Minneapolis Mulls Renter Protections

by Brock Boatman

Housing is one of the largest challenges facing communities across the country, particularly providing housing for those in lower- and middle-income brackets. One of the ways in which these groups are being affected is by the common purchase and repositioning of Naturally Occurring Affordable Housing (“NOAH”). In an effort to preserve NOAH, communities are considering various vehicles for preservation, including variations of Washington, D.C.’s Tenant Opportunity to Purchase Act (“TOPA” or the “Act”). TOPA was enacted in 1980 to address the housing crisis at the time, and remains in place today. States and cities across the country are now considering some variation of the TOPA framework, including Minneapolis. In this article, we explore the process by which property owners would comply with these new proposed laws based on TOPA, and how the Act affects the multifamily real estate market in D.C.

The Act classifies D.C. rental housing into three tiers: single-family housing, 2- to 4-unit housing, and 5+ unit housing. Until recently, all three tiers were treated relatively equally. This proved onerous for several important reasons, including discouraging rentals of Accessory Dwelling Units (“ADUs”) on single-family properties. ADUs are quite common in D.C., taking the form of English basements, carriage houses, and “Granny Flats,” allowing single-unit rentals on existing single-family properties. However, the renters of single-family homes yielded extraordinary power to delay sales. As a result, landlords would commonly either keep potential rentals off the market, find ways to terminate leases, or refuse to renew rents at reasonable rates to avoid the often costly alternative, which would be to buy-out the tenant lease. These results ran counter to many of TOPA’s goals. Under the revised D.C. rules, the only single-family tenant protection that remains is the right to occupy a unit for 12 months after sale under the current terms. TOPA now applies to D.C.’s second and third classifications, the 2 to 4 unit and 5+ unit properties, with the primary difference being the timeframes in which the tenants have to act.

For purposes of our discussion, we focus on the 5+ unit properties as they typify multifamily properties as we generally think of them. This discussion assumes typical market rate rentals and tenants; additional legislation in

D.C. applies to special situations, particularly involving seniors and persons with disabilities, but those minutiae are beyond the scope of this discussion.

The key factor affecting a seller is the timing of all the required notices and the tenants’ response periods. When the owner of a multifamily property enters into a sale agreement, they must notify the tenants. The following chart visualizes the various steps required to complete a sale.

After receiving notification of the sale, the tenants may request information regarding the property: floor plans, rent rolls, and income statements – the same information any buyer or investor would typically request. After review, the tenants may form an association (comprised of 50% or more of the tenants of the occupied units) to exercise their tenants’ rights. At this stage, they have four options. The tenants’ association may:

Attempt to purchase the property with terms roughly equivalent to the proposed third-party deal. In these cases the ownership has a responsibility to negotiate in good faith with the tenants’ association, and not attempt to re-trade the deal with terms different than with the third-party buyer. If the purchase goes through, ownership is then typically controlled by the tenants as a cooperative or limited equity cooperative, with tenants holding the right to purchase their units.

Transfer their rights to purchase to a new investor/developer, in which case the tenants have the right to negotiate how the property will be managed by the new owner. This option can also stipulate renovations and rental increases for existing and future tenants, keeping the property cost-controlled, and may involve public assistance, non-profit involvement, or the creation of a public-private partnership.

Offer to release their rights to purchase the property to the existing owner for some consideration, effectively being bought out in exchange for not slowing the sale process. A key component in this arrangement is that some form of consideration must be given by the current ownership, which can become costly for the seller or new buyer when cash consideration is involved.

Opt to do nothing, and the sale proceeds just as we would see today. This option is most often seen with high-end and luxury developments in which new ownership intends to keep the property “as-is,” with no significant plans to renovate or reposition the property.

