Marks Paneth Real Estate Perspectives Summer 2019

Real Estate Perspectives


Welcome More than halfway through a year that has been marked by sweeping changes to our industry as a whole, New York real estate professionals are experiencing some of the most dramatic changes of all. On June 14, the state Legislature passed the “Housing Stability and Tenant Protection Act of 2019,” bringing about some of the biggest reform to rent regulations our industry has ever seen. In this issue of Real Estate Perspectives , we take a closer look at what those changes mean for New York’s landlords and property owners. We also address the impact of the recent Climate Mobilization Act, which aims to reduce New York City’s greenhouse gas emissions by more than 80% over the next 30 years. With all of this breaking news, we’re still continuing to monitor the federal Oppor- tunity Zones tax incentive program as it develops, along with updates such as the new lease accounting rules, which have now been deferred one year for private companies. By the time I sit down to write my next message, we’ll be looking ahead at 2020 and what the new year will bring, and so far, the only thing I know for sure is that the professionals in our Real Estate Group will continue to be there for you with knowl- edge and advice every step of the way.


2 Who are the Real Winners and Losers of the REFORMED RENT REGULATION LAWS ? Abe Schlisselfeld and Maya Khan 5 What Building Owners Need to Know About the CLIMATE MOBILIZATION ACT Deana Wetzel 8 How the NEW LEASE ACCOUNTING RULES Affect Landlords and Tenants Adeline Lee and Mark Cuccia 11 DEFEASANCE DEDUCTIBILITY in Commercial Real Estate Eduard Suleymanov 14 VALUATION DISCOUNTS Applicable to Real Estate Holding Companies (Part 2) Angela Sadang



Who are the Real Winners and Losers of the Reformed Rent Regulation Laws? ABE SCHLISSELFELD, CPA, EA MAYA KHAN, CPA

N ew York State’s landlords and de- velopers have been in a continued state of uproar since June 14th, 2019, the date that New York State legis- lature passed The Housing Stability and Tenant Protection Act of 2019. This sub- stantial rent overhaul has enacted a historic tipping of the scales – one that appears to favor tenants over landlords but will have far-reaching implications for both groups

over the long term. The six major changes highlighted below illustrate the dramatic effect that the new law will have on the real estate industry. As landlords and property owners brace for the law’s impact on their future financial statements and business opportunities, what remains to be seen is whether the strain will be passed on to the very tenants the bill is intended to help.

2 SUMMER 2019

Real Estate Perspectives

THE NEW RULES REGARDING MAJOR CAPITAL IMPROVEMENTS AND INDIVIDU- AL APARTMENT IMPROVEMENTS Two changes with the potential to have a sweeping effect on our entire industry are those that have been made to the rules surrounding Major Capital Improvements (MCIs) and Individual Apartment Improvements (IAIs). MCIs are building-wide improvements, such as new roofs, boilers or windows. In the past, landlords were able to pass 6% of the costs associated with these improvements onto their tenants. These are known as MCI increases. Under the new law, MCI increases will be capped at 2%. The new regulations also tighten the enforcement of these rules by requiring that 25% of MCIs be inspected and audited. In addition, MCI increases - which were permanent in the past - will now be eliminated after 30 years. IAIs are physical improvements made to vacant apartments in order to appeal to potential renters. Landlords spending significant amounts of money on these improvements would then pass a fraction of the cost onto their tenants through rent increases. The new law dramatically limits this practice, allowing only $15,000 of the renovations to be passed on to the tenants over 15 years – equating to an increase of approximately $89 a month. (To put the $15,000 limit into perspective, landlords are already pointing out that applying for permits alone costs about $6,000 – and that’s just the beginning of a renovation project.) These two major changes have begun to cause a lot discussion within the industry, with many now wonder- ing if landlords will have the financial incentive or motivation to continue improving a property. If landlords no longer receive additional rental income to offset costly property upgrades, one can only specu- late as to whether they will continue to expend those extra dollars. Don’t discount the trickle-down effect these changes may have on the property improvement trades, either – all of the vendors whose livelihoods depend on work performed at these properties may also be directly affected by this. This includes carpenters, plumbers, contractors, suppliers, maintenance workers and many other types of businesses servicing the real estate industry.


