Appropriate Use of the Development Cost Approach in Condemnation

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By: Christopher J. Stockness

In the majority of condemnation cases, damages relate to the loss of value under a property’s highest and best use (HBU) – often the property’s current use. A knowledgeable appraiser can quantify this loss by performing a before and after valuation using the three standard approaches to value. However, what happens if the condemned property is in transition from one use to another?

Consider the owner who was in the midst of developing or redeveloping a site at the time it was condemned. The condemnation process burdens the property owner beyond the fee simple market loss of the property’s HBU. A promising development may be delayed; diminished in size by the taking; or incur unexpected costs in addition to the time and money already invested during the planning stages. In fact, the impact of the taking may render the project physically and/or financially unfeasible.

Unlike the cost, income and market approaches to value, the development cost approach (which incorporates all three approaches) allows the appraiser to quantify the full impact of the taking. The analyst calculates the market value of the proposed development (including land and buildings), subtracts the building costs and then factors in the damages to the project. Using an income analysis, the appraiser establishes the current price a potential buyer would be willing to pay for the land based on the costs of developing it and the likely proceeds from the sale of the development in the future: a before-the-taking value. Once the initial value is determined the income analysis is repeated; this time, the appraiser’s adjustments include the impact of the taking on current property value: an after-the-taking value.

The development cost approach was first recognized by the Minnesota Supreme Court as a valid technique in determining damages for eminent domain purposes in: County of Ramsey v. Miller, 316N.W.2d 917, 919 (Minn. 1982). As to when it is appropriate to use the development cost approach for determining damages, the Minnesota Supreme Court identified three criteria that must be met:

  • The land is ripe for development
  • The owner can reasonably expect to secure the necessary zoning and other permits required for development to take place
  • The development will not take place at too remote of a time

Recently in Winona, Minnesota, a portion of the land owned by Mikrut Properties, LLLP was acquired by the City of Winona. The owners were in the process of developing an intermodal (rail and truck) transit facility (ITF) using the existing land when approximately 20,000 square feet of frontage was taken for the upgrade and expansion of Pelzer Street. Pelzer Street is a major thoroughfare providing access to industrial properties in the immediate area. The taking was deemed necessary to accommodate a bridge across the Canadian Pacific railroad tracks. Unfortunately, the location of the railroad overpass effectively prevented access to the subject from Pelzer Street. The property lost its main access and was forced to utilize a secondary access to the site: a residential road not designed to accommodate heavy commercial truck traffic.

As a result of the taking, what was an underdeveloped industrial land site in the process of being redeveloped was now likely to remain an underdeveloped industrial site with minimal or reduced redevelopment potential due to poor access. Not only was access limited to a residential road, it was problematic (in the after condition) whether residents and local officials would approve a re-development that resulted in heavy truck traffic and noise in their neighborhood.

Clearly, the taking changed the highest and best use of the land from a prime rail transit site in the before condition to continued use as a low intensity industrial site in the after condition. The involved parties agreed that the HBU in the after condition was continued development. After trial, the jury concluded that a cost to cure measure providing an upgraded access via the residential thoroughfare (recognized only in the development cost approach) properly reflected the damages to the subject as compared to the loss in market value resulting from continued use as a low intensity industrial site. Improved access mitigated much of the long term damage, but the project was delayed for a long period while the residential road was upgraded to a commercial thoroughfare. The jury was also presented with a standard direct sales comparison approach analysis for damages that did not, and could not, recognize the cost to cure. That approach was rejected by the jury.

Not every development project under the threat of condemnation will fit into the criteria set forth by the courts. However, since the subject property met all three conditions, using the cost development approach to value was appropriate and effective. Let’s review each the three points:

  1. The Land Is Ripe for Development of the ITF?
    At the time of the taking, the land was underutilized with industrial development located in the north corner of the site, leaving excess land available for an additional development of ±12 acres. A highest and best use analysis determined that the physical, legal, and economically viable uses of the property supported the proposed re-development. Additionally, due to the geographic constraints of having the railroad tracks located between the Mississippi River and the surrounding bluffs, substitute sites for this re-development were virtually non-existent and development opportunities were extremely limited in the Winona Area. Clearly, the land was ripe for development.
  2. The Developer Could Expect to Secure the Necessary Zoning and Permits Required for the Development to Take Place
    The site was zoned M-2 General Manufacturing District which allowed for heavy industrial uses including railroad and transit facilities. The property owner had been negotiating with the Canadian Pacific Railway (CPR) to develop a railroad spur allowing rail access to the subject. CPR expressed strong interest in the development and verbally committed to a spur connection. Discussions with the City of Winona confirmed the viability of the site for development into a rail and truck facility. Additionally, the City of Winona was aware of the property owners’ development plans and had designed the rail overpass to accommodate the spur extension to the site.
  3. The Development Will Not Take Place at too Remote of a Time

The developer was in the advanced planning stages of development at the time of the taking and was preparing the site to accommodate the proposed development. If not for the taking, the developer would have continued to develop the site for use as an intermodal facility. Due to the loss of access from Pelzer Street, the taking forced the development to be delayed indefinitely until the issue of access could be resolved.

The property and the proposed development met all three criteria; it was deemed appropriate and necessary to utilize the development cost approach to determine the damages to the subject based on the taking. The taking of the subject land occurred on May 12, 2005. A court appointed Commissioners’ Hearing took place on June 6 and June 7, 2006. Shenehon Company provided the appraisal and testified to the damages to the subject property relying on the development cost approach. In contrast, the appraiser for the City of Winona relied on a sales comparison analysis and concluded significantly lower damages.

