in the due date or in the amount of my monthly payment unless the Note Holder agrees in writing to those changes.

5. Borrower’s Failure To Pay as Required (A) Late Charge for Overdue Payments

If the Note Holder has not received the full amount of any monthly payment by the end of five calendar days after the date it is due, I will pay a late charge to the Note Holder. The amount of the charge will be 10 % of my overdue payment of principal and interest. I will pay this late charge promptly, but only once on each late payment.

(B) Default If I do not pay the full amount of each monthly payment on the date it is due, I will be in default.

(C) Notice of Default If I am in default, the Note Holder may send me a written notice telling me that if I do not pay the overdue amount by a certain date, the Note Holder may require me to pay immediately the full amount of principal which has not been paid and all the interest that I owe on that amount. That date must be at least 30 days after the date on which the notice is delivered or mailed to me.

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maintaining the property and keeping insurance premiums and property taxes current, the lender’s right to inspect the property, and numerous other issues. If the borrower fails to meet the terms of either the promissory note or the security instrument, the lender may foreclose on the debt, as described below.

| understanding the foreclosure process __________________

When a borrower fails to make payments or defaults on other terms of the mort- gage agreement, the mortgagee can begin foreclosure proceedings to enforce its rights. Foreclosure refers to the process of seizing control of the collateral for a loan

f i g u r e 16.1 Promissory Note (continued)

(D) No Waiver by Note Holder Even if, at a time when I am in default, the Note Holder does not require me to pay immediately in full as described above, the Note Holder will still have the right to do so if I am in default at a later time.

(E) Payment of Note Holder’s Costs and Expenses If the Note Holder has required me to pay immediately in full as described above, the Note Holder will have the right to be paid back by me for all of its costs and expenses in enforcing this Note to the extent not prohibited by applicable law. Those expenses include, for example, reasonable attorney’s fees.

6. Obligations of Persons under this Note If more than one person signs this Note, each person is fully and personally obligated to keep all of the promises made in this note, including the promise to pay the full amount owed. The Note Holder may enforce its rights under this Note against each person individually or against all of us together. This means that any one of us may be required to pay all of the amounts owed under this note.

7. Uniform Secured Note This Note is a uniform instrument with limited variations in some jurisdictions. In addition to the protections given to the Note Holder under this Note, a Mortgage, Deed of Trust, or Security Deed (the “Security Instrument”), dated the same date as this Note, protects the Note Holder from possible losses which might result if I do not keep the promises which I make in this Note. That Security Instrument describes how and under what conditions I may be required to make immediate payment in full of all amounts I owe under this Note. Some of those conditions are described as follows:

Transfer of the Property. If all or any part of the Property or any interest in it is sold or transferred without Lender’s prior written consent, Lender may, at its option, require immediate payment in full of all sums secured by the Security Instrument. If Lender exercises this option, Lender shall give Borrower notice of acceleration. The notice shall provide a period of not less than 30 days from the date the notice is delivered or mailed within which Borrower must pay all sums secured by the Security Instrument. If Borrower fails to pay these sums prior to the expiration of the period, Lender may invoke remedies permitted by the Security Instrument.

Witness the Hand(s) and Seal(s) of the Undersigned

_____________________________________________________________________________________ (Seal) - Borrower

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and using the proceeds from its sale to satisfy a defaulted debt. Usually, however, the mortgage holder will attempt to work out some type of alternative payment pro- gram to avoid the sale of the collateral. Not only is this practice much better for the lender’s community relations efforts, it also avoids the time-consuming, expensive, and generally unprofitable foreclosure process. Foreclosure is, for the most part, an avenue of last resort.

Types of Foreclosure

Specific foreclosure laws vary from state to state, though there are three general types of foreclosure proceedings. In states that recognize judicial foreclosure, the mortgagee must request a court-ordered sale of the property after proving that the borrower has defaulted on the terms of the agreement. Some states allow nonjudi- cial foreclosure. In this situation, the security instrument (either a mortgage or deed of trust) grants the power of sale to the lender should the borrower default. Finally, a few states recognize strict foreclosure, whereby the lender receives title to the property immediately on default by the borrower. The lender can then dispose of the property by sale or keep it as satisfaction of the debt.

Regardless of the specific type of foreclosure recognized, most states require that the lender return any proceeds from a foreclosure sale in excess of the loan amount and certain fees to the borrower. On the other hand, some states permit the mortgagee to pursue a deficiency judgment against the mortgagor if the proceeds are insufficient to satisfy the debt. If the courts grant the judgment, the borrower is held responsible for the remaining amount of debt after the foreclosure sale. Other states do not allow deficiency judgments, and lenders must accept the proceeds of the sale as satisfaction of the debt.

Alternative Security Instruments

The cumbersome foreclosure process is simplified in many states through the use of a security instrument similar to a mortgage called a deed of trust or trust deed. The deed of trust is executed at the time the loan is originated to convey title to a third party, called the trustee. The trustee’s title to the property lies dormant as long as the borrower, or trustor, meets the terms of the debt. In the event of default, however, the trustee sells the property to pay off the debt to the lender, who is the beneficiary of the trust.

Another financing device that simplifies the foreclosure process is the land contract, or contract for a deed. While not a mortgage in the technical sense, land contracts establish an obligation to transfer title from a seller to a buyer at some future date based on an agreed-on payment schedule. The seller retains ownership of the property until the buyer has paid a certain percentage of the purchase price, sometimes 100%. The contract gives the buyer equitable ownership, that is, the right to use the property while making payments, but legal ownership is retained by the seller. If the buyer defaults on the contract, the seller already has ownership of the property and no foreclosure is necessary.

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Because the buyer has fewer rights under a land contract than under a mortgage or deed of trust, the land contract is used almost exclusively when financing cannot be easily obtained in other ways. For example, individual subdivision lots often can be financed through the use of a land contract with a very small down payment paid to the seller. Such loans usually are unobtainable from traditional mortgage lenders. Because the seller is the legal owner until the land contract is satisfied, buyers who use land contracts should make certain that the contract is carefully written to pre- vent the seller from encumbering the property before legal ownership is transferred.

Some Final Thoughts Related to Foreclosure

If a borrower is unable or unwilling to continue making payments on a mortgage debt and foreclosure is imminent, it may be possible to sell the mortgaged property rather than default. If the loan contains a due-on-sale clause, the mortgagor must repay the debt if the property can be sold. In many cases, the satisfaction of the debt and the sale of the property occur simultaneously, with the proceeds of any sale first

f i g u r e 16.2 Mortgage

This Mortgage (“Security Instrument”) is given on February 5 , 2011 . The mortgagor is Frank L. and Elizabeth M. Barr (“Borrower”). This Security Instrument is given to First Savings Bank which is organized and existing under the laws of the State of Missouri , and whose address is 220 Las Olas Boulevard , St. Joseph, Missouri (“Lender”). Borrower owes Lender the principal sum of U.S.$108,000 . This debt is evidenced by Borrower’s note dated the same date as this Security Instrument, which provides for monthly payments, with the full debt, if not paid earlier, due and payable on April 1, 2041. This Security Instrument secures to the Lender (a) the repayment of the debt, with interest, evidenced by the note, (b) the payment of all other sums necessary to protect the security of this Security Instrument, and (c) the Borrower’s covenants and agreements under this Security Instrument and the note. For this purpose, Borrower does hereby mortgage, grant, and convey to Lender the following described property located in Buchanan County, in the State of Missouri :

Lot 3, Block G of the Harris Billups Estate, as recorded in Plat Book 8, page 37, in the Office of the Clerk of the Circuit Court of Buchanan County, Missouri, which has the address of 1097 Timbers Crossing (Property Address); together with all improvements now or hereafter erected on the property, and all easements, appurtenances, and fixtures now or hereafter a part of the property. All replacements and additions shall also be covered by this Security Instrument.

Borrower Covenants that Borrower is lawfully seised of the estate hereby conveyed and has the right to mortgage, grant, and convey the Property and that the Property is unencumbered, except for encumbrances of record. Borrower warrants and will defend generally the title to the Property against all claims and demands, subject to any encumbrances of record.

This Security Instrument implicitly contains all uniform covenants permitted by laws of the applicable jurisdictions to constitute a uniform security interest covering real property.

By signing below, Borrower accepts and agrees to the terms and covenants contained in this Security Instrument and in any rider(s) executed by Borrower and recorded with it.

_____________________________________________________________________________________ (Seal) - Borrower

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being applied to the debt. If no due-on-sale clause is imposed, however, the borrower may sell the property “subject to” the existing mortgage, whereby the buyer begins making the required payments to the lender. In this type of transfer, the original bor- rower remains personally liable for the debt should the buyer subsequently default on the loan.

Another method of transferring mortgaged property is known as assumption. In this situation, the original borrower sells the property and the buyer assumes responsibility for the debt. Whether the original borrower remains personally liable for the debt should the new buyer default depends on the terms of the loan. Finally, if foreclosure is imminent and a buyer cannot be found, a borrower who can no longer meet the obligations of a loan may attempt to transfer title to the property to the lender. Lenders may willingly accept a deed in lieu of foreclosure to avoid the expenses of a lengthy foreclosure process.

| structure of the u.s. housing finance system ____________

The residential lending process begins when a potential borrower contacts a mortgage lender in the hopes of acquiring a loan, either to finance the purchase of a property or to refinance property currently owned. The process of creating a new loan agreement between borrower and lender is known as loan origination. In essence, the borrower is purchasing the use of the lender’s funds over time by paying interest to the lender. Therefore, loan origination refers to the transactions that occur between borrower and lender in the primary mortgage market. When existing loans are sold by originators to investors or from one investor to another, these transactions are said to occur in the secondary mortgage market. This market greatly increases the flow of mortgage funds between regions of the country. In the primary mortgage market, demand for loans depends on potential borrowers’ desires and abilities to qualify for a loan, while the supply of loans depends on mortgage lenders’ willingness to provide debt capital to the borrowers. As with all markets, the price of mortgage capital (the interest rate) depends on the relative supply and demand for debt capital at any given point in time. Obviously, the primary and sec- ondary mortgage markets are dependent on each other, and together serve as the foundation of the U.S. housing finance system.

The U.S. housing finance system is defined as the arrangements and institu- tions that facilitate the financing of owner-occupied residences in the United States using the mortgage concepts discussed above. The many facets of our current system evolved over many years, but its roots lie in New Deal legislative actions taken by the federal government in the wake of massive defaults on owner-occupied housing during the Great Depression of the 1930s. During this time period, the stock market and banking industry were in a virtual state of collapse, new construction was at a standstill, and unemployment was rampant.

The housing market was particularly hard hit during the Depression era owing to the reduction in available mortgage credit. As a matter of national policy, the federal government took steps to provide a steady flow of funds to the housing sector and to shield it from future depressions. The results of these and subsequent actions by the federal government have had a tremendous impact on the current status of our

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nation’s housing finance system. To understand this system requires a review of the history of the government’s role in the mortgage market. We begin with a discussion of the Federal Housing Administration.

Federal Housing Administration

Prior to 1929, most residential mortgages were short-term, interest-only loans: although the interest rate was fixed, regular payments covered interest only for the term of the loan, and the entire principal was due at the end of the term. During the Depression, many borrowers could not repay their debts when the loans came due, and if lenders refused to refinance the loans, default was almost unavoidable. Without intervention from the federal government, the future of the housing market looked dismal at best. New construction had virtually ceased, and many existing short-term, interest-only mortgages were already in default.

In response to the economic crisis, the Federal Housing Administration (FHA) was created in 1934 to, among other things, restore confidence in the mortgage mar- ket. As a federal agency, the FHA had a dramatic impact on the housing finance system. The FHA helped establish rigorous borrowing and lending standards that reduced lenders’ risk and promoted the use of long-term, fully amortizing loans that were more consistent with household budgets than the interest-only loans that were prevalent at the time. (The distinction between these loan types is fully explored in Chapter 18.) In addition, the FHA established a mortgage insurance program to cover losses to lenders who originated these loans using the approved borrowing and lending standards.

Instead of lending money directly to borrowers, the primary role of the FHA in the housing finance system is to act as an insurance company for private lend- ers (banks, mortgage companies, savings associations, etc.) who originate loans for home purchases, repairs, and improvements. To participate in one of its most popu- lar programs, the 203(b) program, borrowers purchase mortgage insurance from the FHA on behalf of the lender by paying an initial fee of 2.25% of the loan amount at the time of origination, followed by an annual fee of ½ of 1% of the original loan amount for the full term of the loan, up to 30 years. (Notice that the upfront cost can be added to the loan amount—the borrower need not pay the money in cash to obtain the insurance.) If a borrower defaults on an FHA-insured loan, the insurance pre- miums collected from borrowers are used to protect the lender from losses resulting from foreclosure. In return for reducing the lender’s risk in this manner, borrowers can receive a loan for as much as 97% of the value of the property at an afford- able interest rate. Although anyone is eligible to apply for an FHA-insured loan, the maximum loan amount available depends on the location of the property. In general, the maximum FHA loan amount for a single-family residence is 95% of the median house price in the community. In Los Angeles County, California, the FHA loan limit for a single-family home was $625,500 in 2014. The FHA loan limit in Charleston County, South Carolina, was $308,200 in the same year.

The success of the FHA in the 1930s and beyond greatly standardized the mort- gage lending process in the United States and reduced lenders’ risk exposure from

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mortgage loans. Life insurance companies with policy reserves and other financial institutions with funds to invest were especially attracted to these standardized mortgages, which resulted in much needed capital flows into depressed areas of the country. Many mortgage bankers began actively originating FHA-insured loans in capital-deficit areas and selling them to investors such as life insurance companies who were in search of high-yielding, relatively safe investments. With the help of other government and nongovernment initiatives in the mortgage industry, the sec- ondary mortgage market expanded rapidly as many other types of investors were attracted to mortgage investments.

Private Mortgage Insurance

Insurance against mortgage default was not unheard of in the mortgage market, even before 1929. In fact, numerous private mortgage insurance (PMI) companies existed in the United States prior to the collapse of the real estate market. The high number of loan defaults, however, caused a complete failure of the private mortgage insurance industry during the Depression. Not until the establishment of the Mort- gage Guaranty Insurance Corporation (MGIC) in 1957 would PMI reappear in the U.S. mortgage market. Since then, numerous PMI companies have been established, and PMI is once again an important aspect of the mortgage industry.

Borrowers who have a choice between FHA insurance and private mortgage insurance will likely find the latter to be the best option because it costs less. There is no upfront fee for private mortgage insurance and the annual fee is around 0.8% of the loan amount for the first 10 years of the loan and 0.20 for the remainder of the loan term. In addition, private mortgage insurance may be the only choice available for borrowers seeking to finance home purchases with amounts greater than the FHA loan limits. A downside of private mortgage insurance is that the loan amount cannot be more than 95% of the property value. (Note that lenders do not require mortgage insurance for loans for less than 80% of property value.)

Department of Veterans Affairs Loan Guarantee Program

Another important government agency in the development of the housing finance system has been the Veterans Administration, now the Department of Vet- erans Affairs. Immediately after World War II, the Veterans Administration (VA) began to guarantee mortgage loans on a large scale as part of the so-called GI Bill of Rights. Congress passed legislation at the end of the war that allowed veterans to obtain mortgage loans for home purchases with little or no down payment and low interest rates. The VA loan program guarantees the payment of a mortgage loan made by a private lender to a qualified veteran should the borrower default. Unlike FHA-insured loans, however, VA-guaranteed loans do not require that the borrower pay premiums for the insurance. Much of the housing boom that occurred during the postwar period is attributed to the tremendous number of VA-guaranteed loans origi- nated to provide housing for returning veterans. Although the program has changed in many respects since its inception, the VA loan guarantee program continues to

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account for approximately 10% of new loans originated each year. The loan maxi- mum loan varies from lender to lender and from location to location.

To be eligible for a VA-guaranteed loan today, the applicant must be a veteran who served on active duty and was discharged under conditions other than dishon- orable during World War II and later periods. The specific rules regarded eligibility can be found on the Department of Veterans Affairs website at www.va.gov. The cost of obtaining a VA-guaranteed loan varies according to the borrower’s status as a veteran and the amount of down payment the borrower is making to the lender. A basic funding fee of 2% must be paid to the VA by all but certain exempt veterans. A down payment of 5% or more will reduce the fee to 1.5%, and a 10% down payment will reduce it to 1.25%. A funding fee of 2.75% must be paid by all eligible Reserve/ National Guard individuals. A down payment of 5% or more will reduce the fee to 2.25%, and a 10% down payment will reduce it to 2%. The funding fee for loans to refinance an existing VA home loan with a new VA home loan to lower the existing interest rate is 0.5%. Veterans who are using entitlement for a second or subsequent time who do not make a down payment of at least 5% are charged a funding fee of 3%. For all VA home loans, the funding fee may be paid in cash or it may be included in the loan.

Federal National Mortgage Association (Fannie Mae)

To increase liquidity in mortgage investments and further stimulate the flow of funds between geographic areas with excess capital and areas with excess demand, Congress decided that a formal secondary market was needed in which mortgages originated in one area could easily be sold to investors in other areas. Only by attract- ing sufficient capital from the investment community would mortgage markets be able to meet the demand for mortgage funds at prices borrowers could afford. Con- gress created the Federal National Mortgage Association (FNMA) in 1938 to buy mortgages from lenders and to serve as a clearinghouse for the secondary mortgage market. Fannie Mae, as the agency became known, was originally established as a government agency to (1) operate a secondary market for FHA-insured loans and (2) provide FHA-insured loans to low-income borrowers in remote areas who would not otherwise have access to the mortgage market.

To increase the availability of mortgage loans and further stimulate the flow of funds between geographic areas with excess capital and areas with excess demand, Congress decided that a formal secondary market was needed in which loans origi- nated in one area could easily be sold to investors in other areas. Only by attracting sufficient capital from the investment community would mortgage lenders be able to meet the demand for mortgage loans at prices borrowers could afford. Congress created a government agency called the Federal National Mortgage Association (now known as Fannie Mae) in 1938 to buy FHA-insured loans originated by lenders, such as banks and savings and loan associations. Fannie Mae either kept these loans for its own portfolio or packaged them into “pools” and sold them to investors. The existence of the secondary mortgage market created by Fannie Mae meant that local banks and savings and loan associations were no longer constrained by the amount of

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deposits available from customers of the bank or savings association. And, knowing that they could sell newly originated loans to Fannie Mae to turn the loans into cash if they needed to, loan originators significantly increased their lending activity.

Fannie Mae began a period of rapid growth in 1949 with the decision to begin purchasing VA-guaranteed loans along with FHA-insured loans. The number of loans purchased by Fannie Mae grew from around 7,000 in 1948 to over 133,000 in 1950. In 1954, this federal government agency was converted into a quasi-government agency under the control of the Department of Housing and Urban Development through the sale of nonvoting common stock to investors and the issuance of pre- ferred stock to the U.S. Treasury. Pressure from investors to gain control of Fannie Mae led Congress to convert the quasi-government agency into a private corporation wholly owned by investors in 1968. Because Congress retained regulatory authority of the company, the company was labeled a government-sponsored enterprise (GSE). The company’s stock began trading on the New York Stock Exchange in 1970.

Recognizing the potential for increasing shareholder value, Fannie Mae expanded the types of loans purchased to include conventional mortgages (mortgages not insured by FHA or guaranteed by the VA) in 1972. Fannie Mae began selling mort- gage-backed securities (MBS) in 1981 as a way of increasing funds for purchasing mortgages from originators. These securities essentially divided the rights to the cash flowing into the pool from mortgage borrowers into a variety of financial instru- ments that were customized to suit the needs of different types of investors. MBS proved to be very attractive to investors who were not interested in purchasing mort- gage pools. With plenty of cash available from the sale of MBS, Fannie Mae was able to significantly increase its activities and soon became one of the largest (and most profitable) publicly traded corporations in the world.

Fannie Mae enjoyed a long period of growth and profitability until housing prices declined dramatically in 2006. As more and more borrowers defaulted on their mortgages and investors grew more wary of mortgage-backed securities whose val- ues were tumbling, Fannie Mae crept closer and closer to bankruptcy. Amid concerns that the company was “too big to fail” without violently destabilizing the national economy, Congress seized control of the company in September 2008. Fannie Mae is now operating under the direct supervision of the Federal Housing Finance Agency (FHFA).

Government National Mortgage Association (Ginnie Mae)

The reorganization of Fannie Mae in 1968 led to the creation of a new federal agency, the Government National Mortgage Association (GNMA), now known as Ginnie Mae. When Fannie Mae became a privately owned corporation, it no lon- ger provided special assistance loans directly to borrowers. To fill this void, Ginnie Mae was organized as a vehicle for providing subsidized loans to borrowers through various FHA loan programs. For example, a lender can originate a home mortgage for a lower-income borrower at a below-market interest rate, then sell that loan to Ginnie Mae for full market value. After purchasing the loans, Ginnie Mae can either sell them for a loss or hold them in its own portfolio. Losses are paid for by funds

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appropriated by the Department of Housing and Urban Development, Ginnie Mae’s primary agency.

In 1970, Ginnie Mae introduced a payment guarantee program aimed at expanding the supply of funds for the mortgage market. Under this program, which was (and is) backed by the full faith and credit of the U.S. government, Ginnie Mae guaranteed the timely payment of principal and interest on mortgages insured by other federal agen- cies to investors. That is, if an investor bought mortgages insured by FHA, Ginnie Mae guaranteed that payments from the borrowers would occur as scheduled. This guarantee, combined with the insurance against default provided by FHA, made mortgages a very attractive investment for investors who did not wish to be concerned with late payments from borrowers. Thanks to this program, many new types of financial instruments were developed that allowed investors to invest in the mortgage market without directly hold- ing mortgages. Referred to collectively as mortgage-backed securities, these instruments have proven to be highly effective at attracting investment funds to the mortgage market.

Mortgage-backed securities (MBS) are securities issued in the secondary mortgage market by mortgage holders to investors who wish to invest indirectly in the mortgage market. The mortgage holders combine loans made to many differ- ent borrowers into “mortgage pools,” then sell securities that are “backed” by the underlying mortgages. In other words, the payments made by the borrowers into the mortgage pool are used to pay back the holder of the mortgage security with interest. Proceeds from the sale of these securities allow mortgage holders to originate new mortgages to borrowers. Investors who wish to commit their funds to the mortgage market can do so by purchasing a variety of MBS, including securities known as pass-through certificates, mortgage-backed bonds, pay-through bonds, and collat- eralized mortgage obligations. Although the specific details of these securities are beyond the scope of this text, it is important to note that the creation of MBS is often credited with the dramatic inflow of capital to the mortgage market that occurred in the 1970s and continued through 2007.

Federal Home Loan Mortgage Corporation (Freddie Mac)

Another important action taken by the federal government designed to increase the flow of funds to the mortgage market was the creation of the Federal Home Loan Mortgage Corporation (FHLMC) in 1970. During this time, the secondary market was well established for FHA-insured and VA-guaranteed loans, but no secondary market was in place for conventional loans. Conventional loans are those that are not insured by government agencies, either because their loan-to-value ratio is lower than 80% or because they carry PMI. Congress authorized the FHLMC, or Freddie Mac, as it is now called, to operate a secondary market for conventional loans simi- lar to the one provided by Fannie Mae and Ginnie Mae for FHA and VA mortgages. Freddie Mac became a major player in the market for all types of mortgages, com- peting directly with Fannie Mae to purchase mortgages and sell mortgage-backed securities.

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Like Fannie Mae, Freddie Mac was a profitable and growing company for many years. When the housing market declined, however, stockholders watched its value quickly erode. Congress seized control of Freddie Mac (and Fannie Mae) in Sep- tember of 2008. The company is currently being operated by the Federal Housing Finance Agency.

| mortgage market participants ____________________________

As of mid-2014, the total amount of mortgage debt outstanding in the United States was slightly more than $13.2 trillion, with most of that amount secured by one- to four-family structures. The system by which this large amount of capital is committed to mortgage loans on the national level involves numerous government and quasigovernment agencies and many private entities. Table 16.1 shows mortgage debt outstanding by type of mortgage and by type of holder in the United States.

Mortgage Originators and Investors

Who are the mortgage originators and investors? The most visible suppliers in the primary mortgage market include mortgage bankers, mortgage brokers, com- mercial banks, savings associations, and credit unions. Mortgage bankers originate about half of all residential mortgage loans in the United States each year. Although we typically think of a banker as someone who accepts deposits from savers and then lends that money to borrowers, mortgage bankers do not accept deposits from savers. Instead, they borrow money from commercial banks, then use these funds to originate new loans to mortgage borrowers. Mortgage bankers then sell the loans they originate to Fannie Mae or Freddie Mac in the secondary market, but they may continue to service the loan (collect and process payments) for a fee on behalf of the investor. The revenues to mortgage bankers include origination fees charged to applicants, servicing fees paid by investors, and the spread between the price of bor- rowed funds and loaned funds.

Closely related to mortgage bankers are mortgage brokers. Mortgage brokers typically do not lend funds directly to borrowers but simply act as brokers between loan applicants and lenders. Unlike bankers, brokers typically do not continue to service the loans they sell. Mortgage brokers’ revenues are dependent on the origina- tion fees charged to borrowers. In general, neither mortgage bankers nor mortgage brokers intentionally hold mortgage loans in a portfolio for their own benefit.

Commercial banks are private financial institutions that are organized to accept deposits from individuals and businesses and to loan these funds to all types of bor- rowers. Commercial banks use their own funds to originate mortgage loans in the primary market and to buy loans in the secondary mortgage market. They provide mortgages on residential and income-producing properties, as well as construction loans for developers and lines of credit for mortgage bankers.

Savings institutions have a long history of providing capital for housing pur- chases. The first savings institution (thrift) was founded in 1831 with the goal of accepting deposits from savers and loaning those funds to residential borrowers.

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C H A P T E R 16 Residential and Commercial Property Financing 337

Since that time, the original intent behind these institutions has remained largely unchanged, but the thrift industry has undergone dramatic cycles of growth and decline. Even after the collapse of many thrifts during the 1980s, these institutions continue to play a major role in the housing finance system. Thrifts continue to origi- nate new loans, both for their own portfolios and for sale in the secondary market.

Credit unions are an important source of consumer loans and a savings institu- tion for many Americans. Members of a specific industry or community can join a credit union and enjoy access to their deposits through checking or savings accounts. Because profits are returned to the members, the yield available to credit union mem- bers on their deposits is slightly higher than that of other thrift institutions. Most credit unions originate mortgages only for their own portfolios, though some do sell their loans in the secondary mortgage market.

ta b l e 16.1 Mortgage Debt Outstanding by Types of Property and Holders (millions of dollars, end of period)

2010 2011 2012 2013Q1 2013Q2 2013Q3 2013Q4 2014Q1

All holders, All property types

13,792,084 13,488,726 13,273,862 13,218,947 13,226,231 13,268,220 13,286,013 13,267,497

By type of property

One- to four- family residences

10,444,612 10,202,516 9,980,936 9,928,565 9,905,566 9,916,328 9,887,091 9,851,321

Multifamily residences

851,211 858,351 892,599 896,693 908,119 918,580 930,081 939,036

Nonfarm, nonresidential

2,342,162 2,260,660 2,227,328 2,218,716 2,235,579 2,254,328 2,287,840 2,294,141

Farm 154,100 167,200 173,000 174,973 176,967 178,984 181,000 183,000

By type of holder

Major financial institutions

4,583,569 4,448,195 4,439,014 4,398,366 4,394,798 4,393,889 4,409,413 4,421,126

Federal and related agencies

5,127,546 5,033,906 4,935,007 4,938,320 4,949,247 4,986,105 4,993,236 4,977,000

Mortgage pools or trusts

3,060,947 3,007,705 2,929,410 2,916,993 2,908,803 2,916,002 2,925,501 2,907,125

Individuals and others

1,020,022 998,920 970,431 965,267 973,383 972,224 957,862 962,247

Source: Board of Governors of the Federal Reserve System, June 2014

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| federal legislation affecting mortgage lending ___________

Upon receiving a completed loan application, the lender has various duties to the borrower as determined by federal lending regulations. These regulations are intended to provide protection to mortgage consumers. Important federal legislation to participants in the mortgage lending industry includes the Equal Credit Oppor- tunity Act (Regulation B); the Consumer Credit Protection Act (Regulation Z); the Real Estate Settlement Procedures Act; the Flood Disaster Protection Act; and the Fair Credit Reporting Act.

Equal Credit Opportunity Act

The Equal Credit Opportunity Act has influenced the mortgage lending indus- try since 1974. Under this act, applicants must be notified within 30 days of appli- cation that their loan request has either been approved or denied, or determined to be incomplete. In addition, the act prohibits lenders from discriminating against borrowers on the following bases: race, color, religion, national origin, sex, marital status, age, whether all or part of an applicant’s income is derived from public assis- tance programs, or whether the applicant has exercised any right under the Consumer Credit Protection Act.

Consumer Credit Protection Act

Title I of the Consumer Credit Protection Act is frequently referred to as Regu- lation Z, or the Truth-in-Lending law. Under this regulation, lenders are required to disclose the full details of the loan to the applicant within three business days of application, including exactly how much the loan will cost. The goal of the Truth- in-Lending requirement is to permit borrowers to shop for the best deal among com- peting lenders. Specifically, lenders are required to inform applicants of the total finance charges associated with the loan and the annual percentage rate (APR) of interest. In the event the loan is to be used to refinance a property already owned by the applicant, Regulation Z requires that the lender inform the borrower of the right to rescind the loan within three business days of origination. The APR is the effective annual interest rate that the borrower will pay after all fees and charges are taken into consideration. The APR is often quite different from the stated interest rate used to determine the payments on the loan. By comparing the APRs of various lenders, a consumer can determine which lender is offering the best deal and thereby make an informed decision about the loan.

Real Estate Settlement Procedures Act

The Real Estate Settlement Procedures Act (RESPA) is another important source of regulation in the mortgage lending industry. This act applies to federally related mortgage loans, and it creates several different duties for mortgage lend- ers following a residential mortgage loan application. First, RESPA requires that

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lenders provide borrowers with a copy the Consumer Financial Protection Bureau’s (CFPB) booklet Shopping for Your Home Loan. The booklet is designed to describe and explain the settlement costs borrowers are likely to incur when purchasing a home using mortgage financing.

Second, RESPA requires that lenders provide borrowers with a “good-faith esti- mate” of the settlement costs associated with the loan within three business days of the application. We examined these costs and the loan “closing” process in detail in a previous chapter. Third, the act prohibits kickbacks or referral fees paid to parties who refer a borrower to the lender. Fourth, the act gives the applicant the right to request and receive a copy of any appraisal report used to evaluate the property that serves as security for the debt. Although the borrower is typically charged a fee for the appraisal, the report technically belongs to the lender, not the borrower. Fifth, RESPA requires the use of the HUD-1 Uniform Settlement Statement by the settlement agent at the loan closing. This settlement statement shows line-by-line costs that will be incurred as a result of the pending real estate transaction, and a copy of this completed form must be made available to both the buyer and seller. Furthermore, the act establishes the borrower’s right to inspect this statement one day prior to the actual closing. At that time, the lender must accurately disclose all known closing costs and must provide a good-faith estimate of all uncertain closing costs that will be charged to the borrower. To enforce this right, the borrower must make a written request to the lender on or before the business day prior to settlement. Sixth, RESPA requires that lenders disclose whether the loan is expected to be sold in the secondary market. If the loan is sold, the lender is required to disclose this information to the borrower within 15 days of transfer. While borrowers can do little to stop the transfer of their loan, it is important that they know who their loan servicer is and how to contact the new servicer after a transfer.

Finally, RESPA limits the amount of money a lender can require that the bor- rower deposit to cover such recurring expenses as property taxes, hazard-insurance premiums, and other periodic assessments. In addition to the principal and interest payments due from a borrower each month, lenders may also require that a borrow- er’s loan payment include reserve payments to be deposited into an escrow account. As the property tax bill or insurance premiums come due, the lender simply pays the bill from the funds in the escrow account. Having the money on deposit ensures that payment will be made promptly, thus protecting the lender’s interest in the collateral for the loan. If these bills are not paid, the property could be destroyed without a cur- rent insurance policy, or a tax lien that has priority over the lender’s lien or encum- brance could be placed on the property. Both of these events could significantly diminish the protection provided to the lender by the mortgage concept. RESPA limits the amount of reserves that the lender can collect at closing to one-sixth of the annual property taxes and insurance.

Flood Disaster Protection Act

The remaining federal legislation that regulates the mortgage lending industry includes the Flood Disaster Protection Act and the Fair Credit Reporting Act. The

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Flood Disaster Protection Act requires that lenders disclose to borrowers whether the property they are purchasing lies within a flood hazard area. If so, the lender must require that the borrower obtain flood insurance if it is available. Flood insurance is generally only available through the Federal Emergency Management Administra- tion’s (FEMA) National Flood Insurance Program. This act puts the burden of noti- fying borrowers that their properties are subject to damage from flooding squarely on the shoulders of the lenders.

Fair Credit Reporting Act

The Fair Credit Reporting Act primarily affects credit reporting agencies, but it also affects the users of information obtained from these agencies. The act requires that lenders obtain permission before investigating an applicant’s credit history and handle the applicant’s credit information with due care. If an applicant’s loan request is denied based on information contained in a credit report, the lender must notify the applicant of this fact and provide the borrower with the name, address, and telephone number of the credit agency that supplied the information.

| mortgage underwriting __________________________________

Once the application for a mortgage loan has been received from the applicant, the lender must evaluate the applicant’s creditworthiness as well as the suitability of the property as security for the debt. From the lender’s perspective, lending money to a borrower is an investment in the borrower’s willingness and ability to repay the debt under the terms of the agreement. As discussed earlier, the property can be used to satisfy the debt (through the foreclosure process) if the borrower is unable or unwilling to abide by the terms of the loan. The process of evaluating the risk of an applicant and a property in order to make a decision regarding a loan application is known as underwriting. We consider the underwriting process for borrowers and properties separately.

