Case Studies

Case 4 - Damages in Paradise

Fri, 19 Aug 2011 04:15:00 GMT

Counting the consequences of financial impairments

Owners of fractional units in a new resort development got a big surprise the day their purchases closed – their interests came with liens attached. A few months later things got worse when the developer missed the first (rather large) HOA payment. It sure looked like the value of the interests had been impaired, but by how much?

The amount owed to contractors was in dispute, somewhere between $7 and $12 million. The developer had not filed for bankruptcy at the time, but had more than $20 million in secured debt coming due, and there was no possibility that he could refinance the obligation. As seller of the units, he had no duty to disclose financial status per sé, but did have an obligation to hold funds received from the owner/claimants, almost $40 million, in trust for payment on the construction contracts.

The liens were against the entire project, but before any foreclosure, they would have to be apportioned between interests; however, not all liens applied to the fractional interests at issue. Thus, a cure amount would not be known until the litigation process had resulted in the apportionment, and there would be substantial uncertainty regarding how apportionment would be handled. The lien claimants were not willing to entertain individual settlements.

Counsel represented nearly 170 claimants, and brought us in to develop an opinion of damages to the ownership interests from the two causes. The value opinion was needed to support a claim before the Bankruptcy Court.

THE VALUATION PROCESS

Financial impairments due to detrimental conditions are most effectively valued by breaking down the discrete steps from the date of value to date of cure; they are generally discovery, assessment, repair and then any market resistance issues. The process for this sort of valuation is well-understood as it applies for physical conditions (affecting land and building, such as contamination, construction defects), external conditions (nuisances), conservation issues and many others [1]. What is not as well-understood is that ownership and financial damages will yield to the same valuation process. Marketability impairments are often viewed as existing on a different planet, but the process and its elements are much the same [2]. Simply put, the degree of value impairment is directly related to time, and inversely related to risk.

OUR SOLUTION

Working closely with counsel, we developed multiple scenarios for possible future events and their timelines, the risk they represented, and weighted their likelihood of occurring. The base was the unencumbered unit value (based on the purchase price), and we were looking for the market impairment of this base. The impairment is a function of the restriction period of each scenario, and the risk to the interest holder during that period. Put another way, the impairment can be understood by observing the multiple phases of each scenario: 1) discovery, 2) assessment, 3) repair (in this case settling outstanding obligations) and 4) any market resistance issues.

Valuation models included present value and options pricing. The impaired positions are riskier than the base, and this risk is accounted for by adjusting the investor's required return, or yield. The unimpaired, base level yield is the real estate (hotel) rate, which is the return required by the owner of the entire project, with no impairments. Next, this yield is increased for conditions associated with individual unit interests, including acquisition conditions (sales pressure) and personal use (intangible) benefits. Yield increases again for specific impairments, including uncertainty of the holding period and lawsuit risk. The models also factor in value growth over the period and costs associated with events during the period. Escrows closed in month 0. Liens were (expected to be) filed in month four.

Scenario A: Claims are settled in month four and liens are not filed. Concluded discount 7%.

Scenario B: Liens are filed and litigation commences, but the matter is settled four months later and the liens released. Concluded discount 17%.

Scenario C: Liens are filed and litigation is protracted. The matter is settled 17 months later and the liens released. Concluded discount 31%.

Scenario D: Same as C except that rather than being settled, the liens are apportioned at 17 months (necessary before foreclosure), then both liens and HOA deficiencies cured by claimants. Concluded discount due to delays and risk 32%, add effect of costs and uncertainty at 38%, concluded discount 70%.

Scenario E: The same as D except that an appeal period is added, and liens are finally apportioned at 30 months. Concluded discount due to delays and risk 44%, add effect of costs and uncertainty at 37%, concluded discount 81%.

The scenarios were weighted mostly toward B and C, with very little likelihood of E occurring. The concluded discount was 22.5%, and this percentage multiplied by the base value of the interests was the value impairment.