The new law bids farewell to not only the decontrol of apartments, but the vacancy bonus as well. In the past, when the maximum legal rent for a rent-stabilized apartment was reached, the apartment would destabi- lize and became available at market rate when the tenant vacated. (For context, prior to June 14, upon reaching the maximum rent of $2,774, over 155,000 units were deregulated.) The new legislation has permanently repealed the practice, meaning that even once the maximum legal rent is reached, units are no longer decontrolled upon tenant vacancy. The vacancy bonus, which is also coming to an end under the new law, previously allowed landlords to raise rents by 20% when tenants changed. These changes have led to industry-wide speculation of whether there will still be a market for investors to purchase buildings with rent-regulated units. THE END OF PREFERENTIAL RENT AND HIGH-INCOME DEREGULATION The end of preferential rent and high income deregula- tion are further changes that may affect landlord revenues. Preferential rent refers to the discounted rent a tenant would pay when the maximum legal rent of a unit exceeded the market value. Upon the renewal of a tenant’s lease, landlords were permitted to increase rent to the higher value. The new legislation has permanently ended that option, guaranteeing that rents remain at the lower preferential value. High-in- come deregulation, which previously occurred when a tenant earned over $200,000 a year for two consecu- tive years, has also ended, making it so that a landlord can no longer deregulate a rent-stabilized unit in instances of high income. The changes outlined above are just a portion of the sweeping reform passed on June 14. With the potential impact of the new law so great, members of the real estate industry have wasted no time reacting. Land- lords and property owners are claiming that these changes will make the continuous renovation of apartments and buildings in New York City unachiev- able. Many of the city’s buildings are 80 to 100 years THE INDUSTRY’S RESPONSE


Real Estate Perspectives


old and growing costlier to repair and maintain. Their concern is that the returns and incentives to invest in their buildings are now too low. The Real Estate Board of New York, The Rent Stabiliza- tion Association (RSA) and the Community Housing Improvement Program (CHIP) are just a few of the organizations that have been challenging these new regulations. The organizations have expressed worry that with impacted revenue streams, obtaining capital is going to become more difficult for property owners, driving capital out of the city and encouraging landlords not to improve their buildings. Ultimately, this would slow growth in affordable housing and the real estate industry as a whole. On July 15, just one month after the law was passed, RSA, CHIP and seven individual landlords filed a federal lawsuit stating that the new law violates the Fifth and Fourteenth Amendments of the U.S. Constitution. The lawsuit intends to end the state’s rent stabilization regulation, alleging that the new law restricts the landlord’s property and claiming that the new law does

not meet the city’s goal of making housing affordable for low-income tenants.


Is there a loud and clear message coming from Albany? The overarching theme of doing business in New York is that it is only getting tougher and tougher. The failed Amazon headquarters deal in Long Island City was one example, and the new rent regulations follow suit. These developments are occurring on top of the usual red tape that all businesses face as they are trying to grow. Since it’s only been a short time since the law was passed, there’s no conclusion yet regarding the lasting effect it will have on landlords, their buildings and the real estate market as a whole. Only time will tell. In the meantime, I know many members of our industry are hoping to find a better way to communicate with New York’s state capital, and vice versa. Only with a stronger partnership between industry and community can we all expect to grow.

Abe Schlisselfeld, CPA, EA is Co-Partner-in-Charge of the Real Estate Group at Marks Paneth LLP. Abe advises commercial and residential real estate owners, real estate management firms and REITs on all facets of accounting and taxation, including multistate taxation, tax planning for high- net-worth individuals and business-entity structuring. He can be reached at or 212.201.3159.

Maya Khan, CPA is a Senior Manager in the Real Estate Group at Marks Paneth LLP. Ms. Khan specializes in providing tax planning and consulting services for partnerships, corporations, trusts and their high-net worth individual owners in both commercial and residential real estate as well as real estate development. She can be reached at or 516.992.5914.