Under the D.C. law, a tenants’ association can easily tie up a deal for 285 days, or longer. The owner has 360 days in order to enter a sale contract; if not, the TOPA process starts over. This protracted period is necessary for the tenants’ association: they need time for research, analysis, and organization in order to decide what their course of action will be. However, this also creates major challenges for the seller. First, there is the financing issue; most lenders will not commit to a term sheet that they might have to hold for over nine months. Changes in market rates can cause a deal to fall apart while a property owner is negotiating with the tenants’ association. Second, it makes using a multifamily property as the upleg of a 1031 exchange nearly impossible, given that there needs to be compliance with the 180-day rule. As a result, tenants can leverage extraordinary power and money over property owners looking to sell.

So what effects do these laws have on the apartment market? Anecdotally, market participants will say that these laws drive down values. However, we found the two largest outcomes were that 1) deal volume reduced dramatically and 2) properties remained on the market for an extended period of time.

In order to isolate the effects of TOPA legislation, we aggregated the last five years of apartment sales in D.C. and compared that activity to the nearby Alexandria and Arlington, Virginia markets, which are not affected by TOPA laws. After controlling for market size, we found that transactions of apartment buildings and complexes (50+ units) were 25% to 30% lower in D.C. than in the Virginia markets, and properties in D.C. typically spent 50% to 55% more time on the market. Both of these factors lead to downward pressure on values. This makes multifamily buildings a less attractive investment type in a TOPA market, and lowers the real property tax base for municipalities.

TOPA rules exempt new construction as properties under construction do not have tenants. This creates a strange quirk in the market as new construction properties often sell 100% vacant before tenants are able to occupy units and trigger the TOPA process. These laws affect both pure merchant developers as well as groups that intend to retain ownership positions in their projects.

TOPA rules also prompt the question of what constitutes a sale. Up until the mid-2000s, owners could sell 95% – and some argued up to 99.99% – of their ownership and still avoid triggering the TOPA process based on the courts’ interpretations of what constituted a sale. Clearly, this went against the spirit of the Act, and has since been nixed by subsequent court decisions. However, the definition of a sale continues to be debated. A court case this summer asked whether a reallocation of ownership interests constituted a sale. The court ruled that a third party was necessary to define a sale and trigger the TOPA process. More importantly, the case demonstrates that TOPA legislation still provokes questions and challenges almost 40 years after its passage.

So why pursue such legislation? Again, the goal of the legislation is to give renters, particularly those that occupy NOAH, seniors, and disabled people, tools to maintain rents and remain in their homes. Generally, these populations are renters “by circumstance” as opposed to those who rent in the newer luxury developments “by choice.” People renting at top of the luxury market, say $3,000 for a two-bedroom unit in newer projects here in the Twin Cities, are generally not at risk of being displaced by new ownership. Additionally, TOPA legislation creates opportunities for those with more moderate means to purchase their apartment through the creation of a co-op. However, as much as the legislation can help empower renters, it can create substantial challenges in capital markets. As the data shows in the closest “apples to apples” comparison, available deal velocity and timing will be affected, particularly for larger investors. If TOPA legislation passes in Minneapolis, it will take years to fully measure its effects on housing and the real estate market.

Spotlight on South Loop

By H. Ellis Beck

Throughout its history, the northeastern portion of Bloomington, Minnesota has been home to plenty of notable developments.  This corner of a second-ring suburb, sandwiched between the Minnesota River and major highways, has hosted farms, a wildlife refuge, a professional football and baseball stadium, a professional hockey and basketball arena, huge surface parking lots, hotels, and a dedicated space for landing approach lights for Minneapolis-St. Paul International Airport.

Today, the area still has the wildlife refuge, the airport lights, and hotels, but the professional sports venues and their parking lots have been replaced by the Mall of America and IKEA.  Since the 2004 opening of the Blue Line, which connects the Mall of America to the airport and Downtown Minneapolis,  office buildings and multi-family developments have sprung up around the district’s stations.

Still, the area now known as the South Loop sees potential for more growth in its future and announced that potential to the world when the site finished as a finalist to host the 2023 World’s Fair, before eventually losing the bid to Argentina.  It announced it again by entering a bid to host the 2027 World’s Fair, the winner of which has not yet been announced.

