Frequently Asked Questions on Tax Increment Financing (TIF)

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By Heather M. Burns
Shenehon Company often works with clients in the early stages of real estate development projects to navigate the options available and determine the best way to set the groundwork for a successful project. One financing tool that can be utilized, but is not always fully understood, is tax increment financing (TIF). Based on our experience, we put together a list of frequently asked TIF questions to shed some light on many of the components considered in the TIF process.

Why use TIF?
TIF can be used in real estate development projects when extraordinary costs result in project expenses that are higher than project financing sources plus equity, which produces a return that is either negative or so low that a market-driven project would not occur. Extraordinary costs may include anything from challenging soil conditions to excessive blight. TIF can provide an additional financing source in these cases to cover the gap, which enables a market-driven project to go forward.

How does TIF work?
In order to enable the development of a blighted area, or incentivize affordable housing or economic development, a city or authority is sometimes willing to negotiate tax increment financing with the developer. Essentially, the city or authority promises their share of future property taxes (over and above the current pre-development tax level) back to the developer for a period of time (up to 26 years depending on the type of district) as a form of project financing. Through proper use of TIF, the developer gains additional financing needed to complete the project, the city or authority keeps the current level of pre-development taxes and receives a portion of the tax increment (or tax increase) for administrative costs throughout the TIF period, and the city or authority receives the full higher tax level once the TIF ends. The TIF ends either when district term expires or is decertified early due to repayment of all TIF-eligible costs.

What is the But-For Test?
In order to establish a TIF district, the local government must determine that the development wouldn’t occur without TIF in the reasonably foreseeable future, and that the subject development produces a market value (after subtracting TIF assistance) that will be higher than what would occur on the property without TIF. This process is called the “But-For Test.”

What is the difference between the Project Area and the TIF District?
The Project Area is the larger footprint where TIF money can be spent, whereas the same or smaller footprint (of Property IDs) delineates the TIF District or properties that will generate the property taxes and TIF increment.

What is the difference between Pay-Go TIF and Bonds?
In Pay-As-You-Go TIF (or Pay-Go TIF), the developer pays for upfront development cost and is reimbursed for TIF-eligible costs twice annually as the increment becomes available (when the tax base increases). In Pay-Go TIF, the developer gets paid pack more slowly over time and carries the risk that the increment generated over the course of the TIF district term may not be enough to cover the total eligible costs. When general obligation tax increment bonds are issued to finance eligible development costs, the developer receives the money upfront, and the bonds are secured by both pledged tax increment (tax increase) and by issuing the municipality’s full faith and credit. There is limited availability for bonds as municipalities are frequently unwilling to secure development activities in case they have to come up with any shortfall.

How can TIF increment be used?
TIF increment can be used to reimburse the developer for TIF-eligible costs such as land/building acquisition, demolition and relocation, environmental/geotechnical studies and correction, site improvements (clearance, earthwork, etc.), public improvements (sidewalks, streets, utilities), parking ramps and lots, TIF administrative costs/professional fees, and paying debt (principal and interest) for the previously listed items. TIF-eligible costs vary for each project depending on the type of district and statutory limitations, terms negotiated between the developer and the municipality, and sometimes include items like buildings (in the case of housing districts) and building rehabilitation/historic preservation.

When is tax increment generated and received?
When tax increment financing is negotiated and put into place, the original net tax capacity of the property is established (based on the city/municipality’s share of the property taxes on the original assessed value of the property). The developer begins constructing the development project and submits the TIF-eligible costs for Year One to the city/municipality. In January of Year Two, the assessor calculates the market value of the property for taxes payable in Year Three. In Year Three, the full property taxes are paid by the developer and the difference between the original net tax capacity (pre-development) and the net tax capacity paid for Year Three is the tax increment paid to the developer (in Pay-Go TIF). These tax increment payments occur twice each year following receipt of property taxes and continue until either all the TIF-eligible costs are repaid or the term of the district expires, whichever comes first. We also note that during the original TIF negotiation, the developer can elect when to receive the first year of increment (which can be up to four years after the district is certified to account for the lag project timing).

What is the five-year rule?
TIF-eligible costs to be submitted by the developer for reimbursement with tax increment must occur within the first five years after the district is certified (per Minnesota Statutes).

The items discussed above summarize many of the important issues our clients encounter when contemplating and negotiating tax increment financing. Please feel free to contact Robert Strachota (612.333-6533 or value@shenehon.com) or Heather Burns (612.767.9448 or hburns@shenehon.com) at Shenehon Company if you are interested in having us consult with you on a particular project and would like to discuss the subjects above in greater detail.

Retooling Older Buildings: A Popular Trend for Urban Office Space

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By Daniel L. Wojcik

The retooling and repurposing of older buildings has become an increasingly popular trend in urban office markets across the country. Companies are investing in modern office spaces as a tool to attract and retain young talent in the workforce. A shortage of modern Class “A” office space has opened the door for expansive renovations of older, historic buildings to add new amenities and features while retaining the building’s original character and charm. Companies are beginning to see the importance of amenities and attractive, exciting workspaces that appeal to employees. Popular renovation amenities include: on-site parking; locker rooms; bike storage; on-site coffee shops/bars; open floor plans; and bright, collaborative spaces with lots of natural light.