4 SUMMER 2019

Real Estate Perspectives

What Building Owners Need to Know About the Climate Mobilization Act DEANA WETZEL, CPA

O n April 18, 2019, in response to the growing threat of climate change, New York City Council passed a package of bills and resolutions collectively called the Climate Mobilization Act. The Cli- mate Mobilization Act is intended to improve the energy efficiency of New York City over the next several decades by significantly reducing greenhouse gas emissions from buildings. Implemented and enforced by the newly created Office of Building Energy and Emissions Performance, the Climate Mobili- zation Act is expected to create thousands

of jobs in New York City and represents a bold step in the fight against climate change. However, as it contains a multitude of laws affecting New York City’s commercial and residential buildings, building owners and developers in the city should familiarize themselves with the Climate Mobilization Act now in order to understand any new requirements that they may need to comply with in the future. Below are some of the key ways the Climate Mobiliza- tion Act will affect building owners and developers in New York City.


Real Estate Perspectives




In the effort to achieve compliance with Local Law 97, building owners will have the option of purchasing carbon offsets or renewable energy credits (RECs) to deduct from their reported annual building emissions. Another option is carbon trading, where building owners can balance their emissions via credits purchased from other building owners whose building emissions fall under the emissions threshold. It is worth noting that property owners with large portfolios may be able to offset poor emission performing buildings with high emission performing buildings via carbon trading. As the cost for some building owners to comply with the new emissions limitations could be substantial, Local Law 96 of the Climate Mobilization Act creates the “Property Assessed Clean Energy” (PACE) program, a long-term financing program tied to a property that will enable building owners to undertake the necessary improvements to bring their buildings into compliance with the greenhouse gas emission limits. This financing will generally be limited to the amount of money saved through the resulting reduction in energy use and will be administered by New York City Energy Efficiency Corporation. It is expected that the financing will be paid back through a form of tax assessments on the property, amortized over the expected useful life of the improvements financed. Those eyeing new development or extensive renova- tions in New York City should take note of Local Law 94 , which increases energy efficiency by requiring the inclusion of solar panels or “green roofs” (roofs which are fully or partially covered in vegetation) in new construction and for buildings undergoing certain types of major renovations. The law applies to both residential and commercial buildings, though Local Law 92 of the Climate Mobilization Act adjusts the requirements for smaller buildings and requires the Department of Housing Preservation and Development (HPD) to study the impact of compliance on affordability. MANAGING THE COST OF BUILDING IMPROVEMENTS GREEN ROOF LEGISLATION

At the center of the Climate Mobilization Act is Local Law 97 , which introduces limits on the greenhouse gas emissions of private buildings exceeding 25,000 square feet as well as tax lots with two or more buildings exceeding 50,000 square feet—which will include many of the city’s co-ops and condos. These carbon emission limits, calculated based on the occupancy group of the building, will go into effect in 2024. In 2025, buildings covered by Local Law 97 will then be required to submit a report showing their carbon emissions from the prior year, with any buildings that release more than the allowed carbon emissions being subject to penalties for non-compliance. (The maximum penalty for non-com- pliance with regard to the carbon emission limitations will be equal to the difference between the building emission limit for the year and the amount of emissions reported by the building that same year multiplied by $268.) In 2029, the emission limits will be lowered even further, with the goal of reducing the carbon emission of New York City’s buildings by 40% in 2030 and 80% by 2050, relative to 2005 levels. In addition to the emissions limitations, Local Law 97 introduces additional energy conservation requirements for covered buildings, including thirteen measures which must be implemented by December 31, 2024. These include adjusting temperature set points for heat and hot water, repairing heating system leaks, maintain- ing the heating system, insulating pipes, upgrading lighting, weatherizing and air sealing. Buildings with one or more rent-regulated units or Housing Development Fund Corporations (HFDCs) will have alternate requirements, such as submitting evidence of having performed the measures required in the law instead of meeting the emissions limits. Certain buildings are exempt from the Climate Mobiliza- tion Act—these include houses of worship, New York City Housing Authority buildings, city-owned buildings, multi-family properties that are three stories or less with no central HVAC or hot water heating systems and industrial facilities primarily used for the generation of electric power and steam. BUILDINGS WITH ALTERNATE REQUIREMENTS

