Archive for year: 2009

By: Heather M. Burns

Helfman v. Johnson – Minnesota Court of Appeals, A08-0396, February 24, 2009
Hennepin County District Court, File No. 27-CV-06-2578

The Minnesota Court of Appeals affirmed the trial court’s decision to apply a 24.6% discount to the undiscounted value of a closely held title insurance company in a fair value determination for a minority shareholder buyout.

The appellant (a minority shareholder) argued that the district court erred in applying a discount to the value of the corporation stating that application of a minority shareholder discount (and a lack of marketability discount) in the context of a court-ordered buyout is improper because the legislature specifically protects minority shareholders from being unfairly prejudiced (Minn. Stat. §302A.751).

Ultimately, the Minnesota Court of Appeals affirmed the trial court’s position that the applied discount was not related to minority shareholder or marketability discounts. Rather, it clarified that the discount rate was applied in order to prevent the appellant from receiving a disproportionate amount of damages. In this case the following factors were considered:

1. there were no non-compete agreements in place;
2. there were no employment contracts binding employees; and
3. the market trend on the valuation date was strongly downward.

Considering the overall evidence and the equities, the district court determined that a 24.6% discount was appropriate due to a serious downward trend in the industry and the fact that the corporation’s employees were able to leave and compete freely with the corporation.

The Helfman v. Johnson case appears not to have changed the basic premise in Minnesota that discounts for lack of control and lack of marketability still do not apply in a minority shareholder buyout. However, as case law changes and evolves over time, it is important to be aware of the current legal climate and the wide discretion that judges have in “Fair Value” cases through their rulings, which could affect the outcome of a case. The Helfman v. Johnson case demonstrates that, in shareholder disputes, the court system does not narrowly define discounts as strictly lack of control or lack of marketability discounts. This ruling affirms that appraisers may consider other factors applicable to a valuation problem as there may be situations in which a business is subject to additional risk and other kinds of discounts can be justified.

Record levels of residential development occurred from 2000 to the peak of the market in roughly 2006. Financing was readily available and potential buyers, eager to take advantage of low interest rates and unusual mortgage terms, flooded the market. This rapid increase in demand for new homes created a development boom. By 2008, as financing for developers and homebuyers dried up, new home sales fell significantly. Many developers with completed, or nearly completed, projects were able to close sales on their new home inventories. However, for those who purchased large tracts of land with the intent of developing them within 2 to 5 years, the business climate changed drastically. Absent the expected demand for new homes, what was anticipated to be a 2 to 5 year holding period is now likely to be a 15 to 20 year hold with no guarantee that the project will remain feasible.

The market for vacant land considered ripe for development in the near term has evaporated. Small and midsize developers with working capital invested in now-illiquid assets are struggling to survive. We find very little in the way of new construction; city planners and developers have delayed many projects indefinitely. When the holding period for development land increases, the highest and best use of residential land on the fringes of developing communities for the near term changes as well. Consider, for example, the impact of altering the development timeline for two cities in the 13-county metro MN area – Belle Plaine and Spring Lake Township. Each of these communities has experienced falling land values and the loss of development potential due to the recession.

From 2000 to 2008, the population in Belle Plaine increased by 57%, making it a hotspot for residential development in the near term. City planners were poised to move forward with utility and infrastructure upgrades and had approved several residential developments in the area. Residents looked forward to the improvements and the potential for additional revenues. However, as the market fell, so did residential home sales, with the equivalent of a 20% drop in homes sold each year from 2005 to 2008. Building permits also declined at an alarming rate during the same period which was even more worrisome for developers. The following table summarizes sales and building permits for the City of Belle Plaine, MN from 2005 – 2008.

These numbers clearly illustrate the sharp reduction in demand for housing. In the 4 or 5 years preceding the recession, land available for residential development was highly prized; it was a seller’s market and land values continued to rise. Recently, however, many people who anticipated selling residential land to developers found few buyers and sharply reduced land values. It comes as no surprise that the price per acre of land ripe for development in the near term is much higher than the price per acre of land that may not be ready for 15 to 20 years.
Illustrating further the effect of the drop in demand, we look at the situation in Spring Lake Township just southwest of Prior Lake, MN. A well-known developer purchased 63.5 acres at $50,000 per acre in November of 2005. The developer planned to extend utilities and build out the site within 5 years. When the recession hit, demand fell, the development failed and the property headed for foreclosure. Subsequently, the previous owner approached the developer and offered to buy the property back. The developer sold 33.5 acres to the previous owner for approximately $19,850 per acre, almost 60% less than what the developer had paid for the property three years earlier. The current owner (also the original owner) plans to hold the 33.5 acres for the long-term (likely 20-30 years) and farm it until the property becomes, once again, ripe for development.