THE OUTCOME

This sort of analysis can be almost infinitely complicated, and there are indeed probabilities within probabilities. The problem can appear quite daunting at first, but mapping them from discovery to cure, then assigning risk-adjusted returns to each scenario, can bring a great deal of clarity. The interest holders indeed suffered when blindsided with liens and developer failures. Their interests were quickly loaded up with potential liability and an uncertain future.

The arguments need to be easily followed, and in the end, must bend to common sense. In this case, Counsel had the advantage of our comprehensive analysis and persuasive narrative. The claim was accepted by the bankruptcy court, and the claimants received a significant payout; a very successful result.

[1] "Nonphysical Damage–Fractional Discounts," a case study included in a book by Randall Bell, MAI, "Real Estate Damages: Applied Economics and Detrimental Conditions" (The Appraisal Institute, Chicago: 2008): pages 266-269. This book is the most current and authoritative on real estate damages.

[2] Ibid, Dennis A. Webb, ASA, MAI, FRICS "Nonphysical Damage – Fractional Discounts Case Study."

Case 3 – When Partnerships Deteriorate

Fri, 17 Jun 2011 04:47:00 GMT

Valuation supports resolution

Our client in this case was a well-known foundation, and at issue were several very large real estate partnerships, with combined assets worth about $400 million. Their principal holdings were large apartment projects in the U.S.

We were asked to help resolve a dispute between the foundation, who is a majority limited partner, and the general partner. Their relationship had degenerated with the souring real estate market, and with the general partner getting fairly exorbitant fees under an old management contract, while there was little cash flow for the limiteds. There were few options left, and their choices all involved the risk of litigation.

LET’S MAKE A DEAL

The client wanted to make some sort of deal, perhaps buying out the general partner, or selling to it, or changing the agreement in some way. But each scenario involved various transfers of rights, and those sets of rights had varying degrees of control, liquidity and claims on cash flow. The client needed to have a pretty good idea of value under a fair market value premise, a fair value premise, and an indication of values the other side could claim in an adversary proceeding. The options were much more complex than initially believed.

INTEGRATING THE REAL ESTATE

Our valuation comprised both the real estate assets and the partnership interests. This was critical because the property facts and value trends were integral to understanding the rights and options of the various partnership positions. Additionally, a large stack of real estate appraisals is unwieldy and expensive; our fee ended up at about half of what it would have been with traditional, individual property appraisals.

The appraised value of the assets at one point in time was only a small part of the problem. What was the value effect of the management contract? (Answer: Huge.) What about the incentive of the GP to maintain its management fees? How might this affect other decisions that would be desirable for the limiteds? How does this affect the discounts? Property characteristics and market trends influence valuation discounts, the relationship of the partners over time and the partnership decision-making process in ways that consideration of the fee interest in the real estate alone would not reveal or anticipate.

CHANGES AND PREMISES

Each of the positions had to be valued under differing premises: The LP position as noncontrolling nonmarketable and noncontrolling marketable (modified because it did have certain negative control abilities, such as approving asset sales), and GP position as controlling, both marketable and nonmarketable, but also considering its liability to the 30 or so other limited partners. Fair market value includes discounts which may or may not show up under the fair value premise.

A second set of issues resulted from changing market conditions. Some of the apartment projects had condo maps, but the market for conversions had never developed in this area. It was all new. This was important for the client, because its position had approval rights for any major asset sale, and conditional offers submitted to management were all over the map. What was the sellout potential based on condo mapping? What sorts of offers could the client reasonably approve?

THE OUTCOME

The conclusions were complex, but organized in a way that supported the client’s decision-making process. In the end, litigation was avoided, and neither side bought out the other. The client’s board of directors was able to approve some asset sales. A long-festering problem was steered to a more amiable conclusion through understanding of how the various positions and scenarios were valued.

Litigation sometimes resolves disputes using Solomon’s method, with appraisers supporting each side’s position and the Court cutting the baby in half. Our approach is to increase our client’s understanding of valuation issues and other likely positions, so that the most constructive choices can be made. And, when it comes to it, providing opinions of value that prevail.