On September 11, 2006 the Commissioners awarded $903,000 in damages to the property owner. They were persuaded that the highest and best use was for an intermodal transit facility and agreed that the development cost approach was the proper method with which to value the subject citing that the three criteria for the development cost approach had been met.

The City of Winona appealed the case and a jury trial was scheduled to take place in November of 2007. Prior to the trial, the City of Winona filed a motion to Exclude Improper Evidence Regarding Valuation claiming that the property owner’s appraisal report methodology did not appropriately utilize a “development cost approach.” The motion for exclusion of the appraisal was overruled and the trial was re-scheduled for November of 2008.

At trial, the jury listened to testimony from both sides’ appraisers and awarded $570,000 in damages to the property owner. The damage award at trial was less than the Commissioners’ award because the City of Winona altered its position regarding reconstruction of the road.

Before the Commissioners, the City (condemnor) made no commitment to rebuild the road and the Commissioners included the cost to rebuild the road in its award. At trial, before the jury, the Public Works Director with the City of Winona indicated his recommendation for the City of Winona to upgrade the road for the proposed development – the property owner would not be assessed for the upgrade. The cost of the road upgrade was estimated at $355,000. The $570,000 jury award reflected a cost to cure of acquiring residential properties fronting the rebuilt road. This had previously been included in the Commissioners’ award. Thus, the combination of the jury award plus commitment to rebuild the road by the City at no cost to the owner was basically equivalent to the prior Commissioners’ award.

In conclusion, the development cost approach to valuation is a valid appraisal technique if a proposed development meets the three tests set forth by the Minnesota Supreme Court in the case of County of Ramsey v. Miller. If the validity tests (ripeness of development; legal feasibility; and a reasonable development time frame) are not met, the objectivity of the appraisal is compromised. Application of the development cost approach in eminent domain law is an important valuation tool which the appraiser can rely upon to measure “just compensation”.

Testing Minnesota Statute 117.186 as It Relates to Business Damages (Loss of Going Concern) in Condemnation – By Scot A. Torkelson

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Introduction

On September 9, 2008, a Court-appointed Commission recognized an important threshold of damages in the area of condemnation law. The decision (State of Minnesota v. Parcel 212 Kindercare) came thirteen months after the Interstate 35W bridge collapse which precipitated the condemnation and taking of the subject real estate. The taking closed and, ultimately, destroyed a thriving day care business. This ruling is significant because it is in stark contrast to past interpretations of Minnesota Statute 117.186 (Compensation for Loss of Going Concern).

Briefly, the power of eminent domain states that: Any property may be condemned and taken by the U. S. Government for public purpose. However, the owner of that property must be paid fair market value under the Takings Clause of the Fifth Amendment to the United States Constitution. Article 1, Section 13 of the Minnesota Constitution describes an even broader scope of government responsibility by guaranteeing that, “private property shall not be taken, destroyed, or damaged for public use without just compensation.” In this case, determining the fair market value of the property (for purposes of just compensation) was complicated by the fact that the taking destroyed the business itself. In the State of Minnesota, fair market value historically includes only the real estate because it is assumed that the business itself could easily move to another location. Thus, it was quite rare that the facts of a case warranted an award for loss of going concern.

Summary of Facts

In light of recent changes, what happens when a business cannot relocate?

In 2006, the State Legislature revised Minnesota Statute 117.186 and expanded the traditional interpretation of loss of going concern, stating as follows within Subdivision 2:

“If a business or trade is destroyed by a taking, the owner shall be compensated for loss of going concern, unless the condemning authority establishes any of the following by a preponderance of the evidence:

  • the loss is not caused by the taking of the property or the injury to the remainder;
  • the loss can be reasonably prevented by relocating the business or trade in the same or a similar and reasonably suitable location as the property that was taken, or by taking steps and adopting procedures that a reasonably prudent person of a similar age and under similar conditions as the owner, would take and adopt in preserving the going concern of the business or trade;
  • compensation for the loss of going concern will be duplicated in the compensation otherwise awarded to the owner.”

The bridge collapse of August 1, 2007 created the circumstances for the test case of compensation for loss of going concern when the subject business is, in fact, destroyed. Numerous properties in the area of the bridge collapse required immediate condemnation action; one of those properties was a day care located on the north side of the Mississippi River, near 10th Avenue.

As a result of the taking of the real estate rented by Kindercare Day Care Center, the operating day care business was destroyed. Minnesota Statute 117.186 became the basis for recovering damages for the loss of going concern, with the plaintiff arguing that all of the above criteria for just compensation were met.

Opposing Viewpoints

In its brief, the State took a narrow view of the use of the word ‘destroyed’ in the Statute, claiming that to destroy meant, “to ruin completely,” “tear down or break up, demolish,” “to do away with or put an end to,” etc. Under this strict interpretation the State argued that the criteria of the Statute were NOT met.

The State further noted that 26% of the affected clients were transferred to other facilities operated by Kindercare and provided evidence that the facility could reasonably be relocated in its market area.

On behalf of Kindercare, Shenehon Company argued that the nature and immediacy of the closing; the difficulty of placing the children in other facilities; the fact that the building was demolished within a very short time frame of the taking; and the significant obstacles to relocating a day care (including the zoning restrictions, planning time to get a day care approved, the need for sufficient play area for outside activities, finding a facility that met all licensing requirements, etc.), placed Kindercare in an impossible situation. In fact, the business could not reasonably relocate and was completely destroyed.

Commission’s Findings

The Commission determined that the transfer of some students to other facilities did not preclude recovery of damages for the taking of a very desirable location. Additionally, it found that the incidental increase in revenue at other locations did not relieve the State from its obligation to compensate the owner for the loss of its location under the statute’s business damage compensation provisions.

