Fee Simple vs. Leased Fee: Valuing the Correct Property Interest

1. Introduction

Under Texas Property Tax Code §23.01, all taxable property is appraised “at its market value as of January 1.” Market value in this context is a value of the property, defined at §1.04(7) as the land, the improvements, and the interests in them — not a value of a specific investor's cash flow stream. Identifying the property interest is the first substantive step of any appraisal assignment under USPAP Standards Rule 1-2(e), and it is the step most often skipped in mass appraisal.

The distinction matters because two competent appraisers, using the same building, the same market, and the same date of value, will produce materially different conclusions depending on whether they capitalize market rent or contract rent. In Texas submarkets where leases signed in 2021 and 2022 are now meaningfully above or below current market, the divergence is not academic — it routinely runs 15% to 40% of value.

This article defines the two interests, explains why the fee simple estate is the correct subject of an ad valorem appraisal, works through two Texas case studies, and provides the evidentiary framework for presenting the issue to an Appraisal Review Board.

2. Defining the Interests

2.1 Fee simple estate

The fee simple estate is absolute ownership unencumbered by any other interest, subject only to the four powers of government: taxation, eminent domain, police power, and escheat. Valued as of January 1, the fee simple assumes the property is available to be leased at market rent, exposed to market vacancy and collection loss, and burdened by market lease-up costs. It is the estate a hypothetical buyer would acquire if the building were delivered empty and re-let on today's terms.

2.2 Leased fee interest

The leased fee is the ownership interest held by a landlord who has conveyed the right of use and occupancy to a tenant. Its value is the present worth of the contract rent over the remaining term plus the reversion. Because contract rent is fixed by an executed document, the leased fee value moves with the credit of the tenant, the length of the term, escalation structure, renewal options, and landlord obligations — none of which are physical or locational attributes of the real estate.

2.3 Leasehold interest

The leasehold is the tenant's position: the right to use and occupy for the term. It has positive value only when market rent exceeds contract rent. Leasehold and leased fee together comprise the fee simple, which is why an appraisal that values only one of them values only part of the taxable property.

3. Why Fee Simple Controls in Texas Ad Valorem Appraisal

3.1 The statute values property, not contracts

Section 23.01 directs appraisal of the property. A lease is personal contract rights between two parties; it does not change the land, the improvements, or the location. Two identical adjacent buildings — one leased in 2021 at $32 per square foot, the other vacant and available at today's $24 — are the same real estate and, under a uniform and equal system, should carry the same assessed value.

3.2 Uniform and equal taxation

Article VIII, §1 of the Texas Constitution requires taxation to be equal and uniform. Assessing on contract rent produces the opposite: an owner who negotiated well is taxed more than a neighbor with an identical building who negotiated poorly, indefinitely, on the basis of a private contract. Market rent is the only input that is common to both properties.

3.3 The income method statute points to market inputs

Section 23.012 directs the chief appraiser using the income method to use rental income and expense data “from generally accepted sources,” to make appropriate adjustments, and to derive the capitalization rate from the market. Each of those instructions describes market-derived, not contract-derived, inputs.

3.4 The market data statute requires adjustment

Section 23.013 requires comparable sales to be “appropriately adjusted,” including for the terms and conditions of sale. A net-leased property that traded at a premium because of a credit-rated tenant on a twelve-year term has a condition of sale that must be adjusted out before the price informs the fee simple value of the subject.

4. Distinctions at a Glance

5. Case Study: Single-Tenant Net Lease, Harris County

5.1 The property

A 9,100 square foot freestanding retail building on a hard corner in northwest Harris County, built in 2019 and occupied by a national pharmacy on a fifteen-year absolute net lease signed in 2019 at $34.00 per square foot with 1.5% annual escalations. Contract rent as of January 1, 2026 is $37.65 per square foot. Second-generation freestanding retail of comparable size and location is leasing at $26.00 to $28.00 per square foot net.

5.2 Leased fee indication — what the district used

5.3 Fee simple indication — the taxable estate

5.4 What the gap represents

• Rent differential: $10.65 per square foot of above-market contract rent, capitalized, accounts for roughly $1.9 million of the spread.
• Cap rate differential: 125 basis points of credit-tenant compression accounts for most of the remainder. That compression prices the pharmacy's balance sheet, not the corner.
• Occupancy assumption: zero vacancy is an attribute of the lease. A fee simple appraisal must assume the building can go dark and be re-let.
• Reversion risk: on expiration the landlord faces re-tenanting at $27, plus downtime and tenant improvements. The leased fee value ignores that; the fee simple value prices it in from day one.

6. Case Study: Multi-Tenant Office, Dallas County

6.1 The property

A 48,000 square foot Class B office building in south Dallas County, built in 2004, 82% occupied across nine tenants. The rent roll is dominated by two leases signed in 2021 at $34.00 full service; the remaining tenants are at $26.50 to $29.00. Current market for comparable Class B space is $27.50 full service, with market vacancy in the submarket at 17%.

6.2 Fee simple income indication

6.3 Leased fee indication

6.4 Reconciliation

The Dallas County spread is narrower than the Harris County spread because a nine-tenant rent roll averages toward market, while a single credit lease does not. That is itself an analytical point worth making at hearing: the fee simple and leased fee conclusions converge as a rent roll approaches market, and diverge exactly where an assessment is most likely to be wrong.

• The correct assessed value is $7.45M, the fee simple indication at market rent and market vacancy.
• The $1.23M difference is the capitalized value of two above-market leases — contract value, not real property value.
• Those leases expire in 2027 and 2028. Taxing them today assesses income the property will not produce over the ownership horizon.
• Sales evidence must be screened the same way: comparables that traded with above-market leases in place require a downward adjustment under §23.013.