A great example of this new trend toward repurposing older buildings is the Highlight Center project that was recently completed in the Northeast Minneapolis submarket by Hillcrest Development. The Highlight Center was a major redevelopment of aging buildings that originally functioned as a light bulb factory and housed the Minneapolis Public Schools Headquarters until 2014.

The renovation included razing buildings on the site to open up space for surface parking while keeping the core buildings intact. The process of reusing the original structures retained the character and charm of the buildings while renovations inside transformed and modernized the space. The development team added a slew of amenities, including: bike storage and locker rooms for commuters; an on-site coffee shop and brewery; open, bright floor plans; and ample free surface parking.

Many companies that would traditionally look in the North Loop area are drawn to the Northeast Minneapolis market in search of more favorable rents. The Highlight Center created the perfect blend between price and attractive amenities in a newly renovated, modern office building. The new space attracted Sports Engine, a software company for managing sports leagues online, which became an anchor tenant occupying nearly 32,000 square feet of office space. The signing of Sports Engine was a catalyst for other tech and creative companies that followed suit and helped the property reach 99% occupancy after its first year. Sports Engine leased an additional 7,500 square feet of space approximately a year after signing the initial lease at rates nearly 11% higher than their initial signing.

Rent increases have continued as demand increased at the property, with recent signings showing strong growth from less than 12 months earlier. Northeast Minneapolis’ close proximity to the Minneapolis Central Business District and cost-effective space options provide a compelling choice for growing companies.
For the most part, repurposing and renovating of older buildings is happening in urban neighborhoods where younger members of the labor force are choosing to live and work. Developers’ responses to increased demand for modern workplace in urban locations will have a direct impact on asset value in the future. The success of the Highlight Center project and interest in the Northeast Minneapolis market as a cheaper, more flexible alternative to the Central Business District or North Loop neighborhoods of Minneapolis bodes well for the area. It will be interesting to keep an eye on the Northeast Minneapolis market to see if other renovation projects emerge, hoping to build on the success of the Highlight Center.

Economy and Real Estate Market View – Q3 2016

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In spite of lingering global economic concerns, the U.S. economy continued to expand through the first nine months of 2016.  According to the latest Beige Book, most districts indicated a modest to moderate pace of growth, and the overall economic outlook for the U.S. economy remains positive.  Providing an optimistic outlook, labor markets remain tight, retail sales and real estate markets are healthy, and the oil and gas markets are beginning to demonstrate signs of stabilization.

Despite an encouraging overall outlook, commodity prices continue to be a source of some concern.  Weakness in commodity prices continues to weigh on the manufacturing and agricultural sectors, with strong yields putting deflationary pressures on food prices.  Although stabilizing around $45 per barrel, spot oil prices remain significantly lower compared to the close of 2013, putting significant pressure on energy-related firms.  Weakness in the energy sector, combined with the strength of the dollar, continues to hold back growth and a more encouraging outlook for the manufacturing sector, with eight of the 18 manufacturing industries reporting contraction in October.

In the face of challenges within a number of industries, the manufacturing sector as a whole continues to keep its head above water.  According to the ISM Report on Business®, the PMI® was recorded at 51.9% in October of 2016, up slightly from 51.5% recorded in the month prior and 50.1% noted in October of 2015.  In comparison, economic activity in the non-manufacturing sectors expanded for the 81st consecutive month in October of 2016.  The following graph presents the five-year historical PMI® and NMI® index readings.

pmi-and-nmi

Non-farm employment at the national level increased by 1.8% over the year ended September of 2016 on the net addition of nearly 2.5 million jobs.  Job growth in the service-producing sectors is leading increasing overall payroll figures, with the most robust gains noted in the professional/business services and education/health services sectors.  From a year-over-year perspective, payroll figures in the service-producing sectors increased by 2.0% in September, followed by the government/public sector (0.8%) and the goods-producing sectors (0.3%).  The following graph presents overall national non-farm employment growth.

non-farm-employment

Employment gains noted across nearly all major markets continue to put downward pressure on unemployment rates.  Nationally, the non-seasonally adjusted unemployment rate decreased to 4.8% in September of 2016, down 20 basis points from 5.0% recorded 12 months prior.  In comparison, the non-seasonally adjusted unemployment rate in the state of Minnesota stood at 3.4% in September of 2016, down 40 basis points from 3.8% recorded in the prior month but up 20 basis points from 3.2% in September of 2015.  From a statewide perspective, unemployment remains lowest in the Mankato and Rochester markets (2.8%), followed by the Twin Cities (3.3%) and St. Cloud (3.3%) markets.  The following graph presents non-seasonally adjusted unemployment rates at the national, regional, and local levels.

unemployment

In addition to a tight labor market, retail sales and real estate markets remain healthy to facilitate economic growth.  Retail sales at the national level are up approximately 1.7% year-to-date through October. While fluctuating in the second half of 2015 and the first half of 2016, consumer confidence appeared to regain some momentum at the close of the third quarter.  The University of Michigan Index of Consumer Sentiment stood at 91.2 in September of 2016, up from 89.8 in the prior month and 87.2 in September of 2015.