Local Law 93 requires the office of alternative energy to post and maintain links on its website with information

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Real Estate Perspectives

Building owners must familiarize themselves with the act in order to begin preparing for the changes that lay ahead.

regarding the installation of green roofs and green roof systems, and Resolution 66 of the Climate Mobilization Act would increase the real property tax abatement for the installation of a green roof to $15 per square foot, to better incentivize building owners to build green roofs.

assessment will be part of a long-term energy plan and will be updated every four years.)

One last feature of the Climate Mobilization Act, worthy of note though it pertains to more than just building owners, is the imposition of a five-cent fee on all paper bags given by stores which will begin on March 1, 2020. (Customers who are part of a supplemental nutrition program would be exempt from this.)


Local Law 95 addresses building owners’ concerns about the grading scale of Local Law 33, which has been called inaccurate. (Local Law 33 is a New York City ordinance that requires buildings over 25,000 square feet to post an energy efficiency grade at each public entrance of the building.) Local Law 95 adjusts the grading scale, giving higher grades to more energy-efficient buildings. Other components of the Climate Mobilization Act include Local Law 98 , which provides a clear process for the design, construction, maintenance and removal of large wind turbines. Local Law 99 mandates an assessment on the feasibility of replacing city gas-fired power plants with battery storage systems. (This


Overall, the Climate Mobilization Act is a forward-think- ing, historic group of bills that can affect major change in New York City’s carbon emissions and overall energy efficiency. In the short-term, however, the city’s building owners must familiarize themselves with the act in order to begin preparing for the changes that lay ahead. Our real estate specialists are closely monitoring how the Climate Mobilization Act will affect property owners and developers in the city and will continue providing important updates.

Deana Wetzel, CPA is a Director in the Real Estate Group at Marks Paneth LLP, where she specializes in audit and consulting engagements for both commercial and residential real estate clients as well as co-ops and condominiums. She can be reached at or 516.992.5746.


Real Estate Perspectives


How the New Lease Accounting Rules Affect Landlords and Tenants


I n February 2016, the Financial Accounting Standards Board (FASB), which deter- mines financial accounting and reporting standards for public and private companies as well as not-for-profit organizations, issued a new lease accounting standard. This new standard, which affects any entity that has entered into a lease, has already become effective for all public companies. At the time of this publication, FASB has tentatively de- ferred the effective date for private compa- nies, offering them welcome relief by shifting the new effective date to January 1, 2021. Private companies in the real estate sector can consider this deferral a major plus, as the new standard significantly changes how

leases are recorded and is anticipated to have a profound impact on the books of both real estate lessors and their tenants. BACKGROUND Under the old lease accounting standard, there were two types of leases - capital and operating. A capital lease transferred the control of the asset to the lessee at the end of the lease, while an operating lease did not. Once a lease was classified as a capital lease, the lease asset and related liability were to be recorded on the balance sheet. Under the new standard, a lease is now categorized as either a finance or an operating lease. A finance lease is very similar to a capital lease - it transfers the control of the asset to the lessee at the end of the lease, while an operating lease does not. The main difference between the old and new standards is that now, both finance and (in most cases) operating leases recognize lease assets


