Inflation Update

by Emma Niemela

Following the report of 5.4 percent inflation for the trailing twelve months ended June 2021, the Federal Reserve is predicting elevated inflation to be a temporary phenomenon, normalizing after the “perfect storm of high demand and low supply” ceases. However, multiple chief executives have differing opinions.

According to the latest Bureau of Labor Statistics (BLS) update, the seasonally adjusted Consumer Price Index (CPI) for all urban consumers rose 0.9 percent in June, the largest one month change since the 1.0 percent increase in June 2008.

Notable category increases in the month of June, included used cars and trucks increasing 10.5 percent, food increasing 0.8 percent, energy increasing 1.5 percent, gasoline increasing 2.5 percent, and the index for all items less food and energy increasing 0.9 percent. These increases show recovery from the price declines due to COVID last year. A chart containing comprehensive BLS data is shown below.

Inflation reflects rising prices for goods and services and often happens when a nation’s money supply is growing faster than the economy; however, there are multiple triggers. Demand-pull inflation happens when an increase in the money supply creates demand for additional goods and services, the effect is accentuated when there is limited supply of those goods and services. Forgivable loans and personal stimulus checks given during the COVID-19 Global Pandemic triggered this type of inflation, increasing the money supply and creating demand while many supply chains were experiencing disruption due to the Pandemic.

Cost-push inflation results from input price increases. Increased cleaning costs and increased material prices as a result of supply shortages have contributed to increased overall costs for producing goods and services during the Pandemic. Supply shortages are expected to alleviate as the impact of COVID-19 fades; in fact, lumber prices are reaching pre-Pandemic norms. Lumber futures closed at $634 on July 23rd, down from a high of $1,711 on May 10, 2021, as shown by data from Yahoo Finance in the chart that follows.

Built-in inflation is driven by expectation that prices will continue to increase in the future. Companies such as PepsiCo, Conagra, and Fastenal voiced plans to increase prices because of expected inflation at their most recent earnings calls. Fastenal already raised prices in the second quarter and intends to continue this trend, as the initial increases were well received.

However, as reported by the Wall Street Journal, not all companies are following this pattern; FreshDirect is currently lowering prices on berries, salmon, and ground beef. The online grocery delivery company is looking to attract more customers by absorbing inflation for the time being. This varied approach is a good signal, as it shows not all companies are raising prices in expectation of future inflation, a move which would add fuel to the inflation cycle.

Wages are tied to built-in inflation, as employees demand wages to maintain their cost of living. As wages rise, costs and prices of products and services also rise, continuing the cycle. Many employers have raised wages to attract employees as the labor market has become more competitive. However, these labor cost increases motivate investment in automation. For example, Applebee’s has recently implemented tablets which allow customers to pay at their table without a waiter. John Peyton, CEO of Applebee’s parent company, Dine Brands Global, Inc., called this move a hedge against labor inflation in a recent earnings call.

The Federal Reserve’s dual mandate is to aim for price stability and maximum sustainable employment. The recent developments in wages and employment discussed above add complexity to these goals, as it can be hard to determine adequate benchmarks. The Fed has been using pre-pandemic employment levels to define “maximum employment,” but with automated labor hedges making certain roles smaller or obsolete and many people re-evaluating their lifestyle and leaving the workforce early, it may be necessary to use a new benchmark. Employment and inflation go hand in hand, and so long as the labor market is transitioning, there will be an effect on inflation.

Last August, the Federal Reserve communicated inflation expectations slightly above two percent following periods of inflation below two percent, resulting in a long-term average of two percent. Even though current inflation is well above two percent, the Federal Reserve has stated that is does not plan to raise interest rates in the short-term as it attributes current inflation to one-time price increases due to the re-opening of the economy. So long as businesses and consumers are not acting as if they altogether expect high inflation, the Federal Reserve will maintain its stance.

