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Excess Rent
By M. Robert Goldstein & Michael J. Goldstein
Recently, a tax certiorari decision was published in the
New York Law Journal which discussed, with a
sophistication we do not always see, a complicated and rare
concept. That decision, Matter of Kato Real Estate Corp.
(NYLJ, 8/23/99, p. 26, col 3, Parness, J.) dealt with the
treatment of actual rent paid which is in excess of market
rental value and its place in the value of real estate. While
the decision, we believe, correctly deals with the issue,
we question whether it should apply to tax certiorari, as
opposed to condemnation. The two authors of this column disagree
as to whether it should. (This happened once before in the
27 years we have been writing this column). A discussion of
the concept and the case law, including Kato
is necessary before we explain why.
It is a rare income producing property that produces a rent
exactly at the market. We doubt that such a property exists
at all. First of all, the market is not static. It goes up
and down, usually up. With the passage of time, market rents
are usually greater than the base rents in the lease and escalation
clauses are not always an accurate predictor of trends. Sometimes,
the negotiated rent is simply improvident.
As everybody in the practice knows, value in condemnation
and tax certiorari is based, not on actual rents, but on market
rents. The reason is that the entire bundle of rights must
be valued. In condemnation, that is what has been taken and
in tax certiorari, that is what is being valued.
Assume, if you will, a ten year lease, which reflects the
market when made. To keep the problem uncomplicated, we will
not consider escalation clauses. Five years go by and inflation
has eroded the value of the dollar to some extent so that
if a new lease were entered into today, a greater rent could
be obtained. For the next five years, that lease remains an
encumbrance on the property and that property will produce
an inadequate return compared to the market.
Assume now that the property is to be sold with that lease.
The buyer knows that in five years, he or she will be able
to obtain market rents for that space but, for those five
years, the lease remains an encumbrance. The tenant, meanwhile,
has a valuable property right, i.e., the right, for the next
five years to pay less rent than he or she would have to if
the lease were negotiated now. He or she could sell that right
for value. The purchaser of the real estate, meanwhile, will
pay less for the property as measured by the fact that he
or she will collect less rent for five years.
What happens in our theoretical situation is that the landlord,
who is selling the property, does not own and, therefore,
is not selling the entire bundle of rights. The balance of
that bundle is owned by the tenant. The value of the property,
all of the bundle included, is the value of what is owned
by the landlord plus the value of what is owned by the tenant.
Of course there may be parts of the bundle owned by others
but they are not relevant to this discussion.
How is this applied? In tax certiorari proceedings it is
not. The property is simply valued at market rents, free of
encumbrances. In condemnation proceedings, as discussed above,
the condemnor usually takes all right, title and interest,
i.e., the entire bundle of rights. It does not take, as does
the ordinary purchaser, a fee subject to the lease. It takes
the tenant's interest as well. In our theoretical situation
above, the appraisers value the property by using market rents
but what has happened is they value a property that is not
fully owned by the title holder. They value the leasehold
interest as well. The lessee, with five years to go of paying
less than market rent, has, in a condemnation, had a valuable
right taken from him or her and, if nothing else intervenes,
he or she is entitled to be paid for it. The difference between
the actual rent, and the market rent is calculated for the
balance of the lease and that is what has been taken from
the lessee for which he or she must be compensated.
The tenant has had this right taken on the date of the condemnation
(title vesting date or date of appropriation, depending on
what court you are in) and it is the value of that right,
on that day, that determines what the lessee is to receive.
Had there been no condemnation, the lessee would have had
the benefit of the lower rent spread out over a five year
period. In theory, at least, he or she is receiving that money,
in one lump sum, five years early. Had there been no condemnation
and the lessee wished to sell the right, no purchaser would
pay the exact amount of the five year difference in rents.
He or she would demand and get a discount for the fact that
the lessee is getting all of the money up front.
In condemnation, the value of the right to pay less rent
over a period of time is measured by the discount the seller
would have to give. This is measured, by the appraisers, by
calculating what amount, if put into in an interest bearing
investment, would accumulate interest in an amount which,
together with the principal, amounts to the difference, over
the remaining period of the lease, between the actual rent
and the market rent. The longer the period, of course, the
more time the principal has to accumulate interest and, therefore,
the less principal is needed. Therefore, the longer the lease
has to go, the deeper the discount. The more reliable, economically,
the lessee is who is bound on the lease, the lower the rate
of interest is required and, therefore, a greater amount of
principal will be necessary to bring the total to the difference
between the actual and market rents. The greater the reliability
of the lessee, therefore, the less the discount. Remember
this last fact as it has an important bearing on a point we
will make later. All of this, however, is usually academic
as most leases contain a condemnation clause which, unless
negotiated differently, has the tenant waiving his or her
leasehold claim. This is generally demanded by landlords because
the leasehold award is carved out of the total that would
otherwise go to the fee owner.
