Income Capitalization Approach in Deficiency Proceedings

A trial court may properly rely on the income capitalization approach of property valuation in a commercial foreclosure deficiency judgment proceeding, at least sometimes.

The Connecticut Supreme Court considered the issue in J.E. Robert Company, Inc. v. Signature Properties, LLC (officially released January 5, 2016). In the trial court, plaintiff sought a deficiency judgment. To support its claim as to the property value, plaintiff offered evidence from its appraiser, who relied primarily on the income capitalization approach.

What is the Income Capitalization Approach?

The income capitalization approach uses the property’s income to determine the property value. The income is the rent. If the property is leased, the lease determines the rent. If the property is not leased, the appraiser uses market rent. If the property is partially leased, as it was in this case, the appraiser uses the contract rent for the occupied portion and market rent for the unoccupied portion. To derive the property value, you divide the rent by the rate of return. For example, if the rent is $125,000 per year the rate of return is 10%, the property value is $1,250,000 ($125,000 / .10 = $1,250,000).

Doesn’t the Approach Value just the Lease and not the Property?

Yes and No. If an income producing property, like an office building, is vacant, the approach assumes that market rent is the most the landlord could obtain in income. Let’s assume you are looking to buy an office building and hoping for a 10% rate of return. The building is unoccupied and your research shows that the market isn’t going to pay more than $125,000/year in rent. That means you could pay up to $1,250,000 for the building and preserve your hoped-for rate of return.

Now let’s assume that the building is fully occupied with tenants who are paying more than market rent — $140,000. If you buy it, you will have to honor those existing leases. The tenants will too. In this scenario, you could pay up to $1,400,000 and still earn your 10% rate of return. Likewise, if the tenants are paying less than market rent, say $110,000, you could not pay any more than $1,100,000 to preserve your rate of return.

So, when using market rent, the income capitalization approach gives you the value of the fee simple interest, i.e. the property without any leases. When using contract rent, the approach gives you the value of the leased fee interest, which is the fee simple interest encumbered by a lease.

The Appeal

Defendant argued that the deficiency judgment statute, CGS § 49-14, required plaintiff to establish the value of the fee simple interest. Plaintiff’s income capitalization approach valued only the leased fee interest. For this reason, the trial court should not have accepted the income capitalization approach in valuing the property.

The court noted that the market and contract rents were the same in this case. Since the rents were the same, under the income capitalization approach, the values of the fee simple and leased fee interests were the same.

Because the values were the same, the court didn’t decide whether § 49-14 requires proof of the value of the fee simple, as opposed to the leased fee, interest. I wouldn’t expect the issue to go away, at least not where the property is leased and the parties liable on the deficiency judgment have assets. Plaintiffs want to access, and defendants to protect, those assets. If the income capitalization approach yields a “better” deficiency for one party or the other, that party will want the court to use the value of leased fee interest, not the fee simple interest.