In our last post we discussed the concept of establishing fair market value (FMV) for rent (  The example below represents a real project we recently did that resulted in expert testimony (we changed the actual numbers, but the percentage differences are the actual percentage differences).

In this situation, we represented a hospital that had leased ground to a developer to construct a medical office building adjacent to the hospital.  The original 25-year ground lease was expiring, and the hospital was looking to exercise the purchase option, which called for each side to obtain a FMV appraisal. Both the hospital (buyer) and developer (seller) had appraisals performed.  Another key point was that the hospital master leased about 90% of the building.  Here is what happened, demonstrating why correctly establishing fair market value is so important.

After doing our analysis, we determined a FMV of $25.5 million for the purchase.  The developer’s appraisal came in with a value of $40.5 million.  That’s almost a 60% premium to what we were proposing.  That magnitude of difference is very uncommon and safe to say the two sides couldn’t come to an agreement.

The dispute was headed toward “baseball arbitration” where an independent arbiter would rule for one side or the other (in baseball salary arbitration, both sides submit proposals and the arbiter decides on one or the other).  There were some indications that the arbiter would side with us, so both sides resumed negotiations and ended up with a price of about $27 million, or just 5% above what we had proposed.

The primary factor that led to this settlement had to do with the anticipated rents utilized in each appraiser’s projections.  As mentioned, the hospital master leased 90% of the medical office building, and the lease was expiring within a month of both the appraisal dates.  The developer’s appraisal value assumed that the hospital would renew the lease and did not factor in the risk with the potential turnover of the lease. In actuality that was not a given, and a fair market value determination needed to factor in the reasonable possibility that the hospital would not renew the lease.  So our valuation appropriately took into account the risk with the hospital potentially not renewing the lease.  Our appraisal accounted for this risk in the potential revenue lost due to the 90% turnover, the costs to potentially re-lease the space (marketing, commissions and tenant improvements) and in the capitalization rate.

We were able to successfully testify as an expert witness based on the strength of our appraisal and ultimately get a “win” for our client.

Recently, we discussed establishing fair market value for physician compensation.  But physician compensation is not the only item requiring establishment of fair market value.  Hospital-owned entities require any real estate lease to be at fair market value when it involves a referral source: in other words, rent that reflects fair market value.

The market value (synonymous with fair market value) is the most probable price which a property should bring in a competitive and open market.  Fair market value assumes the following:

  • The buyers and seller are typically motivated
  • Both parties are well informed or well advised, and acting in what they consider their best interests
  • A reasonable time is allowed for exposure in the open market
  • Payment is made in terms of cash in United Stated dollars or in terms of financial arrangement comparable thereto
  • The price represents the normal consideration for the property sold unaffected by special or creative financing or sales concessions granted by anyone associated with the sale

Fair market rent is the rent a typical market participant would pay based on market metrics. This can be calculated multiple ways:

  • Cost approach, which estimates rent by determining the annual return to the land based on its fair market value plus the annual return on the depreciated replacement cost of the improvements (building and site) over the remaining life of those improvements. This can also include furniture, fixtures and equipment if included in the lease. Expense structure also needs to be considered.
  • Market approach, which estimates rent based on what other comparable properties in the market have rented for.
  • Income approach, which estimates the rent based on the income that can be produced by the space and what other similar tenants have paid in rent for similar space, typically based on a percentage of net operating income.

These three approaches (or less depending on relevance) would then be reconciled to determine the fair market rent for the leased space.

When having a fair market rent analysis performed for your entity, make sure the following steps are included:

  • Discussions with senior management and advisors about the prospective business operation and markets served
  • An analysis of local demographic trends
  • A review of local and national healthcare trends and transactions
  • Conversations with commercial real estate brokers to better understand the local market and confirm land sales

Thomas J (TJ) Griffith is Vice President and Seniors Housing Practice Director at Principle Valuation.  Contact him at

Our clients have used Principle Valuation for valuations for purchase and sale transactions, compensation relationships, and support for tax purposes. They do straightforward and intelligent work, and are very responsive.

Scott Becker, Partner, McGuire Woods

We selected Principle because of their experience and reputation in the market. They are very knowledgeable about the industry, and particularly HUD financing. They were very thorough and hit their deadlines. Their appraisal went through HUD with no issues, which also made the borrower very happy.

Ken Buchanan, Senior Vice President and Chief Underwriter (Eastern Region), Walker Dunlop

Principle Valuation provides excellent valuations for ongoing healthcare enterprises, as well as placing values on the individual assets. They are very timely, reliable, have a solid understanding of the regulatory implications of their work, and are authoritative in the way they present their information.

Mike Anthony, Partner, McDermott, Will & Emery

Principle Valuation is far superior to any other valuation firm we have worked with. They are knowledgeable about businesses, real estate and equipment. And their reports are always right the first time.

Ken Doran, President and CEO, Spectrum Heatlh Partners


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