We Appraise Both Businesses and Real Estate
Including Machinery & Equipment and Livestock
 

June 2010

Appraisal ‘Flavor’ Options 

There are a number of options available to clients needing an appraisal.  The relevance of these various options depends entirely upon the purpose and use of the appraisal report.  Under the relatively new “Scope of Work” rule outlined in the Uniform Standards of Professional Practice (“USPAP”), the client and the appraiser are able to “negotiate” the parameters of the assignment in order to meet the client’s need (often designed to save money when possible).  The charts below illustrate some of the common options for real estate appraisals, business appraisals, and equipment & personal property (including livestock) appraisals – as well as outlining their typical uses, and the degree of defensibility of the determined result:

Real Estate Appraisal Options

 Business Appraisal Options  

Equipment & Personal Property Appraisal Options

Valuations play a part in all strategic transactions, tax, and many litigation matters. For additional information or advice on a current situation, please do not hesitate to call.  We value real estate, businesses, machinery & equipment, and livestock.

May 2010

Do All Appraisals Follow the Uniform Standards of Professional Appraisal Practice (USPAP)? 

Unfortunately, not all appraisers are mandated to comply with the Uniform Standards of Professional Appraisal Practice, and some of those who are required to do so, simply do not.  The Uniform Standards of Professional Appraisal Practice, lovingly referred to by those familiar with them as USPAP, are updated and reprinted every couple of years.  The current version is the 2010-2011 Edition.  USPAP is published by the Appraisal Standards Board, a division of The Appraisal Foundation set up by Congress after the S&L crisis in the early 1980’s.  It outlines how appraisers should both perform appraisals and write appraisal reports for real estate, personal property, and business appraisals.

The Appraisal Foundation has a number of member organizations each of which requires its appraiser members to follow USPAP.  Real estate appraisers, for the most part, are required to follow USPAP while many business and equipment appraisers are either not a member of an organization that requires them to follow USPAP, or they are simply not that familiar with the standards and thus simply do not follow them.

We believe that following the USPAP guidelines is very important and highly recommend that users of appraisal reports demand that appraisers performing appraisals for them follow these important standards.

USPAP has five sections:  Definitions, Preamble, Rules, Standards and Standards Rules, and Statements on Appraisal Standards.  There are ten standards and standards rules.  They are:

Real Property Appraisal, Development
Real Property Appraisal, Reporting
Appraisal Review, Development and Reporting
Real Property Appraisal Consulting, Development
Real Property Appraisal Consulting, Reporting
Mass Appraisal, Development and Reporting
Personal Property Appraisal, Development
Personal Property Appraisal, Reporting
Business Appraisal, Development
Business Appraisal, Reporting

Courses are offered each year by a number of organizations that cover USPAP, including the changes and updates.  The initial class for someone new to USPAP is fifteen hours long; annual or bi-annual updates are seven hour courses.  Beyond the class, appraisers must typically refer to the document regularly to ensure compliance.

Periodically, we are asked to review another appraiser’s work to see if they complied with USPAP and to identify problem areas if they did not comply with the standards.  While an appraisal that does comply or follow the guidelines of the standards may still conclude to a nonsensical value, such an appraisal will at least be formatted in such a manner that a reader will be able to follow the process which lead to this conclusion.  In my years as an appraiser, I have reviewed many appraisals that did follow USPAP as well as many that did not.  Those that followed the standards are consistently superior reports than those that failed to do so.

Valuations play a part in all strategic transactions, tax, and many litigation matters. For additional information or advice on a current situation, please do not hesitate to call.  We value both real estate and businesses including machinery & equipment.

April 2010

Appraising Apples & Oranges

I recently encountered two very different opinions of value for a single property – they appeared to be one appraisal of apples and the other of oranges.  The property in question was a small commercial building located in a very small rural town.  One opinion of value was $100,000; the other was $55,000.  I was asked to determine which was correct. 

The small town is located over forty miles from the nearest city on a small rural highway.  The demographics for the town showed that its population was declining and this trend is expected to continue.  There was very little sales activity within the town in question or in the surrounding area; in fact, a number of the existing commercial buildings in town were vacant, some of them for many years.  Visiting with brokers and other knowledgeable real estate people in the area confirmed that there was very little demand for commercial property in the town and market rental rates for existing properties were very low. 

The higher of the two opinions of value was based on sales and rental comparables in the city forty miles away from the subject.  This city was located on Interstate 84, was experiencing modest growth, and had numerous employers.  It was obvious that the comparables used in this city were not at all similar to the subject property and there was no objective evidence to support the minor adjustments made to these comparables in order to conclude a value for the subject in the very small town.

The lower of the two opinions of value was well supported and based on comparables in the subject’s very small town and included an analysis of the supply and demand for similar properties.  It clearly best represented the value of the subject property.

This experience caused me to reflect once again on the concept of value.  Value is a relative term and not very useful by itself.  The most critical component of any appraisal is the standard of value used and its definition.  The use of different standards of value can, and often will, result in vastly different value conclusions.  For example, in valuing machinery and equipment, there is a large difference between an appraisal done using “fair market value in use and in place” and “liquidation value in a forced sale.”

The following is a typical definition of market value – it was taken from The Uniform Standards of Professional Appraisal Practice:

The most probable price which a property should bring in a competitive and open market under all conditions requisite to a fair sale, the buyer and seller each acting prudently and knowledgeably, and assuming the price is not affected by undue stimulus.  Implicit in this definition is the consummation of a sale as of a specified date and the passing of title from seller to buyer under conditions whereby: 

1.                  buyer and seller are typically motivated;

2.                  both parties are well informed or well advised, and acting in what they consider their own best interests;

3.                  a reasonable time is allowed for exposure in the open market;

4.                  payment is made in terms of cash in United States dollars or in terms of financial arrangements comparable thereto; and

5.                  the price represents the normal consideration for the property sold unaffected by special or creative financing or sales concessions granted by anyone associated with the sale.

First of all, it is critically important to understand that an appraisal represents the value of the subject property as of a specific date – if a different date were used, it is entirely possible that the value conclusion could be quite different.