After hearing evidence from both sides, the Commission ruled that the Kindercare Day Care business was, in fact, destroyed by the taking and awarded the defendants full damages. Therefore, under the revised provisions of Minnesota Statute 117.186, the State is liable for the loss of going concern and must pay the owner just compensation.

As it relates to loss of going concern, the Commission determined that Minnesota Statute 117.186 requires that a taking must demonstrate: (1) that the going concern value will in fact be destroyed as a direct result of the condemnation; and (2) the business either cannot be relocated as a practical matter or that relocation would result in irreparable harm. In this case, the Commission awarded a considerable compensation package to Kindercare.

Summary

According to the findings of the Commission, for businesses that rely heavily on carefully selected locations (such as day care facilities) or are subject to significant regulatory or licensing hurdles in the development of the business, demonstrating a reasonable inability to relocate is sufficient to justify payment for damages due to loss of going concern.

The case is currently being appealed by the State of Minnesota.

Is Assessed Value Based on Market Rent or Contract Rent? – By Andrew T. Donahue

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Walgreen Co. v. City of Madison

On July 8, 2008, the Wisconsin Supreme Court reversed a 2007 Wisconsin Court of Appeals decision and remanded it for further proceedings. In the case of Walgreen Co. v. City of Madison, at issue are the 2003 and 2004 assessed values for two Walgreens properties in Madison, Wisconsin. Walgreens leased the properties from the developer and was also responsible for the property taxes. As is typical with Walgreens’ projects, the developer constructed the properties according to Walgreen Co. specifications, including certain above-market features (super-adequacies). The developer was paid a rent higher than the market rent to cover costs relating to financing, land acquisition, construction, development, and a reasonable developer’s profit. The City’s appraiser based the appraised value on the actual contract rent while Walgreens’ appraiser relied on market rent to determine value. Although the two sides disagreed on several other points, ultimately the case hinged on whether it is proper to use market rent or contract (actual) rent as the basis for determining assessed value.

As expected, concluded values in the Walgreens appraisals differed substantially from those reported in the City’s appraisals. Walgreen Co. appealed the assessed values for 2003 and 2004 to the City of Madison Board of Review without success. It subsequently appealed to the Dane County Circuit Court and the Wisconsin Circuit Court losing each time. Finally, Walgreen Co. took the case to the Wisconsin Supreme Court which reversed the previous decisions.

Methodology

Walgreens argued that the proper methodology, as outlined in the Wisconsin Property Assessment Manual (Manual), is to use market rents to determine fee simple interest. The City argued that the actual contract rents – which were above market rents – should be used in order to determine the full value of the property. The following chart shows the values concluded by the City and Walgreen for the subject properties.

The Court reminded the appraisers that “the power to determine the appropriate methodology for valuing property for taxation purposes lies with the legislature” and that “he goal of the assessor is to estimate the market value of a full interest in the property, subject only to governmental restrictions. All the rights, privileges, and benefits of the real estate are included in this value…also called the market value of a fee simple interest in the property” (¶20 of 2008WI80).

The parties agreed that the income approach to value was the most appropriate method for estimating the market value of the properties. The Court concurred and further clarified the use of the income approach with this quote from the Wisconsin Property Assessment Manual: “hen applying the income approach, the assessor must use the market rent, not the contract rent, of the property (unless valuing federally subsidized housing…)”

The Court emphasized the Manual definition of market rent as: “rent that a property would receive based on the current, arm’s-length rent commanded by similar properties in the marketplace.” It also drew attention to the fact that the value of real property for assessment purposes is based on estimating the market value of a fee simple interest. The Manual requires that market rent be used when determining the fee simple interest of leased retail property. When contract rent is used, the resulting value calculation is that of a leased fee interest, not a fee simple interest. Describing the methodology of the two appraisals, the Circuit Court noted that ” appraised the fee simple interest in the two properties without consideration of the lease, while appraised the leased fee interest” (¶10).

Why the City selected non-market rents

The City argued that it was justified in using contract (actual) rents, as opposed to market rents, for the two Walgreens properties because the Manual is in conflict with Wisconsin’s statutory requirements on this issue. The City claimed that the Manual’s methodology violates the Wisconsin Statute 70.32(1) requirement that property be assessed based on the full value that could be obtained at a private sale. The statute refers to full value as the lease’s value within the scope of the rights or privileges pertaining to real estate defined under Wisconsin Statute 70.03’s definition of real property. Thus, the City’s interpretation is that contract rents provide the proper basis for assessing full value (¶30 of 2008WI80). The City relied on three cases to justify its use of contract rents: Metropolitan Holding, Darcel, and West Bend.

The Court rejected these cases as supporting evidence because they address how to value properties operating with below market rent contracts. In each of the above situations, the Court allowed limited exceptions to the general rule recognized by the Manual (7-4 to 7-5), because a potential purchaser “would be unable to obtain the market rate value of property due to a lease encumbrance” (¶37).

The City also cited a public housing case to further support its claim. However, the Court responded by again pointing to the Manual’s requirement that “assessors must value property based on the market rent rather than the contract rent leased property ‘unless valuing federally subsidized housing'” Property Assessment Manual 7-29 (¶38).

When it is appropriate to apply a non-market rent

The appropriate time to use non-market contract rents is when they are below market levels. The Manual allows this exception because a buyer could not obtain the fair market value at sale, thus the property should not be valued as if obtaining fair market value were possible. The Court defined a property with a below market rent as being “encumbered” and a property with an above market rent as “enhanced”. The Court also cited the Appraisal of Real Estate 12th Addition, which states: ”
lease never increases the market value of real property rights to the fee simple estate.”