Qualifying an Applicant

To evaluate an applicant’s creditworthiness, lenders typically examine the appli- cant’s sources of income, net worth, and credit history, then perform a risk assess- ment. The sources of income that are considered relevant include wages or salary, self-employment, rent, interest, investment, and commission, as well as child sup- port, alimony, separate maintenance income, retirement, pension, disability, and wel- fare benefits. Note that disclosure of information regarding child support, separate maintenance income, and alimony is not required if the applicant does not wish for this information to be considered as an income source. Lenders also obtain permis- sion to request an up-to-date residential mortgage credit report. This report, which is required if the lender intends to sell the loan in the secondary market, contains infor- mation about outstanding judgments, liens, or divorce proceedings; a list of similar credit inquiries within the previous 90 days; and all available credit information

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for the past seven years from at least one national credit reporting agency. If any of this information reasonably suggests that the borrower will not be able or willing to repay the proposed debt, the lender can deny the loan application subject to the regulations imposed by the Fair Credit Reporting Act.

Qualifying the Property

In addition to collecting and verifying information on the borrower’s creditwor- thiness, the lender must also collect and verify information regarding the property being pledged as security for the debt. First, the person pledging the property must in fact be the legal owner of the property. As we discussed in a previous chapter, verifying the ownership or title to real estate requires careful inspection of the public records. If there are defects in or “clouds” on the title to the property involved, the lender will reject the loan application. To protect their interests in the property, lend- ers typically require that borrowers purchase title insurance or obtain a title opinion from an attorney. In general, loans originated without title insurance cannot be sold in the secondary mortgage market.

Besides verifying the applicant’s right to pledge the property as security, the lender also has incentive to verify that the value of the property supports the requested loan amount. If the value of the property is less than the amount of the debt, borrow- ers may be unwilling to meet their obligations. If the lender is faced with foreclosing on the loan in this situation, the sale of the property will likely not result in sufficient proceeds to satisfy the debt. Therefore, the lender may require an appraisal of the property’s value before granting final approval for the requested loan amount. After receiving the appraisal report from a qualified appraiser, the lender must review the appraisal report to verify its acceptability. If the loan involved will be sold in the secondary mortgage market, the appraiser’s conclusions must be presented on the Uniform Residential Appraisal Report form that is accepted by Fannie Mae and Freddie Mac. We examined the topic of real estate appraisal in a previous chapter.

Risk Assessment

In addition to evaluating a borrower’s residential mortgage credit report and the title and value of the pledged property, the lender must consider other factors when making the underwriting decision. Although no absolute rules exist to deter- mine whether a borrower will be able to meet the obligations of a requested loan, there are guidelines that lenders use in the underwriting process. While each lender establishes its own guidelines, the secondary market participants (primarily Fannie Mae and Freddie Mac) provide general guidelines for loans they are willing to buy from loan originators. Because most lenders want to be able to sell their loans in this market, these guidelines are well-accepted in the lending industry. Fannie Mae and Freddie Mac guidelines fall into three categories: loan-to-value ratios, down pay- ment sources, and income ratios.

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Loan-to-Value Ratio Guidelines The loan-to-value ratio, or LTV ratio, is determined by dividing the requested

loan amount by the lesser of the sale price or the appraised value of the property. Generally expressed as a percentage amount, higher LTV ratios imply greater risk. For example, suppose a lender provides $95,000 to a borrower who purchases a $100,000 house (LTV ratio of 95%). Because the borrower has little equity in the property, default is more likely if the value of the property should fall below the loan amount. If default does occur and the property is sold through the foreclosure process, it is doubtful that the proceeds of the sale will be sufficient to cover the loan balance, past-due interest, and the expenses of sale. If the LTV ratio was only 50%, however, there is a much lower probability of default. If the borrower should default, the proceeds from the property sale should be sufficient to protect the lender. As a general guideline, all loans with an LTV ratio of 80% or higher must carry PMI, FHA mortgage insurance, or a VA loan guarantee to be acceptable in the secondary mortgage markets. While most conventional loans have a maximum LTV ratio of 95% even with PMI, some FHA-insured loans may have LTV ratios of up to 98.75%, and VA-guaranteed loan LTV ratios may be as high as 100%.

Down Payment Source Guidelines The second category of guidelines refers to sources for the borrower’s down

payment or equity for a home purchase. In general, secondary market guidelines require that funds used for the down payment be provided primarily by the borrower rather than from outside sources. By requiring that borrowers use their own personal funds for the down payment, the borrower is likely to be more diligent in meeting the obligations of the loan. In most conventional loans with LTV ratios above 80%, at least 5% of the purchase price must represent the borrower’s personal investment in the property. The remaining 15% could be a gift from an outside source, such as a family member or employer, but never a loan. If the LTV ratio is less than 80%, however, the entire down payment amount can be a gift from an outside source. Lenders who intend to sell a loan in the secondary market must verify that the down payment meets or exceeds this requirement by documenting its sources.

The down payment source requirements are applied differently for FHA and VA loans. Some FHA loan programs permit the borrower to contribute only 3% of the purchase price from personal savings, with the other 2% in the form of a gift from an outside source. Other FHA loan programs allow the entire down payment amount to be a gift to the borrower from outside sources. Many VA-guaranteed loans do not require a down payment at all, but the borrower is required to pay a funding fee that decreases as the down payment amount increases.

Income Ratio Guidelines Income ratios compose the third category of underwriting guidelines. These

ratios are designed to assess borrowers’ abilities to repay the mortgage as specified in the loan documents. Two income ratios that are considered by secondary market participants and the various guaranteeing and insuring entities are the mortgage debt ratio (front-end ratio) and the total debt ratio (back-end ratio).

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The mortgage debt ratio (MDR) is defined as the percentage of a borrower’s gross monthly income that is required to meet monthly housing expenses. Monthly housing expenses refers to principal and interest payments, hazard insurance, prop- erty taxes, mortgage insurance, homeowners’ association fees, and any payments on existing or proposed second mortgages on the property. In general, the MDR must not exceed 28% on a conventional loan. For example, consider a loan applicant whose gross monthly income is $5,000. The applicant is applying for a loan with monthly payments of $965. Monthly payments for hazard insurance, property taxes, and mortgage insurance total $210. No second mortgages exist, and the home is not part of a homeowners’ association. The MDR for this applicant is 23.5% (1,175 ÷ 5,000 × 100), which is well below the maximum ratio allowed.

The total debt ratio (TDR) is defined as the percentage of a borrower’s gross monthly income that is required to meet monthly contractual expenses. Contractual expenses include housing expenses as defined above, any revolving credit payments, payments on any installment loans with more than 10 remaining payments, and any alimony or child support. Notice that while applicants are not required to provide information regarding alimony and child support as an income source, they must disclose this information if it represents an expense. As a guideline for conventional loans, total payments for all of the items listed above must not exceed 36% of a bor- rower’s gross income. Continuing the example discussed above, if the applicant has an outstanding car loan that requires monthly payments of $280 and child support payments of $500 per month, the TDR would be 39.1% (1,995 ÷ 5,000 × 100). In this case, the applicant would not qualify for the loan under this guideline.

When assessing the risk of a mortgage loan application, lenders calculate both of these ratios to verify that the borrower is capable of repaying the debt and meeting other contractual obligations. Borrowers must qualify under both ratios simultane- ously to receive approval. While these ratios have evolved from years of experience with millions of loans, there are possible mitigating circumstances that will allow a lender to deviate from these guidelines. Such circumstances include a demonstrated ability to allocate a higher percentage of income to housing expenses, a low LTV ratio, a spotless credit report, large net worth, or other similar factors. In addition, the ratio limits specified above apply to conventional loans only. For FHA-insured loans, the ratio limits are 29 percent for the front-end ratio, and 41% for the back- end ratio. VA-guaranteed loans use a more detailed income standard, and sometimes allow back-end ratios as high as 45%.

The Underwriting Decision

The final step in the loan origination process is for the lender to render an under- writing decision. As mentioned above, the Equal Credit Opportunity Act requires that lenders reach their decision for completed applications within 30 days. With modern technology, most underwriting decisions can be made in minutes instead of days. If the loan is approved, the lender notifies the borrower of acceptance and, in most cases, issues a letter of commitment. If the loan is for home purchase rather than a refinancing, then the real estate closing process can occur as planned. If the

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lender denies the credit application, the lender must notify the applicant, give the reason for the credit denial, and provide a statement of nondiscrimination that is consistent with the provisions of the Equal Credit Opportunity Act.

| sources of capital in commercial property markets _______

Who are the debt and equity investors in commercial property markets? Unlike residential markets, in which most equity capital is provided by households who are seeking a place to live, capital in commercial property markets is provided by investors who are seeking investment returns rather than personal use of the prop- erties. Some of these investors provide equity capital to the market (through their down payments), and other investors provide debt capital by lending money to equity investors. The returns available through debt and equity investments in commercial properties attract individuals, pension funds, life insurance companies, commercial banks, and investment companies that are formed specifically to invest in commer- cial real estate.

Individual Investors

Many commercial properties are owned by individual investors (sometimes called “mom and pop” investors) who invest in relatively small-scale commercial properties as a means of diversifying their investment portfolios, which often include a variety of other asset classes (stocks, bonds, insurance policies, etc.). Individual investors often use a portion of their total wealth portfolio in conjunction with money borrowed from commercial property lenders to purchase properties that are expected to provide investment returns through property value appreciation and cash flow from rental operations to tenants. In addition to direct ownership, mom and pop investors may “hold a mortgage” on a property (provide debt capital) to other equity investors. Mom and pop investors are an important source of capital in many local real estate markets and should not be ignored as critical components of such markets.

Life Insurance Companies

Life insurance companies also invest debt and equity capital in commercial prop- erties. A typical life insurance company sells insurance policies that have expected payouts (on death of the customers) many years into the future. The insurance com- pany invests the proceeds from the policy sales to ensure that funds will be available to pay the eventual policy claims. Commercial real estate is an attractive investment vehicle for many life insurance companies because the assets are durable, long-lived, and provide an acceptable expected rate of return. Insurance companies invest in commercial properties by purchasing properties directly (as equity investors) and also by providing mortgage funds to borrowers seeking to purchase properties.

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Pension Funds

Pension funds represent another important participant in the equity and debt cap- ital markets. Pension funds accumulate contributions made by the fund participants over their working lives. As the contributions are received, the fund managers invest the money with the objective of increasing the income stream that will be available to the fund participant when the participant retires. Some examples of large pension funds in the United States include those operated by labor unions, private corpora- tions, and state and local employment systems such as the California State Teachers Retirement System (CALSTERS), California Public Employees Retirement System (CALPERS), and Teachers Insurance Annuity Association (TIAA).

Since the 1980s, pension funds have increased their involvement in commer- cial property markets and now are a major source of capital in both the debt and equity markets. With plenty of cash on hand, many pension funds invest directly in commercial properties, often on an all-cash basis, while others prefer to underwrite mortgage loans on commercial properties for equity investors. In either case, the investment horizon for pension funds is quite long (the working life of the partici- pants) and thus well matched to the relatively long and durable nature of commercial real estate investment opportunities. In general, investment returns to pension funds are not subject to federal income taxes at the fund level, though the participants may be taxed on the income they receive during their retirement years.

Pension funds may manage their own investments in commercial properties and mortgages, but they often seek the services of an investment management firm to identify properties for investment and to provide portfolio and property management services. In some cases, several different pension funds will combine their money into a commingled real estate fund, or CREF, that is managed by a professional man- agement company. In some cases, these individual CREF participants may sell or buy additional shares of the CREFs as needed to adjust the proportion of real estate held in their total investment portfolios.

Real Estate Investment Trusts

Real estate investment trusts (REITs) are another increasingly important partici- pant in the commercial property equity and debt capital markets. REITs sell shares of stock (units) to investors through public and private markets, then use the proceeds to invest in commercial properties, either as equity or debt investors. In 1990, the total amount of capital invested in publicly traded REITs was approximately $8.7 billion. By the end of 2000, that amount had increased to approximately $138.7 billion and by the end of 2009 that amount had increased to $271.2 billion. As of the end of 2013, the total market capitalization of publicly traded REITs in the United States stood at $670 billion. Publicly traded REITs provide an opportunity for even the smallest investors to participate in commercial real estate markets.

REITs are not subject to firm-level taxation as long as the firm meets certain Internal Revenue Service requirements. Most important, the firm must distribute at least 95% of its taxable income each year to its shareholders (who are then taxed on

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r e a l e s t a t e t o d a y

c l o s e - u p

What Is Credit Scoring?

While most of us are aware that our credit history is a critical consideration when we apply for a loan, many people may not realize how their credit history is

evaluated by a potential lender. Credit bureaus main tain surprisingly detailed databases regarding our financial affairs, including loan and account bal ances, payment activity, bankruptcy filings, and even denied credit and life insurance applications. Potential lenders review these records before approving loan requests in an effort to assess how likely applicants are to pay their obligations.

Many lenders place significant emphasis on an applicant’s “credit score.” Credit scores are calcu lated by the major credit bureaus for every- one with a credit history in an effort to simplify detailed credit history records. The formulas used in calculating the scores are intended to rank credit histories in terms of the probability that borrow- ers will be delinquent with their payments. Loan applicants with higher credit scores are viewed more favorably than those with lower scores. For example, scores calculated using one popular formula range from 300 to 900, with most consum- ers falling between 500 and 800. Scores above 700 are considered good, while scores in the 600 range are considered marginal.

The exact details of the formulas used to calcu late credit scores are proprietary and are not released to the public. The scores used by the three main credit bureaus (Equifax, Experian, and Trans Union) are calculated using a system

devel oped by Fair, Isaac & Co., a California data- management and consulting firm. Scores calculated using this system are determined by 30 different factors available in a standard credit report. The factors relate to the appli cant’s delin- quency history, the level of indebted ness, the length of the applicant’s credit history, the number of recent inquiries regarding the credit his tory, and the types of credit the applicant has out- standing. Through years of research, these factors have proven to be very predictive when it comes to evaluating whether an applicant will repay the debt according to the terms of the loan agreement. Credit scores make it easier and faster to evaluate loan requests, and they are growing in popularity with mortgage lenders.

Because lenders rely heavily on credit bureau reports when evaluating loan applications, it is important that your credit record is accurate and up to date. Many financial planners recommend that consumers check their credit records annually by contacting the three main credit bureaus and requesting a credit report. Federal law requires the credit bureaus to give each person one free copy of their credit report (but not their credit score) each year. You can review your reports for errors and omissions and ensure that your credit history is accurate. In addition to cor recting errors, you can enter in your credit record a statement of up to 100 words explaining the circum stances of any nega- tive information.

To request your free credit report, visit www.annualcreditreport.com.

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this income as dividends). Because of this requirement, REITs have little opportu- nity to grow through the use of retained earnings. Instead, REITs must issue addi- tional shares of stock or borrow from lenders to significantly increase their holdings.

Commercial Banks

Commercial banks are another important source of capital in commercial prop- erty markets. Commercial banks are divided into three broad categories: community banks (less than $500 million in assets), regional banks (more than $500 million in assets), and money center banks (the 10 largest banks in the United States). Most banks attempt to match the maturity structure of their liabilities (deposits that could be withdrawn) with their assets (loans and investments). The spread between the interest rate paid on deposits and the yields earned on loans and investments repre- sents profit to the bank. Because their investment funds are subject to withdrawal by the bank’s customers, commercial banks tend to be more involved in development and construction financing and less involved in long-term mortgage lending or direct property ownership.

CMBS

An important recent advance in the commercial property financing system has been the increase in securitization of commercial mortgages. As discussed previ- ously in this chapter regarding residential mortgages, commercial mortgages can be divided into financial securities that represent claims on the cash flows to the mort- gage holder. These financial securities are called commercial mortgage-backed securities (CMBS).

To understand how CMBS work, consider a commercial bank or investment banking firm that has expertise in evaluating commercial property mortgage applica- tions but does not wish to tie up its money in long-term mortgage loans. That bank may be able to originate several loans to commercial property investors, then pool those loans together and sell “shares” of the pool to other investors who want to invest in mortgage loans but do not have expertise in originating these loans. The bank that puts the pool together creates different types of securities that entitle the security purchasers to different components of the cash flow coming into the pool over time from the mortgage borrowers. One security class, for example, might be entitled to all of the cash flows for the first five years of the life of the loans, at which time this security class will be retired and the next class will be entitled to the cash- flow stream. Investors who might otherwise not have been interested in purchasing mortgage investments will be attracted to the different CMBS that match their invest- ment preferences and horizons.

Tax Increment Financing

An alternative to financing a private venture with public funds is called Tax Increment Financing (TIF). This type of funding is used by many local governments

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to encourage and aid in the redevelopment or revitalization of rundown or abandoned areas of their community. The financing is repaid through property tax increases that come through development of property currently generating minimal or no tax rev- enue. The revenue is used to repay the investment of TIF used for public investment in the project.

How TIF Works TIF is usually a consideration made when a developer comes to a municipality

and proposes a project in an area that is considered in need of revitalization. The municipality may have already made it known to developers that TIF is available for projects or the developer may suggest it, especially if using TIF is the developer’s most attractive option for financing the project. TIF funds can attract development away from areas where no TIF exists. TIF projects could be commercial, residential, manufacturing, or mixed use in nature.

The steps to TIF funding are complicated. An overview of the process follows; note that some of these steps take place simultaneously.

■■ A municipality determines areas for redevelopment that would benefit the public through job creation, housing, or community amenities. The areas might be determined based on the municipality’s desire for rede- velopment or a developer’s plan for an area.

■■ Plans are submitted by the developer and reviewed by the municipality before being presented to a redevelopment authority or a municipality board.

■■ A cost-benefit analysis to demonstrate value for the investment is done.

■■ Once the data is collected, the plan is sent for approval to the govern- ing body of the municipality.

■■ Depending on the municipality and its statutes or processes, the approval might include public input or internal decisions for a project to be awarded TIF funds.

■■ Once the redevelopment is completed, the tax increases are used to repay the TIF funds. When repaid, the taxes can revert to the funds designated by the municipality.

A number of questions arise from this type of funding. For commercial proper- ties, the analysis must consider the length of viability of the business to ensure the funding is repaid. There is also risk to other commercial vendors in the area if public money is given to a larger entity that competes directly with them. For instance, what would be the impact of giving TIF funding to a Home Depot on smaller hardware stores in the community? These risks must be considered given a loss of other busi- nesses based on the support of another.

While TIF funding can be a valuable tool to encourage much-needed develop- ment in areas of a municipality, comprehensive evaluations must be made with this valuable resource to ensure that the project benefits the community at large while not doing substantial damage to those already serving the community.

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C H A P T E R 16 Residential and Commercial Property Financing 349

| commercial financing underwriting criteria _______________

Unlike residential mortgage underwriting criteria that rely heavily on the borrow- er’s personal ability to earn sufficient income to repay the debt, commercial property lenders are much more concerned with the property’s ability to generate sufficient income to repay the debt. Lenders typically require that a property’s expected net operating income (NOI), defined as gross income less operating expenses, be 15% to 20% higher than the payments required to service the debt. This underwriting criterion is often called the debt coverage ratio, or DCR. The DCR is calculated by dividing the NOI by DS, where NOI represents the expected net operating income from the property (rent collections less operating expenses) and DS represents the debt service (payments on the mortgage). A lender who requires a DCR of 1.2 is, in essence, requiring that the property’s expected net operating income be 20% larger than its mortgage payments. The lender can be fairly confident that mortgage pay- ments will be made as scheduled as long as the actual NOI is at least 80% of the expected amount.

In addition to the DCR, commercial property lenders also look closely at the LTV ratios. As we saw in our discussion of residential mortgages, the larger the LTV ratio, the riskier the loan is from the lender’s perspective. In residential mortgages, FHA insurance, VA guarantees, and PMI allow the borrower to purchase residential property with high LTV ratios and relatively small down payment amounts. Because no such mortgage insurance or guarantees are typically available for commercial property mortgages, the LTV ratios on commercial loans are much lower (70% is common) than the LTV ratios for residential mortgages (where 95% or more is quite common). Lower LTV ratios imply that larger down payment percentages are neces- sary for commercial property purchases.

| chapter review __________________________________________

■■ A specialized legal framework has evolved for loans in which real estate is pledged as security for a debt, though the details of the mortgage concept vary slightly from state to state. Most real estate loans involve a promis- sory note, which makes the borrower personally liable for the debt, and a security instrument, such as a mortgage or deed of trust, which enables the lender to foreclose on the property if the borrower defaults on the loan.

■■ Loans are originated to borrowers in primary mortgage markets, and many loans are subsequently sold to investors in secondary mortgage market transactions. The primary and secondary mortgage markets, and the partic- ipants in those markets, have evolved into an efficient system for providing housing financing in the United States.

■■ Some of the more prominent participants in the housing finance system include the Federal Housing Administration, the Veterans Administra- tion, Ginnie Mae, Fannie Mae, Freddie Mac, private mortgage insurers,

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350 PA RT F O U R Real Estate Finance and Investment Analysis

mortgage bankers, mortgage brokers, commercial banks, savings institu- tions, and credit unions.

■■ The underwriting decision involves careful consideration of the borrower’s ability and willingness to repay the debt, as well as the suitability of the property as collateral. Lenders evaluate an applicant’s employment history, income sources, net worth, and previous credit history to assess the risk of the loan application.

■■ Using the general guidelines for risk assessment proposed by Fannie Mae and Freddie Mac, lenders can screen out high-risk applicants and feel confident that their lending decisions are made on a sound basis. These guidelines fall into three categories: loan-to-value ratios, down payment sources, and income ratios.

■■ Mortgage market consumers are protected against discrimination, fraud, and misrepresentation by various federal regulations that govern lender activity, including the Equal Credit Opportunity Act (Regulation B), the Consumer Protection Act (Regulation Z), the Real Estate Settlement Proce- dures Act, the Flood Disaster Protection Act, and the Fair Credit Reporting Act.

■■ The participants in the commercial property financing system include individual investors, life insurance companies, pension funds, real estate investment trusts, commercial banks, and commercial mortgage-backed securities investors.

■■ Commercial property lenders look closely at the debt coverage and the LTV ratio when evaluating the risk of a commercial property loan application.

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C H A P T E R 16 Residential and Commercial Property Financing 351

| key terms _______________________________________________

acceleration clause

commercial bank

commercial mortgage- backed securities

Consumer Credit Protec- tion Act

conventional loans

credit unions

debt coverage ratio

deed in lieu of foreclosure

deed of trust

deficiency judgment

due-on-sale clause

Equal Credit Opportunity Act

Fair Credit Reporting Act

Fannie Mae

Federal Housing Administration

Federal National Mort- gage Association

FHA-insured loan

Flood Disaster Protection Act

foreclosure

Freddie Mac

Ginnie Mae

Government National Mortgage Association

government-sponsored enterprises

hypothecation

judicial foreclosure

land contract

lien theory

loan origination

loan-to-value ratio

mortgage

mortgage-backed securities

mortgage bankers

mortgage brokers

mortgage debt ratio

nonjudicial foreclosure

prepayment clause

primary mortgage market

private mortgage insurance

promissory note

Real Estate Settlement Procedures Act

savings institutions

secondary mortgage market

secured loan

strict foreclosure

subprime mortgage loans

Tax Increment Financing (TIF)

title theory

total debt ratio

underwriting

unsecured loan

U.S. housing finance system

VA-guaranteed loan

| study exercises _________________________________________

1. Define the following terms: secured loan, mortgage, hypothecation, prom- issory note, due-on-sale clause, prepayment clause, acceleration clause, mortgage broker, total debt ratio, mortgage debt ratio, and subprime loan.

2. In what manner can a land contract simplify the foreclosure process?

3. Identify the parties involved in a deed of trust.

4. In states that permit their use, when would a deficiency judgment be in order?

5. Why is PMI generally less expensive than FHA insurance?

6. How does FHA mortgage insurance differ from VA loan guarantees?

7. What is meant by the term conventional loan?

8. List the five major types of mortgage originators.

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352 PA RT F O U R Real Estate Finance and Investment Analysis

9. List the nine factors that mortgage lenders may not use to discriminate against loan applicants as defined by the Equal Credit Opportunity Act.

10. Under the Equal Credit Opportunity Act, how long does a lender have to either accept or reject a completed loan application?

11. What is the general intention behind the Truth-in-Lending law? List three requirements under this regulation.

12. Why does the APR not equal the stated interest rate on a loan? Which rate is usually higher?

13. List seven requirements lenders must observe in conjunction with RESPA.

14. What requirement is imposed on mortgage lenders by the Flood Disaster Protection Act?

15. List three requirements imposed on mortgage lenders by the Fair Credit Reporting Act.

16. What is contained in a residential mortgage credit report?

17. List the three categories of risk assessment guidelines used by mortgage lenders.

18. Consider a borrower who has gross annual income of $48,000 and is apply- ing for a mortgage that requires monthly payments of $1,040. Taxes and insurance premiums for the pledged property total $1,200 per year. The borrower has no other outstanding loans on the property, but she has 24 monthly payments of $260 on her car loan. Based on the MDR and TDR limits for a conventional loan, does she qualify for the loan? Could she qualify for an FHA-insured loan based on the appropriate MDR and TDR guidelines?

19. What is the maximum LTV ratio permitted by secondary mortgage markets on conventional mortgages that do not carry PMI?

20. Why do commercial banks typically limit their involvement in the commer- cial property financing system to short-term loans?

21. Has the total capitalization of REITs increased or decreased in recent years? Why?

22. Suppose a commercial property loan application has a debt coverage ratio of 0.95. What does this say about the property’s ability to cover its debt service payments?

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C H A P T E R 16 Residential and Commercial Property Financing 353

| further reading _________________________________________

William Bruggeman and Jeffrey Fisher, Real Estate Finance and Investments, 14th ed., McGraw Hill/Irwin, 2010.

Clauretie, Terrence M., and G. Stacy Sirmans. Real Estate Finance, 6th ed. Mason, Ohio: Thomson South-Western, 2009.

Kolbe, Phillip T., Gaylon E. Greer, and Bennie D. Waller Jr. Real Estate Finance, 3rd ed. La Crosse, Wisconsin: Dearborn Real Estate Education, 2012.

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17c h a p t e r Risk, Return, and the Time Value of Money

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355

c h a p t e r p r e v i e w

An understanding of basic financial concepts is essential for all real estate market participants. Real estate lending and borrowing decisions, value estima- tion, and investment analysis all require knowledge of the relationship between risk and return, “time value of money” principles, and financial decision rules. The purpose of this chapter is to consider each of these concepts and dem- onstrate their role in the financial framework of real estate. Some readers are already familiar with these concepts, but for others they represent an unexplored frontier. For the first group, many topics considered in this chapter will serve as a review. The second group will want to study the material quite carefully and make certain they master the concepts before moving on to subsequent topics. In all cases, it is helpful to think of the topics discussed in this chapter as tools that market participants should have at their disposal as they engage in real estate decision-making situations.

The topics considered in this chapter include

■■ the relationship between risk and return,

■■ the six time value of money formulas, and

■■ the net present value and internal rate of return financial decision rules.

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| the relationship between risk and return _________________

Financial decision making is defined as the process of comparing the expected benefits from a proposed course of action with the expected costs arising from that course of action. In the case of real estate investment decisions, for example, inves- tors must compare the purchase price of the property with the after-tax cash flows they expect to receive from the property over the holding period.

Rather than dollar amounts, investment returns are frequently expressed as a percentage rate of return—that is, $100 profit on an investment of $1,000 repre- sents a 10% rate of return. Because the returns from an investment opportunity are expected to be realized in future time periods, and because the future is uncertain, it would be imprudent for an investor to make decisions without recognizing that the actual rate of return from a particular investment may vary significantly from initial expectations. Uncertainty about the actual rate of return an investment will provide over the holding period is known as risk. Because most of us are risk-averse rather than risk-seeking (we view higher levels of risk negatively), risk is an additional cost that must be considered when evaluating an investment opportunity.

For financial decision makers to accept an investment, they must expect to receive a sufficient return to justify its cost. Thus, in addition to considering the revenues and operating expenses resulting from a property investment, real estate investors must consider the risk that the expected rate of return from pursuing that investment may deviate from initial expectations. A riskier investment must promise a higher rate of return than less risky investment opportunities. If not, prudent decision makers would prefer a less risky investment that earns the same level of return. Therefore, a positive relationship exists between risk and investors’ required rates of return. This general relationship is depicted graphically in Figure 17.1.

The upward sloping line in the figure illustrates the required rate of return demanded by investors at various levels of risk. As the level of risk increases, so does the required rate of return. The point at which the risk/return line intersects the vertical axis is known as the risk-free rate. This point indicates the rate of return that investors are willing to accept for investments that pose no risk. Although one can argue that there is no such thing as a perfectly risk-free investment, the return available from investing in U.S. government securities, such as Treasury bills, is generally considered the risk-free rate because there is virtually no danger that the federal government will default on its obligation to pay its debts. Even though an investment is risk-free, investors require a return that compensates them for giving up use of their funds over time. As we proceed to the right along the risk/return line, it is immediately apparent that higher risk implies higher required rates of return.

Types of Risk

Uncertainty about future returns from an investment opportunity arises from a variety of factors, but most risk can be characterized as business risk, financial risk, purchasing power risk, or liquidity risk. Business risk is the uncertainty arising from changing economic conditions that affect an investment’s ability to generate returns.

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C H A P T E R 17 Risk, Return, and the Time Value of Money 357

Financial risk is uncertainty associated with the possibility of defaulting on bor- rowed funds used to finance an investment. Purchasing power risk (inflation risk) arises from the possibility that the amount of goods and services that can be acquired with a given amount of money will decline. Thus, returns from an investment may be less valuable in real terms when they are received. Liquidity risk is the possibility of loss resulting from not being able to convert an asset into cash quickly should the need arise. Real estate is often considered less liquid than other investment assets such as stocks or bonds, which can be traded almost immediately at the current market price. In general, investors’ required rates of return are a combination of the returns required for each of these risk types and the risk-free rate of return.

The Time Value of Money

Another important consideration in financial decision making is the “timing” of the expected benefits and costs associated with investment opportunities. Even if risk is minimal, decision makers must recognize that delaying returns until some future time represents an added cost of an investment. As we saw above, investors require a rate of return for any investment whose benefits are expected to occur in the future, even if there is no risk. In other words, a dollar in the hand today is worth more than a dollar to be received in the future because it can either be consumed immediately or put to work earning a return in another investment opportunity. This is known as the time value of money principle. To use this principle effectively in decision- making situations, investors must be able to convert future values into present values and present values into future values. The next section of this chapter presents six techniques for accomplishing these conversions while simultaneously accounting for the risk associated with an investment choice.

f i g u r e 17.1 Relationship Between Risk and Return

Required rate of return

Risk-free rate

Risk

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358 PA RT F O U R Real Estate Finance and Investment Analysis

| time value of money formulas ____________________________

There is an old saying that “a bird in the hand is worth two in the bush,” and a dollar in the hand is certainly worth more than one to be received sometime in the future. Thus, if given a choice today between receiving $5 immediately or $5 one year from now, we would choose the first option. If the choice were between $5 immediately or $15 one year from now, however, the decision becomes more com- plicated. Which of these options is the better one right now? The answer depends on two issues: risk and the time value of money. As we discussed above, both of these issues are incorporated into the decision-making process by specifying an appropri- ate required rate of return. A variety of time value of money formulas exist that allow us to address the choices described above, as well as more involved investment deci- sions. After we consider the intuition behind the first two formulas, we will describe how two popular models of financial calculators (Hewlett Packard 10B and Texas Instruments BAII PLUS) can be used to conduct time value of money analysis.

The first formula we will consider is used to find the future value of a lump sum. This formula allows decision makers to determine what an amount of money in hand today will be worth some time in the future if it increases at a constant rate each period.

Future Value of a Lump Sum

Suppose an investor buys 10 acres of vacant land today for $70,000. If land val- ues are expected to increase at the rate of 10% per year, what will the land be worth at the end of three years? In one year, the land is worth $70,000 plus 10% of $70,000. Written algebraically, the value of the land in one year is

$70,000 + (0.10 × $70,000) = $77,000

This equation can also be written as

$70,000(1 + 0.10) = $77,000

In two years, the land is worth $77,000 plus 10% of $77,000, or

$77,000(1 + 0.10) = $84,700

At the end of three years the original investment of $70,000 is worth

$84,700(1 + 0.10) = $93,170

As shown here and in Table 17.1, the investment has grown from $70,000 to $93,170, for a total increase of $23,170 over three years. The rate of growth is 10% annually, but the total growth is 33.1% ($23,170 ÷ $70,000 = 0.331). This example demonstrates the concept of compound interest, which means that during any given period, interest is earned not only on the original investment, but also on the interest previously earned. Thus, as in this example, after the first year the value of the land increases by 10% of the previous year’s value where this value includes the initial investment plus increases during prior years. Note that multiplying the growth rate by the number of periods (10% × 3 = 30%) does not provide the total percentage

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C H A P T E R 17 Risk, Return, and the Time Value of Money 359

change in value because such a calculation ignores interest earned on previously earned interest. The total percentage change in value is 33.1%.

If the investor is concerned only with the value of the land at the end of three years, as opposed to each year’s value, we can simplify this problem greatly. The value of $70,000 invested today at 10% interest for three years is worth $93,170.

$70,000(1 + 0.10)(1 + 0.10)(1 + 0.10) = $93,170

Equivalently, we can write the future value of $70,000 invested at 10% for three years as follows:

$70,000(1 + 0.10)3 = $93,170

Writing the calculation in this manner leads to the formal specification of the concept of the future value of a lump sum. Equation (1) below is used to find the future value of a known present value when the future amount is to be received in a lump sum at a particular time n.