Real Estate Perspectives


as a right-of-use (ROU) asset and future lease payments as the lease liability on the balance sheet. The amount of the lease liability and the value of the ROU asset is calculated based on the present value of all future lease payments. The longer the lease, the greater the liability. This new standard applies to all leases, including subleas- es, with a few exceptions such as leases of inventory, intangible assets and assets under construction. It does not apply to leases with a lease period less than 12 months and with no option to purchase the asset. It does not require existing and expiring leases to be reassessed, nor does it apply to income tax basis financial statements. The new lease accounting standard significantly affects both real estate lessors and tenants, albeit in different ways. Some of these are discussed below. • Real estate lessor-lessee Real estate lessors are in fact lessees if they have leases of land, office space, office equipment and other leased assets. When a lease meets certain criteria, the ROU asset and related lease liability are to be recorded on the books. This will not only affect the financial statement presentation but also skew the financial metrics. The impact will be even more significant when there are ground leases. Lessors with ground leases should start a conversation with their ground lease lessors and lenders soon. • Lease components The new standard requires real estate lessors to evaluate various lease components within contracts and assign a value to each component unless they meet certain criteria. For a real estate lessor who leases an entire building and is inherently leasing the land underneath the building, the new standard requires the land component to be assessed and a value to be assigned separately from the building compo- nent, unless the accounting effect is not deemed significant. The rationale behind this is that the land component has an indefinite economic life whereas the building component does not. • Non-lease components POTENTIAL IMPACT

services. These services are considered non-lease components. Under the new lease accounting standard, real estate lessors are required to assign a value to both lease and non-lease components based on a standalone price. Real estate lessors can elect to apply a practical expedient to not separating the non-lease components from the lease components, provided both components share the same timing and pattern of transfer, and the lease component would be classified as an operating lease. Real estate lessors that plan to elect the practical expedient should start the evaluation process early in order to determine if they qualify for the election. Once elected, the practical expedient must be applied consistently, by asset class, to all lease transactions of a similar nature. Meanwhile, real estate lessors can expect closer scrutiny of embedded service components by lessees in upcoming lease negotiations. • Initial direct costs Under the new lease standard, initial direct costs are redefined as costs that would not have been incurred if the lease had not been obtained, such as leasing commissions. Costs that meet this definition will continue to be capitalizable and amortizable over the term of the lease. Expenses that are no longer considered initial direct costs under the new standard will be expensed when incurred, such as legal fees related to the leasing. This change will affect certain key financial metrics, such as funds from operations and Earnings Before Interest, Tax, Depreciation and Amortization (EBITDA) calculation. Real estate lessors may be impacted by this new standard if tenants begin looking for ways to restructure their leases in order to mitigate the impact on their financial statements. • Lease term Under the new lease accounting standard, shorter lease terms become more attractive, as they lower the lease liability. Shorter lease terms will help tenants who are particularly concerned with meeting their debt service coverage ratio. This, however, may not align with the lessors’ objectives, as shorter lease terms increase resource outlay in the long run and risk an unknown future. In addition, shorter lease terms

Many real estate lease agreements include services provided by the lessors, such as common area maintenance and janitorial


Real Estate Perspectives


could greatly affect lessors’ real estate valuations and their ability to obtain long-term financing. • Lease payments To mitigate the impact on their financial statements, tenants may wish to negotiate the nature of their lease payments. Under the new standard, variable payments that are not based on index or rate are not includable in the ROU asset and lease liability calculations, as they are not fixed and determinable. As a result, retail tenants might negotiate a lower fixed rent with a higher variable rent component based on percentage rent. Tenants may prefer a net lease to a gross lease when looking to reduce liability. When determining lease payments, payments in connection with options to purchase the lease asset, to renew the lease, or to terminate the lease can be included when it is reasonably expected that the option will be exercised by tenants. • Lease classification Tenants who are concerned with EBITDA might

want to structure their current operating leases with a longer lease term and options to renew in order to meet the finance lease criteria. Lease payments under a finance lease are categorized as interest and amortization expenses of the ROU assets, which will give the EBITDA calculation a boost. However, while restructuring a lease into a finance lease might be beneficial to lessees, it may not be in line with the lessors’ wishes. The new lease accounting standard dramatically affects real estate lessors and lessees, albeit in different ways. Even though the economics of a lease do not change, the reporting requirements do, and these new requirements will have a significant impact on the financial statements of both real estate lessors and their tenants. At the same time as tenants are preparing to adjust to the new standards, real estate lessors can expect to spend additional time and effort preparing for the changes to take effect—at the very least on tenant lease negotiations. CONCLUSION

Adeline Lee, CPA is a Senior Manager in the Real Estate Group at Marks Paneth LLP, where she specializes in advising real estate profession- als and closely held businesses on audit compliance, accounting best practices, financial reporting and tax matters. She can be reached at or 516.992.5718.