As it relates to Walgreen Co. v. City of Madison, the Court pointed out that there is no exception in the Manual which allows for the appraiser to increase the market value of a property based on above market lease rates. In contrast to the property encumbered by below market rents for which the buyer is unlikely to receive market rents, existing above market rents do not prevent the buyer from receiving, at a minimum, market rental rates.

Unusual Financing Arrangements

The parties agreed that including development costs in the rent results in what the Circuit Court described as “higher than normal” lease rates. As mentioned earlier, the subject properties were constructed in a manner that followed Walgreens’ business model – the developer constructs the property which Walgreens then rents (¶6 WI 2008 80). Thus, they enter into a lease that encompasses the real estate costs as well as prior efforts and financial expenses borne by the developer. Furthermore, Walgreens agreed that the “higher than normal” lease rates would increase the value of its stores to potential purchasers, but stressed that the rent would still be based partly on real estate value and partly on contract value: the contract value is represented in the lease payments by the amount of rent paid above market rental rates.
Walgreens argued that using such a lease is not allowed since it relies on unusual financial arrangements and cited Flood and Flint . While these two cases relate to sales and not leases, they address the same underlying principle which states that “a real property assessment should not be based on factors such as unusual financing or above market rent that are not normal conditions of sale reflected in the value of a fee simple property interest.” The Court agreed with Walgreens stating: “These cases establish that unique financing arrangements are not part of the ordinary conditions in the market establishing “full value” within the meaning of Wis. Stat. § 70.32(1).” In relating this to the current case, the Court concluded “that tax assessors must refrain from including creative financing arrangements under a specific property’s lease in their valuations of that property.”

The City also argued that there were prior cases – ABKA, Waste Mgmt., and N/S Associates – in which the courts held that, under the income approach, a property’s business value or income-producing capacity that is “inextricably intertwined” with the property may be considered among those “rights and privileges” of the property. The Court did not accept these cases as evidence stating the City failed to establish that an “inextricably intertwined” situation existed. In all three cases, the courts determined the value was attributable to the underlying real estate. The Court also pointed to Adams and said that in order for the “principle to apply, that all of the value it assigned to Walgreens’ retail properties related ‘primarily to the nature of’ the real property itself’, as opposed to being attributable to the labor, skill, or business acumen of the developer, Walgreens, or other factors.”

The Court continued: “f we were to expand the law in the direction the City requests, property assessments would in essence become business value assessments, with assessors improperly equating financial arrangements with property value. This is in contravention of the general principle that real property assessments should not be based on business value” (¶65) and “it is also bad policy to do so in the manner the City assessor did in this case, in effect taxing business efforts instead of the property”(¶34).

Summary

The Court essentially defined the role of the assessor as one who applies only market data, unless there is substantiated conflict between the Manual and statutory requirements – or in the case of below market rents. Moreover, and specific to this case and income producing property in general, it is the assessor’s duty to use market rent for the purposes of determining full (fee simple) market value. This case has placed Wisconsin in agreement with most other jurisdictions throughout the nation. There are several valuable points for appraisers, attorneys, property owners and tenants of retail, or other income producing properties to consider:

  • In uncertain economic times such as these, many previously determined rents may end up being above market. This is significant because the current market value should reflect the current market rents available.
  • When a rental rate is below market and the property owner isn’t able to obtain market rents, the property’s assessed market value should reflect the situation.
  • The values will be equal only when the contract rents are equivalent to the market rents.
  • A lease’s rent is an encumbrance of the bundle of rights rather than a “right and privilege” of the bundle of rights.

Appraising Development Projects During Challenging Economic Times

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Robert Strachota and Christopher J. Stockness (Shenehon Company) teamed up with Tom Gump (Neighborhood Development Partners) to produce this article for the Minnesota Real Estate Journal. The authors address the difficulty of valuing and marketing a development project in an economic downturn. Economic forecasters are guardedly optimistic as we enter the 4th Quarter 2008, but most housing studies indicate that we will see only a modest increase in demand for the next few years. Launching a successful development project in this environment calls for the use of strategic planning techniques. It is more important than ever that the planning team include an experienced appraiser to analyze and value the proposal to increase the chances of arriving at a unique, viable development project.
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One only has to read the newspaper or watch the news to see how a troubled housing market and the general economic downturn have affected development projects.

Evidence of the weak economy is everywhere. Mortgage interest rates are rising foreclosures are up and the jobless rate is climbing. The housing market is grim and likely to get worse before it gets better.

During these uncertain times, it’s difficult to remain optimistic. There is a large inventory of available housing and new housing starts are at historic lows; investors, developers and lenders are reluctant to break ground on new projects. Those whose projects are already in the pipeline must decide whether to move forward as planned, put everything on hold or attempt to revise their plans. It’s safe to say that we are in the midst of an economic downturn — largely initiated by the troubled housing market — and no one knows when it will end.

For investors interested in launching a large development project, it is easy to buy into the doom and gloom of the current market and assume the worst. Money is tight, carrying costs are high and there are no guarantees that roads and utilities will be in place on schedule. Although not every development plan is feasible, strategic intervention at the onset of a project may increase its chance of success. Hiring an experienced appraiser to analyze a proposed development and offer valuation guidance makes good business sense.

This article focuses on how strategic planning techniques can affect not only a development project’s value, but its success in today’s uncertain market.

