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.

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.

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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.

Relying on Non-Expert Witnesses Can Be Costly

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By: Joshua Johnson

Anderson v. Anderson – Minnesota Court of Appeals, A08-1365, October 10, 2009
Hennepin County District Court, File Number 27-FA-292333, November 20, 2007

In Anderson v. Anderson, (a marriage dissolution), the key issues were the extent of the Respondent’s, (Kurt Anderson) ownership interests in two privately-held companies and the value of his interests as of the date of valuation. Mr. Anderson acknowledged a 90% ownership interest in one of the two companies, but claimed that his relationship with the second company was that of a consultant. Based on the facts, his position was extreme and difficult to defend under the best of circumstances. Mr. Anderson further complicated his situation by failing to engage an outside party to value his interests. When the Court ruled that the Respondent had concealed an ownership interest in a business formed during the marriage, it had only one opinion of value, that of the Petitioner’s expert, upon which to rely for the division of assets.

In 2004, Mr. Anderson owned 90% of an internet hosting company, Honeycomb Internet Services, LLC. In 1999, the year Petitioner, Robyn Anderson, and Mr. Anderson were married, Honeycomb had little to no value. Over the course of their marriage, the company appreciated in value due to the efforts of Mr. Anderson. Under Minnesota law, increased value due to active appreciation is subject to the marital estate. To determine the value of Honeycomb stock, the Court relied on adjusted gross revenues of $112,342. Mrs. Anderson’s hired expert, Stephen Dennis, JD, CPA, ABV, placed a 50% of revenue multiple on Honeycomb. This equated to a value of $56,171; applying the subject ownership interest of 90% brought this down slightly to $50,554. Divided amongst the marital estate, each party received an equitable ownership value of $25,277. No discounts for control and marketability were applied

During the same period of time, Mr. Anderson and two others, William Jurewicz and Mark Setterholm, launched another internet-related company called Space150.com, LLC, (now known as Space150, LLC). Space150 specialized in the design and promotion of websites. There is some confusion as to who actually owned Space150. Messrs. Anderson and Jurewicz claimed that the entire operation was one of “strategic alliances between Honeycomb, Space150 and Mr. Setterholm’s company, Setterholm Productions: that Mr. Anderson had no ownership interest. However, according to the deposition of Mr. Setterholm, that was not the original intent. He testified that each of the three contributed roughly $10,000 to the company. Further, Space150’s website identified Mr. Anderson as a “Founder/IT Director.”

The Court noted that there is no legal definition for “strategic partnership”, thus its meaning is open to a wide variety of interpretations. After reviewing the depositions and testimony of both parties and all witnesses, both the District Court and the Appellate Court determined that the inconsistencies were such that there was, in fact, an attempt to conceal ownership. The actions taken by Mr. Anderson, in his capacity as “IT Director” for Space150, were not those of a disinterested third-party consultant or “strategic partner,” as he and Mr. Jurewicz claimed, but those of an owner with a vested interest in the successful outcome of Space150’s business. Based on original capital invested, the Court determined that Mr. Anderson held a one-third interest in the company.

To determine the value of Space 150 stock, the Court heard testimony from Mr. Jurewicz and Mr. Irving Fish. Mr. Jurewicz opined a value of three times revenue. Mr. Fish, a non-expert, non-credentialed witness, called upon by Mrs. Anderson, was the CFO of Fallon Worldwide, Inc. (an advertising company), until he retired in 2002. His experience established him as knowledgeable with regard to advertising companies and their potential values. The Court did not contest the point, however, his knowledge of internet companies was contested. Mr. Fish offered an opinion of value based on an examination of the company’s financial statements and its client book of business. Based on his analysis, Mr. Fish testified that he concurred with Mr. Jurewicz in applying a multiple of three times revenue (300%). Neither Mr. Anderson (who claimed no ownership) nor Mr. Setterholm offered an opinion of value.

A 300% multiple may appear rather high, especially in light of the 50% multiple applied in valuing Honeycomb. A review of the Pratt’s Stats database revealed that this multiple, though rare, was not entirely unreasonable for a strategic sale of an advertising business during that time period. The Court noted that it would have preferred to hear an opinion of value from an independent expert. However, relying on the testimony of record, it valued Space 150 at $7,135,080 based on 2004 revenues of approximately $2,378,360. Multiplied by Mr. Anderson’s one third interest, the value of the stock going into the marital estate was $2,378,360. No discounts for control and marketability were applied in the Court’s finding.