There are many factors that affect the value of a property, investment, business interest, artwork, livestock, or anything else that is typically appraised.  One of the basic factors that is occasionally forgotten is the concept of supply and demand.  In the example of the small commercial building in the very small rural town, the lack of demand for the property severely impacts the value of it – especially compared to the demand for similar properties in relatively nearby larger cities.  Demand is typically driven by the need for products and services coming from a population base, particularly from a growing population base.  The supply of similar items also directly affects the value at any given point in time.  For example, I recently visited Santa Barbara, California.  Homes in the Santa Barbara area sell for what most of us might consider outrageous prices.  A fifty year old, 2,000 square foot home on one-sixth of an acre is selling for about $800,000 today.  Three years ago, it was selling for about a million.  The reason for the very high prices is the lack of supply.  It takes approximately ten years to get any development project through the legal processes and most are denied due to concerns about water availability.  The lack of supply and the strong demand have resulted in prices much higher than would likely occur if land were allowed to be subdivided and homes built in a timely manner.

Another basic concept that directly affects the value of investments is the anticipation of benefits to be derived in the future.  This concept is most easily explained by looking at income producing real estate.  The value of such a property is directly affected by the amount of competition from similar properties in the area, by the quality of the tenant(s), length of lease(s), economic outlook for the area, and other such factors.  For example, currently in the general Boise, Idaho area, there is a surplus of office and retail space.  This has resulted in much higher vacancy rates than have occurred in the recent past as well as lower rents.  The economic downturn has resulted in both business failures and in reduced demand for office and retail space.  Until the demand improves and the supply of existing properties is absorbed, the market for such properties will suffer, which results in lower values.

There are many different factors that affect valuations of any type.  Simply assuming that one area is similar to another can lead to significant errors in an appraisal.

Valuations play a part in all strategic transactions, tax, and many litigation matters. For additional information or advice on a current situation, please do not hesitate to call.  We value both real estate and businesses including machinery & equipment.

March 2010

Does the Appraisal Conclusion Make Sense?

Sometimes appraisers seem to come up with a value conclusion that is contrary to what makes common sense.  I’m not talking about things like the seller wants an extra million because he or she touched the investment – just because.  I’m referring to the failure by the appraiser to adequately support the value conclusion often by relying on a single method and not using any available checks to see if his or her value conclusion is rational.

Example

I was recently asked to review a business appraisal of a small medical practice located in Idaho that was done by an appraiser on the east coast.  The purpose of the appraisal was to assist a younger doctor in the practice buy the practice from the older doctor (the employer).  The doctor that wanted to buy the practice called me because he could not see how he could possible pay the price for the practice called for in this appraisal.  In other words, the appraisal conclusion did not seem to make any sense!

The appraiser concluded at a value of $708,510 for the outstanding stock in the medical practice.  As soon as I saw the value conclusion, I knew the appraisal likely had lots of problems.  Appraisers can be very good at what they do, but a conclusion as precise as this one is just plain misleading.  It is not possible to be that precise with any degree of reliability!

The appraisal was developed using only one method – the income approach.  The owner physician paid himself an annual salary of $60,000 as the entity was an ‘S’ corporation with the balance of the earnings being taxed to him personally.  The appraiser neglected to adjust the income statement to account for what is called reasonable compensation.  Reasonable compensation is the amount that would have to be paid to hire someone with similar credentials and experience to do the job.  Failure to do this results in either over valuing or under valuing the business or practice depending on what the owner(s) pay themselves.  In this case, the reasonable compensation should have been about $200,000. 

There were some other errors as well.  The appraiser did not adjust the income statement for income taxes.  The corporation was an ‘S’ corporation which does not pay income taxes at the company level, however, the shareholders must pay the taxes.  The appraiser used a capitalization rate based on an after-tax income stream, but applied it to a pre-tax income stream.  This is what we call an “El Screw Up” – clearly a technical appraisal review term, but quite expressive.

The failure to adjust the $60,000 actual salary taken to the $200,000 that would have to have been paid for an equally qualified and experienced physician and the failure to account for income taxes resulted in a considerable over valuation of the practice.  The appraiser did not use any market data – of which there is abundance for medical practices, did not use a purchase justification test, or check any rules of thumb.  Any of these would have screamed out to the appraiser that a mistake had been made.

I was also asked to appraise the same practice.  My appraisal used an income approach as well.  I, however, supported and adjusted for reasonable compensation, adjusted the rents paid to the doctor for the building to market, and accounted for the personal income taxes that would have to be paid on the ‘S’ corporation earnings by the shareholders.  Additionally, I used market data from three sources, a purchase justification test and rules of thumb to show that my value conclusion was reasonable.  Incidentally, my value conclusion came in at about one-third of the other appraiser’s concluded value.  Using multiple appraisal methods and checks for reasonableness supports the appraisal conclusion and allows the reader to see that the concluded value actually makes sense!

Valuations play a part in all strategic transactions, tax, and many litigation matters. For additional information or advice on a current situation, please do not hesitate to call.  We value both real estate and businesses including machinery & equipment.

February 2010

Evaluating Management 

A brilliant acquaintance of mine, who received that got his PhD in business from Harvard, sent me the following:

First, management had plans.
Then, they had strategic plans.
Now they have visions.
We’re only one small step from hallucinations!

At first, I simply thought this was saying funny, however, after thinking about it for a while I realized that it has some appraisal implications that are important.

Most investments require management; some much more than others.  As an appraiser, one of the assumptions that we often make is that the investment, usually a business interest or real property of some type, is similar to the following:

“It should be specifically noted that the valuation assumes the business [or real property, or … ] will be competently managed and maintained by financially sound owners over the expected period of ownership.  This appraisal engagement does not entail an evaluation of management’s effectiveness, nor are we responsible for future marketing efforts and other management or ownership actions upon which actual results will depend.”

Obviously, the quality of management can affect the performance of most investments either positively or negatively.  However, most appraisers are not trained to evaluate management, nor should they be.  Appraisals are time specific evaluations of the fair market value or market value of the investment as of a specified date in time.  As part of the evaluation of the investment, a comparison is made to the performance of similar investments in order to determine if the subject is stronger, weaker, or similar to its peers.  Appraisers are trained to perform this type of analysis.