Comparing Controlling Interest Transactions – Common Mistakes Valuation Analysts Make When Using the Controlling Interest Transaction Method to Value a Business

by Cody Lindman

When valuing a business, valuation analysts consider three approaches to value: the income approach, the market approach, and the asset approach. Two of the most common valuation methods within the market approach are the guideline public company method and the controlling interest transaction method. When utilizing the controlling interest transaction method, the most frequently used transaction database is DealStats. Below are some of the most common mistakes we see other valuation analysts make when utilizing a transaction database such as DealStats.

Searching the Incorrect Industry for Comparable Transactions

When utilizing the controlling interest transaction method, the first step is to search for comparable transactions. It should be easy, right? All you have to do is search by the subject company’s SIC or NAICS industry code. The process should be easy given that companies list the NAICS code most applicable to their business on their federal tax return, right? Wrong. Although some valuation analysts may not admit it, determining the correct SIC and NAICS code for a business is a critical part of the valuation process and more difficult to get right than you would think. One of the reasons for the difficulty is the fact that most businesses do not fit cleanly into a particular SIC or NAICS code. In these instances, it is up to the appraiser to determine what they believe is the most appropriate SIC or NAICS code. As for the NAICS code listed on the subject company’s federal tax return, we have found that the code listed is incorrect approximately half of the time. When this occurs, the valuation analyst must research the subject business, examine the possible NAICS codes, and select the most accurate one.

Including Transactions Involving Companies Dissimilar to the Subject Company

After some difficulty, the valuation analyst has now determined the subject company’s SIC and NAICS code. After searching by either the subject’s SIC or NAICS code, the valuation analyst now has a list of comparable transactions. Now all they need to do is multiply one of the subject company’s financial metrics by the analogous median multiple of the comparable transactions to determine the value of the subject company, right? Wrong. The most important and often overlooked step in utilizing the controlling interest transaction method is to attempt to fully understand and question each of the comparable transactions. As we discussed previously, determining the correct SIC or NAICS code for a business is difficult. Therefore, it should not be a surprise that the people who categorize the comparable transactions sometimes make mistakes and mis-characterize the industry in which a business operates. Additionally, some of the transactions may involve businesses that are significantly smaller or larger than the subject company. Lastly, each transaction is subject to different terms, such as how the transactions will be financed, what is transferred, etc. It is up to the valuation analyst to look at the financial metrics, read the description of the acquired business, and understand the terms of the transaction to determine whether the transaction should be included as a comparable.

Failing to Account for the Differences in Asset and Stock Transactions

One of the most important things to note when analyzing a transaction pulled from DealStats is whether the transaction is characterized as either an “asset sale” or a “stock sale.” In a typical asset sale, the transaction is structured whereby the buyer acquires the inventory, furniture, fixtures, and equipment (FF&E), and intangible assets while the seller retains the company’s cash and receivables and pays off the company’s debt. A stock sale is considerably more straightforward; a buyer purchases all of the target company’s shares that are issued and outstanding. Although both types of transactions can be used to value a business, valuation analysts should be aware of the differences between the two structures. One way to handle the differences is to separate asset sales and stock sales into two different groups and then apply the corresponding multiples separately. However, this can be challenging if there are only a few asset sales or stock sales. Alternatively, a valuation analyst can restate the selling price of asset sales to convert them into a stock sale equivalent or vice-versa. This is normally the approach that valuation analysts at Shenehon undertake because it allows us to consider all of the comparable transactions on an apples-to-apples basis. To convert an asset sale to a stock sale equivalent, a valuation analyst would add net working capital to the asset sale price (however, if inventory changed hands in the asset sale, it should be subtracted from net working capital so as to not double count it). Converting a stock sale to an asset sale equivalent can be more difficult, as the process requires that a purchase price allocation (PPA) was performed. If specific allocation information is not available, it may be impossible to convert a stock sale to an asset sale equivalent, potentially making it necessary to eliminate that particular transaction. The general process for converting a stock sale to an asset sale equivalent is to determine the total asset value of the acquired business and then subtract the value of all assets acquired except for inventory, FF&E, and intangibles. The resulting value is an asset sale equivalent value.