Mr. Anderson did not hire a professional to value his assets and he took the extreme position that he did not own stock in Space 150. The importance of hiring an appraisal professional was very clear once the Court ruled that Mr. Anderson owned a one third interest in Space 150. A qualified appraiser might have offered testimony that a 300% multiple is realistic only for a strategic sale of a company or that discounts for lack of control and lack of marketability should be applied to a one-third interest under the state’s fair market value standard. Either of these had the potential to lower the value of the stock considerably. However, the Court had only one opinion of value on which to rely. The final decision proved quite costly for the Respondent.

Valuing the Private Company in a Recession – By William C. Herber

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Comparable data for private companies has changed dramatically over the last eight to ten years. In light of current economic conditions, the valuation professional must be aware of these changes and carefully consider the reliability of sales multiples and transaction data. Following is a short history of what has transpired from the private company perspective from 2002 to the present.

  • 2002
    The dot.com boom and bust subsided and the value of private companies began to go up.
  • 2003-2007
    Relatively easy access to money from 2002 to 2007 facilitated an increase in private company transactions just as it did for real estate transactions. This trend toward an increase in the size of deals, sales multiples and the number of transactions started in 2002 and continued until 2007. The market for private companies peaked in 2007 both in the number of transactions and multiples.
  • 2008
    By late 2007 and early 2008, there were signs that the market was in trouble. A few Wall Street insiders took notice, but the public markets came crashing down in 2008 as stock prices plummeted. In January of 2008, the Dow Jones Index was over 12,000. By the end of the year, it had fallen to 8,777 – a decline of 27% in one year. Private business transactions would follow the same decline.
  • 2009 1Q
    In early 2009, the market for private companies continued to retract. Declining profits, little or no available financing, and an overall sense of uncertainty prevailed amongst consumers.
  • 2009 3Q
    The market has rebounded, but no to its previous levels. The decline in profits has slowed. However, growth remains weak.

If the economy expands with new jobs before the federal subsidy runs out, we will come out of the recession. If not, we will stay flat or slide a bit more for the next several years. For further information on sales multiples, go to: Inc.com. INC’s Valuation Guide 2009 features a business valuation tool which allows you to calculate the value of your own company. It also includes the results of a study of private company sales from 1/1/2007 to 3/31/2009.

Recent Court Decision Affirms a Broader Scope for Discounts

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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.

Court of Appeals Notes that District Court Relied on Shenehon Company’s Appraisal

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By: Wendy S. Cell

In January 2008, Shenehon Company was part of a team offering expert testimony on behalf of SJC Properties, LLC, et al, concerning the special benefit conferred as a result of the 40th Street project in Rochester, Minnesota. The Olmsted County District Court found the evidence established that the city’s special assessment exceeded the special benefit on SJC’s property and set aside the levied special assessment, remanding the matter for reassessment. The court found the appraisal opinion of plaintiff’s expert (Shenehon Company) to be credible, and relied on its valuation analysis in concluding the city’s special assessment levied against the property exceeded the special benefit conferred. Special assessment cases are difficult to prevail in court. In that case, the appraiser’s attention to details successfully persuaded the District Court.

The city of Rochester appealed the decision arguing the District Court erred in setting aside the special assessment and challenging several of the District Court’s findings, none of which had to do with valuation issues. The Court of Appeals examined the record to determine whether the evidence fairly supported the District Court’s findings and whether those findings supported its conclusions of law. In sum, the Court of Appeals rejected the city’s arguments pertaining to the District Court’s findings and found the District Court did not err in determining that the assessment must be set aside. In its July 2009 decision, the Court of Appeals specifically noted that both parties offered expert witness testimony but that the District Court relied on the testimony and appraisal offered by Shenehon Company.

This is an example of how important it is to prepare a thorough and complete analysis. As is often the case in valuing real estate, one of the primary issues was the determination of the highest and best use. Plaintiff’s expert carefully studied the legally permissible factors, such as zoning and plat approval, and relied on the input of collateral experts, namely, a civil engineer and a traffic engineer, who prepared a site plan, cost estimates for transportation improvements, and a traffic study, among other things. Respondent’s expert 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. Further, plaintiff’s expert valued the property using three methodologies, while respondent’s expert used only one. Plaintiff’s appraiser identified key factors, considered all the available data, applied proper appraisal techniques, and prepared a careful and logical analysis. Along with the other experts, Shenehon Company had successfully persuaded the District Court that the special assessment exceeded the benefit to the property. After considering the appeal issues raised by the city, the Court of Appeals affirmed the decision.

Recessionary Market Alters the Timeline for Development Projects – By Timothy A. Rye

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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.