Case 2 – Agreement Blind Spots Revealed

Fri, 17 Jun 2011 04:48:00 GMT

What you need to know to take control of the outcome

Effective agreements for holding and managing assets don’t have blind spots – or do they? Partnership agreements of one sort or another have legal objectives to be sure, but they often have valuation objectives as well. These valuation objectives can be extremely sensitive to facts & circumstances outside the agreement. This is not about missing legal matters, but about missing other facts that underlie valuation matters, and that have an effect on the overall goals of the lawyer’s engagement.

The lawyer can have better control of the results by engaging in a simple exercise. Imagine a due-diligence consultation in which the hypothetical buyer of the interest is now your client. What facts and issues (about the family, other partners, financing, their plans, etc.) would you raise with this client? The appraiser will eventually be looking at the same information, which, in addition to the agreement, will form the basis for valuing the ownership interests. Your early detection can bring the overall outcome more directly under your control.

This can be helpful in many ways; for example, when choosing between structural alternatives. Whether to go with an LLC, LP, general partnership or just deeded property interests as tenants-in-common, the choice is partly based on how each will affect the value of individual interests.

VALUE-AFFECTING PROVISIONS

There is a long list of agreement provisions that can set up valuation effects from blind spots: Swing vote benefits can result from the selection of voting thresholds; confidentiality provisions and refusal rights can obstruct entry or even assignment; uncertainties can be created by granting specific manager discretion; capital calls can cast an onerous pall over the future; having some control can reduce risk (and discounts) but the prospect that others also have control can act the other way; the ability to block decisions can turn out to be extremely valuable, or worthless; and various types of exit provisions can string out the expected holding period or cut it short. This is not an exhaustive list.

Exits are probably the biggest issue, since the longer an interest-holder is “trapped” in the investment, the greater the discount. Exits are affected by many facts relating to owners, leases, financing, property markets and others. One type of exit provision is the subject of this case study.

It is not within the purview of a valuer to deal with the legal ramifications of agreements, but it is entirely within a valuer’s scope to get inside the thinking of, say, the minority interest holder, and interpret the options and risks attributable to that interest. The valuation question is largely “how would a buyer price the interest, and why?”

SUMMARY

This month’s study of an actual valuation case illustrates how the balance between partner exit rights and other facts comes into play when asking a fairly difficult question: “What is the fair market value of this minority but sort-of-controlling interest?”

An agreement between four families as tenants-in-common was intended to provide all a voice in management decisions, although the partners had historically taken their guidance from one partner based on his amazing real estate skills. The agreement was also intended to prevent legal action in the event that any one of them wanted out. It didn’t waive partition, but it provided a refusal right to the others that would allow them to purchase the interest at its pro rata share of the whole; they could take out the exiting “partner” at the amount it would receive through a partition lawsuit, thus saving all a lot of trouble. This is essentially a “put” clause, effectively giving a right to put the interest to the others at its pro rata share of the whole. Good for exits, but generally bad for discounts.

The valuation was for the estate of one of the partners, so the interest included all the rights that the decedent held. (Even if a gift, the rights that transfer could still include the put.) By itself, this clause would have eased the exit path and removed much of the interest’s marketability impairment that leads to price discounts; however, many other facts & circumstances also influence discounts, and this case was no exception.

These other influences overwhelmed the agreement provisions in a direction that happened to be beneficial. The discount ended up at 39%, fairly high for a largely consent enterprise with an exit provision. A much lower discount would have resulted from ignoring family and property facts.

The moral to this story is that clauses have consequences, but so do facts – and all must be considered for the analysis of value to be credible and the goals set up by the agreement to be achieved.

DETAILED ANALYSIS

This case involves four families who came together in 1957 to build and lease a light industrial/office building in Los Angeles. It has been leased to the same aerospace company since that time, and the lessee has been continuously renewing its 5-year options. The managing partner has always been Dan Developer, a real estate genius who has consistently and successfully developed many properties, nearly all with partners. By now the families rely largely on income generated by his projects.