Most of this excitement for potential growth centers around the South Loop District Plan, adopted by the Bloomington City Council in August of 2013.  The plan focuses on leveraging the area’s existing assets to foster responsible growth.  These unique assets include the country’s largest mall, which serves 40 million visitors annually, and the district’s close proximity to Minneapolis-St Paul International Airport, a major hub for Delta Air Lines.  The area is home to four light rail stops, increasing opportunity for Transit-Oriented Development and improving walkability throughout the area.  A map by the City of Bloomington highlighting the existing assets is below.

So, what does the city think “built out” looks like for the South Loop?  Below are the published projections for the area.

The South Loop’s population, households, and housing units are projected to more than triple from 2010 through 2050.  The annual population growth rate of 3.1% would roughly quadruple growth rates anticipated in Hennepin County over the same period, and Bloomington expects that over two-thirds of its population growth will occur in the South Loop.  Households and housing units are anticipated to follow a similar trend.  While employment growth is anticipated to lag population, household, and housing unit growth, the South Loop already serves as an employment hub due to the Mall of America’s presence.

Residential units are projected to grow at roughly the same rate as population and households, with office and technical space lagging only slightly behind.  Growth in retail and hotel space is anticipated to trail the housing sector, but the South Loop clearly has an established retail base and is already a hotel hub due to its mall and proximity to the airport.

To encourage growth at the projected rates, the city updated its land use plan to emphasize density, walkability, transit, and public green space, as seen in the map below.

The South Loop exemplifies the growing trend of suburbs transitioning portions of their land from the open, auto-centric, and decidedly “sub-urban” style of planning to a far more dense, transit-oriented, walkable, and “urban” style.  We’ve seen this trend play out in mid-size metropolitan areas; Seattle and Denver area suburbs have recently attempted to build around new or planned transit corridors.  However, Bloomington’s situation is unique in the Minneapolis-St. Paul area.

Locally, suburbs have begun to either prepare to reshape downtown areas to accommodate incoming transit (such as along the Southwest Rail Line) or totally rebuild areas from the ground up (e.g. the Ford Site in St. Paul).  The South Loop is uniquely positioned in that the “hard part” is already accomplished:  trains are already running through the area, people are already coming to the Mall and nearby airport, the groundwork is already laid.  The South Loop’s continuing development from Bloomington’s rural “front door” to its fully built-out form should prove interesting to observe.

Waterfalls and Hurdle Rates in Real Estate Private Equity

By Madeline M. Strachota

What is better—tiered returns or pari passu? It’s up to you.

Private equity organizational structures have various merits and demerits.  As appraisers, we see a variety of entity structures—partnerships, limited liability companies (LLC), corporations—all organized in different ways, which makes understanding the governing documents of an entity essential to understanding the value of an interest in that entity.  Some of the most common reasons for the variety of organizational structures include optimizing wealth transfer in estate planning, tax planning, liability mitigation, incentive alignment, and role allocation based on what each partner brings to a deal.

As an asset class, private investment in real estate has grown substantially in the 21st century.  In fact, it was not until the 1990s that real estate private equity in the form of pooled funds for investment in real estate became popular.  These funds grew out of private investors pooling to take advantage of falling real estate prices in the early 1990s and have continued to grow in popularity, especially in the build up to the Great Recession.  In all economic cycles, investors choose real estate to add diversification to their portfolios, and because the assets are income producing, hedge against inflation, and are tangible.  Within real estate private equity, there is a common entity structure that seeks to align entrepreneurs and investors: the equity waterfall.

Each equity waterfall can be different; however, the main idea is to decide which partner(s) control the everyday operations of the deal and how distributions are made to the different equity classes.  Oftentimes these funds are structured as partnerships with one general partner and many limited partners.  Unlike entities that distribute capital on a pro rata (also known as pari passu) basis according to what portion of the initial investment each investor contributed, waterfalls distribute capital by splitting distributions unevenly among partners after certain performance milestones, known as hurdles, are met.