Meanwhile, though entering into a mature stage of the cycle, transaction volume and new construction activity in the real estate markets continues to drive further growth and underlying market fundamentals are generally encouraging.  At the national level, the median home sale price in the for-sale residential sector increased to $240,900 in the third quarter of 2016, up 5.2% from $228,900 reported 12 months prior, as home sale activity remained relatively strong.  In the commercial sector, fundamentals across all four major property types at the national level remain healthy to improving.

Twin Cities market

Conditions in the residential and commercial real estate markets within the Twin Cities market mirror national trends.  In the Twin Cities for-sale residential market, the number of year-to-date closed home sales increased by 4.7% through October of 2016, while the median home sale price increased by 5.7% during this same period, rising from $220,000 in October of 2015 to $232,500 in October 2016.  Further indicating healthy demand, the average days on market decreased by 15.8% and the percentage of original list price received increased by 0.9% during this same period, as available inventory remains relatively limited.  The following graph presents historical median home sale prices in the Twin Cities market.

tc-median-home-sale-price

Conditions in the apartment market remain healthy, with underlying fundamentals in the Twin Cities apartment market among the strongest in the nation.  While new construction activity in the Twin Cities market remains above historical norms, demand continues to exceed the pace of new additions to existing apartment inventory, keeping vacancy rates well below the market equilibrium of 5.0% and putting upward pressure on rental rates.  Demographic trends suggest demand for apartment units will remain healthy over the long term, and a decline in the pace of new construction will put upward pressure on occupancy levels and asking rents.  Benefitting existing apartment owners and operators, new apartment construction activity may have reached a cyclical peak, as year-to-date multifamily permitting activity is down nearly 20.0% compared to the first nine months of 2015.  The following graph presents historical multifamily construction permitting activity in the Twin Cities market.

tc-multifamily-permitting

The region’s broad-based economy and employment growth continue to facilitate healthy demand within both the local for-sale residential and apartment markets.  Non-farm employment in the Twin Cities metropolitan area increased by 2.0% over the year ended in September 2016 on the net addition of 38,000 jobs.  Mirroring trends observed at the national level, growth in the Twin Cities market was strongest within the education/health services, professional/business services, and traditionally low-paying, other services sectors. These sectors combined to account for nearly 75.0% of job growth in the local market during this period.  Further employment growth in the Twin Cities market was held back by year-over-year job losses in the manufacturing, trade/transportation/utilities, and information sectors.  The following graph presents overall non-farm employment growth in the Twin Cities metropolitan area.

tc-non-farm-employment

Improvements also continue to be noted within the industrial, office, and retail sectors in the Twin Cities market.  Strong demand for industrial space exists within the Twin Cities market, and despite an uptick in new construction activity, vacancy rates within the local industrial sector remain resilient though it has caused some landlords to pause rent hikes.  Similar to trends observed at the national level, demand in the Twin Cities industrial market remains strongest for warehouse and distribution space, yet the light industrial segments also continue to record healthy absorption.  Secular trends, most notably including the rise of e-commerce, are driving much of the demand for warehouse and distribution space.  Accounting for over 8.0% of total retail sales, e-commerce is anticipated to continue rising at a robust pace, and will continue to foster strong demand for warehouse and distribution space in the local, regional, and national industrial markets into the long-term.  The following graph presents historical e-commerce retail sales as a percent of total retail sales.

e-commerce-retail-sales

Data referenced in this report was current as of November 13, 2016, and includes preliminary figures, which are subject to revision.

Shenehon Vessel on Lake Superior – Is There a Connection to Shenehon Company?

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Some of our clients have reported seeing a 65.5-foot boat named Shenehon in Bayfield, Wisconsin on Lake Superior and wondered about the boat’s story.

RV_Shenehon_rearview.jpgThe vessel is a converted Tug-Transport (T) boat, built in 1953 by the U.S. Army.  It is now part of a fleet of vessels operated by the National Oceanic and Atmospheric Administration (NOAA) Great Lakes Environmental Research Laboratory.  The vessel was named in honor of Francis Clinton Shenehon, who was Chief Civilian Engineer of the Great Lakes Survey from 1906-1909 and was Dean of the College of Engineering at the University of Minnesota from 1909 to 1917.

rv_shenehon_t465-front-compressedTies to Shenehon Company – There is a connection between this T boat and Shenehon Company. Francis C. Shenehon was an ancestor of the late F.E. “Howard” Shenehon, who in 1929 founded a Minneapolis appraisal firm, which is now known as Shenehon Company.

Below are archive photos of the research vessel, RV Shenehon. The image on the left is from 1972 and the image on the right is from 1965.
shenehon-circa-1965 rv-shenehon-archive

 

Solar Energy: Balancing Interests in Real Property

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By Michael J. Amen

At a time when climate change is having widespread impact on the world’s ecosystem, the need to expedite development of renewable energy sources is vital.  A rising source of renewable energy is solar or photovoltaic cells, the fastest growing source of renewable energy in America, according to a report from the American Petroleum Institute (API).  Approximately ten percent of energy consumed in the United States in 2014 was from a renewable source and solar energy accounted for approximately four percent of this renewable energy, according to the Institute for Energy Research.