Mark Cuccia, CPA , is a Partner in the Commercial Business Group at Marks Paneth LLP. For over 20 years, Mr. Cuccia has provided attest, accounting and advisory services to clients in a wide array of industries, including manufacturing, importing, wholesale and distribution, retail, restaurants and professional services. He can be reached at or 516.992.5908.

10 SUMMER 2019

Real Estate Perspectives

Defeasance Deductibility in Commercial Real Estate EDUARD SULEYMANOV, CPA

R efinancing is common in commercial real estate, as it allows investors to capitalize on equity and save money by lowering interest rates on a loan. Howev- er, commercial real estate owners who are interested in refinancing their loans must first determine if those loans are securi- tized, as a borrower with a securitized loan will need to defease the loan before selling or refinancing the property securing the loan. It is important for borrowers to be

aware of the tax treatment associated with the costs related to a defeasance trans- action. This article will explore the role of defeasance in commercial real estate trans- actions as well as the the tax deductibility of a defeasance premium paid pursuant to a legal defeasance.


Conduit loans are pools of commercial mort- gage-backed securities (CMBS), also referred to as


Real Estate Perspectives


Commercial real estate owners, borrowers and investors interested in refinancing their securitized loans

should consider all the costs associated with a defeasance transaction as well as any possible tax deductions.

securitized loans. CMBS loans are sold into securitiza- tion trusts that elect to be treated as a Real Estate Mortgage Investment Conduit (REMIC). The investors who invest in REMICs are enticed by the predictable payment stream offered by these investments. Due to the various restrictions imposed on REMICs by the tax code, prepayment of the underlying mortgages is generally not allowed, unless the collateral on those mortgages can be substituted with new collateral that guarantees the same payment stream to the investors as the old collateral.

substituted government securities must generate cash flows sufficient enough to cover the periodic payments required under the original loan. Costs to acquire the substituted collateral generally include transactional expenses, such as fees paid to attorneys, defeasance consultants and tax advisors, and may include a defeasance premium . A defeasance premium is a function of the spread between the interest rate on the conduit loan and the yield on the government securities on the date the securities are purchased. A defeasance premium occurs when the interest rate on the substituted securities is lower than the interest rate on the original conduit loan. Note: If the interest rate on the conduit loan is lower than the yield on the government securities, there is a defeasance discount. A defeasance premium can be deducted immediately by the borrower so long as the transaction satisfies the definition of a legal defeasance .

This substitution and release of the old collateral for new collateral is referred to as a defeasance .


In commercial real estate transactions, defeasance generally means that the original real estate securing a conduit loan is released as collateral and new collateral is substituted. (The new collateral is generally a portfolio of high-quality government securities, such as treasury notes, zero-coupon bonds, etc.) These

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Real Estate Perspectives

4. The conduit loan lender assigns the mortgage loan to the new lender and releases and dis- charges the borrower from all claims, liabilities and obligations under the conduit loan. Following these steps, the borrower is able to sell or refinance the property subject to the promissory note and mortgage now owned by the new lender. In an in-substance defeasanc e, the original borrower’s debt is not legally discharged, and the borrower remains legally liable to the lender to make required payments under the loan in the event there is a shortfall in cash flow generated by the substitute collateral. Thus, the borrower is not eligible for an immediate deduction of a defeasance premium attributable to an in-sub- stance defeasance. Instead, the defeasance premium may only be deducted over the remaining term of the conduit loan. Commercial real estate owners, borrowers and investors interested in refinancing their securitized loans should consider all the costs associated with a defeasance transaction as well as any possible tax deductions. If a defeasance is necessary, these individuals should consult with a defeasance consul- tant, their attorneys and especially their tax advisors to make sure a legal defeasance is achieved and the appropriate deductions are taken. TIP: AVOID IN-SUBSTANCE DEFEASANCE CONCLUSION


