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When Lease Clauses Involve Valuation: Keeping the Appraiser in Mind

Arbitration and valuation are distinct processes, and the language creating each process should use terminology that will control the intended process, be that arbitration, valuation, or some combination of the two.

By Paula K. Konikoff

Leasing transactions often require the amount of rent, a purchase price, or other financial terms to be determined by some type of valuation process. Many parties and their attorneys prefer to use appraisers rather than brokers or other real estate professionals in that process because appraisers are required to comply with valuation standards, and those standards require them to be independent.

When negotiating and drafting leases, therefore, the parties should be mindful of the fact that they are often addressing appraisers and that appraisers use profession-specific terminology and some legal terms with meanings other than those set forth in Black’s Law Dictionary. Being sensitive to these issues allows practitioners to draft clauses that will be understood by valuation professionals and carry out the intentions of the parties when a valuation provision is triggered—which could be many years after the document is executed.

Identifying the Valuation Professional

Appraisers are different from many other experts and arbitrators in two ways. First, they are required to comply with valuation standards in performing their work. State appraiser licensing laws require certain types of assignments comply with the Uniform Standards of Professional Appraisal Practice (USPAP). Appraisal Foundation, Uniform Standards of Professional Appraisal Practice (1989). Affiliation with the Appraisal Institute requires compliance with the Appraisal Institute’s Code of Professional Ethics (CPE), see Appraisal Institute, Code of Professional Ethics, https:www:appraisalinstitute.org/professional-practice/ethics-and-standards/code-of-professional-ethics/, plus USPAP or other sets of standards as applicable to the assignment such as its Standards of Valuation Practice (SVP) or other applicable national or international standards such as the International Valuation Standards (IVS).

The second distinction is that appraisers are expected to render independent and unbiased judgments. In its Code of Professional Ethics and Standards of Valuation Practice, the Appraisal Institute defines “valuer” as “one who is expected to provide services in an unbiased and competent manner,” and USPAP defines “appraiser” as “one who is expected to perform valuation services competently and in a manner that is independent, impartial, and objective.” On the basis of those definitions, “any potential client of [a valuer] should be able to expect a certain level of professionalism from anyone representing himself or herself as an appraiser.” Appraisal Institute, The Appraisal of Real Estate, 14th ed. 2013, p. 2, fn. 5.

The Appraisal Institute confers several different designations for appraisers, including the MAI, SRA, AI-GRS, and AI-RRS designations; differences are based on the types of property valued and the types of services provided. See Appraisal Institute, AI Designations, https://www.appraisalinstitute.org/our-designations/. These designations signify that the member has met certain educational, experience, and ethical requirements “to produce a valuation that ensures confidence.” Id. Thus, arbitration provisions often require appraisers with the MAI designation, particularly in large space leases, ground leases, and net and master leases.

What Is the Valuation Professional’s Role?

Valuation professionals provide a wide of services, ranging from providing an opinion regarding the value of a property interest to testifying as an expert or serving as an arbitrator in an arbitration proceeding. The professional will have varying responsibilities—and operate under different sets of standards—depending upon the role that person has in a particular transaction.

Valuation professionals do not independently determine the role they are to fill in an assignment, but rather they rely on the expectations of their clients to make that determination. The Appraisal Institute recently issued guidance for valuation professionals in the form of Guide Note 16: Arbitration, addressing the importance of the appraiser’s knowing the client’s expectations: “The first issue to be considered is the expectation of the potential client regarding the Valuer’s role in the process.” Guide Note 16: Arbitration, www.appraisalinstitute.org/assets/1/7/guide_note_16_2016_v3.pdf.

USPAP Advisory Opinion 21 similarly observes that the expectation of the intended user “is the basis for determining when an individual providing a valuation service is acting as an appraiser.” USPAP 2018-19 AO-21, Lines 70-71 fn. 6 (USPAP ed. updated).

Guide Note 16 recognizes that this concept can be confusing.

[T]he USPAP discussion of “acting as an appraiser” is often mistakenly thought by valuers to be equivalent to “does the individual have an appraiser designation or license?” or “is the individual providing an appraisal?” However, this fails to consider the standards’ definition of “appraiser” or “valuer” which address independence and competence rather than licenses, designations, or services provided. Thus, one may be “acting as an appraiser” (independent and competent) but not providing value or appraisal review opinions.