If the subject investment has performed poorly compared to its peer group, the valuation conclusion is generally lower than if it had met or exceeded the performance of other similar investments.  Under performing businesses and properties are the target for many astute buyers that plan to supply great management, turn the investment around, and resell at a profit.  Does this mean that the under performing investment is incorrectly appraised?  No, it does not.  Future improvement in performance that someone else brings to the deal is not included in the value.  This is sometimes a problem when a business owner or manager tries to influence the income forecast demanding that planned, but not yet executed, future improvements be incorporated into the forecast (which would, of course, result in a higher current value for the investment).  If the appraiser does include such things in the income forecast, the discount rate, i.e. the risk associated with the achievement of such an income stream, must be increased, often substantially, to account for the difference in risk as said future “improvements” may not actually occur.

A couple of examples will illustrate this point:

Years ago, two existing fast food restaurants were purchased by an individual who had left a big company complete with a “golden parachute” when it was acquired by another larger company.  This person used these funds to buy the restaurants even though he had no experience in the food industry.  He planned to stay at home and listen to the cash registers ring over the phone.  It wasn’t a very good plan.  When I evaluated the restaurants, I sat and timed the drive thru customer service times.  They were averaging over ten minutes and often had cars pull up over the curb and drive across the grass median to get out of the line – not a good situation.  When I met with the owner as we toured the restaurants, his opening comment to me was “when I cross this threshold, I become physically ill.” Needless to say, these two restaurants were seriously under performing, yet, the fair market value as of the date viewed was accurate.  However, new management resulted in a vast increase in the fair market value in a short period of time.

A great real estate example is a neighborhood shopping center I appraised a while ago.  This center was in relatively good condition, however, the owner did not want to be bothered with it and had left the rents the same for over ten years.  The center was full, the tenants were happy, but the income produced by the property was significantly less than the market due to rents that were considerably less than the market.  The market value of the leased fee interest in the property (“value as leased”) was significantly less than its fee simple market value (“value with current market leases”).  This represented an opportunity to a buyer willing to invest the work and time necessary to bring the center’s rents to market.  It would likely be difficult to raise the rents to market without displacing all or at least a large number of the long-term tenants.  However, once this task was completed, the value difference would be significant.

Valuations play a part in all strategic transactions, tax, and many litigation matters. For additional information or advice on a current situation, please do not hesitate to call.  We value both real estate and businesses including machinery & equipment.

January 2010

December 2009

Known or Knowable

The effective date of the appraisal determines a lot of things that are reflected in an appraisal report.  Generally, the effective date is not that important within the scope of the assignment -- other times it is critical.  Most appraisals are done some time after the effective date; perhaps months or even years later.  Occasionally, they are done with a prospective date (a date that occurs in the future) that is typically dictated by someone or something besides the appraiser.  When preparing an appraisal for an estate, the effective date is generally either the date of death, or the alternative date which is six months after the date of death.  Many engagements for litigation are done as of the date the complaint was filed, the date some event took place, or the court date.

Regardless of the reason for the appraisal, the critical aspect to be considered by the appraiser is what information was known or knowable as of the effective date.  When the effective date is the date someone passed away, it is not unusual to have an effective date land somewhere in the middle of a month rather than a date conveniently at the months end.  Most companies issue financial statements as of the end of a month, the end of a quarter, or annually.  So, if the effective date is September 22^nd, is it appropriate to use a September 30^th financial statement or must the August 31^st financial be used?  What if the company is small and prepares statements only quarterly?  Would it then be appropriate to use the September 30^th statement or should the June 30^th statement be used?  If statements are only prepared annually, or only tax returns are prepared, should the December 31^st of the prior year or the year following the date of death be used?  The answer to all of these questions is the most commonly found response within the appraisal field:  It depends!  The answer relies on what information was known or knowable as of the effective date and the appraiser must use his or her best judgment in determining what data to include or exclude. 

As discussed previously, the availability of data as of specific dates is sometimes a problem.  For example, the Idaho Economic Forecast is published quarterly in January, April, July, and October.  If the valuation date is September 22^nd, which economic information report should be used?  Generally, I would use the July report for a September valuation date, however, depending on what was happening within the market, it might be more appropriate to use the October information.  In 2008, I was asked to value an auto dealership with an effective date of mid-August.  I used the October 2008 Idaho Economic Forecast which included data primarily from August and September rather than the July data which included data primarily from May and June.  This decision was important because the October data reflected the downturn in the economy, which had been affecting the auto industry all year in 2008, whereas the July 2008 forecast indicated a much rosier and more positive outlook for the State of Idaho than was being experienced by the auto industry at that time.  There was information in the October data that occurred after the effective date in August, however, overall, it was much more appropriate given the specifics of the industry.  Since I used information that contained some data after the effective date of the appraisal, I had to use other means, including market participant interviews to make sure I actually used only that data that was known or knowable as of my effective date.

It is important to recognize that information that is known or knowable as of the effective date of an appraisal may not show up in a compiled and published report until later on in the (sometimes distant) future.  The key for allowing this information’s use is: “was it known or knowable as of the effective date?”  CPAs generally take some time to prepare and issue formal financial statements for a company, however, the data is generally available from the company’s accounting program as of, or close to, the end of each month.  In today’s electronic environment, there is very little information that is not known or knowable close to the time when events actually occur.

Valuations play a part in all strategic transactions, tax, and many litigation matters. For additional information or advice on a current situation, please do not hesitate to call.  We value both real estate and businesses including machinery & equipment.

November 2009

Divorce & “Cash Businesses”

I recently received an inquiry from a former business appraisal student (now working as a business appraiser) on an appraisal for a divorce.  Here is the question:

I have a case where I am working with the “out-spouse” (spouse that is not involved in the business) in a marital dissolution case.  The business is a liquor store that collects a lot of cash and my client claims that much of the cash is skimmed off and thus does not show up in the reported revenue for the business.  What do you think the court will allow us to do to confirm the amount of cash received?  Would it allow us to watch the till for a specific period of time?  If not, what other methods could be used to confirm the amount of cash the business generates?

This kind of question comes up fairly frequently.  There are a surprising large number of businesses that generate significant amounts of cash and a surprising number of owners that skim sizeable amounts of cash off the top.  Years ago when I was selling businesses as a business broker, when a seller came to me with such a situation, they almost always tried to convince me that they should get paid for the business based on what it really generated in cash, not based on what they could prove.  My typical response was they would get a price based only on what they could verify and that they had already been paid for the portion of the business tied to the unreported income.

