QUESTION:        We have been provided with a range of fair market rental values from a local real estate appraiser. Is this sufficient to benchmark the fair market value of the rent that we are charging?

ANSWER:        A range of fair market value from an experienced appraiser is an excellent start. However, in order to establish that the rent that you are charging constitutes a commercially reasonable, fair market value rent, you have to consider the totality of the circumstances that resulted in that range.

In U.S. ex rel. Goodstein v. McLaren Regional Medical Center, 202 F.Supp.2d 671 (E.D. Mich. S. Div. 2002) (the “McLaren Case”), a qui tam relator alleged that the rent being paid by a hospital to several orthopedic surgeons who owned a medical office building (and who were in a position to refer Medicare and Medicaid patients to that hospital and its orthopedic and physical therapy services) exceeded fair market value.

In the McLaren Case, the physicians were the landlord and the hospital was the tenant, so the issue was whether the rent paid by McLaren exceeded fair market value. However, the same legal principles apply, where a hospital is the landlord and a physician is the tenant, with the issue being whether the rent that the hospital will charge the physician is less than fair market value. In either event, the legal issue remains the same – whether the parties can prove that the rental rate set forth in the lease constitutes the fair market value of the space being leased.

The Court in the McLaren Case then ruled that based on the totality of the circumstances that the respective experts used to determine the rental rates set forth in their respective appraisals, the rental rate that McLaren agreed to pay the physician landlords was consistent with fair market value.

In reaching its conclusion, the Court carefully considered the facts that the Government’s experts used to determine the rent that the Government alleged should have been paid, and compared those facts to the facts that McLaren’s experts relied upon when they opined that the rental rate that was actually paid was at fair market value.

The key to the Court’s analysis was the comparability studies performed by each appraiser. This was so much so that the Court specifically stated that it did not consider the analysis performed by one of the Government’s experts because during his testimony this appraiser did not identify the comparables he used in his appraisals. Thus, the Court had no way of evaluating whether the appraiser used appropriate comparables in his appraisal.

The facts that the Court in the McLaren Case considered in its comparability analysis included the manner in which the rent in each building was determined (i.e., triple net versus a gross rental rate). The Court found that while comparing a triple net rental rate to a gross rental rate required the appraiser to adjust the respective rental rates to take into account the different rental formulas used, the Court also found that otherwise comparable buildings should not have been excluded from a comparability analysis merely because the manner used to determine the rental rate in that building was different than the rental charged in the building at issue.

However, the most important factor in the Court’s analysis was whether the buildings used in each expert’s comparability studies were of similar quality and location to the building at issue. The Court disagreed with the buildings that the Government used to allege a lower rate should have been charged in the building under consideration because of the Government experts’ use of comparables buildings that included: (i) a building without an elevator to one that contained one; (ii) an ADA-compliant building to one that was not; (iii) an older, “run down” building of inferior construction to a newer building; (iv) a building located in a flood plain to one that was not; (v) a building where the building and the parking lot had water problems to one that did not; (vi) a financially viable building to one that was in foreclosure or purchased at a fire sale; (vii) a building with numerous occupants to one where there was no commercial space for lease because it was entirely owner-occupied; and (viii) an older building with low ceilings and small windows that have not been remodeled since their construction 20 years earlier and was not well maintained to a modern, well-maintained building.

So, it is important to have a clear understanding as to how the range of fair market value was determined and to make sure that the comparable properties that were used as the basis for that range are truly comparable in physical structure and terms of the lease (i.e., Triple Net versus all inclusive).