Central Corridor: Underlying Valuation Issue

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By: John T. Schmick

While many people are aware of the plans to expand light rail service between Minneapolis and St. Paul, few understand how underlying zoning issues will impact property values in the new corridor. The Minnesota Department of Transportation (MnDOT) must acquire enough land to support the construction and operation of the light rail system. Property owners along the corridor, with land subject to the eminent domain process, will be asked to sell/rent their land for the project. Determining a fair price for the land to be taken is complicated by recent zoning changes.

In 2008, the city of St. Paul added a Central Corridor Overlay District to the city’s zoning code. The overlay district is an interim measure which restricts new development in advance of the actual eminent domain process and construction of the corridor. The Central Corridor Overlay District includes a provision that the district will expire on June 20, 2011, roughly three years after its adoption. The temporary nature of this zoning classification is meant to give the city time to review and update its zoning code. It also reduces potential claims for damages to new development projects. However the timing of the provision and the fact that it applies to the anticipated eminent domain acquisitions does raise some questions.

Look for a full discussion of zoning changes and their impact on property values in the next issue of our newsletter, Valuation Viewpoint.

The Recession is Over: Should Someone Inform the Real Estate Industry?

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By: Robert J. Strachota
It’s official!

The National Bureau of Economic Research recently announced that the recession ended in June of 2009. However, most real estate professionals, including the majority of our clients, report that economic conditions for the real estate industry have worsened.

On a positive note, of 170 major metropolitan areas in the United States, the Twin Cities ranks 66th on the affordability index for residential housing. The affordability index is a ratio which compares housing costs for median-priced existing homes to income levels. It gives us a good indication of which markets are over-priced and, therefore, subject to additional decline. Currently, mortgage costs and household income in the Twin Cities are relatively well-balanced. The residential market is unlikely to experience further decline. However, the commercial markets are much less stable and, depending upon the submarket in question, declines are expected to continue for the near term.

St. Thomas University Creates Real Estate Hall of Fame

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By Scott Carlson, Finance & Commerce

Reprinted with permission from Finance & Commerce.

Aviation has one. So do bass fishing, radio broadcasting, professional hockey and rock music.

Soon, there will also be a hall of fame for Minnesota real estate pros.

The head of the Shenehon Center for Real Estate at the University of St. Thomas has created the Minnesota Real Estate Hall of Fame to recognize Minnesotans who have been innovators and successful leaders in the field.

The Hall of Fame idea is also the latest in the Shenehon Center’s attempts to establish itself as a storehouse of real estate knowledge; earlier this year; the center established the Minnesota Commercial Real Estate Survey and Index; a sort of biannual “consumer confidence” survey of decision-makers in the sector.

“Creating the Minnesota Real Estate Hall of Fame gives UST the ability to honor; preserve and perpetuate the outstanding accomplishments of men and women in real estate,” said Herb Tousley. “We just want to give people an award that would recognize their achievement over a long period of time.”

The Shenehon Center plans to honor two to four inaugural Hall of Fame members at an induction ceremony Oct. 27, at Schulze Auditorium on St. Thomas’ Minneapolis campus. Tony Downs, a senior fellow at the Brookings Institution in Washington, D.C., will be the featured speaker.

 The Shenehon Center plans to announce the names of the inductees during the first week of October.

“We are very excited about it, “Tousley said.

Tousley said he and a group of his St. Thomas real estate professors came up with the idea last fall after searching for something that could be a signature event at St. Thomas’ real estate center.

“When we started looking around, there were a lot of groups doing a real estate person of the year but there really wasn’t a real estate hall of fame,” Tousley said.

In June, the St. Thomas Real Estate Advisory Board received 17 nominees for the Real Estate Hall of Fame and is now reviewing that list, he said.

“The basic criterion for acceptance into the Hall of Fame is that an inductee will have an outstanding business performance coupled with a high standard of ethics and sense of community.” Tousley said.

Credibility in the Tax Court

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By Timothy A. Rye, Appraiser

Three recent tax appeal cases illustrate that comprehensive research and attention to detail are key components of credibility in the Tax Court. The burden of proof weighs heavily on the appraiser; indeed, it may make or break a case. To prevail in court, the appraiser must submit evidence that the assumptions, comparable data, and methodologies used in the appraisal are relevant and accurate.

Eden Prairie Mall LLC v. County of Hennepin
October 13, 2009

The assessor’s estimated market value, upon which property taxes are based, is presumed accurate until proven otherwise. In this 2009 case, the Eden Prairie Mall tax assessments for tax years 2005 and 2006 were challenged. After hearing evidence from both sides, the Court did not find either appraiser’s opinion credible. Rather, the Court relied on selected components from each expert’s appraisal to arrive at its own value conclusion. In the final analysis, the Court’s value for tax year 2005 was nearly $23 million higher than the 2005 assessed value, and its value for tax year 2006 was $20 million higher than the 2006 assessed value.

