A Practical Guide to Understanding Zoning Laws

Why is zoning important? Zoning laws determine what kind of structures can be built, whether or not an existing property can be re-purposed, and even whether or not an existing structure can be replaced with something new at all. Of course, even if these aren’t changes you are currently considering, you might have a neighbor trying to make one of these changes… to the detriment of your own property.

Understanding zoning is important because it will in large part determine whether or not you get the change you want, and also whether or not you can prevent or modify the change you don’t want. In this article we’ll give you a practical guide to how zoning works, step by step.

I. The Purpose of Zoning

First of all, let’s start with the big picture. What exactly is zoning and what is its purpose? Zoning is the legislative process for dividing land into zones for different uses. Zoning laws are the laws that regulate the use of land and structures built upon it.

If you’ve ever dealt with a city, then you’ve probably heard some variation of the phrase “For the health, safety and general welfare of the public.” It means that every act of governance should (ideally) be made in the best interests of the people. Accordingly, zoning laws are created for the simple purpose of protecting the health, safety and general welfare of the people as relates to land use.

To achieve this purpose, zoning laws regulate the impacts of land use that may not be in the best interests of the people, generally including such things as:

  • Protecting the value and enjoyment of properties by separating incompatible land uses and minimizing their potentially negative impacts upon each other
  • Protecting the value and enjoyment of properties by allowing a property its most appropriate land use given its location and surrounding uses
  • Providing for the orderly development of a city, including making provisions for land uses in the best interests of its citizens, and
  • Providing adequate public infrastructure, e.g., roads, water and sewers

Cities want industrial uses for economic growth, but cities also want single-family residential areas for people to live. But will either the industrial users or residential users be happy if the two uses sit side-by-side? Not likely. When are neighboring uses happy? When they are compatible. This compatibility of the whole is the task of zoning; a sort of government-imposed “love thy neighbor as yourself.”

To accomplish this compatibility of uses, zoning gives the community a road map and a set of rules for driving. It considers how the city would like to grow. It then divides the city into different districts, limiting the uses allowed in each. It then creates laws regulating:

  • How each district can be used (e.g., commercial, residential, agricultural),
  • What types of buildings and other structures can be constructed within each district (e.g., size, number of stories, configuration)
  • Where those structures can be located (e.g., setbacks, green space), and
  • What measures the landowner must take to further compatibility with neighboring uses (e.g., buffers, flood control).

And then because the law recognizes life is not black and white, zoning laws provide flexibility for inevitable changes (who knew the state would construct that overpass, and make west-side ideal for retail instead of a quarry?) and also for inevitable special circumstances.

Let’s take a closer look at how zoning works.

II. The First Step: The Comprehensive Plan

How do you get from Boston to Los Angeles? Do you start driving in any direction and hope you’ll get there? Sure it might work, and sure a million monkeys banging on a million typewriters will eventually reproduce the entire works of Shakespeare. But you might have better chance of finding L.A. if you have a road map. A comprehensive plan (or “master plan”) is the road map a city creates to arrive at its desired social, economic, and physical development. Of course, because the growth of a city takes a little longer than a road trip across the U.S., comprehensive plans look long-term. Like five to 20 years long-term.

To create such plans a city considers what it wants regarding land use (including public infrastructure to support those uses), and how it will achieve it. For example, if a city decides it’s in the best interests of its population to be a hub for high-tech industry, it will designate areas within its boundaries for such industries.

The plan also acts as a guide for the creation of regulations that define what uses are permitted, what structures are permitted, their design, and where (both within a district and in relation to other districts) these uses and structures may be placed. The plan itself is not legally binging, but it’s the foundation for legally binding instruments like the zoning ordinance.

II.A. Creation of a Comprehensive Plan

A plan is created through a collaborative effort of planning professionals, the public, city staff, the city’s planning commission and the city’s governing body (and sometimes even neighboring communities).

The process is not universal, but creation generally begins by soliciting input from citizens and interested parties regarding how the city should evolve. If there is a developer who has, or wants to be, a part of the city’s growth, it makes sense to give them a place at the table. The city staff can then use this input to assemble, on its own or in concert with a planning consultant, a draft plan. The draft is given to the city’s planning commission, who reviews it with staff advice. If the commission finds the plan satisfactory, it is forwarded to the city council with a recommendation for approval (if the plan wasn’t ideal, the commission can put it back in staff’s hands for changes).

The council is the final decision-maker. Because the plan is supposed to be the vision and desire of the public, and serve their general welfare (and not the desires of a few commissioners or councilpersons), the council may seek further public testimony before it approves, approves with modification, or denies the plan.

II.B. What’s In a Comprehensive Plan?

Pictures and words, maps and text. Where streets, sewers and other infrastructure should go. Where different land uses should go. What are limitations on these uses and the structures supporting them? Again, the plan’s recommendations aren’t an instruction for the city to run out and grow, but rather a road map for getting to L.A…. over five to 20 years.

You may be wondering why should you care about the plan? Well, if you’re a landowner who may develop your property, or sell it to another to do so, you might want to let your voice be heard in the creation of a plan. Or if you are a resident who lives next to undeveloped land (or land ripe for redevelopment), or who believes the city should grow in a certain way, attract certain uses (remember that idea to become a hub for high-tech industry?), again you’ll want to make your voice heard.

What if a plan already exists? Then you better make sure you know what it says about the property you own, the property next to you, and the property across the city. The plan could play a large part in the value of your ground and the type of community you are (or might be) living in, building in, or running a business in.

Take a peek here at the City of Overland Park, Kansas’s Comprehensive Plan to see what one looks like

Often a city will maintain a copy of its plan on the city’s official website. If it can’t be found there, a call to City Hall (and likely a couple of transfers to get you to the planning department) will unearth the plan.

III. The Second Step: The Zoning Ordinance

You have the road map to L.A. Now what? How about you learn which roads have the highest speed limits, or are the most direct route, or which allow your type of vehicle? In zoning, the how-to details of the comprehensive plan are established in a city’s zoning ordinance. This ordinance is the local (e.g., county, city, township, etc.) set of regulations governing land uses and structures within the local government’s boundaries.

III.A. Creation of a Zoning Ordinance

How is the ordinance created? See above. Seriously. The creation of the ordinance is similar to the comprehensive plan’s creation and approval: staff and planning consultants (often lawyers) create a draft ordinance; a public hearing is held (or multiple hearings) for public input; the draft is modified by staff and consultants; eventually a draft ordinance is given to the planning commission for review; more public input; commission makes a recommendation to the council; more public input; approval, approval with modifications, or send it back to the commission. Rinse and repeat.

Unlike the plan, because the ordinance is a legally binding instrument, and provides the rules dictating how and where land can be used, its creation must clear certain legal hurdles. One of the principal hurdles is ensuring the ordinance complies with the law.

Why should you care? Well, unless you’re the city who will have to defend challenges to the ordinance, you shouldn’t, or at least won’t, until you believe you’ve been treated unfairly. Below are some of the laws to be considered:

  • Federal and state common law (court decisions; check out Village of Euclid, Ohio v. Ambler Realty Co., 272 U.S. 365 (1926) and Penn Central Transportation Co. v. New York City, 438 U.S. 104 (1978) if you want to impress your friends and know the stories behind two of zoning’s landmark cases)
  • State and federal statutes, codes and regulations
  • The Religious Land Use and Institutionalized Persons Act of 2000 (“RLUIPA” protects individuals, houses of worship, and other religious institutions from discrimination in zoning)
  • Federal Fair Housing Act (Title VIII of the Civil Rights Act of 1968)
  • Sections 332(c)(7) and 1455(a) of the Communications Act (which imposes limitations on state and local land use authority to make zoning decisions over certain wireless facilities), and
  • Endangered Species Act of 1973 (ESA; 16 U.S.C. § 1531 et seq.)

It should be noted that the ordinance, like all laws, is not set in stone. It can be amended, and generally mirrors the creation process.

One interesting issue that can occur in the amendment arena is when (1) a city wants to make a change to the ordinance, (2) hasn’t determined yet what that change should be, but (3) wants to temporarily halt development that, while lawful under the current ordinance, would be prohibited under the likely change, until (4) the city has had time to make well-reasoned analysis and planning decision. Such a temporary stop is referred to as a moratorium. While lawful, the moratorium must be reasonable because landowners seeking to develop their properties will be delayed (or prevented from developing if the ultimate change prohibits the use they intended).

Courts will consider whether the moratorium advances a legitimate governmental interest, is being made in good faith, and doesn’t deprive the landowner of all reasonable use for too long. If it fails these criteria, it may be characterized as a regulatory taking (we’ll talk about takings in a little bit). Again, if you want to impress your friends with your knowledge of landmark zoning cases, the Super Bowl of moratorium decisions is Tahoe-Sierra Preservation Council, Inc. v. Tahoe Regional Planning Agency, 535 U.S. 302 (2002).

III.B. What’s in a Zoning Ordinance?

Zoning ordinances generally cover three areas: (1) a zoning district section defining different types of use districts (e.g., commercial district, residential district) and the regulation of these uses; (2) a performance standards section defining regulations that apply uniformly to all districts (e.g., parking, noise, fencing and signage standards); and (3) an administrative section outlining procedures for requests under the ordinance (e.g., notices are required for a conditional use permit (“CUP”), the number of days a person has to approve a denial of rezoning).

Click here to see an example of a zoning ordinance (the City of Kansas City, Missouri’s)

As with a comprehensive plan, a city’s zoning ordinance is often found on the city’s official website (hint: click until you find the city code or the planning department’s page). If not, a quick call to City Hall should point you in the right direction.

III.B.1. The Zoning District Section

III.B.1(i). District Types and Uses

If the goal of land use-compatibility to serve the health, safety and welfare of the public can be met, the first step is defining land uses. The broad use categories are commercial, residential, industrial and agricultural. Of course, just as all ice cream does not come in the same flavor, all commercial uses are not the same, all industrial uses are not the same, etc. Accordingly, cities break down these broad categories into as many sub-categories and districts as needed. For example, the residential category may be divided into R-1 for single-family on less than 1 acre, R-2 for single-family on less than 0.5 acres, R-M1 for multi-family with a density of 50 units per acre, R-M2 for multi-family with 100 units per acre, ad infinitum.

Ordinances may include other types of districts for special circumstances, such as floating districts, mixed-use districts, or planned use districts (“PUDs”). Floating districts are those districts permitted under the ordinance, but haven’t yet been placed on the zoning map. They’re often employed for unique land uses (e.g., major entertainment centers, intense industrial uses) that are anticipated in the future, but for which no specific location has yet been identified, or districts to afford special protection when needed, such as historic or floodplain districts. Essentially the zone floats over the community until a use meeting its criteria materializes and a site is identified. At this point the zone floats earth.

Mixed-use districts allow for a combination of broader use categories (e.g., both commercial and residential), and are often used in downtown areas.

A PUD (Planned Use District) is a type of mixed-use development (often residential, retail and office) with a cohesive design plan. To encourage the feasibility of such developments, a city may waive or modify regulations that would otherwise be required of the individual uses. This is done to allow flexibility in the development’s design.

Historic districts are created to preserve structures that are significant historically, architecturally or culturally. Regulations in these districts limit the structures’ demolition or modification, or, if new construction is proposed, require that it conform to certain requirements (e.g., built in the same type of architecture).

Once district categories are established, the ordinance then spells out the uses permitted within each. Typical use types include:

  • Permitted Uses: Permits for these expressly listed uses are issued as a matter of right.
  • Conditional Uses: CUPs are given at the discretion of a city, on a permanent basis, so long as the attendant conditions are met. CUPs are needed where the use could negatively impact properties unless it operates under certain conditions.
  • Accessory Uses: These uses are, in addition to the parcel’s principal use, customary, appropriate, subordinate, incidental to, and serve the principal use. For example, typical accessory structures in residential districts include garages, decks, swimming pools and storage sheds.

One quick aside: annexation. Cities may be able to expand their boundaries through annexation of neighboring unincorporated land. The ordinance may include rules dictating how annexed property will be zoned when brought within city limits.

One more quick aside: legal non-conforming uses (“LNCU”). A non-conforming use is any use, structure or building that doesn’t comply with the zoning ordinance. Where the use was originally in compliance, but the regulations changed to make it non-compliant, the use became an LNCU. As the name suggests, these uses are lawful, and may continue, but under the ordinance they’ll face certain restrictions. Common restrictions are:

  • The use must be made compliant within a certain period of time (an “amortization period”)
  • The use cannot be expanded
  • If the LNCU is changed, it may not return to the prior use, and
  • Where the property is damaged beyond a certain point, it may not be repaired

III.B.1(ii). Regulation of Districts

Once you know your use is permitted, to determine what you can build you’ll have to check the regulations, i.e., ordinance’s details. The devil is in the details.

As a general caution, while a city has the right to regulate uses, if such regulation effectively deprives a landowner of all economically reasonable use or value of their property, it can be considered a regulatory taking. A taking in the real property arena refers to the government exercising its power of eminent domain to acquire ownership of private property for a public use or benefit. While a government has this right, if they use it they must compensate the landowner for the loss of his land.

In the case of a regulatory taking, the government hasn’t taken title to the property, but because its regulations rendered the land essentially worthless, the regulation is viewed as a taking. Time for the city to get out its checkbook.

With that said, regulations most commonly dictate the size, density and location of structures within a parcel, as well as parking and green space requirements. Size can relate to the footprint, height, number of stories, etc. Density refers to the amount of development allowed per acre, calculated either by the number of dwelling units per acre (for residential) or floor area ratio (for commercial). Location is governed in part by setbacks, the distance between structures and property lines.

The zoning ordinance may potentially regulate how property looks through “aesthetic” regulations. These are used to maintain aesthetic features within a district by permitting only uses, designs and structures that conform to or complement the area’s existing structures. Examples include limitations on parking, setbacks, the colors and architecture of structures, and types of landscaping, roofs and building materials.

The ordinance may also impose regulations to protect natural resources such as: (1) prohibiting building within floodplains, or requiring remediation if floodplains are eliminated; and (2) mitigating the impact of shoreline development by, for example, requiring larger setbacks from a shoreline.

Additionally, some ordinances will highly regulate uses the city wishes to minimize, such as the sale of alcohol, adult uses, and the operation of pay-day loan businesses. Such regulations often stipulate these uses must be a certain minimum distance from schools or churches, though other conditions appear. The zoning regulation of adult uses is especially complex as Constitutional issues of free speech are involved.

Lastly, as described below, the ordinance will allow for a “variance” from some of these regulations where circumstances merit.

III.B.2. Administrative Section

This section describes how actions under the ordinance are reviewed, approved, denied and appealed. It typically details:

  • Who is in charge of each action (e.g., city staff, planning commission, city council, or board of zoning adjustment (“BZA”; sometimes called a board of zoning appeals))
  • What form the applications must take
  • What steps are involved (e.g., public notice, hearings, adoption, etc.), and
  • Deadlines for each step

As these items vary among jurisdictions, it’s only appropriate to note here the two most important procedural directions: (1) follow the ordinance’s procedures, and (2) do it in a timely manner. Cities and courts generally strictly interpret these provisions. If the ordinance states appeals of denials must be made within 30 days of the council’s decision, and you file on the 31st day, well, there are smarter things you could do.

III.C. What Actions are Considered Under the Ordinance?