Part I – Analyzing a Development Project

Introduction

Typically, as a part of a potential investor’s due diligence, an appraiser is hired to analyze the proposed development and the land associated with the project. Often considered the simplest of appraisal assignments, appraising land for development purposes is actually quite complex. When large parcels of raw land are involved, the highest and best use (HBU) of the land may be in transition from rural or agricultural use to a more urban use. Anytime there is a change in the HBU, value is affected.

In addition to relying on the traditional valuation methods to arrive at a value (cost, market and income approaches), the experienced appraiser relies on a subdivision analysis of the development to further confirm the value. A subdivision analysis forecasts the overall performance of the proposed project based on market evidence. The appraiser may suggest valuing several scenarios in order to clearly define the relationship between current costs and future benefits. When appropriately and correctly executed, the subdivision analysis provides one of the most accurate looks at the behavior of typical market participants.

Before hiring an appraiser, inquire about the firm’s experience in the area of subdivision appraisal. A qualified appraiser not only has the knowledge and experience to complete the assignment, he or she has a wealth of relevant information from previous assignments. The appraiser is familiar with the many stages of a project, recognizes typical subdivision infrastructure costs and has monitored the success or failure of previous developments.

The Appraiser’s Role

The appraiser’s role in development analysis can vary – from that of consultant to that of appraiser. As a consultant, the appraiser may be asked to analyze market data, make recommendations, suggest strategies for moving the project forward and/or offer an opinion of value. Determining housing absorption rates, quantifying market supply and demand, performing highest and best use analyses, and providing a feasibility analysis for the proposed development are all examples of appraisal consulting.

If the investor decides to move forward, the appraiser may be asked to render a formal opinion of value. In this capacity, the appraiser does not advocate for or against the project, but remains independent in his or her analysis, valuing the project as of a certain date, based on current market information and appropriate assumptions. When the market is less optimistic, the success or failure of the project may depend upon the depth of analysis leading to the appraisal report. Both the land development proposal itself and the appraisal supporting its value are subject to greater scrutiny in a weak economy. Whereas a verbal opinion or a summary report may have been sufficient in the past, a more detailed, inclusive self-contained report may be necessary to adequately address investor concerns at this point in time.

It is often a good idea to tackle development assignments in phases. This is particularly true during times of economic uncertainty. A Phase I appraisal analysis ranges in scope from consultation on the feasibility of a development to providing a verbal opinion of a likely value range. Let’s say that as a result of the feasibility study, the appraiser determines that the infrastructure costs are much higher than those of similar development projects. He or she may suggest that the developer pay less for the raw land to offset these anticipated costs.

During a Phase I analysis, the appraiser has the opportunity to provide feedback on the subject’s value and make recommendations without writing a complete appraisal. The client and the appraiser will discuss the Phase I findings and determine if or when to proceed with a Phase II analysis. Phase II typically involves the completion of a full summary or self-contained report which meets the criteria (scope and methodology) outlined in the client’s engagement letter.

When appraising a proposed development, the appraiser usually starts by meeting with the developer to hear, firsthand, the details of a project. The more sophisticated the developer the more analysis will have been completed and the further along in the planning stages a project will be by the time an appraiser is engaged. After meeting with the developer and armed with an understanding of the vision, marketing plans and scope of the project, the appraiser begins an independent study of the market and the proposed development. It is important for the appraiser to keep the client in the loop throughout the process. When the appraiser and the stakeholders work together, the client is more likely to make an informed decision. The following discussion focuses on the more complex issues of a subdivision appraisal and describes several strategies common to successful development plans.

Telling the Story – Extraordinary Assumptions

To determine the highest and best use of raw agricultural land, the appraiser may rely on the use of extraordinary assumptions to accurately depict the value of land. In-depth research allows him or her to identify the appropriate use(s) of the land and come up with a time-table of development – ultimately affecting the appraised value of the land.

Consider, for example, agricultural land which may be considered for a mixed-use development in the near future. Its appraised value will be greater than what it is as agricultural land, but less than its value if it were already fully entitled for development. Because the land is raw and the developer’s vision not yet a reality, value is based on defining the relationship between current costs for the developer and future benefits. The appraiser often includes extraordinary assumptions in the report to show how various anticipated conditions change overall value.

According to the Uniform Standards of Professional Appraisal Practice (USPAP), an extraordinary assumption is an assumption, directly related to a specific assignment, which could alter the appraiser’s opinions or conclusions if it were untrue. Development projects, by their nature, are dependent on events which may or may not happen in a timely fashion. For example, if a project is delayed six to 12 months due to construction problems or the inability to obtain city approvals, the value conclusion may no longer be valid. When the most likely scenario is based on extraordinary assumptions, those assumptions must be prominently mentioned in the transmittal letter and supported by the research and analysis in the report.

From evidence presented in the appraisal, the reader should be able to judge the validity of the extraordinary assumptions. Some types of assumptions involve more risk than others. If a development plan has received preliminary plat approval and is expected to receive final plat approval within six months, it is considered valid to assume that final approval will be forthcoming. Typically, facts of this nature can be verified by contacting the appropriate city officials. In comparison, if value is dependent upon municipal utilities, originally scheduled to be extended to a site by 2009, but now not likely to be in place until 2015, the appraiser is dealing with a different level of risk. The delay may create a less feasible scenario and that should be reflected in the conclusion of value. Extraordinary assumptions serve a purpose, but in order for the appraisal to be credible, they must be clearly stated and supported by strong, reliable evidence.

Part II – Development Strategies

Flexibility

When the market is weak, it’s essential that the investors consider not only the type of real estate currently in demand, but also the mix of uses most likely to enhance feasibility and accommodate the ever-changing market. Having a complementary zoning designation, such as a Planned Unit Development (PUD) or Mixed-Use zoning designation, gives the project flexibility by allowing a variety of land uses.

