From a small northwestern observatory…

I devote a whole chapter in Real Estate Valuation and Strategy to this topic, with some additional insights in other chapters as well. Time and time again I’ve seen family businesses (car dealerships, restaurants, manufacturing, etc.) with a substantial portion of their net worth tied up in the real estate needed to support the business. There is no question that this real estate investment is necessary, but three issues seem to regularly arise:

1. The value of the real estate changes over time in a different arc from the business itself. In fact, I’ve seen situations where the business value dissipates to near nothing but the value of the underlying real estate increases, to the point where the real estate, if vacant, would be worth more than it is presently worth incumbered with a business. This phenomenon is often masked because the family business fails to account for the imputed rent on the real estate (the rent it would pay every year if it didn’t own the dirt) and all of the so-called profits in the business are really just foregone imputed rents.
2. The real estate isn’t managed well over time. This includes, but is not limited to, failures to maintain proper insurance, failures to manage environmental issues, and mismanagement of property taxes.
3. When the business passed thru generations, some family members may want to actively participate in the business, while others may want to enjoy passive income on the assets. Proper allocation of “rents” (business returns versus real estate returns) and proper compensation of the family members who do managed the business can be complicated without realistic value allocations.

Naturally, a lot of these problems get settled at probate, but waiting until then often leads to costly and time-consuming problems For example, waiting for the inevitable limits the options for estate planners to develop orderly and tax minimizing solutions. Further, it often entails wealth dissipation over time, as the underlying real estate is mis-managed.

For example, we knew one extraordinarily wealthy investor who had a bad habit of putting the vast real estate holdings that supported his extensive business interests in his personal name. This became even more complicated when it was found that some net ground leases and other contracts supporting real estate investments were also personal contracts. After he passed away, it took a team of not-inexpensive attorneys a decade to straighten out the problems.

Another family, with substantial real estate holdings underpinning their business, finally asked to have all of the property valued when the principals (several elderly family members with complex joint ventures and family holdings) neared retirement. The real estate had been accumulated opportunistically over many years, and often adjacent to existing holdings (and thus gaining some hidden aggregation values). Most of the holdings were in areas which enjoyed above-average value growth over time. The final valuation came in with some substantial sticker shock, with liquidity implications for any sort of estate settlement.

Over time, the real estate needs of the business may change. For example, the site size may not be optimal, either too much or too little land. Recent word from southern California indicates that Disneyland, thanks to ride-share and such, no longer need as much parking as they did just a few years ago. With that, they plan to convert some parking into new attractions for the park. In a somewhat different example, a manufacturing / distribution firm saw a very significant shift in the highway on which it fronted, necessitating trucks approach the facility from a different direction. This, in turn, had very real implications for truck turning space, parking, and even the location of loading docks and doors.

Family business owners with underlying real estate should, at a minimum, consider the following for internal and estate planning purposes:

1. Have the real estate and the business valued separately, as if they had separate owners, preferably by different valuers. Then compare this to the value of the integrated whole. Repeat this process periodically, as valuations shift over time.
2. At least for internal discussions, compute the imputed rent on the real estate (the rent you would pay if you didn’t own the dirt) and then deduct this from the business ledger as if it was an actual expense. Even if you don’t have passive family member-owners, this exercise lets you know how much you earn from the effort of running the business, and how much you’d alternatively earn as a passive real estate investor.
3. Periodically, review the real estate holdings with a qualified consultant, with an eye to long-term holdings and optimizing both the real estate owned and the business served by that real estate. Such an “audit” should include a review of property taxes and an allocation of the real estate rents.

Obviously, I put a lot more into the book chapter, and if this is a problem you or a client faces, I would encourage more research into the topic. If I can be of any assistance, or answer any other questions, please let me know.

John A. Kilpatrick, Ph.D., MAI — john@greenfieldadvisors.com

While much of my writing is on real estate investing, we’re probably better known at Greenfield for our work in complex property-related litigation. Naturally, we keep track key issues in the field as they affect finance, economics, and valuation. Here are a few choice pieces that recently crossed my desk.

Leasehold, Leased Fee, or Fee Simple?

More often than not, the valuation goal in litigation is the determination of market value, but market value of what? The often misunderstood link is the interest being valued. Fee simple is the most common (it is the complete bundle of rights — what you normally think of when buying real estate). Leasehold is the interest held by a tenant, and may have positive value if the lease rate is below market. Leased fee is the bundle of rights retained by the landlord, and it, too, may have positive value. These questions are at the heart of many commercial tax appeals, and the valuation questions are still very much up in the air.