What should be done in this situation with a divorce appraisal engagement?  The answer is “it depends.”  The first question I ask a client that talks about unreported revenue is “since you are aware of this situation, did you sign the historical tax returns knowing that they were fraudulent?”  This is often the case.  In such a case, I suggest that the client talk to their attorney and ask about the ramifications to admission to committing tax fraud in court under oath – probably not a good idea.   Settlement sounds like a wiser course of action.

In cases where the client has not signed historical tax returns and has had no direct involvement in the business; i.e. is not involved in the tax fraud, there are a couple of options.  The best option is to hire a CPA firm that does forensic audits.  They can go in and examine the business, the life style and expenditures of the owner, and determine what has really been going on.  This is not an inexpensive option, and the cost and time required must be considered.  A second option is to have a hypothetical appraisal done in which industry average costs of sales are used instead of reported cost of sales.  A hypothetical appraisal is one in which facts contrary to what exist are assumed for purposes of the analysis.  For example, a fast food hamburger restaurant typically runs with food costs of about 33% and payroll costs of 25%.  If the company in question has food costs of 55% and payroll costs of 40% due to skimming cash, a hypothetical appraisal based on industry average food costs and payroll costs can reveal the likely value of the business without the skimming -- useful for settlement discussions.

Each type of business, particularly those that generate lots of cash, has some methods that can be used to estimate unreported revenue.  The amount of water used in a car wash or a coin laundry provides a good indication of the revenue actually generated.  The amount of liquor purchased each month in a bar is used to estimate the beverage revenue.  The number of paper plates used monthly in the sandwich shop is useful.  It should be noted that the IRS is well aware of these techniques and uses them in certain situations.  This is a tricky area – good legal advice is critical before pursuing what should be done. 

Valuations play a part in all strategic transactions, tax, and many litigation matters. For additional information or advice on a current situation, please do not hesitate to call.  We value both real estate and businesses including machinery & equipment.

October 2009

Highest and Best Use Issues

We recently appraised an industrial property that had been occupied for many years by a horse trailer manufacturer that had gone out of business.  The buildings are older, were specifically built to accommodate that particular use, and their layout makes use by other types of companies very difficult.  The purpose of our appraisal was for estate tax purposes, however, the client took a copy to the county assessor’s office and used it as support for a property tax appeal.  Interestingly enough, the county assessor valued the improvements on the property significantly higher than our valuation – we viewed the improvements as having no contributory value and deducted the estimated demolition cost from the land value.  The problem can easily be summarized as a difference in opinion as to the Highest and Best Use of the property.

The highest and best use is defined as:  “The reasonably probable and legal use of vacant land or an improved property that is physically possible, appropriately supported, and financially feasible and that results in the highest value.”[1]  This is a key concept in virtually all market value real estate appraisals.  The point is to develop an opinion of value of the most profitable use of the property.

In addition to being reasonably probable, the highest and best use must meet the following four tests:

1.                  Physically possible.  What uses of the site can physically be made needs to be answered?  The size, shape, terrain, accessibility of the land, flood area, amount of frontage, visibility, availability of utilities, etc. should be considered.  The possibility that certain physical changes can be made to the existing improvements that will improve the return on the property should also be explored.  The highest and best use of the property as improved may involve renovation, rehabilitation, expansion, adaptation, conversion to another use or partial or total demolition of the structure.

2.                  Legally permissible.  What uses are allowed under the current zoning and any deed restrictions?  If a use is not permitted under current zoning regulations, the possibility of a zoning change or a conditional use permit allowing the use should be explored.  For nonconforming uses or uses that are significantly different from the ideal improvement, investigation needs to be made to determine if modifications necessary to become legally permissible are possible.

3.                  Financially feasible.  What physically possible and legally permissible uses will produce a sufficient return to the land and improvements to motivate a real estate investor to make the investment?  The estimated future net operating income of the proposed uses must be determined or if the use is not income producing, the analysis must be made to determine which use is likely to generate the highest future profit.

4.                  Maximally productive.  Among the feasible uses, which use will produce the highest rate of return or the highest present worth?[2]  The use of the land that generates the highest residual land value represents the highest and best use of the land as though vacant.  Also, which use will produce the highest and best use as improved.

The concept of highest and best use must be determined for the use of the land as if it were vacant even if an existing structure exists.  If an existing structure exists on the property, then the highest and best use must also be determined for the property as it is improved.  If the highest and best use of the land as if vacant is higher than the highest and best use of the property as improved, it may mean that the existing building should be demolished.

When considering the maximally productive use of the property as improved, generally the five options shown below are considered: 

1.                  Demolition of the existing structures and redevelopment of the site

2.                  Additions to the improvements

3.                  Renovation of the existing improvements

4.                  Conversion of the existing improvements to another use

5.                  Continue the existing use.

September 2009

Considering the Value of Promissory Notes

A promissory note is, in itself, a promise to pay money (generally over time) to another party, usually consisting of both principle and interest in some form.  This payment, or series of payments, becomes an income stream for the party receiving the payments.  Like any other source of income, promissory notes can be sold or transferred to third parties.  Sales of promissory notes happen frequently among lenders and other investment based institutions, however, when notes between two private parties become the subject of consideration, deciding the value of the note in question becomes problematic. 

The value of any promissory note is based on the time value of money.  The premise of the time value of money is simple.  A dollar received today is worth more than a dollar received a year or more from today unless the dollar to be received in the future is adjusted for risk (interest).   

Obviously the interest accrued on borrowed money, such as a mortgage, attempts to account for the time duration before a loan is repaid, but there are many laws and regulations that banks have to follow in order to calculate the amount of interest allowed.  Notes made between private parties are regulated to a lesser extent and some very different terms and rates may be agreed upon. 

We recently valued a note with a beginning balance of $180,000 at 5.0% interest, due twenty-five years after inception with no payments required at all in the interim.  What would you pay for such a note?  If it was an unsecured note, probably very little, if anything, due to the risk of waiting twenty-five years for a payment.  Now if the loan was secured by real estate, what would you pay for it?  Likely you would consider this note to have some value were it backed by a tangible asset.  Now suppose we add monthly payments to the mix, does that change the value of the note?  It certainly does!  Value is increased as both the risk of non-payment decreases and as the time until payment decreases. 