In a legal defeasance, the borrower is legally released from any continuing liability on the debt. The substi- tuted collateral purchased to defease the loan is treated as a repayment of the original loan. The loan is retired from the perspective of the borrower. A defeasance premium paid under a legal defeasance is deductible as a payment of interest in the year incurred. A TYPICAL LEGAL DEFEASANCE The transactional steps of a typical legal defeasance are listed below. 1. In order to implement the defeasance, a conduit loan borrower borrows money and executes a defeasance promissory note from a new lender. The amount borrowed from the new lender is equal to the outstanding principal of the borrower’s existing conduit loan. 2. The borrower is then required to use the pro- ceeds of the new loan to purchase U.S. govern- ment securities to serve as collateral for the new loan. The purchased U.S. government securities must generate sufficient cash flow to make all remaining debt service payments of the existing conduit loan. 3. The new lender then assigns its promissory note and its rights to the U.S. government securities serving as collateral for the new loan to the conduit loan lender.

Eduard Suleymanov, CPA is a Director in the Real Estate Group at Marks Paneth LLP. Mr. Suleymanov specializes in providing tax and consulting services to commercial and residential real estate clients, including real estate management firms and high-net-worth property owners. He can be reached at or 212.710.1776.


Real Estate Perspectives


Valuation Discounts Applicable to Real Estate Holding Companies (PART 2) ANGELA SADANG, MBA, CFA, ASA

A fter discussing the application of a minority discount or discount for lack of control (DLOC) in the last issue of Real Estate Perspectives , I will now turn to discussing the next incremen- tal adjustment in the valuation of partial, non-controlling interests in entities holding real estate as their primary and most valu- able asset. In this article, we will address the use of the discount for lack of marketability (DLOM) applicable to interests in real estate holding companies.

The diagram below graphically illustrates the basic levels of value as we apply discounts: the starting point is the control level which, as discussed in my last article, emanates from the 100% net asset value of the real estate holding entity. The marketable minority (or “as-if freely traded”) level results from the application of a minority discount (which was the subject of my first article) and conversely, the application of a control premium from the freely traded value brings you back to the control level. The lowest level is called the nonmarketable minority level which results from the application of a DLOM and represents the concep- tual value of nonmarketable (i.e., illiquid) minority interests of privately held real estate holding entities that lack active markets for their shares.

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Real Estate Perspectives

As mentioned in my previous article, business appraisers review the independently performed appraisal of real estate properties as a first step in performing the valuation of certain ownership interests in real estate holding entities. Such inde- pendent appraisals of underlying real estate properties typically assume a marketing period of at least six months to a year, and do not include any opinions on the DLOM of the real estate properties, except in unusual circumstances. Therefore, the determination of the DLOM applica- ble to interests in real estate holding entities falls on the business valua- tion specialist/appraiser. In determining the DLOM, we review and dissect data obtained from various sources, the most widely used of which are restricted stock studies and pre-IPO studies. There are a multitude of empirical studies and methods to determining the DLOM. Some business appraisers turn to regression analyses and other mathematical formulas to better support their DLOM calculations. Aside from benchmark restricted stock studies and pre-IPO studies, option pricing models such as the Black-Scholes, Finnerty and Chaffee

Controlling Interest Basis

Control Premium

Minority Interest Discount or Discount for Lack of Control (DLOC)

Marketable Minority Interest Basis

Discount for Lack of Marketability (DLOM)

Nonmarketable Minority Interest Basis

A discount for lack of marketability is used to compensate for the difficulty of selling shares of stock that are not traded on a public stock exchange. For instance: while shares of IBM, Google or Apple trade on public stock exchanges and can be convert- ed to cash within three days, investments in real estate holding entities or any privately held business can take months or even years to sell. The degree of impaired marketability is even more significant for an owner of a non-controlling (i.e., minority) interest in a privately held entity that owns real estate, due to the inherent riskiness of real estate as an asset class versus other alternative assets and the inability to sell a real estate asset quickly.