We’re Hiring – Real Estate Valuation Analyst / Appraiser

Real Estate Valuation Analyst / Appraiser

Company Description

Founded in 1929, Shenehon Company is a highly respected and established commercial real estate and business valuation company. Shenehon provides clients with specialized knowledge necessary to solve their valuation problems. Shenehon is one of the few valuation firms in the nation to successfully integrate the practices of business valuation and real estate appraisal. Shenehon also provides consultation and litigation support to clients. Our service area encompasses the Upper Midwest with continued expansion throughout the country. Shenehon Company is an Affirmative Action/EEO employer.

Position Summary

The Real Estate Analyst will work closely with senior appraisers in the preparation of appraisal reports which would cover a wide range of commercial property types such as multi-family housing, office, mixed-use, vacant land, commercial, senior housing, and more.  The analyst’s work may be used in condemnation, development, tax appeal, sale of the property, gifting, internal management decisions, and more.

Duties and Responsibilities

>Assist senior appraisers with research and confirmation of data
>Prepare market analyses and perform research on property trends
>Utilize Argus and/or Microsoft Excel to analyze income-producing properties
>Inspect subject and comparable properties
>Assist in comparative analyses
>Assist in writing narrative appraisal reports
>Additional duties as necessary

Knowledge, Skills and Abilities

>Knowledge of valuation and financial concepts
>Basic understanding of commercial real estate
>Bachelor’s degree in real estate, business, finance, or accounting (Real Estate major is a plus)
>2 years of applicable experience or coursework
>MS Office with advanced Word and Excel
>Ability to comprehend, analyze, and interpret various business and real estate documents
>Strong communication (verbal and written) skills
>Ability to meet aggressive deadlines
>Basic understanding of Argus software is a plus
>Research oriented
>Intrinsically motivated to solve problems
>Willingness to work independently as well as part of a team
>Desire to produce high-quality work
>Good organizational skills with the ability to prioritize and manage multiple projects simultaneously
>Open to constructive analysis

Send resumes to

We’re Hiring – Business Valuation Analyst

Business Valuation Analyst

Company Description

Founded in 1929, Shenehon Company is a highly respected and established commercial real estate and business valuation company. Shenehon provides clients with specialized knowledge necessary to solve their valuation problems. Shenehon is one of the few valuation firms in the nation to successfully integrate the practices of business valuation and real estate appraisal. Shenehon also provides consultation and litigation support to clients. Our service area encompasses the Upper Midwest with continued expansion throughout the country. Shenehon Company is an Affirmative Action/EEO employer.

Position Summary

The Business Valuation Analyst will work closely with senior analysts to prepare valuation reports for business enterprises.  Assignments may include valuing professional practices, service, retail or manufacturing companies, minority interests, holding companies, intangible property rights and other unique valuation challenges. The analyst’s work may be used in the potential sale or purchase of a business, gift and estate matters, divorce matters, dissenting shareholder lawsuits, internal management decisions, and purchase price allocations.

Duties and Responsibilities

> Analyze financial statements, company governing documents, and other business information
> Perform detailed financial modeling, including income, market, and asset-based valuation approaches
> Research industry data
> Write narrative appraisal reports
> Collaborate with other appraisers on best practices and quality control
> Interface with clients and senior management during preparation and delivery of valuation assignments
> Additional duties as necessary

Knowledge, Skills and Abilities

> Knowledge of valuation concepts, financial theory, and general accounting
> Superior critical thinking and analytical math skills
> Strong utilization of Microsoft Excel to analyze financial data
> Ability to write clearly and concisely
> Aptitude in quantitative and qualitative analysis
> Must be able to give attention to detail while having the ability to step back and see the “big picture”
> Ability to comprehend, analyze, and interpret various business and real estate documents
> Research oriented
> Excellent communication skills, both verbal and written
> Desire to work both independently and in team environments
> Demonstrated ability to meet deadlines
> Positive and enthusiastic attitude
> MS Office with advanced Word and Excel
> Bachelor’s degree in business, finance, or accounting
> 2 years of applicable experience or coursework

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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.

The Condition of Business and Real Estate Asset Values

By Robert J. Strachota, MAI, MCBA, CRE®

Note:  The following article is a presentation given by Shenehon President Robert Strachota at the Minneapolis Business Law Institute on May 2, 2016.