Zoning ordinances will typically govern applications for rezonings, conditional use permits, and variances.

III.C.1. Rezoning

In order to change a property’s zoning district, application must be made for a rezoning. Because this act is an amendment to the ordinance’s district map, the procedure for rezoning is the same as for an amendment to the ordinance. A rezoning application may be judged not only on its compliance with the ordinance, but in some cases its compliance with the comprehensive plan.

One situation that will fail this consideration is “spot-zoning.” Spot zoning occurs when a parcel is zoned differently than its surrounding uses for the sole benefit of the landowner. While property may lawfully be zoned differently than its surrounding uses, such varying uses are typically permitted because they serve a public benefit or a useful purpose to the other properties. For example, sound-planning policies would permit a school to be located in the center of a residential neighborhood. Locating an adult bookstore in the same neighborhood would not.

III.C.2. Conditional Uses

As noted above, conditional uses for each district are set forth in the ordinance, and are uses which need “special attention.” They may not be the primary intended use in a district, and may have some negative attributes, but if they comply with certain conditions, they can be beneficial. A common example is allowing a convenience store or gas station in a residential area. If the negative aspects of the use can be minimized through conditions, the use will be valuable to the area. If the use requested in a CUP application is one of the conditional uses specified in the ordinance, and if the conditions are accepted, the permit must be granted as a matter right.

III.C.3. Variance

Variances may be granted, at the city’s discretion, to relieve a party from strict compliance with zoning regulations where such compliance would result in a practical difficulty or unnecessary hardship for the landowner. Variances typically are only available for exceptions to physical regulations (e.g., setback requirements) and not to uses, but some jurisdictions allow for variances from the permitted uses.

IV. Who Makes the Zoning Decisions?

You’ve hit the road, road map in hand, a binder of all the details that impact your progress to L.A., and then you see the toll booth ahead. And the flashing blue lights of the police car behind. And the tow truck driver pulling a car that had gotten lost on his journey. The help and approval of all these people will determine if your drive is a success. In zoning, these gatekeepers are the city’s zoning staff, the planning commission, the Board of Zoning Adjustment (BZA) , and the city council.

IV.A. City Staff

An old adage for people who regularly work with public bodies is that elected officials change every couple of years, but staff is there forever. Accordingly, if you work well with staff, they can make the process easier and (providing your request is reasonable) become an unofficial advocate for project after project.

Staff are the first folks to touch a zoning request. They review the application and work with the applicant to ensure it’s compliant with the zoning ordinance. They then make a recommendation on the application, as well as advice to, the planning commission, city council or BZA depending on the request. Although staff has no authority to approve or deny applications, the other bodies often value their expertise and guidance, and may defer to their opinions.

IV.B. Planning Commission

Many cities have a planning commission, comprised of residents appointed by the city council (commissioners may, but are not required to have real estate, legal, engineering or other backgrounds valuable to land use decisions), who act in an advisory capacity to the city council. Depending on local and state law, planning commissions are often the first body to consider CUPs, rezonings, PUDs, and the creation of and amendments to the comprehensive plan and zoning ordinance.

Some planning commissions will consider applications for variances, though this responsibility can also fall to the BZA. The commission conducts public hearings, takes evidence, creates a record of the proceedings, and then makes a recommendation of approval, approval with modifications, or denial of the application to the city council.

IV.C. Governing Body

The city council is the final decision-maker on all zoning applications, though in some jurisdictions it may delegate its authority to another body (e.g., the planning commission). The council however cannot delegate its authority over rezoning decisions, as they are most often considered a legislative act, and only the governing body has legislative authority. In those jurisdictions that characterize rezoning as administrative rather than legislative, the council can delegate the decision-making authority to non-legislative bodies.

IV.D. Board of Zoning Adjustment (or Appeals)

Some jurisdictions create a BZA to (1) hear and act upon variance applications, and (2) hear appeals to rezoning denials where the basis for appeal is an alleged irregularity in the council’s application of the ordinance. In some cases the BZA will act like the planning commission, and make only recommendations to the council. BZA decisions may, depending on the zoning ordinance, be subject to appeal directly to the courts or to the council.

V. Conclusion

Now you understand the basics of the purpose of zoning, the creation of its guiding documents, its zoning ordinance, how zoning applications are made and appealed, and who makes these determinations. You have the road map and maybe even a GPS to get you to L.A…

And what is your take-away? Well, you can decide for yourself, but given the complexities and variations between jurisdictions of what you’ve just read, you might want to take a passenger along for the ride who has already made the trip many, many times. What I’m saying is, because this article is only for informational purposes, and not to give legal advice, if you have any particular zoning issues, please consult a licensed attorney.

Do You Know These Essential Zoning Terms?

The concept of zoning is fairly simple. A governing body enacts laws to create districts within its jurisdiction and regulations to govern the uses and structures inside those districts. The creation of these districts and regulations are designed to serve the jurisdiction’s general welfare by promoting growth and development in accordance with the body’s planning policies. To accomplish this, the body regulates the types of uses permitted, the design or layout of developments, and the design of structures within each district.

While the concept is straightforward, the terms used in the zoning world are numerous. Because being able to verify that an existing or proposed use of property is permitted (or if it isn’t, how it may become permitted) is at the heart of any commercial real estate transaction, a real estate professional must be well versed in the language of zoning.

Accordingly, this article sets out (alphabetically) many of the most common zoning terms, what they mean, and how they’re used.

A

Accessory Use. Accessory uses are land uses within a property that are, in addition to the parcel’s principal use, customary, appropriate, subordinate, incidental to, and serve the principal use. The governing body often includes in its zoning ordinance specific accessory uses it believes meet these criteria, but as an example, typical residential accessory uses include garages, decks, swimming pools and storage sheds.

Aesthetic Regulation. Aesthetic zoning regulations are used to maintain aesthetic features within a district by permitting only uses, designs and structures that conform to or complement the area’s existing uses and structures. Examples of aesthetic regulations are limitations on parking, setbacks, the colors and architecture of structures, and types of landscaping, roofs and building materials.

Agricultural Districts. These districts are limited to agricultural uses such as raising of crops, livestock grazing, and the raising of poultry. The permitted uses and regulation of such districts vary depending on the size of the parcel, e.g., an A2 district could be for parcels of at least 2 acres, and an A3 district for parcels of at least 3 acres. Typical conditional uses in these districts include the retail sale of agricultural-related products and storage of agricultural-related vehicles.

Amortization. When a building or use becomes non-conforming due to a change in zoning regulations, the property will be given a period of time to comply with the new regulations. This period of time is called the amortization period. If a property is not compliant within the amortization period, the use will be prohibited.

Ancillary Uses. Such uses are permitted land uses that are secondary and complementary to the principal use, but not accessory. An example of an ancillary use is an office supply store in an office park that only serves the principal office uses within the district.

B

Bulk Regulations. These regulations control the size and layout of structures, including regulations as to open space, lot lines, maximum building height, and maximum floor area ratio.

Buffer Zones. When two adjacent districts have incompatible permitted uses, in order to reduce the conflict between the uses, the governing body may require a buffer zone. Typically such zones will include park areas, grass, trees or berming. Such zones are commonly used when the development of a multi-family complex is proposed adjacent to a single-family district.

C

Commercial Use. These uses, permitted only in commercial districts, typically include wholesale, retail, or service business uses operating for profit, including office uses.

Comprehensive/General Plan. A long-term planning instrument, these plans set forth policies for the future development of the jurisdiction in a manner that will satisfy the jurisdiction’s goals, e.g., maintain orderly growth and protect the general welfare. Comprehensive plans often include local area plans, land use-related resolutions by the governing body, maps, and policy statements.

Conditional Use. These uses are permitted on a permanent basis within a district so long as the governing body’s conditions are met. These uses require conditions because without them, they could negatively impact the parcel or bordering properties. Permits for conditional uses are given at the discretion of the governing body.

Contract Zoning. Contract zoning occurs when a property owner and the governing body enter into an agreement that the property will be rezoned and the owner will accept the body’s use and design restrictions.

Cumulative Zoning. Under this zoning scheme, property zoned for specific uses can be used for that use and for less intensive uses. For example, an area zoned for multi-family uses would also permit a single-family use within the parcel.

D

Density. Density is the amount of development allowed per acre, and typically calculated by the number of dwelling units per acre (for residential) or floor area ratio (for commercial).

Discriminatory/Exclusionary Zoning. This type of zoning refers to a community’s use of zoning regulations to exclude certain groups of people. Though it is unlawful to expressly exclude people based on race or ethnicity, regulations relating to development densities can still have exclusionary effects. For example, communities will limit the number of dwellings permitted, reducing the housing supply, and thus lowering opportunities for new buyers. Further, reducing the housing supply increases market prices, having the effect of excluding lower-income families. Similarly, zoning regulations that limit or prohibit low-income multi-family complexes have the direct effect of excluding lower-income households from residing in the community.

Down-Zoning. Down-zoning occurs when a parcel is rezoned to a classification permitting only less intensive uses. Communities will utilize down-zoning to limit less-desired intensive uses. For example, a community may rezone a parcel from a multi-family designation to a single-family district.

E

Exactions. New development will often increase the use of, and the need for, improved or new public infrastructure and facilities, e.g., water and sewer lines, road improvements, and parks. Exactions are how a community forces developers to contribute to the cost of such infrastructure. They can take the form of requiring a developer to pay for a portion of the infrastructure improvements necessitated by the development, impact fees, or the donation of a portion of the developer’s land.

F

Floating Zones. These are districts that are permitted under the zoning ordinance, but not placed on the zoning map. They are typically used for unique uses (e.g., major entertainment centers, intensive industrial uses) that are anticipated in the future, but no specific location has been identified within the community. When an application is made for such a use on a specific parcel, a floating zone can be established and located on the zoning map, provided the regulations set forth in the zoning ordinance are met.

G

Grandfathering Clauses. The term “grandfathering” is a misnomer for a legal prior non-conforming use. A “grandfathering” situation occurs when an existing use was in compliance with zoning regulations at the time it began, but changes to the regulations have caused the use to become non-conforming. If the owner sells the property, the buyer will have the right to continue the non-conforming use, causing people to label the use as “grandfathered.” However, because this situation is simply the transfer of a lawful non-conforming use, the laws related to such uses create certain limitations, e.g., the use may not continue indefinitely as it will be subject to an amortization period, and the use cannot be expanded.

I

Industrial Uses. These uses are non-residential, non-agricultural, and non-commercial uses such as mining, milling, and manufacturing. Zoning ordinances generally include many classes of industrial uses, and the regulation of each varies depending on the intensity and impact of the use. Common examples of light industrial uses are warehouses, manufacturing and distribution where they operate without negative impacts on the surrounding uses. Heavy industrial uses have the potential to create public nuisance conditions (e.g., noise, environmental impacts), and are thus more stringently located and regulated. Examples of heavy industrial uses include quarries, landfills, and asphalt or concrete mixing plants.

M

Master Plan. Master plans are the overall plan for a community’s development. They must be consistent with the goals and policies described in the comprehensive/general plan and other local plans, e.g., an area plan. Generally master plans include the location of proposed land uses, description of the types of uses, intensities of uses, and building and structure limitations, though they may also include descriptions of desired parking, open space, and layout.

Mixed-Use Designation. This designation allows for the integration of multiple types of uses within a single district. For example, a development that includes multi-family residential, retail and office uses.

Moratorium. When a governing body is considering the amendment of its zoning ordinance or planning documents, it may decide to enact a temporary ban, a “moratorium,” on zoning applications for the uses being considered. Though it is generally accepted that a body has the right to use moratoriums in order for to have time to make sound planning decisions, because landowners seeking to develop their properties will be delayed (or, prevented from developing in the event the ultimate change prohibits the use they intended), the moratorium must be reasonable. In determining reasonableness, courts have considered whether the moratorium advances a legitimate governmental interest, is being made in good faith, and doesn’t deprive the landowner of all reasonable use for too long.

N

New Urbanism. New urbanism is a planning and design concept based primarily on two objectives: neighborhoods should have a sense of community and be environmentally friendly. To affect these goals, new urbanists lobby and work with communities to create or amend planning and zoning laws to allow neighborhoods with multiple uses, require communities to be designed for pedestrian and car traffic, and require environmentally conscious building designs and construction.

NIMBY. An acronym for Not In My Backyard, NIMBY refers to groups that oppose a new land use near their residential property. NIMBY efforts are directed at every type of use they deem incompatible with their residential use, including commercial retail or office uses, industrial or more intensive housing uses. The arguments against such uses near residential neighborhoods include that they will increase car and truck traffic, noise and crime, and lower property values. The power of such opposition is largely political, with a group appealing to their elected officials to deny approval of the opposed project.

Non-Conforming Use. A non-conforming use is any use, structure or building that doesn’t comply with the applicable zoning regulations. Where the use was originally in compliance, but  a regulations change made it non-compliant, the use became a lawful prior non-conforming use (LPNCU). As the name suggests, LPNCUs are lawful, and may continue, but they face certain restrictions. Common restrictions are (1) the use must be made compliant within a certain period of time (an amortization period), (2) the use cannot be expanded, (3) if the LPNCU is changed, it may not return to the prior use, and (4) where the property is damaged beyond a certain point, it may not be repaired.

O

Open Space. Open spaces are utilized in zoning ordinances to allow for public or private uses for enjoyment, such as park areas or simply green space. Open space requirements are often calculated as a certain percentage of a parcel’s size.

P

Planned Unit Development (PUD). A PUD is a mixed-use development (often residential, retail and office) with a cohesive design plan. To encourage the feasibility of such developments, zoning regulations, otherwise required of the individual uses, may be waived or modified to allow for flexibility in the development’s design.

Primary Use. A primary use is the principal or dominant use of the land, such as residing in a home, running business or manufacturing a product.

R

Regulatory Taking. A taking in the real property arena refers to the government exercising its power of eminent domain to acquire ownership of private property for a public use or benefit. A taking is lawful, but the government must pay for the land acquired. A regulatory taking occurs where a governing body enacts regulations that effectively deprive a landowner of all economically reasonable use or value of their property. While the government doesn’t actually take title to the property, because the regulations have made the property essentially worthless, it is viewed as a taking, and thus requires compensation to the landowner.

Residential Districts. These districts permit residential uses, and typically vary depending on lot size and the number of families that the dwellings in the district are meant to house (e.g., single-family, two-family, etc.). Residential districts for multi-family apartments typically consider the number of units within a defined space (e.g., up to 50 units per acre).

Rezoning. Rezoning is simply a change in the zoning district applied to a parcel of land, and thus a change to the permitted uses and accompanying regulations within that parcel.

S

Setbacks. Setbacks are distances between structures and property lines, and vary depending on the zoning district.

Smart Growth. Similar to New Urbanism, smart growth is an urban development and planning concept stressing mixed-used neighborhoods, walkability and environmentally conscious development and design.

Spot Zoning. Spot zoning is unlawful, and occurs when a single parcel is zoned differently than surrounding uses for the sole benefit of the landowner. While property may lawfully be zoned differently than surrounding uses, in those cases the uses are typically permitted because they serve a public benefit or a useful purpose to the surrounding properties. For example, sound planning policies would permit a school to be located in the center of a residential neighborhood. Locating an adult entertainment store in the same neighborhood would not.