FV = PV(1 + i)n (1)

where FV is the future value we are seeking to determine, PV is the initial value, i is the rate of return per period, and n is the number of periods.

Present Value of a Lump Sum

The converse of the above problem requires a present value calculation—that is, what is the value today of a sum to be received some time in the future? Suppose there is a parcel of land that an investor believes will be worth $93,170 in three years. If the investor requires a 10% annual rate of return on investments with comparable risk, how much would he or she be willing to pay for the land today? The present value of a lump sum is given by solving equation (1) to move PV to the left side of the equality sign as shown in equation (2):

PV = FV (1 + i)n

(2)

ta b l e 17.1 Future Value of a Lump Sum

Year Present Amount × (1+ i) = Future Amount

0 $70,000

1 $77,000 (1.10) $77,000

2 $84,700 (1.10) $84,700

3 $93,170 (1.10) $93,170

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360 PA RT F O U R Real Estate Finance and Investment Analysis

where PV is the present value we are seeking to determine, FV is the known future value, i is the required rate of return per period, or discount rate, and n is the number of periods.

Applying the present value of a lump sum formula to this investment problem reveals that the present value of $93,170 to be received three years in the future is $70,000.

PV = $93,170 (1 + 0.10)3

Note that the equations for present value and future value are mathematically reverse operations, the key difference being the variable that we are trying to find. If we know the present amount, we can find the future amount using the future value formula. Conversely, if we know the future amount, we can find the present amount using the present value formula. In solving time value of money problems, it is often helpful to recognize that when calculating present values we are looking “backward” in time, and when calculating future values, we are looking “forward” in time. The process of finding present values is known as discounting, and the process of finding future values is known as compounding.

Both time and the rate of return enter into present value calculations. The farther into the future the money will be received, the lower the present value. Also, the greater the rate of discount is, the lower the present value. The opposite is true for future value calculations. The longer a present amount is allowed to grow, the greater the future value. And, the greater the rate of growth is, the greater the future value.

Using Financial Calculators and Computer Spreadsheets to Solve for Present and Future Values

While the formulas presented above are relatively simple, we soon consider four other formulas that can become quite cumbersome to work with. We believe that students should work through these formulas to establish an understanding of how to use basic financial concepts in real estate decision making, but we also know that more efficient methods exist for working with time value of money formulas once a base level of knowledge is established.

For many years, financial analysts used cumbersome tables that listed time value of money factors for various values of i and n. These tables were a grand improve- ment over pencil and paper, but today such tables have been replaced by relatively inexpensive financial calculators and computer spreadsheet programs such as Micro- soft Excel. Instead of laboriously working through these formulas or selecting the appropriate factor from a table and multiplying it by the appropriate present or future amount, we need only understand how to press a few keys on these wonderful devices. Spending time memorizing the formulas is not necessary for most readers of this text, but learning how to use financial calculators and computer spreadsheets is a worthwhile endeavor.

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C H A P T E R 17 Risk, Return, and the Time Value of Money 361

Using Your Financial Calculator We encourage you to learn how your calculator works by first solving the prob-

lems using the formulas presented here, then by referencing the manual that came with your calculator to “plug in the numbers” and arrive at the answers. Doing so will ultimately give you confidence in your ability to use the calculator in more com- plex decision-making situations. The user’s manual can be very useful for learning how your calculator operates!

Here are some tips for helping you solve the problems in this chapter using your calculator. First, recognize that each calculator manufacturer uses slightly different keys to solve time value of money problems, but there is some degree of uniformity. Almost all financial calculators have keys labeled PV, FV, I/Y or I/YR, and n or N. These buttons correspond to the notation used in equations (1) and (2) above and in the other equations we will consider shortly.

Second, all of the problems considered in this chapter require that your calcula- tor be set in “END” mode. If the screen displays the word “BEGIN” or “BGN,” you will not be able to calculate the correct answer.

Third, it is important that you know how to correctly change your calculator’s settings to reflect the correct number of periods per year over which payments or compounding will be performed. For example, most mortgages involve monthly pay- ments (12 periods per year), while most investment decisions are based on annual cash flow totals (1 period per year). Most calculators will have a P/Y or P/YR key where the periods per year can be set appropriately.

Fourth, it is important that you know how to completely clear your calculator’s memory registers so it is not using “old” information from a previous calculation. In most calculators, clearing the screen is not equivalent to clearing the memory reg- isters. Clearing the memory registers is a second or even a third step. Consult your calculator’s user manual to be sure you can clear the memory completely between problems.

Fifth, with most calculators you will notice that the screen displays a negative sign in front of the final answer of most time value of money problems. The nega- tive sign is a result of the algorithm used by the calculator to solve the time value of money formulas, and it should not be a great cause for concern. Just remember that if you enter a positive value in your calculator for a present value, then calculate future value, your calculator will always give you a negative future value. Similarly, if you enter a negative present value, the calculator will always give you a positive future value. If you enter both a present value and a future value and ask your calculator to solve for n or i, either the PV or FV must be entered with a negative sign or the calculator will not be able to solve the equation. The same is true for other time value of money calculations we consider next. The negative sign indicates an outflow of money, while the positive sign indicates an inflow.

Using Microsoft Excel A computer spreadsheet program like Microsoft Excel also can be a valuable tool

when considering time value of money problems like those encountered in real estate investment and financial analysis situations. Excel has financial functions available

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362 PA RT F O U R Real Estate Finance and Investment Analysis

that work in much the same way as a financial calculator. The syntax for these func- tions is straightforward. For example, to calculate the present value of $93,170 to be received in three years at 10% interest, simply type the following entry into a blank Excel spreadsheet cell:

= pv (0.10,3,,-93170).

The spreadsheet will display $70,000. Notice the extra comma in the function syntax. This comma tells Excel that

this is a present value of a lump sum problem rather than a present value of annuity problem (to be discussed shortly). Also, notice the negative sign on the future value. Like most financial calculators, Excel will return a negative number in most time value of money calculations if all of the “inputs” are positive numbers. The negative sign in the syntax converts the negative number into a positive number. And, if you are trying to use Excel to solve for n or i in a time value of money problem, either the PV or the FV (but not both) must have a negative sign or Excel will not be able to solve the equation. To learn more about each of the many financial functions that are incorporated into Microsoft Excel, consult the Excel help screen by clicking on “help” or pressing the F1 key.

Applying the Present Value Formula to Cash-Flow Streams

Up to this point we have focused our attention on finding the value of present and future lump sum amounts. In many real estate investments, however, the project gen- erates flows of cash to the investor throughout the life of the investment. Consider an investment that promises to pay $500 in one year, $1,000 in two years, and $1,500 in three years. If your required rate of return is 10%, how much would you be will- ing to pay for this investment? To solve this problem, first recognize that we know three future amounts. Applying the present value formula to each of these amounts with the proper values for the exponent n, then adding the three results, yields the total present value of this stream of cash flows. The present value of this stream at a discount rate of 10% is

PV = 500 (1 + 0.10)1

+ 1,000 (1 + 0.10)2

+ 1,500 (1 + 0.10)3

= $2,407.96

Thus, if we invested $2,407.96 in this project, we would earn exactly our required 10% rate of return.

In the event the stream of cash flows extends over many years, calculating the present value by repetition of the present value of a lump sum formula can be time consuming. (We describe how to use the “cash flow” features of financial calcula- tors and Microsoft Excel to solve this type of problem later in this chapter.) If the periodic cash flows are a series of equal amounts, however, the problem is greatly simplified. Such a series of equal cash flows is called an annuity.

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C H A P T E R 17 Risk, Return, and the Time Value of Money 363

Present Value of an Annuity

Consider an investment that promises to pay $1,000 at the end of each year for three years. The required rate of return is 10%. What is the present value of this stream of payments? Applying the present value of a lump sum formula three times and then adding the results yields

PV = 1,000 (1 + 0.10)1

+ 1,000 (1 + 0.10)2

+ 1,000 (1 + 0.10)3

= $2,486.85

While this calculation is certainly valid, it can be cumbersome when a large number of future cash flows are involved. Fortunately, there is a simpler method. Because the amounts in each period are equal, we can use the present value of an annuity formula shown in equation (3).

PVA A i

= −

+ 



   





   

1 1

1( ) (3)

where A is the amount each period (the annuity), i is the discount rate per period, and n is the number of periods. Applying this equation to the present prob- lem yields

PVA = −





   





   

=1,000 1

0.10 2 486 8

3( ) $ , . 551 + 0.10

Using a financial calculator to solve this problem is quite simple using the PMT key to enter the annuity amount.

Financial Calculator Solution: PMT = 1,000, N = 3, i = 10, PV =?

Microsoft Excel Solution: = PV(0.10,3,-1000)

The following example demonstrates the use of the present value of annuity con- cept in a real estate context: calculating the outstanding balance on a mortgage loan. Suppose you are a lender entitled to receive payments of $16,274.54 from a borrower once per year for the next seven years. If the interest rate on this loan is 10% annu- ally, what is the outstanding balance on this loan today? In other words, what is the stream of payments (an annuity) worth to you today at a required rate of return of 10%? To find the answer, apply the formula to the annuity amount.

PVA = −





   





   

=16 274 54 1

0.10 79

, . $ ,, .231 28 (1 + 0.10)

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364 PA RT F O U R Real Estate Finance and Investment Analysis

Financial Calculator Solution: PMT = 16,274.54, N = 7, i = 10, PV = ?

Microsoft Excel Solution: = PV(0.10,7,-16274.54)

Future Value of an Annuity

In some instances, particularly in personal finance, we are interested in finding the future value of equal payments received over time. In this type of problem, we could apply the future value formula described above to each payment individually using the proper exponent n and then add the results of each calculation, but this can be simplified by using the future value of an annuity formula.

Consider the following example. Suppose you invest $100 at the end of each year for the next five years in an interest-earning bank account paying 10% interest per year. How much money would you have in the account at the end of five years?

The first payment will be deposited one year from today and will earn interest for four years. The second deposit will earn interest over three years, and so on for the third and fourth deposits. Note that the fifth payment will not earn any interest, because it will only be deposited at the end of the fifth year. We can solve for the future value at the end of five years using the future value factor for each of the five deposits:

FV = 100(1 + 0.10)4 + 100(1 + 0.10)3 + 100(1 + 0.10)2 + 100(1 + 0.10)1 + 100(1 + 0.10)0 = $610.51

To solve this problem quickly, however, we can use the future value of an annuity formula given in equation (4).

FVA A i

= + − 

 



 

( )1 1 (4)

In this example,

FVA = 

 



  =100 0.10

610 51 5

$ . (1 + 0.10) – 1

Financial Calculator Solution: PMT = 100, N = 5, i = 10, FV = ?

Microsoft Excel Solution: = FV(0.10,5,-100)

Sinking Fund Payments

The next time value of money principle, the sinking fund payment formula, is algebraically equivalent to the future value of an annuity formula. The important

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C H A P T E R 17 Risk, Return, and the Time Value of Money 365

difference is that the unknown variable is not the future value of the stream of pay- ments, but the amount of each payment required to accumulate the future amount.

Suppose, for example, that you wish to buy a home but do not have the required down payment of $20,000. You decide that you will save that much over the next five years by making equal, annual deposits into a savings account paying 10% annually beginning one year from today. How much must you deposit each year to accumulate $20,000? This type of problem is known as a sinking fund problem—that is, how much must you “sink” into the account each year to accumulate the desired amount in the future? Just as we solved the future value formula [equation (1)] to get present value on the left side of the equality sign in equation (2), we can also solve equation (4) for the annuity A. To avoid possible confusion, we replace the variable A with the symbol SFP to represent “sinking fund payment.” These manipulations of the FVA formula provide equation 5, the formula for finding sinking fund payments.

SFP FVA i

i n =

+ − 

 



 ( )1 1

(5)

Applying the sinking fund formula to this problem shows that you must deposit $3,275.95 into the account each year for five years to accumulate $20,000 at 10% interest.

SFP = 

 



  =20,000

0.10 3 275 95$ , .5(1 + 0.10) – 1

Financial Calculator Solution: FV = 20,000, N = 5, i = 10, PMT = ?

Microsoft Excel Solution (notice the “extra” comma): = PMT(0.10,5,,-20000)

Mortgage Payments

The sixth and final time value of money formula to be considered is the mort- gage payment formula. This formula is used to calculate payments due on a “fully amortizing” loan. Because we will consider the concept of amortization in greater detail in Chapter 18, our discussion here is limited to using this formula to calculate mortgage payments.

Suppose you wish to borrow $100,000 to buy a parcel of real estate. A mortgage company is willing to lend the money at 10% interest, provided that you amortize the debt with annual payments over the next 10 years. How much will your payments be? Notice the similarity between this problem and the one we examined during our discussion of the present value of annuities. In both examples, we know the interest rate and the number of periods. In the present value of annuity problem, we know the amount of the annuity, but we do not know the present value. In this problem, we know the present amount, but we do not know the amount of the payment or, in other words, the annuity. Because the problems are identical except for the unknown

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366 PA RT F O U R Real Estate Finance and Investment Analysis

variable, we can solve equation (3) to move the annuity (variable A) to the left side of the equality sign. To avoid confusion, we then rename A to PMT to represent mort- gage payment. This results in the mortgage payment formula:

PMT PVA i

i n

= −





   





   1

1( )

(6)

Why does the symbol PVA appear in the formula for mortgage payments? The answer to this question is simple, but very important. From the lender’s point of view, a mortgage is an investment in the borrower’s ability to repay the debt. In return for giving the borrower cash today, the lender will receive an annuity for n periods into the future. The lender is willing to give the borrower the present value of that annuity today in the form of a loan. To the borrower, the present value of the series of future payments represents the loan amount. Thus, the loan amount, or the remaining amount outstanding, can always be thought of as the present value of an annuity, where the annuity is the future mortgage payments. Applying equation (6) to the problem at hand shows the annual mortgage payment the lender will require for a 10-year loan of $100,000 at 10% interest.

PMT = −





   





   

=100,000 0.10

1 1

16 2

$ , 774 54.

(1 + 0.10)

Financial Calculator Solution: PV = 100,000, N = 10, i = 10, PMT = ?

Microsoft Excel Solution: = PMT(0.10,10,-100000)

Monthly Compounding

We now have developed the six time value of money formulas, but in each of the examples used thus far we have dealt with annual time periods. In many instances, however, the compounding and discounting periods in real estate problems are semi- annually, quarterly, or even monthly. For example, almost all residential mortgage loans call for monthly payments. The preceding analysis remains valid for periods of any length, but with one word of caution: Time and interest must always be measured in the same unit—that is, if we wish to solve for a monthly mortgage payment, we must use a monthly interest rate.

Suppose, for example, we wish to calculate the monthly payment required to amortize a $100,000 loan at 12% annual interest for 30 years. The number of com- pounding periods becomes 360 (12 times 30), and the periodic interest rate becomes

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C H A P T E R 17 Risk, Return, and the Time Value of Money 367

1% (12% divided by 12). Substituting these numbers into the formula for finding the mortgage payment yields a monthly payment of $1,028.61.

PMT = −





   





 100 000

12 12

1 1

360

, . /

 

= $ , .1 028 61 0

(1 + 0.12 / 12)

We can generalize each of the six formulas to account for any compounding period by “dividing i by m and multiplying n by m,” where m is simply the number of compounding or discounting periods per year, i is the annual interest or discount rate, and n is the number of years. Applying this rule restates the six time value of money formulas as follows:

FV = PV(1 + i/m)nm

PV = FV (1 + i/m)nm

PVA A i m

i m

= −

+ 



   





   

1 1

1( / ) /

FVA A i m

i m

= + − 

 



 

( / )

1 1

SFP FVA i m

i m nm =

+ − 

 



 

( / )1 1

PMT PVA i m

i m nm

= −





   





   

( / ) 1

Most financial calculators can be set to automatically convert the time value of money formulas for any compounding or discounting frequency. Of course, you can do this manually by dividing the interest rate and multiplying the number of years by the number of compounding or discounting periods per year before pressing the appropriate keys, but you must enter all the decimal places (without rounding) to avoid getting the wrong answer. (Dividing 10% by 12, for example, will yield 0.01 if your calculator is set to display only two decimal places, but the value to eight deci- mal places is 0.00833333, which is a very different number from 0.01.) In Microsoft Excel, remember to divide the annual interest rate by 12 and to multiply the number of years by 12 to get the correct answers.

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368 PA RT F O U R Real Estate Finance and Investment Analysis

| financial decision rules: npv and irr _____________________

Now that we understand the concept of risk and the time value of money for- mulas, we will examine a framework for making decisions concerning investment choices. This framework compares the benefits of an investment to its costs, includ- ing risk and the time value of money. The key concept is net present value (NPV), which is the difference between how much an investment is worth to an investor and how much it costs. Suppose an investment promises to pay you a stream of cash flows that has a present value of $10,000. If the asking price of this investment is $9,000, the investor obviously would decide to buy it. In this case, the net present value is $1,000 ($10,000 – $9,000).

The question is this: How do we determine the present value of the stream of cash flows? We discount the cash flows at the proper discount rate, which is the rate of return we require to compensate for the risk of the investment. If the stream occurs in uneven amounts, we use the present value of a lump sum formula to discount each cash flow. If the stream is an annuity, we can simplify the calculations by using the present value of an annuity formula. The appropriate discount rate to use is one that accounts for the risk of the investment opportunity, usually determined by comparing the rates of return on alternative investment choices of similar risk. Formally, we can define net present value as follows:

NPV = Present Value of Cash Inflows – Present Value of Cash Outflows

In decision-making situations, we use the NPV concept as part of the following NPV decision rule. If the NPV of an investment is greater than or equal to zero, we choose to invest because the investment is worth at least as much as it costs, given our required rate of return. If NPV is less than zero, we choose not to invest because we would not be earning our required rate of return. Remember that the required rate of return reflects both the time value of money and the risk of the investment opportunity. We can take this rule a step farther and say that if faced with several alternative investment choices, we should accept the one with the highest positive NPV, because it will increase our wealth more than the others.

This leads us to another important concept in financial decision making. If the net present value of an investment is greater than or equal to zero, we must be earn- ing at least our required rate of return. In fact, if NPV equals zero, the rate of return on the investment is exactly equal to the required rate. If NPV is not zero, what rate are we earning? We can define the internal rate of return (IRR) of an investment as the discount rate, which makes NPV exactly equal to zero. To determine an invest- ment’s IRR, we can search a variety of discount rates by trial and error until we find one that makes NPV equal zero. (Finding algebraic solutions to complex IRR problems generally is not feasible.) This rate will be the internal rate of return on the investment. Fortunately, most financial calculators (and Microsoft Excel) have a feature that allows automatic searches for the internal rate of return for a series of cash flows.

The definition of IRR provides another rule for financial decision making that states that if the IRR is greater than or equal to our required rate of return, we choose

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C H A P T E R 17 Risk, Return, and the Time Value of Money 369

to invest: Otherwise, we forgo the investment opportunity. While the IRR rule and the NPV rule are based on the same principles, the NPV rule is generally the best choice to use because IRR calculations may yield multiple discount rates that set NPV equal to zero. When our objective is to determine the rate of return provided by an investment, however, the IRR calculation is extremely useful. The following example demonstrates the NPV rule and the IRR rule.

NPV and IRR Decision Rule Example

Suppose you are faced with making a decision about whether to invest $10,000 today in a risky real estate investment. In return for your investment, you expect to receive the following stream of cash flows: year one, $100; year two, $1,600; year three, $1,800; year four, $450; year five, $12,500. You believe other investment opportunities with similar risk offer a 12% rate of return. What are the NPV and IRR of this investment? Should you invest? We can find the NPV of this investment by applying the NPV definition:

NPV = PV of Cash Inflows – PV of Cash Outflows

NPV = 100 (1 + 0.12)1

+ 1,600 (1 + 0.12)2

+ 1,800 (1 + 0.12)3

+ 450 (1 + 0.12)4

+ 12,500 (1 + 0.12)5

– 10,000 = $24.82

Because the NPV is greater than zero, the investment is worth more than it costs and we should choose to accept this opportunity. Likewise, we know that the IRR must be greater than our required rate of return, simply because NPV is positive. To determine the IRR of this investment, we apply different discount rates in the above calculation until NPV becomes exactly zero. In this problem, the IRR is 12.0646%.

Financial Calculator Solution: CF0 = -10,000, CF1 = 100, CF2 = 1,600, CF3 =1,800, CF4 = 450, CF5 = 12,500, NPV = ?, IRR = ?

Microsoft Excel Solution: Enter the following cash flows in contiguous cells (for example, A1 through F1): -10,000, 100, 1,600, 1,800, 450, 12,500. Then, in a blank cell, enter =NPV(0.12,B1:F1)+A1.

Notice that the NPV function in Excel assumes that all cash flows inside the parentheses begin one year from today. If the first cash flow happens at the start of the investment (as is most often the case) rather than one year from the start of the investment, omit it from the cell range inside the NPV function and subtract it from Excel’s NPV calculation as shown here. To solve for the IRR, make the following entry into another blank cell in the spreadsheet =IRR(A1:F1).

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370 PA RT F O U R Real Estate Finance and Investment Analysis

| chapter review __________________________________________

■■ All financial decisions can be thought of as a comparison of the expected benefits from a particular course of action and the costs of pursuing it. In addition to the purchase price, however, prudent investors consider the costs of an investment resulting from uncertainty about those future ben- efits and forgoing the use of the investment capital over time (risk and the time value of money).

■■ Because most people are risk-averse rather than risk-seeking, there is a positive relationship between risk and return. The greater the risk of an investment, the greater the investor’s required rate of return.

■■ The six time value of money formulas are useful tools for evaluating financial choices whose risky cash flows are distributed over time. These formulas allow calculation of the present value of a lump sum, the future value of a lump sum, the present value of an annuity, the future value of an annuity, sinking fund payments, and mortgage payments.

■■ By definition, net present value is the present value of cash inflows minus the present value of cash outflows. If the net present value of an investment opportunity is negative, the investment is not worth its cost and should therefore be rejected by the investor.

■■ The internal rate of return is defined as that discount rate which sets net present value equal to zero. This is the actual return that is provided by an investment opportunity. If the IRR is less than the investor’s required rate of return, the investment should be rejected by the investor.

| key terms _______________________________________________

annuity

business risk

compounding

compound interest

discounting

financial risk

future value of a lump sum

future value of an annuity

internal rate of return

liquidity risk

mortgage payment

net present value

NPV decision rule

present value of a lump sum

present value of an annuity

purchasing power risk

rate of return

risk

sinking fund payment

time value of money principle

| study exercises _________________________________________

1. Define the following concepts: risk, business risk, financial risk, purchas- ing power risk, liquidity risk.

2. Describe the “risk/return relationship.”

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C H A P T E R 17 Risk, Return, and the Time Value of Money 371

3. What is the time value of money principle?

4. Joe Saver deposits $5,000 in the Granite City Savings and Loan. To what value will his money accumulate in five years if the account pays 5% inter- est compounded annually? (Future Value of a Lump Sum)

5. How much should Joe be willing to pay today for an investment that is expected to pay $5,000 10 years in the future if he requires a 10% rate of return? (Present Value of a Lump Sum)

6. Define the following terms: compound interest, compounding, discounting.

7. Joe is offered the opportunity to receive $5,000 each year for 10 years. How much would he be willing to pay for this future income stream if he desires a 10% return? (Present Value of an Annuity)

8. Joe expects to receive $5,000 each year for the next 10 years beginning one year from today. If he deposits each payment into an account earning 8% interest annually, what will the balance of the account be when the last pay- ment is deposited? (Future Value of an Annuity)

9. Joe hopes to accumulate $200,000 with 10 annual deposits into a savings account earning 6% interest annually. What amount must Joe deposit each year to achieve his objective? (Sinking Fund Payment)

10. Harold and Helen purchase a $180,000 house using a down payment of $15,000 and a fixed rate mortgage for $165,000. The annual interest rate on the loan is 10% and the term is 30 years. What monthly payment is neces- sary to amortize this loan?

11. Define the following terms: net present value, internal rate of return, NPV decision rule, IRR decision rule.

12. An investor is considering purchasing a small retail property at a price of $820,000. The investor has established a required rate of return of 14%. Based on the following cash flow forecast, what is the NPV of this invest- ment opportunity? Cash flows: year 1 = 100,000; year 2 = 120,000; year 3 = 110,000; year 4 = 140,000; year 5 = 950,000. Should the investor pur- chase this property?

13. What is the internal rate of return for the investment in question 12?

14. Bill and Ami borrowed $220,000 at 9% interest using a fixed rate mortgage with a maturity of 25 years. Answer the following questions about their loan.

a. What is the monthly payment necessary to amortize this loan?

b. If the loan required annual payments instead of monthly, what would the annual payment be?

c. Multiply the answer in part (a) by 12. Why does this amount not equal the answer in part b?

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18c h a p t e r Mortgage Mechanics

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373

c h a p t e r p r e v i e w

Now that we have a basic understanding of the time value of money, we can turn our attention to the mechanics of mortgage loans. In this chapter, we investigate the process of amortization in contrast to “interest-only” loans. We also consider how the internal rate of return can be used to determine the effec- tive interest rate on a mortgage loan. Finally, we examine several alternatives to the fixed-rate mortgage that may be encountered in today’s mortgage market, including the two-step mortgage and the adjustable-rate mortgage.

The topics considered in this chapter include

■■ loan amortization,

■■ prepayment,

■■ refinancing,

■■ discount points,

■■ effective interest rates, and

■■ alternatives to the fixed-rate mortgage.

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374 PA RT F O U R Real Estate Finance and Investment Analysis

| mortgage mechanics _____________________________________

Because most real estate investments involve long-term commitments of rel- atively large amounts of money, most real estate transactions involve long-term mortgage financing from a third party. Understanding the mechanics of mortgage financing is an important financial concept for students of real estate and real estate practitioners. In this section of the chapter, we explore mortgage mechanics in detail. Our first tasks are to distinguish between amortizing loans and interest-only loans and to fully explore the concept of amortization.

Interest-Only versus Amortizing Loans

As we discussed in Chapter 16, most loans used to finance real estate purchases prior to the 1930s were short-term, interest-only loans. In these loans, the borrower must pay interest on the full loan amount each period, and when the loan term expires, the borrower must repay the loan in one lump sum. During the Depression era, many borrowers could barely afford to make the required interest payments on these loans, much less repay the loan balance when the loan matured. One of the most successful activities of the Federal Housing Administration was the promotion of long-term, amortizing loans for home financing rather than short-term, interest- only loans. Amortizing loans are much easier to budget for most borrowers, and when combined with mortgage insurance, they are much less risky for most lenders. Amortizing loans are the dominant loan type in the housing finance industry. To fully understand the process of amortization, it is often useful to first understand how the payment streams differ between interest-only loans and amortizing loans.

Interest-only loans require that the borrower pay interest each period during the loan term, then repay the full loan amount in one lump sum at the end of the loan term. In contrast, amortizing loans require equal periodic payments composed of both interest and principal. As payments in this type of loan are made, the balance of the loan is gradually reduced to zero by the end of the loan term. Interest-only loan payments are calculated by multiplying the periodic interest rate by the loan amount. Amortizing loan payments are calculated using the mortgage payment formula, one of the six time value of money formulas discussed in the previous chapter.

The difference in payment streams between an amortizing loan and an interest- only loan is illustrated in Figure 18.1. Repayment of a five-year, $1,000 interest-only loan carrying a 10% interest rate requires a $100 interest payment for each of the first four years. At the end of the fifth year the entire principal amount of $1,000 is due plus $100 interest. (This much larger final payment is often referred to as a bal- loon payment.) The same $1,000 loan can be amortized by five annual payments of $263.80. Notice that although the periodic payments are higher for the amortizing loan, the payment is the same in each period. There is no balloon payment at the end of the loan because the loan balance is gradually reduced by the periodic payments. Also, notice that the total amount of interest paid to the lender ($500) is higher in

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C H A P T E R 18 Mortgage Mechanics 375

the interest-only loan, because none of the principal is repaid until the final payment. In the amortizing loan, part of the principal is repaid with each payment, so the total interest paid is less ($319).

f i g u r e 18.1 Repayment of Five Year, $1,000 Fully Amortizing Loans and Interest-Only Term, Each Carrying 10% Annual Interest

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376 PA RT F O U R Real Estate Finance and Investment Analysis

Understanding the Amortization Process for an Annual Payment Loan

An amortization schedule can be developed for any amortizing loan. A loan amortization schedule describes the payments in each period, the interest and prin- cipal contained in each payment, and the amount outstanding in each period. Table 18.1 shows an amortization schedule for a $100,000, 10-year, annual payment loan at 10% interest. Figure 18.2 plots the periodic payments and the interest and principal components of each payment. Note that while the payment amount is constant over the life of the loan, the portion going to interest decreases with each payment as the balance owed falls. Conversely, the portion going to payment of principal increases at an increasing rate over the life of the loan. Also, the loan balance decreases slowly in the earlier years of the loan and more rapidly as the loan approaches maturity.

Understanding the amortization process requires careful consideration of the principal and interest components of each payment as well as the changing loan balance over time. Table 18.1 shows that $10,000 of the first year’s payment on the above loan goes for interest, while only $6,274.54 is used to reduce the principal owed. With the loan balance reduced to $93,725.46, interest for the second year drops to $9,372.55, while the principal component of the payment rises to $6,901.99.

ta b l e 18.1 Amortization Schedule for a $100,000 Loan at 10% Annual Interest for 10 Years

Year

Payment PMT

Interest It

Principle Pt

Amount Outstanding AOt

0 — — — $100,000.00

1 $16,274.54 $10,000.00 $6,274.54 93,725.46

2 16,274.54 9,372.55 6,901.99 86,823.47

3 16,274.54 8,682.35 7,592.19 79,231.28

4 16,274.54 7,923.13 8,351.41 70,879.87

5 16,274.54 7,087.99 9,186.55 61,693.32

6 16,274.54 6,169.33 10,105.21 51,588.11

7 16,274.54 5,158.81 11,115.73 40,472.38

8 16,274.54 4,047.24 12,227.30 28,245.08

9 16,274.54 2,824.51 13,450.03 14,795.05

10 16,274.54 1,479.40 14,795.05 00.00

Total $162,745.40 $62,745.40 $100,000.00

Note: Component items may not add to totals due to rounding.

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C H A P T E R 18 Mortgage Mechanics 377

The process continues until the last year, when interest is only $1,479.51 and prin- cipal is $14,795.05. The total amount of principal repaid equals the original loan amount, $100,000, and the total interest paid is $62,745.40. If the loan had been an interest-only loan, the borrower would have paid a total of $200,000 to the lender: $100,000 interest and $100,000 principal.

From this example we can establish several principles regarding the amortiza- tion of real estate mortgage loans:

■■ With a level, constant payment, the portions of each payment going to interest and principal vary greatly over time.

■■ The interest portion of each payment decreases at an increasing rate over time.

■■ The principal portion of each payment increases at an increasing rate over time.

■■ The amount outstanding declines to zero at the end of the loan term.

Being able to construct an amortization table is a valuable tool in many real estate decision-making situations. While most financial calculators and computer spreadsheet software packages have built-in amortization functions, we believe it is instructive for students to be able to construct a simple table “manually.” To con- struct an amortization table, begin by calculating the periodic payment required to amortize the loan using the mortgage payment formula we discussed in Chapter 17. Rather than solving the equation directly, you could also enter the necessary infor- mation into your financial calculator or Microsoft Excel. Because the payments on this type of loan are the same in each period, this calculation need only be done once.

f i g u r e 18.2 Amortization of a $100,000 Loan over 10 Years at 10%

Years

D o

lla rs

Payment

Interest

Principal

2,000

14,000

4,000

6,000

8,000

10,000

18,000

16,000

12,000

1 2 3 4 5 6 7 8 9 10

Fully Amortizing Loan

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378 PA RT F O U R Real Estate Finance and Investment Analysis

To complete the amortization schedule, proceed down the rows of the table, one row at a time, by calculating the interest due, subtracting interest from the payment to get principal for the period, and then subtracting the principal paid in the period from the previous year’s balance to get the new balance for the period.

These steps, for the first two years of the loan in Table 18.1, are shown below. As you can see, each year’s principal, interest, and amount outstanding are found in the same manner. The following notation will prove useful as we consider more complicated aspects of mortgage mechanics: PMT = mortgage payment, I

t = interest due in period t, i

= periodic interest rate, P t = principal paid in period t, and AO

t = amount outstanding

at the end of period t.

Amortization: Period One

I t = AO

t–1 × i 10,000.00 = 100,000 × 0.10

P t = PMT – I

t 6,274.54 = 16,274.54 – 10,000

AO t = AO

t–1 – P

t 93,725.46 = 100,000 – 6,274.54

Amortization: Period Two

I t = AO

t–1 × i 9,372.55 = 93,725.46 × 0.10

P t = PMT – I

t 6,901.99 = 16,274.54 – 9,372.55

AO t = AO

t–1 – P

t 86,823.47 = 93,725.46 – 6,901.99

Understanding the Amortization Process for a Monthly Payment Loan

At the risk of beating the proverbial dead horse, let’s see how the amortization process works for a monthly payment loan. Table 18.2 shows the first year of an amortization schedule for a $100,000, 10-year, monthly payment loan at 10% annual interest. Figure 18.3 plots the periodic payments, and the interest and principal com- ponents of each payment. Just as we saw with the annual payment loan, the payment amount is constant over the life of the monthly payment loan, but the portion going to interest decreases with each payment as the balance owed falls. Conversely, the portion going to payment of principal increases at an increasing rate over the life of the loan. Also, the loan balance decreases slowly in the earlier years of the loan and more rapidly as the loan approaches maturity.

| understanding the fixed-rate mortgage: prepayment _______

Now that we have explored the concept of amortization, we can take a closer look at other mechanics of mortgage loans. The most common mortgage loan is the fixed-rate mortgage, in which the interest rate is fixed at the time of origination. We have already seen how this type of loan is amortized by the payment that is calcu- lated using the mortgage payment formula, and we now examine the concepts of pre- payment, refinancing, discount points, origination fees, and effective interest rates.