Typically, when one goes about valuing a promissory note there are a few basic things to look into, but as mentioned above, some specific characteristics of a promissory note can also significantly modify its value.  The following are five examples of these characteristics:  

The first characteristic to consider is the interest rate charged.  Is the rate at, below or above market?  Is it a variable rate or fixed?   

Second, what kind of collateral is the note secured by, if any?  In the example above, the real estate collateral has some environmental concerns and may not ever be developed.  That adds some additional risk to the note. 

Third, what is the financial health of the payee?  Can they continue to make regular payments?  Is the payment history clean and straightforward, or have there been missed and/or late payments? 

Fourth, are payments due on the note?  In the example above, the note does not require any monthly payments.  This increases the risk of the loan and should be considered in the valuation process. 

Fifth, is there a payment history?  A history of regular payments made on time reduces risk.  A lack of history or a history of irregular or late payments increases risk. 

Determining the value of a promissory note requires the measurement of several different types of risk.  Incorporating them all into one supportable, quantitative discount rate to determine the present value of the note is the appraiser’s task.

Valuations play a part in all strategic transactions, tax, and many litigation matters. For additional information or advice on a current situation, please do not hesitate to call.  We value both real estate and businesses including machinery & equipment.

August 2009

Conflicts Between the Real Estate and Business Appraisals

Some entities have both business and real estate aspects.  Examples of such interdependent properties are hotels/motels, convenience stores, golf courses, bowling alleys, nursing and assisted living facilities.  It is often difficult to allocate the valuation of these entities between the real estate portion, the furniture, fixtures & equipment portion, and the intangible business portion.  The real fun begins when the entire entity is being valued by both a real estate appraiser and a business appraiser as each of them view such entities differently.  The following is a summary of a recent problem; a valuation of an assisted living center done by both a real estate appraiser and a business appraiser for a divorce:

·         Valuation Assignment:           Value of 10% ownership in an Assisted Living Facility

Value conclusions:     

Real Estate Appraiser       $8,700,000     100%          $870,000   10%

Business Appraiser            $1,800,000     100%          $100,000   10%

Both appraisers missed the value by a considerable amount.  The real estate appraiser was too high and the business appraiser too low.  The real estate appraiser did not account for the lower historical earnings and did not properly adjust the sales comparables for the differences in earnings.  His overall capitalization rate was likely appropriate for the real estate portion of the enterprise, but it was much too low to deal with the risk of the business portion.  The real estate appraiser also erred by not taking into consideration the difference between owning a control interest (i.e. 100% of the entity) and owning only a 10% minority interest (different from a pro rata interest of the whole).  The business appraiser did a better job dealing with the minority interest, but he ignored the large real estate value of the entity.  He also used the WACC inappropriately.  His biggest problem was that he attempted to value an interdependent property without being licensed to value real estate.

Real estate appraisers typically view all properties, including interdependent properties, as a real estate income stream with comparatively low risk when compared to business entities.   Business appraisers typically view most privately held business entities, including interdependent properties, as high risk compared to many alternative investments.  The differences in perceived risk often result in value conclusions that are very hard to reconcile.

Interdependent properties are some of the most difficult appraisal assignments because so few appraisers understand how to value both real estate and business entities.  These properties are best valued either by a team working together consisting of a real estate appraiser and a business appraiser or by one appraiser that is trained in both real estate and business appraisals.  This type of entity is one of our specialties:  I am both an MAI real estate appraiser and a MCBA/ASA business appraiser.  These designations, my training, and experience allow me to value interdependent properties without the problems encountered by those appraisers not qualified in both areas.

Valuations play a part in all strategic transactions, tax, and many litigation matters. For additional information or advice on a current situation, please do not hesitate to call.  We value both real estate and businesses including machinery & equipment.

July 2009

What Would You Pay for 10% of a Privately Held Company?

Let’s suppose that you have means available to pursue investment opportunities, but let’s also assume that you only have the following investment options available to you:

1)    100% interest in a privately held business that has generated $100,000 in net cash flow each year for the last three years adjusted for inflation.

2)    10% interest in a privately held business that has generated $1,000,000 (from the entire business) in net cash flow each year for the last three years adjusted for inflation.

Assuming, a 20% percent capitalization rate is applicable to both of these business interests, business number one would be worth $500,000 and business number two would be worth $5 million.  However, what would a ten percent interest in business number two be worth to you as a possible investor?  Would you pay $500,000 for a 10% interest in this company?  Would you prefer to own a 100% interest in the smaller company rather than a 10% minority interest in company number two?

Obviously, there are a number of unknowns about each of the two businesses.  Generally, a minority interest in a privately held company is less desirable than a controlling interest in a privately held company.  A control interest can and a minority interest generally cannot:

·         Appoint management.

·         Determine management compensation and perquisites.

·         Set policy and change the course of business.

·         Acquire or liquidate assets.

·         Select people with whom to do business and award contracts.

·         Make acquisitions.

·         Liquidate, dissolve, sell out, or recapitalize the company.

·         Sell or acquire Treasury shares.

·         Declare and pay dividends.

·         Change the articles of incorporation or bylaws.

·         Block any of the above actions.[1]

June 2009

Goodwill or Blue Sky?

A business appraiser I know well recently asked me about the following situation:

“I am valuing a fitness center for a divorce.  It opened up a little more than three years ago.  It generates revenues of approximately $800,000 a year over the last three years and has basically broke even or lost a little income.  The husband hasn’t taken much in a salary, certainly not what they would have to pay someone to run it for them.  The wife’s appraiser is claiming goodwill in the amount of ten times monthly revenue per a rule of thumb.  I am very skeptical of this idea.  What do you think?”

First, some definitions:

According to IRS Revenue Ruling 59-60, “…goodwill is based upon earning capacity.  The presence of goodwill and its value, therefore, rests upon the excess of net earnings over and above a fair return on the net tangible assets.” 

According to the Merriam-Webster dictionary, “blue sky is defined as “having little or no value (blue- sky stock).”

In the fitness center example, the business clearly has no goodwill.  Fitness centers typically require a significant investment in exercise equipment and facilities to allow people to use the equipment.  In order for goodwill to exist, the company in question must generate earnings in excess of what is required to operate, pay the owner (or manager) a market level salary, and generate earnings above and beyond a typical or fair rate of return on the investment in the business assets such as the equipment.  Absent these earnings, goodwill, by definition, does not exist.  Now it must be understood that the business could have some intangible assets that might have some value; for example, a customer or membership list might be able to be sold.