Standard State Zoning Enabling Act (SZEA). Federally developed in 1921, SZEA was a standard act on which states could model their own zoning enabling acts. SZEA provided that legislative bodies could divide their jurisdictions into different districts, made a statement of purpose for zoning regulations, and created procedures for establishing such regulations.

T

Temporary Use. A temporary use is the use of property permitted for a specified period of time, provided that the use complies with required conditions of use.

V

Variance. A variance is a discretionary, limited waiver or modification of a zoning requirement. It is applied in situations where the strict application of the requirement would result in a practical difficulty or unnecessary hardship for the landowner. Typically, the difficulty or hardship must be due to an unusual physical characteristic of the parcel.

Vested Rights. The vested rights doctrine permits a landowner to build pursuant to a prior zoning regulation when there has been a substantial change of position or expenditures by an innocent party in reliance upon the issuance, or probable issuance, of a building permit. However, where no permit had been issued, and the owner has only an anticipation that it could develop their land under the existing zoning, then a change in zoning prohibiting their anticipated development doesn’t create a vested right. Put simply, there is no guarantee that zoning classifications or regulations will stay the same.

Z

Zoning Ordinance. Created in compliance with a governing body’s comprehensive plan, zoning ordinances are comprised of maps showing the zoning districts and text setting forth the regulation of uses and structures within each type of district.

And now you’re ready to tackle that next zoning discussion. As always though, this article is only for informational purposes, and not to give legal advice. So, if you have any particular issues, you should consult a licensed attorney. And if we’ve missed a term, let us know in the comments below!

10 Boring Boilerplate Commercial Lease Clauses You Should Understand

You’ve read the first ten pages of the proposed commercial lease and are satisfied that it reflects the deal points. And then you get to the last three pages and the section titled “Miscellaneous.” Your eyes glaze over and you consider pouring that fourth cup of coffee. Or, you think, these are just “boilerplate” terms and you don’t really need to read them.

This would be a mistake. Commercial leases are important contracts that must be read thoroughly in order to be fully understood. While most people read the important contract clauses such as rent amount, term, and escalations, some people ignore the common “boilerplate” lease clauses such as force majeure or jurisdiction. However, since these common lease clauses can and do vary, it’s also important that they are read thoroughly and understood, in addition to the rest of the contract. In this article we’ll take a closer look at 10 common “boilerplate” commercial lease components with examples and items to look out for.

Boilerplate Legal Definition

The term boilerplate, as it’s used in law, has been defined as “A description of uniform language used normally in legal documents that has a definite, unvarying meaning in the same context that denotes that the words have not been individually fashioned to address the legal issue presented.”

The problem though is that virtually all the language in commercial real estate leases has been individually fashioned, and while it may reflect the desires of the drafting party, it may not meet the needs or intentions of the second party. Since these terms can dramatically affect your rights and duties under the lease, understanding their purpose and pitfalls is vital.

Let’s take a look at 10 common “boilerplate” provisions in commercial real estate leases (and in fact, in most commercial contracts), their purpose, examples of each, and items to consider when reviewing them.

1. Notice

How can you terminate the lease? How can you renew? How and when can rent be increased? While the right to do any of these may include many conditions, one will almost always be that you gave proper notice to the other party. Failure to follow the terms of the notice provision can thus deprive you of a right you would otherwise have, or subject you to an obligation you wished you did not have.

A typical notice provision will include (1) to whom and where notice must be addressed, (2) by what methods must it be sent, and (3) when notice is deemed received. Here is an example Notice provision:

“Notice. (a) Form of Notice. All notices provided for under this Lease must be in writing and addressed to the following: (i) Landlord: John Smith, ABC Company, 1234 Main Street, City, State, (ii) Tenant: Jane Smith, XYZ Company, 5678 State Street, City, State. (b) Method of Notice. Notices must be given by (i) personal delivery, (ii) a nationally recognized, next-day courier service, (iii) first-class registered or certified mail, postage prepaid. (c) Receipt of Notice. A notice will be effective upon receipt by the party to which it is given or, if mailed, upon the earlier of receipt or the fifth business day following mailing.”

Notice Clause: What To Watch For

Email: A common modification will allow for notice by email. To avoid the loss of an email to a spam filter (or simply overlooked because of the massive amount of email one receives in a day), a notice provision may also require that hard-copies of the notice be provided along with the email. Where this is the case, the section should clarify when the notice is deemed received (e.g., receipt of the email or receipt of the hard copy).

All Communications: Often a notice clause refers to “notices provided for under this Agreement,” but it may be wise to broaden the clause to include all communications between parties. While this may take a little more effort to comply with, it can reduce arguments as to what qualifies as a “notice.”

Specificity of Time: Because notices must be received by a certain date, it is important to clarify when that date ends. At the end of the business day? At midnight? What if the parties are located in different time zones? Specificity is your friend (e.g., “Notices must be received no later than 5:00 p.m. CST on [date].”)

Language: With an increasing number of commercial leases occurring between parties of different nations, it may be appropriate to state that all notices will be in a certain agreed-upon language.

2. Attorneys’ Fees

Most commercial leases include an attorneys’ fees provision that provides that where a lawsuit is brought relating to the lease, the party that prevails in court may recover its attorneys’ fees from the losing party. In the absence of such a clause, the general rule will apply, meaning that each party will bear its own litigation costs, win or lose. Here is an example attorneys’ fees provision:

“If either Party brings legal action to enforce its rights under this Lease, the prevailing party will be entitled to recover its expenses, including reasonable attorneys’ fees, incurred in connection with the action.”

Attorneys’ Fees Clause: What to Watch For

What Suits are Subject to the Clause: This clause can be written to cover all or only specific types of suits. For example, does the clause state fees are recoverable for “breaches” of the lease, or all claims “related to” or “arising from” the lease. The broader language could include non-contract based claims such as fraud.

Do Both Parties Have the Right: Although generally leases with an attorneys’ fees provision will grant each party the right to recover litigation costs if it prevails, some leases may allow only the landlord to recover its fees.

What Kind of Suits are Likely: What kinds of claims are you most likely to make, and for what amounts? If the amount of potential recoveries is small, and thus less than potential attorneys’ fees, then in the absence of a prevailing party clause the other party may simply ignore the claim, believing you won’t sue for less than your costs. Accordingly, if small damage claims are likely, a prevailing party clause would be beneficial.

What Costs are Covered: Many clauses grant not only attorneys’ fees to the prevailing party, but all litigation costs, expenses, court fees, etc. Additionally, one should check to see if the clause relates only to litigation, or if it also applies to other dispute resolution processes (e.g., arbitration, mediation).

3. Merger/Entire Agreement

Right before you sign the lease you ask the other party to confirm an email they sent that morning, “you’re paying for all HVAC repairs, right?” They agree. Or, you hand them a piece of paper stating that they’re responsible for these costs, they agree and place the paper in their briefcase. The lease is then signed, the HVAC dies, and you look to them to fix it. Must they? Maybe. Maybe not. Look at the lease. If the lease included a merger clause (also called an entire agreement or integration clause), and if the lease states that you are responsible for such repairs, then that conversation, that email, and that briefcased piece of paper may not help.

The merger clause provides that all agreements, representations, warranties, etc. regarding the lease are set forth within the “four corners” of the documents. Any terms outside of the lease are of no force or effect. Put simply, the words in the lease overrule any other agreements you think you had.

The purpose of the clause is to ensure that all of the agreements between parties are contained in one place, and give certainty to the terms of a contract. An example clause is as follows:

“This Lease and exhibits attached hereto constitute the entire agreement between the parties concerning the subject matter of the Lease. All prior agreements, discussions and representations are merged herein. There are no agreements, discussions or representations, express or implied, between the parties except those expressly set forth in this Lease.”

Merger Clause: What to Watch For

Multiple Agreements: One common issue is where parties have multiple agreements relating to the same subject matter. Where this clause appears, it may have the unintended consequence of ignoring or conflicting with some of the terms of the prior agreements. For example, where a lease is in place, a new issue arises, and a separate agreement relating to the property is executed with this clause, will a court recognize terms in the lease? Maybe, maybe not. To avoid this issue, prior agreements can be referred to in, and attached as exhibits to, the new agreement.

Attach Everything: Because the merger clause means all agreements outside the lease are unenforceable, the most important practice is to make sure every agreement, whether it established in an email, conversation, or a separate document, is included in the body of the lease or incorporated as an exhibit.

4. Choice of Law/Governing Law

A choice of law provision establishes what law will be used to interpret the lease (e.g., the laws of the State of New York). Because laws vary from state to state (or country to country), this gives the parties clarity as to how the lease will be constructed, and how it is likely to be interpreted. Here is a sample choice of law provision:

“The provisions of this Agreement shall be governed by and construed and enforced in accordance with the laws of the State of __________.

Choice of Law/Governing Law Clause: What to Watch For

Know the State Law: Not every state interprets leases the same way. There are different presumptions, standards of review, and calculations and limitations on damages. So understanding how your lease would be interpreted under the chosen law will help you not only assess the risks under that law, but also understand how to write the lease to minimize those risks.

Many corporations elect to use Delaware law in their contracts’ choice of law clause. While there are a number of reasons for this (the State regularly updates its corporate laws for clarity, and has a special court for corporate law issues), one of the primary benefits is that Delaware’s laws have been well-parsed, removing some uncertainty as to how a dispute will be resolved. Of course, selecting Delaware may not be the right fit for your lease, and some courts may require a connection to the state before allowing the choice (e.g., if one of the parties is incorporated in Delaware), but it is a good example of companies understanding the importance of which law will govern an agreement.

5. Jurisdiction/Forum Selection

The jurisdiction (or forum) selection clause stipulates where suits relating to the lease must be brought. Selecting a single forum reduces the time and cost that would otherwise be spent arguing over where an action should be filed, as well as preventing two simultaneous actions in different jurisdictions. A simple forum choice clause is as follows:

“The Parties agree that all actions or proceedings arising in connection with this Lease shall be tried and litigated exclusively in the state courts located in the County of __________, State of __________, and that each Party is and shall continue to be (i) subject to the jurisdiction of the state courts in the County of __________, State of __________, and (ii) subject to service of process in the County of __________, State of __________.”

Jurisdiction/Forum Selection Clause: What to Watch For

What Suits are Subject to Clause: The above language requires that “all actions or proceedings arising in connection” with the agreement must be litigated in the chosen forum. However, as with the attorneys’ fees clause, some leases will use less encompassing language, such as “actions regarding the breach of the Lease.” This narrower language could then allow a non-breach actions (e.g., fraud), to be brought in a different jurisdiction.

What are the Costs: If you agree to forum in a state other than your own, be aware of the practical costs that will arise if litigation occurs. You may have to find local counsel who is familiar with the state’s laws and local courts. And of course, consider the time and cost of traveling out-of-state for what could be an extended period of time.

6. Force Majeure

A force majeure clause (meaning “superior force”) provides that a party is relieved of its obligation to perform a certain act when it is prevented from doing so by a circumstance beyond its control. A typical force majeure clause provides:

“In the event that either Party is delayed or prevented from the performance of any act by reason of strikes, lockouts, unavailability of materials, failure of power, restrictive governmental laws or regulations, riots, insurrections, war or other reason beyond its control, then performance of such act shall be excused for the period of the delay and the period for the performance of such act shall be extended for a period equivalent to the period of such delay.”

Force Majeure Clause: What to Watch For

Are All Obligations Subject to Force Majeure: A party may want to carve out some lease obligations from the force majeure clause, meaning that these duties must be performed regardless of external forces. One common carve-out is a tenant’s obligation to pay rent.

What Duty is Required if a Delay Occurs: Even when an unforeseeable event prevents or delays a party from timely performance, it should not simply throw up its hands if there is some way mitigate the delay. Some courts may require that the party made reasonable efforts to perform its duty despite the event. For example, if there is a material or labor shortage in the area preventing a timely build-out, the party may have to look to other areas to see if similarly-priced options are available.

In leases dealing with construction, one should pay special attention to the force majeure language regarding labor and materials to ensure it is not to broad or narrow for their interests.

Catch-All: Many clauses will list numerous specific events that will qualify as a force majeure, and then end the list with a catch-all phrase to the effect of “and all other unforeseeable events beyond the Parties’ control.” Because some courts have held that where there is a specific list followed by a catch-all, the catch-all will not be enforced. This does not mean a catch-all shouldn’t be used, but rather reinforces the need to make sure the clause reflects the specific events you would want to excuse timely performance.

7. Definition of Premises

The definition of the leased premises not only identifies where the tenant will conduct its business, but may also be used to determine tenant costs under the lease. Understanding the precise boundaries and dimensions of the premises can reduce confusion and unnecessary litigation. The following is a sample boundary description:

“The Premises, located at __________, and legally described on Exhibit __________, consists of __________ square feet, calculated by measuring: (i) from and to the interior midline of the interior walls, and (ii) from the ceiling tiles to the top of the slab, the perimeter boundary of which is outlined on Exhibit __________. The Premises shall not include the exterior walls or roof of the Building.”

Definition of Premises Clause: What to Watch For

Approximations: Because the lease will likely tie certain tenant costs to the square footage of the premises, the lease should state a specific square footage verified and agreed to by both parties.

Common Areas: If the tenant will be leasing or have the right to use common areas, interior or exterior, these areas, and what rights and obligations the tenant has to them, should be included in the definition of the premises. For example, if the tenant has a duty to repair carpeting in the premises, does that include carpeting in common areas.

CAM: Many CAM charges will be based on the tenant’s proportionate square footage of the total leasable area. Accordingly, the parties will want to establish that other tenants’ premises within the total project area are measured in the same way.

8. Dispute Resolution

Disagreements happen, and this provision outlines the steps each party must take to resolve the disagreement. A common progression (referred to as a multi-tiered dispute resolution clause) is (1) informal negotiation, (2) mediation, (3) arbitration, and then (4) litigation. The benefits of such a provision is that if the first steps can resolve the issue, it will reduce the time and cost involved in a lawsuit, and hopefully allow the parties to maintain a cordial commercial relationship. The following is a sample clause:

“Any dispute relating to the Agreement which cannot be resolved by negotiation between the parties within __________ days of either party giving notice to the other party that a dispute has arisen shall be submitted to mediation pursuant to the mediation rules of the __________, and failing settlement of that dispute by mediation within __________ days thereafter, the dispute shall be submitted by any party for final resolution by arbitration by __________ arbitrator in accordance with the arbitration rules of __________, and failing settlement of that dispute within __________ days thereafter, the dispute shall be submitted by any party for final resolution by the courts of __________ County, __________ State.”

Dispute Resolution Clause: What to Watch For

Time-Sensitive Issues: Because some disputes will need a fairly quick resolution, one of the benefits of this approach is that a party has options other than filing suit. Litigation can be a very slow process, and thus not effective where time is critical.

Abuse by Delay: Although the tiering can allow for quick resolution, where one party has no intention of changing its position absent litigation, and it believes that it will benefit from a delayed resolution, a poorly drafted clause can allow them to drag the other party through all the steps. The best way to avoid this issue is simply to be very clear in when one of the tiers begins (e.g., within five days of notice), when it ends (e.g., within 30 days of the mediation beginning), and what time is allowed for each step.