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C H A P T E R 18 Mortgage Mechanics 379

For a variety of reasons, borrowers may decide to extinguish an outstanding mortgage loan by repaying the loan balance before the end of the loan term. Because all loans require “repayment,” we use the word prepayment to indicate that the loan is repaid before its full term has expired. Based on historical evidence, many residential borrowers “prepay” their loans after five to seven years. Because the loan balance declines with each payment due to amortization, it is important that we be able to calculate the amount outstanding on a loan at any point in time. To simplify the calculations, we assume that all prepayments occur on a payment date, rather than between payment dates.

Consider a fixed-rate mortgage with the following characteristics: loan amount of $133,000, 30 years to maturity, an annual interest rate of 7.5%, and monthly pay- ments of $929.96 (rounded to the nearest penny). Assume the borrower decides to sell the collateral and buy a new property. The loan contract contains a due-on-sale clause, so the borrower must “prepay” the loan if the property is sold. If the borrower prepays at the end of month 60, what is the amount outstanding on this loan at the time of prepayment?

To answer this question, we could construct an amortization schedule for the first 60 months of this loan. Fortunately, there is a less time-consuming method that uses the “annuity” concept to answer this question. Recall that an annuity is a series

ta b l e 18.2 First 12 Months of the Amortization Schedule for a $100,000 Loan at 10% Annual Interest for 10 Years

Month Payment Interest Principle Amount Outstanding

0 0 0 0 $100,000.00

1 $1,321.51 $833.33 $488.17 93,725.46

2 1,321.51 829.27 492.24 99,019.58

3 1,321.51 825.16 496.34 98,523.24

4 1,321.51 821.03 500.48 98,022.76

5 1,321.51 816.86 504.65 97,518.11

6 1,321.51 812.65 508.86 97,009.25

7 1,321.51 808.41 513.10 96,496.15

8 1,321.51 804.13 517.37 95,978.78

9 1,321.51 799.82 521.68 94,457.10

10 1,321.51 795.48 526.03 94,931.07

11 1,321.51 791.09 530.42 94,400.65

12 1,321.51 786.67 534.84 93,865.82

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380 PA RT F O U R Real Estate Finance and Investment Analysis

of equal payments over time. Obviously, the remaining payments on a mortgage meet our definition of an annuity. If we want to find the amount outstanding on a mortgage loan on any payment date, we simply need to calculate the present value of the remaining payments by discounting them at the interest rate on the loan. We can find the present value of an annuity (or amount outstanding at month 60, AO

60 ) using

the appropriate formula or calculator keystrokes. First, find the monthly payment amount, then calculate the present value of the 300 payments remaining at the end of month 60. In this example, we know the payment is $929.96 and we can find the amount outstanding at the end of month 60 as follows (AO

60 = $125,841.83).

PVA A i m

i m

= −

+ 



   





   

1 1

1( / ) /

AO 60

300

929 96 1

0.075 / 12 =

− 



   





.    

= $ , .125 841 83(1 + 0.075 / 12)

Financial Calculator Solution Clear the memory registers, set the periods per year to 12, then enter PMT = –929.96, N = 300, I/Y = 7.5, and solve for PV.

Microsoft Excel Solution Enter =PV(0.75/12,300,-929.96).

f i g u r e 18.3 Dollars/Months

200

400

600

800

1,000

1,200

1,400

Months

D o

lla rs Payment

Interest

Principal

1 9 17 25 33 41 49 57 65 73 81 89 97 105 113 121

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C H A P T E R 18 Mortgage Mechanics 381

Using the present value of an annuity formula (see equation [3] in Chapter 17) to determine the amount outstanding on a loan is useful in many different situations. For example, how can we determine the amount of principal repaid during the sixth year of a loan? First, find the amount outstanding at the end of month 60 (300 payments remaining) as shown above. Second, find the amount outstanding at the end of month 72 (288 pay- ments remaining). Then, subtract AO

72 from AO

60 to get $1,781.81.

AO 72

288

929 96 1

= −





   





.    

= $ , .124 060 02(1 + 0.075 / 12) 0.075 / 12

P 61 through 72

= AO 60

– AO 72

= $125,841.83 – $124,060.02 = $1,781.81

Financial Calculator Solution Clear the memory registers, set the periods per year to 12, then enter PMT = –929.96, N = 288, I/Y = 7.5, and solve for PV to get AO72.

Microsoft Excel Solution Enter =PV(0.075/12,288,-929.96) to get AO72.

Taking this idea a step farther, we can also find the amount of interest paid in the sixth year by subtracting the principal paid in that year from total payments. In this example, total payments in any one year amount to $11,159.52. Subtracting the principal amount of $1,781.81 leaves $9,377.71 as interest paid in payments 61 through 72.

PMT 61 through 72

= $929.96 × 12 = $11,159.52

I 61 through 72

= PMT 61 through 72

– P 61 through 72

= $11,159.52 – $1,781.81 = $9,377.71

This technique of finding the amount outstanding is also useful when we are interested in determining the amount of interest or principal contained in any one monthly payment. How much interest is contained in payment number 61? We know that interest is paid on the outstanding balance after the last payment was made, so we multiply AO

60 by 0.075 x 12 (the previous balance multiplied by the monthly

interest rate) to determine the interest contained in payment number 61.

I 61

= AO 60

× i

= $125,841.83 × 0.075/12

= $786.51

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382 PA RT F O U R Real Estate Finance and Investment Analysis

To find the principal contained in payment 61, we use the following relationship: P

t = PMT – I

t . In this case, P

61 = 929.96 – 786.51 = $143.45.

P 61

= PMT 61

– I 61

= $1929.96 – $786.51

= $143.45

| understanding the fixed-rate mortgage: refinancing _______

In many cases, borrowers may find that the interest rate on an outstanding loan is substantially higher than rates available on new mortgages in the market. If the rate on the existing loan is higher than the market interest rate, the borrower can reduce total borrowing costs by refinancing the loan amount at the prevailing market rate. Refinancing involves retiring the existing loan with the proceeds of a new loan for the same property. The borrower may obtain the new loan from the same or a dif- ferent lender. A reduction in borrowing cost can be obtained by either reducing the payment amount or reducing the number of payments required to amortize the loan.

Consider the loan described in the previous example. At the end of 60 months, suppose that current interest rates are at 6% and the borrower will replace the old loan with a new loan with the same number of months remaining. We can calculate the payment on the new loan as follows.

PMT = −





   

$ , .125 841 83 1

1 300





   

= $ .810 80

0.06 / 12

(1 + 0.06 / 12)

Financial Calculator Solution P/Y = 12, PV = 125841.83, N = 300, I/Y = 6, PMT = ?

Microsoft Excel Solution Enter =PMT(.06/12,300,-125841.83)

If the borrower obtains a new loan for the same amount for 25 years, the monthly payments will be $810.80. Subtracting the new payment from the old payments shows that the borrower’s monthly payment amount will be reduced by $119.16. Over the remaining 25 years (300 months) of the loan, refinancing this loan at the lower interest rate will provide interest savings of $35,748.00.

On the other hand, if the borrower wishes to take advantage of the lower interest rates available in the market and is comfortable making the payments of $929.96, refinancing can reduce the remaining term of the loan. We can determine the number of monthly payments of $929.96 at 6% annual interest (instead of 7.5%) required to

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C H A P T E R 18 Mortgage Mechanics 383

amortize the loan by solving the following equation for the exponent N. While the algebra may look daunting, the problem can be solved easily with a financial calcula- tor or Microsoft Excel.

Financial Calculator Solution P/Y = 12, PMT = –929.96, PV = 125841.83, I/Y = 6, N = ?

Microsoft Excel Solution Enter =NPER(0.06/12,–929.96,125841.83)

In this problem, if the borrower refinances the loan amount of $125,841.83 at 6 per- cent annual interest, but continues making payments of $929.96 each month, the number of monthly payments required to repay this debt falls from 300 to 227. (The last payment made will be for less than the full amount.) Thus, refinancing the loan at a lower interest rate, but keeping the payments at the same level, reduces the time required to retire the debt by 73 months.

$ . $ , .929 96 125 841 83 1

1 =

−





 

 





   

=N 226 34.

0.06 / 12

(1 + 0.06 / 12)

Financial Calculator Solution P/Y = 12, PMT = -929.96, PV = 125841.83, I/Y = 6, N = ?

Microsoft Excel Solution =NPER(0.06/12,-929.96,125841.83)

| understanding the fixed-rate mortgage: discount points and effective interest rates _____________________________

Another important aspect of mortgage financing is the use of discount points and origination fees to increase the lender’s yield on the loan. The charges represent additional income to the lender and, therefore, additional cost of borrowing to the borrower. When expressed as a percentage of the loan amount, the charges are called discount points. By definition, one discount point is equal to 1% of the loan amount. When expressed as a dollar amount, the charges are generally classified as origina- tion fees. These charges cover the lender’s cost of processing the loan application, obtaining credit reports, and other costs associated with loan origination. Of course,

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384 PA RT F O U R Real Estate Finance and Investment Analysis

the lender could simply increase the interest rate on the loan, but many choose to charge these fees at the time of origination rather than throughout the term of the loan.

From the borrower’s perspective, discount points and other fees result in an effective interest rate that may be substantially higher than the stated interest rate on the loan. The term effective interest rate refers to the actual cost of borrowing funds from a lender, expressed as an annual rate, after consideration of discount points and origination fees. Comparing one loan with another requires careful consideration of the effective interest rate. The calculations presented here are similar to those used by lenders to calculate the annualized percentage rate, or APR, which must be dis- closed to all loan applicants under Regulation Z (see Chapter 16).

The table below shows a sample of interest rates and discount points offered by competing lenders. The quotes are based on a $100,000, 30-year loan for an owner-occupied, single-family home. Which loan provides the lowest effective inter- est rate? The answer to this question requires use of the internal rate of return (IRR) concept discussed previously in Chapter 17.

Lender Interest Rate Points %

Loan Shack 7.875 0.50

Marley Lenders 7.625 1.00

First Bank 8.000 0.00

Spider Savings 7.250 3.50

To determine which loan provides the lowest effective interest rate, we first must calculate the payments required under each loan. Notice that payments are based on the full loan amount of $100,000. In three of these loans, borrowers must pay “points” to the lender at the time of origination. Therefore, the net amount dis- bursed by the lender at origination is determined by subtracting the fee from the loan amount. Using the definition of discount points and the mortgage payment calcula- tions described earlier, the cash flows for each loan are seen in the table below.

Lender Cash Flow at Origination Cash Flow in Periods 1–360

Loan Shack – $99,500 $725.07 Marley Lenders – 99,000 707.79 First Bank – 100,000 733.76 Spider Savings – 96,500 682.18

The effective interest rate for each of these loans is equivalent to the IRR of the cash flow stream. We can find the IRR of the cash flows in each loan using our finan- cial calculators or Microsoft Excel as shown below for the Spider Savings loan.

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C H A P T E R 18 Mortgage Mechanics 385

Financial Calculator Solution CF0 = –96500, CF1 . . . CF360 = 682.18, IRR = ?

(Some calculators report the monthly IRR. Multiply by 12 to convert to annual.)

Microsoft Excel Solution Put the cash flow amounts in 361 contiguous cells (A1=–96500, A2=682.18, A3=682.18, . . . ,A361=682.18).

In a blank cell, enter =irr(A1:A361,.10/12)*12.

Notice that Excel needs a starting “guess” in some IRR problems to find the solution in a rea- sonable amount of time.

Repeating this calculation for each of the loans provides the effective inter- est rates shown below. Notice that the effective interest rate on the loan from First Bank is the same as the stated interest rate because there are no points involved. The answer from our calculators (7.9999%) is slightly less than the stated rate because we rounded the payment amount to the nearest penny. As seen in the table below, of all four loans, the loan from Spider Savings provides the lowest effective interest rate, in spite of the large amount of points charged at origination.

Lender Stated Interest Rate Points % Effective Interest Rate

Loan Shack 7.875 0.50 7.9275

Marley Lenders 7.625 1.00 7.7287

First Bank 8.000 0.00 7.9999

Spider Savings 7.250 3.507 7.6123

Discount points and origination fees can have a dramatic impact on effective interest rates if the borrower prepays the loan. As we mentioned earlier, most loans are prepaid within five to seven years. To determine the effective interest rate when a loan is prepaid, we must calculate the amount outstanding on the loan at the time of prepayment. To demonstrate the effect of discount points and prepayment on effec- tive interest rates, assume that the loan from Spider Savings is prepaid at the end of month 60. What is the effective interest rate on the loan? To answer this question, first find AO

60 for each loan as described earlier, then enter the cash flows into your

financial calculator or Microsoft Excel. The solutions to the effective interest rate for the loan from Spider Savings are shown on the next page.

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386 PA RT F O U R Real Estate Finance and Investment Analysis

Financial Calculator Solution

1. Find AO60 = $94,379.29 by finding the present value of the remaining 300 payments of $682.18 at the stated annual interest rate of 7.25%: P/Y = 12, PMT = 681.19, N = 300, I/Y = 7.25, PV = ?

2. Find IRR using cash flows of: CF0 = –96500, CF1 = 682.18, . . ., CF59 = 682.18, CF60 = 682.19 + 94379.29 = 95061.47, IRR = ? (Multiply by 12 if your calculator doesn’t do this automatically).

Microsoft Excel Solution

1. Find AO60 = $94,379.29 by entering the following in a blank cell: =pv(.06/12,300,-682.18)

2. Put the cash flow amounts in 61 contiguous cells (A1=–96500, A2=682.18, A3=682.18, . . . ,A60=681.18,A61=682.18+94379.29=95061.47).

3. In a blank cell, enter irr(A1:A61,.10/12)*12. Notice that Excel needs a starting “guess” in some IRR problems to find the solution in a reasonable amount of time.

As you can see, prepaying a loan with high origination costs can increase the effective interest rate considerably. Prepaying the Spider Savings loan at the end of five years raises the effective interest rate to 8.1253%, which is significantly above the stated interest rate of 7.250%. Notice that the loan from First Bank has an effec- tive interest rate of 8%, regardless of prepayment. Furthermore, you should also realize that the earlier you prepay a loan with discount points, the greater the effec- tive interest rate. When shopping for a new mortgage among competing lenders, you should consider how long you expect to keep the loan before making a final choice.

| alternatives to the fixed-rate mortgage __________________

In addition to shopping for the best deal on a mortgage by comparing effective interest rates resulting from discount points or origination fees, borrowers may also wish to consider various alternatives to the fixed-rate mortgage. Several alterna- tive mortgage types are available, including two-step mortgages and adjustable-rate mortgages. The distinguishing feature of each of these loans is that the payments are not necessarily the same in each period. In the two-step mortgage, the pay- ment amount is re-established once during the life of the loan, usually at the end of year five or year seven. Payments in an adjustable-rate mortgage change more frequently, usually at the end of each year. Lenders are able to offer these loans at lower initial interest rates because the borrower is assuming some of the risk of future interest rate increases. If the general interest rate in the economy increases, the lender’s yield on the outstanding loan amount increases as well. Borrowers who are willing to accept this additional risk enjoy a lower initial interest rate. Borrow- ers who plan on prepaying the loan before it matures find this type of loan, as well

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C H A P T E R 18 Mortgage Mechanics 387

as the adjustable-rate loan discussed below, especially attractive. The tools we have developed in earlier sections help us understand the mechanics of these alternative loan types.

Understanding the Mechanics of Two-Step Mortgages

Two-step mortgages (also known as reset mortgages) are a relatively new type of loan in the residential lending market. Initial payments on this type of loan are calculated using the mortgage payment formula. At the end of five or seven years, depending on the contract terms, the payment is recalculated for the remaining bal- ance and term of the loan based on the prevailing interest rate. The prevailing interest rate is usually defined as the yield on 10-year Treasury bonds (or some other readily available national or international interest rate) plus 2 percentage points. In other words, the interest rate is “indexed” to the Treasury bond yield with a “margin” of 2%. Because the new interest rate may be higher or lower than the original interest rate, the payment amount changes accordingly.

This loan is advantageous to borrowers because the interest rate used to deter- mine the initial payments is lower than the interest rate on a fixed-rate mortgage. Borrowers who do not expect to hold their loans for the full term find the two-step mortgage especially attractive. Even if the loan is held to maturity, the borrower is protected against large payment changes by an interest rate “cap” that typically limits the increase in the interest rate to a maximum of 5 percentage points. The following example demonstrates the payment stream required in a typical two-step mortgage.

Two-Step Mortgage Example Consider a 30-year, two-step mortgage for $110,000. This type of loan is com-

mon in the subprime lending market discussed in Chapter 16. Borrowers are attracted to this type of loan because the initial rate is lower than the rate on a fixed-rate loan, but the rate is subject to increase (sometimes by large amounts) after some initial period (1 to 7 years). Most subprime borrowers who opt for this type of loan are hop- ing to improve their credit rating during the initial period or hoping that interest rates will decline when the adjustment occurs.

In this example, suppose the initial interest rate is 6 percent, but the loan contract requires that the interest rate be adjusted at the end of year 7 to 2 percentage points above the 10-year Treasury bond yield. The maximum increase in the interest rate is capped at a 5 percentage point increase over the initial rate. (In some subprime loans, the margin is as high as 6% and there is no cap on the increase over the initial rate.) At the end of year 7 , the 10-year Treasury yield is 6.9%. Assuming the loan is held to maturity, monthly payments are determined as follows.

First, calculate the payment due in months 1 through 84 using the loan amount of $110,000, 6% interest, and 30 years. The payment amount is $659.51. Second, find the amount outstanding at the end of month 84 ($98,603.32). Third, determine the new interest rate of 8.9% by adding the margin and the current Treasury yield.

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388 PA RT F O U R Real Estate Finance and Investment Analysis

Notice that the new interest rate is 2.9 percentage points above the initial rate, which is well within the limits of the interest rate cap. Finally, calculate the payment due in months 84 through 360 using the current loan balance, 23 years, and the new interest rate of 8.9%. The new payment is $840.69.

Financial Calculator Solution

1. Find monthly payment during first 84 months of $659.51: P/Y = 12, PV = 110000, I/Y = 6, N = 360, PMT = ?

2. Find AO84 = $98,603.99: PMT = -659.51, N = 276, I/Y = 6, PV = ?

3. Find new monthly payment for remaining 276 months of $840.69: PV = -98603.99, I/Y = 8.9, N = 276, PMT = ?

Microsoft Excel Solution

1. Find monthly payment during first 84 months of $659.51 by entering =pmt(.06/12,360,-110000)

2. Find AO84 = $98,603.99 by entering =pv(.06/12,276,-659.51)

3. Find new monthly payment for remaining 276 months of $840.69 by entering =pmt(.089/12,276,-98603.99)

Understanding the Mechanics of Adjustable-Rate Mortgages

Adjustable-rate mortgages are a common type of loan in both residential and commercial lending. As with two-step mortgages, the interest rate on an adjustable- rate mortgage (ARM) is subject to change as the general interest rate level in the econ- omy changes. The key difference is that the rate changes more than once during the term of the mortgage. In fact, most ARMs require annual rate adjustments, though some require adjustments every three or five years. In general, the initial interest rate on an ARM is lower than the rate on fixed-rate or two-step mortgages, which makes this an attractive loan type for many borrowers. Of course, ARM borrowers must be confident that they can afford the payment increases that are likely to occur over the life of the mortgage.

ARM interest rates are indexed to some general interest rate in the capital market. The most common index for residential ARMs is the one-year Treasury bill. The contract inter- est rate in any year of an ARM is defined as the index rate plus a margin of 2 or 3 percentage points. In the first year of an ARM, some lenders offer a “teaser” that reduces the margin by 1 or 2 percentage points. At each adjustment period, the contract interest rate is adjusted and the payments are recalculated. To protect borrowers (and lenders) against large payment changes, most ARMs have two types of interest rate caps. Annual caps limit the change in the contract interest rate to 2 percentage points above the prior year’s contract rate, and

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C H A P T E R 18 Mortgage Mechanics 389

lifetime caps establish a maximum and minimum contract rate that is within 5 percentage points of the initial contract rate. In many ARM loans, the caps “work” in both directions and thus may limit both increases and decreases in the interest rate.

ARM Example

Consider a 30-year ARM loan for $110,000. The interest rate is indexed to the one-year Treasury bill yield, with a margin of 2 percentage points. The lender offers a teaser of 1 percentage point for the first year. The loan requires annual rate adjust- ments, with an annual cap of 2 percentage points and a lifetime cap of 5 percentage points. We can use the following assumptions regarding the T-bill yield to determine the payment stream for the first four years of this loan.

T-Bill Contract Time Yield % Margin % Teaser % Rate % Payment $

At origination 4 2 –1 5 590.50

At end of first year 5 2 0 7 728.43

At end of second year 3 2 0 5 593.34

At end of third year 6 2 0 7 724.83

For each year, calculate the monthly payment using the current loan amount, remaining years, and the contract interest rate. Finding the current loan amount is accomplished by finding the amount outstanding at the end of each year. Notice that the teaser rate reduces the contract rate in the first year to 5%, and that the annual cap limits the contract rate at the end of the third year to 7%.

Financial Calculator Solution

1. Find the first year’s payment amount of $590.50: P/Y = 12, PV = –110000, I/Y = 5, N = 360, PMT = ?

2. Find the amount outstanding (balance) of $108,376.40 at the end of the first year: PMT = 590.50, I/Y = 5, N = 348, PV = ?

3. Find the second year’s payment amount of $728.43: PV = –108376.40, I/Y = 7, N = 348, PMT = ?

4. Find the amount outstanding (balance) of $107,183.75 at the end of the second year: PMT = 728.43, I/Y = 7, N = 336, PV = ?

5. Etc.

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390 PA RT F O U R Real Estate Finance and Investment Analysis

Microsoft Excel Solution

1. Find the first year’s payment amount of $590.50 using =pmt(.05/12,360,-110000)

2. Find the amount outstanding (balance) of $108,376.40 at the end of the first year using =pv(.05/12,348,-590.50)

3. Find the second year’s payment amount of $728.43 using pmt(.07/12,348,-108376.40)

4. Find the amount outstanding (balance) of $107,183.75 at the end of the second year using =pv(.07/12,336,-728.43)

5. Etc.

| chapter review __________________________________________

■■ In contrast to interest-only loans, amortizing loans require the periodic payment of both principal and interest. The balance outstanding on the loan decreases gradually through amortization of the principal.

■■ The amount outstanding on an amortizing loan at any regular payment date can be determined by finding the present value of the remaining payments. This rule is useful when faced with prepayment and refinancing decisions.

■■ The effective interest rate on a loan can be much higher than the stated contract rate, especially if the lender charges discount points or origination fees. One discount point means that the borrower must pay 1% of the loan amount at the time of origination. The internal rate of return provides a measure of the effective interest rate for loans that charge discount points or origination fees.

■■ Alternatives to the fixed-rate mortgage include two-step mortgages and adjust- able-rate mortgages. In both of these types of loans, the interest rate is subject to change over time which can cause adjustments in the payment amount. The borrower accepts some of the risk of future interest rate changes in exchange for a lower initial interest rate.

| key terms _______________________________________________

adjustable-rate mortgages

amortization schedule

amortizing loans

balloon payment

discount points

effective interest rate

fixed-rate mortgage

interest-only loan

origination fees

prepayment

refinancing

two-step mortgages

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C H A P T E R 18 Mortgage Mechanics 391

| study exercises _________________________________________

1. Define the following terms: interest-only loan, amortizing loan, balloon payment.

2. Construct an amortization schedule for a loan with the following character- istics. Loan amount = $10,000; term = 5 years; interest rate = 8%; annual payments.

3. Ron borrows $3,000,000 to purchase a warehouse. The annual interest rate on the loan is 8.25%, and the term of the loan is 15 years. Answer the fol- lowing questions about this loan:

a. What is the monthly payment necessary to amortize this loan?

b. What is the balance on the loan at the end of month 36?

c. How much interest will Ron pay in month 37?

d. How much principal will Ron pay in month 37?

e. How much principal will Ron pay in the fourth year of this loan (pay- ments 37 through 48)?

4. Suppose the loan in question 3 required 2 discount points at the time of origination.

a. If Ron keeps this loan for the full term, 180 months, what is his effective interest rate?

b. If Ron prepays the loan at the end of month 48, what is his effective interest rate?

5. Suppose Ron refinances the loan at the end of month 48 at the prevailing interest rate in the market (8%). Rather than reducing his monthly payment, however, Ron decides to keep making the same monthly payments.

a. How many months must Ron continue to make the payments on this new loan?

b. By how many months has Ron shortened the term of the loan with this strategy?

6. Consider a 30-year, two-step mortgage for $335,000. The initial interest rate is 5.5 percent, but the loan contract calls for a rate adjustment at the end of year 5. The new rate will be 2 percentage points above the 10-year Treasury bond yield. The interest rate is capped at 5 percentage points above the initial interest rate. If the T-bond yield is 7.5% at the time of the adjustment, what will the payments be for the last 25 years of this loan?

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392 PA RT F O U R Real Estate Finance and Investment Analysis

7. Consider a 30-year ARM for $335,000. The loan is indexed to the one- year T-bill yield, which is currently at 5.25%. The margin is 2 percentage points, and the teaser is 1.5%. The contract rate adjusts once at the end of each year, but the loan has annual and lifetime interest rate caps of 2 and 5 percentage points, respectively. The caps work in both directions and may limit both increases and decreases in the interest rate. Answer the following questions assuming that the actual T-bill yields for the first four years of this loan are the same as those shown below.

T-Bill Contract Time Yield % Margin % Teaser % Rate %

At origination 5.25 2 –1.5 ?

At end of first year 6.50 2 0.0 ?

At end of second year 7.75 2 0.0 ?

At end of third year 4.25 2 0.0 ?

a. What is the monthly payment during months 1 through 12?

b. What is the amount outstanding at the end of month 12?

c. What is the monthly payment during months 13 through 24?

d. What is the amount outstanding at the end of month 24?

e. What is the monthly payment during months 25 through 36?

f. What is the amount outstanding at the end of month 36?

g. What is the monthly payment during months 37 through 48?

8. A prospective homebuyer can afford to make monthly loan payments of no more than $475. If the best rate she can obtain on a mortgage is 10% (for a 25-year term), what is the maximum amount she can borrow?

9. Congratulations! You won the sweepstakes. The sweepstakes rules entitle you to a choice of one of the following prizes. Using the concept of present value, which choice is the most valuable to you if your opportunity rate is 8%?

Choice A: $40,000 per year for the next 20 years

Choice B: $25,000 today, plus $35,000 per year for the next 25 years

Choice C: $200,000 today, plus $12,000 per year for the next 40 years

10. Nikki’s mortgage requires her to pay $1,230 per month for the next 180 months. The balance on her loan is $130,000. What is the annual interest rate on Nikki’s loan?

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C H A P T E R 18 Mortgage Mechanics 393

| further reading _________________________________________

www.fanniemae.com

www.freddiemac.com

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19c h a p t e r Analyzing Income-Producing

Properties

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395

c h a p t e r p r e v i e w

One of the most exciting aspects of the real estate industry is investment in income-producing properties. History is filled with the names of people who have made, and sometimes lost, fortunes through real estate investments. The primary question to be considered in this chapter is this: “How do investors decide whether to invest in a particular project?” Successful investment decision making requires careful analysis of the risks and returns offered by an invest- ment opportunity.

The objective of this chapter is to describe the analysis methods successful investors use to make real estate investment decisions. In general, this process involves (1) evaluating a project’s competitive environment, (2) forecasting the cash flows that are expected to accrue to the investor, and (3) making a final decision about whether to proceed with the project. Our focus throughout this chapter is on decision-making situations facing equity investors who are consid- ering investing in existing income properties. In this chapter we

■■ discuss the advantages and disadvantages of real estate investment;

■■ review the concepts of investment and wealth maximization; and

■■ discuss how investors compare the costs and benefits of investment opportunities using net present value, the internal rate of return, and the discounted cash flow model for both “buy-and-holds” and “flips.”

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| advantages of real estate investment ____________________

What makes real estate an attractive investment category? While there are numer- ous motivations for pursuing real estate investments, investors often cite cash flow from operations, the possibility of value appreciation, portfolio diversification, and the ability to use financial leverage as the major incentives for pursuing real estate projects.

Cash Flow from Operations

For many investors, the primary attraction of real estate investments is the oper- ating cash flow generated by income-producing properties. The source of this cash flow is the rent paid by tenants for the use of space in the property. Because real estate is a durable asset, most properties are capable of generating rental revenue for many years into the future. From this revenue, the investor must pay the property’s operating expenses, debt service, and income taxes. Operating expenses typically include utilities, maintenance, property management, insurance, and property taxes. Debt service includes principal and interest payments on any outstanding mortgage debt. Income taxes are due on any taxable income generated by the property. Inves- tors refer to the annual operating cash flow that remains after these items are paid as after-tax cash flow from operations. Often referred to by its acronym, ATCF, this cash flow represents the money the investor puts in his or her pocket at the end of each year of the investment holding period.

Appreciation

Another motivation for investing in income-producing real estate is the possi- bility of appreciation in property value over the investment holding period. While investment properties do not always increase in value, investors generally choose properties whose values are expected to grow at the rate of inflation or greater. Fur- thermore, changing market conditions can improve a property’s competitive position in a market, allowing it to command higher rents and thereby increase its value to investors. When an investor sells an income-producing property, the proceeds from the sale, less selling expenses, are used to retire any outstanding mortgage debt and to pay any income taxes due as a result of the sale. To the investor, the sum of money that is generated by the sale of an investment is known as after-tax equity rever- sion, or ATER. The term equity reversion refers to the return of funds originally invested in the property, plus any change in the value of the investor’s investment in the property.

Portfolio Diversification

Another important motivation for investing in real estate is the diversification real estate adds to a portfolio. Combining real estate investments with investments in stocks and bonds allows investors to develop a diversified portfolio. Diversification

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C H A P T E R 19 Analyzing Income-Producing Properties 397

allows investors to maximize their investment returns while spreading their risk exposure across different types of investments. Such a strategy provides protection against an economic downturn in any one sector of the economy. In addition, many people are attracted to the security offered by investments in tangible assets that are under their personal control.

Financial Leverage

Real estate investors are also attracted to real estate because it allows the use of financial leverage, or “other people’s money.” The real estate finance industry makes debt capital readily available to most investors, with many lenders willing to provide 70% or more of the funds necessary to purchase investment properties. By borrowing additional investment funds from lenders, investors can control more real estate with less of their own funds. The use of borrowed funds has the effect of leveraging, or magnifying, the returns on funds invested by the investor. The benefits of leverage come at a price, however, because investors face increased risk. If the project fails to generate sufficient revenue to satisfy the debt service payments, the project may be forced into foreclosure.

Example of Financial Leverage To understand the impact of leverage on an equity investor’s rate of return, con-

sider the following example. Lou Lever has $100,000 to invest. He can (1) purchase a $100,000 property without using any borrowed funds or (2) use the $100,000 to make a 10% down payment on a $1,000,000 property and borrow $900,000 at 11% annual interest on an interest-only loan. If each of the two properties provides a 15 percent return before debt service and income taxes are considered, the second is clearly more advantageous owing to the effects of financial leverage. To see why, calculate Lou’s rate of return on his equity investment for both properties.

If Lou follows the first strategy, he would earn $15,000, or 15%, on his equity investment of $100,000. If he follows the second strategy, Lou would earn $51,000. This amount is calculated by first determining the total return on the investment (0.15 × $1,000,000 = $150,000), then subtracting the interest due on the borrowed funds (0.11 × $900,000 = $99,000). As a percentage of his equity investment of $100,000, the $51,000 ($150,000 – $99,000) reflects a 51% rate of return.

As you can see, financial leverage can greatly magnify the rate of return on equity. If the property in the second strategy provides an overall return of 18% instead of 15%, Lou’s rate of return on equity would jump to 81%; an overall return of 20% would balloon Lou’s return to 101%.

Of course, the magnification of the return on equity also works in the opposite direction. If, for example, the property provides a return of only 5% overall, then Lou would suffer a negative rate of return on equity of 49% (0.05 × $1,000,000 – 0.11 × $900,000 = –$49,000). The ability of leverage to magnify returns on equity implies that leverage increases risk. The additional risk comes from the fact that Lou has a fixed liability (interest on the debt) that he must satisfy each year. If the property’s

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398 PA RT F O U R Real Estate Finance and Investment Analysis

earnings are insufficient to cover the debt service, Lou stands to lose cash out of his pocket to keep the investment alive.

As a rule, financial leverage will increase the investor’s return on equity as long as the cost (interest rate) of the borrowed funds is less than the overall return on the investment. If the interest rate exceeds the overall return, then financial leverage will reduce the return on the investor’s return on equity, possibly causing it to be negative.

Disadvantages of Real Estate Investment

Though there are numerous advantages to investing in real estate, the disadvan- tages must not be ignored. For example, even with borrowed funds, real estate invest- ments often require relatively large capital requirements. Large-scale properties such as office buildings and shopping centers are often beyond the resources of individual investors. In addition, investing in real estate is risky, and the risk exposure may not be suitable for every investor.

In the preceding discussion we saw how financial leverage could increase the risk of an investment. Another aspect of real estate risk comes from the lack of liquid- ity that real estate investments have in comparison with other types of investments. Liquidity refers to the ability to convert an asset into cash quickly without having to accept a low price. For example, stocks are considered a liquid asset because an investor who wishes to sell a portfolio of common stocks can do so by simply call- ing a stockbroker. The broker will immediately sell the shares at the current market price. Real estate investors should anticipate that selling a property quickly may mean that the property will sell at a lower price than could otherwise be obtained.