models quantify the cost of an option based on the price of comparable publicly traded stock options and inputs related to the subject interest. Other quantitative models include the Quantitative Marketability Discount Model (QMDM) and Long-Term Anticipation Equity Securities (LEAPS). The quantita- tive models have been criticized due to the number of subjective inputs required to conclude on a DLOM. In Mandelbaum v. Commissione r, Judge David Laro proposed a list of nine factors for valuators to consider when quantifying a DLOM:


Real Estate Perspectives


1. Financial statement analysis; 2. Company dividend policy; 3. Nature of the company (history, position in industry, economic outlook); 4. Company management; 5. Amount of control in subject business interest; 6. Restrictions of transferability of stock; 7. Holding period for stock; 8. Company redemption policy; and 9. Costs associated with making a public offering. There are many other methods used to develop DLOM, such as flotation cost or bid-ask spread methodologies, however, there is no consensus on what methods are definitive or acceptable. And none is likely to gain universal acceptance in the foresee- able future. restricted stock study. I have heard a few clients ask, “Why can’t we just apply a DLOM of say, 25% or a total discount of 40% and call it a day?” The long answer is that in order for DLOM to withstand IRS scrutiny, we synthesize the available empirical data with our intimate understanding of the specific facts, circumstances and marketability features of the real estate holding entity - including the transfer restric- tions specific to the minority interest in the entity, the dividend policy, potential buyers of the interest, We valuators do not simply apply a methodology or refer to the mean or median from a pre-IPO or

remaining term of the entity, riskiness and type of real estate assets owned by the entity, and size and value of the interest. Analyzing the specific characteristics of the company may include applying a discounted cash flow analysis typically over an investment time horizon and determining a market value for the interest that would generate an appropriate internal rate of return (IRR). We may make assumptions on annual yield and annual appreciation on the property for a specific period, the rate of distributions, the expected dissolution date of the entity. Based on these as- sumptions, we determine a reasonable DLOM based on investors’ expected rates of return when partici- pating in a publicly registered real estate limited partnership. Anticipated returns on investments in various types of portfolio funds are reported in Partnership Profiles, Inc.’s annual Rate of Return Study which, as mentioned in my previous article, we also defer to when determining DLOC. Thus, in the end, the determination of DLOM is intertwined with the determination of DLOC and ultimately, in the determination of the fair market value of the interest. The valuation process for real estate holding entities involves complexity and multiple considerations. Hiring a qualified and experienced business appraiser to prepare a comprehensive and defensible valuation report provides more than tax savings - it can also lower the risks of an audit and potential costly litigation.

Angela Sadang, MBA, CFA, ASA is a Principal in the Advisory Services group at Marks Paneth LLP. She specializes in business valuations and the valuation of intangible assets for both publicly traded and closely held companies in a wide range of industries that also involves various asset classes. She can be reached at or 212.201.3012.

16 SUMMER 2019

Real Estate Perspectives

Leverage Our Expertise Marks Paneth has served the real estate industry for more than 100 years and has built a solid track record advising many of the industry’s premier commercial and residential real estate owners, developers, builders, REITs, property managers and prominent real estate families. Our dedicated Real Estate Group offers a full range of accounting, tax and advisory solutions that are customized to satisfy the requirements of virtually every real estate stakeholder, from the individual real estate owner to the largest global institutional investor. Other specialty services offered by Marks Paneth include international tax, state and local tax, family office and business management, cybersecurity and technology risk assessment, forensic accounting and valuation, high-net-worth, trusts and estates and employee benefit plans. Visit to learn more.

•Tax Planning, Compliance and Controversy • Audit & Accounting • Cash flow management and analysis • Affordable and Low-Income Housing • Low Income Housing Tax Credit (LIHTC) • Cost Segregation • Hospitality • Construction

• REITs • 1031 Exchanges • Transactional Services • Restructuring & Workout Services • Mergers & Acquisitions • Succession Planning • Strategic Planning • Litigation Support Services






I N S I G H T S A N D E X P E R T I S E T O D R I V E Y O U R B U S I N E S S F O R W A R D. S U C C E S S I S P E R S O N A L


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