Guide Note 16, at 2. The potential for confusion is particularly great when a lease specifies the use of an “appraiser” in an arbitration proceeding. As Guide Note 16 observes: “[P]rospective clients sometimes use the words ‘appraiser’ and ‘arbitrator’ interchangeably, and the leases and other contracts setting forth the terms of the arbitration proceeds also use the terms as synonyms[.]” Id. at 3. It is unclear, therefore, whether the professional is expected to serve as an expert witness (providing a valuation opinion) or as the arbitrator (rendering the ultimate decision resolving the parties’ dispute).

These distinctions have significant implications for the rules and standards by which the professional must abide. When serving as an expert witness, for example, an appraiser must perform an appraisal or review in compliance with all of the rules and standards governing an opinion of value. When serving as the arbitrator, however, it is critical to know whether the professional is making arbitral decisions “while acting as an appraiser” or is making such decisions “while not acting as an appraiser.” An arbitrator who is acting as an appraiser will be required to comply with certain rules governing appraisers in general (such as ethical standards and independent judgment) but is not required to follow the appraisal standards in determining an award. By comparison, an arbitrator who is not acting as an appraiser is not required to follow either the rules or standards (other than a duty to not mislead). Guide Note 16 at 2.

So, parties and their counsel should expect valuation professionals to be seeking clear guidance regarding both the role that professional is expected to fill in an arbitration and the specific tasks the parties and counsel expect the valuation professional to perform. This inquiry typically takes place during the interview and retention process.

Arbitration Clause, Valuation Clause, or Both?

There are two overarching issues in rent reset clauses that are particularly sensitive to appraisal terminology and theory. The first is the type of alternative dispute resolution (ADR) process desired by the parties. The second is what the parties want to have valued to establish the new rent or sale price. Each of these issues will be discussed below.

When a lease transaction contemplates the use of valuations at the time of rent resets, if the parties do not agree on the amount in advance, basic procedural decisions will need to be made regarding the dispute resolution process. One decision is whether the parties intend that valuation professionals will determine the amount or value among themselves, thus setting up a valuation process, or instead whether the valuation professionals will provide expert opinions to a sole arbitrator or to a panel of arbitrators.

Language governing a process to be completed by the valuation professionals should be very different from language establishing an arbitration process that includes input from those professionals serving as experts. And it is important to make the language used—the labels—align with the activities contemplated by the parties. When state-licensed and designated appraisers are used in arbitrations, whether as arbitrators, expert valuation witnesses, or consultants, clarity is needed first in the minds of the attorneys representing the parties to the arbitration, and then in the minds of the valuation professionals, as those valuers must comply with those portions of valuation standards, if any, that are applicable to their role in that arbitration.

If the lease is not clear on the appraiser’s role, the arbitration process will slow while the lease’s language is being considered and interpreted. When the drafters of the lease are not sensitive to the possible interpretations that appraisers may give the language in the arbitration or appraisal provision, unintended consequences may result, including increased fees and a longer arbitration period.

Many leases require that “arbitrators” be appraisers with, for example, the MAI designation, or that they have a state license. Appraisal guidance indicates that this type of provision means that the professional is required to comply with the ethics and competency provisions of standards. However, whether she must also comply with the performance standards applicable to appraisal or appraisal review (either in rebutting an appraisal report or in determining which of the parties’ expert opinions to adopt) may become a difficult decision if the language is unclear. Lease provisions may conflate “arbitrator” and “appraiser,” for example in “arbitration process (or clause)” versus “appraisal process (or clause).” See Paula K. Konikoff, The Appraiser’s View of the Lease, in Negotiating and Drafting Office Leases (John Busey Woods and Alan M. Di Sciullo, eds.), Law Journal Press, 2017.

The following excerpt from Guide Note 16 should help attorneys appreciate how appraisers are attempting to understand specific lease language. In addition to offering insights to aid in drafting, the guide note might also provide some insights as to how valuation professionals think about arbitration situations. Keep in mind that the guide note was written to advise appraisers and not attorneys.

Are You Providing an Opinion or a Decision? The Valuer must clarify whether he or she is being engaged as a valuation expert witness or as an arbitrator.

Confusion may arise as prospective clients sometimes use the words “appraiser” and “arbitrator” interchangeably, and the leases and other contracts setting forth the terms of the arbitration proceedings also use the terms as synonyms; it sometimes happens that the term “appraiser-arbitrator” is used and this term is by definition inaccurate, as a valuation professional can provide services as one or the other, but generally not both at the same time. The instances in which a Valuer might provide both value or review opinions and an arbitration award are established by statutes in certain jurisdictions or by the lease or other contract controlling the proceeding.