Real estate investors also face the risk of changing economic conditions that may affect the rents they are able to charge to tenants and the value of investment properties. Successful investors spend considerable time and effort evaluating the markets in which their properties compete to understand how changing market con- ditions affect the risk exposure of their portfolios.

Weighing the benefits and costs of a real estate investment opportunity requires a high degree of knowledge about the characteristics of real estate markets and trans- actions, as well as careful consideration of the risks involved in real estate invest- ment. The next section takes a closer look at the process that real estate investors use when making the investment decision.

| financial decision making ________________________________

As we discussed in Chapter 17, all financial decisions involve a comparison of the expected benefits from a proposed course of action with the expected costs arising from that course of action. In this context, investment is defined as present sacrifice in anticipation of expected future benefit. Based on this definition, the deci- sion to continue your education is an investment, as is a decision to place money in a savings account for future use. If you do not expect the benefits of these activities to be greater than the sacrifices you must make, you would choose not to engage in

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C H A P T E R 19 Analyzing Income-Producing Properties 399

them. Similarly, real estate investment decisions require a comparison of the benefits a project is expected to generate with the sacrifices one must make in order to engage in the project.

The Wealth Maximization Objective

In order to make investment decisions, investors must define their criteria for determining the acceptability of alternative projects. Some investors pursue proj- ects that will generate income, while others are more interested in the appreciation potential that real estate offers. Other investors are in search of projects that provide tax-sheltering benefits, or those that have minimum management concerns. Although each investor has different interests, tastes, and preferences, the ultimate goal of all investors is to accept those projects that will maximize their wealth. Investors who pursue a wealth maximization objective will choose only those projects that offer expected benefits in excess of the costs of pursuing them and, if faced with a choice between two or more projects that increase wealth, wealth-maximizing investors will choose the project in which benefits exceed costs by the largest amount.

The NPV Rule

To evaluate the impact a project will have on wealth, investors use the net pres- ent value decision rule and the internal rate of return decision rule discussed in Chapter 17. We will review each of these rules in turn.

Recall that net present value (NPV) is defined as the present value of cash inflows less the present value of cash outflows. The conversion of future cash flows into present values is accomplished by discounting the future cash flows at the inves- tor’s required rate of return. The required rate of return reflects both the time value of money and the risk of the investment opportunity.

Investors use the NPV of a particular project as a decision rule by evaluating its sign (positive or negative). If the NPV of an investment is greater than or equal to zero, the investor should choose to invest because the investment is worth at least as much as it costs, given the investor’s required rate of return. If NPV is less than zero, the investor should choose not to invest.

Taking this rule one step further, if we are faced with several alternative invest- ment choices, we should accept the one with the highest positive NPV because it will increase our wealth more than the others. To use this rule in investment analysis, we must estimate the cash flows associated with an investment opportunity, then convert the cash flows into present values using the appropriate discount rate. The following example demonstrates the NPV decision rule.

Using the NPV Rule

Consider an investor who is facing a choice between two alternative investments. The investor has performed a detailed analysis of both projects’ competitive environ- ments and has developed the cash-flow forecasts shown below. He believes that both

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400 PA RT F O U R Real Estate Finance and Investment Analysis

projects are equally risky, and that the level of risk of the projects suggests an annual required rate of return of 15% for both projects. Which project should the investor choose?

Project A Project B

Initial investment $90,000 $80,000

Cash flow in year one 10,000 9,100

Cash flow in year two 11,100 10,000

Cash flow in year three 12,000 11,000

Cash flow in year four 12,000 11,000

Cash flow in year five 120,000 104,000

Given that the investor’s objective is to choose the project that increases his wealth by the greater amount, he should calculate the NPV of each project and choose the one with the higher NPV. These calculations are shown below:

Project A

NPV = 10,000 (1.15)1

+ 11,000 (1.15)2

+ 12,000 (1.15)3

+ 12,000 (1.15)4

+ 120,000 (1.15)5

– 90,000 = $1,501

Project B

NPV = 9,100 (1.15)1

+ 10,000 (1.15)2

+ 11,000 (1.15)3

+ 11,000 (1.15)4

+ 104,000 (1.15)5

– 80,000 = $703

Both projects result in a positive NPV, which suggests that both are good proj- ects that will result in a wealth increase to the investor above and beyond the cost of pursuing them. Because the NPV of project A is greater than the NPV of project B, the investor should choose A. By doing so, the investor expects to receive a return of 15%, plus a wealth increase of $1,501.

Using the IRR Rule

The internal rate of return decision rule also provides us with a “yes or no” deci- sion about whether to proceed with an investment opportunity. Notice that in project A, above, the investor’s required rate of return was 15%. Because the net present value is greater than zero, and because its NPV is larger than project B’s NPV, the investor should choose to accept this project. But what rate of return does the inves- tor expect to earn? Obviously, the investor expects to earn some rate above 15%. To find the exact return the investor expects to earn, we can define the internal rate of return (IRR) of an investment as the discount rate that makes NPV exactly equal to zero. To determine an investment’s IRR, we can search a variety of discount rates by trial-and-error until we find one that makes NPV equal zero. This rate will be the IRR on the investment. Fortunately, most financial calculators and computer spreadsheet software packages allow automatic searches for the IRR for a series of cash flows.

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C H A P T E R 19 Analyzing Income-Producing Properties 401

To use the IRR as a financial decision-making rule, we simply compare the IRR of an investment opportunity with our required rate of return. If the IRR is greater than or equal to our required rate of return, we choose to invest; otherwise, we forgo the investment opportunity. While the IRR rule and the NPV rule are based on the same principles, the NPV rule is generally the best choice to use because IRR calcu- lations may yield multiple discount rates that set NPV equal to zero. Furthermore, the NPV rule should be used when forced to choose between mutually exclusive projects such as those described above. When our objective is to determine the rate of return provided by an investment, however, the IRR calculation is extremely useful.

Real estate investors can use these decision rules to evaluate individual proj- ects and to decide whether to pursue them. Applying the rules, however, requires a forecast of the cash flows that the investor expects to receive during the investment holding period. The discounted cash flow model described below provides a system- atic framework for calculating the expected NPV and IRR of real estate investment opportunities on an “after-tax” basis.

| the discounted cash flow model __________________________

The NPV and IRR decision rules provide a sound basis for defining the suitabil- ity of an investment opportunity by identifying its impact on the investor’s wealth. Using these rules, we know that a “good” investment is one that is worth more than it costs, assuming all benefits and sacrifices are identified correctly. To put the deci- sion rules into practice, real estate investors often rely on the following discounted cash flow model.

NPV ATCF

ATER

i initial equityt

t t

T t T

= +

+ +

− = ∑

( ) ( )1 11

In this model, ATCF is the annual after-tax cash flow from operations, ATER is the after-tax equity reversion realized on the sale of the property at the end of the holding period, i is the investor’s required rate of return, T is the expected number of years the property will be held, and initial equity is the difference between the purchase price and any debt used to finance the purchase. Understanding the model requires careful consideration of the components of ATCF and ATER. The following example describes each of these concepts in detail.

Applying the Discounted Cash Flow Model

To illustrate some of the issues involved in real estate investment analysis, con- sider the decision facing Susan Adrep, an advertising account executive who is con- sidering adding real estate to her investment portfolio. Susan became interested in buying an income-producing property several months ago. She has discussed her interests with her accountant, local lenders, other real estate investors, and several different real estate brokers. Because this is her first real estate investment, she has decided to focus on smaller residential properties located in her neighborhood. After

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402 PA RT F O U R Real Estate Finance and Investment Analysis

looking at several properties that are currently available in the market, Susan feels that one property, a four-unit apartment building, deserves further consideration.

The property is located on a quiet street between a commercial district and an area containing single-family homes. Property values in this area have been increas- ing at approximately 3% per year over the past 10 years. The eight-year-old building was well-constructed and the owner has maintained the property in excellent condi- tion. The owner is moving to another city and has decided to sell the property rather than manage it as an absentee owner.

John Block, a local real estate broker, has agreed to market the property for the owner at a firm asking price of $455,000. John provides Susan with a summary of the rental income and operating expenses for the past several years. In addition, Susan talks with several lenders and learns that a 25-year, monthly payment mortgage loan can be obtained at 7% interest for 75% of the property value. Based on this infor- mation, as well as her own analysis of local market conditions, Susan develops the following forecast for income and expenses for her first year of ownership of the property.

Year 1

Rent ($1,325 per unit per month) $63,600

Annual rent increases 3.5%

Operating expenses

Maintenance and repairs 4,550

Insurance 3,975

Property taxes 11,375

Property management services 5,520

Total $25,420

Annual operating expense increase 3.5%

The question Susan faces is whether this property is a suitable investment for her portfolio. To make a decision about buying the property, Susan must identify the sacrifices she must make to acquire the property and compare those sacrifices with the benefits she expects to receive from this investment.

The sacrifices facing Susan Adrep in this project include the initial equity con- tribution she must make at the time of purchase and the risk she will be exposed to as a result of her decision to invest. Initial equity is the purchase price of a project less any debt that is used to complete the purchase. Risk is defined as the possibil- ity that the actual benefits provided by the investment will deviate from the inves- tor’s initial expectations. The benefits Susan expects to receive from pursuing this opportunity include the net cash flows that will occur during the investment holding period. Susan plans to hold this property for five years, beginning January 1 and end- ing December 31 five years later.

Expected benefits from real estate investments are typically divided into two categories: after-tax cash flows from operations and after-tax equity reversion. The first category refers to income received each year of the investment holding period,

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C H A P T E R 19 Analyzing Income-Producing Properties 403

and the second category refers to income that is realized when the property is sold. Because income taxes are an important consideration in any investment strategy, Susan must consider their impact on the income she expects to receive from this investment.

Forecasting ATCF

To forecast the after-tax cash flows from operations for the investment opportu- nity under consideration by Susan, we use the relationships shown in Table 19.1. We will consider the second category of cash flows in real estate investments, after-tax equity reversion, in the next section.

The starting point for estimating annual cash flows from operations in a real estate investment is potential gross income (PGI). PGI is the total income potential of the investment, assuming all leasable space is rented and all rents are collected. Investors must have knowledge of the expected rent for the space in the property to estimate PGI. The source of this knowledge is usually a survey of rental rates for similar space in other properties in the marketplace. For the property Susan is con- sidering, the PGI in the first year of her holding period is expected to be $63,600 ($1,325 rent per unit × 12 months × 4 units). Susan also believes that rents will increase at 3.5% per year for the next five years, which is her anticipated holding period.

ta b l e 19.1 After-Tax Cash Flows from Operations for Year 1

Potential Gross Income – Vacancy and Credit Losses

PGI – VCL

$63,600 3,180

= Effective Gross Income – Operating Expenses

= EGI – OE

$60,420 25,420

= Net Operating Income – Debt Service

= NOI – DS

$35,000 28,943

= Before-Tax Cash Flow – Income Tax (calculated below)

= BTCF – Tax

$6,057 279

= After-Tax Cash Flow = ATCF $5,778

Tax Calculations

Net Operating Income – Interest Expense – Cost Recovery Allowance (depreciation)

NOI – Int

– CRA

$35,000 23,722 10,280

= Taxable Income × Ordinary Tax Rate

= TI × OTR

$998 0.28

= Income Tax = Tax $279

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404 PA RT F O U R Real Estate Finance and Investment Analysis

Calculating Net Operating Income Because some of the PGI may not be received as a result of vacancies or uncol-

lected rents, an allowance for these items should be deducted from PGI in the form of vacancy and credit losses (VCL). The forecasted allowance of VCL (often expressed as a percentage of PGI) depends on observations of historic data, comparable prop- erties, and general market conditions. For new properties, the vacancy rate may be quite high during the initial leasing period, and older properties in declining areas may experience high credit losses from faltering tenants. Susan believes that 5% of PGI is a reasonable allowance for the property she is considering, so the VCL in year one is expected to be $3,180 (63,600 × 0.05). Subtracting VCL from PGI results in effective gross income (EGI), or the actual amount of rental revenue expected to be received each year.

With revenues accounted for, the next step is to subtract operating expenses (OE) from EGI to determine net operating income (NOI). OE includes any expen- ditures made in the operation of the investment property such as maintenance costs, management fees, property taxes, insurance premiums, and utility fees. NOI is the amount of revenue left after paying the expenses of operation, but before paying the mortgage payments and income taxes on the investment. In this case, Susan feels that OE for year one will be $25,420, resulting in NOI of $35,000. She also believes that these expenses will increase by 3.5% each year.

Debt Service Susan now must consider the impact of financing on this investment opportu-

nity. Using the mortgage payment formula described in Chapter 13, Susan calculates the monthly payment required to amortize a 25-year loan for $341,250 ($455,000 × 0.75) at 7% annual interest. Multiplying this amount, $2,411.88 × 12 gives debt service (DS) of $28,943. Subtracting DS from NOI results in the before-tax cash flow (BTCF) of $6,057. Because taxes are a real expense, however, the analysis must be based on after-tax cash flow (ATCF). To calculate the annual income tax consequence of Susan’s investment, we must first determine the taxable income (TI) generated by this project.

Taxable Income Two items that require careful consideration when determining TI in most real

estate investments are (1) interest expense and (2) cost recovery allowances. Con- sidering interest expense (Int) first, notice that we subtracted the debt service from NOI to get BTCF. DS, however, also includes principal repayments, which are not tax-deductible. Therefore, BTCF is not the same as TI. To determine TI, we subtract only the interest component of DS from NOI. Recall from the discussion of amortiz- ing loans in Chapter 18 that the amount of interest in each payment is reduced as the loan balance declines. Developing an amortization schedule for the loan used to finance a property investment allows us to determine the amount of interest paid each year. To construct an amortization schedule, the mortgage payment is calculated by the mortgage payment formula, then each payment is separated into interest and principal components. If payments are made more frequently than once each year,

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C H A P T E R 19 Analyzing Income-Producing Properties 405

annual totals are necessary. An amortization schedule for Susan’s loan is shown in Table 19.2. Interest in year one totals $23,722.

The second item to consider when calculating TI is the amount of the cost recov- ery allowance (CRA). Income tax laws allow CRAs (also known as depreciation deductions) that provide investors with a means of recovering their original capital investment without paying taxes on this amount until the property is sold. Nonresi- dential and residential property improvements have depreciable lives of 39 and 27.5 years, respectively. Land is not depreciable under current tax laws, so the amount of the purchase price attributable to improvements must be identified separately.

To determine the annual CRA, we divide the value of the improvements by the appropriate depreciable life. Assuming that the value of the building alone is $295,000, the annual CRA is $10,727 ($295,000 ÷ 27.5). Under current tax laws, however, an investor must make some additional calculations to determine the CRA during the first and last years of ownership. As a rule, the investor is presumed to have purchased the property in the middle of the month in which the property was purchased or sold, regardless of the actual day of the month the transaction occurs. For example, if an investor buys a property in January, the CRA for the first year of ownership is 11.5 ÷ 12 of the annual amount. Similarly, if the investor sells the property in July of a later year, the CRA is 6.5 ÷ 12 of the annual amount for the last year of ownership.

In the example being considered here, we can assume that Susan buys the prop- erty in January of year one and sells the property in December of year five. The cost recovery allowances in those two years will be $10,280 ($10,727 × 11.5 ÷ 12). For years two, three, and four, the full deduction of $10,727 is used. In this example, subtracting interest and CRA from NOI yields TI in year one of $998.

Income Taxes Annual income taxes are calculated by multiplying TI by the investors’ ordi-

nary income tax rate. Susan faces an ordinary income tax rate of 28%. Therefore,

ta b l e 19.2 Amortization Schedule

Year Debt Service Interest Principal Amount Outstanding

0 0 0 0 $341,250

1 $28,943 $23,722 $5,220 336,030

2 28,943 23,345 5,598 330,432

3 28,943 22,940 6,003 324,429

4 28,943 22,506 6,436 317,993

5 28,943 22,041 6,902 311,091

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406 PA RT F O U R Real Estate Finance and Investment Analysis

the taxes from operations in year one are $279 ($998 × 0.28). (In the event that TI is a negative number, which is sometimes the case in real estate investments, the tax loss may be used to offset TI from other investments in the investor’s portfolio, or carried forward. (A full discussion of the tax implications of real estate investment is beyond the scope of this text.) Subtracting taxes from BTCF yields ATCF in year one of $5,778.

These calculations are repeated for each year of the investment holding period as shown in Table 19.3. Thus far in her analysis of this property, Susan knows that she must invest $113,750 (purchase price minus the loan amount) in return for annual cash flows from operations shown in the table for years one through five. Susan must now forecast the cash flow she will receive at the end of year five from selling the property.

Forecasting ATER

The second source of cash flow in real estate investments to be considered comes from the sale of the property at the end of the holding period. After-tax equity rever- sion (ATER) is the term used to represent the after-tax cash flow to the investor

ta b l e 19.3 After-Tax Cash Flows from Operations

Year 1 Year 2 Year 3 Year 4 Year 5

Potential Gross Income – Vacancy

$63,600 3,180

$65,826 3,291

$68,130 3,406

$70,514 3,526

$72,982 3,649

= Effective Gross Income – Operating Expenses

$60,420 25,420

$62,535 26.310

$64,723 27,231

$66,989 28,184

$69,333 29,170

= Net Operating Income – Debt Service

$35,000 28,943

$36,225 28,943

$37,493 28,943

$38,805 28,943

$40,163 28,943

= Before-Tax Cash Flow – Income Tax (calculated below)

$6,057 279

$7,282 603

$8,550 1,071

$9,863 1,560

$11,221 2,196

= After-Tax Cash Flow $5,778 $6.680 $7,479 $8,302 $9,025

Tax Calculations

Net Operating Income – Interest Expense (from amortization table below) – Cost Recovery Allowance (depreciation)

$35,000 23,722 10,280

$36,225 23,345 10,727

$37,493 22,940 10,727

$38,805 22,506 10,727

$40,163 22,041 10,280

= Taxable Income × Ordinary Income Tax Rate

$998 0.28

$2,153 0.28

$3,826 0.28

$5,572 0.28

$7,842 0.28

= Income Tax $279 $603 $1,071 $1,560 $2,196

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C H A P T E R 19 Analyzing Income-Producing Properties 407

when the property is sold. The relationships involved in the calculation of ATER for Susan’s investment opportunity are presented in Table 19.4.

The starting point in determining the ATER is forecasting a future sale price. Gross selling price is the estimated transaction price that will be negotiated between the buyer and the seller at the time of the transaction. To estimate the selling price, Susan assumes that the value of her property will increase by about 4% each year. If it is worth $455,000 at the time of purchase, and increases in value by 4% annually, it will sell for approximately $554,000 at the end of five years.

From this amount, Susan subtracts $33,240 (6% of gross selling price) for expenses she expects to incur during the sale, including such items as brokerage commissions and attorney fees. The difference between the sale price and selling expenses gives net selling price of $520,760. Subtracting the mortgage payoff amount (amount outstanding at the end of year five from the amortization schedule) of $311,091 from the net selling price gives the before-tax equity reversion (BTER) of $209,669.

ta b l e 19.4 After-Tax Equity Reversion

Gross Selling Price – Selling Expenses

$554,000 $33,240

= Net Selling Price – Mortgage Payoff (amount outstanding)

$520,760 311,091

= Before-Tax Equity Reversion – Tax Due on Sale (calculated below)

$209,669 15,138

= After-Tax Equity Reversion $194,531

Tax Due on Sale

Cost Recovery Allowance Recapture Tax Calculations Total Cost Recovery Allowance × Recapture Tax Rate

$52,741

25%

= Cost Recovery Allowance Recapture Tax $13,185

Capital Gain Tax Calculations Net Selling Price – Total Cost Recovery Allowance – Purchase Price

$520,760 $52,741

$455,000

= Capital Gain × Capital Gain Tax Rate

$13,019 15%

= Capital Gain Tax $1,953

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408 PA RT F O U R Real Estate Finance and Investment Analysis

The next step is to calculate the income tax due on sale of the property. Under current Internal Revenue Service rules, two different tax rates are applied to the gain from the sale of a capital asset: the cost recovery allowance recapture rate of 25% and the capital gain tax rate of 15%. (Note that these rates and, indeed, all IRS rules are subject to change and may not be the same for all taxpayers. Also note that we are ignoring any state and local taxes in this example.) The cost recovery allowance recapture tax rate is applied to the total of of the cost recovery allowances during the investment holding period. In this example, Susan has claimed a total of $52,741 in cost recovery allowance. Thus, her cost recovery recapture tax is $13,185, or 25% of $52,741. The capital gain tax rate is applied to the remaining gain on the investment, which is calculated by subtracting total cost recovery allowance and the initial pur- chase price from the net selling price. This results in a capital gain of $13,019 that is subject to the 15% capital gain tax rate. Susan must pay $1,953 in capital gain tax. The total tax due on sale (the sum of the cost recovery allowance tax and the capital gain tax) is $15,138. ATER is determined by subtracting tax due on sale from the BTER. Based on these calculations, Susan expects to receive an ATER of $194,531.

Now that we have carefully estimated ATCF and ATER for Susan’s investment opportunity, we can apply the discounted cash flow model and decide whether she should proceed with this project. Given a loan amount of $341,250 and a purchase price of $455,000, the equity required to buy this property is $113,750. Assume that Susan believes a required rate of return of 10% reflects the risk of the investment as well as the time value of money over the holding period. Using the estimated ATCF for each year of the holding period and the estimated ATER, Susan calculates NPV as follows:

NPV = 5,778 (1 + 0.10)1

+ 6,680 (1 + 0.10)2

+ 7,479 (1 + 0.10)3

+ 8,302 (1 + 0.10)4

+ 9,025 (1 + 0.10)5

+ 194,531 (1 + 0.10)5

– 113,750 = $34,705

Susan also calculates the IRR for this cash flow stream to be 17%. Based on both the NPV and IRR decision rules, Susan should choose to purchase this property. While there is no guarantee that this property will be a profitable investment, the discounted cash flow model provides a systematic process for analyzing investment choices and evaluating them with the objective of maximizing investor wealth. The accuracy of the technique depends on the quality of the information used to develop the cash-flow forecasts and on the appropriate evaluation of the risk of the invest- ment when formulating a required rate of return.

Another Type of Real Estate Investment: Property Flipping

The above discussion focuses on analysis of the “buy-and-hold” real estate investment strategy. Another popular way for entry-level investors to get involved in real estate investments is known as property flipping. Whereas buy-and-hold investors count on income produced by the property during the holding period as well as appreciation in property value that is captured upon sale of the property, flip

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C H A P T E R 19 Analyzing Income-Producing Properties 409

investors rely on the increase in property value as a result of property improvement during a very short holding period.

There are many variations of property flipping investment, but a common strat- egy of flippers is to identify a house or other property that has a current market value below the market value of other properties in the neighborhood, buy that property at the lowest possible price, then spend funds to update the property to bring its value up to the value of other properties, then sell it for a profit in excess of the original purchase price and the funds expended to improve it. This type of flipping can also be thought of as a redevelopment project.

The same tools we used to analyze a buy-and-hold investment opportunity can easily be used to consider flips. The NPV and IRR decision rules are the recom- mended tools for evaluating a flipping opportunity. Let’s consider the following example of a property flip.

Suppose you find a neighborhood in which houses are typically selling for around $325,000. You find a house that is in need of updating and repair that can be purchased for $265,000 including all acquisition costs. You estimate (perhaps with the help of qualified contractors) that updates and repairs will cost $40,000 and your research indicates that you will be able to sell the renovated property for $320,000 net of all disposal costs (broker fees, etc.). Further suppose that you approach a lender who agrees to provide a short-term, non-amortizing loan at 10% annual interest with a maximum loan balance of 70% of the estimated market value upon completion of the redevelopment project from the sale proceeds of $320,000. The interest on this loan will accrue during the development period and must be paid (along with the original loan balance) upon sale of the property. The maximum term of this loan is six months. How do you decide if this flip opportunity is a worthwhile investment if your required rate of return is 18% annually?

Subtracting the cost of purchasing the property, the cost of renovating the prop- erty, and the interest cost on the loan from the ultimate selling price gives the expected profit on the flip. Of course, the cash flows (in and out) in this deal occur over time, so we must incorporate time value of money into our analysis. Let’s assume for this example that the purchase occurs on January 1. We have to pay 30% of the purchase price in the amount of $96,000 ($320,000 × 0.30 = $96,000) on this date. Notice that the down payment is based on the expected sale price, not the actual purchase price. This condition of the loan ensures that the loan amount (not including interest) does not exceed 70% of the value of the property.

Based on the work that needs to be done to the property, we expect to pay the contractors who do the work $20,000 on February 1, $15,000 on March 1, and $5,000 on April 1. Our lender will give us these funds at the times we pay the contractors for their work. We need to know how the loan balance grows during the renovation period. The timeline for the loan balance is as follows.

Date Loan Balance (including accrued interest)

January 1 $169,000.00 ($265,000 – $96,000 = $169,000)

February 1 $190,408.33 ($169,000 × (1 + 0.10/12) + $20,000 = 190,408.33)

March 1 $206,995.07 ($190,408.33 × (1 + 0.10/12) + $15,000 = $206,995.07)

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410 PA RT F O U R Real Estate Finance and Investment Analysis

April 1 $213,720.03 ($206,995.07 × (1 + 0.10/12) + $5,000 = $213,720.03)

May 1 $215,501.03 (213,720.03 × (1 + 0.10/12) = $215,501.03)

We forecast that we will sell the property on May 1 for $320,000. The timeline for our cash flows is as follows:

Date Cash Flow

January 1 –$96,000

February 1 0

March 1 0

April 1 0

May 1 $104,498.97 ($320,000 – $215,501.03 = $104,498.97)

Solving for the NPV at our annual required rate of return of 18% gives $2,457.28 as shown below. The monthly IRR of this investment opportunity is 2.14% and the annual IRR is 25.7%.

NPV = –96,000 + 104,498.97 / (1 + 0.18/12)4 = $2,457.28

Both the NPV and IRR decision rules suggest that this is an opportunity we should pursue.

While this rate of return looks impressive, flippers must keep in mind that there are risks to flipping. The flippers might not be able sell the property for as much as they expect, or they may discover that the time to sell the property is longer than they expect which would cause them to incur additional interest expense. Experience and good market research helps flippers properly evaluate the risk of the flip and deter- mine their required rate of return for the given risk level.

| chapter review __________________________________________

■■ Investing in real estate is one of the most exciting aspects of the real estate industry. To be a successful real estate investor requires considerable knowledge about all of the topics addressed in this text. In addition, inves- tors must have a clear understanding of the criteria they should use when evaluating an investment opportunity.

■■ Advantages of investing in income-producing properties include cash flow from operations, appreciation in property value, portfolio diversifica- tion, and financial leverage. Disadvantages include relatively large capital requirements, risk, and the lack of liquidity of real estate investments.

■■ The net present value decision rule provides a basis for sound financial decision making that is consistent with the objective of wealth maximiza- tion. To apply this rule to real estate investment opportunities, we must develop a forecast of the expected cash flows the projects are likely to generate.

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C H A P T E R 19 Analyzing Income-Producing Properties 411

■■ The discounted cash flow model is the recommended framework for mak- ing real estate investment decisions. By forecasting the cash flows that are likely to result from operating the property during each year of the hold- ing period and the cash flow that will result when the property is sold, we can calculate the expected net present value of an investment opportu- nity. Using the net present value rule, we can then make a decision about whether the project is expected to increase our wealth.

■■ Estimating after-tax cash flow requires estimates of potential gross income, vacancy and credit losses, operating expenses, mortgage amortization, and a thorough understanding of income tax rules regarding real estate invest- ment. Estimates of after-tax equity reversion are obtained by subtracting selling expenses, taxes due on sale, and the amount outstanding on any loans from the sale price of the property. Converting these cash flows into present value is accomplished by discounting them at the rate of return that reflects the time value of money and the risk of the investment opportunity.

■■ If the present value of after-tax cash flow and equity reversion exceed the equity required, then the net present value is positive, and the investor should choose to accept the project.

■■ The same tools used to evaluate “buy-and-hold” properties can be used to analyze other types of real estate investment, including property flips.

| key terms _______________________________________________

after-tax cash flow

after-tax equity reversion

appreciation

before-tax cash flow

before-tax equity reversion

book value

capital gain

capital gain tax

capital gain tax rate

cost recovery allowance

debt service

discounted cash flow model

effective gross income

financial leverage

gross selling price

income taxes

initial equity

internal rate of return

investment

net operating income

net present value

net selling price

operating cash flow

operating expenses

potential gross income

property flipping

required rate of return

risk

taxable income

vacancy and credit losses

wealth maximization objective

| study exercises _________________________________________

1. What are the attractions of real estate as an investment?

2. What are the disadvantages of real estate as an investment?

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412 PA RT F O U R Real Estate Finance and Investment Analysis

3. Explain the logic behind the net present value decision rule and the internal rate of return decision rule.

4. Why do you suppose the depreciable life for residential investment proper- ties is shorter than that of nonresidential properties? How does this fact influence an investor’s decisions?

5. A real estate broker is offering an apartment building for sale that has the following characteristics:

a. The asking price is $3.5 million, with the land valued at $500,000.

b. The 160 apartment units rent for $450 per month with rent expected to increase by 4% per year starting in year two.

c. Vacancy and bad debt allowance is 6% of the potential gross income.

d. Operating expenses are expected to be 32% of effective gross income each year.

e. The real estate agent estimates that the value of the property, net of sell- ing expenses, will be $4.4 million at the end of a five-year investment horizon.

f. A 12%, 20-year mortgage for $2 million is available with monthly payments.

g. The cost recovery allowance recapture tax rate is 25%. The investor’s ordinary income tax rate is 28% and his or her capital gain tax rate is 15%. The investor has several profitable real estate investments and can utilize any tax losses. The appropriate discount rate for this investment (the required rate of return) is 18%.

Calculate the relevant cash flows for this investment and apply the NPV and IRR rules to decide whether to pursue this project.

6. Suppose the property in the flip example on page 413 sells for only $315,000 and instead of selling on May 1 sells on June 1. Taking into con- sideration the addition accrued interest, what is the expected return to the investor (annualized IRR)?

| further reading _________________________________________

Jaffe, A.J., and C.F Sirmans. Fundamentals of Real Estate Investment, 3rd ed. Englewood Cliffs, N.J.: Prentice-Hall, 1995.

Kolbe, Phillip T., and Bennie D. Waller Jr. Investment Analysis for Real Estate Decisions, 8th ed. La Crosse, Wisconsin: Dearborn Real Estate Education, 2013.

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413

absorption rate the number of units capable of being absorbed by the market over a given time period.

acceleration clause clause in a promissory note that permits the lender to demand payment in full of any unpaid principal and any interest due in the event of default.

acceptance an expression of satisfaction with an offer.

accrued depreciation loss in value from any cause.

actual cash value the cost of replacing an insured item minus the amount by which the item has depreci- ated in value since it was new.

adaptive use use of a building in a manner different from the use for which it was originally designed.

adjustable-rate mortgage a loan whose interest rate is periodically adjusted based on the current interest rate environment.

ad valorem tax a tax levied as a percentage of the value of the taxed item.

adverse possession the acquisition of property as a result of “actual and exclusive, open and notorious, hos- tile and continuous” possession under a claim of right for a statutory period of time.

after-tax cash flow annual operating cash flow that remains after expenses, debt service, and taxes have been paid.

after-tax equity reversion the amount of money gen- erated by the sale of an investment after taxes have been paid and any debts extinguished.

agency a legal relationship between a principal and an agent.

agent the party authorized to conduct business on the principal’s behalf.

agreements for deed a type of seller financing in which the borrower/buyer makes payments to the seller/ lender until an agreed-upon amount has been paid and the seller/lender then delivers the deed to the buyer.

air lot property that does not actually touch the ground.

airport hotel a hotel near an airport that caters to business travelers.

air rights property rights associated with the space above the surface of the earth.

alienable a property owner’s right to transfer interests owned in a property during his or her lifetime.

amortization the process of gradually retiring a loan or other asset; also, the requirement that a nonconform- ing use be discontinued after a stated period of time.

amortization schedule a table showing the break- down of principal and interest paid over the life of a mortgage.

amortizing loan a loan whose balance is gradually retired by periodic payments.

annuity a series of equal amounts, received one at the end of each period, for a specified number of periods.

anticipation the idea that the current value of a prop- erty depends on the anticipated utility or income that will accrue to the property owner in the future.

appraisal an estimate of value.

g l o s s a r y

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414 Glossary

Appraisal Foundation a nonprofit educational orga- nization formed by the appraisal profession in 1987.

appraisal process a systematic procedure employed to arrive at an estimate of value and convey that estimate to the appraisal user.

Appraisal Qualification Board under FIRREA, established minimum education and experience guide- lines that states must use to issue appraisal licenses and certifications.