The original limited partnership was dissolved in 2004, and the property distributed in kind to the four families, in equal parts. They entered into a cotenancy agreement, which named Dan as supervisor, although operations were to be managed jointly by the cotenants. The agreement had a 25-year term, provided for capital calls, required distribution of net revenues, and allocated distributions pro rata. Management decisions required more than 50% approval (3 votes of 4), except for borrowing and selling or leasing the property, which required unanimous approval.

The agreement allowed interest transfers, but subject to an interesting first refusal right. Rather than trying to give up the state’s absolute right to partition, it provided a “right of first offer for partition” where a cotenant desiring to bring a partition action must first notify the other cotenants, who may elect to purchase the interest. Price is to be set at its pro rata share of the fair market value of the whole property, unadjusted for any discounts. It also provided a timed process for determining the price, which maxed out at 180 days; all in all, a fairly quick exit.

The discount and the facts

Keep in mind that the fair market value premise presupposes a hypothetical buyer and seller of the interest, and it is largely the future options of the hypothetical buyer that are of interest for valuation purposes. With this idea in mind, the lawyer can think “buyer’s due diligence” just as easily as the appraiser, and sometimes more effectively.

For example, what would you advise the hypothetical buyer of the interest, as a matter of due diligence, when considering its ability, under the agreement, to force its way out of the entity in the future? Would you advise that taking advantage of the “put” provision would be no big deal – an easy way for your buyer/client to get out? Should he pay more for that right?

This is important, because the valuation discount for cotenancy arrangements is always heavily dependent on the time it would take for the interest holder to exit with its pro rata share of the whole. (The other component of the value equation is the risk associated with a particular holding or exiting scenario.)

A buyout in the short term is possible, but for a new interest holder to force such an action in a family that has successfully operated as a group for 50 years is a little extreme. Also, the fact that they are worth over $100 million suggests that the ability to force anything, agreement or not, might want long consideration. If it were attempted, then the timeline could be much longer than expected, particularly if it generated lawsuits. Either way, risk would not be low.

There are several other facts having to with a possible holding period: Dan is 76 years old, and his actuarial remaining life is another 11 years; death of a principal is sometimes an exit opportunity. The lease is up for renewal in five years. The remaining term of the agreement is 25 years. (There was no loan in this case, but sometimes its remaining term, balloon payments and prepayment conditions can have a big influence.)

A successful near-term buyout could very well be disadvantageous from a real estate point of view. Renewal of the lease would add to value, but there was some concern about the tenant’s desire to remain in the old improvements. Economic conditions were declining, and profitable redevelopment of the property could be iffy in five years. If the buyout process had to work its way through court, conditions would be anybody’s guess, and the risk that a buyout would occur when the property’s value was substantially lower was significant. A holder of real estate who cannot control timing faces increased risk. These conditions should be part of any buyer’s due diligence, and therefore must be part of the discount analysis.

Our analysis and conclusion of value

The valuation question (for the buyer’s part) turns to how he or she would see their future prospects as part of the association. How would they exit if they had to? What risks would they face? The results of a thorough due diligence investigation from the set of facts that are material to the discount analysis.

Our analysis postulated that a hold as long as Dan’s remaining life would be possible, a very short hold would be unlikely because of the lease and ownership circumstances, and concerns about exercising the agreement’s put clause; a five-year hold would be most likely (for modeling purposes). The assumption includes an orderly exit, accounting for the risk that the lease would not be renewed, the period might be different from five years, and a small possibility that any exit would require enforcing rites under the agreement. Income methods are able to incorporate all these conditions with more than reasonable precision, making the valuation quite rigorous and persuasive.

The effective discount from net asset value, concluded for the subject interest, was 39%, fairly high based on the long history of stable cash flow and the theoretical ability to exit in 180 days. However, a close look at the family, the lease and other real estate facts, and the rest of the hypothetical buyer’s due diligence suggests a much different likely outcome. Explicit consideration of the facts and agreement terms led to a deep discount, which was accepted repeatedly as we valued this and later interests in the same common tenancy association.

