Valuing Undivided Property Interests

By: Charles A. Miller and Scot A. Torkelson

There are many forms of ownership for real estate assets: Closely Held Corporations, in which the owners are stockholders; Partnerships, in which the owners are partners or members; and Direct Ownership, where the owners are common tenants. Within each ownership type, the owners have certain rights and responsibilities. This article focuses on the factors which affect the value of the undivided fractional interests of common tenants. Common tenancy exists when more than one person has an ownership interest in the same property at the same time. Although common ownership interests can occur with any type of underlying asset, our discussion is limited to undivided interests in real estate.

An undivided property interest is typically created among family members or between persons in a relationship. The arrangement is often the result of no planning - it just happens. Predictably, this can lead to annoying misunderstandings among the common owners-at one end of the spectrum and lengthy litigation disputes-at the other end of the spectrum. Recent statutory reforms have changed the nature of shared interests themselves, the tax consequences associated with this type of ownership, and the methods of valuing the interests. There are two types of undivided interest situations: the joint tenancy agreement and the tenancy in common agreement.

Joint Tenancy
Joint tenancy is defined as the ownership of real estate by multiple individuals under the same deed with the right of survivorship. Joint tenancies are determined by the five "unities"
* Unity of Interest -owners share one and the same interest
* Unity of Time-ownership commences at one and the same time
* Unity of Title-ownership interests are created by a single deed; consent is required to encumber the property
* Unity of Possession-ownership of the undivided interest is of the whole property
* Unity of Person-owners have the right of survivorship

When one joint tenant dies, the interest of the deceased tenant is terminated. The surviving tenant is entitled to exclusive possession and surviving tenant's interest is correspondingly enlarged.

Tenancy in Common
Tenancy in common is a form of ownership whereby each owner holds an undivided interest in the property. Here, there is only unity of possession, i.e., an undivided interest in the whole property, not merely separate divisions of the property. Titles are separate and distinct. The owners have a shared ownership interest in the common areas, but upon the death of one owner, his/her ownership interest passes to the heirs, not to the surviving owners. 100% of the decedent's undivided interest in the property is included in the decedent's gross estate. Tenancies in common do not have the right of survivorship.

History of Tenancy in Common
In Europe during the Middle Ages, peasants were legally bound to live and work in one place - in servitude to the wealthy landowners. In return for working the owner's land, the peasants received: a house and some farm animals; a small adjoining plot of ground; a share of the surrounding fields and protection from outlaws and other lords. This "sharing of the fields" with other farmers formed the basis of the "commons" or "tenancy in common". The resulting relationships and rules related to tenancy in common originated in this period and pre-date modern democracy.

Rights and Duties of Co-tenants
Co-tenants, irrespective of the type of tenancy, share certain rights relative to each other and to the property, except to the extent they have modified these rights through an agreement among themselves. Each tenant has an unrestricted right of access to the property. Where one co-tenant wrongfully excludes another from making use of the property, the excluded co-tenant can bring a cause of action for 'ouster', and may receive the fair rental value of the property for the time that he was dispossessed. Each tenant has a right to an accounting of profits made from the property. If the property generates income such as rent, each tenant is entitled to a pro-rata share of that income. Each tenant has a right of contribution for the costs of owning the property. Co-tenants can be forced to contribute to the payment of expenses such as property taxes and mortgages on the entire property. Co-tenants do not have an obligation to contribute to any costs of repairing or improving the property. If one co-tenant adds a feature that enhances the value of the property, that co-tenant has no right to demand that any of the others share in the costs of adding that feature even if the other co-tenants reap greater profits from the property because of it. However, in situations where a partition lawsuit is undertaken, a co-tenant is entitled to recover the value added by his or her improvements of the property.

Conversely, if the co-tenant's "improvements" decrease the value of the property, the co-tenant is responsible for those decreases as well. Each co-tenant can independently encumber the co-tenant's own share in the property by taking out a mortgage on that share. Other co-tenants have no obligation to help pay a mortgage that only runs to another tenant's share of the property. The mortgagee can foreclose only on that mortgagor's share. In tenancy in common arrangements, each owner can mortgage his or her interest, but under a joint tenant arrangement, there is one mortgage for all owners.

If any party to a tenancy in common wishes to terminate the joint interest, he or she can do so through a partition of the property: a division of the land into distinctly owned plots - if such a division is legally permitted. If such a division is not legally permitted, the joint interest may be terminated by a forced sale of the property followed by a division of the proceeds. When the parties do not agree to a partition, any or all of them may seek the ruling of a court to determine how the land should be divided. The land may be physically divided among the joint owners (partition in kind), leaving each with ownership of a portion of the property representative of his/her partnership interest. The court may also order a partition by sale in which the property is sold and the proceeds are distributed to the owners commensurate with the shares owned. When local law does not permit physical division, the court must order a partition by sale.

Valuation Process
In order to value a co-tenant's interest, one must collect all the necessary data required to understand the subject interest such as obtaining an accurate description of the ownership interest, copies of any agreements among the owners, pertinent financial data, and any other relevant information. It is essential to define the valuation problem and thoroughly understand the attributes of the subject interest before determining the most appropriate valuation approach or approaches to use. The appraisal process for the ownership of an undivided interest in real estate is similar to the process used in the analysis of other forms of real estate asset ownership. The basic steps follow:
* Define the appraisal problem
* Describe the ownership interest
* Ownership group history and percentages
* Distributions
* Real Estate Assets - Description
* Past sales of interests
* Analyze the ownership attributes and any agreements
* Develop the value of pro-rata equity (use the Asset Approach for real estate)
* Develop discounts for lack of control and lack of marketability
* Calculate the value of the subject interest

During the valuation process, keep the following questions in mind.
* Are there any relevant legal issues?
* Does the agreement provide for property management, policies, fees, and other factors which affect control and marketability? For example, in an agreement, the co-tenants may give up rights of partition which negatively affects marketability. Conversely, the co-tenants may be afforded a put option which enhances marketability.
* What is the nature of this ownership group?
* Is a partition suit likely?
* Is the membership group cohesive?
* Is a sale of the property likely to occur; if so, when?