What happens, however, when, for whatever reason, the actual
rent is greater than market rents? In the few cases where
this has come up, not surprisingly, there has been a similar
process to what we have described above but with the landlord
this time, not the tenant, being the beneficiary. For the
most part, it has occurred in condemnation proceedings. Although
the case usually cited for the principle involved in awarding
excess rent to a condemnee is Matter of City of N.Y.
(Maxwell), (1961) 15 A.D.2d 153, 170, 222 N.Y.S.2d
786, 801, our discussion will use In re East N.Y. (1)
Community Devel. Plan Section II (Willonia Amusement Co.,
Inc.), 45 A.D.2d 1007, 358 N.Y.S.2d 52 (1974) because
that case was tried and argued by us and we are more familiar
with its facts.
The condemnee, in the Willonia Amusement Co.
case owned a once prosperous theater in what became a rather
bad section of the City. It had a lease with United Artists
Theater Circuit, Inc., at the time, the second largest theater
owner in the United States, and, at title vesting date, United
Artists was paying, to Willonia, $26,250 a year.
Because of the nature of the neighborhood and the impossibility
of running a profitable theater there, United Artists gave
it up and subleased to Piel Bros., a well known local brewer,
who took out the seats, leveled the floor and used it as a
warehouse. The lease from United Artists to Piel Bros. called
for $12,000 to be paid to United Artists and who, in turn,
paid $26,250 to Willonia.
The appraisers for both sides valued the building as a warehouse,
the condemnee, as well as the condemnor, adopting a rent substantially
less than the $26,250 paid by United Artists, capitalizing
that lesser rent. It occurred to us, however, that Willonia
lost, by virtue of the condemnation, a valuable right, i.e.,
the right to collect a higher than market rent from a giant,
financially responsible corporation. That right was taken
from it by the City when it took the property and the lease,
by operation of law, terminated. So the fee owner made a claim
for the value, as of title vesting date, of the difference
between the market rent and the rent Willonia would have collected
had that right not been taken from it by the condemnation.
The beauty of this, as we saw it, was that if the court adopted
a lesser rent than claimant's appraiser estimated was
the market, it would then automatically increase the difference
between the market rent and the rent paid by United Artists.
As the value of the property went down in the eyes of the
Court, the value of the excess rent, of necessity, had to
increase although not in the same numbers, as the market rent
was capitalized and the excess rent was discounted.
The trial court, unfortunately, did not agree with our position
and declined to award the value of the excess rent. An appeal
was taken and the Appellate Division modified the award by
paying for the excess rent, saying:
"In our opinion, notwithstanding that the rental
paid by [United Artists to Willonia] was unrelated
to the best use found by Special Term, Willonia was
entitled to recover its property's excess rental
value that Willonia would have received from [United
Artists] pursuant to its lease . . . had condemnation
not intervened . . ." (45 A.D.2d 1007, 358 N.Y.S.2d
52, supra)
The Appellate Division cited In re Maxwell, supra,
which said, in pertinent part:
". . . A lease for a rental in excess of the
reasonable rental value may be considered as an item
of value when the excess is due to the availability
of the property for a particular use by the tenant
in occupation (Matter of Port of New York Authority
(Lincoln Tunnel), 2 N.Y.2d 296, 159 N.Y.S.2d
825, 140 N.E.2d 740). Where these factors appear and
the continuation of the lease is not threatened by
any question of the tenant's responsibility,
the present value of the excess for the period of
the lease, plus renewals provided for therein, is
an additional element of value . . ." (15 A.D.2d
153, 170, 222 N.Y.S.2d 786, 801, supra).
It should be noted that nowhere in the discussion of this
issue in the Port Authority case, cited by the
Appellate Division in In re Maxwell, did the
Court of Appeals make reference to necessity of financial
responsibility on the part of the tenant. As we said earlier
in this column, part of the process of valuing the difference
between actual and market rent is assigning an interest rate
based on risk. The higher the risk (assumedly based on the
financial responsibility of the tenant), the higher the interest
rate and the deeper the discount. There is no need to require
financial responsibility in order to apply the principle as
it is already factored in in calculating the discount.
This brings us to the tax certiorari case that prompted this
discussion, Matter of Kato Real Estate Corp.,
(NYLJ, 8/23/99, p. 26, col 3, Parness, J., supra).
As with the previous condemnation cases discussed, this tax
certiorari case had to do with excess rents. The subject property
is ". . . a 45 story central air conditioned class A
office tower, 12 East 49th Street, Manhattan, known
as Tower 49." The assessed values for the years in question
ranged from $91,800,000 in 1990/91 to $65,250,000 in 1997/98
indicating an assessor's value, using an assessment ratio
of 45%, of $204,000,000 (1990) to $145,000,000 (1997).