In contrast, a development project zoned primarily for single-family units may saturate the market with a specific type of housing. It does not attract a diverse pool of potential buyers which results in a longer absorption period than for comparable mixed use developments. By offering a variety of housing types and a commercial component, the developer appeals to a broader sub-market than is possible with a project exclusively marketing single-family homes. Additionally, when the developer has the flexibility to adjust the ratio of residential units to multi-family rental units and/or commercial uses based on demand, the community benefits as well.

Think Smaller

The housing boom of the earlier part of the decade is not likely to recur in the near future. Recent housing studies indicate only a modest increase in housing demand over the next few years. In an effort to avoid costly vacancies due to overbuilding, developers may reduce the overall size of the project, accommodate a range of uses and schedule construction in manageable phases.

Well-designed projects attract a good mix of residential and commercial buyers, promote economic stability and reduce the chances of obsolescence during future market swings. Five or 10 years ago, it was more common than it is now for investors and developers to focus exclusively on projects exceeding 100 acres in size. They anticipated sustainable growth in the single family market over several years. As the market trended downward, the economics of development projects have changed. As the absorption rate of housing units drops off, purchasing large tracts of land in the early stages of development becomes less economically feasible. In a strong market, developers purchased available land outright, building as needed. Now, large upfront investment costs can hinder the success of a development and increase the capital recovery time.

One way for developers to minimize the initial costs of a project is to pay less for the land. By purchasing smaller tracts of land and using first rights of refusal or purchase option agreements to lock in adjacent land parcels for the future, additional land is available if needed. This strategy creates an advantage not only for the developer, but also for the property owner. The owner receives some money upfront for the right of refusal or option while waiting for a turnaround in the market to create additional demand for the land. The potential seller might not be able to sell the property in today’s market for what he/she could have sold it for in 2005, but banking on the success of the adjacent development and a market turnaround, he/she hopes to sell it at a comparable price in the near future.

Going Green

Global warming, rising energy costs, and environmental consciousness have created a huge market throughout the United States for environmentally conscious products. The opportunity to create energy-efficient green housing is not only a responsible approach to development it is also a great way to tap into a new market of potential buyers. In commercial real estate, green building — especially Leadership in Energy and Environmental Design (LEED) certified development — has seen strong growth from coast to coast throughout the United States. Developers, building owners and occupants enjoy the energy savings while creating a good public image. Although green residential development has not been as widely visible as it is in commercial developments, it represents an area of demand in the housing market. As such, it has the potential to set a new development apart from existing housing and development projects.

Part III – Stone’s Throw Development

Shenehon Company was hired to appraise the future Stone’s Throw development in spring 2006. The development consists of 600-plus acres of land where the developer intends to develop approximately 200 acres of commercial land and 400 acres of mixed residential land. The property, located in the southeast corner of Hassan Township, is considered to be one of the few prime development parcels remaining along the northwest metro’s Interstate 94 corridor — a fast-growing portion of the metropolitan area.

This assignment was complicated from the beginning – the property was still in a very raw agricultural state — it was zoned agricultural — and there was no finite plan in place for the extension of sewer and water to the site. Additionally, city planners and developers in neighboring municipalities (as well as nationally) knew there was potential interest in an interchange at Brockton Lane North and Interstate 94. If the interchange became a reality, it would further increase the commercial viability of the site.

Initially, the appraiser, developer and investors met to share information and determine the appropriate scope and methodology of the assignment. Considering the site’s raw nature and the multiple variables involved with potential development options it was determined that two valuations were needed. The first was a “Best Case Scenario,” assuming a mixed-use development with a strong commercial component. The second was a “Moderate Case Scenario,” which would conservatively analyze the development under a highest and best use of single-family development. We also engaged the services of a local law firm with land-planning experience to help make the appropriate assumptions regarding the regulatory, statutory and other legal constraints associated with the proposed development.

One of the most challenging aspects of this appraisal was that during the research and analysis phase, it became apparent that the residential boom of the past 10 years was about to end. Most of the evidence was based on hearsay: reports of builders and developers backing out of purchase agreements and options for land purchases. There were definite signs that the economy was trending down, but no one knew for sure how it would affect the market. We used two value scenarios in our analysis so that the investors could see the impact of choosing one over another. The lower end of our concluded value range for a mixed use development (Best Case Scenario) actually fell above the purchase agreements for the land, providing a strong indication that the project had a very good chance of being successful. We were, therefore, quite comfortable with our valuation of the development. In situations like this, where the development’s location, legal and infrastructure issues might result in a development vastly different from the one laid in our Best Case Scenario, the investors were wise to stipulate two valuations.

Each valuation scenario required extraordinary assumptions to arrive at a reasonable value range for the proposed development. The extraordinary assumptions were set forth based on extensive market research as well as regular meetings attended by the appraisers, the developer, investors, legal counsel, land planners and local municipal officials. In this appraisal assignment, the use of extraordinary assumptions allowed the land and proposed development to be appraised under a scenario that all parties involved were comfortable relying upon.

Despite its large size, the site and potential development have several unique characteristics: a development plan with significant green space, a strong potential for a diverse mix of housing and commercial uses and a great location. On the southeast corner of Hassan Township, the property is adjacent to the municipalities of Rogers, Dayton, Maple Grove and Corcoran. Rogers was deemed the most suitable development partner, but the surrounding cities expressed interest in being involved as well. Demand was also supported by several letters of intent from national development firms expressing strong interest in developing large tracts of land. The ideal location was further complemented by the types of uses being considered and the development flexibility the site offered.