Blue sky is a term that has different meanings to different people.  In the fitness center example, the amount equal to ten times the fitness center’s revenue would, in my opinion, be blue sky.  I define blue sky as an amount asked for by a potential business seller that is unsupportable.  Let’s assume that our example fitness center had equipment and other “hard” assets with a fair market value of $500,000.  Ten times monthly revenue for our example would be approximately $667,000.  If someone decided to pay $667,000 for the fitness center example above, the amount of $167,000 would be blue sky.  $500,000 of the purchase price could be justified as the fair market value of the hard assets, however, without sufficient earnings to cover the owner-manager salary and a fair return on the $500,000 invested in hard assets, the company has no goodwill. 

Over the last 28 years, I have seen many business owners that have wanted to sell their business for the amount they wanted to have in order to retire rather than a value based on the earnings generated by the business.  These individuals have often wanted an additional million or so simply because they had been involved in the business and it “ought to be worth that.”  Needless to say, I have yet to see a business buyer that was willing to pay additional money to a seller based on what the seller wanted to have to retire, or as compensation for the amount of time the seller spent with the business.  Business buyers base their purchase price on what they expect to realize from operating the business in the future compared to the rate of return they expect on the investment.

The business appraiser’s job is to determine what the appropriate value for the business should be as of a specified date using market rates of return adjusted for the risks associated with the business using expected future earnings based on historical results. 

Valuations play a part in all strategic transactions, tax, and many litigation matters. For additional information or advice on a current situation, please do not hesitate to call.  We value both real estate and businesses including machinery & equipment.

May 2009

What is an Appropriate Cap Rate?

I am often asked, “What is an appropriate cap rate for ___________? (fill in the blank with some type of investment – typically income producing real estate or some type of business).  The answer to this question is always a very unsatisfactory, “it depends.”  Unfortunately, or fortunately if you are an appraiser, this question is very difficult to answer because the answer really does depend on many factors. 

First, it is important to remember what a capitalization rate or “cap rate” really represents.  A cap rate represents a combination of the expected future periodic, usually annual, return ON investment PLUS the future expected return OF the investment.  The combination of both a return on investment and the return of the investment makes a cap rate difficult to understand.  The alternative, which is easier to explain, but more difficult to apply is to calculate the expected annual return on investment each year for the anticipated holding period and then the expected return of the investment when it is anticipated that the investment will be sold or otherwise end usually called the “reversion”. 

Second, it is important to note the income stream to which the cap rate is applied in order to estimate the value.  When appraising income producing real estate, the income stream typically used is net operating income, a pre-income tax income stream.  For business entities, typically an income stream referred to as net cash flow to equity is used.  Net cash flow is an after-income tax income stream that is also adjusted for non-cash expenses, changes in working capital, and changes in long-term debt.  Net cash flow is generally much smaller than a corresponding net operating income stream would be.  Accordingly, cap rates cannot usually be compared from one type of investment to another in order to judge risk and reward potentials.

The following is an example of a horse appraisal which shows the return ON and return OF more clearly than does a business or real estate example: 

 As shown in this example, the annual return ON investment is expected to be 25.9% and the annual return OF the initial investment is expected to be 2.7% for a total annual cap rate of 28.6%. 

The following is an example showing income producing real estate that starts with a low occupancy rate and moves to full occupancy in year five, the year of the expected sale: 

 In this example, an annual discount rate of 11% is used for the annual return with a lower discount rate of 9% for the expected reversion.  The reversion is calculated using the net operating income in year five divided by the reversion capitalization rate of 9%.  Often a lower risk is associated with the sale of the property once it is fully occupied and stable, hence the lower rate for the eventual sale.  The calculated capitalization rate based on the initial year’s net income and using the indicated value is five percent.  The capitalization rate using the first year’s net operating income is deceptively low based on the very low first year’s net operating income due to the high vacancy in relation to the value based largely on the expected reversion using the stabilized income stream in the fifth year.  Determining a capitalization rate for this investment in the first year would be next to impossible as the income is not expected to stabilize until year five.

The last example shows a business investment using net cash flow to equity instead of a pre-income tax income stream as is shown in the other two examples:

April 2009

The Value of Leasehold Improvements

It is not unusual for a new Chinese restaurant to spend a lot of money installing interior walls, equipment, furniture, decorations, and other fixtures that contribute to the desired atmosphere of the business.  At the end of the lease, or much earlier in the case of a failed restaurant, the money spent on leasehold improvements may have little, if any, value.  In a similar fashion when a dentist takes new generic office space and installs significant electrical, plumbing, interior walls, cabinets, and equipment, the space is no longer useful to many other tenants without significant alterations.

Leasehold Improvements are improvements made by a tenant or by a landlord on behalf of a tenant to real property.  Typically, at the end of the lease, the leasehold improvements become the property of the Landlord.  Tenant Improvements (TIs) are the same as leasehold improvements, however, they are often called tenant improvements at the beginning of a lease period.  Generally, the tenant is given a certain allowance towards the cost of building out the tenant improvements or the landlord may build them for the tenant.  The costs of the tenant improvements are recovered by the landlord over the period of the lease and are typically accounted for in developing the lease rate.  If a tenant defaults on the lease, the landlord can suffer a significant loss as many tenant improvements are specific to the tenant and must be replaced or greatly modified before the property can be leased to another tenant.

When leasehold improvements are made by the tenant, they are typically shown as an asset on the tenant’s balance sheet.  Depending on the nature of the business, the amount expended on leasehold improvements can be substantial.  Leasehold improvements are amortized, often over the term of the lease, however, the amount shown on the company’s books as the net cost of leasehold improvements rarely is representative of its actual fair market value.  When evaluating a company’s assets and liabilities in a cost or asset approach, many appraisers give little thought to the sometimes very large amount shown for leasehold improvements.  If the company were liquidated, often the leasehold improvements will return no value at all as they typically become part of the real estate and thus belong to the landlord.

The value of leasehold improvements is highly dependent on the remaining term of the lease and the benefit to the tenant of the leasehold improvements during the lease.  Generally, the shorter the remaining term of the lease, the less value associated with leasehold improvements.  Often the value of leasehold improvements to the tenant is zero or a nominal amount.  However, if the lease contains a provision requiring the tenant to restore the premises to the “before” conditions, the leasehold improvements could have a negative value representative of the costs to restore the property.