Optional or Mandatory: The clause should specify whether the steps are optional or mandatory. If you agree that they are mandatory, then understand that suit can’t be brought until the other steps are taken first, otherwise a court may be without jurisdiction to hear your claim.

9. Tenant Self-Help

Because landlords may not always perform their duties as quickly as possible, a self-help provision allows a tenant to take corrective measures in an emergency. A landlord may not want to include this provision because it risks the tenant making repairs instead of the landlord, and gives the tenant control over the costs. A sample self-help provision is as follows:

If Landlord shall default in the performance of any agreement of this Lease, and Landlord shall not cure such default within thirty (30) days after notice from Tenant, Tenant may, at its option, at any time thereafter cure such default, and Landlord agrees to reimburse Tenant for any amount paid by Tenant in so doing. If Landlord fails to reimburse Tenant for any amount paid by Tenant, this amount may be deducted by Tenant from the next or any succeeding payments of Rent.

Self-Help Clause: What to Watch For

Can Tenant Still Sue: The above provision states that the tenant can offset rent due if the landlord doesn’t reimburse them. However, simply getting paid back for repairs may not make the tenant whole. For example, where the landlord is responsible for access to tenant’s store, the access is damaged and preventing customers from patronizing the store, and the tenant is forced to repair the damage, a reimbursement for repair will not reflect lost sales. Accordingly, a tenant will want to ensure that self-help doesn’t waive their right to pursue damages for breach.

When Does Tenant Get Reimbursed, and for What: Again, specificity avoids conflict. The provision should state not only that the landlord will reimburse the tenant for its self-help costs, but also (i) specify what costs are reimbursable, (ii) when repayment must occur, (iii) and if a penalty or interest charge should arise if timely payment is not made.

What if There is no Self-Help Provision: If tenant doesn’t have an express right to self-help, and does so anyway, it risks (among other things) not being able to recover its costs and opening itself up to a claim for improper repair from the landlord.

10. Parties/Signature Blocks

The parties to a lease are typically set forth at the beginning of the lease, and then again in the signature blocks. The named parties are the ones responsible for performing the duties outlined in the lease, and the parties against whom recovery can be sought. Accordingly, it is critical to ensure the right parties are named.

Parties/Signature Blocks: What to Watch For

Is the Right Company Named: This is mostly self-explanatory, other than to note that where companies are often divided into many entities, one should verify that the correct entity is named in the lease. Of course, it doesn’t hurt to verify that the named landlord actually owns the property being leased.

Authorized Signatories: Where a business entity is the responsible party, the individual signing the lease must be authorized to bind the company. This may require a formal act of the company. Further, to avoid personally binding the person signing on behalf of the company, the signature block should include the entity’s name, state of formation, and the signator’s title. Some states have mandated the proper form for signature blocks by statute.

Conclusion

What should be clear from this article is that there are no true “boilerplate” provisions. Rather, there are concepts (e.g., attorneys’ fees) common to many leases, but what the parties agree to regarding these concepts can vary widely depending on the language used. Accordingly, it is vital that these “miscellaneous” provisions be read carefully, and where necessary, modified with the help of an attorney to meet the parties’ expectations. As always, this article should not be taken as legal advice and on all legal matters you should consult with a qualified real estate attorney.

How to Analyze Tax Increment Financing (TIF) Projects

A commercial real estate developer identifies a property ideal for its use, but because he can’t find a way to make the project financially feasible, he considers looking elsewhere. The city though wants the developer to undertake the project because it would replace property that generates negative social and economic impacts with a property that offers positive ones. What is a possible solution?

Tax increment financing, or “TIF.”

What is Tax Increment Financing (TIF)?

In its simplest terms, TIF:

(1) redirects the incremental increase in certain tax revenues generated by a redeveloped property from taxing districts to the redeveloper

(2) to cover a portion of the project’s costs

(3) in order to make the project financially feasible.

It is the marriage of private (the developer’s) and public (the taxing districts’) monies to facilitate a project that will benefit both private and public, where the project would not otherwise happen.

TIF revenue is only created if the proposed project will generate an increase in tax revenue over that generated by the existing use (or non-use). For example, where a retail center has lost tenants, whether because of changing demographics, moves to newer centers, or other reasons, the tax revenue generated from this property decreases. A fall in rental income reduces the owner’s ability to maintain and repair the property, its real property value goes down, and real property taxes fall. Likewise, the loss of tenants reduces sales and the consequent sales taxes. Further, fewer tenants results in less taxable personal property and personal property taxes.

When a project will rehabilitate the center (or demolish it and construct a new one) and locate new tenants, real and personal property value, sales, and the related tax revenue, all increase. The difference between the increased taxes resulting from the redevelopment and the taxes generated by the existing property is the “increment” potentially available to incent and facilitate the redevelopment.

How Do Cities and Developers Determine if TIF is Appropriate for a Project?

TIF redirects tax revenue from taxing districts to the redeveloper. Accordingly, as part of a city’s determination as to whether the use of TIF is appropriate, it will consider whether the amount redirected is necessary for the project to move forward, and whether the project benefits outweigh the potential impact to taxing districts. This consideration is accomplished through different financial analyses. This article outlines common analyses, and how to decipher them.

It should be noted that while TIF projects generally create benefits other than just increased tax revenue (e.g., new jobs, elimination of blighting conditions such as crime, impairing potential redevelopment of surrounding properties, etc.), this article examines only the financial analyses.

The statutes governing TIF vary by state. Accordingly, this article uses the general framework of TIF within the State of Missouri, and the analyses often considered by local governing bodies and taxing districts within the State. The principles outlined however are applicable to many other jurisdictions.

The three analyses considered here are (1) TIF revenue projections, (2) tax revenues to the taxing districts with the project and the use of TIF compared to revenues with no project (Tax Impact Analysis), and (3) an analysis to determine if the amount of TIF requested is necessary to make the project financially feasible (this can be referred to as part of a “but for” requirement, i.e., that “but for” the use of TIF, the project would not occur).

TIF Revenue Projections

From the developer’s perspective, the determination of how much TIF revenue is available to offset project costs is paramount. It determines, when coupled with the developer’s private monies, the expected return on its investment. Which incremental tax revenues can be redirected most commonly involve real property taxes. Some jurisdictions also permit TIF to capture taxes from increases to activity with the project, such as sales tax. Other activity taxes may also include an incremental increase to individual and corporate income taxes where the local jurisdiction has imposed them.

The starting point for all projections are the assumptions. Below are typical assumptions pages for real property, sales, and personal property. Although personal property is not captured by TIF in Missouri, because the tax revenues created by new property impacts the taxing districts, its assumptions are included.

Real Property Tax Revenue Assumptions

Tax Increment Financing TIF Real Property Assumptions

In order to determine the incremental increase to real property tax revenue, the developer estimates the fair market value (FMV) of the project when completed, and compares it to the FMV of the current property. The FMV is the estimated price that a buyer would pay to a seller for property in the current marketplace, provided both parties are knowledgeable, willing and not under duress. In this case, the projected FMV is calculated by adding to the purchase price 50% of the redevelopment costs ($10,000,000 + (50% x $7,500,000) = $13,750,000). Simplified valuations like this are not uncommon, though cities and developers may use other agreed upon methods, such as the three appraisal approaches to value (i.e., cost, income and comparable sales).

The existing property’s FMV is taken from the tax rolls ($5,000,000). The governing body and taxing districts may challenge such calculations, or require an appraiser to determine projected and existing FMVs. Of course, all the assumptions noted in these analyses can be a point of contention between the public and private parties.

The FMVs are then converted into assessed values (AV). Assessed value is a property’s dollar value, determined by the local government, which is used to calculate real property taxes. Generally the assessed value is determined by taking the FMV and multiplying it by an assessment rate. These rates may differ by land use (e.g., assessment rates could be 15% of FMV for industrial property, and 10% of FMV for agricultural uses).

Real property values are not static over time, and TIF is captured for a period of years. Accordingly, TIF revenue projections will include inflation factors rates for the new project (2%) and depreciation factors if the new project does not occur (-2%). Guidance on all real and personal property valuation assumptions, including inflation and depreciation factors, is often sought from the local tax assessment department, which will determine valuations for tax purposes.

Lastly, the above assumptions note that 100% of the real property increment will be redirected to offset project costs (“captured” by TIF). Because only the incremental increase is captured, the taxing districts will continue to receive the real property taxes generated by the property’s current use through the term of the TIF.

Sales Tax Revenue Assumptions

Tax Increment Financing Sales Assumptions

As with real property, the sales tax revenue projections must establish starting points for existing and post-redevelopment sales. The above assumptions provide that current sales are $500,000, and the projected sales in Year 1 of the redeveloped project will be $3,000,000. New sales are further projected to grow at an annual rate of 3%. Often construction and tenancy will occur in stages. In such cases, more detailed assumptions will show phased-in sales, and then a fixed growth rate upon completion of the phases.

Because the analysis relating to the impact of the project on taxing districts will compare district revenue with the project and TIF vs. no project, the assumptions estimate that if no redevelopment occurs, sales will decrease by 3% every year. A decrease in sales in a blighted property is often supported through sales tax data for the declining property, and the assumption that this decline will continue absent redevelopment.

In the above, the starting increment is projected at Year 1 new sales of $3,000,000 less existing sales of $500,000 = $2,500,000.

The assumptions further note that only 50% of the incremental increase to sales tax revenue (as opposed to 100% of real property taxes) will be captured by TIF.

Personal Property Tax Revenue Assumptions

Tax Increment Financing Personal Property Assumptions

As with the real property assumptions, FMVs are determined for the existing personal property (Initial FMV $100,000) and completed project ($2,000,000), and then multiplied by the assessment rate for personal property (35%).

These projections assume that all personal property, whether redevelopment occurs or not, will annually depreciate at a rate of 10%. Depending on the new project use, however, this assumption will vary. For example, technology companies may frequently update equipment to keep pace with the industry, meaning that because depreciated personal property is regularly replaced with new property, there is no projected decrease in value (and in some cases, there may even be an increase).

Lastly, these projections state that no part of the personal property increment will be captured by TIF. The taxing districts will retain all revenue.

Taxing District Levy Rates

Tax Increment Financing TIF Impact Analysis Totals

The above detail of taxing district levies stresses the importance of understanding not only which types of tax revenue the districts receive, but also whether under the applicable state law those revenues are subject to TIF capture. For this example five districts were used to illustrate four different revenue treatments.

The City and County can levy real property, personal property and sales, but its personal property taxes are not subject to TIF. The State can levy only sales taxes, but they are not subject to TIF. The School District can levy only real and personal property, and only the real property taxes are subject to TIF. And, lastly, while the Blind Pension District can levy real and personal property, none of its tax revenue is subject to TIF. Understanding how state law treats taxing districts differently is vital to projecting a redevelopment’s potential TIF revenue, and the impact of the project on all districts.

TIF Revenue Projections – Real Property Increment

Tax Increment Financing Real Property Revenue Projections

TIF revenue is captured over a period of years. In Missouri it can be redirected for up to 23 years. For space reasons, this example runs for six. The first two columns pull the existing AV and projected AV of the real property from the assumptions page. The initial value remains constant through the TIF term, and the taxing districts will continue to receive tax revenue based on this assessed value. As the projected property value grows at the assumed rated, the incremental AV grows too. The incremental real property tax revenue is simply the incremental AV multiplied by the total levy rate. In Year 1: $2,625,000 x 6.9% = $181,125.

The annual real property increment is then totaled for the TIF’s term. Many analyses will determine the net present value (NPV) of the TIF revenue stream, as developers may borrow funds secured, in part, by such revenue. In the example, the total gross projected revenue over six years is $4,006,895, and the NPV is $3,429,624.

TIF Revenue Projections – Sales Increment

Tax Increment Financing TIF Sales Tax Revenue Projections

The calculation of incremental sales tax revenue is similar, though it must account for, in the case of this example, the limitation that only 50% of the sales tax increment is captured. The initial (existing) sales are shown in the first column, and remain fixed through the term. Taxing districts will receive all tax revenue calculated on this base. The estimated sales increase annually at the assumed growth rate (3%), resulting in a growing sales increment. The revenue calculation is then the total sales levy subject to TIF capture x incremental sales x 50% (in Year 1: 2.25% x $2,500,00 x 50% = $56,250).

The table then reflects the gross and NPV incremental sales tax revenues available to offset project costs. Adding the real property and sales tax increments estimates the total available TIF funds (gross $5,261,185, NPV $4,502,563).

These revenues will be used in the “but for” analysis to determine if the redevelopment, with the assistance of TIF, is projected to generate an acceptable IRR. Additionally, some municipalities may cap TIF revenue at a certain percentage of total project cost. In this example, total TIF revenue divided by total project costs (TIF $5,261,185 / (purchase price $10,000,000 + redevelopment costs $7,500,000)) means that TIF is available to fund 30% of the project. In all cases, however, TIF revenues must exceed the costs the developer is asking be reimbursed by TIF.

Tax Impact Analysis

The purpose of the tax impact analysis is to quantify the projected impact of a TIF project on all affected taxing districts. This requires looking at each type of tax for each district, with and without the project. It should be noted that this type of analysis does not consider the scenario where redevelopment occurs without TIF, as the presumption is that the developer, and all other developers, would not take on the project without TIF revenues.

No Project – Real Property Tax Revenues

Tax Increment Financing TIF Impact Analysis Real Property

This sheet considers real property taxes in the event the project does not happen. The State is absent from this calculation as it has no real property levy. Based on the assumptions discussed above, it is assumed that absent redevelopment, the property’s FMV will decrease annually. The revenue per year per district is simply the initial AV times the district levy rate (Year 1 for the City: $1,500,000 x 1.3% = $19,500).

No Project – Sales Tax Revenues

Tax Increment Financing TIF Impact Analysis Sales

Similarly, the sales tax revenues projected to the three districts with the authority to tax sales (City, County and State) decrease over the six year period as retail sales decrease in the declining property. Revenue per year per district is projected sales multiplied by district levy rate (Year 1 for the City: $500,000 x 3% = $15,000).

No Project – Personal Property Tax Revenues

Tax Increment Financing TIF Impact Analysis Personal Property

While personal property is not captured by TIF in this example, it is impacted by the project, and thus included in the tax impact analysis. Revenue per year per district equals the personal property AV (decreased annually by 10%) multiplied by the district levy rate (in Year 1 for City, $35,000 x 1.3% = $455).

Project With TIF – Real Property Tax Revenues – Real Property Tax Revenues

Tax Increment Financing TIF Impact Analysys Real Property

The “Project with TIF” pages reflect only those tax revenues received by the districts under TIF, and thus do not include any revenues redirected by TIF. Accordingly, in the case of real property, the above table shows that the City, County and School District receive tax revenues equal to the initial AV multiplied by their respective levies. The AV is held static over the term of the TIF. All revenues generated from the increase in real property value over the initial AV is redirected to the project.

Note that the Blind Pension District revenues increase over the period. This is because this district’s levy, in this example, is not subject to TIF capture. Thus, its revenue is equal to the actual real property AV, growing each year, times its levy rate.

Project With TIF – Sales Tax Revenues

Tax Increment Financing TIF Impact Analysis Sales

In this example, 50% of the incremental increase in sales taxes is redirected to TIF. Accordingly, the two districts subject to TIF capture, the City and County, receive 100% of their levy against the initial sales, plus 50% of the increase from this initial amount. The calculation in Year 1 for the City is (initial sales x City tax rate) + (sales increment x City tax rate x 50%) = ($500,000 x 3%) + ($3,000,000 x 3% x 50%) = $52,500.