I am Bob Strachota, president of Shenehon Company, which appraises businesses and commercial real estate throughout Minnesota and more than 40 other states.  We know the pulse of the Minnesota business climate and are in tune with market expectations of the near future.

Today, we will discuss the condition of the Minnesota business climate for commercial and residential real estate, and the general level of profitability for small and large businesses in our state.

The Minnesota business climate has two major tiers:  the 16-county Twin Cities metropolitan area, and the outstate Minnesota market. Rochester is an exception:  an outstate city that behaves differently than all other outstate cities because of the effect of the Mayo Clinic. Nonetheless, we will keep Rochester in the outstate category because it is not nearly as strong as the 16-county metro area.

The general health of the Twin Cities market is positive, and the prognosis is for a continued upward trend.  The healthy growth curve has not reached the crest of the wave or the high point of a business cycle.  The same applies for the outstate market, but the size of the wave is much smaller.

How do we know this? We typically focus on 6 critical community characteristics when sizing up the economic health of a market. They are:

  • Unemployment rate
  • Average wage level
  • Average age of population
  • Population growth
  • Employer and labor force data (new jobs)
  • Education level of workforce

Characteristics gauging economic health in Twin Cities 16-county area:

  • Unemployment rate: 3.9%
  • Average wage level: $20.75/hour
  • Average age of population: 36.0
  • Population growth: 4.3% from 2010 to 2015
  • Employer and labor force data (new jobs): 1.8%
  • Education level of workforce: 24.2% with Bachelor’s degree

Characteristics gauging economic health in outstate Minnesota:

  • Unemployment: 6.1% (up two-tenths over last year)
  • Average wage level: $17.35/hour
  • Average age of population: 41.8
  • Population growth: 0.7% from 2010 to 2015
  • Employer and labor force data (new jobs): 0.4%
  • Education level of workforce: 14.5% with Bachelor’s degree

Comparing the 16-county metro area and the outstate statistics with statistics for the United States at large underscores the strength of the Minnesota market.

16 counties-outstate-US

By analyzing data like this, we conclude that the Minnesota economy remains in an ongoing expansion, particularly in the 16-county metro area.  As this recovery matures, inflation, high interest rates, and cost-push will tamp down the expansion.  The risk of a Minnesota recession in the near term is low, and it does not appear that the recovery will be ending anytime soon.

Why?  Well, for one, the Minnesota economy is highly diversified. This is one of its strengths.  Of the various market sectors, the energy industry was the only one that was a strong component of the recovery but has now sharply corrected. A handful of Minnesota companies took it on the chin when oil prices plummeted.  The energy industry appears to be refreshing itself in recent weeks and may have already bottomed out.

Currently, there are no storm clouds on the horizon for the Minnesota economy. These would appear if the economy showed evidence of “excesses” by consumers or businesses. On the consumer side, there is little evidence of excessive spending and, in fact, the household savings rate has risen to near record levels in Minnesota.  Furthermore, household net worth is approaching record levels.  As a result, household debt service ratios are near record lows.

As for businesses, we do not see the kinds of excesses that typically reveal themselves ahead of a recession. Instead, we observe that most businesses are not overstaffed, and their capital spending has not been overdone.  Average factory utilization rates have not exceeded 80%.  The housing industry has not boomed out of control, and consumer confidence has been timid.  And, lastly, excessive lending and overbuying is not evident in the marketplace.

Growth image

Business has been good for most Minnesota companies. For 2015, the top 75 public companies operating in the state reported a combined increase of profit of over 5% from the previous year. This includes the energy-related companies that lost over $2 billion.  The total revenue for these 75 companies was over $512 billion, which tops every year since 2004.  Fifty of the companies on the list posted higher revenues than they did in 2014.

IRS and Medtronic

These are impressive results, but there is one statistic that we need to be aware of. The list we could previously study was called the Top 100 Public Companies.  A major reason for the list shrinking is that fewer companies are choosing to be headquartered in Minnesota. The trend is downward, but diagnosing the severity of the problem is difficult.