The Court determines credibility based on, “the quality of the work, the adherence to relevant meaningful industry standards, the witness’s comportment and persuasiveness on the stand, their candor and ability to explain their analyses.” Further, the Court states that it will “rely upon the testimony and appraisals of the experts to assist us in our determination of value.” If the Court is not satisfied with the work of either side’s appraiser, it may take on the role of appraiser. The Court took bits and pieces from the experts’ appraisals and cobbled them together to arrive at an alternative value. When the Court, rather than the appraiser, determines value, it sends a strong message to attorneys, appraisers, and property owners. In this decision, it appears that the whole was greater than the sum of its parts.

The Shoppes of Woodbury Village v. County of Washington
November 12, 2009

In this tax appeal case, the assessor’s estimated market values for tax years 2006 through 2008 were upheld. The subject property, built in 2001, is a 15-unit retail building with a net rentable area of 21,836 square feet. In addition to the building, there is a pipeline easement on the edge of the property. Although the exact location of the pipe is unknown, half of the easement (30 feet) encumbers the subject property. At trial, the county’s expert was found ineligible to testify. Further, the Court determined that the Petitioner’s appraisal report was fatally flawed in all three approaches to value and could not be used to refute the assessor’s estimated market value.

According to the Court, an assessor’s estimate of market value is assumed valid unless credible evidence that the assessor’s value is incorrect is introduced. Although the Court did not explain how much or what type of evidence is sufficiently credible to overcome that presumption, it detailed the fatal flaws in the taxpayer’s appraisal report as follows:

The sales comparison approach: the Court determined that the comparables were substantially different from the Subject (different uses, different sizes, and different classifications – one comparable was a condominium); additional adjustments were necessary; and the appraiser excluded a more recent sale (at a higher price) of one of the comparables from the report without justification.

The income approach: the appraiser used only 11 of the 14 leases in place for the Subject, but did not provide evidence to support the decision to exclude the remaining leases; the actual vacancy rates were considerably lower than the vacancy rates used; the capitalization rate was distorted because the data was accumulated from the sale of older buildings; and the appraiser did not use appropriate expenses.

The cost approach: the appraiser did not rely on final construction costs despite the fact that the subject is a “fairly new” building (2001); reported physical deterioration was not supported by the photographs or the testimony; and the land valuation was not based upon comparable properties (according to the Court).

The pipeline easement on the property: the appraiser accounted for the presence of a pipeline by applying a discount to the comparable land sales and adding 50 basis points of risk to the capitalization rate. The Court did not accept the negative impact of the pipeline due to the lack of evidence presented. Thus, adjustments for the pipeline constituted an additional flaw.

Despite the fact that the Respondent’s witness was disqualified, the Petitioner did not prevail. The appraiser’s failure to pay attention to detail and several erroneous judgments on his part resulted in the Court’s upholding the assessed market value. The Court cited the relevancy, completeness, and timeliness of data presented; the relationship between the Subject’s actual rental rates and the ones upon which the appraiser relied; and the justification of adjustments or assumptions. Attention to detail sets the stage for a successful tax appeal and, in this case, the Petitioner’s expert did not produce a reliable appraisal for the client.

Geneva Exchange Fund XVII, LLC, v. County of Dakota
November 19, 2009

Accurate data is essential to the expert’s credibility. In this tax appeal, the subject property is a Class C multi-tenant single-story office/warehouse built in 1996. The building is approximately 50,283 square feet of which 52% is office space and 48% is warehouse space. Due primarily to inadequate verification of data and a lack of attention to detail, the Petitioner’s expert failed to sway the Court. The Petitioner’s sales comparison analysis was flawed. Although he used the net rentable area (NRA) as the unit for comparison, he did not verify the NRA for his comparables. As a result, he potentially understated the value conclusion. In addition, the comparable sales had significantly lower office percentages than the subject and the locations of the comparables were further from the subject than the comparables selected by the Respondent’s expert. The Court found this approach to be lacking in sufficient detail and no weight was given to the sales comparison approach of the Petitioner’s expert.

In the cost approach to value, the Petitioner’s appraisal included a flawed land analysis. He failed to inspect the land comparables, which led to inaccurate adjustments. In addition, his comparables were located in superior zoning districts further from the subject than the comparables in the Respondent’s report. Thus, the Court questioned the reliability and the quality of the cost approach by the Petitioner’s expert.

In the income approach, the Court noted that the Petitioner’s expert did not investigate all of the leases for each comparable building, leaving the possibility that the leases used were not representative of the building as a whole. The Court also suggested that the comparable rentals’ lack of similarity with the subject resulted in an inaccurate rental rate. The capitalization rate of the Petitioner was found unreliable because the appraiser failed to identify the sources used to calculate the capitalization rate via the band of investments method and he failed to identify what information from the comparable sales was included in the capitalization rate calculation. Thus, the capitalization rate conclusion was found unreliable.

