Textron Financial-New Jersey Inc. v. Herring Land Group, LLC,

2011 WL 2600749 (U.S. Dist. Ct. D. N.J. 2011) (Unpublished)
  • Opinion Date: June 29, 2011

LEASES; DRAFTING — When a lease calls for the use of fair market rent but does not provide a methodology for determining fair market rent, only calling for the appointment of appraisers, a court may require the appraisers to consider physical possibility, legal permissibly, financial feasibly, maximum productivity, as well as other factors.

A bank had its corporate headquarters and operations center on its own property. It entered into a sale-leaseback transaction in which it sold the building and improvements to a third-party and leased back the building, but it retained title to the land. As part of the transaction, the bank entered into a ground lease with the building’s owner. The original size of the land subject to the ground lease was 55 acres, but was later reduced to approximately 16 landlocked acres of property, with its only means of egress by way of a paved road across the other 39 acres. The ground lease set an initial rent for the land at $1.00, but provided that at the termination of the building lease, the bank would pay fair market rent, which would then be re-set every five years. The ground lease, however, did not provide a methodology for determining the fair market rent. It provided that the fee owner and the ground tenant would each appoint an appraiser, and, if the higher appraisal was more than 105% of the lower appraisal, a third appraiser would be chosen.

The parties agreed that the proper determination of fair market value was through the identification of the property’s highest and best use (HBU), but a property’s HBU often depends on many variables. One can look to the potential uses of vacant land when trying to determine the property’s HBU. But, the existing value of any improvements and the possible alteration of those improvements must also be considered. One appraisal report recognized that in order to determine a property’s HBU, one needs to consider the property under two scenarios: as vacant land and as presently improved, and then decided whether alteration of demolition of the improvements is the property’s highest and best use. In this case, that required treating the property as encumbered by the ground lease with an office building located on it. Another appraiser did not consider the ground lease or the existing improvements in calculating the property’s HBU, seeking only to determine its value as if it were vacant. The third appraiser concluded that the land must always be valued with the existing improvements for the remainder of the term of the ground lease, but failed to consider that, at some point in the future, the improvements could be obsolete and redevelopment would be more appropriate in order to achieve the HBU.

The Court found that the first appraiser’s methodology of factoring in the land’s value as vacant and improved was sound, but not completely proper in this case. The second appraisal was not acceptable because it failed to factor in the practical realities regarding redevelopment of the property as it did not evaluate the costs and financial feasibility of developing the property for its highest and best use. The third appraiser failed to consider that the buildings could become functionally obsolete prior to the end of the ground lease, and therefore, at some time in the future, the fair market rent would need to be determined by viewing the land as vacant. The Court found that, when evaluating value based on HBU, one must consider physical possibility, legal permissibility, financial feasibility, and maximum productivity, as well as other factors. These additional factors included vacancy rates and whether the density of a proposed development density would exceed demand and be out of character with the surrounding market. In this case, at the moment, financial feasibility weighed in favor of finding the existing building non-obsolete and against demolition or re-development of the property. But, every fifth year thereafter, when the fair market value had to be determined again, the valuation process would need to take into account the continued use of the building (which might then be past its useful life) and compare its continued use to other potential and financially feasible uses in order to determine the property’s highest and best use.