At Shenehon, we also appraise many private companies. This gives us access to financial information that is not public.  Right now, the patterns of success we have just reviewed for public companies are mirrored in the private sector.

For small businesses specifically, we conduct valuations for federal government Small Business Administration (SBA) loans, and we can report that small businesses are opening up at record levels, creating new jobs and becoming profitable on timely schedules.

So how does the current state of the Minnesota economy affect real estate asset values? Let’s study this by submarkets, which are residential, retail, office and industrial.


residential sales

The residential submarket has to be subdivided further into single-family homes and apartment rental housing.  The single-family home market in the 16-county metro area has been strong and will continue to get stronger.  Short sales and foreclosures no longer dominate the market and have fallen back to historical norms.

homes prices

The traditional home sale transaction dominates the market; both in the metro area as well as most outstate markets.  Average home prices throughout Minneapolis rose 3.98% in February 2016, compared to a national average increase of 5.1%.

Building activity

New housing starts are steady and nearly fully restored to historical levels.  The top cities in the metro area for new housing permits are shown in this next exhibit, with Lakeville leading in dollar value of permitted units, and Minneapolis leading in number of housing units.

Top cities for building

projects under construction

The apartment market is expanding at a record pace, with apartment projects planned throughout the metro area.  Outstate, we have over 1,000 new units planned in Rochester, coinciding with the Mayo expansion, and Duluth is way up as well – five developers have announced plans for a total of 577 new units planned for next year.


Rents continue to rise, and vacancies have shrunk to abnormally low levels.  Exhibit H shows average rents and vacancy levels in various areas in the 16-county metro area and certain outstate markets.

Twin Cities Apartments

Outstate Apartment market

There are two reasons why the rental market is so strong. First, many people lost money in the housing downturn and have chosen a different lifestyle while in recovery.  Second, most young people are saddled with substantial educational debt that precludes them from buying homes, either single-family or condominiums.  Many of us in the real estate industry believe the educational debt crisis will be the next financial debacle that the federal government will need to fix to return normality to the single-family home ownership market.

Student debt


Bolstered by a relatively modest rate of increasing personal income levels and lower fuel prices, demand in the national retail market outpaced supply during all of 2015.  Demand for available retail space in the neighborhood community segment was particularly strong during the year.

The average vacancy rate in the national retail market trended downward another 20 basis points in 2015, declining to the low 10% range.  The national average net asking rates increased 2% during 2015.

The first quarter of 2016 marked the fifth consecutive quarter of positive net absorption in the Twin Cities market.  Across all Twin Cities submarkets the 1st quarter vacancy rate sits at a mere 6.0% and average net asking rental rates are $15.66/sf.

The Minneapolis/St. Paul market experienced a moderate decline in asking rents during the first quarter of 2016.  However, due to the number of new retailers and new restaurants entering the market, demand is expected to cause rents to increase in most submarkets.  Market value of retail space has remained constant over the past year, but has now surpassed the all-time highs from before the real estate recession.

Let’s move onto the office market.


Overall the office market has been affected by somewhat slower job growth, increased financial market volatility, and a marked slowdown in the tech sector.  These influences contributed to a deceleration in the demand for office space in the first quarter of 2016.  During that time, the average rent in 87 metro markets in the US was $28.50/sf.  That was up 4.3% from the prior year.

Overall, vacancy throughout the United States is 13.5% in the office sector.  Current vacancy in the Twin Cities market is slightly higher at 15.1%, however that is down 1% overall from last year at the same time.  It is important to note that the vacancy for office space in the new, north warehouse loop is 6.4%, that is less than half of the national vacancy percentage and it is the tightest office market in our metro area.

In the Twin Cities, the average rent is $21.82/sf in the first quarter of 2016, which is up from $20.63/sf for a 5.8% increase from the prior year.  Office values in the Central Business District, or CBD, are the strongest and have experienced an increase over the past year.  The suburban office market in the Twin Cities as well as other cities has remained rather static throughout the past year.


Our fourth submarket is Industrial.