Cox v. Grady Hotel Investments (Missouri Court of Appeals. Western District, July 28, 2020, 605 S.W.3d 575) addressed this very question. Grady purchased hotel improvements located on land leased from the Kansas City International Airport. Note that the land is exempt from property taxation. The County assessed Grady’s leasehold interest in the property at $13,447,000, but the state tax commission hearing officer demurred, holding that Grady had a possessory interest and as such the appropriate value was the purchase price less any costs toward new construction, or $7.3 million.

The full commission set THAT aside, and concluded that Grady did indeed have a leasehold interest, but the airport still owned the fee simple interest in both the land and the improvements. Thus, the commission held that the proper valuation should use the “bonus” method, which is the difference between the economic rent and the contract rent. Based on that, the Commission assigned a bonus value of zero. The Assessor appealed, and the Circuit Court held that the zero value was arbitrary and not supported by law, and thus the bonus value was not applicable. The Court ordered the commission to consider the sales price as evidence of value. Grady then appealed. The Court of Appeals concluded that the that the language of Grady’s original quit-claim deed was unambiguous, that Grady had purchased the “leasehold improvements” and that the title to the land and the title to the improvements were to be treated as separate items and that the bonus method was inappropriate.

Do the birds like it?

In 2002, Pollard Land Company purchased over 2000 undeveloped acres along the Savannah River north of Augusta, Georgia. It conveyed 463 acres to the Champions Retreat Golf Founders LLC which built a 27-hole golf club open only to members. Champions also sold 66 homesites on 95 acres and left 57 acres along the river undeveloped. The property is home to several rare species of birds, to the southern fox squirrel, and to several rare plant species. In 2009, Champions contributed a conservation easement to the North American Land trust covering 348 acres, including the golf course and the 57 acres (but not the course buildings and homesites). Notably, while the general public cannot access the land directly, they can view the land from the river, and across the river there is a large national forest.

The IRS and the Tax Court disallowed the conservation easement deduction, and Champions appealed. The IRS’s valuation expert agreed that many birds do use the property but opined that the habitat itself was not “relatively natural” due to the fairways and greens, which contained non-native grasses. The IRS also argued that the land was not open to the general public. However, in Champions Retreat Golf Founders LLC v. Commissioner of the IRS (11th Circuit Ct of Appeals, May 13, 2020, 959 F3d 1033) the appeals court found that Champions was entitled to the deduction, noting that members of the public could canoe and kayak thru the easement, and birds do live on the property and “apparently find the habitat quite suitable.”

Is the easement in perpetutity?

Hoffman Properties of Cleveland, Ohio, donated a historic façade easement to the American Association of Historic Preservation, and took a tax deduction of $15 million. One requirement for such a deduction is that the easement must be in perpetuity. However, Hoffman and the Association included a caveat in the donation that Hoffman could alter, reconstruct, or change the appearance of the façade upon approval of the Association. Further, if the Association failed to give or deny approval within 45 days, then approval was deemed to have been granted.

The Court held that this caveat constituted a lack of perpetuity to the easement. Further, the Appeals Court held that the 45-day clause went even further, divesting the Association of the power to enforce protections if it failed to act within a narrow window. Thus, the deduction was disallowed in Hoffman Properties II LP v Commissioner of Internal Revenue (6th Circuit Ct of Appeals, April 14, 2020, 956 F3d 832).

Is a rezoning likely?

In Helmick Family Farms LLC v. Commissioner of Highways (Sup Ct of Virginia, August 29, 2019, 297 Va. 777) the key issue in valuation for a highway department condemnation was whether or not the rezoning of the ag land to commercial. The Commission valued the land, which zoned agricultural and used for cattle grazing and growing hay, at $20,281. However, Helmick offered expert testimony and valuation that the county had planned for several years to redesignate this for commercial or industrial use, and that the market value was thus actually $321,000. At the trial court level, the Commission successfully moved to have Helmick’s expert testimony excluded, holding that it was speculative. On appeal, the Supreme Court noted that Virginia law had never directly addressed this, but that there was a “avalanche of authority” from other jurisdictions that such testimony was generally permitted. The key element was that this rezoning was likely, and therefore a willing buyer, with reasonable knowledge of this, would factor it into the purchase price and thus this testimony should be admissible.

Thanks to Benjamin A. Blair, JD, of Faegre Baker Daniels LLP, writing in various recent issues of The Appraisal Journal for bringing these to my attention. As always, if we can elaborate on any of this, or answer any of your questions about these or other complex property cases, please let us know.

John A. Kilpatrick, Ph.D., MAI, john@greenfieldadvisors.com.

It’s a bit off topic for me, but I was struck by an article this morning about the movie business. I spend very little time in that subsector, but naturally have been intrigued given the impact of COVID. While the pandemic has damaged many sectors, it has absolutely eviscerated the movie chains. Given the amount of real estate devoted to this sector, it’s worth taking a peek.