Appraisal Professionals
At a high level, the ownership of real property is a business, and the valuation of the different forms of real estate ownership broadly fall within the business appraisal discipline. However, the specific knowledge required to appropriately value the real property assets as well as the necessary state licensure required to appraise real property in the U.S. typically falls outside of the qualifications of most business appraisers. Similarly, the business valuation elements required to value a fractional interest are not typically part of the real property appraisal body of knowledge. Therefore, the appraisal of an undivided interest in real estate is typically a multi-discipline process involving specific knowledge in both the appraisal of real property and business valuation. As a result, it is common for two different practitioners to be involved in the appraisal of an undivided interest in real estate.

Typically, the real property appraiser values the whole real estate asset following the appraisal process as defined by professional standards bodies and the state in which the property is located. The business valuation professional performs any necessary balance sheet adjustments, prepares any financial forecasts specific to the undivided interest, analyzes the ownership structure and agreements, and develops any applicable minority and marketability discounts.

Asset Approach to Value for a Pro-Rata Interest
The asset approach is typically the most appropriate approach to value used to arrive at the pro-rata value of the equity (before discounts) for an undivided interest in real property. An appraisal for the 100% interest in the real property is often performed by a real estate appraisal professional. Subsequently, that appraisal is analyzed by a business valuation professional. When analyzing the real estate appraisal, it is important for the business valuation practitioner to note any assumptions or conditions which affect future cash flows, holding time, discount rates, etc. He/she must also:
* Review the financial statements and determine what adjustments should be made.
* Adjust the real estate asset to market value on the balance sheet analysis.
* Subtract any relevant debt obligations to arrive at the adjusted 100% equity value.
An example of the type of calculation the business valuation professional might use follows:



Discount Analysis
Because no one co-tenant has the right to sell or terminate his/her interest at will, one must discount the value of the subject interest. Discounting the market value for a lack of control and a lack of marketability provides a method of arriving at a realistic value of the subject interest. What discounts does one use and why? The following methods are often used or considered by business valuation professionals in the discount analysis of an undivided interest in real estate.

o We can use a direct application of discounts from lack of control minority discount studies (LOC discount) and the lack of marketability discounts from restricted stock studies (LOM discount). Although the studies relate to discounts for stockholders, the basic reasons for a discount are the same for stock as they are for tenancies in common in that both forms of ownership have attributes that lack control and both forms of ownership have a very limited market to sell. However, because the ownership attributes and risk profiles of the entities themselves differ, adjustments must be made. The typical tenancy in common has superior control and often requires less management (lower LOC discount) than stock ownership. Normally, a tenancy in common ownership in real estate is based only on tangible assets while stock ownership in an operating company may involve significant intangible assets. In aggregate, the ownership of stock in operating companies is often a much riskier asset class than real estate (lower LOM discount).

o A direct application of data from fractional interest transactions (combined discount) is, potentially, the purest form of valuation if comparable transactions are available. This type of data is very hard to find, but there are some published studies which discuss combined discounts for undivided interests in real estate. Combined discounts are aggregate discounts which factor in both the lack of marketability of the interest and the discount for a fractional ownership position.

o Business valuation professionals may consider relying on the sale data from private real estate partnership interests and the resulting discounts (combined discount) as provided in Partnership Profiles. This publication tracks and reports the sales of minority interests in real estate partnerships, organizing the data based on the underlying type of real estate. Again, the indicated discounts must be adjusted because the tenancy in common ownership (undivided) typically has superior control compared to those of private partnerships.

o Data estimating the cost to partition (combined discount) may be available in certain cases. The cost to partition analysis involves an analysis of the time and cost necessary for the subject interest to realize full pro rata value of the whole. Realistically, however, the property may not be divisible. Further, costs and time to settle could vary greatly depending upon the number of parties involved, whether the partition is contested, and the complexity of the partition. A study of data from 158 partition suits, during the years 1978 - 1994, revealed costs of up to $50,000 for each party involved and an average of three years to resolve contested actions.

o Finally, one might use an income approach model to arrive at a value for the subject interest. The income approach to value is an appropriate approach to consider when the subject underlying real property is income producing property and especially if there is a real estate appraisal available that lays out the financial projections, holding period, and risk assumptions. In this approach, the business valuation professional develops a discounted cash flow scenario based on: cash flows directly to the subject interest; estimated holding period; and incremental required rate of return for the subject interest. Depending upon the input assumptions, cash flow models can be very sensitive.

Conclusion
Appraising an undivided interest in real property is typically a multi-disciplinary process that involves the services of both a real estate appraiser and a business valuation professional, or someone who is qualified in both fields. Valuing a fractional undivided interest in real estate is different from valuing the typical partnership or corporation interest. In the case of an undivided interest, the business valuation professional must take into account the unique attributes of the tenant in common agreement. These factors influence the quantification of the appropriate discounts applied for lack of control and lack of marketability. There is no foolproof method of determining discounts. A valuation professional experienced in the unique attributes present in the ownership of an undivided interest in real estate is best able to address those unique attributes in order to arrive at an appropriate value opinion.

Back To Top