Bob Strachota to Chair IBA’s Board of Governors

Bob Strachota has been elected Chair of the Institute of Business Appraisers (IBA) Board of Governors. As Chair of the Board of Governors, Bob Strachota will be responsible for participating in strategic planning, overseeing Board of Governor meetings and activities, and other Boards and Committees. IBA is very pleased that Bob has offered his strong commitment to ensure IBA’s continued efforts to improve member participation and governance, IBA’s business valuation curriculum, and its accreditations, standards, and membership benefits.

IBA’s Chairs of the Board of Governors are elected by the Board of Governors to three year terms. IBA Regional Governors oversee regional educational events, help support members in their regions, host the IBA National Conference, and provide IBA Headquarters with input and feedback about IBA’s policies and programs. All IBA’s Regional Governors hold the CBA designation. Local chapters are active in several states and metropolitan areas providing members with networking and educational opportunities. For more information about existing local chapters, or starting one in your area, contact your local Regional Governor or IBA Headquarters.

The Institute of Business Appraisers was the first organization to adopt business appraisal standards and ethics codes. Established in 1978, the Institute was the pioneer in business appraisal education and professional accreditation. IBA offers the following designations: Certified Business Appraiser (CBA), Accredited in Business Appraisal Review (ABAR), Business Valuator Accredited in Litigation (BVAL) and Master Certified Business Appraiser (MCBA).


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

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 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’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

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

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

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.

Investment Properties: Valuing Partially Completed Construction Projects – By Robert H. Brown

Appraising investment properties which are incomplete is complicated in the best of times. Developing a reliable valuation in the current economic downturn requires attention to detail and methodology. Shenehon Company has provided fair market values of partially completed residential, industrial, office and retail projects in various stages of development ranging from footings-only-in-place to a nearly finished state. The methods we’ve been using for a number of years are consistent with those recently proposed by the International Valuation Standards Council for accounting for investment property under construction.

When valuing real property, most appraisers rely on the three basic valuation techniques (cost approach, income approach and market approach) to arrive at a reasonable range of value. The market approach is based on sales of comparable properties. Since very few investment properties transfer among market participants during the construction phases, using the market approach to determine the value of partially completed projects is precluded.

Likewise, if the appraiser relies exclusively on costs (the cost approach), the value estimate is artificially low because this technique does not take into consideration the entrepreneurial risks and incentives of the marketplace. The risks associated with a partially completed project are much higher than those associated with a completed one.

To adequately value unfinished construction projects, the appraiser assumes that the project is complete as of the valuation. Using this hypothetical situation, the appraiser now applies the three standard valuation techniques adjusting, as necessary, to account for the unfinished nature of the subject. It is common to adjust for: remaining construction and financing costs; the costs of leasing the property to a stabilized occupancy; and the development profit requirement necessary to attract a buyer to assume the risks inherent in the successful completion of a project.

The Real Estate Investment Market

By: John T. Schmick

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

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

Summary of: State of Minnesota vs. Union Pacific Railroad, et al.

By: Christopher J. Stockness

Court File No. 27-CV-07-20490, Fourth Judicial District Court

In the above matter, State of Minnesota vs. Union Pacific Railroad, et al., Shenehon Company aided Malkerson Gilliland Martin LLP in successfully obtaining a reasonable damage award for the property owner. The Commissioners’ findings, dated December 23, 2008 and filed on January 5, 2009, supported the respondent’s claim for damages in the amount of $1,200,000. Reasonable appraisal fees were also stipulated and, in the event that ongoing investigation shows damages to a retaining wall were due to the taking, additional compensation may be forthcoming.

This case involved a fee simple taking of land adjacent to the I-35W bridge and a temporary easement following the August 2, 2008 collapse. The taking, along with a 40 month temporary easement encumbering the entire property, resulted in significant changes to the owner’s plans and delayed the project (a retail development) for the duration of the temporary easement. Shenehon Company completed a development cost approach, which appropriately analyzed the damages of the taking by factoring in the impact of the loss of fee simple land and its impact on the development as well as the delay of the project as a result of the temporary easement that encumbered the entire property.

The Commissioners’ award, in the amount of $1,200,000, exceeded the amount offered the State ($800,000).

Look for full details of this case and the valuation techniques used in the Fall, 2009 issue of Valuation Viewpoint.

Cap Rates Fluctuate with the Market – By John G. Flaherty

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

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

How is Value Created? – By Clayton J. Shultz

The time-honored understanding of the purpose of a business is that it exists to maximize the wealth of its shareholders. Despite much agreement on this definition, there is relatively little agreement on how firms should go about maximizing this wealth. In fact, this is perhaps what makes business such a dynamic endeavor. This article focuses on two key areas of value creation: (1) short-term versus long-term orientation and (2) stockholder versus stakeholder orientation.

True economic value is created over the long run. Despite some well publicized (though artificial) gains made in the recent investment bubbles, public and private markets continue to demonstrate that short-term gains are no substitute for strategic, long-term investments that create a sustainable, competitive advantage.

Given the preceding, one might wonder whether or not privately-held firms enjoy some key advantages over their publicly-traded counterparts in today’s troubled economic times. Clearly, there are benefits to going public. Public firms have considerably more access to capital through the stock and bond markets. Going public also provides an exit opportunity for founders and other original investors of the firm in addition to generally increased valuation multiples as compared to privately-held companies.

On the other hand, public firms are at the mercy of the market. Due to the publicly-traded status of their stock, these companies must report earnings on a quarterly basis. This constant cycle of earnings announcements may shift the chief executive’s focus away from the long-term and toward the short-term. Often, the toughest pressure comes from activist investors who have taken large equity positions in firms and who lobby for short-sighted strategies such as the disposal of key assets or one-time dividends.

To illustrate this tension consider the example of a company in need of investment with a long-term payoff such as a branding initiative. It may take several years to realize a pay off from this project. One can see that it may be more attractive to invest in smaller projects with modest, but immediate returns, which will be rewarded by Wall Street.

Another key issue central to the creation of value is the stockholder versus stakeholder view of the corporation. Stockholder theory says that the company must focus entirely on the value it is creating for the equity owners of the firm. Stakeholder theory says that a company must seek to maximize the benefits for all stakeholders of the firm. A stakeholder group is any party that is engaged in helping the business operate. These groups would include shareholders, employees, customers, suppliers, communities, and others.

While the two theories may appear mutually exclusive, there is room for compromise. One opinion is that by following a stakeholder approach, the company will ultimately maximize the wealth of the shareholders. For example, if a corporation is too aggressive with suppliers, treats employees unfairly, or uses unethical marketing tactics with customers, mistreating these stakeholders will ultimately prove troublesome for the corporation. Suppliers will find other customers, key employees will leave, and customers will resent the brand. Any of these may negatively impact the value of the company in the long run. By focusing on all its stakeholders, the company will maximize the wealth of the shareholders.

This article explored two key considerations in creating value: (1) short-term versus long-term orientation and (2) stockholder versus stakeholder orientation. In the end, a firm can create greater economic value, and potentially a sustainable, competitive advantage, by focusing on long-term strategies and considering their impact on all stakeholders.