Note that the State, because its levy is not subject to TIF, receives 100% of its levy against 100% of the projected sales. In Year 1, the State sales tax revenue equals $3,000,000 x 3% = $90,000.

Project With TIF – Personal Property Tax Revenues

Tax Increment Financing TIF Impact Analysis Personal Property

The calculation for personal property tax revenue with TIF is the same as without TIF. In either case, personal property tax revenue is not captured by TIF. However, because the redevelopment assumes that it will include an increased amount of personal property, the related tax revenues to the districts have increased in the With Project calculation.

Tax Impact Analysis – Totals

Tax Increment Financing TIF Impact Analysis Totals

Totaling the above tables by district and tax type, this table details the increase in tax revenues to the affected districts projected to occur as a result of the project with the use of TIF.

“But For” Feasibility Analysis

Tax Increment Financing TIF IRR

A common method to determine whether the use of TIF is necessary for a project’s financial feasibility is through an analysis of internal rates of return (IRR) with and without the use of TIF. Above is a simplified pro forma and unleveraged IRR calculation using the TIF revenues projected above.

The reasonableness of the proforma assumptions is a large part of examining the reasonableness of this analysis. Was the cap rate of the proposed purchase reasonable (10%)? What about the projected cap rate for the reversion calculation (6%)? Rent, vacancy and rent escalation rates? Operating costs? Whether the “Without TIF” IRR is insufficient to incent a private developer to make the investment given the risk of redevelopment (7.14%)? Is the “With TIF” sufficient to incent the investment (13.51%)?

A common method to answer these assumption questions is to look for guidance from third party consultants engaged by the city, the developer, or both. Additionally, for assumptions relating to the valuation of the property for tax purposes, many will look to the local assessment department.

The above analysis begins with a calculation of net operating income (NOI) over the term of the TIF. In order to calculate the IRR, it sets the developer’s initial outlay ($17,500,000) and the projected TIF revenue ($4,502,563) available to offset the developer’s cost. The analysis projects that the gross reversion proceeds ($19,414,965 = Year 6 NOI $1,164,898 / cap rate 6%), less a selling expense of 4%, results in net reversion proceeds of $18,638,366.

The “With” and “Without” TIF IRR calculations are identical except for the initial developer expense. Without TIF utilizes the full project cost ($10,000,000 purchase price + redevelopment costs $7,500,000), and for With TIF, this amount is reduced by the NPV of TIF revenues ($4,502,563). The resulting IRRs are then compared against industry benchmarks and comparable projects to determine (1) if the developer would pursue the project without TIF (is 7.14% worth the risk?), and (2) if the amount of TIF revenue being redirected to the developer is too great (e.g., if 13.51% is unreasonably high in this market, then TIF revenues should be limited).

Consideration as to whether the IRRs do or do not reflect acceptable levels of return to the developer may consider factors like the nature of the project (e.g., including the life cycle of the property, local market conditions such as new development, major employers and their plan, and demographics), the overall risk associated with the property, inflation expectations, and other factors.

A Common Misconception Relating to TIF Analyses

A common challenge to TIF is that the taxing districts will lose tax revenues. The misconception is that if there was no redirection of taxes, the revenues to the districts would be greater because property values and sales would increase. The problem, however, is in the premise that there is the potential for the project occurring without the use of TIF. As discussed above, TIF is generally not available unless the developer can establish that the project is not feasible, and would not happen in the absence of TIF assistance.

Taxing districts can, nonetheless, challenge this assertion through a critique of the “but for” analyses provided (e.g., the IRR analysis above). Additionally, parties can consider how long the property has been on the market, and surrounding properties, to weigh the likelihood of its future development without TIF.

The district’s concerns should also take into account how the TIF is calculated to determine if a reduction in non-captured tax revenue is projected to occur. This of course varies by state, but in the example above, because the districts will continue to receive taxes based on the existing assessed value of the real property during the term of the TIF, and because the projections assume that the property, if not redeveloped, will continue to decrease in value, the taxing districts will actually receive greater real property tax revenue with TIF. Similarly, those taxing districts with the right to tax sales, will receive an increase in revenue owing to the increase in taxable sales if the project occurs, even though 50% of the sales tax increment will be redirected to the project.

Can the Analyses be Manipulated?

This article raises the question, “can developers or cities manipulate the analyses to reach the conclusion they desire?” While it is possible to change the method of each analysis (e.g., change the holding period in the Feasibility Analysis to return different IRRs), because many local governments tend to require similar formats for the analyses (e.g., in Kansas City, most TIF applications provide a Feasibility Analysis covering a 10-year period), such manipulation is less common.

However, results for each analysis can be changed fairly significantly by changes to the assumptions. Attached are the Excel sheets used for this article. Make a change to any of the assumptions and see what happens to the results.

Download TIF Excel Analysis

Fill out the quick form below and we'll email you the Tax Increment Financing (TIF) Analysis Excel worksheet used in this article.

For example, if the post-redevelopment FMV is changed from $13,750,000 to $18,000,000, the available TIF revenue increases from $5,261,185 to $7,171,489, and the “With TIF” IRR rises from 13.51% to 16.58%. Or, if the cap rate for reversion calculation is changed from 6% to 8%, the “With TIF” IRR drops from 13.51% to 9.37%. And these are only two of many of assumptions (e.g., redevelopment costs, calculation of real and personal property FMV, real and personal property and sales inflation and deflation rates, projected sales, NPV rate, projected project income (and all the assumptions within projected income and expenses like rent rate, vacancy rate, CAM charges, insurance costs, management fees, etc.), selling expenses, cap rates, etc.

Accordingly, any party interested in understanding or challenging a TIF analysis may want to focus their attention on the reasonableness of assumptions. For this very reason, of course, developers and cities will look to third-party consultants to provide supportable assumptions.

Conclusion

We’ve discussed common projections and analyses used to determine whether tax increment financing is appropriate, as well as underlying assumptions and how to determine if they’re reasonable. Given that TIF law varies by state, it’s best to consult with an experienced public incentives attorney if you are dealing with TIF. Have you ever prepared, reviewed or challenged any of these analyses? Let us know in the comments below!

Prescriptive Easements: A Comprehensive Guide

Everyone enjoys a surprise now and then. That is, everyone except commercial real estate owners who just discovered their ability to use and develop their property has been severely limited without their consent. The neighbor claims it has the right to drive delivery trucks across the owner’s parking lot. Another neighbor asserts it has the right to drain treated effluent into a stream on the owner’s land. How did this happen?

Prescriptive easements were established.

A prescriptive easement is a property interest acquired through a party’s unauthorized use of another’s real property for a certain period of time. If that party can prove their use met the required elements discussed below, the easement grants the party a right to use a specific portion of the property for a specific use. Because a prescriptive easement is by definition established without the landowner’s consent, and because it can have a significant impact on the property’s value and marketability, its appearance can be a most unwelcome surprise.

This article briefly describes the history and rationale for prescriptive easements, and then outlines:

  • The elements necessary to create one
  • How buyers can identify prescriptive easements, including the role title insurance can play
  • Steps landowners can take to identify and quash potential easements
  • How they can be terminated
  • The legal action used to enforce or eliminate an easement, and
  • Limitations on uses under prescriptive easements

But first… a cautionary tale.

The Drive-Through Bank with Drive-Through Delivery Trucks

In 1971, the Felgenhauers purchased property in Paso Robles, CA to build and run a restaurant. Felgenhauer v. Soni, 121 Cal.App.4th 445 (2004). Immediately behind their property was a parking lot owned by and servicing a neighboring bank. And immediately behind that, a public alley. From 1974 until 1999, trucks entered the alley and then crossed over the bank’s lot to make deliveries to the rear of the restaurant. Although the Felgenhauers owned the property during this entire period, they leased the land at certain times to third parties who bought the restaurant business.

The Felgenhauers never asked for permission to use the lot, nor did they assert they had a right to the truck use.

In 1988, the bank manager told one of the restaurant operators that the bank was going to erect a fence to separate the two properties. The operator asked if the bank would install a gate so deliveries could continue across the lot, and the bank manager agreed.

Given that the bank never intended to grant an easement, and because no one had ever brought a legal action to enforce or terminate the right to use the lot, there was no easement of record.

In 1998, the bank property, including the parking lot, was sold. The new owners informed the Felgenhauers their delivery trucks could no longer use the lot, and the bank was going to cut off the restaurant’s access. The Felgenhauers brought a quiet title action asserting the prior deliver truck use, done continuously and uninterrupted, openly, adverse to the bank owner’s property interest, and for the required period of time, established they had created a prescriptive easement.

The court agreed.

It turned out the new bank owners had purchased real estate not only with drive-through banking services, but also with drive-through delivery truck service to the restaurant next store.

A Brief History of Prescriptive Easements

As described in Michael V. Hernandez’s article “Restating Implied, Prescriptive, and Statutory Easements,” courts have recognized the right to prescriptive easements for centuries. Before 1275, English common law allowed for a prescriptive use if it extended beyond “living memory” or to the Norman Conquest (1066). After 1275, pursuant to Parliament’s enactment of the Statute of Westminster, the requisite period became the “limit of English Memory,” meaning to the time of King Richard (1189). The English courts then once more modified the prescriptive period, requiring that the continuous use had existed during “living memory.”

This practice continued until the 17th century, at which point the courts replaced the living memory standard with a specific number of years. This change coincided with the court-created fiction of a “lost grant.” This fiction meant that where property was used for a specific period of time, such use was evidence that the user had once been granted a right for such use, but the grant had been lost. The initial period selected was 20 years, the time related to an ejectment action. While the fiction of the “lost grant” has largely been abandoned by U.S. courts, the right to an easement based on continuous and unauthorized use for a specific period of time remains.

Rationales for the Concept of Prescriptive Easements

It seems counter-intuitive that a court would give away a portion of an owner’s property rights without their consent, especially to a party that had acted adversely to the owner’s rights. As Professor Hernandez discussed, the various rationales for prescriptive rights appear at times illogical, and often in conflict with the reality of modern day real estate usage. Nonetheless, courts and commentators have proffered the following justifications:

  • Punish an Owner for “Sleeping” on Their Rights: Some courts have suggested that well-established land uses should be protected, and owners who sleep on their property rights (not paying attention to others who may be infringing upon them), should be punished by losing some of those rights.
  • Incent the Productivity of Property: Courts have argued that society benefits when a property is put to productive use. Where an owner doesn’t do so, the owner should give way to those who are. As Prof. Hernandez pointed out, however, there are instances where society benefits from unproductive land. As an example, he cites farms that are paid by the federal government to not operate.
  • Quieting Title Increases Certainty and Marketability: Some have opined that a process to determine if a use has met the prescriptive elements, and thus whether an easement exists, removes uncertainty about interests in the property. It is argued that increased certainty encourages market transactions, and gives lending institutions greater comfort when providing credit for these transactions.  However, given that a prescriptive easement is created when the requisite elements are met, and not when a court is asked to enforce the easement by legal action, the ability for a prescriptive easement to exist without being of-record actually promotes uncertainty.
  • Reducing Litigation: Some have suggested that if a specific legal right can be created through granting a prescriptive easement, then litigation relating to arguments over property uses that have existed for a long time should be reduced. Prof. Hernandez responds that the statutes authorizing prescriptive uses actually increase litigation because they provide the use becomes a right after a set period of time. This forces the owner to bring a lawsuit to challenge the easement before the period has run.

Elements Required to Establish a Prescriptive Easement

To establish a prescriptive easement one must prove that all the requisite elements have been met: that the use was (1) adverse (sometimes referred to as “hostile”), (2) actual, open and notorious, (3) continuous and uninterrupted, and (4) for the statutorily required period of time.

Adverse

Adverse means the user is acting without the consent of the owner, and in conflict with the owner’s property interest. Typically, if a use would give rise to a trespass, then it would satisfy this element.

In the Felgenhauer case, the bank claimed that the adverse element was eliminated in 1988 when the then-manager agreed to put a gate in the dividing fence and allow the restaurant’s delivery trucks continued passage over the lot. An act cannot be adverse to a property owner if the owner has given consent. Why then didn’t this consent defeat the prescriptive easement? Because the court found the prescriptive period had been satisfied before 1988, and the easement had already been created. Naturally, an owner’s consent to a use that has already been perfected will not extinguish the right to use.

Actual, Open and Notorious

This requirement means that the party seeking the easement must have actually used the property, and that his use was visible enough to give the owner actual or constructive notice. Constructive notice is when a hypothetical reasonable landowner should have noticed the use.

In one California case, a party sought to establish a prescriptive easement allowing them to cross a neighbor’s property with their motorcycles. However, no one had ever seen a motorcycle on the property, and in fact, the party had hidden their motorcycles following crossings. The court held that such “clandestine” uses failed the open and notorious element, and would not support granting a prescriptive easement.

It should be noted that while a user must make actual use of the property, their use doesn’t have to be exclusive. Another’s use may not disqualify a claim for prescription. And, as shown by the Felgenhauer case, a prescriptive use will not be denied simply because the owner also uses the easement property (the bank had used its own parking lot).

Continuous and Uninterrupted

The party seeking to enforce an easement must establish they have used the property continuously for the statutory time period, but continuously does not mean constant. For example, an easement for a car crossing property may be established if the driver crosses the property only twice a day–on its way to and from work. Seasonal uses may even meet this standard, provided the uses regularly occur each “on” season.

Additionally, the use must not have been interrupted by the owner. Generally, if a party other than the owner interrupts the use, this will not defeat continuity.

Required Period of Time

The period required to establish a prescriptive easement varies by state. For example, it is five years in California, 10 years in New York, and 20 years in Wisconsin. While the use must exist for this period, through the doctrine of “tacking” it can be accomplished by combining the times that successor parties used the property. For example, where Andrew uses Zach’s property for 10 years, Andrew sells his property to Barbara, and Barbara continues the same unauthorized use for another 10 years, a 20-year prescriptive period has been met.

Impact of Prescriptive Easement

Property Interest: Right to Use, Not Ownership

If a prescriptive easement is established, it conveys only a right to use the property, and conveys no ownership interest. Title to the property is maintained as it was prior to the easement. In contrast, when real estate is acquired by adverse possession, actual ownership of the land is transferred.

Diminished Value of Burdened Property

The marketability and value of real estate can be significantly reduced as a result of an unanticipated easement. When a property owner works with utility companies and public bodies regarding utility and roadway easements, and even when working with neighboring landowners for access easements, the easements are located and limited in scope to allow for the owner’s anticipated use of the property. But when an easement is created without the input of the owner, its location and intensity can drastically impact an owner’s ability to develop or sell their property.

Consider the bank’s position following the enforcement of Felgenhauers’ prescriptive easement. Is the property more or less attractive to future buyers with a permanent easement for truck traffic across its lot?

Owner May Not Interfere With Easement Holder’s Rights

Once a prescriptive easement is established, the landowner cannot interfere with the easement holder’s use. Nonetheless, an owner may continue to use the land underlying the easement so long as its use doesn’t unreasonably prevent the holder from its own rightful use.