While solar energy currently accounts for less than one percent of the total electricity generation in the United States, it is gradually becoming more affordable and consequently, more popular.  As the accessibility of solar panels has grown, the number of new installations has skyrocketed.  Almost 30 percent of the electric-generating capacity brought on-line in the United States in 2015 was solar, reports the Solar Energy Industries Association (SEIA), and the one-millionth solar panel installation occurred in early 2016.

To encourage installation of solar panels, more than 30 states have adopted legislation providing solar protections.  While it is imperative that state and local governments be proactive in developing land planning policies that foster growth in renewable energy, it is equally as important to maintain the rights of individual property owners.  This article discusses the rights of the owner of the solar panels and neighboring property owners, and outlines solutions that balance the interests of each property owner.

The Case for Solar Panels

In 1954, scientists harnessed the energy of sunlight and converted it into electricity using photovoltaic (PV) cells, made of silicon. Photovoltaic cells make up the solar panels that are becoming more common as power sources for residential and commercial properties.  These systems are pricey and can cost  anywhere from $15,000 to $40,000 or more for a single home.  Property owners who install these systems depend on the electricity that is generated to reduce or even eliminate their utility expenses.  Photovoltaic cells convert sunlight into electricity, so it follows that the more sunlight that a cell is exposed to, the more electricity it can generate.  It is clearly favorable for the owner of a solar panel to have as much exposure to sunlight as possible.  Given the substantial initial investment of a photovoltaic solar panel system, property owners rely on sunlight, and the energy that it produces, to generate a financial return on their investment.

Hypothetical Case studies: Solar panels versus trees

To help visualize this, let’s look at two hypothetical situations involving two property owners, Sunny Savings and Debbie Developer.  Sunny is an eco-conscious consumer who rides his bike everywhere, composts his organic waste in his garden, and has recently taken an interest in renewable energy, specifically photovoltaic panels.  Debbie is a real estate mogul who has made her fortune building and selling luxury hotels, resorts, and golf courses and believes that real estate development is an essential part of the economy that should not be restricted.

Scenario One: Sunny wants to construct a $30,000 solar panel system on his home and anticipates that it will take 10 to 12 years to recoup his initial cost.  Debbie recently purchased the property to the west of Sunny’s property and would like to plant a grove of trees along the border between her property and Sunny’s.  These trees will cast shadows onto Sunny’s property and will hinder the solar access of his system, at times blocking nearly all of the sunlight from reaching his panels.  In this scenario, Sunny’s solar system will produce far less electricity than a system with unobstructed access to the sunlight, which results in a diminished opportunity to save money on his utility bills.  Consequently, the 10-to-12-year payback window he was originally expecting could be increased to 20 years or more.    What if the lengthened payback period exceeds the economic life of the system and the system stops producing electricity before Sunny can even reach his “break even” point?  If the government wants to promote renewable energy sources, shouldn’t it protect Sunny and his investment in a photovoltaic system?  Land planning regulations have begun to, and will likely continue to, promote the installation of photovoltaic systems, but at what cost?

DebbieSunny_ScenarioOne (2)

Scenario Two: Sunny has once again installed a photovoltaic system on his property. Before the installation, Debbie purchased the vacant lot to the west of Sunny’s property and is looking to escape the rush of a life in real estate development in a charming cottage that she plans to construct on the property.  Their properties are located on a hill that slopes downward towards the east, such that even though Debbie is only proposing a small, single-story home, it will still block sunlight from reaching Sunny’s solar panels.  Debbie is aware of this, but she is also an astute hotel developer that is aware of the famous “spite fence” case, Fontainebleau Hotel Corp. v. Forty-Five Twenty-Five, Inc. (1959).  In this case, the courts ruled that “there being, then, no legal right to the free flow of light and air from the adjoining land, it is universally held that where a structure serves a useful and beneficial purpose, it does not give rise to a cause of action, either for damages or for an injunction.”  The Fontainebleau case is just one example of how the English doctrine of “ancient lights,” has consistently been rejected in the United States.

DebbieSunny_ScenarioTwo

Based on the Fontainebleau decision, no property owner in America has the right to the free flow of light so Debbie should be in the clear, right?  What she is not aware of is that the Fontainebleau decision has not always held true when solar energy is involved.  In Prah v. Maretti, a homeowner that installed a solar panel system on his roof sued an adjacent property owner, who had proposed the development of a residential building on his property.  The plaintiff claimed that the residence would block sunlight to his solar panels and constituted a private nuisance.  The circuit court initially upheld the precedent of the Fontainebleau case, ruling that no one has the right to the free flow of light.  However, the Wisconsin Supreme Court later reversed the circuit court decision and ruled in favor of the plaintiff, because he was using the sunlight not just for aesthetic purposes, but as a source of energy.  The Wisconsin Supreme Court concluded that the law of private nuisance protects the plaintiff from obstruction of access to sunlight, claiming that “access to sunlight as an energy source is of significance both to the landowner who invests in solar collectors and to a society which has an interest in developing alternative sources of energy.”

It is therefore not outside the realm of possibility that Sunny could prevent Debbie from building her home and could even eliminate any development potential of the property, stripping her of all economically beneficially uses of her property.  In essence, Debbie, a private land owner, is prevented from developing her property to its highest and best use for the benefit of the public, so shouldn’t she be entitiled to “just compensation” under the Fifth Amendment?