Fixtures or Trade Fixtures are personal property items owned by the tenant that are placed in or attached to leased real estate by a tenant to help carry out the trade or business of the tenant.  Typically, a fixture when attached to real property becomes part of the real estate.  A Trade Fixture, on the other hand, typically remains personal property even with attached to the real estate.  There is often a disagreement between tenants and landlords as to what is a fixture, i.e. real property belong to the landlord and what is a trade fixture, i.e. personal property that may be removed by the tenant.  Lenders that lend on fixtures or trade fixtures generally demand that the landlord sign a Landlord Waiver confirming that the collateral is personal property belonging to the tenant so that they can remove the collateral if the tenant defaults on a loan.  If a major asset is considered a trade fixture by the tenant and shown on their balance sheet, the possibility that it is considered a fixture by the landlord should be explored.  Documentation should be available and reviewed by the appraiser to clarify the asset’s nature.  Should such documentation not be available, problems will likely result when the tenant attempts to remove the asset in question at the end of the lease.  The appraiser, particularly when using a cost or asset approach, must be careful not to consider such an asset as a trade fixture belonging to the tenant unless it can clearly be established that such is the case.  Typically, in a dispute between a tenant and a landlord, items that have been attached in a permanent type nature will likely be considered to belong to the landlord as a tenant or leasehold improvement rather than as a trade fixture.

Valuations play a part in all strategic transactions, tax, and many litigation matters. For additional information or advice on a current situation, please do not hesitate to call.  We value both real estate and businesses including machinery & equipment.

March 2009

Cheap, Fast & High Quality:  Pick Any Two

I typically get several phone calls a day from someone who needs some type of an appraisal.  Most of these calls are serious and we are happy to see if we can help the potential client meet his or her need, however, a few of them are simply humorous.  The funny calls generally go something like this:

I need an appraisal of a 2,500 acre ranch in Southern Nevada with a feedlot, seven homes, and a Bureau of Land Management grazing permit for 3,600 acres.  Can you get it done for me by next week, we need it to be of high quality because we are going to court for a divorce and property settlement, and we have a limited budget so can you get it done for $1,000? 

or

My partner and I don’t get along and we need to have our manufacturing business appraised so we can figure out how much I have to pay him to leave the business.  We just need a quick, simple idea of what the business is worth because we are sure to settle things without going to court.  We have been in business for 14 years and did $32 million in revenue last year.  Can you give us what it is worth by tomorrow for $500?

As stated in the title, Cheap, Fast & High Quality:  Pick Any Two defines fairly well the options available.  Professional work such as business, real estate, and machinery & equipment appraisals, come in a variety of configurations depending on the client’s need.  If you need it Fast, generally it must be expensive because everything else must be dropped in order to get a specific panic project done on time and often weekend and evenings must be worked.  If you want it Cheap, it generally takes longer as it can be worked on when nothing pressing is due and can be used to fill up under utilized time or staff.  If you want it to be of High Quality, it generally isn’t going to be cheap and may take a while to cover all of the needed bases and it certainly won’t be cheap and fast. 

Professional services, such as appraisals, legal work, accounting & tax work, etc., are not commodities.  A commodity, according to Wikipedia, “is something for which there is demand, but which is supplied without qualitative differentiation across a market. It is a product that is the same no matter who produces it, such as petroleum, notebook paper, or milk.  In other words, copper is copper. Rice is rice. Stereos, on the other hand, have many levels of quality. And, the better a stereo is, the more it will cost.”

It is often difficult to differentiate between professional service providers.  Price alone is not generally a good way to decide between a quoted professional service providers unless each provider is equally qualified based on experience, education, and training.  For example, I have seen legal professionals in a specific field quote a much higher hourly fee for work than a general practitioner for the same work.  However, the specialist at the higher rate who regularly does this type of work in the end is much less expensive than the generalist that you must pay for considerably more hours at a lower hourly rate while he or she figures out how to deal with the issues at hand.  In addition, it is generally much less expensive to have a project done correctly the first time rather than to have it done several times before it is done correctly.

I find it amusing to hear about the astronaut that when sitting in the space shuttle about to blast off into space thinks “I am sitting on top of a rocket and in a space craft in which every component was made by the lowest bidder.”  Components of such equipment, however, are made to very specific specifications and are examined by other professionals to make sure they are properly made before being put into use.  Such objects are in fact, similar to a commodity.  One such object is as good as any other as long as they each meet the required specifications.

As an appraiser, I am often asked to simply provide a fee quote on a job, often without the person asking for the quote understanding the many differences in quality and scope that could be construed to cover what is being asked for.  Real estate appraisals, for example, come in three report categories:  self-contained, summary, and restricted use, however, there are really considerable gray areas in the definitions of these report types.  Some appraisers include great detail and high quality work in a summary report that others would call a self-contained report.  I believe the best way to select a professional is to check with others that have used their services – in other words, check their references and find out if the professional meets their client’s needs.  Certainly, no one wants to pay more for a service than is needed and we all like to get a “deal”, however, getting a cheap appraisal that does not meet your needs is never a bargain.  While I believe we are competitive on our pricing, we are more expensive than some less qualified and less experienced appraisers.

As we are a smaller firm, we offer flexibility to our clients.  We can and do tailor the assignments to meet our client’s specific needs.  We have worked evenings and weekends on panic projects that simply must be done by a certain time and date and, for whatever reason, did not get started early.  We pride ourselves on our high quality work, however, when all that is needed is something simple and preliminary, we can and do those types of projects affordably.

We look forward to assisting you and your clients with whatever type of business, real estate, machinery & equipment appraisal need.  We also do economic damages calculations and reports and some consulting assignments. 

Valuations play a part in all strategic transactions, tax, and many litigation matters. For additional information or advice on a current situation, please do not hesitate to call.  We value both real estate and businesses including machinery & equipment.

February 2009

Appraisal Assumptions

The person who came up with the phrase, “The Devil is in the details” certainly knew what he or she was talking about!  This concept was brought home to me as I recently reviewed a business appraisal report submitted to The Institute of Business Appraisers, Inc. by an individual desiring to become a Certified Business Appraiser.  The report was prepared for submission to the IRS to support gifts of stock to the owner’s children.  The report was well prepared, the financial analysis quite good, the valuation calculations well supported.  It had one major problem though that was buried in the fine print – the appraisal included what was listed under “Hypothetical Conditions or Extraordinary Assumptions” the assumption that “We accepted Management’s representation that the book value of the real estate is a fair representation for the fair market value of the real estate.”  This is a big problem.