Appraising development projects when the market is trending downward creates a new set of challengers for appraisers, developers, lenders and other real estate professionals. Creativity and the flexibility to adapt to a changing market are crucial to the success of a development. There is still a market for land development, even when the economy is weak, especially if the plan has unique features that set it apart from run-of-the-mill existing and potential projects.

In the case of Stone’s Throw, the purchase of land and start of development took place as the market weakened. Although the developer may make a few changes, having a unique and flexible development will keep the project on track toward the original expectations.

Appraising development land is complex during the best of times. To arrive at a credible value conclusion in a weak economic environment, it is more important than ever for the appraiser to complete the necessary due diligence and maintain open communication with all members of the development team.
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Questions or Comments? Please email Chris Stockness at CStockness@Shenehon.com

Christopher J. Stockness, senior real estate appraiser, joined the real estate division of Minneapolis-based Shenehon Company six years ago. His experience in appraising special purpose property ranges from resorts, marinas and airplane hangars, to restaurants and development projects.

Robert J. Strachota is president of Shenehon Company. For more than 30 years, he has prepared real estate and business enterprise valuations. He regularly serves as an expert witness in Federal, State and District courts and spends some time each year teaching at the local universities.

Tom Gump is principal and managing broker of Neighborhood Development Partners, LLC. He invites comments and questions about this column. He can be reached at:

Neighborhood Development Partners, LLC
750 2nd St NE Ste 100
Hopkins, MN 55343
952.224.9140
TomG@NDP-MN.com

A Persuasive Special Assessment Appeal

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By: Wendy S. Cell

In early 2008, Shenehon Company was part of a team of experts which appealed a special assessment on behalf of SJC Properties LLC in Rochester, Minnesota. The plaintiffs relied on legal counsel, appraisers, civil engineers and traffic engineers to contribute detailed information for each aspect of the analysis. Following is a brief description of how the experts successfully demonstrated to the Court that the assessment exceeded the benefit to the property.

Special Assessment Summary

A special assessment is a tax, intended to offset the cost of local improvements such as sewer, water, and streets, which is selectively imposed upon the beneficiaries. The power to impose special assessment is limited in that (1) the property must receive a special benefit from the improvement, (2) the assessment must be uniform upon the same class of property, and (3) the assessment may not exceed the special benefit to the property. Further, the special assessment must be (a) necessary, (b) cost effective, and (c) feasible.

In special assessment cases, the appraiser prepares an analysis to determine any impact on value, or special benefit, to the property from the improvements. This entails valuing the property before the special assessment and then valuing the property after the special assessment. The estimated change in value is then measured against the special assessment to determine whether the change in the property’s value is less than, equal to, or greater than the amount of the assessment.

Case Findings

In SJC Properties LLC, et al v. City of Rochester, a municipal corporation, File Nos. 55-C6-05-1988, et al (Minn. Dist. Ct. July 3, 2008), the Court found that the evidence established that the city’s special assessment exceeded the special benefit on plaintiffs’ properties and set aside the levied special assessment, remanding the matter for reassessment. Moreover, the Court awarded expert costs to plaintiffs. Plaintiffs own undeveloped land in Rochester, MN. Rochester, Olmsted County, and the Minnesota Department of Transportation constructed improvements to convert a portion of Highway 63 from an expressway to a controlled-access freeway. The subject property is located at the corner of one of the new local access interchanges.

Appraisal Testimony

Plaintiffs’ appraiser determined that the highest and best use of the property – both before and after the assessment – was commercial and residential development. To calculate the amount of any special benefit, plaintiffs’ appraiser valued the property using three methodologies – the sales comparison approach, the direct cost approach, and the development savings approach. Under the sales comparison approach, Plaintiffs’ appraiser analyzed comparable properties and adjusted them to reflect the differences. In performing this analysis, the appraiser reviewed the infrastructure of each of the comparable properties, including roadway conditions and available utilities. Based on the difference between the before and after values of the property, the sales comparison approach indicates a special benefit of $525,000. The direct cost approach evaluates the costs associated with those transportation improvements that benefit the property. Based on the engineer’s estimate, the total cost benefit is $383,715. The development cost savings approach involves estimating the total development costs before the project and subtracting the development costs after the project. With the assistance of the engineer, the appraiser arrived at a total development savings of $415,000. Plaintiffs’ appraiser concluded the city’s special assessment of $1,700,000 exceeded the $525,000 benefit to the property.

Defendant’s appraiser performed a before and after appraisal using only a single appraisal methodology – the sales comparison approach. He testified that the highest and best use before the assessment was residential development and concluded that the value of the property was $3,100,000. He testified that the highest and best use after the assessment was commercial and residential development. He concluded that the value of the property after the assessment was $10,900,000, thereby concluding the special benefit on the property is $7,800,000, the difference between his before and after values.

Special Benefit Findings

Overall, the Court found the appraisal opinion of plaintiffs’ appraiser to be mostly credible, with the supplementation of an additional sum attributable to the benefit of the new bridge over Willow Creek and some possible soft costs. Regardless of which of the three approaches prepared by plaintiffs’ appraiser is used, the Court found that the city’s special assessment of $1,700,000 exceeded the special benefit to the subject property resulting from the improvements. Further, the Court found that the special assessment was not uniformly assessed.