The Valuer must clarify whether he or she is expected to provide valuation opinions or arbitral decisions in any given proceeding in order to competently develop and provide those opinions or decisions, as well as to properly identify which ethical rules and standards and laws or regulations are applicable.

Which Tasks Are You Performing? Practitioners in different professions often use the same terms and phrases as Valuers but with different definitions and meanings.

The clearest way to discern whether a Valuer is being considered as an expert witness or as an arbitrator in situations where the language is unclear, is to reach agreement with the prospective client on which services he or she is expected to provide in the course of the matter. Some long-term ground and net leases that describe arbitration procedures were drafted as far back as the 1960s, when valuation terminology was not as specifically defined as it is now.

If the prospective client is seeking a valuation expert witness in arbitration, the Valuer would typically be expected to provide the following services:

• Perform an appraisal pursuant to the requirements in the lease, contract or other document that sets forth the requirements for the arbitration that complies with applicable standards (if USPAP, Standard 1).

• Prepare a written report that typically will be exchanged with the opposing party and submitted to the arbitrator(s) and that complies with applicable standards (if USPAP, Standard 2).

• If asked to prepare a “rebuttal” report, review and opine with regard to the opposing expert’s appraisal report (If USPAP, Standard 3, as “rebuttal” is the arbitration procedure term for “appraisal review”).

• Present oral testimony at an arbitration hearing (the controlling document or rules of arbitration may permit or require a deposition be taken of expert witnesses, in which case deposition testimony will also be provided).

If the prospective client is seeking an arbitrator, the Valuer would typically be expected to provide the following services:

• Interact with the parties and their counsel to establish the ground rules for the arbitration process.

• Conduct a preliminary hearing.

• Decide any pre-hearing issues (it is not unusual for the lease or other controlling document to be vague with regard to date of value to be determined, highest and best use requirements, property characteristics to be considered or not in the valuations, etc.) and prepare interim awards on these points.

• Conduct the arbitration hearings (Arbitrators are the triers of fact, or the “judge”).

• Render a decision and write the final award, and do not develop and report an appraisal or appraisal review.

A Final Award is not an Opinion of Value One reason for the confusion in this area is that the decisions required from the arbitrators as described in the controlling documents often use the word “value” although the expectation is not that the arbitrators will perform an appraisal. This collision of common English usage and valuation terminology often causes unintended results in arbitration awards if the arbitrators think they are to provide an appraisal opinion, albeit with a rather unusual scope of work, and so think they must comply with applicable reporting standards in writing the award. It is not unusual for a lease to require the arbitration panel to provide an award of “fair market value” or “fair market rent” of a specified ownership interest in an identified real property asset as of a specific date, and yet this is not expected to be, nor should it be, an appraisal opinion.

The arbitration award sets forth an amount determined to be appropriate to settle the dispute based on an assessment of the evidence presented in the arbitration and the terms of the lease or other controlling documents. The final award does not communicate what the arbitrators might determine the market value of the asset to be if they had individually or collectively performed an appraisal.

Guide Note 16 at 3-4.

Avoiding Confusion

Let’s look at some examples of actual lease language that have created confusion. The following excerpt is taken from the Appraisal Institute’s book, Appraisers in Arbitration, and it explores the examples presented in the guide note.

The following examples are based on actual lease provisions, and are the examples used in the Appraisal Institute’s Guide Note 16.

Baseball Example 1 The lease states: Minimal Annual Rent shall be determined by appraisal. Each party appoints an appraiser and a third is selected by the process described in the lease. The party-selected appraisers will exchange appraisal reports with one another and submit their reports to the third appraiser. The third appraiser will choose the more reasonable of the two appraisals within 10 calendar days. “The third appraiser’s decision on which appraisal is the most reasonable will be final and binding on the parties, and will be based solely on the [third] appraiser’s review of the two appraisals.”

This lease clause is unclear. How is “the most reasonable” appraisal to be determined? Is the third “appraiser” to provide an independent appraisal opinion by reviewing the two appraisal reports and then providing his or her own opinion of value by agreeing with one of the two value opinions? Or is that third “appraiser” to provide an arbitration award by selecting the amount that will resolve the dispute based on the weight of the evidence presented?