But why would investors agree to receive a distribution that is not proportionate to their initial investment? The rationale is that entrepreneurs bring ideas and investors bring capital.  As such, each partner needs to be compensated for what they bring to the table and the relative risk they bear.  When capital markets are flowing and good deals are sparse, organizational structures skew to provide a higher reward to the entrepreneur.  Alternatively, if capital markets are tight and deals are plentiful, organizational structures skew to favor the “money” investors.  Furthermore, a waterfall structure incentivizes the general partner to achieve higher rates of return because at each higher rate of return, the general partner receives a disproportionately higher percent of the distributions compared to the limited partners.  Lastly, oftentimes the entrepreneur bears most of the up-front costs associated with real estate development or investment; as such, they must be compensated for this higher level of risk.

Following is a comparison of a typical waterfall structure to a pari passu structure:

Most waterfall models follow the same general principals; however, organizational documents can specify different arrangements that materially impact management decisions and distributions.  Although entity management and distribution allocations are the key differentiators, an infinite number of provisions in the organizational documents can impact value.  For example, there may be a general partner or managing member that controls the entity and receives separate returns; other times there are equally divided interests, each with management voting rights.  In another arrangement, some equity partners are entitled to a “guaranteed” preferred return over other equity partners.  Furthermore, members, partners, or shareholders could be individuals, LLCs, partnerships, or corporations, and these subsidiary entities could have an equally complex structure.

Following are a few additional differentiators among waterfall agreements and why they might matter:

The provision.  Distributions based on individual investments versus aggregate investments.

→ The impact.  If a fund has one investment that performs extremely well, crossing the highest hurdle, but the other investments are a “bust,” the general partner may receive an excessive return on the successful investment, and there may be no returns to any partners on the other investments.

The provision.  A clawback provision.

→ The impact.  If a fund does not perform consistently over time, historical distributions made to a general partner can be clawed back and redistributed to limited partners.

The provision.  General partner in both the voting and nonvoting equity pools.

→ The impact.  Whether the entrepreneur is in the deal as a common equity investor and/or a controlling investor entitled to the promote will determine how the equity splits flow.

The provision.  The waterfall difference between operating cash flow and reversion cash flow.

→ The impact.  If the waterfall specific to operating cash flow favors the general partner as compared to the waterfall specific to reversion cash flow, this incentivizes the manager to hold investments instead of selling.

It is important to understand the governance of an organization with an equity waterfall distribution to fully understand the potential upside and downside of investments.  Additionally, to better understand what cash flows to the entrepreneur, investors should consider the additional fees to entrepreneurs that hit the income statement and are not considered equity distributions.

Real estate private equity has championed the use of waterfall structures for operating and reversion distributions.  Although the intent of the waterfall organizational structure is good, the complexity of the structure begs the question—is it necessary? For those who do not run the numbers daily on these types of funds or do not have years of experience with this asset class, the structure of these pooled investment funds can seem overly complex.  Some critics argue that this structure falls into the category of the exact opaque financial practices that gave way to the Great Recession.  Of course, with any partnership structure, the fiduciary is trusted to make value creating decisions for all partners, and it is possible to exploit investors that do not have specialized knowledge of real estate finance.  However, the waterfall structure alone is not problematic—sure, it may create additional work for accountants and appraisers—yet many argue that this structure efficiently allocates risk and demonstrates an evolving sophistication in the industry.  Time will tell if investors demand simplified organizational structures for the sake of transparency.