Appraisal Standards Board set forth the rules appraisers must follow when developing an appraisal and reporting its results.

appreciation increase in property value of a property for tax purposes.

assessed value the estimated value of a property for tax purposes.

assessment the process of estimating the market value for all properties within a property tax jurisdiction.

assessment ratio the fraction used to determine assessed value from market value.

asset manager a company executive charged with management of the firm’s real estate facilities and activities.

assignment the act of passing all of one’s rights and responsibilities under a legal agreement to a third party.

axial model a model of urban growth patterns based on transportation routes.

balloon payment a lump sum payment due on a speci- fied date in the future.

bargain and sale deed a deed that simply states that the grantor has title to the property and the right to con- vey it but does not contain any express covenants or warranties to the title’s validity.

base lines east-west lines used as reference points in the rectangular survey system.

before-tax cash flow annual operating cash flow that remains after expenses and debt service have been paid.

before-tax equity reversion the amount of money generated by the sale of an investment before taxes have been paid.

bid-rent curve theoretical relationship between dis- tance and land rent.

blockbusting the illegal practice of encouraging prop- erty owners to sell their homes when minorities begin moving into an area.

book value value of a property as stated on the com- pany’s books.

breach of contract failure to perform a required con- tractual obligation.

broker an intermediary who brings together buyers and sellers, assists in negotiating agreements between them, executes their orders, and receives compensation for services rendered.

building codes regulations that establish standards for the construction of new buildings and the alteration of existing ones.

bulk limitations zoning regulations that control the percentage of lot area that may be occupied by buildings.

business owner’s policy an insurance policy for small and medium-sized businesses.

business risk uncertainty arising from changing eco- nomic conditions that affect an investment’s ability to generate returns.

buyer representation agreement the legal agreement between a buyer and a broker hired to represent the buy- er’s interests.

buyer’s agent a broker who is legally obligated to represent a buyer’s interests.

capacity legal ability to understand and accept the terms of a contract.

capital gain the amount calculated as net sale pro- ceeds less original purchase price plus all depreciation deductions taken in previous years.

capital gain tax taxes assessed on capital gains.

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Glossary 415

capital gain tax rate a preferential tax rate given to long-term investors.

capitalization rate the relationship between income and value, where the capitalization rate equals net oper- ating income divided by property value.

capital market the market for capital assets of all types.

cash on cash return the amount calculated by dividing the amount of equity invested in a property by an esti- mate of annual before-tax cash flow (BTCF ÷ equity).

CC&Rs convenants, conditions, and restrictions.

central business district an unplanned series of buildings constructed along major streets in the center of town.

certified general appraiser an appraiser who is certi- fied by the state to perform appraisals on all property types.

certified residential appraiser an appraiser who is certified by the state to perform residential appraisals regardless of complexity.

chain of title ownership history of a specific property.

change the idea that economic, social, political, and environmental forces are constantly causing changes that affect the value of real estate.

chattel personal property.

closing the settlement of a real estate transaction.

closing costs costs associated with closing a real estate transaction.

closing statement a worksheet showing the sources and uses of funds in a real estate transaction.

coinsurance the joint assumption of risk by two or more parties.

commercial bank private financial institutions orga- nized to accept deposits from individuals and businesses and to loan these funds to all types of borrowers.

commercial hotel a hotel that caters primarily to busi- nesspeople and conventioneers.

commercial mortgage-backed securities traded securities that have commercial mortgages as their col- lateral and source of cash flow.

commission the compensation received by a broker for services rendered.

commission agreement an agreement between a seller and a broker for the payment of a commission if the broker is successful in locating a buyer for the seller’s property.

common area maintenance fees (CAM fees) costs of maintaining the common areas of a commercial prop- erty that are typically passed through to tenants.

community an area containing properties of similar type. It also can be defined by reference to geographi- cal area; to social, religious, or ethnic ties; or to income group.

community center designed to serve an area within a 3- to 5-mile radius with a wider variety of merchandise than a neighborhood center.

community property theory under which all property acquired during a marriage is considered to be equally owned by the husband and wife, regardless of the finan- cial contribution each spouse actually made to the prop- erty’s acquisition.

community shopping center a shopping center con- taining between 100,000 and 300,000 square feet of gross leasable area that is designed to serve an area within a 3- to 5-mile radius.

comparative advantage the advantage one locale has over another because of transportation facilities, created environment, natural resources, or its labor force.

compounding the process of converting present amounts into future amounts.

compound interest interest earned on a principal amount plus any interest previously earned.

comprehensive general plan a statement of land- use policies that shape the future development of a community.

comprehensive zoning division of a community’s land into specific land-use districts to regulate the use of land and buildings and the intensity of various uses.

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416 Glossary

concentric-circle model a model of urban growth pat- terns based on concentric zones surrounding a central business district.

concurrent estate ownership interests held jointly by two or more owners.

condominium a form of joint ownership whereby the property owners own their individual units separately but share ownership of common areas; a building owned in this manner.

condominium declaration legal document that describes the individual units and common areas of a property owned as a condominium, creates an associa- tion to govern the property, and sets forth restrictions on use.

conservation easement a type of negative easement that prevents specific uses of the real estate by the owner, generally used to protect open space.

consideration anything that incurs legal detriment or the forgoing of a legal benefit.

Consumer Credit Protection Act the Truth-in-Lend- ing law.

contingencies terms of a contract that may result in the contract being canceled if certain events occur.

contingent remainder a remainder interest that has conditions attached that can prevent the remainderman from receiving a present interest in the property.

contract a legal device used by two or more persons to indicate they have reached an agreement.

contract for deed an arrangement that stretches out payments to the seller over time while allowing the seller to retain legal title until the debt is paid.

contractual capacity the mental ability to understand what a contract represents and the meaning of its terms.

contribution the idea that the value of a component part of a property depends on the amount it contributes to the value of the whole.

conventional loan mortgage loans not insured or guaranteed by a government agency but that may carry private mortgage insurance.

cooperative a form of joint ownership whereby the property owners own shares of stock in a corporation that owns the property and are entitled to occupy space within the building.

cost approach a method used to estimate value by implementing the following steps: (1) estimate the value of the site as though it were vacant, (2) estimate the cost to produce the improvements, (3) subtract accrued depreciation, and (4) add site value to the estimated depreciated cost of the improvements.

cost recovery allowance a deduction from taxable income provided to investors under the IRS code that allows investors to recover their initial investment in the property and delay taxes on this amount until the sale of the property in the future.

counteroffer a response to an offer that represents a new offer.

covenant a promise or guarantee made by a grantor in a deed.

covenant against encumbrances an assurance made by the grantor that no liens or encumbrances other than those of public record exist against the property.

covenant of further assurances an assurance made by the grantor that the grantor will execute any future documents needed to perfect the grantee’s title.

covenant of quiet enjoyment an assurance made by the grantor that no other party will disturb the grantee claiming to own the property or to have a lien on it; a promise from the lessor that the tenant has the right of exclusive possession of the property during the term of the lease.

covenant of seisin an assurance made by the grantor that he or she is in full possession of the interest being conveyed by a deed and thus has the right to convey it.

covenants, conditions, and restrictions (CC&Rs) private techniques for restricting land use.

credit union credit institution designed to serve a spe- cific industry or community.

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Glossary 417

debt coverage ratio calculated by dividing net oper- ating income by debt service (NOI ÷ DS).

debt service total amount paid to lenders to service outstanding debt.

deed a written document that evidences ownership.

deed in lieu of foreclosure a process by which a bor- rower transfers ownership of a mortgaged property to the lender rather than face foreclosure.

deed of trust a security instrument that conveys title to the property pledged as collateral to a trustee until the loan is repaid.

defeasible estate an estate that can be lost should some event or stated condition come to pass.

deficiency judgment a judgment against a borrower following a foreclosure that permits the lender to recover any shortfall between the sale price and the balance of the loan.

demand the amount or quantity of the good or service that will be desired at various prices.

depreciation the amount by which the value of a building has declined since it was built as a consequence of physical deterioration, functional obsolescence, and economic obsolescence.

depreciation deduction a noncash deduction permit- ted by the Internal Revenue Service (IRS) for capital recovery.

descendible a property owner’s right to transfer inter- ests owned in a property to legal heirs should the owner die without a valid will.

devisable a property owner’s right to transfer interests owned in a property via a will.

direct losses costs of replacing or repairing property destroyed or damaged.

discounted cash flow model model used by investors to judge the suitability of a real estate investment.

discounting the process of converting future amounts into present amounts.

discount point 1% of the loan amount.

discount shopping center a community shopping center that contains a discount store as the main tenant.

documentary stamp tax a fee charged by the public records authority to record a document in the records system.

dominant estate the property benefited by the exis- tence of an easement appurtenant.

dual agency a legal relationship that exists when an agent is legally obligated to represent the best interests of two competing principals.

dual agent an agent who attempts to work in the best interest of two parties on opposing sides of a transaction.

due-on-sale clause a clause in a promissory note that requires the borrower to repay all amounts due immedi- ately upon transferring the property to a new owner.

easement a right given to another party by a land- owner to use a property in a specified manner.

easement appurtenant an easement with clearly identifiable dominant and servient estates.

easement by implication an easement created from the factual circumstances even though an easement is not expressly created.

easement by prescription a method of creating an easement as a result of “actual and exclusive, open and notorious, hostile and continuous” use for a statutory period of time.

easement in gross an easement with only a servient estate.

economic base employment in industries that bring income into a region from beyond its borders.

economic obsolescence loss in value resulting from factors outside the property that affect its income- producing ability or degree of use.

effective gross income potential gross income less vacancy and credit losses.

effective interest rate the actual cost of borrowed funds expressed as an interest rate.

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418 Glossary

eminent domain the government’s power to take private property for public use upon payment of just compensation.

encroachment an unauthorized invasion or intrusion of a fixture, building, or another improvement onto another person’s property.

encumbrance restriction or limitation on ownership rights.

Equal Credit Opportunity Act act that prohibits dis- crimination in mortgage lending.

equilibrium when the price negotiated between demanders and suppliers results in the quantity of the good or service offered by suppliers equaling the quan- tity of the good or service as desired by the demanders.

escheat the government’s right to own real estate fol- lowing the owner’s death in the absence of a valid will or legal heirs.

escrow agent a third party who facilitates a real estate closing.

escrow closing a closing using an escrow agent.

estate in land ownership interests in real property.

estate in severalty term used to describe ownership interests without regard to the number of owners.

estate pur autre vie when a life tenant is someone other than the person whose life the life estate is tied to.

eviction when a tenant is forced to vacate the prem- ises for failing to adhere to the terms of the rental agreement.

exclusive-agency listing a listing agreement that guarantees the broker’s right to a commission if the property is sold by any licensed real estate broker or salesperson.

exclusive-brokerage listing an agreement between a property owner and a single broker authorizing that broker to seek a buyer for the property in exchange for compensation.

exclusive-right-to-sell listing a listing agreement that guarantees the broker’s right to a commission if the

property is sold by the seller or any licensed real estate broker or salesperson.

executed process of placing one’s signature on a legal document.

executor’s deed a special use deed used by the execu- tor of an estate to transfer ownership without any assur- ances regarding the quality of title being transferred.

exemption an amount that is subtracted from taxable value to provide tax relief for certain types of property owners.

expense stop a limit on the amount of operating costs to be borne by the landlord in a commercial lease agreement.

export activities activities that produce goods and ser- vices for sale or consumption outside an area’s borders.

express grant method of expressly creating an ease- ment on a grantor’s property.

express reservation method of expressly creating an easement on a grantee’s property.

factory outlet center a shopping center consisting of retail outlet facilities where goods are sold directly to the public in stores owned and operated by the manufacturers.

Fair Credit Reporting Act law regulating credit reporting agencies.

fair housing laws laws that protect the rights of cer- tain citizens in housing transactions.

Fannie Mae See Federal National Mortgage Assoc- iation.

Federal Housing Administration an agency that was created by the federal government in 1934 to act as an insurance company for private mortgage lenders.

Federal National Mortgage Association an agency that was created by the federal government in 1938 to buy mortgages from lenders and to serve as a clearing- house for secondary mortgage markets. Also known as Fannie Mae.

00RePrinciples_BOOK.indb 418 11/25/2014 8:04:11 AM

Glossary 419

fee interest time-share a type of concurrent estate that splits ownership of a property over time across joint owners.

fee simple absolute estate the fullest and most com- plete set of ownership rights one can possess in real property.

FHA-insured loan a loan insured against default by the Federal Housing Administration.

fiduciary a person who is obligated to act in the best interest of another.

filtering the passage of housing to less affluent fami- lies as the housing ages.

Financial Institution Reform, Recovery, and Enforce- ment Act (FIRREA) law that established a regulatory framework for appraisers.

financial leverage the use of borrowed funds with the intention of magnifying investment returns.

financial risk uncertainty associated with the possi- bility of defaulting on borrowed funds used to finance an investment.

financing capacity the ability of a potential borrower to incur debt.

financing contingency a clause in a sales contract that permits the cancellation of the contract if the buyer can- not successfully obtain financing for the purchase of the property according to the terms specified in the sales contract.

fixed-rate mortgage a loan with a fixed interest rate over the loan term.

fixed-rent lease a lease contract that stipulates a fixed rent amount for the period of the lease.

fixture an item that was once personal property but has become part of the real estate.

flipping See property flipping.

Flood Disaster Protection Act law establishing the federal flood insurance program.

floor-area ratio relationship between the total floor area of a building and the total area of a site.

foreclosure the process of seizing control of the col- lateral for a loan and using the proceeds from its sale to satisfy a defaulted debt.

fraud a false statement made with the intention to mislead, that is material to a transaction, that is justifi- ably relied on by a client, and that results in injury to the client.

Freddie Mac Federal Home Loan Mortgage Corporation.

freehold estate ownership interests in real property.

freestanding retail a retail building not located in a shopping center.

functional obsolescence loss in value that occurs because a property has less utility or ability to generate income than a new property designed for the same use.

future value of a lump sum FV = PV(1 + i)n

future value of an annuity

FVA A i

= − − 

 



 

( )1 1

garden apartment a two-story or three-story building with a density of 10 to 20 units per acre.

general lien a security interest on all property owned by an individual.

general warranty deed the deed that offers the most protection to the grantee, complete with all relevant cov- enants and warranties.

gentrification the process of neighborhood rehabilita- tion causing value to rise dramatically as it becomes a desirable location.

gestation period the time between conception of the idea for a development project and its completion and entry into the available supply.

Ginnie Mae See Government National Mortgage Assoc- iation.

00RePrinciples_BOOK.indb 419 11/25/2014 8:04:12 AM

420 Glossary

Government National Mortgage Association a gov- ernment organization that provides subsidized loans for certain mortgage borrowers. Also known as Ginnie Mae.

government-sponsored enterprises organizations such as Fannie Mae and Freddie Mac, which are authorized and supported by the U.S. government to operate a sec- ondary mortgage market for residential loans.

graduated-rent lease a lease contract that stipulates scheduled rent increases over the period of the lease.

grant deed a type of deed that transfers ownership of property to the grantee.

grantee the party who receives a freehold estate in real property from a grantor.

grantor the party who transfers a freehold estate in real property to a grantee.

grantor and grantee indexes an index of grantors who have given an interest in real estate to another and people who have received such an interest (grantees).

gross absorption the total number of units or square footage absorbed by the market in a specified period of time.

gross income multiplier the relationship between income and value, where the gross income multiplier equals value divided by gross income.

gross leasable area the total floor area of a building designed for the tenants’ use.

gross lease a lease contract stipulating that the land- lord will pay all operating expenses, taxes, and insur- ance for the property during the period of the lease.

gross rent multiplier the relationship between rent and value, where the gross rent multiplier equals value divided by gross rent.

gross selling price the selling price before any deductions.

ground lease a long-term lease for vacant land.

height limitation regulations governing the maximum height of a building in feet or stories.

highest and best use that use, found to be legally per- missible, physically possible, and financially feasible, that results in the highest land value; that use of land most likely to result in the greatest long-term economic return to the owner.

highrise apartment apartment buildings containing more than eight stories.

highway hotel a motel that caters primarily to busi- nesspeople and vacationers who are in transit.

homeowner’s policy an insurance policy that provides coverage of losses from fire and other perils, personal liability, medical payments, and theft.

housing finance system the arrangements and insti- tutions that facilitate the financing of residential buildings.

HUD-1 Uniform Settlement Statement a settlement form approved by the Department of Housing and Urban Development.

hypothecation the practice of leaving borrowers in possession of their property while repaying a loan with interest.

impact fees fees charged to developers to raise funds for expansion of public facilities needed as a result of the new development.

impact zoning a technique to relate permitted uses of land to certain performance standards.

implied grant a method of implicitly creating an ease- ment on a grantor’s property.

implied reservation a method of implicitly creating an easement on a grantee’s property.

incentive zoning a practice used by communities to encourage developers to provide certain publicly desired features in their developments in exchange for relaxed enforcement of the zoning code.

00RePrinciples_BOOK.indb 420 11/25/2014 8:04:12 AM

Glossary 421

income approach a method used to estimate value by discounting or capitalizing the expected future income that is expected to accrue to the property owner.

income tax taxable income multiplied by the tax rate.

index lease a lease in which rent payments are adjusted based on changes in the cost of living.

indirect losses additional living expenses or loss of business income suffered before a damaged property is restored.

industrial park controlled, parklike developments designed to accommodate specific types of industry.

in-filling a method of city growth where open spaces between structures are filled in with new structures.

infrastructure investment in public facilities such as roads, schools, etc.

inheritable freehold estate an ownership interest that passes to heirs upon the death of the owner.

initial equity purchase price of a project less a debt that is used to complete the purchase.

inspection and repair contingency clause in a real estate contract that permits the buyer to have a qualified inspector examine the property for any physical defects that the seller may be obligated to repair.

insurable title a title in real estate that a reputable title insurance company is willing to insure. An insur- able title most frequently is one without major defect.

insurable value an estimate of value for insurance purposes.

insurance binder temporary evidence of insurance.

intensity of use extent to which land in a particular zone may be used for its permitted purposes.

interest-only loan a nonamortizing loan that requires periodic payments of interest and a single balloon pay- ment of the principal at the end of the loan term.

interim use temporary use of a property until such time that conditions are favorable to convert it to another use intended to be permanent.

internal rate of return the discount rate that sets net present value exactly equal to zero.

inverse condemnation a lawsuit initiated by a prop- erty owner to force the government to purchase a property whose value has been diminished by a gov- ernmental action.

investment present sacrifice in anticipation of expected future benefit.

investment value the worth of a property to a particu- lar investor, based on that investor’s personal standards of investment acceptability.

IRR decision rule if the internal rate of return is greater than or equal to the required rate of return, accept the investment.

joint tenancy joint ownership in which all owners have an equal, but undivided, interest in a property.

judgment lien a lien placed on property to settle a judgment from a lawsuit.

judicial foreclosure a court-ordered sale of the prop- erty following default by the mortgagor.

just compensation the amount that must be paid a landowner when property is taken under eminent domain.

land contract a contract that establishes an obligation to transfer title from a seller to a buyer at some future date based on an agreed-upon payment schedule.

land rent the return that a parcel of land will bring in the open market.

lease a legal agreement between lessor and lessee.

leased fee estate the property owner’s interest when the property is leased.

leasehold estate a tenant’s rights to use and pos- sess (but not own) a property as defined in a lease agreement.

legal description specific language that uniquely identifies a parcel of real estate.

lessee the person who receives a leasehold interest in a property from the lessor.

00RePrinciples_BOOK.indb 421 11/25/2014 8:04:12 AM

422 Glossary

lessor the person who gives a leasehold interest in a property to a lessee.

liability insurance insurance that protects the insured against lawsuits brought in response to supposed acts of negligence that result in injury or loss of property to the public.

license a revocable personal privilege to use land for a particular purpose.

licensed real property appraiser a person licensed by the state to perform noncomplex residential appraisals.

lien a claim on a property as security for a debt or ful- fillment of some monetary charge or obligation.

lien theory a concept adopted by some states that rec- ognizes that the mortgagee must foreclose on the prop- erty through a court action to acquire possession in the event of default.

life estate an ownership interest in real property that normally ends upon the death of a named person.

life tenant the person who holds the present interest in a life estate (may or may not be the person whose life the estate is tied to).

limited-service listing an agreement between a prop- erty owner/seller that authorizes a broker to perform certain tasks to seek a buyer for the property.

liquidity risk possibility of loss resulting from not being able to convert an asset into cash quickly should the need arise.

listing agreement the legal agreement between a bro- ker and a property owner that authorizes the broker to attempt to sell the property.

listing broker the broker who negotiates the listing agreement with the seller.

littoral proprietor owner of land that adjoins navi- gable bodies of water.

loan origination the process of creating a new loan agreement between a borrower and a lender.

loan-to-value ratio (LTV ratio) the ratio obtained by dividing the loan amount by an estimate of property value.

management agreement a legal agreement authoriz- ing a property manager to conduct business on behalf of the landlord.

mandatory dedication a requirement that developers donate property to the community for public use as a condition for obtaining development approval.

manufactured home a dwelling unit that is manufac- tured in a factory and then moved to a particular site.

market set of circumstances and arrangement through which buyers and sellers exchange goods and services.

marketable title a title free and clear of all past, pres- ent, and future claims that would cause a reasonable purchaser to reject such title.

market analysis vacant space plus space in construc- tion divided by net absorption per month.

market value the most probable price that a property should bring in a competitive and open market under all conditions requisite to a fair sale, the buyer and seller each acting prudently and knowledgeably, and assum- ing the price is not affected by undue stimulus. Implicit in this definition is the consummation of a sale as of a specified date and the passing of title from seller to buyer under conditions whereby

1. buyer and seller are typically motivated;

2. both parties are well informed or well advised and acting in what they consider their best interests;

3. a reasonable time is allowed for exposure in the open market;

4. payment is made in terms of cash in U.S. dollars or in terms of financial arrangements comparable thereto; and

5. the price represents the normal consideration for the property sold unaffected by special or creative financing or sales concessions by anyone associated with the sale.

mechanic’s lien a claim on a property held by a sup- plier of materials or labor for nonpayment of a debt.

00RePrinciples_BOOK.indb 422 11/25/2014 8:04:12 AM

Glossary 423

metes-and-bounds description a legal method for describing the exact boundaries of a property; metes refers to the distances and bounds refers to the direc- tions of the property’s boundaries.

midrise apartment apartment building consisting of four to eight stories.

mill one one-thousandth, or 0.001.

millage rate the tax rate imposed on property own- ers, expressed as the dollars of tax for each $1,000 of property value.

mineral rights ownership rights associated with min- erals that may be located below the surface of the earth.

minimum lot sizes the minimum lot size allowed by zoning or other land-use regulations.

misrepresentation a false statement that is material to a transaction, that is justifiably relied upon by a client, and that results in injury to the client.

months supply the number of months required to absorb the current supply.

monument a visible marker, either a natural or an arti- ficial object used to establish the lines and boundaries of a survey.

mortgage a contract by which real property is pledged as security for a loan.

mortgage-backed securities securities issued by mortgage holders to investors who wish to invest indi- rectly in the mortgage market.

mortgage banker firms that borrow money from commercial banks to originate new loans to mortgage borrowers.

mortgage broker firms that act as brokers between loan applications and lenders.

mortgage debt ratio the percentage of a borrower’s gross monthly income that is required to meet housing expenses.

mortgagee the lender in a mortgage loan transaction.

mortgage life insurance a diminishing term life insurance policy whose amount is keyed to the outstand- ing mortgage balance.

mortgage payment

PMT PVA i

i n

= −



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mortgagor the borrower in a mortgage loan transaction.

multiple listing service (MLS) an arrangement in which brokers share their listings with other brokers in exchange for a share of the commission generated by a transaction.

multiple-nuclei model a model of urban growth pat- terns that emphasizes more than one center of commer- cial activity.

negative renewal clause a clause in a lease contract that automatically renews the lease in the event neither party desires to terminate the agreement.

neighborhood a geographic area containing comple- mentary land uses in which property values tend to move together.

neighborhood center a shopping center intended to serve customers from a specific geographic area.

net absorption the amount of space rented to tenants or sold to buyers after taking into consideration space vacated by tenants or owners.

net lease a lease that stipulates that the lessee will pay operating expenses for a property during the lease period.

net listing a listing agreement in which the broker is entitled to receive as commission any amount above a base price.

net-net lease a lease that stipulates that the lessee will pay operating expenses and insurance for the property during the lease period.

net-net-net lease a lease that stipulates that the les- see will pay operating expenses, insurance, and property taxes for the property during the lease period.

00RePrinciples_BOOK.indb 423 11/25/2014 8:04:13 AM

424 Glossary

net operating income annual operating cash flow that remains after expenses have been paid.

net present value present value of inflows minus pres- ent value of outflows.

net sales proceeds proceeds from sale after selling expenses have been paid.

net selling price the difference between the sales price and selling expenses.

nonconforming use a use of land that does not con- form to the current land-use controls imposed by the government.

nonjudicial foreclosure a situation in which the secu- rity instrument grants the lender power of sale should the borrower default.

NPV decision rule if the net present value is greater than or equal to zero, accept the investment.

nuisance the use of property in such a way as to harm the property of others.

offer a statement that specifies the position of its maker (offeror) and indicates that the offeror is willing to be bound by the conditions stated.

offeree the receiving party in a contact.

offeror the party making the offer in a contract.

Office of Federal Housing Enterprise Oversight a federal agency that oversees the operations of govern- ment-sponsored enterprises in the mortgage market.

office park a community of lowrise office structures under central management and administration, usually located in the suburbs and adjacent to a major freeway.

open listing a listing agreement in which a broker is entitled to receive a commission only in the event the broker procures a buyer for the property.

operating cash flow rent paid by tenants for the use of space in a property.

operating expense ratio defined as operating expenses divided by effective gross income (OE ÷ EGI).

operating expenses the direct expenses of a property.

option-to-buy contract a contract that gives one party the right, but not an obligation, to purchase a property within a specified time horizon at a specified price.

origination fees fees charged by lenders in the origi- nation process.

partial performance fulfillment of the terms of an agreement to such an extent that the existence of the agreement may be reasonably inferred.

patio house a detached house with at least one wall that touches the property line.

percentage lease a lease for a property used for com- mercial purposes under which the rental payments are based on some percentage of sales made on the premises.

performance zoning regulations that restrict land- use based on the environmental carrying capacity of the site.

personal articles floater policy an insurance policy that insures specific personal property items for specific amounts.

personal excess liability policy an insurance policy that insures against disastrous liability claims involving a home, automobile, or boat.

personal property movable items such as cars, cloth- ing, books, and so on.

personal property replacement cost endorsement an insurance policy that allows the holder to recoup the full replacement cost of stolen or damaged goods rather than the actual cash value of the goods.

physical deterioration loss in value that occurs from ordinary wear and tear, vandalism, or neglect.

planned unit development a type of zoning that may allow waivers of certain bulk and use regulations.

plat a detailed land survey drawing, usually prepared by a professional surveyor, that shows the features of a property and its legal description.

plex a form of attached housing containing two or more units, each with its own outside entrance.

00RePrinciples_BOOK.indb 424 11/25/2014 8:04:13 AM

Glossary 425

police power the government’s power to regulate the way private property is used to protect the health, safety, morals, and general welfare of the public.

policy a contract providing insurance coverage.

population-serving activities activities that produce goods and services for sale or consumption within an area’s borders.

positive renewal clause a clause on a lease that states that if no notice of renewal is given properly, normally one to two months prior to the expiration of the lease, the lease terminates at the end of the lease period.

possibility of reversion the future interest that fol- lows a qualified fee determinable estate.

potential gross income the total income potential of an investment, assuming all space is leased and all rents are collected.

power center a large strip-style shopping center that is anchored by one or more “big box” retailers, along with smaller shops.

power of termination the future interest that follows a qualified fee conditional estate.

premium the consideration paid for an insurance policy.

prepayment early repayment of principal.

prepayment clause a clause in a promissory note that determines the borrower’s right to prepay any or all of the principal before it is due.

prescriptive easement an easement created when someone other than the owner uses the land “openly, hostilely, and continuously” for a statutory time period.

present value of a lump sum

PV = FV

(1 + i)n

present value of an annuity

PVA A i

= −

+ 



   





   

1 1

1( )

price actual amount paid for a property in a particular transaction.

primary mortgage market transactions that occur between a borrower and a lender.

primary trade area the geographic area immediately surrounding a shopping center that typically accounts for 60% to 70% of the center’s sales.

principal the person who authorizes an agent to con- duct business on his or her behalf.

principal meridians north-south lines used as refer- ence points in the rectangular survey system.

principle of anticipation the anticipated utility or income that will accrued to the property owner in the future.

principle of change the notion that economic, social, political, and environmental forces are constantly caus- ing changes that affect the value of real property.

principle of contribution the principle that the value of a component part of a property depends on the amount it contributes to value of the whole.

principle of substitution the principle that holds that a prudent buyer will pay no more for property than the cost of acquiring an equally desirable substitute.

prior appropriation doctrine theory that states that the first person to use a body of water for some benefi- cial economic purpose has the right to use all the water needed, even though landowners who later find a use for the water may be precluded from using it.

private mortgage insurance (PMI) nongovernment insurance that provides protection for the lender against the borrower’s default.

profit a prendre a nonpossessory interest in real prop- erty that permits the holder to remove specified natural resources from a property.

promissory note a written promise to pay money owed.

property an object that can be owned or possessed.

property flipping the process of buying properties, renovating them to some degree, and reselling them with the goal of making a profit.

00RePrinciples_BOOK.indb 425 11/25/2014 8:04:13 AM

426 Glossary

property manager a person authorized by a property owner to manage the property on his or her behalf.

proprietary lease a co-op lease that gives the owner the right to occupy a specific unit.

purchasing power risk uncertainty associated with the possibility that the amount of goods and services that can be acquired with a given amount of money will decline.

qualified estate an estate that can be lost should an event or stated condition come to pass.

qualified fee conditional estate an estate that a court may rule has been terminated should some condition be violated.

qualified fee determinable estate an estate that termi- nates automatically should some condition be violated.

qualified fee estate type of ownership in which the owner’s rights can be lost in the future.

quitclaim deed a deed used to transfer any interest a grantor may or may not have in a property, without implying that the grantor has a valid interest to convey.

range lines north-south lines that run parallel to prin- cipal meridians in the rectangular survey system.

rate of return the percentage return from a property.

real estate land and structures that are attached to it.

real estate asset market the market in which owner- ship of investment properties is traded between buyers and sellers.

real estate broker an individual licensed by a state to represent others in real estate transactions in exchange for compensation.

real estate investment trusts (REITs) publicly traded companies that own and manage real estate portfolios.

real estate salesperson an individual licensed by a state to assist real estate brokers in arranging real estate transactions in exchange for compensation.

Real Estate Settlement Procedures Act (RESPA) law regulating the closing procedures in a real estate loan.

real estate space market market in which occupancy of investment properties is purchased by tenants from owners.

real property the legal interests associated with the ownership of real estate.

reappraisal lease a lease that stipulates that the rent will be adjusted periodically as the value of the building changes, as determined by an appraisal.

rectangular survey system a grid-based system used to legally describe the location of a property.

refinancing the process of obtaining a new loan and using the proceeds to repay an existing loan.

regional center a shopping center that contains between 300,000 and 750,000 square feet in gross leas- able area and contains at least one full-line department store.

remainder the future interest associated with a life estate held by someone other than the grantor.

remainderman the party who holds the remainder interest associated with a life estate.

renewal option a clause in a lease agreement that defines the parties’ agreement regarding renewal of the lease upon termination.

rental agreement contract between a landlord and a tenant authorizing the tenant to use and occupy space under certain terms and conditions.

replacement cost the estimated cost of replacing the property being appraised with a property built at today’s prices, by current construction methods, and with the same usefulness as the one being appraised.

reproduction cost the cost of constructing an exact replacement of the property being appraised with the same or similar materials, at today’s prices.

required rate of return a minimum acceptable rate of return.

00RePrinciples_BOOK.indb 426 11/25/2014 8:04:13 AM

Glossary 427

residential mortgage credit report a standardized credit report used in the underwriting process for resi- dential loans.

resort hotel a hotel that caters to individuals or fami- lies on vacation.

restrictive covenant limitations placed on a property by a landowner or previous landowner that prevents the property from being used in certain ways.

reversion the future interest associated with a life estate held by the grantor.

right of first refusal the right of a person to have the first opportunity to either purchase or lease real property.

right of reentry the landlord’s reversionary right to reoccupy the property at the expiration of the lease.

right of survivorship the right of surviving joint owners to automatically divide the share owned by a deceased owner.

right to use time-share a form of leasehold estate that permits the holder to use a property for a certain period each year.

riparian rights doctrine theory that permits land- owners whose land underlies or borders non-navigable bodies of water to use all the water needed as long as the use does not deprive other landowners who are also entitled to use some of the water.

risk the chance of loss; also, the uncertainty about the actual rate of return an investment will provide over the holding period.

sale-and-leaseback an arrangement whereby a prop- erty owner sells the property to an investor and immedi- ately leases the property back from the investor.

sales comparison approach a method used to esti- mate value by comparing the property to other proper- ties that have recently sold for known prices.

sales contract a contract providing for the transfer of property.

savings institution firms that receive deposits from savers and loaning those funds to residential borrowers.

secondary mortgage market transactions involving mortgages that occur between investors.

secondary trade area the area outside the primary trade area that typically accounts for 15% to 20% of sales at a shopping center.

section 1-square-mile rectangles that divide townships into 36 equal areas of 640 acres each.

sector model a model of urban growth in which types of development tend to extend outward in wedge-shaped sections from the center of the city.

secured loan a loan for which a specific item has been pledged as collateral.

security deposit an amount required by a lessor in advance of occupancy as security against potential dam- ages caused by the lessee.

seller’s agent a real estate broker who is obligated to represent the best interest of the seller.

selling broker the broker who actually locates a buyer for a property.

servient estate the property burdened by the existence of an easement appurtenant or easement in gross.

setback a common land-use regulation that requires a certain amount of space between improvements on a property and the property lines.

setback requirements the amount of distance between the property border and the location of the structure.

settlement closing of a real estate transaction.

sinking fund payment

SFP FVA i

i n =

+ − 

 



 ( )1 1

specialty shopping center a shopping center that focuses on unusual market segments and usually offers high-quality, high-priced merchandise in boutique-type stores.

special warranty deed similar to a general warranty deed, except the covenants and warranties apply only to events that occurred during the grantor’s period of ownership.

