Lease Must Be Considered in Determining Fair Market Value

Facts: An owner and a tenant entered into a 20-year lease, with an option to renew for two additional 20-year terms. Under the terms of the lease, if the tenant exercised the renewal option, the annual rent would “seven percent of the value of the demised premises as of the date of commencement of each successive 10-year period.”

The lease defined the value of these premises to include the value of both the land and the buildings, and improvements located on it. The lease also stated that if the parties could not agree on the value of the premises for purposes of calculating the annual rent, an appraiser would be selected to value the property.

In March 2005, the tenant renewed the lease for the second 20-year term, but it was unable to negotiate the rent for the first 10 years of that renewal term. As a result, appraisers were called to value the premises. The owner’s appraiser valued the premises at $7.1 million, while the tenant’s appraiser concluded that the premises were worth $3.43 million. The tenant’s appraiser, who offered a much lower number, explained that he had considered the effect of the net lease in his appraisal, whereas the owner’s appraiser did not.

The tenant filed suit, asking the court to rule that the lease and its terms must be considered when calculating the value of the premises to determine the rental rate. The lower court ruled in favor of the owner, and the tenant appealed.

Decision: A New York appeals court reversed and ruled in favor of the tenant.

Reasoning: The court, relying on case law, determined that in valuing real property, “appraisers must pay attention to the limitations of ownership rights, which includes easements, encroachments, leases and the disposition of air or subsurface rights.” Therefore, the court held that absent an agreement to the contrary, the effect of a net lease must be considered in valuing property for the purpose of calculating rent for a renewal lease term.

Case in Point: 936 Second Avenue L.P. v. Second Corporate Development Co., Inc., June 2008