The bottom line is that there are two interests in real property at stake here and they must both be considered in order to arrive at a conclusion that is fair for each party.  State and local governments need to take proactive steps to ensure that solar energy is encouraged while simultaneously balancing the rights of the surrounding property owners.  Many states have already taken such steps, enacting solar access laws to protect property owner access to sunlight.  These can generally be grouped into four categories: prohibition of covenants, conditions, and restrictions, solar easements, solar shading laws, and solar access regulations by local zoning authorities.

Prohibition of Covenants, Conditions, and Restrictions

Covenants, conditions, and restrictions, or CC&Rs, are often enforced by developers of large, common interest commercial and residential developments.  These restrictions can dictate the size, color, design, and most importantly, the use of the property in the development, which means that they can prohibit photovoltaic systems.  In 2012, Southshore Heights Homeowners Association in Omaha, Nebraska sued Tim Adams, a resident of the community, to force him to remove the $40,000 solar panel system from his home.  The association claimed Adams had violated the neighborhood covenants against “solar heating and cooling devices” and Adams was eventually forced to remove his solar system.

Residence_PictureOver 20 states have passed legislation that prevents homeowners associations and other common interest developments from restricting the installation of solar energy (unfortunately for Adams, Nebraska is not one of them).  This legislation will limit “NIMBY” (not in my back-yard) fights and is certainly a step in the right direction.  Common interest communities should not only permit photovoltaic panel developments, they should look for ways to encourage them while reducing any negative impacts to surrounding property owners.  Developers and homeowners associations could work in tandem with solar energy companies to bring large-scale, wholesale solar panel systems to residential communities.  These “solar communities” would create an economically efficient way for environmentally conscious residents to enjoy sustainable living using renewable energy.  This idea is already being implemented around the country with “green” common interest communities that have Covenants, Conditions, and Restrictions that require homes to be environmentally friendly and sustainable.  These communities are able to regulate the size and placement and screening of the panels to reduce any negative aesthetic effects to surrounding properties.  Overall, the prohibition of covenants, conditions, and restrictions works well to prevent common interest communities from holding back photovoltaic development with unwarranted regulations.

Solar Easements

The second type of solar access law is the most common, with more than 30 states having enacted solar easement legislation.  Solar easements are a type of negative easement, which can restrict surrounding landowners from developing their land in any way that would interfere with the rights of a landowner to receive sunlight to their solar panels.  Typical solar easements include height restrictions placed on structures and vegetation that could impair the passage of sunlight onto the dominant estate (the land that benefits from the easement).  These easements are negotiated between the two parties and often involve compensation for the servient estate (the land that is burdened by the easement).  Given the already heavy price tag of photovoltaic systems, an added cost for a solar easement could render the investment economically unfeasible.  However, the easement does protect the solar panel owner from the risk of obstruction of sunlight to their system.  It also gives property owners a mechanism to reach an agreement that can work for both of them without resorting to litigation.

Solar Shading Regulations

Only two states have enacted the third form of solar access protections, California and Wisconsin.  Under California’s Solar Shade Control Act, a tree or shrub placed after the installation of a solar collector cannot cast a shadow greater than ten percent of a solar collector’s absorption surface between 10 a.m. and 2 p.m. local standard time.  When it was first enacted, the Solar Shade Control Act did not make exceptions for vegetation that existed prior to the installation of a solar panel system, which had potential consequences for property owners adjacent to a photovoltaic system.  California lawmakers passed an amendment to the Solar Shade Control Act which made all trees and shrubs that have been or will be planted prior to the installation of a solar panel system exempt from the restrictions of the Solar Shade Control Act.  This is an effective law that has worked well in California and would have protected Sunny’s solar panels from the shade of Debbie’s grove of trees in our hypothetical case.

Local Zoning Authority Creates Solar Access Regulations

The final type of solar access legislation is permitting local zoning authorities to include solar access regulations in their zoning ordinances and comprehensive plans.  Zoning ordinances include area, height, and placement regulations including minimum lot sizes, maximum height, and required setbacks from the front, rear, and sides of each lot.  These regulations are useful for balancing the rights of each property owner.  Property owners that have photovoltaic systems have protections for these systems with “solar setbacks” that account for the height of neighboring structures, the angle of the light, and the slope of the lot.  Moreover, the impact of these systems on surrounding property owners can be mitigated by regulations controlling aesthetic effects, such as glare, with setback and screening requirements. Proper zoning and land planning regulations can prevent many disputes between property owners from ever arising.

The disagreement in our hypothetical case regarding Debbie’s proposed single-family home could have been prevented with proactive zoning/land planning that regulated setbacks and lot configurations as to maximize the development potential of the area while mitigating any negative impacts on potential photovoltaic systems.  In this case, Sunny can install his solar system, Debbie can develop her property, and both parties are satisfied.  Using zoning as a solar access protection method effectively balances the rights of each property owner and offers the greatest solar access protection of all of the current methods.  More cities should adopt these proactive regulations and as they do, the policies will be continue to be updated and improved, creating stronger solar access protections while maintaining private property rights for all landowners.