00RePrinciples_BOOK.indb 427 11/25/2014 8:04:13 AM

428 Glossary

specific lien a security interest that relates only to a specific parcel of real estate.

specific performance a requirement that the terms of a contract be exactly complied with.

statute of frauds a law designed to prevent fraudulent practices involving contracts.

steering the illegal practice of steering potential homebuyers into certain areas to influence the racial or ethnic composition of the areas.

step-up rent lease a type of rental agreement in which the rent is scheduled to increase over time according to an agreed-upon schedule.

strict foreclosure a situation in which the lender is entitled to immediate ownership of the property should the borrower default.

strip shopping center a neighborhood shopping cen- ter built in a straight line, with stores tied together by a canopy over a pedestrian walk.

subagent an agent of an agent of a principal.

subdivision regulations the standards and procedures that regulate the subdivision of land for development and sale.

subleasing the act of transferring a portion of the leasehold estate to a third party.

subprime mortgage loans a type of loan made to borrowers with less than stellar credit histories or other issues that prevent the borrower from obtaining the most favorable loan terms.

substitution the idea that a prudent buyer will pay no more for a property than the cost of acquiring an equally desirable substitute in the open market.

super-regional shopping center a shopping center that exceeds 750,000 square feet of gross leasable area and includes at least three department stores.

superstore a very large discount store with between 60,000 and 150,000 square feet under one roof.

supply the amount or quantity of the good or service that will be offered at various prices.

Tax Increment Financing (TIF) An alternative to financing a private venture through the use of public funds. This funding is used by many local governments to encourage and aid in the redevelopment or revitaliza- tion of rundown or abandoned areas of their community.

taxable income income subject to taxation.

taxable value assessed value for property taxes less exemptions.

tenancy at sufferance a leasehold estate that defines a tenant’s rights to occupy the property against the wishes of the lessor.

tenancy at will an informal leasehold estate of inde- terminable length that may last as long as the parties agree.

tenancy by the entirety a form of concurrent estate in which a husband and wife can own property jointly.

tenancy for a stated period a leasehold estate that has definite starting and ending dates.

tenancy from period to period a leasehold estate that continues to automatically renew each period unless ter- minated by either party.

tenancy in common a form of concurrent estate in which each owner has an undivided interest in the property.

term the length of time a landlord and tenant agree to maintain their relationship involving rental property.

test of adaptability test to determine whether an item of personal property has become a fixture. An item that has been specifically adapted to the real estate is gener- ally considered a fixture.

test of attachment test to determine whether an item of personal property has become a fixture. An item that has been permanently attached to the real property and could not be removed without damage to the land or building is generally considered a fixture.

test of intent of the parties evidence, usually written, showing that the parties intended the item of personal property to become a fixture.

00RePrinciples_BOOK.indb 428 11/25/2014 8:04:13 AM

Glossary 429

time-sharing a form of concurrent estate that splits ownership of a property across owners and across time.

time value of money principle a dollar in hand is worth more than a dollar to be received in the future because it can either be consumed immediately or put to work to earn a return.

title the legal right to ownership.

title abstract a written history of a property’s chain of title.

title contingency a clause in a sales contract that can- cels the contract if the seller cannot provide clear title to the buyer.

title insurance an insurance policy that protects prop- erty owners and lenders against undiscovered defects in a property’s chain of title.

title opinion an attorney’s opinion of the quality of title for a specific property.

title perfect of record a property for which there are no defects.

title search the process of verifying the quality of title.

title theory a concept adopted by some states that recognizes that the mortgagee has the right to imme- diate possession of mortgaged property in the event of default.

Torrens system a system of land registration used by a few states as an alternative to grantor/grantee indexes.

total debt ratio the percentage of a borrower’s gross monthly income required to meet monthly contractual expenses.

town house a form of attached housing in which each unit has its own front door but shares one or two walls with adjacent units.

township a 36-square-mile area formed by township and range lines in the rectangular survey system.

township lines east-west lines that run parallel to base lines in the rectangular survey system.

trade area the geographic area from which the major portion of the patronage necessary to support the shop- ping center is to be drawn.

trade fixture personal property used in a trade or business.

trainee appraiser a beginning appraiser who must work under the supervision of a licensed or certified appraiser who is responsible for the work of the trainee.

transaction broker a broker who provides lim- ited representation to a seller or buyer in a real estate transaction.

transferable development rights the right to sell one’s ability to develop a property to another property owner who desires a more intense use of the second property.

transfer of development rights a system whereby landowners can sell their development rights to other property owners so the other property owners can use their property more intensely.

two-step mortgage a loan whose interest rate is adjusted once during the term of the loan.

underwriting process of evaluating the risk of a loan applicant and the property being pledged in order to make a decision regarding the loan application.

unsecured loan a loan for which no specific item has been pledged as collateral.

urban and regional economics the study of the eco- nomics of urban and regional growth.

U.S. housing financial system the system of financing mortgages in the United States.

vacancy and credit losses revenues not received due to vacancy in the property or uncollectible rents.

vacancy rate the percentage of units vacant in a property.

VA-guaranteed loans a loan in which the lender is protected from the borrower’s default by a guarantee of repayment from the Department of Veterans Affairs.

variance permission granted by a government for a landowner to use the property in a manner not ordinarily permitted.

00RePrinciples_BOOK.indb 429 11/25/2014 8:04:14 AM

430 Glossary

vested remainder a remainder interest when the remainderman is guaranteed ownership of the property at some time in the future.

voidable capable of being rescinded, as a contract entered into by a minor or by a person who has been declared insane.

warranty a promise or guarantee made by a grantor in a deed.

warranty deed a deed that transfers title from a grantor to a grantee and obligates the grantor to certain promises specified in the document or by reference to statute.

warranty deed without covenants a warranty deed that omits some or all of the promises typically made by the grantor to the grantee.

warranty forever an assurance made by the grantor to always defend the title conveyed to the grantee.

warranty of habitability an assurance made by a les- sor that the property is fit for its intended use.

water rights the right to withdraw water from the land.

wealth maximization objective the investment objec- tive of investors.

zoning the process of dividing a community’s land into districts in which only certain uses of the land are allowed.

zoning variance administrative relief that allows an owner to deviate slightly from a strict interpretation of the zoning ordinance.

00RePrinciples_BOOK.indb 430 11/25/2014 8:04:14 AM

431

Time Value of Money Tables

This appendix presents the time value of money tables (often called capitaliza- tion tables) for interest rates of 6, 8, 10, 12, and 14%.

a p p e n d i x

00RePrinciples_BOOK.indb 431 11/25/2014 8:04:14 AM

432 A P P E N D I X Time Value of Money Tables

TIME VALUE OF MONEY AT 6%

Periods

Future Value Factors

Future Value of Annuity Factors

Sinking Fund Factors

Present Value Factors

Present Value of Annuity Factors

Mortgage Constant

1 1.060000 1.000000 1.000000 0.943396 0.943396 1.060000 2 1.123600 2.060000 0.485437 0.889996 1.833393 0.545437 3 1.191016 3.183600 0.314110 0.839619 2.673012 0.374110 4 1.262477 4.374616 0.228592 0.792094 3.465106 0.288592 5 1.338226 5.637093 0.177396 0.747258 4.212364 0.237396

6 1.418519 6.975319 0.143363 0.704960 4.917324 0.203363 7 1.503630 8.393838 0.119135 0.665057 5.582381 0.179135 8 1.593848 9.897468 0.101036 0.627412 6.209794 0.161036 9 1.689479 11.491316 0.087022 0.591898 6.801692 0.147022

10 1.790848 13.180795 0.075868 0.558395 7.360087 0.135868

11 1.898299 14.971643 0.066793 0.526787 7.886875 0.126793 12 2.012196 16.869941 0.059277 0.496969 8.383844 0.119277 13 2.132928 18.882138 0.052960 0.468839 8.852683 0.112960 14 2.260904 21.015066 0.047585 0.442301 9.294984 0.107585 15 2.396558 23.275970 0.042963 0.417265 9.712249 0.102963

16 2.540352 25.672528 0.038952 0.393646 10.105895 0.098952 17 2.692773 28.212880 0.035445 0.371364 10.477260 0.095445 18 2.854339 30.905653 0.032357 0.350344 10.827603 0.092357 19 3.025600 33.759992 0.029621 0.330513 11.158117 0.089621 20 3.207135 36.785591 0.027185 0.311805 11.469921 0.087185

21 3.399564 39.992727 0.025005 0.294155 11.764077 0.085005 22 3.603537 43.392290 0.023046 0.277505 12.041582 0.083046 23 3.819750 46.995828 0.021278 0.261797 12.303379 0.081278 24 4.048935 50.815577 0.019679 0.246978 12.550358 0.079679 25 4.291871 54.864512 0.018227 0.232998 12.783356 0.078227

26 4.549383 59.156383 0.016904 0.219810 13.003166 0.076904 27 4.822346 63.705766 0.015697 0.207368 13.210534 0.075697 28 5.111687 68.528112 0.014593 0.195630 13.406164 0.074593 29 5.418388 73.639798 0.013580 0.184557 13.590721 0.073580 30 5.743491 79.058186 0.012649 0.174110 13.764831 0.072649

31 6.088101 84.801677 0.011792 0.164255 13.929086 0.071792 32 6.453387 90.889778 0.011002 0.154957 14.084043 0.071002 33 6.840590 97.343165 0.010273 0.146186 14.230230 0.070273 34 7.251025 104.183755 0.009598 0.137911 14.368141 0.069598 35 7.686087 111.434780 0.008974 0.130105 14.498246 0.068974

36 8.147252 119.120867 0.008395 0.122741 14.620987 0.068395 37 8.636087 127.268119 0.007857 0.115793 14.736780 0.067857 38 9.154252 135.904206 0.007358 0.109239 14.846019 0.067358 39 9.703507 145.058458 0.006894 0.103055 14.949075 0.066894 40 10.285718 154.761966 0.006462 0.097222 15.046297 0.066462

41 10.902861 165.047684 0.006059 0.091719 15.138016 0.066059 42 11.557033 175.950545 0.005683 0.086527 15.224543 0.065683 43 12.250455 187.507577 0.005333 0.081630 15.306173 0.065333 44 12.985482 199.758032 0.005006 0.077009 15.383182 0.065006 45 13.764611 212.743514 0.004701 0.072650 15.455832 0.064701

46 14.590487 226.508125 0.004415 0.068538 15.524370 0.064415 47 15.465917 241.098612 0.004148 0.064658 15.589028 0.064148 48 16.393872 256.564529 0.003898 0.060998 15.650027 0.063898 49 17.377504 272.958401 0.003664 0.057546 15.707572 0.063664 50 18.420154 290.335905 0.003444 0.054288 15.761861 0.063444

00RePrinciples_BOOK.indb 432 11/25/2014 8:04:14 AM

A P P E N D I X Time Value of Money Tables 433

TIME VALUE OF MONEY AT 8%

Periods

Future Value Factors

Future Value of Annuity Factors

Sinking Fund Factors

Present Value Factors

Present Value of Annuity Factors

Mortgage Constant

1 1.080000 1.000000 1.000000 0.925926 0.925926 1.080000 2 1.166400 2.080000 0.480769 0.857339 1.783265 0.560769 3 1.259712 3.246400 0.308034 0.793832 2.577097 0.388034 4 1.360489 4.506112 0.221921 0.735030 3.312127 0.301921 5 1.469328 5.866601 0.170456 0.680583 3.992710 0.250456

6 1.586874 7.335929 0.136315 0.630170 4.622880 0.216315 7 1.713824 8.922803 0.112072 0.583490 5.206370 0.192072 8 1.850930 10.636628 0.094015 0.540269 5.746639 0.174015 9 1.999005 12.487558 0.080080 0.500249 6.246888 0.160080

10 2.158925 14.486562 0.069029 0.463193 6.710081 0.149029

11 2.331639 16.645487 0.060076 0.428883 7.138964 0.140076 12 2.518170 18.977126 0.052695 0.397114 7.536078 0.132695 13 2.719624 21.495297 0.046522 0.367698 7.903776 0.126522 14 2.937194 24.214920 0.041297 0.340461 8.244237 0.121297 15 3.172169 27.152114 0.036830 0.315242 8.559479 0.116830

16 3.425943 30.324283 0.032977 0.291890 8.851369 0.112977 17 3.700018 33.750226 0.029629 0.270269 9.121638 0.109629 18 3.996020 37.450244 0.026702 0.250249 9.371887 0.106702 19 4.315701 41.446263 0.024128 0.231712 9.603599 0.104128 20 4.660957 45.761964 0.021852 0.214548 9.818147 0.101852

21 5.033834 50.422921 0.019832 0.198656 10.016803 0.099832 22 5.436540 55.456755 0.018032 0.183940 10.200744 0.098032 23 5.871464 60.893296 0.016422 0.170315 10.371059 0.096422 24 6.341181 66.764759 0.014978 0.157699 10.528758 0.094978 25 6.848475 73.105940 0.013679 0.146018 10.674776 0.093679

26 7.396353 79.954415 0.012507 0.135202 10.809978 0.092507 27 7.988061 87.350768 0.011448 0.125187 10.935165 0.091448 28 8.627106 95.338830 0.010489 0.115914 11.051079 0.090489 29 9.317275 103.965936 0.009619 0.107327 11.158406 0.089619 30 10.062657 113.283211 0.008827 0.099377 11.257783 0.088827

31 10.867669 123.345868 0.008107 0.092016 11.349799 0.088107 32 11.737083 134.213537 0.007451 0.085200 11.434999 0.087451 33 12.676050 145.950620 0.006852 0.078889 11.513888 0.086852 34 13.690134 158.626670 0.006304 0.073045 11.586934 0.086304 35 14.785344 172.316804 0.005803 0.067634 11.654568 0.085803

36 15.968172 187.102148 0.005345 0.062625 11.717193 0.085345 37 17.245626 203.070320 0.004924 0.057986 11.775179 0.084924 38 18.625276 220.315945 0.004539 0.053690 11.828869 0.084539 39 20.115298 238.941221 0.004185 0.049713 11.878582 0.084185 40 21.724522 259.056519 0.003860 0.046031 11.924613 0.083860

41 23.462483 280.781040 0.003562 0.042621 11.967235 0.083562 42 25.339482 304.243523 0.003287 0.039464 12.006699 0.083287 43 27.366640 329.583005 0.003034 0.036541 12.043240 0.083034 44 29.555972 356.949646 0.002802 0.033834 12.077074 0.082802 45 31.920449 386.505617 0.002587 0.031328 12.108402 0.082587

46 34.474085 418.426067 0.002390 0.029007 12.137409 0.082390 47 37.232012 452.900152 0.002208 0.026859 12.164267 0.082208 48 40.210573 490.132164 0.002040 0.024869 12.189136 0.082040 49 43.427419 530.342737 0.001886 0.023027 12.212163 0.081886 50 46.901613 573.770156 0.001743 0.012321 12.233485 0.081743

00RePrinciples_BOOK.indb 433 11/25/2014 8:04:14 AM

434 A P P E N D I X Time Value of Money Tables

TIME VALUE OF MONEY AT 10%

Periods

Future Value Factors

Future Value of Annuity Factors

Sinking Fund Factors

Present Value Factors

Present Value of Annuity Factors

Mortgage Constant

1 1.100000 1.000000 1.000000 0.909091 0.909091 1.100000 2 1.210000 2.100000 0.476190 0.826446 1.735537 0.576190 3 1.331000 3.310000 0.302115 0.751315 2.486852 0.402115 4 1.464100 4.641000 0.215471 0.683013 3.169865 0.315471 5 1.610510 6.105100 0.163797 0.620921 3.790787 0.263797

6 1.771561 7.715610 0.129607 0.564474 4.355261 0.229607 7 1.948717 9.487171 0.105406 0.513158 4.868419 0.205406 8 2.143589 11.435888 0.087444 0.466507 5.334926 0.187444 9 2.357948 13.579477 0.073641 0.424098 5.759024 0.173641

10 2.593742 15.937425 0.062745 0.385543 6.144567 0.162745

11 2.853117 18.531167 0.053963 0.350494 6.495061 0.153963 12 3.138428 21.384284 0.046763 0.318631 6.813692 0.146763 13 3.452271 24.522712 0.040779 0.289664 7.103356 0.140779 14 3.797498 27.974983 0.035746 0.263331 7.366687 0.135746 15 4.177248 31.772482 0.031474 0.239392 7.606080 0.131474

16 4.594973 35.949730 0.027817 0.217629 7.823709 0.127817 17 5.054470 40.544703 0.024664 0.197845 8.021553 0.124664 18 5.559917 45.599173 0.021930 0.179859 8.201412 0.121930 19 6.115909 51.159090 0.019547 0.163508 8.364920 0.119547 20 6.727500 57.275000 0.017460 0.148644 8.513564 0.117460

21 7.400250 64.002499 0.015624 0.135131 8.648694 0.115624 22 8.140275 71.402749 0.014005 0.122846 8.771540 0.114005 23 8.954302 79.543024 0.012572 0.111678 8.883218 0.112572 24 9.849733 88.497327 0.011300 0.101526 8.984744 0.111300 25 10.834706 98.347059 0.010168 0.092296 9.077040 0.110168

26 11.918177 109.181765 0.009159 0.083905 9.160945 0.109159 27 13.109994 121.099942 0.008258 0.076278 9.237223 0.108258 28 14.420994 134.209936 0.007451 0.069343 9.306567 0.107451 29 15.863093 148.630930 0.006728 0.063039 9.369606 0.106728 30 17.449402 164.494023 0.006079 0.057309 9.426914 0.106079

31 19.194343 181.943425 0.005496 0.052099 9.479013 0.105496 32 21.113777 201.137767 0.004972 0.047362 9.526376 0.104972 33 23.225154 222.251544 0.004499 0.043057 9.569432 0.104499 34 25.547670 245.476699 0.004074 0.039143 9.608575 0.104074 35 28.102437 271.024368 0.003690 0.035584 9.644159 0.103690

36 30.912681 299.126805 0.003343 0.032349 9.676508 0.103343 37 34.003949 330.039486 0.003030 0.029408 9.705917 0.103030 38 37.404343 364.043434 0.002747 0.026735 9.732651 0.102747 39 41.144778 401.447778 0.002491 0.024304 9.756956 0.102491 40 45.259256 442.592556 0.002259 0.022095 9.779051 0.102259

41 49.785181 487.851811 0.002050 0.020086 9.799137 0.102050 42 54.763699 537.636992 0.001860 0.018260 9.817397 0.101860 43 60.240069 592.400692 0.001688 0.016600 9.833998 0.101688 44 66.264076 652.640761 0.001532 0.015091 9.849089 0.101532 45 72.890484 718.904837 0.001391 0.013719 9.862808 0.101391

46 80.179532 791.795321 0.001263 0.012472 9.875280 0.101263 47 88.197485 871.974853 0.001147 0.011338 9.886618 0.101147 48 97.017234 960.172338 0.001041 0.010307 9.896926 0.101041 49 106.718957 1057.189572 0.000946 0.009370 9.906296 0.100946 50 117.390853 1163.908529 0.000859 0.008519 9.914814 0.100859

00RePrinciples_BOOK.indb 434 11/25/2014 8:04:14 AM

A P P E N D I X Time Value of Money Tables 435

TIME VALUE OF MONEY AT 12%

Periods

Future Value Factors

Future Value of Annuity Factors

Sinking Fund Factors

Present Value Factors

Present Value of Annuity Factors

Mortgage Constant

1 1.120000 1.000000 1.000000 0.892857 0.892857 1.120000 2 1.254400 2.120000 0.471698 0.797194 1.690051 0.591698 3 1.404928 3.374400 0.296349 0.711780 2.401831 0.416349 4 1.573519 4.779328 0.209234 0.635518 3.037349 0.329234 5 1.762342 6.352847 0.157410 0.567426 3.604776 0.277410

6 1.973823 8.115189 0.123226 0.506631 4.111407 0.243226 7 2.210681 10.089012 0.099118 0.452349 4.563757 0.219118 8 2.475963 12.299693 0.081303 0.403883 4.967640 0.201303 9 2.773079 14.775656 0.067679 0.360610 5.328250 0.187679

10 3.105848 17.548735 0.056984 0.321973 5.650223 0.176984

11 3.478550 20.654583 0.048415 0.287476 5.937699 0.168415 12 3.895976 24.133133 0.041437 0.256675 6.194374 0.161437 13 4.363493 28.029109 0.035677 0.229174 6.423548 0.155677 14 4.887112 32.392602 0.030871 0.204619 6.628168 0.150871 15 5.473566 37.279715 0.026824 0.182696 6.810864 0.146824

16 6.130394 42.753280 0.023390 0.163121 6.973986 0.143390 17 6.866041 48.883674 0.020457 0.145644 7.119631 0.140457 18 7.689966 55.749715 0.017937 0.130039 7.249670 0.137937 19 8.612762 63.439681 0.015763 0.116106 7.365777 0.135763 20 9.646293 72.052442 0.013879 0.103666 7.469444 0.133879

21 10.803848 81.698736 0.012240 0.092559 7.562003 0.132240 22 12.100310 92.502584 0.010811 0.082642 7.644646 0.130811 23 13.552347 104.602894 0.009560 0.073788 7.718434 0.129560 24 15.178629 118.155241 0.008463 0.065882 7.784316 0.128463 25 17.000064 133.333870 0.007500 0.058823 7.843139 0.127500

26 19.040072 150.333934 0.006652 0.052521 7.895660 0.126652 27 21.324881 169.374007 0.005904 0.046893 7.942554 0.125904 28 23.883866 190.698887 0.005244 0.041869 7.984423 0.125244 29 26.749930 214.582754 0.004660 0.037383 8.021806 0.124660 30 29.959922 241.332684 0.004144 0.033378 8.055184 0.124144

31 33.555113 271.292606 0.003686 0.029802 8.084986 0.123686 32 37.581726 304.847719 0.003280 0.026609 8.111594 0.123280 33 42.091533 342.429446 0.002920 0.023758 8.135352 0.122920 34 47.142517 384.520979 0.002601 0.021212 8.156564 0.122601 35 52.799620 431.663497 0.002317 0.018939 8.175504 0.122317

36 59.135574 484.463116 0.002064 0.016910 8.192414 0.122064 37 66.231843 543.598690 0.001840 0.015098 8.207513 0.121840 38 74.179664 609.830533 0.001640 0.013481 8.220993 0.121640 39 83.081224 684.010197 0.001462 0.012036 8.233030 0.121462 40 93.050970 767.091420 0.001304 0.010747 8.243777 0.121304

41 104.217087 860.142391 0.001163 0.009595 8.253372 0.121163 42 116.723137 964.359478 0.001037 0.008567 8.261939 0.121037 43 130.729914 1081.082615 0.000925 0.007649 8.269589 0.120925 44 146.417503 1211.812529 0.000825 0.006830 8.276418 0.120825 45 163.987604 1358.230032 0.000736 0.006098 8.282516 0.120736

46 183.666116 1522.217636 0.000657 0.005445 8.287961 0.120657 47 205.706050 1705.883752 0.000586 0.004861 8.292822 0.120586 48 230.390776 1911.589803 0.000523 0.004340 8.297163 0.120523 49 258.037670 2141.980579 0.000467 0.003875 8.301038 0.120467 50 289.002190 2400.018249 0.000417 0.003460 8.304498 0.120417

00RePrinciples_BOOK.indb 435 11/25/2014 8:04:15 AM

436 A P P E N D I X Time Value of Money Tables

TIME VALUE OF MONEY AT 14%

Periods

Future Value Factors

Future Value of Annuity Factors

Sinking Fund Factors

Present Value Factors

Present Value of Annuity Factors

Mortgage Constant

1 1.140000 1.000000 1.000000 0.877193 0.877193 1.140000 2 1.299600 2.140000 0.467290 0.769468 1.646661 0.607290 3 1.481544 3.439600 0.290731 0.674972 2.321632 0.430731 4 1.688960 4.921144 0.203205 0.592080 2.913712 0.343205 5 1.925415 6.610104 0.151284 0.519369 3.433081 0.291284

6 2.194973 8.535519 0.117158 0.455587 3.888668 0.257158 7 2.502269 10.730491 0.093192 0.399637 4.288305 0.233192 8 2.852586 13.232760 0.075570 0.350559 4.638864 0.215570 9 3.251949 16.085347 0.062168 0.307508 4.946372 0.202168

10 3.707221 19.337295 0.051714 0.269744 5.216116 0.191714

11 4.226232 23.044516 0.043394 0.236617 5.452733 0.183394 12 4.817905 27.270749 0.036669 0.207559 5.660292 0.176669 13 5.492412 32.088654 0.031164 0.182069 5.842362 0.171164 14 6.261349 37.581065 0.026609 0.159710 6.002072 0.166609 15 7.137938 43.842414 0.022809 0.140097 6.142168 0.162809

16 8.137249 50.980352 0.019615 0.122892 6.265060 0.159615 17 9.276464 59.117601 0.016915 0.107800 6.372859 0.156915 18 10.575169 68.394066 0.014621 0.094561 6.467420 0.154621 19 12.055693 78.969235 0.012663 0.082948 6.550369 0.152663 20 13.743490 91.024928 0.010986 0.072762 6.623131 0.150986

21 15.667578 104.768418 0.009545 0.063826 6.686957 0.149545 22 17.861039 120.435996 0.008303 0.055988 6.742944 0.148303 23 20.361585 138.297035 0.007231 0.049112 6.792057 0.147231 24 23.212207 158.658620 0.006303 0.043081 6.835137 0.146303 25 26.461916 181.870827 0.005498 0.037790 6.872927 0.145498

26 30.166584 208.332743 0.004800 0.033149 6.906077 0.144800 27 34.389906 238.499327 0.004193 0.029078 6.935155 0.144193 28 39.204493 272.889233 0.003665 0.025507 6.960662 0.143665 29 44.693122 312.093725 0.003204 0.022375 6.983037 0.143204 30 50.950159 356.786847 0.002803 0.019627 7.002664 0.142803

31 58.083181 407.737006 0.002453 0.017217 7.019881 0.142453 32 66.214826 465.820186 0.002147 0.015102 7.034983 0.142147 33 75.484902 532.035012 0.001880 0.013248 7.048231 0.141880 34 86.052788 607.519914 0.001646 0.011621 7.059852 0.141646 35 98.100178 693.572702 0.001442 0.010194 7.070045 0.141442

36 111.834203 791.672881 0.001263 0.008942 7.078987 0.141263 37 127.490992 903.507084 0.001107 0.007844 7.086831 0.141107 38 145.339731 1030.998076 0.000970 0.006880 7.093711 0.140970 39 165.687293 1176.337806 0.000850 0.006035 7.099747 0.140850 40 188.883514 1342.025099 0.000745 0.005294 7.105041 0.140745

41 215.327206 1530.908613 0.000653 0.004644 7.109685 0.140653 42 245.473015 1746.235819 0.000573 0.004074 7.113759 0.140573 43 279.839237 1991.708833 0.000502 0.003573 7.117332 0.140502 44 319.016730 2271.548070 0.000440 0.003135 7.120467 0.140440 45 363.679072 2590.564800 0.000386 0.002750 7.123217 0.140386

46 414.594142 2954.243872 0.000339 0.002412 7.125629 0.140339 47 472.637322 3368.838014 0.000297 0.002116 7.127744 0.140297 48 538.806547 3841.475336 0.000260 0.001856 7.129600 0.140260 49 614.239464 4380.281883 0.000228 0.001628 7.131228 0.140228 50 700.232988 4994.521346 0.000200 0.001428 7.132656 0.140200

00RePrinciples_BOOK.indb 436 11/25/2014 8:04:15 AM

437

SYMBOLS

203(b) program, 331

Abandonment (of easement), 64 Absorption rate, 229, 274 Abstractor (title examiner), 109 Accelerating decline and abandonment,

295–296 Acceleration clause, in promissory note,

325 Acceptance, 118 Accredited Resident Manager, 208 Acquisition, 216 Acre, 36 “Actual and exclusive” possession, 66 Adjustable-rate mortgages (ARMs), 386,

388–390 Ad valorem tax, 72 Advance fee, 175 Adverse possession, 66–68 Affirmative duty, 169 After-tax cash flow, 396 After-tax equity reversion (ATER), 396,

401 forecasting, 403–408

Agency relationships, 165, 166–186, 177 Broker-buyer relationship (buyer’s

agent), 168 broker’s duties, 169–171 disclosure of, 171 duties and rights under, 168–171 termination of, 171–172, 177

Agent (employee), 164 Agins v. City of Tiburon, 92–93 Agreements for deed, 129 Agreement (to terminate easement), 63 Agricultural space market, 269 Air lot, 43 Airport hotel, 255

Air rights, 20 Alienable right, 24 Amortization, 84 Amortization schedule, 376–379 Amortizing loans, 374–375 Anchor tenants, 246, 249 Annual percentage rate (APR), 338, 384 Annuity, 362–364 Anticipation principle, 186 Antitrust statutes, 175 Appraisal/appraisers, 12, 14, 181–208.

