Piecing Together the Puzzle of Partial Interest
In most cases, appraisals are completed as “fee simple” interest, which is based on full unencumbered ownership of the property. However, in some instances, a client may request the value of a smaller percentage of interest due to the property being held by multiple owners. This “partial interest” type of appraisal is complex. To provide a credible value, the appraiser needs to understand the basics of legal and economic principles of property rights.
In my office, I have a poster of Albert Einstein and his quote “If you can’t explain it simply, you don’t understand it well enough.” So, let’s see if I can shed some light on the topic of partial interest so you may explain it simply.
Partial interest ownership is where a property is broken down into different fractional ownership shares such as 50-50 partners, four partners each owning 25 percent, and so on. This type of ownership generally happens over time as families, through estate planning, pass down property to multiple inheritors. Therefore, all owners must work together when making decisions involving the property. No one partner can sell or make decisions concerning the entire property; however, they may sell their percent interest.
One may presume the value of a partial interest property would be as simple as taking the fee simple value multiplied by the percentage of ownership. However, valuing partial ownership is not this straightforward; the percentage of property is actually worth less than the whole. Most buyers are not interested in buying a fraction of a property due to lack of control and non-liquidation. Bankers may also refuse to grant financing because they would have no way to foreclose on only a portion of the property if the buyer could not make payments. These points reduce the property’s marketability in the open market. Therefore, a discount on the value for the partial interest is necessary.
Hertz Appraisal Services uses the recommended guidelines from the Internal Revenue Service National Office Technical Advice Memorandum June 7, 1999; Number 199943003, released 10/29/1999 as a basis for analyzing partial interest. Simplified below is the method described in the IRS memorandum:
Start with the fee simple value
Calculate the estimated costs of partition (i.e. survey, appraisal, legal fees, etc.)
Calculate a net present value
Calculate the percentage ownership of this adjusted value
Calculating the costs of partitioning involves several assumptions because no two situations are the same. Some of the “negatives” of an undivided ownership interest include: the number of other co-owners; the time required to realize income from use or achieve a rate of return on the investment; the time and cost to partition; legal fees; lack of management; and lack of liquidity.
All of these factors help to define a discount rate for the less desirable partial interest property. The risks associated with partial ownership can reduce the market value of the property beyond the fractional ownership percentage. An appraiser must consider the facts related to the partial interest ownership to calculate a reasonable value discount.
Simply put, partial interest appraisals are complex puzzles that must be pieced together using assumptions to determine the discounted rate.