Conclusion

Balancing the rights of the Sunnys and the Debbies of the world is a complicated task with a variety of potential solutions.  Although the methods vary, a proactive model to handling solar access conflicts is always ideal.  Local zoning and land planning authorities are best suited to establish such a proactive model that accounts for the rights of adjacent property owners.  Solar easements, solar shading regulations, and the prohibition of covenants, conditions, and restrictions offer additional protections for solar system owners.  With photovoltaic technology becoming more affordable every year, more and more of these potential disputes will transpire around the county.  Thus, it is vital to have regulations in place that will promote solar energy and protect the development rights of the surrounding property owners for years to come.

(Sources for this article: American Petroleum Institute, Institute for Energy Research, Solar Energy Industries Association, The Journal of Sustainable Real Estate, and National Renewable Energy Laboratory.)

Three named to Shenehon Center’s MN Real Estate Hall of Fame

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Three more leaders in the Minnesota real estate industry are being added to the Minnesota Real Estate Hall of Fame, which was established by the Shenehon Center for Real Estate at the University of St. Thomas Opus College of Business.  The 2016 inductees are developer Fred Wall, broker Walter Nelson and real estate attorney Mark Westra. Hall of Fame members are selected for their outstanding business performance, high standard of ethics, and activities in the community.

Fred Wall launched his career at the Spring Co., the most prominent residential real estate company in the Twin Cities at the time, and he was quickly promoted to sales manager. From there, Wall co-founded Wall-Martin Co. and Norse Realty, and later founded WallCo.  Wall’s real estate accomplishments included owning and renovating the Foshay Tower, and partnering with Trammel Crow Co. to develop the Normandale Office Park in Bloomington. His community involvement includes supporting the United Way and the University of Minnesota Landscape Arboretum, plus leading community outreach through the Fred and Alice Wall Family Foundation.

Walter Nelson’s career spanned 56 years at the Eberhardt Co., a Minneapolis real estate advisory firm. He joined the firm in 1939 and purchased the company in 1951 after Alex Eberhardt’s death, serving as president until 1976.  Nelson remained chairman of the board until 1995.  His contributions to the community include volunteer leadership positions:  director of the Minneapolis YMCA and president of the Minneapolis Downtown Council.  Nelson was president of the Mortgage Bankers Association of America in 1959 and received the Association’s Distinguished Service Award. He has also been a director at several mortgage and real estate related companies.

Mark Westra has been a leading commercial real estate attorney in the Twin Cities since 1975.  He’s been involved in hundreds of local real estate projects and has represented some of the largest lenders, developers, owners and investors in the Twin Cities.  A longtime partner at Fabyanske, Westra, Hart and Thompson, Westra’s expertise included real estate finance, zoning, land use, and leasing.  Westra has served as an instructor at Hamline Law School and has mentored many real estate attorneys in the Twin Cities area.

Measuring a Company’s Risk of Bankruptcy

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By Mark T. Jude

In the world of finance there are many different types of risk and even more ways that attempt to measure or estimate that risk.  There are a numerous models and methods to estimate the risk of a company’s equity or debt, which are important in determining value.  But what about estimating a company’s risk of bankruptcy?

When Shenehon Company values a business, it calculates the business’s Altman Z-Score, which looks at a company’s risk of bankruptcy.  The Altman Z-Score model measures a company’s probability of bankruptcy within two years using financial ratios.  Instead of looking at financial ratios independently, this model uses multiple ratios to get a complete view of the company as a whole.  Ratios in the model look at liquidity, profitability, leverage and operational activity.  Each ratio on its own reveals important information and may highlight points of risk for the company, but the Z-Score measures the overall risk of the company.

This model was created in 1968 by Edward Altman, who is still a Professor of Finance in the Stern School of Business at New York University. The original model was created for public companies and Altman later created two additional Z-Score models: one for private manufacturing companies and another for private non-manufacturing companies.  For private business valuation we look at the latter two models.

Z-Score Model for Private Manufacturing Companies

The model for private manufacturing companies consists of five weighted factors:

  1. Working Capital to Total Assets Ratio
  2. Retained Earnings to Total Assets Ratio
  3. EBIT (earnings before interest and tax) to Total Assets Ratio
  4. Book Value of Equity to Book Value of Total Liabilities Ratio
  5. Sales to Total Assets Ratio

Factor 1 measures the liquidity (current assets minus current liabilities) of the company compared to its assets, in this case net current assets as a percentage of the total asset base.  Factor 2 measures the financial leverage of the company, with the difference between the two metrics implying debt or other liabilities.  Factor 3 measures the profitability of the company relative to its assets.  Factor 4 is another measure of the company’s financial leverage, looking at total capital.  Factor 5 measures the company’s ability to generate sales with its current level of assets.  After the ratios are calculated they are entered into the Z-Score formula shown below:

Z-Score = 0.717(F1)+0.847(F2)+3.107(F3)+0.42(F4)+0.998(F5)

To interpret the Z-Score one must compare it to three scoring ranges.  A score above 2.9 indicates that bankruptcy is not likely.  A score between 2.9 and 1.23 is known as the “grey” zone where bankruptcy may occur but is not imminent.  A score below 1.23 indicates the company is distressed and is likely to file for bankruptcy within two years.