CONCLUSIONS

TIC arrangements and general partnerships usually involve fewer limits on control and marketability than more complicated structures such as LPs and LLCs. This makes the valuation process much less straightforward. Clearly, understanding the facts & circumstances can be a critical part of a credible and persuasive analysis. The agreement and the facts must be considered together as a whole.

Of course, facts can influence discounts in both directions. Having cake and eating too can often work, but the proof requires full consideration of the facts. The discount was significant in this instance, and some practitioners would have wanted it capped at, say, 15%, given that the ownership arrangement was largely as tenants-in-common. Such caps are entirely unnecessary, as described in “Taxpayers and Short Sticks.”[1]

There are so many variations on this theme that it would require quite a lot of space to describe even the main possibilities. A paper that provides a catalog of likely facts, terms and conditions that are encountered with fractional ownership, “Asset Fractions: Integrating Real Property and Business Valuations (Getting a Handle on the Facts)”[2] is available for download. The lawyer can take many other actions to assure successful outcomes; these are presented in detail in “Reappraising the Appraisal Process: A Guide to Successful Results.”[3]

We are normally called in after the cake is baked, but do consult on formation of entities designed for wealth transfer and on repair of existing agreements prior to making gifts. We can help clarify the terms, conditions, facts & circumstances affecting value, and their interactions, which can place outcomes more securely within your control.
__________________________________
References:
[1] A blog essay on the crisis with tax overpayment, based on “Dennis Webb: Estate Plans in Chains – The Unfortunate Trend Toward Unnecessary Discount Caps,” LISI Estate Planning Newsletter #1802 (Leimberg Information Services, Inc., April 21, 2011) at http://www.leimbergservices.com
[2] Dennis A. Webb, ASA, MAI, FRICS “Asset Fractions: Integrating Real Property and Business Valuations [Getting a Handle on the Facts],” paper presented at the ASA International Appraisal Conference, Los Angeles, CA (July 15-18, 2007).
[3] Dennis A. Webb, Susan A. Beveridge “Reappraising the Appraisal Process: A Guide to Successful Results,” Estate Planning, (September 2010): 11-18.

Case 1 – Tax Court Tool Blunts IRS Challenge

Fri, 17 Jun 2011 04:49:00 GMT

This year and next may go down in history as the best for tax-advantaged gifting, particularly of fractional interests in real estate. LLCs, FLPs and tenancy-in-common structures all work, and in each case, current economic conditions argue for low values and low expectations, which means greater discounts on top of low value pro rata interests. Tax leverage can be legitimately quite extreme. The deepest discounts generally apply for the more restricted entity interests, but simple deeded structures can also obtain some pretty significant discounts. The recent case of Ludwick[1] might give a practitioner pause, though, since its half-interest in a Hawaii vacation home ended up with only a 17% discount. Will the Service use this case to go after vacation home discounts in particular, and maybe tenancy-in-common interests in general? Proper use of Judge Halpern's model usually tells a different story…

SUMMARY

We had a recent opportunity to help a client who faced that exact problem – and the subject vacation home was in Hawaii. Support supplied by the taxpayer (the appraisal was not ours) claimed a 31% discount but was extremely weak, having less than one full page of case-specific facts – the rest was boilerplate. It is easy to see why IRS selected it for audit.

The agent indicated that Ludwick would be applicable, and the discount should therefore have something to do with 17%. (See Ludwick, a Wake-up Call for Lawyers for a detailed examination of Judge Halpern’s memorandum.) A bit of a gift in one sense, since we didn’t have to deal with the taxpayer’s appraisal at all.

We supplied counsel with the same mathematical model that Judge Halpern spelled out quite explicitly in Ludwick, but with the inputs and assumptions adjusted for the fact pattern particular to the case at issue. The model was used directly by counsel in forming their arguments, and it showed discounts as great as 36%; the parties settled on 25% (see detail, below). This was a successful outcome, but it might have been even more favorable if we had been able to make a proper investigation and assemble all the facts.