Most movie goers — even those of us in the real estate biz — have little understanding of how movie real estate works, and indeed there is no exact one-size-fits-all. Going into the pandemic (as of March, 2020), there were 5,477 movie theaters in the U.S. (not including 321 drive-ins). The unit of comparison in that industry is the “screen”, much like the unit of measure for a hotel is “rooms” and for apartments is individual apartment units. As of that same date, there were 40,449 screens, for an average of slightly over 7 screens per theater. In recent years, however, the trend has been toward fewer but larger locations, and the modern movie multi-plex has more like 11 screens. About 20 years ago or so, there was a very real consolidation, with many theater locations closing but many more screens popping up, as shown below.

Data courtesy the National Association of Theater Owners

The typical modern theater has an owner and an operator who may be different entities. For example, AMC, the largest operator in the U.S., operates 8,218 screens. Their nearest competitor, Regal, operates 7,350. Of course, these numbers were as of pre-COVID. In the same way that Marriott “operates” many hotels that they do not actually own, many (most?) of these theaters are owned by private entities. EPR Properties, for example, is a specialty REIT focused on “experiential” real estate, such as theaters, day-care centers, golf courses, and such. They own 179 theaters as of the end of 2019, although there is no report on exactly how many screens they have. They don’t operate any of these, but rather lease them out to operators like AMC.

Measuring the market value of this real estate is tough. Based on recent data from EPR and AMC, we can very roughly estimate that the value of a stand-alone movie theater is about $2 million per screen. With that, we have about $81 Billion in movie theater real estate in the U.S., including the furniture, fixtures, and equipment. These have been basically dark since the onset of the pandemic, much like other hospitality real estate, such as hotels and restaurants. Of course, when the pandemic is finally over, hotels and restaurants will eventually fill up again. However, movie theaters had already been feeling the headwinds of Netflix and other on-line services even before the pandemic came along. The industry is facing the very real possibility that movie-going habits will significantly change when the restrictions are lifted. Indeed, the streaming services are banking on that, and investing billions to back up that theory.

Movie-going has enormous spin-offs, including adjacent restaurants, parking lots, and shopping. Some large multi-plexes are part of malls, and some small boutique theaters are attached to bowling alleys and other experiential venues. Much like the change in brick-and-mortar retail, the impact of this shift on the real estate landscape may be very large and very real.

“May you live in interesting times”.

As always, if you have any questions or comments on this, please reach out!

John A. Kilpatrick, Ph.D., MAI — john@greenfieldadvisors.com

Last week, I talked about one value-added proposition for real estate investing — looking for 1 + 1 = 3 opportunities. Today, I want to take that theme another step with the idea of looking for Class “C” properties in Class “A” locations. First, though, a little terminology may be in order. There are no hard and fast definitions for Class “A”, “B”, and “C” properties. One can generally think of a Class A property as the top of the heap (perhaps even including Trophy Properties). Considering an office building, these will usually be very large, have top-tier security and decorated lobbies, more than sufficient elevators, and attract the top-tier tenants. Class A properties will almost always be large, and located on major arterials in the central business district (“CBD”) There are of course exceptions, but this is the norm in major cities. Corner locations (or even full city blocks) are preferred. Class B properties in the CBD will be located near Class A, but will not feature the same caliber of amenities. Lobbies will be smaller, and the building services will be somewhat reduced. These buildings will usually (but not always) be located on interior lots on main arterials, but not on corners or full city blocks in the CBD. Of course, in secondary neighborhoods, where there are no Class A buildings, the Class B building may occupy what would be a Class A spot if it was downtown.

From a location perspective, the Class C properties are usually located in secondary or tertiary neighborhoods. These are bare-bones properties, often smaller, plainly built and decorated, and with very few amenities. However, there are important exceptions to the rule, and this is what we’re seeking today. Consider a small, plain building located on a side street in the CBD. First, from a purely theoretical perspective, why is it there? Among office buildings, there are often tenants who need close access to Class A tenants but do not want (or need) to pay Class A prices. In the retail sector, there are many businesses that want benefit from the traffic generated by the top-tier retailers on the corner. Of course, in any CBD there will be a need for small lunch counter-type restaurants, bank branches, and the like.

It’s axiomatic that no one wants to invest in a declining market (although there are exceptions!). However, in an improving market, these “C” properties may get overlooked. After all, serious investors want to snatch up the “A” properties and plaster their names on the big signs, right? However, an improving market probably sees an increase in class “A” tenants, and as such an enhanced demand for the sort of spill-over tenants that occupy the C properties. Class C properties are more likely to be owned by individuals (rather than institutions) who may not have the resources to properly maintain them or keep abreast of technology. As such, they can be very likely candidates for the sort of 1 + 1 = 3 strategy I talked about last week.