Z-Score Model for Private Non-Manufacturing Companies

The model for private non-manufacturing companies is altered slightly.  This model omits Factor 5 and has different weighting and scoring ranges.  The model for private non-manufacturing companies is shown below:

Z-Score = 6.56(F1)+3.26(F2)+6.72(F3)+1.05(F4)

For this model a score above 2.6 indicates that bankruptcy is unlikely and a score under 1.1 indicates that bankruptcy is likely, while a score between 2.6 and 1.1 is the “grey” zone and is not a clear indicator.  According to Predicting Financial Distress of Companies: Revisiting the Z-Score and ZETA Models by Professor Altman, multiple tests performed from 1968 to 1999 have demonstrated that “the accuracy of the Z-Score model on samples of distressed firms has been in the vicinity of 80-90%, based on data from one financial reporting period prior to bankruptcy.”  The model predicted that a company would be bankrupt within the next two years and was incorrect on 15% to 20% of the time in these studies.

This model can point to weak areas in a company’s financials and show where efforts of improvement would make the largest impact, thereby minimizing the probability of bankruptcy.  For manufacturing companies or asset-intensive companies, it is common that the sales to total asset ratio has the largest impact on the Z-Score.  The model for non-manufacturing companies does not have a clear key factor and will vary on a case by case basis.

Z-Score Advantages

An advantage of the Z-Score Model is that all of the inputs are readily available on financial statements, making it simple to gather the required inputs.  There is no regression, calibration or complex statistical model needed to implement this model.  There are no assumptions made and the model does not rely on market data.  Another benefit is that the model is easy to interpret.  The score falls into one of the three categories, likely of bankruptcy, not likely of bankruptcy or in the “grey” zone of no indication.  Overall, this model is a good way for an investor, credit analyst, auditor, appraiser or business owner to estimate the company’s risk of bankruptcy.

The Complexity of Valuation Standards: Making Sense of the Acronyms

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By Joseph M. Mau

The various business valuation societies rely on different valuation standards. What are they and how do they impact you?

  • The American Society of Appraisers Business Valuation (ASA) business valuation standards are to be used with the Uniform Standards of Professional Appraisal Practice (USPAP), developed by the Appraisal Foundation.
  • The American Institute of CPAs (AICPA) valuation standards are the Statement on Standards for Valuation Services (SSVS).
  • The International Society of Business Appraisers (ISBA) valuation standards are three sections of USPAP (Standard 3: Appraisal Review, Development and Reporting, Standard 9: Business Appraisal, Development, and Standard 10: Business Appraisal, Reporting).
  • The Institute of Business Appraisers (IBA) has developed its own valuation standards.
  • The National Association of Certified Valuators and Analysts (NACVA) has developed its own standards.

Although some of these societies have identified their own valuation standards, the one standard that is relied on above all else is USPAP.  USPAP is the only standard mentioned by the IRS in its definitions of qualified appraiser and qualified appraisal and is the standard followed in Shenehon Company valuations. That does not discredit the other standards as they are still able to meet IRS requirements for a qualified appraisal; they just are not mentioned by the IRS.

The biggest difference between all of the organizations listed above is the difference in their engagements and reporting.  There are two different types of engagements: valuation engagements and calculation engagements.  Through these engagements there are different reports that can be prepared.  For a valuation engagement, there is the appraisal also known as a detailed report, which is a comprehensive report that provides sufficient information to permit intended users to understand the data, reasoning, and analyses of the valuation analyst’s conclusion of value.  Additionally there is a restricted appraisal (USPAP and ISBA) also known as a limited appraisal or summary report. A restricted appraisal is structured to provide an abridged version of the information that would be provided in a full appraisal, and therefore, it does not require the same level of detail as a full appraisal.

For a calculation engagement, there is a calculation report.  A calculation report is in some regards similar to a summary report but the valuation analyst and client agree in advance on the approaches and methods that will be used as well as the extent of procedures that will be used to calculate the value of a business or interest, and the valuation analyst must follow that arrangement.  Calculation engagements are also required to include the following statement: “This Calculation Engagement did not include all the procedures required for a Conclusion of Value. Had a Conclusion of Value been determined, the results may have been different.”  This statement shows that a calculation engagement is not a conclusion of value and would not hold up in court.  Below is a chart of the all the organizations and the reports they perform.

Valuation reports

When it comes to the valuation societies, each society has preference on which engagements are used.  For USPAP and ISBA, only valuations are performed and calculation engagements are not used.  ASA does a calculation but does not have a full calculation report.  AICPA, IBA, and NACVA perform calculation engagements and valuation engagements.

Another key part of a valuation report is its ability to comply with IRS Revenue Ruling 59-60.  Revenue Ruling 59-60 is structured as a list of eight factors-to-consider in valuations, followed by a discussion of each factor.  USPAP is the best example of including Ruling 59-60 in its standards as USPAP Standard Rule 9-4 is almost verbatim to the IRS definition.  The eight factors from Revenue Ruling 59-60 appear in all of the organizations’ standards for a comprehensive or full report although not for a calculation or calculation report.