The manufacturing sector has improved in the first quarter of 2016.  US factory activity expanded in March for the first time since last August.  This is a sign that the nation’s economy is shaking off the effects of a strong dollar, depressed oil prices, and weak global growth.  Current production has picked up, with factory orders rising to their highest level since November of 2014.  All signs suggest there is a pickup in industrial production, yet businesses continue to work through the elevated stockpiles accumulated over the first half of 2015, when record inventories outpaced demand.

There has been progress because inventories have declined in four of the past five months, with one exception being a flat reading in December.  But despite these back-to-back inventory declines, the inventory-to-sales ratio remains elevated at 1.4 percent. This suggests that businesses will need to continue to work through the inventory overhang – which is hampering manufacturing and will curb GDP growth through the first half of 2016.

The average asking rent on a national basis in the first quarter of 2016 was $5.44/sf, which is 3.8% higher than the first quarter of 2015.  The United States national average of vacancy for industrial space is 6.1%, which is down from the historical average rate of 6.8% in the first quarter of 2015.

In the Twin Cities market, the overall vacancy for industrial space at the end of the first quarter of 2016 was 9.4% compared to 10.6% one year ago.  The weighted average rent per square foot for industrial space in the Twin Cities market at the end of the first quarter of 2016 was $6.72/sf, which was up 6% from 2015 when it was $6.32/sf.  At the end of the first quarter of 2016, approximately 900,000 square feet of positive absorption occurred in our industrial market.  Over the last five quarters, the industrial market has absorbed 4.4 million square feet of space.

This is a lot of data to crunch… suffice it to say that in my professional opinion, we can conclude from these numbers that, in the Twin Cities area, the industrial market is healthy and will likely only get stronger.

During 2016, we expect to see an increase in market values or pricing of industrial space that will set new high water marks for industrial property.

Another proof point for this expectation is that the average price per square foot on a national basis increased 9.5% in 2015, which reaffirms the strength of the industrial market.


I would like to wind down by sharing a brief listing of real estate and development opportunities for 2016.

Investment opportunities in gateway markets like the Bakken fields have come and gone. However, opportunities now exist in:

  • Technology Centers. Companies are collaborating on larger facilities with enhanced security to safeguard data and confidential records.
  • Neighborhood development. There is some small neighborhood development available for retail, such as coffee shops, small stores, and specialty services. Anything that starts with an “R” is a safe bet – renovation, rehabilitation, re-position, re-lease, refinance.
  • Residential condominium development. Opportunities exist in spot markets, such as downtown Minneapolis, where there is an acute shortage of “for sale” condominiums. But a 10-year clawback by homeowners is a deterrent.
  • Most Mixed-use urban infill development and redevelopment will be strong, if strategically located.
  • Prime retirement land. Development opportunities will be back as demand for retirement homes in warm places like Florida and Arizona reignites.


  • Last opportunities to lock down favorable long-term, fixed rate debt. Commercial mortgage-backed securities (CMBS) are back, the competition in the lending market is strong and interest rates are below long-term norms. Some owners are refinancing and leveraging up with cheap debt – in a sense, selling to themselves without paying income taxes by using non-recourse debt. But the interest rates are rising and the time is limited to lock down favorable long-term debt.
  • Bargains in Downtown Minneapolis leasing. As Wells Fargo moves to new offices, look for bargain pricing on Class B office lease and subleases in the core of downtown Minneapolis.


Before I close today’s presentation, I want to make a few cautionary comments about market pricing for 2016.

Market pricing is strong across all submarkets; bargains can still be found in large, high-end luxury housing.  There is a strong risk of overpricing in apartment buildings, while hotels are not far behind.  The expectation of low capitalization rates, i.e. sub-6%, is not sustainable.  Corporate balance sheets are strong and earnings are holding, but for foreign exchange issues for multi-nationals.  Unemployment is tightening, but wage growth will be slow because the US competes in a world market of lower wage levels.