Consider apartments, for example. Older apartment complexes may look the part, with older appliances, tired landscaping, peeling paint, and worn out carpets. Even the parking lot may look tired and worn. However, these are cheap things to fix. An older apartment complex in a good neighborhood can be a very real investment opportunity, given the resources to fix-up and modernize. Smaller rental units in great neighborhoods — duplexes and single family residences — can also fall into this category.

The lesson last week was to look for tired properties that need some repair or rehab. The lesson this week is to look for those tired properties in great locations. I discussed a lot of this in Real Estate Valuation and Strategy. As I mentioned last week, over the course of the next few blog posts, I’m going to share some ideas that work in the real market, at a variety of value points such that even the most fledgling investor can find some opportunities.

As always, if you have any questions or comments, please reach out! I look forward to hearing from you.

John A. Kilpatrick, Ph.D., MAI — john@greenfieldadvisors.com

Several years ago, I had a client – a family fund, actually – that had a neat, very long term investment strategy. To simplify, imagine that they started with $2 million. They found a “fixer upper” property that could be purchased for $1 million, and then spent the other $1 million on repairs, upgrades, etc. After the fix-up, the property was worth $3 million. They then finance the property, taking out $2 million in cash, and do it again. Do this 100 times, and you have $300 million in property and $100 million in net equity. Neat, eh?

Now, there are three caveats to this precise strategy. First, you need to start with $2 million. Second, you need to think VERY long term. Finally, it’s helpful (but not necessary) to have a market where real estate values are steadily growing. However, these aren’t barriers to entry, and even a more modest investor in a flat market can make this math work.

One of the important benefits in real estate investing is the value of entrepreneurial effort. In the stock market, informational efficiencies and rational expectations generally prevent significant abnormal returns for your effort. While there are noteworthy exceptions, the stock market investor is usually a tape reader (as they used to call them) and a victim of the systemic shifts in the market.

Conversely, the savvy real estate investor enjoys a significant return for his or her effort, and in the case of my client, this entrepreneurial effort can be capitalized into a non-taxed increase in value. The key, however, is finding value-added projects, where the value increase exceeds the cost. All too many real estate investors miss the mark on this, and end up with no net increase in equity, or worse spending more than they receive in value return. The graphic below simplifies the decision rule. Consider investments where the value exceeds the cost, rather than the other way around. As simple as this seems, all too many real estate investors trip up on this simple rule.

Another key element — you make money when you buy real estate, not when you sell. My clients were careful to seek out investments that needed a facelift — ugly properties that could benefit from some significant sweat equity.

So, how and where do you find these diamonds in the rough? I have a few ideas, and in fact discuss many of them in Real Estate Valuation and Strategy. Over the course of the next few blog posts, I’m going to share some ideas that work in the real market, at a variety of value points such that even the most fledgling investor can find some opportunities.

As always, if you have any questions or comments, please reach out! I look forward to hearing from you.

John A. Kilpatrick, Ph.D., MAI — john@greenfieldadvisors.com

February started off like gangbusters, and indeed by mid-month we’d reached record return levels. Then the air leaked out of the tires the last week of the month, leaving us disappointed. We continue to outpace the S&P and the global REIT index overall, but February did little to contribute to those numbers.

As you can see, a dollar invested in ACCRE at the inception would be worth $1.68 today (an annualized return of about 14.5%), compared to that same dollar in the S&P which would be worth $1.61. The S&P Global REIT Index has performed very well this year, climbing out of its negative return hole last year into positive territory, albeit still only at $1.22 overall for the life of our fund.

On a risk-adjusted basis, ACCRE’s Sharpe Ratio continues to best the S&P, albeit somewhat less than last month. Part of this is a very real improvement in returns to the S&P, and part is a slightly higher level of volatility for ACCRE. I would note that for the past few months, ACCRE has been nearly uncorrelated with the S&P, but in February returned to its normal correlation of about 50% (positive).

Again, for the uninitiated, the Average Daily Excess Return is the daily return minus the return that would have been earned in a risk-free asset (here, the coupon-equivalent 13-week T-Bill, measured daily). The Sharpes Ratio is the ratio of those excess daily returns to the standard deviation of those returns (the measure of volatility) and serves as a proxy for risk-adjusted returns. ACCRE usually has higher excess returns and almost always has lower volatility, hence a higher risk-adjusted returns.

Best wishes to you all, and if I can answer any of your questions on REITs or real estate strategies, please drop me a line.