Bitcoin, Blockchain, and Banks

by Cody J. Lindman

Like Dutch Tulip Mania during the 17th century, the price of a single Bitcoin increased astronomically during 2017, starting the year at $998 per Bitcoin before eventually peaking at $19,666.  However, in 2018, Bitcoin’s luck ran out, with the price of a single Bitcoin declining to $3,747 as of January 1, 2019, an approximately 81% decrease from the all-time high.  Despite becoming a popular buzzword after its impressive price growth during 2017, many people still do not have a firm grasp of what Bitcoin is.  In simplified terms, Bitcoin is a digital medium of exchange.  However, Bitcoin has no intrinsic value and its value is not pegged to another currency.  Instead, Bitcoin has value because of its sought-after characteristics, namely security and anonymity.  The technology behind Bitcoin and other cryptocurrencies that provides security and anonymity for transactions is called blockchain.

Although a cryptographically secured chain of blocks was originally described by Stuart Haber and W. Scott Stornetta in 1991, blockchain (and Bitcoin) was invented by Satoshi Nakamoto in 2008.  At its core, blockchain is a distributed ledger or a growing list of records (known as “blocks”) that are linked using cryptography.  Blockchain allows unfamiliar parties to agree on a common history without the use of an intermediary.  Anyone can view the blockchain; however, the information identifying users involved in a transaction is limited to online aliases.

Every computer in a blockchain network has its own copy of the blockchain that is updated automatically whenever a new block is added, resulting in potentially thousands of copies of the same blockchain.  Since each copy of the blockchain is identical, the information contained within the blockchain is difficult to alter, as there is not a single, definitive account of events.  Instead, there are thousands of copies of the same chain of events, requiring someone to modify every copy of the blockchain in the network to alter data.  As a result, it is significantly more difficult to alter data stored on a blockchain compared to a traditional database.

Like any new technology, blockchain has received a considerable amount of lip service from business leaders attempting to appear forward-thinking.  Blockchain differs from most new technologies, however, because it has the potential to radically impact a wide variety of industries.  One of the industries that stands to benefit the most from the implementation of blockchain technology is banking.  Banks currently only process transactions during business hours, Monday through Friday.  However, with the implementation of blockchain technology, banks could process transactions immediately, regardless of when the transaction occurred, reducing settlement time.

J.P. Morgan seized the first-mover advantage when it became the first U.S. bank to create a digital coin representing a fiat currency in February 2019.  J.P. Morgan’s digital coin (called JPM Coin) is designed to make instantaneous payments using blockchain technology.  Despite both utilizing blockchain technology, JPM Coin differs from Bitcoin due to JPM Coin being a digital coin representing U.S. dollars held in accounts at J.P. Morgan.  Therefore, a JPM Coin is collateralized and always has a value equivalent to one U.S. dollar.  When one client sends money to another over the blockchain, JPM Coins are transferred and instantaneously redeemed for the equivalent amount of U.S. dollars.  It will be interesting to see if, how, and when banks decide to implement blockchain technology into their operations.



Waving, not Drowning

by Brock L. Boatman

Physical retail is not dead, and it is not dying.  Online retailing is not so much a killer of the mall as we know it, but more like a personal trainer:  it’s pushing existing product to adapt, and the owners and locations that are willing to do the work will emerge stronger than before.  Major retail closures – Toys R Us, Sears, and recently Payless Shoes – tend to grab headlines and make it appear that retail and malls are dying, but in many cases those closures allow retail centers to revamp to better accommodate the 21st century customer. It’s been well noted how the various classes of malls have responded during the current economic cycle:  Class A/Fortress Malls have thrived, leaving lower class properties to die. A brief analysis of what we consider the true Class A mall REITs supports this. Additionally, the relatively recent acquisitions of General Growth Properties by Brookfield and the acquisition of Westfield by the Paris-based Unibail-Rodamco leads one to believe that there is some smart (re: BIG) money that sees the value in these types of assets.


Source: NAREIT, FTSE Russell

The following table shows 3rd quarter data (most year-end filings were not completed as of the date of this writing) for the three most prominent national owners of Class A malls compared to retail REITs as a whole.