In sum, the Court found the Petitioner’s expert unreliable and/or not adequately credible due to insufficient detail and the failure to verify the information upon which he relied.

In summary:

  • The success of the expert relies not only on the validity of the value conclusion, but on the quality of the individual building blocks of the appraisal.
  • The assessor’s estimate of market value is presumed correct unless proven otherwise.
  • The Court is willing to reject the experts’ appraisals and conduct its own valuation.

Overhead Utility Crossings: Is the Impact Based on Perception or Reality?

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Shenehon Company is pleased to announce an upcoming article by John Schmick and Robert Strachota in the July/August 2010 issue of International Right of Way Association Magazine regarding compensation for Overhead Utility Crossings.

The extensive infrastructure of utility pipelines and power lines in the United States ultimately creates situations where utility lines cross active railroad tracks and/or non-active rail corridors. Historically, crossing fees were little more than negotiated agreements between the utility company and the railroad. Fees were not based on market-supported land valuations which reflect the actual impact of a crossing on the corridor. This article describes how to measure the change in value, if any, due to the presence of overhead power lines on a rail corridor.

At this time, the railroad industry favors two methods to determine usage fees. The first is the Rate Sheet method; it is essentially a fixed price list based on wire, pole, or pipe size. However, the Rate Sheet method bears no relationship to land values and is contradictory to the railroad’s most widely used valuation technique, the across-the-fence (ATF) method.

A second method for determining usage fees is the Occupancy Factor. A percentage of fee simple land value (typically 30%) is randomly selected to represent the impact of the utility line on the rail corridor. However, there is no market support for this method because appraisers and railroad companies fail to consider the economic profile and highest and best use of the subject land when assigning an occupancy factor.

The article presents a discussion of larger parcels, highest and best use, valuation and the adjustment process, and economic profile of the subject. While individual crossings have unique characteristics, the majority of utility crossings have little to no measurable impact on the rail corridor. In the final analysis, the usage fee must relate to the value captured by the utility crossing.

The Importance of an Expert Witness

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By: Wendy S. Cell

In December 2009 Shenehon Company provided expert testimony on behalf of the city of Minneapolis (defendant) regarding the viability of a 21-story condominium project near Loring Park. The city council denied plaintiff’s application for two conditional use permits, two variances, and a site plan review for height, setback, and capacity. Plaintiff filed the lawsuit alleging violations of procedural due process, substantive due process, and equal protection. District Court dismissed plaintiff’s substantive due process and equal protection claims. Because defendant was found liable for a violation of procedural due process, a second phase of trial was necessary to hear evidence on the issue of damages. Plaintiff sought compensatory damages in excess of $11 million for the profits he claims would have been realized had the project been approved and built. The court found Shenehon’s analysis and testimony to be more credible and awarded $0 in damages.

Credibility is the heart of every case. This case demonstrates the importance of retaining an expert witness to prepare a thorough analysis and to provide independent testimony. Robert Strachota of Shenehon Company testified on behalf of defendant while real estate developer and plaintiff, Bradley Hoyt, testified on his own behalf. Mr. Strachota prepared a clear, logical, and well-supported analysis and presentation. He utilized a recognized valuation method and demonstrated his knowledge regarding the subject matter. Mr. Strachota provided expert testimony about his appraisal to assist the trier of fact in understanding the material. In contrast, plaintiff relied on his own informal estimates which were unsupported by any documentation or market evidence. Because Mr. Strachota studied market data and analyzed each market factor, the court found his evidence more persuasive.

The court found plaintiff’s estimates of revenue, costs, and profit highly conjectural and optimistically speculative. Plaintiff’s testimony was based solely on his own informal estimates and was unsupported by contemporaneous documentation. Plaintiff had no feasibility analysis, no agreement with a contractor, no lending commitment or other formal plan for financing, no building permits, no final building plans, no pre-sales, and no marketing plan. Plaintiff’s profit projections hinged upon the accuracy of each of his sanguine construction and market assumptions. Any inaccuracy in plaintiff’s assumptions would have had a dramatic impact on the bottom line actually realized.

The court found that Mr. Strachota’s analysis was based on more realistic assumptions and was supported by actual experiences of other projects under development during the timeframe. Mr. Strachota studied and testified specifically to the condominium market, condominium development, unit mix, construction period, unit pricing, absorption, development costs, and marketing. Mr. Strachota’s experience established him as knowledgeable regarding new development projects, in general, and condominium projects, in particular. Mr. Strachota testified that plaintiff actually would have lost $10 to $20 million had he pursued this project during the timeframe in question.