Every community is in a different position with regard to its potential for growth and each piece of land is unique. However, statistics indicate that improved properties have suffered a significant loss of value in the last three years. Additionally, losses in demand and financing, and declining values for property in other markets have changed the highest best use for many residentially guided land parcels. At present, the price-per-acre for vacant land has dropped significantly and the holding period has increased dramatically. It is unlikely that the market will correct itself in the immediate future.

By: John T. Schmick

Investment real estate encompasses a broad range of real property types. Transactions often involve large properties bought and sold by institutional investors at the national level or in a national investment market. Participants include pension funds, investment advisers, insurance companies, and investment banks. In general, these are buyers and sellers that take direct ownership of an investment property and manage it for their own benefit. Defining or measuring the health of the investment market based on transaction activities of this type is somewhat unreliable. One is limited to data such as descriptions of capitalization rates, prices per square foot, and vacancy rates. Little information is publicly available on the periodic returns earned from these types of transactions until an individual property is resold. How, then, does one gain an understanding of the investment market on a broader scale?

The answer is found in a specialized form of real estate ownership known as a Real Estate Investment Trust, or REIT. A basic REIT is an entity that “pools investor money to purchase and manage real estate” for the benefit of its owners. REITs offer liquidity in investment real estate through ownership of shares in an entity that directly owns and manages investment real estate. Consequently, a review of the REIT industry is an effective surrogate to profiling the national investment real estate market. The ability of REIT data to reflect the overall market is related to the overall composition of REITs. In general, equity REITs include all property types, all age brackets, all geographic locations and all level of demographics

Appraisers are frequently asked where “cap rates” are heading – another way of asking whether values are going up or down. The capitalization rate (cap rate) is the ratio of net operating income to property price. It determines the return on investments. Fluctuating cap rates have a significant impact on property values. The capitalization rate is a weighted average comprised of the mortgage rate and the equity yield rate; a change in either variable impacts the overall rate. With the capital markets in disarray, buyers fortunate enough to secure financing are finding that bank lending requirements are more stringent than in the past. Higher mortgage rates and shorter amortization terms have raised the loan constant. Additionally, lenders changed the weighted average of the cap rate by requiring more equity from the borrower which is at a higher rate compared to the mortgage rate. Investors are looking for higher risk premiums compared to prior years. Below are two examples showing the impact of the change in the mortgage rate (mortgage constant), amount of equity required, and the higher yield rate:

To determine the appropriate cap rate, appraisers rely on sales of similar properties for support, however the number of sales in today’s environment is low for several reasons. First there is a gap in pricing between what the seller perceives the property is worth and what the buyer is willing to pay – buyers and sellers have radically different perceptions of values in the current market. Appraisers also depend on Information provided by investment brokers in local markets as to the direction of capitalization rates. In their listings of Class A and B quality properties, investment brokers have found that prospective buyers have increased their cap rates 150 to 250 basis points higher than those of one year ago. The increase in the capitalization rate was most pronounced after the September/October 2008 credit meltdown when financing suddenly became more difficult to secure.
Investment brokers cited examples of listings in which the asking prices were lower due to the higher cap rates. One office building, originally listed with a capitalization rate of 7.6% in early 2008, posted a cap rate in the low 8% range by the summer of 2008; it is currently listing a cap rate in the low 9% range. Two grocery-anchored centers are listed with cap rates of 9.5%. An industrial building in the suburbs was purchased in 2006 with a long term lease in place at a 7.25% capitalization rate is now being offered, with the same lease, at a cap rate of 9.0-9.5%. Class B office buildings currently being offered in the Twin Cities are in the 9% to 10% cap rate range depending on the length of the leases. Class A property capitalization rates are in the upper half of the 8%s. The chart below offers a historical look at capitalization rates and the anticipated outlook on a national basis.