Some people believe that a valuation based on more than one standard is not valid. Actually that is not the case. Standards of the AICPA, ASA, IBA, NACVA, ISBA and the Appraisal Foundation’s USPAP are quite complimentary.  USPAP has more specific requirements than the other sets of standards but they are generally very similar.  Additionally, to try and remain consistent across the industry, some of the organizations have adopted a uniform set of definitions and terms that appear in their glossary/appendix; organizations following this practice are: AICPA, ASA, NACVA and IBA.

Valuation standards are a tricky concept to understand, but once you understand the basis of each engagement and report you can quickly identify which report you need.  If you are only doing retirement planning or just inquiring about how much your business might be worth, a full appraisal or detailed report is not needed, a restricted appraisal, limited appraisal, or summary report would be sufficient.  However, if you are performing estate planning or shareholder dissolution, a more thorough report such as an appraisal or detailed report would be required to hold up in court.

John Schmick articles noted in Spring 2016 issue of Appraisal Journal, called “important”

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Several articles by Shenehon Company appraiser John Schmick were identified in the Spring 2016 issue of the Appraisal Journal as important resources for appraisers. The Journal is the official publication of the Appraisal Institute and is the industry’s leading publication.

DSC_5925An article by Schmick and Jeffrey K. Jones published in the Fall 2014 Appraisal Journal was called “one of the very important articles for appraisers involved in corridor valuations.” This article was titled, “Is Across the Fence Methodology Consistent with Professional Standards?”

Four articles by Schmick that have appeared in Right of Way magazine are also listed as “Noteworthy Corridor Valuation-Related Articles.”

Schmick’s expertise in corridor valuation was included in Resource Center, an Appraisal Journal column by Dan L. Swango, PhD, MAI, SRA.  Swango is one of the most well-respected valuation experts in the United States.

You can see Schmick’s extensive list of published articles and access the articles by visiting his online bio at www.shenehon.com/john-t-schmick/.

Congratulations John on being recognized in Appraisal Journal!

External Obsolescence Issues in Guardian Energy, LLC vs. County of Waseca (Heard in State of Minnesota Supreme Court)

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By William C. Herber and Laura A. Wisneski

External obsolescence is a type of depreciation that results from external influences, and often reduces the value of a property.  For example, if a landfill is constructed next to a home, the value of the home will likely fall, through no fault of its own and regardless of the condition of the home itself.

Several years ago, Guardian Energy (Guardian) contested the property tax value assessed to their property in Waseca County, Minnesota.  Guardian Energy operates an ethanol plant on 140 acres in Janesville, and felt the County Assessor’s values for the property in 2009, 2010, and 2011, were too high.  After their grievances were heard by the Tax Court, an appeal was made to the Minnesota Supreme Court.  The case was eventually heard in 2015 by the Minnesota Supreme Court, which focused on two issues: 1) whether the determination that the ethanol tanks on the property were real property, and 2) the tax court’s independent determination of external obsolescence.  For this article, we will only focus on the application of external obsolescence.

ethanol plant reduced

Both sides presented the court with their determination of external obsolescence for the property.  Guardian proposed a 33.3 percent reduction for each year, based on the 40% decline in commercial market values generally, and an industry-wide decrease in the profit margin of ethanol resulting from overcapacity, lower demand, and the increased price of corn.  Upon further examination, however, Guardian admitted that its profit margins were higher than industry averages.  The court also took issue with Guardian’s reliance on the price per gallon of ethanol as an indicator of the decline in value of the property, stating that the price is related to the value of the business rather than the value of the property.  The tax court cited a previous case where it was determined that “a failure to meet sales projections, does not, by itself, demonstrate that a property suffers from external obsolescence.1”

Guardian’s property, however, was not a run-of-the-mill office building, where any number of businesses could operate.  An ethanol plant is a special-purpose property, and the County, while estimating slightly different reduction percentages, agreed with Guardian’s methods in this respect by also considering the price per gallon and general industry trends in its calculations.   The county concluded 45 percent, 35 percent, and 25 percent reductions for external obsolescence for each year, while Guardian Energy used 33 percent for all three years.

Rather than relying on the testimony of either side, the tax court used an entirely different approach to calculate its own determination of external obsolescence.  By taking national levels of demand and comparing these to levels of production, the tax court determined the property’s function obsolescence reduction at 16 percent, 8 percent, and 0 percent.  While the tax court would have been within its rights to reject the methods used by both sides, if it deemed them inappropriate, it would still be required to explain why it used the method it ended up choosing.  The Supreme Court decided that the tax court failed to adequately explain its reasoning for selecting this particular method of determining external obsolescence and failed to show that the method it selected is an accepted approach.

The Supreme Court could also not understand how the property value could be separated from the value of the viability of the business, because as stated previously, this was a special-use property that could only have one practical use, and “capitalization of the income loss attributable to the negative market influences is a generally respected approach to calculating external obsolescence.”  The Supreme Court acknowledged the complexity involved in determining the value of property and would not provide an opinion of which method(s) should apply, but instead recommended the case be remanded to the tax court for further proceedings.

Shenehon Company supplied the appraisal report for Guardian Energy.

1 State of Minnesota in Supreme Court A14-1883, A14-2168