Baseball Example 2 The lease states: Renewal FMRV (fair market rental value) is to be determined by each party selecting a real estate professional with at least 10 years’ experience in the property type at the relevant location, and the selected Qualified Professionals shall each submit a memorandum to the third arbitrator, copy the landlord and tenant. Further evidence is to be presented at the arbitration hearing in the form of oral testimony and opening and closing arguments of counsel for each party. After the close of the arbitration hearings, the third arbitrator “shall choose the estimate set forth in either Landlord’s or Tenant’s memorandum, whichever the third arbitrator believes most accurately reflects the fair market rental value of the Premises in accordance with Article xxx for the subject term… and such choice shall be binding on Landlord and Tenant.”

In this example, the use of the phrase “the third arbitrator” implies that all three valuation professionals are “arbitrators,” while in the first example all three were referred to as “appraisers.” This clause creates confusion about the tasks to be performed by the two professionals who are to each produce a “memorandum.” The general language might be interpreted to mean that these are two expert witnesses, each of whom is to provide an appraisal report and then testify about the contents of the appraisal report.

Three-Person Panel Example The lease states: Arbitration and Appraisal. The arbitration of disputes or appraisal of value….The party desiring such arbitration or appraisal shall…appoint a disinterested person with recognized competence in the field involved as one of the arbitrators or appraisers…and such three arbitrators or appraisers shall as promptly as possible determine such matter…Landlord and Tenant shall each be entitled to be represented by counsel at the arbitration or appraisal and to present evidence and argument to the arbitrators or appraisers.

The confusion here is whether the parties have agreed to an appraisal or arbitration scenario, as this clause appears to apply to either dispute resolution process. Without input from the parties to the dispute and their counsel, the valuation professionals could have a difficult time figuring out what each of them is to do in this situation.

The following language taken from a recent lease may indicate an attempt to use terms as defined in the appraisal profession, but the result is confusing:

“The function and authority of the Impartial Person shall be only as herein provided, and he shall not act as an arbitrator or appraiser.”

It is very difficult to know which tasks to perform if a valuer is instructed to be neither an arbitrator nor an appraiser in the arbitration.

Paula K. Konikoff, Appraisers in Arbitration, 14-16 (2018).

What Should the Valuation Experts Value?

Once the process is properly defined, the next information appraisers seek from the language of the controlling document is exactly what should be appraised to answer the question posed by the parties in the lease or other documents controlling the dispute resolution process. Turning again to the Appraisal Institute’s text:

As a valuation expert, it is important to remember that the identification of the property and other elements of the assignment are likely in the lease or other agreement that controls the arbitration. So, rather than getting assignment conditions from your client, you will be reading the contract clause to learn specifically what is to be appraised. As with other contract provisions, some of those describing the appraisal assignment are clear and understandable, while others are not.

If the arbitration involves ground rent re-sets, the property identification issues we want to see clarified in the lease typically include:

The value of land as if vacant;

The value of land as if vacant, subject to existing zoning;

The value of land as if vacant and available for development to its current highest and best use;

The value of land as if vacant and available for development to its highest and best use at the date of valuation;

The value of land as if vacant, encumbered by all use restrictions in the lease; and

The value of land as if vacant, to be developed with existing improvements (or improvements contemplated herein).

This list is focused on the “subject of the assignment and its relevant characteristics;” however, if the lease language leaves any open questions regarding any of the assignment elements we need to identify in order to determine an appropriate scope of work, we should seek the advice of the attorney(s) who retained us. It may be that the lease addresses all needed aspects of property identification but is vague with one or more of the other assignment elements.

Appraisers in Arbitration, supra, p. 36-37 (footnotes omitted).

Conclusion

Arbitration and valuation are distinct processes, and the language creating each process should use terminology that will control the intended process, be that arbitration, valuation, or some combination of the two. The clauses controlling arbitration and appraisal or valuation clauses may require the use of different concepts and terminology from other contract provisions. The points to keep in mind include that these clauses need to be understood by both valuation professionals and attorneys and that they will be read and used many years after the agreement is executed. The guidance the Appraisal Institute offers valuation professionals should help inform the drafting of these clauses; however, the best advice is often provided by a valuation professional retained as a consultant during the initial drafting process. 

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By Paula K. Konikoff

Paula K. Konikoff is chair of the Appraisal Institute’s Professional Standards and Guidance Committee and is an adjunct professor at New York Law School, New York, New York.