How CRE Buyers Can Protect Themselves Against Potential Prescriptive Easements

Because prescriptive easements, prior to being validated by a court, are unrecorded, their presence will not be revealed by a due diligence process that only reviews title documents. However, there are steps a buyer can take to lessen the chance an undisclosed prescriptive easement exists.

Physical Inspection of Property, Aerials, and Interviews

When performing a traditional physical inspection of structures, buyers may also consider walking the property with a surveyor, reviewing the property lines and located improvements to look for signs of use other than the owner’s (e.g., paths, tire tracks, structures not included on the survey). While common prescriptive easements relate to a party passing over property, they can also permit other uses such as a drainage pipe discharging treated effluent into a stream on another’s land. Given that uses may be visible at limited times, if possible, a buyer may make multiple inspections at different times on different days of the week.

A review of aerial photographs can be helpful with property that is not easily accessible, e.g., heavily forested parcels (Google Earth is one resource for aerials). The bird’s eye perspective can also help identify uses that are more readily seen from a distance (e.g., a path across property which is well-worn in certain areas and near invisible in others). Additionally, the buyer may interview neighboring landowners and tenants about their use of the property, and whether agreements exist between the seller and neighbor.

Title Insurance

Due to the unrecorded nature of many prescriptive easements, a title review will not help a buyer identify an easement. But, title insurance can transfer the risk of one from the buyer to the insurer. Under their general exceptions, American Land Title Association (“ALTA”) policies exclude coverage for “unrecorded easements and claims of easements.” However, a buyer may purchase an extended coverage policy to eliminate this exception, putting the onus on the title company to determine the risk of a prescriptive easement.

Additionally, if a buyer provides the title company with an acceptable survey, the buyer may secure a survey endorsement (also referred to as a “same as survey” endorsement), which provides that the insured land is the same as that shown on the survey. Accordingly, if it is later discovered that a prescriptive easement existed at the time the policy was issued, and the survey did not include the easement, the title company would be responsible for the omission.

How Owners Can Prevent Prescriptive Easements

As to Identified Users: Consent or Self-Help

If a landowner has identified the party using its property without consent, and if the use has not yet existed for the statutory period, the most effective way to end the threat is to simply give express and written consent to the user. If the owner consents, the “adverse” element is then lost and no prescriptive easement can be established. There are different ways an owner may accomplish this, but common practices include a revocable and non-transferable license or written agreement. Either should define the scope and location of the permitted use, state the permitted users, and explain how and when the permission can be revoked. While the licensed use may be permitted for a specific period of time, in order to protect against the use negatively impacting the ground’s value, sellers often require that the right terminates upon transfer of the seller’s property.

An owner may also consider using “self-help” methods to prevent the ripening of a prescriptive easement, such as posting “no trespass” signs, erecting fences to interrupt the use, or sending notices demanding that the use stop. However, there is a risk with these methods. If the use continues after the self-help measure, and the owner makes no further efforts to prevent it, the self-help act may then become evidence that the use was in fact adverse.

As to Unknown Users: Consent and Monitoring

When a landowner is not aware of any specific threat, but believes there is the potential for prescriptive use (e.g., undeveloped or rural real estate is susceptible to claims of easement because they often cannot be efficiently monitored), the owner may still attempt to issue a consent to unknown users. Such attempts include posting signs stating something to the effect of “Private property. Permission to cross, but may be revoked at any time.” An owner should determine whether the state in which the property sits has codified language for signs to defeat the adverse element.

If the owner is in a position to monitor its property, it may regularly make the same kinds of inspections suggested for a buyer’s due diligence review.

How to Terminate a Prescriptive Easement

Easements can be terminated through release, merger, condemnation or abandonment, and lost by adverse possession.

Release (Or Release Plus License)

The most straightforward way to eliminate a prescriptive easement is to buy it from the user, thereby releasing their rights to use. If they are unwilling to immediately release their rights (this may happen where immediate loss of the easement makes the present use of their property impossible), they may agree to a release in exchange for a license. The license would allow the use, but will expire at a future, specified time. If the easement has not been validated by a court’s judgment, this option can be especially attractive to the holder because the license specifies the permitted use and location, eliminating the risk that a court either denies the easement or limits it beyond what the user anticipated. Of course, the licensee also enjoys the compensation they negotiated and the litigation costs they avoided.

Merger

The doctrine of merger provides that when the property owning the easement (referred to as the “dominant estate”) and the property burdened by the easement (the “servient estate”) are merged into a single ownership, the easement is extinguished. Put simply, an owner can’t have an easement over his own land. As this method requires the landowner to purchase the dominant estate, it may not be a desirable or feasible alternative.

Condemnation

Only a public body may condemn property through its exercise of the power of eminent domain. However, condemnation may be available to terminate a prescriptive easement across real property where a statutory public-private partnership is in use. For example, in certain states, the power of eminent domain may be used to advance a tax increment financing (“TIF”) project.

Abandonment

To establish that an easement holder has abandoned its rights, and terminate the easement, an owner must show the holder’s intent to permanently cease its use of the easement, plus an affirmative act (or a failure to act) that evidences this intent. Non-use of the easement will not on its own support a finding of abandonment.

Adverse Possession

An owner may attempt to terminate a prescriptive easement by the same steps used to create it in the first place: meet the elements of prescriptive easement. This commonly begins with an owner using some form of “self-help” to prevent the use. Provided this act satisfies the requisite elements, the easement will terminate.

However, two risks make this an unattractive method. First, the elements must continue for the statutory period. If at any point during that period the user asserts their easement rights, the owner’s prescriptive period will be reset, and they’ll have to start the process all over again. Additionally, the holder may not just assert its rights, but where the owner’s “self-help” constitutes substantial interference with an easement, the holder may pursue an action against the landowner for a private nuisance.

What Happens to a Prescriptive Easement When Land is Sold? When Land is Leased?

An easement is a property right, and as such passes with the property. The dominant estate’s right to use the easement is passed to its new owner, and the servient estate’s obligation to not interfere with the use passes to its new owner.

In contrast, where a prescriptive easement was created during a lessee’s possession of the servient estate, the statutory clock for the potential easement will reset when the lease term ends. This happens because although the user’s actions were adverse to the lessee’s interest, they were not to the landlord’s, as it held only a reversionary interest during the lease term.

Quiet Title Action: How to Enforce or Challenge a Prescriptive Easement

In order to enforce or challenge a prescriptive easement, a party must bring a quiet title action. This lawsuit is brought in a court with jurisdiction over the property to determine ownership and other property rights.

However, the action is not necessary to establish the easement. As shown in the Felgenhauer case, the easement is perfected as soon as the elements of prescription are met. The quiet title action only validates the easement (and the judgment then becomes part of the property’s record).

Limitations on Permitted Uses of Prescriptive Easements

Use Cannot be Intensified

An easement holder is granted the use established by its action during the prescriptive period, and the type or scope of this use cannot be expanded or intensified. For example, the delivery truck use granted to Felgenhauer could not be expanded to allow for constant semi-truck traffic if the Felgenhauers replaced the restaurant with a distribution center. Subject to the limitation below, exceptions to this rule may occur where a natural evolution in a dominant property’s use requires a change to the easement use.

Use Can’t Prevent Owner from Meaningful Use of Its Land

Where a prescriptive easement denies the landowner any meaningful use of his property, courts will recognize that it has the same effect as taking ownership by adverse possession. In such cases, no such easement will be enforced. Accordingly, while a use may be modified to accommodate a natural evolution, it will not be permitted if doing so would effectively eliminate any meaningful use of the servient estate.

Conclusion

In this article we discussed prescriptive easements by outlining what they are as well as how to create, protect against, and also prevent them. As always, it’s best to consult with an experienced real estate attorney if this is an issue you are dealing with. Have you encountered a prescriptive easement? Does your due diligence process include a physical inspection? Let us know in the comments below!

How The Equity Multiple Works In Commercial Real Estate

The equity multiple is a commonly used performance metric in commercial real estate, and yet it’s not widely understood. In this short article we’ll take a look at the equity multiple as it’s used in commercial real estate and we’ll also walk through several examples step-by-step.

What Is The Equity Multiple?

First of all, what exactly is the equity multiple? In commercial real estate, the equity multiple is defined as the total cash distributions received from an investment, divided by the total equity invested. Here is the equity multiple formula:

Equity Multiple

For example, if the total equity invested into a project was $1,000,000 and all cash distributions received from the project totaled $2,500,000, then the equity multiple would be $2,500,000 / $1,000,000, or 2.50x.

What does the equity multiple mean? An equity multiple less than 1.0x means you are getting back less cash than you invested. An equity multiple greater than 1.0x means you are getting back more cash than you invested. In our example above, an equity multiple of 2.50x simply means that for every $1 invested into the project, an investor is expected to get back $2.50 (including the initial $1 investment).

What’s a good equity multiple?  As always, this depends. Context is required in order to determine what a “good” equity multiple means. Typically, the equity multiple is most relevant when compared with other similar investments.

Equity Multiple Proforma Example

Let’s take a look at an example of how to use the equity multiple in a commercial real estate analysis. Suppose we have an acquisition that requires $4,300,000 in equity and we expect the following proforma cash flows:

equity multiple real estate example

If we add up all of the before tax cash flows in the proforma above, then we’ll end up with total profits of $9,415,728. This results in a calculated equity multiple of $9,415,728/$4,300,000, or 2.19x.

What does a 2.19x equity multiple mean? This simply means that for every $1 invested into this project an investor is expected to get back $2.19 (including the initial $1 investment).

Is 2.19x a good equity multiple? As mentioned earlier, the fact that it’s higher than 1.0x means the investor is getting back more money than initially invested. However, the equity multiple alone doesn’t say anything about the timing because the equity multiple ignores the time value of money. In other words, a 2.19x equity multiple is much better if the holding period is 1 year versus 100 years. This is why the equity multiple is most relevant when compared to equity multiples of other similar investments.

Equity Multiple vs IRR

What’s the difference between the equity multiple and the internal rate of return? This is a common question since the equity multiple is often reported along with the IRR.

The major difference between the IRR and the equity multiple is that they measure two different things. The IRR measures the percentage rate earn on each dollar invested for each period it is invested. The equity multiple measures how much cash an investor will get back from a deal. The reason why these two indicators are often reported together is because they complement each other. The IRR takes into account the time value of money while the equity multiple does not. On the other hand, the equity multiple describes the total cash an investment will return while the IRR does not. Let’s take a look at an example of how these two measures can be used together.

The equity multiple is a performance metric that helps put the IRR into perspective by sizing up the return in absolute terms. The equity multiple does this by describing how much cash an investment will return over the entire holding period. Suppose we have two potential investments with the following cash flows:

Equity Multiple vs IRR

As you can see, the first investment produces a 16.15% IRR while the second investment only produces a 15.56% IRR. If we were using the IRR alone then the choice would be clearly be the first set of cash flows. However, the IRR isn’t a silver bullet and doesn’t always tell the full story. This can be seen by looking at the equity multiple for both investment options. Although the second potential investment has a lower IRR, it has a higher equity multiple. This means that despite a lower IRR, investment #2 returns more cash back to the investor over the same holding period.

Of course there are other factors to consider. For example, Investment #1 returns $50,000 at the end of year 1 whereas with Investment #2 you have to wait for 4 years to get $50,000 of cash flow. Depending on the context of these deals, this may or may not be acceptable. For example, if you plan on putting all of the cash flow from Investment #1 into a checking account earning next to nothing, then perhaps Investment #2 would make more sense since your cash will be invested longer. On the other hand, perhaps the cash flows from Investment #2 are more uncertain and you’d prefer the peace of mind that comes with getting half of your investment back in Year 1 with Investment #1.

These are issues that would be addressed in a full investment underwriting and there are also several other metrics and qualitative factors that could be considered. With that said, the equity multiple allows you to quickly understand how much cash a project will return to the investors, relative to the initial investment. It also adds some additional context to the IRR when looking at a set of cash flows to help you quickly size up an investment’s absolute return potential.

Conclusion

The equity multiple is commonly used in commercial real estate investment analysis. In this article we defined the equity multiple, discussed what it means, and the walked through an example step by step. We also compared the equity multiple to the internal rate of return since these two metrics are commonly reported side by side. We showed an example of how the equity multiple can add some context to the IRR by indicating an investment’s absolute return potential.

What You Should Know About Equity Waterfall Models in Commercial Real Estate

Equity waterfall models in commercial real estate projects are one of the most difficult concepts to understand in all of real estate finance. Cash flow from a development or investment project can be split in a countless number of ways, which is part of the reason why real estate waterfall models can be so confusing. In this article we’ll take a deep dive into real estate waterfall distributions, dispel some common misconceptions, and then we’ll tie it all together with a step-by-step real estate waterfall example.

What are Investment Waterfall Distributions?

First of all, what exactly is a “waterfall” when it comes to cash flow distributions? An investment waterfall is a method of splitting profits among partners in a transaction that allows for profits to follow an uneven distribution. The waterfall structure can be thought of as a series of pools that fill up with cash flow and then once full, spill over all excess cash flow into additional pools.

This type of arrangement is beneficial because it allows equity investors to reward the operating partner with an extra, disproportionate share of returns. This extra share of returns is called the promote, which is used as a bonus to motivate the operating partner to exceed return expectations. Under a waterfall structure the operating partner will receive a higher share of profits if the project’s return is higher than expected, and a lower share of profits if the project’s return is lower than expected.

The Importance Of The Owner’s Agreement

With investment waterfalls, cash flows are distributed according to the owner’s agreement. Because there are so many variables when it comes to investment waterfall structures, it’s critically important to always read the owner’s agreement. The agreement will spell out in detail how profits will be split among partners. While there are some commonly used terms and components in investment waterfall structures, waterfall structures can and do vary widely. This means there is unfortunately no one size fits all solution and the only way to understand a specific waterfall structure is to read the agreement.

Common Real Estate Waterfall Model Components

Although waterfall structures vary widely, there are several commonly used waterfall model components. Before we dive into our step-by-step waterfall model example, let’s first take a look at some basic building blocks.

The Return Hurdle

The return hurdle is simply the rate return that must be achieved before moving on to the next hurdle. This is important to clearly define because the return hurdles (or tiers) are what trigger the disproportionate profit splits. Since the term “rate of return” can be defined many different ways, the return hurdle in a waterfall distribution structure can also be defined in many different ways. In practice, the the Internal Rate of Return (IRR) or the Equity Multiple are commonly used as return hurdles. The IRR is the percentage rate earned on each dollar invested for each period it is invested. The Equity Multiple is simply the sum of all equity invested plus all profits divided by the total equity invested, or [(Total Equity + Total Profits) / Total Equity].

Once the return hurdle has been defined the next logical question is, from what perspective will the return be measured? Since a project will have a sponsor and at least one other investor, the return can be calculated from several different perspectives. The return hurdle could be measured from the perspective of the project itself (which could include both the sponsor and the investor equity), the third-party investor equity only, or the sponsor equity only.

The Preferred Return

Another common component in equity waterfall models is the preferred return. What exactly is the preferred return? The preferred return, often just called the “pref”, is defined as a first claim on profits until a target return has been achieved. In other words, preferred investors in a project are first in line and will earn the preferred return before any other investors receive a distribution of profit.  Once this “preference” return hurdle has been met, then any excess profits are split as agreed.