How are you going to gift an interest in that vacation home in light of Ludwick? Just short the discount (pretend 17% is correct) and hope for the best? Blind application and a conclusion below, say, 20%, drastically understates discounts for most situations, especially in the current real estate market. The Ludwick decision actually supports much greater discounts in most cases; it’s attention to the facts that makes all the difference.

It is clear that the taxpayer would have been better off if the appraisal submitted with the gift tax return were attentive to the facts and persuasive in developing its opinion of value. It is likely that a greater concluded discount would have been acceptable to the IRS in the first place, and the tax savings would have been far in excess of the higher cost of such an appraisal.

DETAILED ANALYSIS

This case concerned a 50% interest in a Hawaii condo. The taxpayer’s appraiser claimed a 31% discount, and the IRS agent countered with 17%. The agent cited Ludwick; his argument focused on the $40,000 cost of partition in the valuation model, but excluded operating costs and the time element. He dismissed deducting selling commissions as “usually paid by the seller.” The date of value was October 2008, and the date of the eventual sale was December 2008.

Ludwick considered a partition model, where costs (court and operating), revenues (none) and the eventual sale are discounted to present value, taking into account a 90% chance that the parties (hypothetical buyer and current holder of the other half) would simply agree and sell the whole property rather than going to court.

In this instance, the present value part eluded the agent, as did the premise of value. His dismissing the deduction of selling commissions ignored the fair market value postulate of a hypothetical transfer of the interest at the date of value, and then an eventual sale (whether voluntary or court-ordered), in which the new interest holder is indeed one of the sellers. That eventual cost, along with other costs, reduces proceeds and forms the basis for a pricing decision using the partition method.

We prepared a valuation model for use by counsel, which followed Judge Halpern’s model in Ludwick. It showed two scenarios, one with a partition action and one in which an action was not necessary, and three variations using differing assumptions. The partition period was 1.5 to 2 years, and the nonpartition (agreeable sale) period was 1 year. Actual operating and estimated partition costs were deducted for each year, and selling costs were deducted from estimated sale proceeds at the end of the period. Market value was grown at 3% in one variation, and held flat in the others; market conditions did not support any growth, and further investigation might have supported an expected value decline.

One more key variable is the rate used to discount cash flows and sale back to present value. The 10% rate used in Ludwick (and in other notable cases) is far too low; it is a rate that would be applied to a fee interest in real estate, not to a lawsuit involving a fee interest in real estate. There is a catalog of risks that must be considered, which raises the discount rate to at least 15% or more. Our scenarios used both 10% and 15%, the latter based on case facts.

Counsel was able to present a model that addressed the specific case using Judge Halpern’s method, and concluded a 36% discount. Our conclusion might have been greater if we had been able to make our own investigation of case facts, but the IRS settled at 25%; under the circumstances, a very good day.

CONCLUSIONS

We have been called in on a number of these cases where the appraiser had claimed a discount in, say, the 30% range, and on further analysis, we either agreed or thought it should’ve been greater. But if all the facts are not available, then this sort of rebuttal can’t be well-supported when the audit comes around. It still argues for a settlement, and like the above situation, the IRS typically settles for something more favorable to the taxpayer. An even better outcome would be obtained by having a well-supported valuation in the first place. Methods of engaging appraisers to produce good results are presented in detail in Reappraising the Appraisal Process: A Guide to Successful Results [3].

Our approach is to pay attention to the facts, give the IRS what they need to work with (and what they need to be persuaded by), and conclude the right discount. It works.

References:
[1] Ludwick v. Commissioner, T.C. Memo. 2010-104
[2] LISI Estate Planning Newsletter #1687 (Leimberg Information Services, Inc. Subscribe at www.leimbergservices.com
[3] Dennis A. Webb, Susan A. Beveridge “Reappraising the Appraisal Process: A Guide to Successful Results,” Estate Planning, (September 2010): 11-18.

Case 1 - A Great Year for Discounted Gifts - but with a cautionary tale from Ludwick

Wed, 22 Jun 2011 15:29:00 GMT