Closer to home, here are the takeaways for Minnesota’s economy:

  • Our state’s economy is growing ahead of national trends in the 16-county metropolitan area, and ever so slowly in the outstate areas.
  • Minnesotans are back to work and consumer spending will continue to improve, due to increased “housing wealth,” a recovery stock market, and confidence from de-leveraging.
  • Minnesota businesses will postpone spending and hiring decisions because of a lack of confidence in our current politicians and their strategies for government spending in the future.
  • The Minnesota economy will continue to recover, but it will not boom until the federal government restores confidence in the marketplace on key factors such as employment, inflation and bipartisan cooperation on balanced budgets and deficit reduction policies.

And thanks to each of you for the opportunity to share my thoughts on Minnesota’s business climate for commercial and residential real estate, and the general level of profitability for small and large businesses in our state.

Sources for this article:  Standards & Poor/Case-Schiller, U.S. Census Bureau, Bureau of Labor Statistics, Jones Lang LaSalle, CBRE, Colliers International, Metropolitan Council, The Builders Association of the Twin Cities, Duluth News Tribune, City of Rochester Comprehensive Annual Financial Report, Northstar/MLS, NAI Everest, MPF Research, Zillow

Industrial Market – 2015 Recap


Posting positive demand for the 23rd consecutive quarter in the fourth quarter of 2015, absorption in the national industrial market totaled nearly 220 million square feet during the year, with the pace of absorption increasing across most major markets.  Several trends and factors are supporting strong demand in the industrial sector.

Most notably, e-commerce sale activity continues to increase at an impressive rate and companies are responding to consumer preferences by shortening the supply chain to deliver goods more quickly.  Additionally, a number of coastal markets are also benefitting from the anticipated opening of the Panama Canal expansion.  Given the changing landscape, demand in the industrial sector is projected to be healthy through at least the near and into the long term, and to a significant degree, a sizeable amount of absorption in the industrial sector will come at the expense of the retail sector.

Absorption in the industrial sector during the year was led by the logistics segments, though positive demand was also noted in the light industrial segments.  Demand remains robust throughout all regions.  The strongest absorption figures continue to be noted for logistics space in primary industrial markets, including the Atlanta, Chicago, Dallas-Ft. Worth, and Inland Empire markets.  Absorption in the Midwest region is led by the Chicago market, followed by the Indianapolis, Detroit, and Twin Cities markets.

Led by demand for warehouse and distribution space, absorption in the Twin Cities industrial market totaled approximately 3.55 million square feet in 2015.  The light industrial segment in the local market also was consistently healthy during the year.

New Construction

Led by growth in the logistics segment, new construction activity in the industrial sector increased at a rapid pace in 2015, with the amount of new distribution space added during the year particularly impressive.  New construction deliveries involving logistics space, including both distribution and warehouse properties, increased by 2.5% over the year ended December 2015, while new construction in the light industrial segment increased by 0.2% during this period.  Accounting for a significant portion of the sectors pipeline, speculative construction activity in the industrial sector has surpassed pre-recession levels, with sources indicating as much as 40.0% to 60.0% of new logistics properties under construction are being built as speculative projects.

Among regions, new construction activity is strongest in the West and South regions, but construction levels were also strong in the Midwest and Northeast regions.  Over 20 million square feet of new inventory was delivered in the Inland Empire market during the year, while new construction added over 15 million square feet of space in both the and Chicago and Dallas-Ft. Worth markets.  Despite widespread industrial construction activity in the Inland Empire market, the market’s vacancy rate decreased into the low-3.0% range at the close of 2015, down 80 basis points compared to the fourth quarter of 2014.  In the Northeast region, developers continue to remain active in the Lehigh Valley market, with Liberty Property Trust construction a 1.7 million-square-foot distribution building for Uline and Duke Realty scheduled to deliver a 1.1 million-square-foot speculative building in 2016.

Development activity in the Midwest region was led by the Chicago market, but supported by widespread new construction in the Indianapolis, Kansas City, and Twin Cities markets.  Although the pace of new construction activity in the Indianapolis market appears to be slowing, developers added nearly 6.5 million square feet of speculative space to the market over the last 18 months, adversely affecting occupancy levels in the face of healthy absorption figures.  Developers added roughly 1.77 million square feet to the existing Twin Cities inventory in 2015.  Development activity in the Twin Cities was strongest in the Southwest submarket, but developers are active throughout much of the area.