A few key questions with the preferred return are:

  • Who gets the preferred return? Preferred investors could include all equity investors or only select equity investors.
  • Is the preferred return cumulative? This becomes relevant if there isn’t enough cash flow to pay out the preferred return in any given year. In waterfall models this preferred return can either be cumulative or non-cumulative. If the pref is cumulative then it will be added to the investment balance for the next period and accumulate until it’s eventually paid out.
  • Is the preferred return compounded? A preferred return can also be compounded or non-compounded. When the pref is cumulative a key question is, is this unpaid cash flow compounded at the preferred rate of return as it accumulates?
  • What is the compounding period? If the pref is compounded then it’s also important to know the compounding frequency. The compounding frequency could be annually, quarterly, monthly, daily, or even continuous.

The Lookback Provision

The lookback provision provides that the sponsor and investor “look back” at the end of the deal and if the investor doesn’t achieve a pre-determined rate of return, then the sponsor will be required to give up a portion of its already distributed profits in order to provide the investor with the pre-determined return.

The Catch Up Provision

The catch up provision provides that the investor gets 100% of all profit distributions until a pre-determined rate of return has been achieved. Then, after the investor achieves the required return, 100% of profits will go to the sponsor until the sponsor is “caught up.”

The catch up provision is essentially a variation on the lookback provision and seeks to achieve the same goal. The key difference is that with the lookback provision the investor has to go back to the sponsor at the end of the deal and ask the sponsor to write a check. With the catch up provision, the investor gets 100% of all profits until the required return is achieved and only then will the sponsor receive a distribution. Typically the sponsor prefers the lookback provision (since they get to utilize money even if they have to eventually give it back), while the investor prefers the catch up provision (since they get paid first and won’t have to ask the sponsor to make them whole at the end of the deal).

Again, the important thing to remember about waterfall structures is that there is no one sized fits all solution and these terms and conditions will all be spelled out in the owners agreement. With these basic building blocks in our toolkit, let’s next move on to a detailed, step-by-step example of a real estate waterfall model.

Multi-Tier Real Estate Investment Waterfall Calculation Example

Suppose we have a general partner and an outside investor who contribute a combined total of $1,000,000 into a project. The general partner invests 10%, or $100,000, and the outside investor contributes the remaining 90%, or $900,000. All equity investors (which includes both the general partner and the third party investor) receive a 10% annual preferred return on their invested capital. If distributions in any year fall below the preference level of 10%, then the deficiency will be carried over to the following years and compounded annually at the preferred rate of return. In other words, the pref is both cumulative and compounded.

After the 10% preferred return hurdle has been achieved, then all additional profits up to a 15% IRR will be allocated at a rate of 20% to the general partner and 80% to the equity investors. After a 15% IRR hurdle has been achieved, then all additional profits will be allocated at a rate of 40% to the general partner and 60% to the equity investors. All IRR hurdle calculations will be at the project level.

So, based on the above assumptions, we have a 3 tier waterfall model with all IRR hurdles measured at the project level. The first tier or hurdle is a 10% IRR, the second tier is a 15% IRR, and the 3rd tier is anything above a 15% IRR.

Now, let’s looks how how we actually calculate these waterfall distributions.  First let’s take a look at our project level cash flow before tax and equity contributions over the holding period:

Waterfall Distribution Project Cash Flows

The first line is simply our before tax cash flow calculation from a standard real estate proforma. As you can see, the calculated IRR for the entire project is 21.24%. Intuitively this tells us we will reach the third IRR hurdle since 21.24% is greater than our third waterfall hurdle of 15%. The next few lines show how much equity is contributed to the project by the sponsor and investor and when it is contributed. Since all of the equity for this project is required at the beginning, it is all shown at time period 0.

Here is a summary including percentage allocations of the total equity contributions to the project:

Waterfall Distribution Equity Split

As you can see, the sponsor provides 10% of the equity, or $100,000, and the third-party investor contributes 90% of the equity, or $900,000. Next, let’s take a look at a summary of our promote structure discussed above:

Waterfall Distribution Promote Structure

There are 3 tiers (or hurdles) in this promote structure. Profits are split pari passu up to a 10% IRR. After the 10% IRR is achieved, then profits will be split disproportionately. Profits above a 10% IRR up to a 15% IRR will be split 80% to the third-party investor and 20% to the sponsor. In other words, the sponsor gets an additional 10% of profits in addition to his 10% pro-rata share of profits. This additional 10% is the “promote”. Finally, all profits above a 15% IRR will be split 60% to the third-party investor and 40% to the sponsor. This means the sponsor is getting a 30% promote after the final 15% IRR hurdle is achieved.

So far all of our assumptions are pretty straight forward and easy to understand. We have a 90%/10% equity split between the third-party investor and the sponsor, and then we have a 3 tier promote structure.  Now we need a way to actually calculate the profit splits at each tier.

Real Estate Waterfall Model Tier 1

To calculate the profit splits at tier 1 we have to first determine the cash flows required to achieve a 10% IRR. Then, we’ll allocate these cash flows to the sponsor and the investor based on the agreed upon profit splits at this tier. Finally, we’ll calculate how much remaining cash is available from the project that can flow into the next waterfall tier.

This is where waterfall distribution models get complicated, so let’s take it step by step.

Real Estate Waterfall Model Hurdle

The table above has a lot of information, so as we work through it below remember that all we are doing is calculating what a 10% IRR (Tier 1) looks like. Then, once we figure out what cash flows are needed for a 10% IRR, we simply allocate those cash flows (or available cash flows) between the Sponsor and Investor based on our Tier 1 promote structure. Finally, after netting out our Tier 1 cash flows from our before tax cash flows for the project, we figure out how much cash flow is remaining for Tier 2. With this big picture in mind, let’s walk through each line item in the table above.

Year 0 is the beginning of the project and as you can see our beginning balance is $0. On the next line below, you can see our equity contributions at the beginning of the project total $1,000,000. Next is the Tier 1 Accrual line item. This is simply the amount that is owed to the equity investors based on the 10% IRR. In this case the calculation is just 10% times the beginning balance, which for Year 0 is $0 since there is no beginning balance.

The Accrual Distribution line item is next and this is what actually gets distributed in this tier. This may or may not equal the prior Accrual line item. This accrual distribution calculation takes the lesser of 1) the Beginning Balance, plus Equity Contributions, plus the Tier 1 Accrual line item, or 2) the project’s cash flow before tax. The reason why this is the lesser of these two items is because we are limited by the cash flow available from the project and can’t pay out more than this amount. Conversely, if there is more than enough cash flow from the project to pay out what’s owed to us, then we don’t want to pay out any more than this.

The Ending Balance line item takes the sum of the beginning balance, equity contributions, Tier 1 accrual, and Tier 1 distributions. This is simply taking what we start with (beginning balance), then adding in any new equity contributions, then accounting for the difference between what’s owed to us at this tier (the accrual) and what’s been payed out (the distribution).

In Year 1 we use the ending balance from the prior year (Year 0) as our Year 1 Beginning Balance. Then we simply repeat the process discussed above by calculating our Accrual based on the beginning balance for this period, then we calculate our actual distributions for this period, and finally our Ending Balance for this period. We continue this process for all years in the holding period and once completed we can then move on to splitting up cash flows between the Investor and the Sponsor in this tier.

The cash flow splits are shown on the three line items below the Ending Balance: Investor Cash Flow, Sponsor Equity Cash Flow, and Sponsor Promote Cash Flow. Investor cash flow is the percentage of Tier 1 distributions that flow to the investor and sponsor cash flow is divided into two components. First, the sponsor equity cash flow is the portion of Tier 1 distributions attributed to the sponsor’s pro-rata (10%) equity investment. Second, is the sponsor promote cash flow, which is the bonus cash flow that flows to the sponsor for achieving the IRR hurdle. In Tier 1 there is no promote, which means 90% of the Tier 1 distributions flows to the investor and 10% flows to the sponsor.

Real Estate Waterfall Model Tier 2

Now let’s take a look at the second IRR hurdle and repeat the same process we followed for Tier 1:

Real Estate Waterfall Model Hurdle 2

This table is exactly like the table used above for the first hurdle. The key difference is that this time we are calculating the cash flows required for a 15% IRR and then we are splitting them up between the investor and the sponsor at different rates. When calculating the cash flow splits we are also taking into account any distributions made in Tier 1. Let’s take a look at how this works.

In Year 0 we start off with $0, contribute $1,000,000 in equity, and since our beginning balance is $0 there aren’t any accruals nor any distributions. In Year 1 we start off with the $1,000,000 ending balance from Year 0, and our Year 1 accrual is 15%, which is $150,000. However, the project cash flow before tax is only $90,000, so there is a deficiency of $150,000 minus $90,000, or $60,000. This $60,000 deficiency gets added to our ending balance and carried over to the next year, where this process continues.

Once we’ve followed this process for all years in the holding period, we can then move on to calculate the cash flow splits between the investor and the sponsor. This is the same process we followed for Tier 1, except now the sponsor has a 10% promote. This is an additional 10% allocated to the sponsor above and beyond the sponsor’s 10% pro-rata share. Since we are allocating an additional 10% to the sponsor, this 10% is taken away from the investor’s original 90% allocation, which leaves the investor with 80% of the cash flow in Tier 2.

Besides including the promote in this Tier, the other difference here is that we are also netting out the cash flow taken in Tier 1. Since Tier 1 was calculated based on a 10% IRR, the Tier 2 15% IRR already includes the first 10%. In other words, the cash flow distributed in Tier 2 is only the incremental cash flow above 10% and up to 15%. To account for this we must subtract out any cash flow taken in prior tiers when calculating the cash flow for the current tier. This is why the cash flow is $0 for the first four years in the holding period (all of the cash flow was already distributed in Tier 1).

Real Estate Waterfall Model Tier 3

Finally, let’s take a look at the last hurdle, which is an IRR above 15%:

real estate waterfall model hurdle 3

This is the easiest to calculate since we don’t have to figure out the required cash flow for a particular IRR. Instead we simply take all remaining cash flow and allocate it according to the percentage splits at this tier. In this case the sponsor gets a 30% promote in addition to his original 10% share, which leaves the investor with 60% of the cash flow. Just like in Tier 2, all of the cash flow in years 1 through 4 is distributed in the prior tiers, which is why all the cash flows in Tier 3 are from the sale in Year 5.

Waterfall Model Returns Summary

The last component in our real estate waterfall model is to look at the total cash flows across all tiers for the investor and the sponsor and then finally we’ll calculate some overall return metrics.

real estate waterfall returns

In this table we are simply adding up the cash flows from each tier for both the investor and the sponsor. Then we calculate the overall IRR and equity multiple for both the investor and the sponsor. Recall from our project’s cash flow before tax that our project level IRR was 21.24%. However, based on our promote structure the sponsor earns a disproportionate share of these cash flows resulting in a 36.34% IRR for the sponsor and an 18.91% IRR for the investor. This disproportionate cash flow split is also reflected in the equity multiple, which is 1.98x for the investor and 3.85x for the sponsor.

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Conclusion

In this article we tackled the real estate equity waterfall model, which is perhaps the most complicated topic in real estate financial modelling. The reason why real estate waterfall models are so complex is because there are so many variables that can be changed. We discussed some common components in equity waterfall models and emphasized the importance of reading the owner’s agreement in order to truly understand a waterfall structure. Finally, we walked through a detailed 3 Tier waterfall model example step-by-step.

How The Mortgage Constant Works In Real Estate Finance

The mortgage constant, also known as the loan constant, is an important concept to understand in commercial real estate finance. Yet, it’s commonly misunderstood. In this article we’ll take a closer look at the mortgage constant, discuss how it can be used, and then tie it all together with a relevant example.

What is The Mortgage Constant?

First of all, what exactly is the mortgage constant? The mortgage constant, also known as the loan constant, is defined as annual debt service divided by the original loan amount. Here is the formula for the mortgage constant:

Mortgage Constant Formula

In other words, the mortgage constant is the annual debt service amount per dollar of loan, and it includes both principal and interest payments.

How to Calculate the Mortgage Constant

There are two commonly used methods to calculate the mortgage constant. The first simply divides annual debt service by the total loan amount. The second allows you to calculate the mortgage constant for any loan amount by solving for the payment based on a loan amount of $1. Let’s take a look at both methods.

Suppose we have a $1,000,000 loan based on a 6% interest rate and a 20 year amortization. With this information you can simply find the annual debt service using the above assumptions, then divide the annual debt service by the loan amount. On our financial calculator, if we plug in 240 months for N, -$1,000,000 for PV, .50% for I (6%/12), and 0 for FV, then we can solve for the monthly payment. To convert this to an annual payment amount we simply multiply by 12.

mortgage constant calculation

Since the mortgage constant is simply the ratio of annual debt service to the total loan amount, this calculation is just simple division. In this case we take $85,972 / $1,000,000 to get a mortgage constant of 0.085972. As a percentage this would be 8.5972%.

The method above works if you already know the loan amount, but what if you want to find the mortgage constant for any loan amount? If you only know the amortization period and the interest rate, then you can easily solve for the mortgage constant. This is accomplished by plugging this information in on a financial calculator, while using $1 as the present value. For example, consider the same loan terms above of a 20 year amortization (240 months) and a 6% interest rate (0.50% per month). Since we don’t know what the loan amount is (present value), we can simply use $1 as the present value:

Mortgage Constant Calculation 2

When we solve for payment we get 0.007164. Since this is a monthly payment we can multiply by 12 to get an annual mortgage constant of .085972. Notice this is the same 8.5972% mortgage constant we found above. Two different approaches that will result in the same result.

Mortgage Constant Example: Band of Investment

Once you have calculated the mortgage constant, it can be used in a variety of ways. Let’s take a look at a mortgage constant example that uses the band of investment approach to calculate the cap rate, which is commonly used by appraisers.

The band of investment method is a popular appraisal approach to deriving a market based cap rate. It’s frequently used by appraisers to support a market cap rate used in the income approach to valuation. The band of investment method is simply a weighted average of the returns to both debt and equity. These returns can be found by surveying lenders to find out their typical loan terms for a particular property, and also surveying investors to find out their required cash on cash returns for a particular property. Let’s take a look at how the mortgage constant is used with the band of investment.

Suppose we want to find an appropriate cap rate to value an office property in Orlando, FL. First, we can call around to several lenders in the area and ask them what their current loan terms are for this kind of property. If lenders are currently underwriting office properties at a 75% loan to value, with a 25 years amortization, and a 5% interest rate, then we can calculate the mortgage constant using one of the methods above. When we do this the resulting annual mortgage constant is 0.07015.

Next, we can survey local investors to see what their required cash on cash return would be in order to invest in a property like ours. Suppose our investor survey reveals an average 11% cash on cash return requirement. Now we can use these debt and equity returns to estimate a market based cap rate using the band of investment method.

To do this we simply take a weighted average of the two rates of returns to get 8.01%. This is found by taking the mortgage constant times the LTV ratio, then adding this result to the cash on cash return times 1 minus the LTV ratio: (7.015% x .75) + (11% x .25) = 8.01%.

Of course there are pros and cons to using the band of investment method to estimate a market based cap rate, but it’s frequently used in the commercial real estate industry and the mortgage constant is a critical component.