It seems that First Boston Corp. (FBC) occupied 305,000 square
feet on the upper floors paying a rent of $53 a square foot.
However, FBC, was "a significant participant in the entity
that built and originally operated the building" and,
apparently, it entered into the lease when it was in that
position. The current owners, petitioners, were unrelated.
The City adopted this actual rent in the capitalization process
while petitioner, regarding it as a non-arms length lease,
disregarded it and estimated market rents ranging from $33
to $38 a square foot.
Justice Parness, a very sophisticated judge in the area of
real property valuation, addressed this:
"If as [petitioner] contends, the rents received are
substantially above market and that the excess above market
should not be capitalized because its duration may be limited,
then such claimed excess may be valued in a manner to account
for the additional risk to the purchaser that they may not
continue past the lease term. However, the excess rents
should not — as [petitioner] suggests — be ignored.
Any foreseeable risk of a decrease in rental income is but
one of many factors which a purchaser would take into account
when purchasing . . ."
". . . . if [petitioner] is correct in his opinion
that FBC rent is above market and that the excess over market
should not enter into the capitalization process, the fact
remains that it is an additional source of rental income
which impacts on what a property can bring on the market
since it contributes to the property's return on investment.
If as [petitioner] contends, continuation of the FBC rent
is not sufficiently predictable so as to foreclose its contribution
to value through capitalization, the value of such excess
can be accounted for . . . through a present value analysis
. . . ‘Where continuation of the rent is not threatened
by any question of the tenant's responsibility, the
present value of the excess [rent] for the period of the
lease is an additional element of value' (Matter
of City of New York (Maxwell), supra, 170) . . ."
(Bracketed word "rent" inserted in the original
Kato decision)
". . . Following [petitioner's] method the court
will apply appropriate capitalization and effective tax
rates to the above NOI's, and to those results add
the present value of tax escalation incomes as [petitioner]
did, but in addition, also add the present value of receiving
the FBC ‘excess' income."
We said, at the beginning of this column, that we question
whether adding the value of excess income in tax certiorari
cases is appropriate. In fact, one of us believes it is not.
The reason one of us believes it is not appropriate is as
follows.
The principle case cited for this concept is Matter
of City of New York (Maxwell), 15 A.D.2d 153, 170,
222 N.Y.S.2d 786, 801, supra. In re Maxwell
was a condemnation case. As with the case we described earlier,
In re East N.Y. (1) Community Level Plan Section II,
(Willonia Amusement Co., Inc.), 45 A.D.2d 1007, 350
N.Y.S.2d 52, supra. as well as the Court of
Appeals case cited in Maxwell, In re Port of New York
Authority (Lincoln Tunnel), 2 N.Y.2d 296, both condemnation
cases, when the condemnors acquired the properties, by operation
of law, the leases that provided the excess income terminated.
The owners of the properties were deprived of the right they
had to collect that excess rent for the balance of the terms
of the leases. Regardless of whether the excess rent was part
of the value of the real estate or independent of it, it was
acquired by the condemnor and had to be compensated for.
However, it was not a part of the value of the real estate.
Its existence was due to an agreement between two individuals
or entities and although dependent upon the availability of
the space to which it referred, it was not produced by that
space but rather by a personal agreement. The real estate
produced the market rent. The agreement produced the excess.
But for that agreement, the space could not and would not
generate that income. It was not inherent in the space itself,
independent of the personal agreement. It was not one of the
attributes of real estate that contributes to value such as
location, condition, etc. Not being produced by that space,
i.e., by that real estate, it was not a part of the value
of that real estate in spite of the fact that it, independently,
would be transferred to a purchaser with the sale of the real
estate.
The problem, we believe, stems from wording in In re
Maxwell, supra, which was not carefully considered.
In that decision, quoted by Special Term in the Kato
decision, the Appellate Division, unfortunately, said, ".
. . the present value of the excess for the period of the
lease . . . is an additional element of value."
(emphasis supplied) This wording is misleading.
Did the excess rent have a value? Yes, but on its own merits.
Should it have been compensated for in a condemnation context?
Yes, because it was taken, not because it was part of the
unencumbered value of the real estate. It was awarded in the
cited cases, not as part of the value of the real estate but
over and above it. As stated above, it was produced by an
agreement between two individuals, independent of the value
of the real estate, not by the real estate itself and was
not, therefore, part of the value of the real estate. As it
is only real estate that is being valued in a tax certiorari
case and it is only real estate that is being taxed, it was
not appropriate to add it to the value of the real estate
for tax purposes.
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