In the face of robust new construction activity, vacancies in the national industrial sector decreased by 40 basis points in 2015, declining into the mid-7.0% range at the close of the year.  Vacancy rates in over 20 major markets have fallen below 6.0%, and on the national level, vacancy rates have declined by approximately 3.5% in the last five years.  Occupancy levels in the light industrial segment noted the most significant improvement in 2015, but vacancy rates continue to remain tighter in the logistics segment, in spite of new development activity.

Occupancy levels further increased within most major markets.  Vacancy rates remain tightest in the West region, but softer occupancy levels were noted within some markets in the region compared to the year prior.  Occupancy levels in industrial markets throughout the Midwest largely remain strong, but a surge in speculative development is testing demand in several Midwestern markets.  Vacancy rates in the Twin Cities market declined by a sizeable amount in 2015, and though excess capacity exists, noticeable improvements in occupancy levels were recorded in the Southwest submarket.

Asking Rent

Over 50.0% of major markets recorded year-over-year asking rent growth of greater than 3.0% in 2015, as rents increased at a robust pace in both the logistics and light industrial segments.  Strong rent growth was noted across several Midwestern markets, and asking rents advanced across all submarkets in the Twin Cities industrial market, but the strongest growth was observed in the Southwest submarket.

Investment Activity

The industrial sector has emerged as a preferred asset type for institutional and foreign investors.  Favorable investment returns and minimal capital expenditures compared to other asset types as well as the emergence of e-commerce have attracted investors to enter and expand their reach into the industrial market.  Sales activity in the national industrial market increased by 44.0% year-over-year in 2015, with sales volume totaling nearly $72 billion for the year.  Sales activity in the industrial market began the year at a robust pace, before reaching a lull in the second and third quarters of 2015, and then finished strong in the final three months of the year.  Sales volume in the light industrial segment increased by approximately 30.0% year-over-year in 2015, but activity in the light industrial segment remains overshadowed by investment in logistics space.

Industrial assets have become a favored property type among foreign and institutional buyers, resulting in stronger pricing and capitalization rate compression.  The average sale price on a per square foot basis in the national industrial market increased by 9.5% year-over-year in 2015, while average capitalization rates in the sector decreased by 40 basis points during the year.  Prices increased in both segments of the industrial market, with the average price per square foot in logistics approaching $70 per square foot and surpassing the $80 per square foot in the light industrial segment.  Capitalization rates in both the logistics and light industrial segments compressed at a similar rate during the year, and private investors in the industrial sector remain aggressive in underwriting rents and vacancy.

Some concern in the national industrial market, and in the broader commercial real estate market, is the greater amount of portfolio and entity-level transactions.  Three massive sales accounted for over 20.0% of all industrial sales volume in 2015.  Exeter Property Group sold a 57.9 million-square-foot industrial portfolio for $3.15 billion in December of 2015.  Earlier in the year, Global Logistic Properties and Singapore’s sovereign wealth fund completed an $8.1 billion purchase of IndCor Properties industrial assets and operating company from Blackstone, while Prologis and Norges Bank Investment Management purchased a portfolio from KTR for $5.9 billion.  The KTR portfolio contained 60 million square feet of operating space, 3.6 million square feet of space under construction, and a land bank with a build-out potential of 6.7 million square feet.

A number of large single-property sales also occurred during the year, with a significant amount of activity noted in the Midwest region.  Two of the largest single-property transactions at the national level in 2015 involved Duke Realty selling a mission-critical building leased by Amazon in Delaware for $91 million, equating to approximately $89.50 per square foot, and the sale of a newly-built Home Depot Fulfillment Center in Ohio for $97 million or $59.20 per square foot.

Mirroring trends at the national and regional levels, industrial investment activity in the Twin Cities was strong in 2015.  Several large portfolios in the Twin Cities market were sold during the year, but sales velocity drove sales volume in the local market and investment activity in the local market was consistent throughout the year, with healthy activity noted across all segments and submarkets.  One of the largest transactions in the Twin Cities market during the year included the sale of the BAE building for $46.8 million to Gramercy Property Trust in July.