See also Appraisal process appraisal principles, 186–187 categories of appraisers, 182–183 cost approach, 196–200 income approach, 199–203 licensing and certification guide-

lines, 182–183 regulatory environment, 182–183 sales comparison approach,

192–196 value, 184–187

Appraisal Foundation, 182, 201 Appraisal process, 187–192. See

also Appraisal/appraisers application of three approaches to

value, 190–191 data selection and collection, 188 definition of the problem, 187–188 highest and best use analysis,

188–189 highest and best use of vacant land,

189 reconciliation of value indications,

190 report of defined value, 191–192

Appraisal Standards Board, 182, 201 Appraiser Qualifications Board, 182, 201 Appreciation, 396 Assessed value, 72, 185 Assessment, 73

Assessment ratio, 72 Assessor, 73 Asset management/managers, 12,

215–216 Assignment, 147 Associate, 163 Association of homeowners, 222 Assumption, of mortgage, 330 Attic inspections, 315 Automobiles

city growth and, 292 impact of, on land-use dispersion,

289 Axial growth, 289–290

Back-end ratio, 342 Balloon payment, 374 Bargain and sale deed, 102, 103 Base lines, 36 Basement, inspection of, 315 Basic activities, 282 Beachfront Management Act (South

Carolina), 92 Before-tax cash flow, 404 Before-tax equity reversion, 407 Beneficiary, of trust, 328 Berman v. Parker, 77 Bid-rent curve, 286–289 Birkdale Village (NC) case study, 251 Birmingham, AL, 281 Blockbusting, 171 Boiler Room Office Building (NV) case

study, 255 Boulder Meadows v. Saville, 172 Boundary survey, 66 Breach of contract, 120, 131, 137 Breckenridge, CO, 81

i n d e x

00RePrinciples_BOOK.indb 437 11/25/2014 8:04:15 AM

438 Index

Brokerage and brokerage specialties, 10. See also Agency relationships

choosing an agent, 319 commission agreement, 163,

166–167 compensation, 162, 175–176 definitions, 163 legal aspects of broker-client rela-

tionship, 164–165 licensing, 163–164 real estate sales process, 162–163 regulation, 164 role of brokers, 165 types of, 174–175

Broker-buyer relationship (buyer’s agent), 168, 176

Broker, defined, 163 Broker-seller relationship (seller’s agent),

166–175, 176 Budget, in property taxation process,

73–74 Building codes, 85–86 Bulk limitations, 79 Bureau of Economic Analysis, 247 Burgess, Ernest, 288 Business education, real estate and, 2 Business risk, 356–357 Buyer(s)

qualifying, 162 responsibilities of, at closing,

131–134 Buyer’s agent, 166

duties to buyers, 170–171 duties to sellers, 170

Buyer’s broker, 168 Bylaws (condominium), 31

California Public Employees Retirement System (CALPERS), 345

California State Teachers Retirement System (CALSTERS), 345

Canham, Lily, 135 Capital asset vehicles, 271 Capitalization rate, 201 Capital market, 270 Cash flow, 396 Cash-flow rights, 270 Causby, U.S. v., 92 Census of Population and Housing, 247 Census of Retail Trade, 247 Central business districts, 291 Certificate of satisfaction, 133

Certified general real property appraiser, 183

Certified Property Manager (CPM), 208 Certified residential real property

appraiser, 183 Chan, Eddie, 55 Change principle, 186 Chattel (personal property), 18 Cheung, Fat Fan, 55 Chicago, IL

as railroad center, 280 industrial parks, 252

Civil Rights Act of 1866, 171 “Claim of right”, 67–68 Clear decline, 294 Climate, 281 Closing. See Title closings Coast and Geodetic Survey, 43 Collateralized mortgage obligations, 335 Colliver, Don and Carolyn, 55 Colliver v. Stonewall Equestrian Estate

Assoc., 55 “Color of title”, 67 Commercial banks, 336, 347 Commercial hotels, 256 Commercial mortgage-backed securities

(CMBS), 347–348 Commercial real estate, 11, 267–271. See

also Industrial real estate agricultural space market, 269 buyer responsibilities, 133 financing underwriting criteria, 349 hotel, motel, and resort develop-

ments, 254–257 individual investors in, 344–345 industrial space market, 269 life insurance company investors,

344 market analysis, preparing, 272–273 office buildings, 249–251, 255, 268 pension fund investors, 345–347 real estate space markets, 267–268 retail space market, 268 seller responsibilities for, 134 shopping centers, 242–251 sources of capital, 344–348

Commercial zoning districts, 76 Commingled real estate fund (CREF), 345 Commission, 163, 175–177

agreement, 166 “commission split”, 168 compensating the buyer’s broker,

168

Common area maintenance fees, 147 Communications improvement, 291 Community association, 223 Community banks, 347 Community leadership, 281–282 Community property, 30 Community shopping center, 243–244 Comparables, 192–193, 202 Comparative advantage

educational facilities, 280–281 transportation facilities, 280

Comparative-unit method, 197 Compensation

of property manager, 209 of real estate professional, 163,

175–177 Compounding, 360 Compound interest, 358 Comprehensive general plan, 76 Compulsory partition, 29 Concentric-circle model, 288 Concurrent estates, 29–31

community property, 30 joint tenancy, 29–30 tenancy by the entirety, 30 tenancy in common, 29

Condemnation proceeding, 74 Conditions of sale, 193 Condominium ownership, 31–32, 223,

223–224 bylaws, 31 condominium declaration, 31 covenants, conditions, and restric-

tions (CC&Rs) and, 50–51 individual unit deed, 32 legal description, 43

Congressional survey system. See Rectan- gular survey system

Conservation easement, 64–65, 233 Consideration, 100–101 Construction, 12 Construction costs, 197 Construction lien, 57 Consulting, 12 Consumer Credit Protection Act, 338 Contingencies, 121–122, 137 Contingent remainder, 26 Continuing education, 164 “Continuous” possession, 67 Contract for deed, 129–130, 137, 328 Contract(s). See also Real estate sales

contracts breach of contract, 120

00RePrinciples_BOOK.indb 438 11/25/2014 8:04:15 AM

Index 439

brokers and, 163 contingencies, 121–122 defined, 137 leases, 143–159 necessary elements of, 118–120

Contractual capacity, 118–119 Contribution principle, 186 Convenience center, 243 Conventional loans, 335–336 Conventions, 256 Cooling system, inspection of, 316 Cooperative ownership, 31, 32, 223–224 Corporate real estate asset managers, 215,

217 Cost approach, 190, 196–200, 203

accrued depreciation estimation, 198–199

application of, 198–199 example of, 198 production cost estimation,

197–198 site value estimation, 196

Cost recovery allowance, 405 Counteroffer, 118 Country Club Plaza (Kansas City), 245,

250 Covenant against encumbrances, 102 Covenant of further assurances, 103 Covenant of quiet enjoyment, 153 Covenant of seisin, 102 Covenants, conditions, and restrictions

(CC&Rs), 50–53, 67 Crawlspace, inspection of, 315 Created environment, 281 Credit bureaus, 346 Credit scores, 346 Credit unions, 337 Crime statistics, 313 Culpepper, Douglas, 62

Davis, John, 62 Davis v. Culpepper, 62 Debt assets, 270 Debt coverage ratio (DCR), 349 Debt service, 404 Deed in lieu of foreclosure, 330 Deed of trust, 328–329 Deed(s), 18, 100–107

bargain and sale deed, 102, 103 covenants and warranties, 102, 114 degree of protection, 102–103 execution of, 101

executor’s deed, 107 for special uses, 107 legal description of property, 101 necessary elements of, 100,

105–107 quitclaim deed, 102, 105–106 seller responsibility for, 133 special warranty deed, 102, 103,

133 warranty deed, 102–103, 104–105,

133 Deficiency judgment, 328 Deflation, 307–308 Denver, CO, 281 Department of Veterans Affairs Loan

Guarantee Program, 332–333 Depreciation

deductions, 405 estimating, 198

Descendible right, 25 Desk fee arrangements, 174–175 Destination hotels, 256 Development, 12. See also Residential

development developmental density, 79 lodging, 253–257 zoning restrictions, determining,

132 Devisable right, 24 Disclosure, of agency relationship, 171 Discounted cash flow model

after-tax cash flows, 403–407 applying, 401–403

Discounting, 360 Discount points, 383–385 Discount shopping center, 244 Discrimination, 171–172, 177, 211 Disposition, of property, 216 Diversification, 396–397 Dolan v. Tigard, 94 Dominant estate, 59 Down payment source guidelines, 342 Dual agent, 165 Due-on-sale clause, 325

Earnest money, 170 Easement(s), 58–64

and license compared, 63–64 conservation easement, 64 defined, 58, 67 easement appurtenant, 59 easement by implication, 60

easement by prescription, 61–62, 103

easement in gross, 59 express grant or reservation, 60 implication, 60–61 in title insurance policy, 111 nature of, 62–63 public and private restrictions, 49,

67 termination of, 63–64 types of, 59

Easton v. Strassburger, 169 Economic obsolescence, 198 Economics

and real estate, 9 economic base, 282–283 factors influencing city growth and

decline, 280–283 vitality of location, 5

Edenton Cotton Mill Village, NC, 296 Educational facilities, 280–281 Effective gross income, 404 Effective interest rate, 404 Electrical system, inspection of, 315 Eminent domain, 74, 75–76 Empire State Building, 28 Employment

demand, and housing, 284 trends, 286

Empty nesters, 223 Encroachment, 64 Encumbrances, 49. See also Private land

use controls; Public land use controls in title insurance policy, 111 seller responsibility for removing,

133 Equal Credit Opportunity Act, 338, 343 Equifax, 346 Equitable ownership, 328 Equity assets, 270–271 Equity reversion, 396 Erie Canal, 280 Escheat, 90 Escrow accounts, 170 Escrow agent, 136, 318 Escrow closing, 136–137 Estate planning, 26 Estate pur autre vie, 26 Estates in land, 23–28

freehold estates, 23–26 types of, 24

Estates in severalty, 29 Euclid, Village of v. Ambler Realty Com-

pany, 91

00RePrinciples_BOOK.indb 439 11/25/2014 8:04:15 AM

440 Index

Eviction proceedings, 27, 214–216 illegal subleasing, 147 state laws regarding, 155 tenancy at sufferance and, 145

Exclusive-brokerage (exclusive agency) listing, 167–170, 171

Exclusive-right-to-represent, 168 Exclusive-right-to-sell listing, 167 Executor’s deed, 107 Exemptions, 72 Expense stop, 147 Experian, 346 Export activities, 282 External obsolescence, 198

Factory outlet center, 244 Fair Credit Reporting Act, 339–340 Fair housing, 171–172, 177 Fair Housing Act of 1988, 171, 211 Fair, Isaac & Co., 346 Fannie Mae, 333 Farm and open land, 11, 39 Federal Emergency Management Admin-

istration (FEMA), 340 Federal Home Loan Mortgage Corpora-

tion (Freddie Mac), 335–336 Federal Housing Administration (FHA),

331–332 Federal legislation affecting mortgage

lending, 338 Federal National Mortgage Association

(Fannie Mae), 333 Fee interest time-share, 32 Fee simple absolute estates, 24–25 Fee simple transaction, 144 FHA (Federal Housing Administration),

331–332 FHA-insured loan, 331 Fiduciary, 164–165, 169 Filtering, 288 Final plat, 87–90 Finance/financing, 11

asset managers and, 215–216 buyer and, 131 financial decision making, 398–401 internal rate of return, 368–369 IRR rule, 400–401 net present value, 368–369 shopping for a mortgage loan, 317 terms, 193–194

Financial calculators, 361

Financial feasibility analysis, 237 Financial Institutions Reform, Recovery,

and Enforcement Act (FIRREA), 182, 201

Financial leverage, 397–398 Financial risk, 357 Financing contingency, 121, 131 Fixed location, 4, 13 Fixed-rate mortgage

alternatives to, 386–390 discount points and effective inter-

est rates, 383–386 prepayment, 378–382 refinancing, 382–383

Fixed-rent lease, 146 Fixtures, 18–20

test intent of the parties, 19 tests for status of, 19–20

Flipping, 408–410 Flood Disaster Protection Act, 339 Floor-area ratio (FAR), 79–80 Floors, inspection of, 315 Foreclosure, 56, 327–329

alternative security instruments, 328–330

foreclosure sale, 74 types of, 328

For-sale-by-owner (FSBO), 122 Fort Lauderdale, FL, 265–267 Franchises (brokerage), 174 Fraud, 119–120, 170 Freddie Mac, 335–336 Freehold estates, 23–26

fee simple absolute estate, 24–25 life estate, 25–26 qualified fee estate, 25, 44

Front-end ratio, 342 Functional obsolescence, 198 Future value of an annuity, 364

General lien, 54 Gentrification, 297 Gestation period, 7, 13, 295 Ghiran, Maria, 57 GI Bill of Rights, 332 Ginnie Mae. See Government National

Mortgage Association (Ginnie Mae) Ginsberg, Laurence, 85 Glass, Joan, 22 Glass v. Goeckel, 22 Glossary, 413–430

Goeckel, Richard and Kathleen, 22 Good title, 107, 114 Government National Mortgage Associa-

tion (Ginnie Mae), 334–335 Government survey system. See Rectan-

gular survey system Graduated-rent lease, 146, 157 Grant deed, 103 Grantee/grantor, 23, 100 Grantor and grantee indexes, 110, 113 Green, Elmo, 172 Green v. Sabre Village, 172 Gross absorption, 274 Gross income multiplier, 200–201 Gross leasable area, 243 Gross lease, 145, 155 Gross selling price, 407 Ground lease, 145, 155 Growth patterns. See Urban growth

patterns Guide meridians, 36 Gunter, Edmond, 36

Heating system, inspection of, 316 Height limitations, 79 Highest and best use analysis, 188–189 Highest and best use concept, 286–288 Highest and best use of land with

improvements, 189 Highland Falls Country Club (NC), 230 Highway hotel, 254 Highway improvement, 291 Home inspections, 314–316 Home purchase decisions

affordability, 310–311 making and closing the deal,

316–318 property choice, 312–316 real estate agent and, 316 rent-or-buy decision, 304–309, 319

Homestead Act, 39 “Hostile” possession, 67 Hostile use, 61 Hotels, 256–259

lodging space market, 269 Housing discrimination, 171 Housing finance, 330–336 Housing trend analysis, 231 Hoyt, Homer, 289 HUD-1 Uniform Settlement Statement,

339

00RePrinciples_BOOK.indb 440 11/25/2014 8:04:15 AM

Index 441

Impact fees, 90 Impact zoning, 80–81 Implied grant, 60 Implied reservation, 61 Incentive zoning, 81 Incipient decline, 295 Income approach, 190–191, 199–203, 203

gross income multiplier, 200–201 net income capitalization, 201

Income ratio guidelines, 342–343 Income taxes, on investment properties,

405 Index lease, 146 Individual unit deed, 32 Industrial real estate, 10. See also Com-

mercial real estate case study, 254 industrial parks and distribution

facilities, 252 site analysis, 254–255

Industrial zoning districts, 76 In-filling, 288 Inflation, 307–308 Infrastructure, 291 Initial equity, 401–402 Inspection, 316

rental property, 213 repair contingency, 122 seller and, 134

Institute of Real Estate Management certifications, 208

Insurable title, 107 Insurable value, 185–186 Insurance

flood, 339 private mortgage insurance, 332 property, 132 title, 107

Insurance binder, 132 Intensity of use, 79 Interest-only loans, 374–375 Interest rates, 307

effective interest rate, 384 interest rate caps, 388 teaser rates, 388–389

Internal rate of return, 368–369, 384, 400–401

Interstate North Industrial Park (GA), 254 Interval ownership (time-share), 32 Inverse condemnation, 75, 78 Investment properties. See Real estate

investment

Investment value, 185 Involuntary liens, 54 IRR decision rule, 400–401 Irwin, Robert, 211 Isakson, Andy and Kevin, 8

J.C. Nichols Company, 250 Johnson-Perkins appraisal firm, 255 Joint tenancy, 29–30 Judgment lien, 58 Judicial foreclosure, 328 Judicial sale, 58 Just compensation, 74

Kelly, Richard and Mary, 121 Kelly v. Ryan, 121 Kelo v. the City of New London, 77 Krish, Howard, 57

Labor force, 281 Lakewood Greens Homeowners Assoc. v.

Silberman, 56 Land contracts, 129, 328 Landlord(s)

adequate maintenance duty, 154 liability of, for injuries to guests of

tenants, 156 rights and obligations of, 153–156 state statutes affecting landlord-

tenant relationship, 155 Landlord’s Troubleshooter, The (Irwin),

211 Land rent, 286 Land-use controls, 6 Land-use planning, 14 Land uses, interdependence of, 4–5, 75 LaSalle Investment Advisors, 275 Lawful purpose, of contract, 119 Leadership, community, 281–282 Leased fee estate, 27, 144 Leasehold estate, 23, 26–27, 144 Leasehold interest, 147 Lease(s), 18, 143–159

assignment and subleasing of, 147 classification of, 144–146 defined, 144, 155 expenses, 147

improvements to property and, 148 landlord-tenant relationship,

146–159 legal highlights, 154–155 renewal options, 147, 153–154 rent payment or adjustment meth-

ods, 145–146 rights/obligations of tenant and

landlord, 153–156 security deposits, 148, 155 type of use, 145

Lee, Joe, 230 Legal descriptions, of property, 32–43

air lot, 43 metes and bounds, 33–35, 40 rectangular survey system, 36–41 references to recorded plats, 42–44

Lending system, 330–336 Department of Veterans Affairs

Loan Guarantee Program, 332–333

Federal Home Loan Mortgage Corporation (Freddie Mac), 335–336

Federal Housing Administration (FHA), 331–332

Federal National Mortgage Associa- tion (Fannie Mae), 333

Government National Mortgage Association (Ginnie Mae), 334–335

Lessee/lessor, 23 Letter of commitment, 343 Levittown, NY, 228 Levitt, William, 228 License

and easement compared, 63–64 of real estate professional, 163

Licensed residential real property appraiser, 183

Lien(s), 54–58 defined, 54, 67 for unpaid taxes, 74 general, 58 in title insurance policy, 111 mechanics’ liens, 57–58 mortgages, 56 voluntary and involuntary, 54

Lien theory, 324 Life estate, 23, 25–26 Life insurance company investors, 344 Life tenant, 26 Limited service listing, 167–169

00RePrinciples_BOOK.indb 441 11/25/2014 8:04:16 AM

442 Index

Liquidity risk, 357, 398 Listing agreement, 162, 166, 176 Listing broker, 165 Listing price, 162 Littoral proprietors, 22 Loan assumption papers, 133 Loan origination, 330

duties of the originator, 338 fee, 134, 383–385

Loan repayment schedule, 308 Loan-to-value ratio guidelines (LTV

ratio), 342–343 Location

factors influencing desirability of, 312–316

fixed, 4 importance of, 5 locational characteristics, 193 shopping centers and, 248–250

Lodging space market, 269 Long-run demand, analysis of, 285–286 Loretto, Jean, 91–92 Loretto v. Teleprompter Manhattan CATV

Corp., 92 Lucas v. South Carolina Coastal Council,

92 Luck, Thomas, 156 Luck v. GWWS L. P. (1997), 156

Mains Farm Homeowners Association v. Worthington, 53

Maintenance, property manager and, 213 Mall of America (MN), 246 Management agreement, 208–212, 217

manager powers, 209–210 Mandatory dedication, 87, 93–94 Manufactured homes, 226 “Marital community” property, 30 Marketable title, 107 Market analysis, 237

basic inputs to, 273–274 supply and demand changes and,

274 Market area, delineation of, 231 Market conditions, 193 Marketing, 162 Market value, 72, 184

cost of production versus, 185 price versus, 185

McCune, John and Faye, 65 Meadow Brook Ranch use covenants,

51–52

Mechanic’s lien, 74 Megamall, 246 Merger (to terminate easement), 63 Metes and bounds, 33–35, 40

combined with rectangular survey systems, 40–43

Microsoft Excel, 360–362 Milford Hills case study, 232–234

pro forma cash flow statement, 236 projected development expenses,

235 Millage rates, 74 Mineral rights, 20 Minimum lot sizes, 79–80 Misrepresentation, 170 Mobile home, 226 Money center banks, 347 Monthly housing expenses, 343–344 Months supply, 274–275 Mortgage-backed bonds, 335 Mortgage-backed securities, 271, 334,

335 Mortgage bank and brokerage industries,

11 Mortgage bankers, 336 Mortgage brokers, 336 Mortgage companies, 112 Mortgage credit, 11 Mortgage credit report, 340 Mortgage debt, 14, 337 Mortgage debt ratio, 342 Mortgagee, 56 Mortgage Guaranty Insurance Corpora-

tion (MGIC), 332 Mortgage insurance, 331–332 Mortgage interest rates, 307 Mortgage market participants, 336–338 Mortgage mechanics, 374–378

amortization schedule, for annual payment loan, 376–378

amortization schedule, for monthly payment loan, 378

fixed-rate mortgage and prepay- ment, 378–382

interest-only versus amortizing loans, 374–375

Mortgage originators and investors, 336–338

Mortgage payment formula, 365–366 Mortgage(s). See also Fixed-rate mort-

gage; Lending system; Mortgage mechanics

adjustable-rate, 388–390 and contract for deed, 129–130

as lien on property, 56 conventional loans, 335–336 credit scoring and, 346 default, 74 defined, 324 down payment, 342 foreclosure, 56, 328–330 history of mortgage concept, 324 income ratio guidelines, 342 loan repayment schedule, 308 modern concepts of, 324 payments, calculating, 310–311 promissory note, 325–328 qualification of applicant, 340 qualification of property, 341 refinancing, 382–383 risk assessment, 341–343 shopping for a mortgage loan, 317 two-step (reset) mortgages,

387–388 underwriting, 340–341, 343 U.S. housing finance system,

330–336 U.S. mortgage practice, 325

Mortgagor, 56 Motels, 255 Multifamily residences, 223–226 Multiple listing services, 174 Multiple-nuclei growth, 290–291

National Flood Insurance Program, 340 Natural resources, 281 Negative easement, 64 Negative renewal clause, 154 Negotiation

brokers and, 162–163 of contract, 122–123, 129–130, 137,

317–318 of lease, 212

Neighborhood case study, 296 defined, 194, 294 life cycle, 294–295 revitalization, 296 stabilization and rehabilitation, 296

Neighborhood shopping center, 243 Net absorption, 274 Net income capitalization, 201 Net lease, 146, 157 Net listing, 167 Net-net lease, 146 Net operating income (NOI), 349, 404

00RePrinciples_BOOK.indb 442 11/25/2014 8:04:16 AM

Index 443

Net present value, 368–369, 399–400 Net selling price, 407 New Haverford Partnership v. Stroot and

Watson, 154 New York, NY, 280 Nonbasic activities, 282 Nonconforming uses, 84 Nonjudicial foreclosure, 328 Northgate Shopping Center (Seattle),

245–246 Notice to renew, 154–155 Notice to terminate, 154 NPV decision rule, 368–369, 399–400 Nuisance law, 75–76

Offer, 118 Offeree/offeror, 118 Offering price, 162 Office buildings, 249–250

case studies, 253, 255 Office of Fair Housing and Equal Oppor-

tunity, 171 Office park, 249 Office space market, 268–269 Oglethorpe, James, 227 Olmsted, Fredrick Law, 227 “Open and notorious” possession, 67 Open listing, 166, 167, 171 Operating cash flow, 396 Operating expenses, 404 Option-to-buy contracts, 128 Oral contracts, 120–121 Origination fees, 383–385 “Other people’s money”, 397 Owner-occupied residential, 11, 262–265

market dynamics, 263–265 supply/demand equilibrium model,

262–263 Ownership, restrictions on. See Private

land use controls; Public land use controls

Park Springs retirement community case study, 8–9

Parkview Associates v. City of New York, 85

Partial performance, of contract, 120 Partition of property, 29 Pass-through certificates, 335 patio house, 222

Pay-through bonds, 335 Penn Central Transportation Co. v. New

York City, 93 Pennsylvania Coal Company v. Mahon,

91 Pension fund investors, 345–347 Percentage lease, 146, 155 Percolating water, 23 Performance zoning, 80–81 Period of ownership, 308–309 Personal property, 4, 18 Physical characteristics, in comparables,

194 Physical deterioration, 198 Pittman, Jeffrey, 135 Pittman v. Canham, 135 Pittsburgh, PA, 281 Planned unit developments (PUDs),

80–81 Plats, 42–44

final plat, 87, 87–88 preliminary plat, 87–88 reference to recorded plat, on deed,

101 Plexes, 223 Points, 134 Police power, 75, 78–79 Population-serving activities, 282 Portfolio diversification, 396–397 Portland, OR, 83–84 Positive renewal clause, 154 Potential gross income, 403 Power center (shopping center), 244 Preapplication conference, 86 Preliminary plat, 87 Prepayment

clause, in promissory note, 325 of fixed-rate mortgage, 379

Prescriptive easement, 61–62, 103 Presently possessed interests, 23 Present value calculation, 359 Present value of an annuity, 363–364 Preservation North Carolina, 296 Price

impact of inflation or deflation on, 307–308

versus market value, 185 Primary mortgage market, 330 Primary trade area, 247 Principal (employer), 164 Principal meridians, 36 Principle of anticipation, 186 Principle of change, 186 Principle of contribution, 186

Principle of substitution, 186 Prior appropriation doctrine, 22 Private land use controls, 49–69. See

also Public land use controls adverse possession, 66–67 covenants, conditions, and restric-

tions (CC&Rs), 50–53 disputes, 53–55 easements, 58–64 encroachments, 64 liens, 54–58 profit a prendre, 64

Private markets, 270 Private mortgage insurance (PMI), 332 Professional market analysis reports, 275 Profit a prendre, 64, 68 Promissory note, 325–328 Property appraiser, 73 Property assessor, 73 Property, choosing, 312–316 Property expenses, 136 Property flipping, 408–410 Property insurance, 132 Property management/manager, 11, 14

administrative functions, 210 lease negotiation function, 212 management agreement, 208–212 marketing and advertising func-

tions, 210–211 move-in inspections and, 212 move-out inspections and, 215 property maintenance and, 213 property manager compensation,

209 rent collection function, 214–216 rent schedules and, 224 role of property manager, 208 security deposits and, 215 tenant selection function, 211–212

Property rights conveyed, 193 Property tax

administration of, 73–74 assessment, 185 billing and collection, 74 calculation of, 72–73 process, 72–73 rates, and quality of public services,

313 Property value

appreciation, 396 assessment, 73 uniqueness of real estate and, 4

Przybylo, Paul and Denise, 66 Public debt market, 271

00RePrinciples_BOOK.indb 443 11/25/2014 8:04:16 AM

444 Index

Public land use controls, 71–96. See also Private land use controls

building codes, 85–86 comprehensive general plan, 76 eminent domain, 74 escheat, 90 impact fees, 90 mandatory dedication, 87 police power, 75–78 property tax, 72–77 “public use” defined, 77 subdivision regulations, 86–88 takings, 91–95 zoning, 76–83

Public liens for delinquent taxes, 58 Public markets transactions, 270 Public services, property tax rates and,

313 Public use, 74–75 Purchase decisions. See Home purchase

decisions Purchasing power risk, 357

Qualified fee estates, 24, 25 Qualifying the buyer, 162 Quantity-survey method, 197 Quitclaim deed, 102, 105–107

Racial discrimination, 171–172, 177 Radburn, NJ, 227–228 Range lines, 37 Rate of return, 356 Real estate

classifications of, 11 defined, 4, 13 description, for deed, 101–102 economic importance of, 9 special characteristics of, 4–9

Real estate asset markets, 270–272, 276 price determinants in, 271–272 tying space and asset markets

together, 272–273 Real estate associate, 163 Real estate brokerage. See Brokerage and

brokerage specialties Real estate broker, defined, 163 Real estate decisions, 2–3 Real estate demand, analyzing, 284–285 Real estate improvements

gestation period of, 7

long life and long-term commit- ments of, 6–7

Real estate investment advantages of, 396–398 disadvantages of, 398 discounted cash flow model,

401–410 financial decision making, 398–401 financial leverage and, 397–398 portfolio diversification, 396–397 property flipping, 408–410 wealth maximization objective, 399

Real estate investment trusts (REITs), 271, 345

Real estate sales contracts, 122–128. See also Contract(s)

contract for deed, 129–130 example of, 123–127 negotiating, 122–123, 129–130, 138 option-to-buy contracts, 128

Real Estate Settlement Procedures Act (RESPA), 338–339

Real estate system, 273 Real property, 4, 18

and personal property compared, 18 transfer of ownership rights (title),

18 Reappraisal lease, 146, 155 Recovery fund, 164 Recreational facilities, 313 Rectangular survey system, 36–41

combined with metes-and-bounds method, 40–43

principal meridians, 38 principal meridians and base lines,

36 sections, 39–41 townships, 37–38

Refinancing, 382–383 Regional banks, 347 Regional economics. See Urban and

regional economics Regulation Z, 338 Regulatory environment

appraisal, 182–183 brokerage, 164

Remainder interest, 23, 26 Rent

collection, 214–216 nonpayment of, 155

Rental agreement. See Lease(s) Renter-occupied residential, 11 Replacement cost, 197 Reproduction cost, 197

Required rate of return, 399 Reset mortgages, 387–388 Residential development, 222–229

financial feasibility analysis, 237 manufactured homes, 226 market and feasibility analysis,

229–237 multifamily residences, 223–226 second homes, 229 single-family detached, 222–223

Residential markets, owner-occupied, 262–265

Residential space market, 270 Residential zoning districts, 78 Resort hotels, 256 Reston, VA, 228 Restrictions of record, 131 Reversion interest, 23, 25 Right of reentry, 27 Right of survivorship, 29 Right to use time-share, 32 Riparian rights doctrine, 22 Risk

defined, 402 types of, 356–357

Risk and return, 356–357 Risk-free rate, 356 Riverside, IL, 227 Roof, inspection of, 315 Root of title, 113 Row houses, 222–223 RREEF Research, 275 Ryan, William, 121

Sale-and-leaseback, 216–217 Sales associates, 163–164, 175 Sales comparison approach, 190,

192–196, 202 adjustment of sales data, 192–195 applying, 194–196 comparable sales data, 192–193 market data grid, 195

Sales contracts. See Real estate sales contracts

San Francisco, CA City Planning Code, 81 geographic constraints, on growth,

289 Savannah, GA, 227 Saville, Barbara, 172 Savings institutions, 336 School quality, 313

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Index 445

Seasonal hotels, 256 Secondary mortgage market, 11, 330,

333–338 Secondary trade area, 247 Second homes, 229–232 Sections, 39–41 Sector growth, 289–290 Secured loan, 324 Security deposits, 148, 155

return of, by property manager, 215 Segregated-cost method, 197 Seller, responsibilities at closing, 133–135 Seller’s agent, 166–175

duties to buyers, 170–171 duties to seller, 170

Selling a home, 318–320 choosing a real estate agent, 319 preparing the house for sale, 318 setting an asking price, 319

Selling broker, 165 Servient estate, 59 Setback requirements, 79–80 Settlement. See Title closings Sewer facilities, 293–294 Shields, Greg and Kristin, 283 Shopping center

anchor tenants, 246, 249 case study, 251 competition, analysis of, 247–248 development, 242–245, 246–251 evolution of, 244–245 market and feasibility analysis,

246–251 tenant selection, 249 types of, 243–244, 256

Short-run demand, analysis of, 284 Silberman, Sol and Renee, 56 Simon, Robert E., 228 Single-family attached houses, 222–223 Single-family detached houses, 222 Sinking fund payments, 364–365 Sinking fund problem, 365 Smart growth controversy, 83–84 Social unit, 294 Southdale Center Mall (MN), 246 South Pointe, Miami Beach, FL, 81 Space market, 267–268 Specialty shopping center, 244 Special-use permit, 82 Special warranty deed, 102, 103, 133 Specific lien, 54 Specific performance, 120 Sprawl, 83 Standard parallels, 36 Statement of nondiscrimination, 344

State real estate commissions, 164 Statute of frauds, 119 Steering, 171 Step-up rent lease, 146 St. Juste, Andre, 86 Stock market, 270 “Straw man”, 30 Strict foreclosure, 328 Strip style shopping center, 243 Subdivision

plat of, 44 regulations, 86–88

Sublease, 147 Substitution principle, 186 Subterranean stream, 23 Suburbs, 222, 244 Super-regional shopping center, 244 Superstore, 244 Supply and demand, 7

analysis of future supply, 231, 235 analysis of local real estate demand,

284–285 analysis of long-run demand,

285–286 analysis of short-run demand, 284 determination of future demand,

231 Surface rights, 20 Survey, competitive, 248 Survey of Buying Power, 247 Surveys

buyer’s responsibility for, 132 to avoid adverse possession, 66

Takings, 90–91 Taxable income, 404–406 Taxable value, 72 Tax digest, 74 Tax(es). See also Property tax

ad valorem tax, 72 deductions for ground lease pay-

ment, 145 flat tax proponents, 310 income tax savings, and ownership,

305–306 public liens for delinquent taxes, 58 records, and title search, 110

Tax Increment Financing (TIF), 347 Tax rate adjustments, 74 Tax sale, 74 Teachers Insurance Annuity Association

(TIAA), 345 Teaser rates, 388–389

Telecommuting, 252 Tenancy at sufferance, 27, 145, 155 Tenancy at will, 27, 145, 155

termination notice for, 27 Tenancy by the entirety, 30 Tenancy for a stated period, 27, 144, 155 Tenancy from period to period, 27, 145,

155 Tenancy in common, 29 Tenant selection

property managers and, 211–212 shopping centers and, 249

Term (stated period of time), 144 Test of adaptability, 19 Test of attachment, 19 Test of intent of the parties, 19 Thomas A. McElwee v. Southeastern

Pennsylvania Transportation Author- ity, 78

Thrift industry, 337 Tien Tao Association v. Kingsbridge Park

Community Association, 55 TIF (Tax Increment Financing), 347 Time-shares, 32, 229 Time value of money

annuity, 362–364 applying present value formula to

cash-flow streams, 362 compound interest, 358 financial calculators and computer

spreadsheets and, 360–362 future value of a lump sum,

358–359 monthly compounding, 366–367 mortgage payment formula,

365–366 present value of a lump sum,

359–360, 362 principle, 357 sinking fund payments, 364–365

Title, 18. See also Title closings; Title search

defect, 109, 112, 131 examining title evidence, buyer

and, 131 good title, 107, 114 recording system, 109–110 title abstract, 110–111 title insurance, 111–112 title opinion, 110 title search, 109 Torrens system, 112, 114

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446 Index

Title closings, 130–142 attorneys and escrow agents and,

318 brokers and, 163 buyer’s responsibilities, 131–134 costs, 134–135, 138 escrow closing, 136–137 parties present at, 136 seller’s responsibilities, 133–135

Title contingency, 121–122 Title examiner (abstractor), 109 Title insurance, 107 Title opinion, 107 Title perfect of record, 107 Title search, 107, 109–110

completion of, 110 grantor and grantee indexes, 110,

113 recording system, 109–110

Title theory, 324 Torrens system, 112, 114 Torto Wheaton Research, 275 Total debt ratio, 342–343 Town houses, 222–223 Township lines, 37–38 Townships, 37–38 Trade area, defining, 247 Trade fixtures, 19 Trainee appraiser, 182–183 Transaction broker, 165 Transactions, 7 Transferable development rights, 81 Transportation

facilities, 280 nodes, 289 urban growth and, 289, 292–293

Trans Union, 346 Triple-net lease, 146 Trump Building case study, 253 Trump, Donald, 82, 253 Trust deed, 328–329 Trustee, 328 Trustor, 328 Truth-in-Lending law, 338 Two-step mortgages, 386–388

Unconscionable condition, 122 Underground stream, 23 Underwriting (mortgages), 340–341 Uniform Settlement Statement (HUD-1),

339 Uniform Standards of Professional

Appraisal Practice (USPAP), 182–183 Uniqueness, of real estate, 4, 13 Unity of interest, 30–31 Unity of possession, 30 Unity of time, 30 Unity of title, 30 Unsecured loan, 324 Urban and regional economics, 280–283

axial growth, 289–290 bid-rent curve and highest and best

use, 286–289 case studies, 285 commercial growth, 297 industrial growth, 297–298 neighborhood change and, 293–298,

294–295 people and, 283–285 public facilities and, 291–293 residential growth, 298 urban growth pattern models,

287–291 water and sewer facilities, 293–294

Urban growth patterns axial growth, 289–290 concentric-circle growth, 288–289 multiple-nuclei growth, 290–291 sector growth, 289–290

U.S. Department of Housing and Urban Development (HUD), 171, 211

Vacancy and credit losses, 404 Vacancy rate, 274 Vacant land, highest and best use of, 189 VA-guaranteed loans, 332–333 Value, 184–187. See also Appraisal/

appraisers assessed value, 185 insurable value, 185–186

investment value, 185 market value, 184

Value in exchange, 185 Variance, 82 Vested remainder, 26 Voluntary liens, 54 Voluntary partitions, 29

Walling, Scott and Kathleen, 66 Walling v. Przybylos, 66 Walls, inspection of, 315 Warranty deed, 102–103, 133 Warranty deed without covenants, 103 Warranty forever, 103 Warranty of habitability principle, 153 Waste disposal, inspection of, 316 Water facilities, 293–294 Water rights, 20–23

navigable bodies of water, 21–22 nonnavigable bodies of water,

22–23 underground water, 23

Water supply, inspection of, 316 Wayne, County of v. Edward Hathcock, 77 Wealth maximization objective, 399 Worthington, Salma, 53

Zoning administrative relief, 82–83 amendments, 82 innovative issues, 79–81 intensity of use, 79–80 judicial relief, 84 legislative relief, 82, 84 nonconforming uses, 84 rezoning process, 233 type of use, 78 variance, 82 zoning changes, 82–86

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447

c h a p t e r 1 Why Study Real Estate? Courtesy of Chris Joith, Atlanta, Georgia. page 9

c h a p t e r 2 Property Rights and Legal Descriptions The Empire State Building design is a trademark of ESBC. page 28 Courtesy of Charles Floyd. page 40 Courtesy of Charles Floyd. page 41 Courtesy of Charles Floyd. page 43

c h a p t e r 11 Residential Land Uses Courtesy of Charles Floyd. page 230

c h a p t e r 12 Commercial and Industrial Land Uses Country Club Plaza. Photo provided by Highwoods Properties. page 250

Birkdale Village, Owned and Managed by Developers Diversified Realty, www.ddr.com. page 251

c h a p t e r 14 Urban and Regional Economics Photo courtesy of Preservation North Carolina. page 296

c r e d i t s a n d a c k n o w l e d g m e n t s

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Notes

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Notes

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Notes

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Notes