7. Where Leased Fee Data Is Still Useful

Rejecting leased fee as the basis of assessment does not mean ignoring lease data. Properly used, the rent roll is evidence:

• Recent leases signed within twelve months of the lien date are among the best evidence of market rent for the subject.
• Expense recovery structures in the leases establish which expenses are non-recoverable in the fee simple pro forma.
• Tenant improvement and leasing commission history establishes market lease-up cost.
• A leased fee sale becomes a usable comparable once adjusted for the rent differential and the credit-driven cap rate spread.

The analytical discipline is directional: lease data informs market inputs; it does not replace them.

8. Presenting the Issue at an ARB Hearing

8.1 Opening statement

“There is one question before the Board today, and it is not whether our numbers are lower than the district's. It is which property interest Texas law requires you to value.

Section 23.01 requires appraisal of the property — the land and the improvements. It does not authorize appraisal of a lease. The district's value capitalizes $37.65 per square foot of contract rent at a 6% cap rate. That rent exists because of a fifteen-year corporate guarantee signed in 2019. It is not what this building would rent for on January 1, 2026.

Market rent for comparable freestanding retail in this submarket is $26 to $28. At $27, market vacancy, and a real-estate cap rate of 7.25%, the fee simple value of this property is $3.03 million.

We are not asking the Board to discount the value. We are asking it to value the correct estate. The building across the street is physically identical and vacant. Uniform and equal taxation does not permit two assessments for the same real estate based on who signed the lease.”

8.2 For the ARB written brief

Frame the record around the interest, then the inputs, then the conclusion. The Board should be able to identify a single decision point:

9. Common Appraisal District Errors

9.1 Capitalizing the rent roll as filed

The mistake: treating an owner's rendition or rent roll as the income input without testing it against market. The rent roll is the leased fee; converting it to fee simple requires substituting market rent, market vacancy, and market lease-up costs.

9.2 Using unadjusted net-lease sales as comparables

The mistake: pulling a $5.6 million single-tenant sale into the grid at face value. Section 23.013 requires adjustment for terms and conditions of sale; a credit-tenant lease is such a condition.

9.3 Using actual vacancy in a fee simple pro forma

The mistake: applying 3% vacancy because the building is 97% leased. Actual occupancy is an attribute of the current lease structure. A fee simple analysis uses the submarket rate.

9.4 Double counting business value

The mistake: capitalizing income attributable to tenant credit, franchise operations, or below-market management contracts. Those are intangible and business components, not real property, and are not taxable as real estate.

9.5 Applying the argument only when it helps the owner

The mistake — on both sides: the fee simple standard cuts both ways. Where in-place rents are below market, the fee simple value exceeds the leased fee value, and an owner cannot argue contract rent then. Credibility at hearing depends on applying the standard consistently.

10. Conclusion

The fee simple versus leased fee question is not a valuation technique; it is a threshold identification of what is being appraised. Texas law answers it plainly: §23.01 taxes property, §23.012 directs market-derived income inputs, §23.013 requires adjustment of sales for the conditions that produced them, and the constitutional requirement of uniform and equal taxation forecloses assessing identical buildings differently because of private contracts.

In practice, the two interests converge when a rent roll sits at market and diverge sharply when it does not. The divergence is the diagnostic: a 40% spread on a single-tenant net-leased asset is a reliable signal that the assessment has captured a lease rather than a building.

• Identify the interest before selecting inputs — the assignment governs the arithmetic.
• Substitute market rent, market vacancy, and a real-estate cap rate for their contract counterparts.
• Adjust leased fee sales before they enter the market data grid.
• Present the gap as a restatement of the estate appraised, not as a request for relief.

Property owners appealing assessments of leased commercial property should place the interest question first in the record. Once the Board accepts that the fee simple estate is the taxable estate, the quantitative work is straightforward and the evidentiary burden shifts to the district to justify contract-based inputs the statute does not authorize.

References

1. 01Texas Property Tax Code §23.01: “Appraisals Generally.” Requires appraisal of property at its market value as of January 1 using generally accepted appraisal methods and techniques.
2. 02Texas Property Tax Code §23.013: “Market Data Comparison Method of Appraisal.” Requires comparable sales to be appropriately adjusted, including for differences in the terms and conditions of sale.
3. 03Texas Property Tax Code §23.012: “Income Method of Appraisal.” Directs use of market rental income, market expenses, and a capitalization rate derived from the market.
4. 04Texas Property Tax Code §23.0101: “Consideration of Alternate Appraisal Methods.”
5. 05Texas Property Tax Code §25.02 and §1.04(7): identification of the estate appraised; real property defined as land, improvements, and the interests therein.
6. 06The Appraisal of Real Estate, 14th ed. Chicago: Appraisal Institute, 2019 — Ch. 6 (Real Property Interests) and Ch. 20 (Income Capitalization).
7. 07The Dictionary of Real Estate Appraisal, 7th ed. Chicago: Appraisal Institute, 2022 — definitions of “fee simple estate,” “leased fee interest,” and “leasehold interest.”
8. 08USPAP 2024–2025 Edition, Standards Rule 1-2(e): identification of the property interest to be valued.
9. 09Appraisal Review Board Training Manual, Texas Comptroller of Public Accounts — Ch. 4 (Approaches to Value) and Ch. 5 (Evidence).
10. 10Texas Comptroller of Public Accounts, Property Value Study and Self-Report Manual: guidance on market rent and mass appraisal of leased commercial property.
11. 11CoStar Market Data (Q4 2025): asking and effective rent series and cap rate ranges for Texas retail, office, and industrial submarkets.
12. 12Marcus & Millichap and Partners Real Estate Texas market reports: net-lease pricing, credit-tenant cap rate spreads, and second-generation space rents.