The courts generally rely on expert testimony and this case is no different. Here, plaintiff presented no testimony by an appraiser and the only evidence of value he presented was his own opinion. He failed to present convincing testimony or documentation to substantiate his opinion as to his claim of lost profits. In sum, the court found plaintiff’s claim of damages remote and speculative.

Applying the Principle of Consistent Use

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Shenehon Company is pleased to announce that the International Right of Way Association will publish an article by John T. Schmick in the May/June 2010 issue of Right of Way.

John reviews what happens to value when the principle of Consistent Use is applied incorrectly. The basic concept is that land and improvements must be valued on the same basis. Once the highest and best use (HBU) of land as vacant is established, the principle of consistent use requires that the improvement be valued on that same basis. Inappropriate application of this principle leads to appraisal errors that may invalidate the opinion being offered. Two common errors are discussed in the article.

The first is the use of a building residual methodology to create a hybrid property value where the building component is valued on one basis and the land component is valued on another basis. The resulting hybrid value is inaccurate and not supported by market data. Another common error is an inappropriate application of the consistent use principle so as to subrogate highest and best use requirements. This second type of error is a violation of the Uniform Standards of Professional Appraisal Practice.

Application errors involving the concept of consistent use often surface when the appraiser encounters a property where the improvement is near the end of its economic life and may be an interim use. Another tricky area is when the property is in an area which is transitioning from one type of use to another. A link to the article will be forthcoming.

Visit the International Right of Way Association Website

Does Your Partnership Entity Pass the Validity Test for Estate Tax Purposes?

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By: Robert J. Strachota

Selecting an ownership structure that fits your business needs and goals requires thoughtful consideration and professional know-how. There are advantages and disadvantages to each type of entity, and one size does not fit all. Before you settle on a partnership structure, discuss the estate tax ramifications with your planner. Keep in mind that the key to maximizing the benefits from these asset protection devices is to follow the rules. Relying on cookie-cutter do it yourself models to save money at the front end may result in unexpected tax consequences down the road. Does your business partnership entity meet the most basic validity test requirements? To see if you are on the right track, answer the following questions. Next, consult with your estate planner to verify that your current ownership structure is the most appropriate one for your business.

Is it a Qualified Entity for Tax Planning Purposes?

Formation Questions:

  1. What are the non-tax reasons for forming the entity?
  2. Did other partners make real contributions of property or services to the entity?
  3. Does the client setting up the entity have sufficient assets outside the partnership on which to live and pay non-partnership estate tax liabilities?
  4. Were personal assets placed in the entity?
  5. Are financial obligations properly followed?
  6. Is each partner given the opportunity to participate in drafting the terms of the agreement?
  7. Is each partner given the opportunity to determine which assets are contributed to the entity?
  8. What is the discretion regarding distributions to the general partner?
  9. Is time period between the date of funding and the date of transfer adequate? Was the time period sufficiently documented?

Operation Questions:

  1. Are the non-tax reasons for creating the entity consistent with how it is operated?
  2. Are the partnership assets in any way co-mingled with the general partner’s personal assets?
  3. Are distributions made in accordance with the terms outlined in the agreement?
  4. Is the entity treated and respected as a separate entity?
  5. Are personal expenses paid from the partnership?
  6. Are taxes paid directly from the partnership?

How do Adverse Market Conditions Affect Lease Renewals? – By Laura Lamont

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In general, one may associate adverse market conditions with high vacancy rates, declining rental rates, and tenant-friendly incentives. Landlords are offering prospective tenants free rent, increased tenant improvements, and at times, moving allowances. Despite an abundance of tenant perks, why do some leases, especially renewal leases, remain at previous market levels or actually increase?

In the next issue of Valuation Viewpoint, available in late May or early June, we will propose some answers to this and additional questions.

Residential Home Market Update

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By: Kate A. Ostlund

The single family home market has shown signs of improvement in the past several months and may be on its way to recovery from the economic slump. Historically, the luxury home market moves at a slower pace than the general single family market. It has seen prices decrease and sales slow down, but not at such a drastic rate compared to average single family homes. However, if the economy continues to languish, it is likely that the luxury home market will fall further.

In general, the market for average, single family homes has benefited from low mortgage rates and the Federal First-Time Home Buyer Tax Credit which combine to offer historic affordability. According to the Minneapolis Association of Realtors, home sales below $150,000 jumped 72% from over a year ago as first-time home buyers rushed to take advantage of the tax credit. With many people purchasing their first homes, some of the excess supply was absorbed which helped to stabilize communities.

In contrast, the luxury home market does not benefit from this tax credit and, while it has limited access to lower mortgage rates, it has become increasingly more difficult to secure financing for any luxury property. There has been a descending trend in luxury home sales over the last few years. Nevertheless, the luxury home market has shown signs of stabilization in recent months with some notable sales.

Single family and luxury home markets are expected to continue on the path to recovery as the economy heals and people take advantage of low interest rates.