3Q 2018 Data Simon Property Group (SPG) Taubman Centers (TCO) Macerich (MAC) Mall Owners All Retail REITs Retail REITs excluding Malls
Total Market Cap (millions) $54,650.0 $3,649.0 $7,799.0 $66,098.0 $173,361.4 $107,263.4
Annualized FFO* $3,774.4 $704.4 $598.4 $5,077.2 $15,024.0 $9,946.8
Multiple 14.48 5.18 13.03 13.02 11.54 10.78

Sources: 3rd quarter 10-Qs, NAREIT, market capitalization provided by ycharts.com
*Annualized FFO based on trailing 3-months results

Two of the three mall REITs trade well above the average for all other retail REITs, and even factoring in the lagging Taubman Centers REIT, the three are valued at a premium compared to all other retail REITs. Investors recognize that these quality assets, generally in prime national locations and operated by best in class asset and property management, are excelling in the current retail climate.

These national trends hold true locally.  A map of the major malls in the Twin Cities – the Mall of America, Eden Prairie Center, and The Dales (Rosedale, Southdale, and Ridgedale) – reveals their locations as some of the most desirable real estate in the metropolitan area, due largely to locational advantages provided by highway system access and strong demographics.  For those reasons, these sites are also public transportation hubs, either for bus-only (Rosedale and the proposed Ridgedale improvements), or bus and light rail (blue line to the Mall of America, and proposed stops for the Southwest Extension through Southdale and Eden Prairie).

While there is inherent risk in any retail concept becoming obsolete due changes in consumer tastes and trends, technology, logistics, new concepts and trends rise to take their place, and our local malls offer an excellent study in different ways in which owners are able to adapt and maximize value.

Southdale Center is in the process of reinventing itself as a mixed-use development. Recently, One Southdale Place delivered over 200 Class A multifamily units, and a Homewood Suites by Hilton provides a hotel component. The shuttering of the J.C. Penney at Southdale Center is being redeveloped into a flagship Lifetime Fitness, creating a new concept that is less a gym and more a “fitness lifestyle” destination, keeping in accordance with the demographic profile of the local area;

Rosedale Center recently repurposed the former Borders bookstore into a 30,000 square foot food hall, as part of the mall’s broader renovations to create a more welcoming aesthetic, encouraging shoppers to spend more time (and money) at the center. The recent closing of Herberger’s will create a challenge, although the addition of the second Von Maur location in the metro gives evidence that consumers still have an appetite for department stores.  Additionally, the mall is planning a new aquarium concept, again attempting to make the center more than a “soft goods only” destination, and even plans for office and/or residential development are being contemplated;

Ridgedale Center recently lost its Sears and has yet to name a replacement. This site will likely be a more lengthy and challenging development for the mall ownership, Brookfield Properties, compared to the other centers in the market as the competitive centers have been able to execute their strategies first. Part of any immediate redevelopment will also have to take place concurrently with the recently approved plans to improve infrastructure in the immediate area for both vehicular access and pedestrian utility, as well as the creation of a new urban park at the center;

Eden Prairie Center has taken a more traditional approach to replacing an anchor by reconfiguring the former Sears space for outdoor goods seller Scheels, giving the massive retailer its first location within the Twin Cities metropolitan area proper, and;

The Mall of America continues to threaten expansion, with the eventual Phase II set to create a more mixed-use style development with more shopping, hotel, office, and entertainment attractions to what is already a one-of-a-kind destination in North America.

Treating these locations not just as shopping malls but as local centers for uses that run the gamut of development, and seeing these locations not just as a stronghold of private commerce but as potential civic investments, lends credence that these places are more than just monuments to consumerism, and the public investment in and around these centers will only help these destinations maintain the status that they enjoy.  Victor Gruen designed Southdale Mall in Edina, the nation’s first enclosed shopping mall, in 1956.  In the 1960 treatise Shopping Towns USA: The Planning of Shopping Centers he wrote, along with Larry Smith, that “The shopping center which can do more than fulfill practical shopping needs, the one that will afford an opportunity for cultural, social, civic and recreational activities will reap the greatest benefits,” and as we see 60 years later this is still holding true.

Rosedale Center (Photo: Shenehon Company)