Conclusion

In this situation, the burden of proof is on the plaintiff and it may be difficult to prevail in Court. The Court acknowledged that this was a very complicated case. One of the primary issues was the determination of the highest and best use before the special assessment. In analyzing this issue, plaintiffs’ appraiser carefully studied the legally permissible factors such as zoning and plat approvals, and relied on the input of collateral experts. In his testimony, plaintiffs’ appraiser relied on analyses from the civil engineer who prepared a site plan and cost estimates for transportation improvements and on the traffic engineer who studied traffic volume, the necessary number of required lanes based on the traffic volume, and the uniformity as it pertained to the use of the improvements by adjacent developed properties. Defendant’s appraiser admitted that he did not consult with any engineers nor did he consider the rezoning of the property, the city’s plat approval, sound barriers, the other local access interchange, or the build-out of residential property. As with any valuation case, the appraiser’s due diligence includes the research of local zoning ordinances and development approvals, a study of market conditions, determining the highest and best use of the property, and the research of comparable sales. Clearly, the plaintiff’s appraiser’s attention to the details successfully persuaded the Court that the special assessment exceeded the benefit to the property.

“Real Estate and Partial Interest Valuation” – By William C. Herber

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Shenehon Company’s Clay Shultz Receives ASA Designation

Shenehon Company is proud to announce that Clay Shultz has been awarded the Accredited Senior Appraiser (ASA) designation in business valuation from the American Society of Appraisers. Candidates for this designation must have five years of professional business valuation experience, successfully complete over 100 hours of valuation-specific coursework, and submit two demonstration valuation reports for review by a board of examiners.
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“Real Estate and Partial Interest Valuation”

A General Review of Real Estate Appraisal in Divorce

By William C. Herber, CBA, Senior Vice President; and Robert J. Strachota, MAI, CRE, MCBA, FIBA, President

William C. Herber and Robert J. Strachota co-authored a chapter in The Family Law Financial Deskbook, 2008 Edition, published by the Minnesota State Bar Association. “Real Estate and Partial Interest Valuation” (Chapter 7) is a general review of real estate appraisal in divorce.

Successful Property Tax Appeals are Based on Solid Evidence: 200 Levee Drive LLLP v. County of Scott

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File Nos. 70-CV-07-9031; 70-CV-07-9041

Tax appeals provide property owners with the opportunity to show that the subject’s assessed value is not in line with the values of similar properties. The burden of proof is on the petitioner who must present a solid appraisal supporting the case for reduced property taxes. To determine market value, the appraiser must first consider: the nature and history of the subject property, local zoning ordinances, market conditions, conditional use permits and the highest and best use of the subject and then analyze the subject using the three approaches to value: cost, market and income. In the analysis section of the report, the appraiser discloses assumptions, states the facts and describes adjustments in great detail. It is up to the judge to decide which expert has the most credible, persuasive appraisal based on the evidence presented. The Courts expect the appraisal report to reveal and support the appraiser’s line of reasoning. Although the Court allows direct testimony, the report is tantamount to the actual testimony.

In 200 Levee Drive LLLP v. County of Scott, the findings of fact regarding the property are straightforward. The subject is a 66-bed subsidized senior housing facility (with a legal conditional use permit), operating in Shakopee, MN. The facility is of good quality, an asset to the community and an income-producing property. The County Assessor agreed with the findings of fact and valued the subject accordingly. The Taxpayer disagreed with the highest and best use (HBU) as senior housing, arguing that it should be valued as an unrestricted living facility rather than non-subsidized senior housing. Additionally, he argued that it was a non-conforming use due to inadequate parking. No credible evidence supporting his opinions was introduced, and the Court agreed with the County Assessor that:

  • the facility operates with a legal conditional use permit
  • the facility has adequate parking for its current use and additional land could be made available on site for expansion of parking if needed
  • the HBU is senior housing
  • the market value for the years in question (2005 and 2006) is $3,300,000 as decided by the Court. Each party’s position is shown in Exhibit I.

Exhibit I

Each expert relied on the income and sales approaches to arrive at a value. Due to the age of the improvement, the cost approach was not used. Subsidized housing, according to case law, must first be valued as if it were general, unrestricted housing using market rent comparables. The comparables are subsequently adjusted to account for rental restrictions; differences in age, quality, size and location; rate of risk, net operating income and so on. Although the experts used the same methods, they disagreed significantly in their analyses and value conclusions.
Exhibit II

The Taxpayer’s expert presented no compelling evidence to support his assumption that 61% of the facility was non-conforming and should not be included in the assessed value. The judge determined that no zoning violations existed and ruled in favor of the County Assessor in all instances. As indicated, in Exhibit II, one of the most interesting aspects of this case is that despite using different comparables, market rents, cap rates and adjustments, the concluded per unit values and market rents were not that far apart. The difference was due to the fact that the County’s appraiser based his analysis on all 66 existing units, while the Taxpayer’s appraiser based his value on only the number of units for which he opined there was adequate parking: 25 units. His entire case hinged upon the Court’s acceptance of his assumption that 41 units were non-conforming and, therefore, not subject to property taxes.
This case clearly speaks, once again, to the fact that the burden of proof is on the taxpayer. Ironically, the assessed value of the subject property was increased for both 2005 and 2006 as a result of the evidence presented. Appraisals destined for use in Tax Court must be well-documented yet simplistic enough to convey the appraiser’s reasoning to the Court. Either the Tax Court is ruling more frequently in the government’s favor or the Taxpayer and/or his appraiser relied on a flawed analysis. According to the Court, a compounding of small errors, misguided thinking and unsupportable assumptions left the Taxpayer out of the competition. Upon review, the facts spoke for themselves, and the judge ruled accordingly.

A copy of the case is attached. We invite you to read it carefully and come to your own conclusions. It is an excellent example of how difficult it is to prevail in a tax appeal, and it indicates how high the bar has been raised to be successful in this type of litigation.