Conclusion

The mortgage constant, sometimes called the loan constant, is a commonly used calculation in real estate finance. In this article we defined the mortgage constant, discussed two common approaches to calculating the mortgage constant, and then we showed how the mortgage constant is used with the band of investment approach to calculating the cap rate.

 

How to Calculate The Debt Yield Ratio

The debt yield is becoming an increasingly important ratio in commercial real estate lending. Traditionally, lenders have used the loan to value ratio and the debt service coverage ratio to underwrite a commercial real estate loan. Now the debt yield is used by some lenders as an additional underwriting ratio. However, since it’s not widely used by all lenders it’s often misunderstood. In this article we’ll discuss the debt yield in detail and we’ll also walk through some relevant examples.

What is The Debt Yield?

First of all, what exactly is the debt yield? Debt yield is defined as a property’s net operating income divided by the total loan amount. Here’s the formula for debt yield:

debt yield

For example, if a property’s net operating income is $100,000 and the total loan amount is $1,000,000, then the debt yield would simply be $100,000 / $1,000,000, or 10%.

The debt yield equation can also be re-arranged to solve for the Loan Amount:

Debt yield loan amount formula

For example, if a lender’s required debt yield is 10% and a property’s net operating income is $100,000, then the total loan amount using this approach would be $1,000,000.

What The Debt Yield Means

The debt yield provides a measure of risk that is independent of the interest rate, amortization period, and market value. Lower debt yields indicate higher leverage and therefore higher risk. Conversely, higher debt yields indicate lower leverage and therefore lower risk. The debt yield is used to ensure a loan amount isn’t inflated due to low market cap rates, low interest rates, or high amortization periods. The debt yield is also used as a common metric to compare risk relative to other loans.

What’s a good debt yield? As always, this will depend on the property type, current economic conditions, strength of the tenants, strength of the guarantors, etc. However, according to the Comptroller’s Handbook for Commercial Real Estate, a recommended minimum acceptable debt yield is 10%.

Debt Yield vs Loan to Value Ratio

The debt service coverage ratio and the loan to value ratio are the traditional methods used in commercial real estate loan underwriting. However, the problem with using only these two ratios is that they are subject to manipulation. The debt yield on the other hand is a static measure that will not vary based on changing market valuations, interest rates and amortization periods.

The loan to value ratio is the total loan amount divided by the appraised value of the property. In this formula the total loan amount is not subject to variation, but the estimated market value is. This became apparent during the 2008 financial crises when valuations rapidly declined and distressed properties became difficult to value. Since market value is volatile and only an estimate, the loan to value ratio does not always provide an accurate measure of risk for a lender. Consider the following range of market values:

debt yield vs LTV

As you can see, the LTV ratio changes as the estimated market value changes (based on direct capitalization). While an appraisal may indicate a single probable market value, the reality is that the probable market value falls within a range and is also volatile over time. The above range indicates a market cap rate between 4.50% and 5.50%, which produces loan to value ratios between 71% and 86%. With such potential variation, it’s hard to get a static measure of risk for this loan. The debt yield can provide us with this static measure, no matter what the market value is. For the loan above, it’s simply $95,000 / $1,500,000, or 6.33%.

Debt Yield vs Debt Service Coverage Ratio

The debt service coverage ratio is the net operating income divided by annual debt service. While it may appear at that the total debt service is a static input into this formula, the DSCR can in fact also be manipulated. This can be done by simply lowering the interest rate used in the loan calculation and/or by changing the amortization period for the proposed loan. For example, if a requested loan amount doesn’t achieve a required 1.25x DSCR at a 20 year amortization, then a 25 year amortization could be used to increase the DSCR. This also increases the risk of the loan, but is not reflected in the DSCR or LTV. Consider the following:

debt yield vs amortization

As you can see the amortization period greatly affects whether the DSCR requirement can be achieved. Suppose that in order for our loan to be approved, it must achieve a 1.25x DSCR or higher. As you can see from the chart above, this can be accomplished with a 25 year amortization period, but going down to a 20 year amortization breaks the DSCR requirement.

Assuming we go with the 25 year amortization and approve the loan, is this a good bet? Since the debt yield isn’t impacted by the amortization period, it can provide us with an objective measure of risk for this loan with a single metric. In this case the debt yield is simply $90,000 / $1,000,000, or 9.00%. If our internal policy required a minimum 10% debt yield, then this loan would not likely be approved, even though we could achieve the required DSCR by changing the amortization period.

Just like the amortization period, the interest rate can also significantly change the debt service coverage ratio. Consider the following:

debt yield vs interest rate

As shown above, the DSCR at a 7% interest rate is only 1.05x. Assuming the lender was not willing to negotiate on amortization but was willing to negotiate on the interest rate, then the DSCR requirement could be improved by simply lowering the interest rate. At a 5% interest rate the DSCR dramatically improves to 1.24x.

This also works in reverse. In a low interest rate environment, abnormally low rates present future refinance risk if the rates return to a more normalized level at the end of the loan term. For example, suppose a short-term loan was originally approved at 5%, but at the end of a 3 year term rates were now up to 7%. As you can see this could present significant challenges when it comes to refinancing the debt. The debt yield can provide a static measure of risk that is independent of the interest rate. As shown above it’s still 9% for this loan.

Market valuation, amortization period, and interest rates are in part driven by market conditions. So, what happens when the market inflates values and banks begin competing on loan terms such as interest rate and amortization period? The loan request can still make it through underwriting, but will become much riskier if the market reverses course. The debt yield is a measure that doesn’t rely on any of these variables and therefore can provide a standardized measure of risk.

Using Debt Yield To Measure Relative Risk

Suppose we have two different loan requests, and both require a 1.20x DSCR and an 80% LTV. How do we know which one is riskier? Consider the following maximum loan analysis for both loans:

Debt Yield Comparison

As you can see both loans have identical structures with a 1.20x DSCR and an 80% LTV ratio, except the first loan has a lower cap rate and a lower interest rate. With all of the above variables it can be hard to quickly compare the risk between these two loans. However, by using the debt yield we can quickly get an objective measure of risk by only looking at NOI and the loan amount:

Debt Yield Comparison 2

As you can see the first loan has a lower debt yield and is therefore riskier according to this measure. Intuitively this makes sense because both loans have the same exact NOI, except the total loan amount for Loan 1 is $320,000 higher than Loan 2. In other words, for every dollar of loan proceeds, Loan 1 has just 7.6 cents of cash flow versus Loan 2 which has 10.04 cents of cash flow.

This means that there is a larger margin of safety with Loan 2, since it has higher cash flow for the same loan amount. Of course, underwriting and structuring a loan is much deeper than just a single ratio, and there are certainly other factors that the debt yield can’t take into account such as guarantor strength, supply and demand conditions, property condition, strength of tenants, etc. However, the debt yield is a useful ratio to understand and it’s being utilized by lenders more frequently since the financial crash in 2008.

Conclusion

The debt service coverage ratio and the loan to value ratio have traditionally been used (and will continue to be used) to underwrite commercial real estate loans. However, the debt yield can provide an additional measure of credit risk that isn’t dependent on the market value, amortization period, or interest rate. These three factors are critical inputs into the DSCR and LTV ratios but are subject to manipulation and volatility. The debt yield on the other hand uses net operating income and total loan amount, which provides a static measure of credit risk, regardless of the market value, amortization period, or interest rate. In this article we looked at the debt yield calculation, discussed how it compares to the DSCR and the LTV ratios, and finally looked at an example of how the debt yield can provide a relative measure of risk.

How to Calculate The Debt Service Coverage Ratio (DSCR)

The Debt Service Coverage Ratio, usually abbreviated as DSCR or just DCR, is an important concept in real estate finance and commercial lending. It’s critical when underwriting commercial real estate and business loans, as well as tenant financials, and is a key part of determining the maximum loan amount. In this article we’ll take a deep dive into the debt service coverage ratio and walk through several examples along the way.

Debt Service Coverage Ratio Definition

First of all, what exactly is the debt service coverage ratio? The debt service coverage ratio (DSCR) is defined as net operating income divided by total debt service.

DSCR formula definition
For example, suppose Net Operating Income (NOI) is $120,000 per year and total debt service is $100,000 per year. In this case the debt service coverage ratio (DSCR) would simply be $120,000 / $100,000, which equals 1.20. It’s also common to see an “x” after the ratio. In this example it could be shown as “1.20x”, which indicates that NOI covers debt service 1.2 times.

What The DSCR Means

What does the debt service coverage ratio mean? A DSCR greater than 1.0 means there is sufficient cash flow to cover debt service. A DSCR below 1.0 indicates there is not enough cash flow to cover debt service. However, just because a DSCR of 1.0 is sufficient to cover debt service does not mean it’s all that’s required.

Typically a lender will require a debt service coverage ratio higher than 1.0x in order to provide a cushion in case something goes wrong. For example, if a 1.20x debt service coverage ratio was required, then this would create enough of a cushion so that NOI could decline by 16.7% and it would still be able to fully cover all debt service obligations.

What is the minimum or appropriate debt service coverage ratio? Unfortunately there is no one size fits all answer and the required DSCR will vary by bank, loan type, and by property type. However, typical DSCR requirements usually range from 1.20x-1.40x. In general, stronger, stabilized properties will fall on the lower end of this range, while riskier properties with shorter term leases or less credit worthy tenants will fall on the higher end of this range.

DSCR Commercial Real Estate Example

The DSCR is critical when sizing a commercial real estate loan. Let’s take a look at how the debt service coverage ratio is calculated for a commercial property. Suppose we have the following Proforma:

DSCR Proforma

As you can see, our first year’s NOI is $778,200 and total debt service is $633,558. This results in a year 1 debt service coverage ratio of 1.23x ($778,200/$633,558). And this is what the debt service coverage ratio calculation looks like for all years in the holding period:

DSCR calculations

As shown above the DSCR is 1.23x in year 1 and then steadily improves over the holding period to 1.28x in year 5. This is a simple calculation, and it quickly provides insight into how loan payments compare to cash flow for a property. However, sometimes this calculation can get more complex, especially when a lender makes adjustments to NOI, which is a common practice.

Adjustments to NOI When Calculating DSCR

The above example was fairly straightforward. But what happens with there are significant lender adjustments to Net Operating Income? For example, what if the lender decides to include reserves for replacement in the NOI calculation as well as a provision for a management fee? Since the lender is concerned with the ability of cash flow to cover debt service, these are two common adjustments banks will make to NOI.

Reserves are essentially savings for future capital expenditures. These capital expenditures are major repairs or replacements required to maintain the property over the long-term and will impact the ability of a borrower to service debt. Similarly, in the event of foreclosure, a professional management team will need to be paid out of the project’s NOI in order to continue operating the property. While an owner managed property might provide some savings to the owner, the lender will likely not consider these savings in the DSCR calculation.

Other expenses a lender will typically deduct from the NOI calculation include tenant improvement and leasing commissions, which are required to attract tenants and achieve full or market based occupancy.

Consider the following proforma, which is the original proforma we started with above, except with an adjusted NOI to account for all relevant expenses that could impact the property’s ability to service debt:

DSCR adjusted NOI

As you can see in the proforma above, we included reserves for replacement in the NOI calculation as well as a management fee. This reduced our year 1 NOI from $778,200 down to $728,660. What did this do to our year 1 DSCR? Now the debt service coverage ratio is $728,660 / $633,558, or 1.15x. This is much lower than what we calculated above and could reduce the maximum supportable loan amount or potentially kill the loan altogether. Here’s what the new DSCR looks like for all years in the holding period:

debt service coverage ratio calculations

Now when the debt service coverage ratio is calculated it shows a much different picture. As you can see, it’s important to take all of the property’s required expenses into account when calculating the DSCR, and this is also how banks will likely underwrite a commercial real estate loan.

How to Calculate The DSCR for a Business

The debt service coverage ratio is also helpful when analyzing business financial statements. This could come in handy when analyzing tenant financials, when securing a business loan, or when seeking financing for owner occupied commercial real estate.

How does the DSCR work for a business? The general concept of taking cash flow and dividing by debt service is the same. However, instead of looking at NOI for a commercial property, we need to substitute in some other measure of cash flow from the business available to pay debt obligations. But which definition of cash flow should be used? Given the importance of debt service coverage, there is surprisingly no universal definition used among banks and sometimes there is even disagreement within the same bank. This is why it’s important to clarify how cash flow will be calculated.

With that said, typically Earnings Before Interest, Taxes, Depreciation and Amortization (EBITDA) or some form of adjusted EBITDA will be used. Common adjustments include adding back an appropriate capital expenditure amount required to replace fixed assets (which would offset the depreciation add back), and also taking into account working capital changes (to cover investments in receivables and inventory).

Let’s take an example of how to calculate the debt service coverage ratio for a business.

DSCR business

As shown above, EBITDA (cash flow) is $825,000 and total debt service is $800,000, which results in a debt service coverage ratio of 1.03x. This is found by dividing EBITDA of $825,000 by total debt service of $800,000. This gives us an indication of the company’s ability to pay its debt obligations.

If this analysis were for a tenant, we might want to subtract out existing lease payments and add in the new proposed lease payments. Or, if this were for an owner occupied commercial real estate loan, we would probably subtract out the existing lease payments and add in the proposed debt service on the new owner occupied real estate loan.

Based on the above 1.03x DSCR, it appears that this company can barely cover its debt service obligations with current cash flow. There could be other ways of calculating cash flow or other items to take into account, but strictly based on the above analysis it’s not likely this loan would be approved. However, sometimes looking at just the business alone doesn’t tell the whole story about cash flow and debt service coverage.

Global Debt Service Coverage (The Global DSCR)

Calculating the debt service coverage ratio like we did above doesn’t always tell the whole story. For example, this could be the case when the owner of a small business takes most of the profit out with an above market salary. In this case looking at both the business and the owner together will paint a more accurate picture of cash flow and also the debt service coverage ratio. Suppose this was the case with the company above. This is what a global cash flow analysis might look like if the owner was taking most of the business income as salary:

 

global DSCR

In the above analysis we included the business owner’s personal income and personal debt service. Assuming the owner was taking an abnormally high salary from the business, this would explain the low debt service coverage ratio when looking at the business alone as in the previous example. In this new global debt service coverage calculation we take this salary into account as cash flow, as well as all personal debt service and living expenses. Digging into how personal cash flow is calculated is beyond the scope of this article, but most of this information can be found just from personal tax returns, the personal financial statement, and the credit report, all of which will be required by a lender when underwriting a loan.

As you can see, this new global DSCR paints a much different picture. Now global income is $1,575,000 and global debt service is $1,100,000, which results in a global DSCR of 1.43x. This is found by simply dividing global income by global debt service ($1,575,000/$1,100,000). More often than not, a global cash flow analysis like this tells the full story for many small businesses.

Conclusion

In this article we discussed the debt service coverage ratio, often abbreviated as just DSCR. The debt service coverage ratio is a critical concept to understand when it comes to underwriting commercial real estate and business loans, analyzing tenant financials, and when seeking financing for owner occupied commercial real estate. We covered the definition of the debt service coverage ratio, what it means, and we also covered several commercial real estate and business examples for calculating the debt service coverage ratio. While the DSCR is a simple calculation it’s often misunderstood and it can be adjusted or modified in various ways. This article walked through the debt service coverage ratio step by step to clarify these calculations.