Guest Article: The Mysteries of Investments with Conservation Easements
By: Michael C. Ning
By: Michael C. Ning
This weekend, I was lucky enough to be invited to a 2018 due diligence symposium, which was held at the Scottsdale Marriott at McDowell Mountains in Scottsdale, Arizona.
I noticed at this event and at numerous other 2018 financial alternative investment events that there is expanded interest in real estate products where conservation easements are options. Perhaps this is due to the shortage in availability of real estate-based products including NNN income REIT products and because firms must have products for their financial advisors to sell or for wealth managers to place. I call these ICE products or “Investments with Conservation Easements.”
What are ICE products? They are alternative investment products usually structured under Regulation D for accredited investors. Every ICE product after escrow break first purchases membership interests in an LLC, which owns a pre-identified piece of land. Under most circumstances, the majority of the membership interests are controlled by the investors.
The ICE product investors are then provided with an opportunity to vote between (1) landbanking of their property for speculation, (2) development of a real estate project or mining operation for minerals using their property, or (3) extinguishing future development by electing to place a conservation easement on their property.
If conservation easement option was selected by the investors, which seems to be 100 percent of the time, ICE product investors receive a charitable deduction under Internal Revenue Code Section 170(h).
In all the conservation easement seminars that I have attended, almost all ICE product sponsors have been reluctant to answer (a) if their ICE products have been audited and if completed, what the outcomes were, and (b) where the investor funds went when conservation easement was selected.
As an investment banker and broker-dealer owner, I have had the chance to review many ICE product PPMs since 2012. While I cannot state how many IRS audits sponsors may have received to date, I can shed some light as to how investor funds are used inside ICE products and help unravel some of the mystery.
First, look how much a landowner is getting for the land that the investors are buying. How many years have the last landowners owned the land? Anything over five or six years would probably tell that the land was probably not purchased just to be sold as an ICE product.
As readers may know, it is illegal to sell charitable deductions. Apply the smell test. Is 20 acres by a lake in Midwest or Southeast really worth $20 or $30 million? How much is being paid for the land? Land is often purchased by investors for comparatively higher than commercial value.
Second, a big chunk of investor funds seem to disappear under “developer termination fee” if conservation easement is elected. Basically, someone gets to keep a lot of money for doing nothing.
If the amount is reasonable, there is nothing wrong with the concept of “termination fee.” But if the fee is outrageous, what do you think is happening? Check carefully to see who gets this “termination fee.” It’s often not the person who the PPM refers is the anointed developer. If you cannot figure it out, its typically because the sponsor does not want to reveal the true answer to you.
Third, a big chunk of investor money might disappear under one or several types of “consultancies.” There are valid consultancies and make-believe consultancies. If you suspect that a particular consultancy is “make believe,” check the owners of the consultancy in question. If it does not clearly state who owns the consultancy, it’s probably because the sponsor doesn’t want you to figure it out.
All in all, when I have calculated the numbers, I have found that ICE product sponsors and/or landowners might altogether pocket 30 percent to 60 percent of the funds raised.
Most syndicated offerings today provide charitable deductions multiples of 4.3x to 5.5x. This is the ratio of fair market value to offering size.
In the fourth quarter of 2016, the IRS announced that all syndicated ICE products with multiples of 2.5x or more are “listed” transactions. These supposedly carry a higher risk of audit. This has scared a lot of people. Still, more ICE products are claimed to have been sold in 2017 than in 2016. Some sponsors now try to create ICE products that have multiples less than 2.5x to escape the listed status.
I believe that the next real battle between the IRS and investors will be fought on the notion of “economic substance.” Most determinations of “fair market value” by qualified appraisers are today based on the value of the development option.
To analyze the attractiveness of any ICE product, one might first assess how real the development model might be. Don’t stop at the basics such as if a land has received proper permits to develop certain properties or if a mining permit exists.
There are various definitions for economic substance but in my opinion, economic substance should mostly be about believability. How believable is the development option? If investors choose to develop rather than conserve, can it be started right away? If not, it’s probably not very real and may compromise the assessed value.
An example of a major weakness in many of the ICE products today I believe is the assumption that cash calls are necessary for development.
Additional financing is often needed for development or mining. I believe that if guaranteed financing is not arranged, then one cannot claim that the development model is real. Since most fair market values are based on the development model, how does one defend a fair market value with a compromised development model?
What are signs of a “best of breed” ICE product?
I believe that ICE products with reasonably attractive multiples AND the most believable development options or economic substance fits the bill. Let’s not forget that we must always assume that audits will happen.
What’s a representative great ICE product? (1) Land owned for at least 10 years by the last landowner; (2) if mineral model, proven mineral reserves with a current market value which is supported by a qualified appraisal; (3) a real means to dig up the commodity and distribute competitively which supports a real demand; and (4) competitive transportation.
Michael C. Ning is President and CEO of ConserVerde, LLC, a creative consultant to firms and family offices who are considering various land conservation options. Mr. Ning is also president and CEO of Arque Capital, Ltd., an investment bank, which has funded almost $500 million of alternative investment products of which $110 million have featured conservation easement options.
The views and opinions expressed in the article are those of the author and do not necessarily reflect the views of The DI Wire.