First, it is important to understand what a hypothetical condition and an extraordinary assumption are as well as the difference between them.  A hypothetical condition is something that is assumed for purposes of the analysis that is contrary to the actual facts.  For example, if valuing an old gas station site with known contamination due to leaks from old tanks the assumption is made to value it “as if” no contamination existed, this would be a hypothetical condition. 

The official definition of a hypothetical condition is:

That which is contrary to what exists but is supposed for the purpose of analysis.  Hypothetical conditions assume conditions contrary to known facts about physical, legal, or economic characteristics of the subject property; or about conditions external to the property, such as market conditions or trends; or about the integrity of data used in an analysis.  A hypothetical condition may be used in an assignment only if:

An extraordinary assumption is the assumption that some uncertain fact or facts are assumed to be true and if they are found to be false, the appraiser’s opinion or conclusion would likely be different.  The example the business appraiser used in this case of assuming that management’s representation that the book value of the real estate is a fair representation of its market value is a good example of an extraordinary assumption.

The official definition of an extraordinary assumption is:

An assumption, directly related to a specific assignment, which, if found to be false, could alter the appraiser’s opinions or conclusions.  Extraordinary assumptions presume as fact otherwise uncertain information about physical, legal, or economic characteristics of the subject property; or about conditions external to the property such as market conditions or trends; or about the integrity of data used in an analysis.  An extraordinary assumption may be used in an assignment only if:

In the appraisal I reviewed, clearly the appraiser stated an extraordinary assumption, however, this extraordinary assumption was included only in the body of the report in small print.  In this case, the real estate consisted of a large multi-acre property with a saw mill, planer mill, and other large buildings, some of which were purchased over twenty years ago.  Clearly the book value of the real estate had nothing to do with the real estate’s market value.  Missing the value of real estate owned by the company and treating it as an operating asset almost always results in an erroneous value conclusion.

Not understanding assumptions and limiting conditions included in an appraisal can create big problems.  The use of unrealistic hypothetical conditions or extraordinary assumptions can result in even larger problems.  Whenever a hypothetical condition or an extraordinary assumption is encountered in an appraisal, some serious thought and consideration must be made to decide whether or not the value conclusion is useful for the appraisal’s intended purpose.  It should be understood that sometimes a hypothetical condition or an extraordinary assumptions are appropriate and necessary, however, they are sometimes used to cover up incomplete work and may result in conclusions that are not useful and in fact may be misleading.

In the case I reviewed, the value conclusions were totally worthless based on the inappropriate extraordinary assumption.  The appraiser should have, at the very least, obtained market rental estimates for the real estate from knowledgeable real estate brokers in the area to support management’s representation.  A better approach would have been to have the real estate appraised as issues of highest and best use should have been addressed in addition to determining the market rental rate of the property.  The company had a history of volatile earnings with losses in recent years.  A real estate appraisal would have let the business appraiser know if perhaps the highest and best use of the real estate was for some other potential use.  It might have been better suited for residential development, for example.    

Valuations play a part in all strategic transactions, tax, and many litigation matters. For additional information or advice on a current situation, please do not hesitate to call.  We value both real estate and businesses including machinery & equipment.

[1] The Dictionary of Real Estate Appraisal, Fourth Edition, published by the Appraisal Institute, p. 141.

January 2009

Site Visits—Are They Necessary?

When asked in court, “Why did the appraiser not view the site that was the subject of the appraisal?” what would be the correct response? 

Site visits and management interviews are often taken for granted on appraisal assignments, however, especially in business appraisal assignments, sometimes a site visit is not done. 

What benefit to the appraisal assignment is a site visit?  

1. How else would the appraiser find out what condition the improvements are in order to accurately employ the sales comparison method?
2. How else would the appraiser be able to judge whether or not the business was operating at capacity and that forecasting a 20% surge in growth might be inappropriate?
3. How else would an appraiser find out that the property is surrounded on three sides by undesirable properties?
4. How else would an appraiser be able to judge the condition of the equipment utilized to maintain the cash flow generated by the subject manufacturing facility?
5. How else would an appraiser be able to see how well the subject’s neighborhood complied with the current zoning ordinance?

The list goes on, but the point should be made that the benefits of having a site visit are many.  The answer to the five questions above however is the same; the client could be asked, or an assumption could be made. 

The fact of the matter is, in some cases a site visit and management interview are impossible to complete or would incur costs that the client is either unwilling or unable to pay for.  Some scenarios that would preclude an appraiser from completing the site visit or management interview are as follow: 

1. When the subject property no longer exists, i.e. it had burned down.
2. The subject business is caught in the middle of a hostile divorce proceeding.
3. The business is located on the other side of the country.
4. The business does not in fact have any operating facility to view, i.e. a Family Limited Partnership.
5. The subject property is so large and remote that viewing the entire parcel would not be feasible.

 Google Earth has become a great help for overcoming some of the obstacles mentioned above, but the problem then becomes trying to figure out when the images made available by Google Earth were taken, and if they accurately represent the conditions of the subject as of the date of the appraisal.

 The correct response to the initial question posed in this letter, like so many others often asked in front of a judge, vary depending upon the circumstances of each assignment.  The one thing that does not vary, is that the appraiser in each assignment better have a very good reason for not visiting the subject or interviewing management.  In cases where site visits and management interviews were not completed for whatever reason, the appraiser needs to disclose that fact in the report, as the lack of same may reduce the confidence level of the value conclusion.

Valuations play a part in all strategic transactions, tax, and many litigation matters. For additional information or advice on a current situation, please do not hesitate to call.  We value both real estate and businesses including machinery & equipment.

December 2008

Valuation Issues and the IRS

There are a number of situations that might require a business or real estate appraisal to be submitted to the Internal Revenue Service.  In such cases, it is important to make sure that the appraisal is well documented and written by a highly qualified appraiser.  

Often, the IRS appraisal reviewer is experienced and knows what to look for, however, there are also times when, the IRS Officer who becomes involved knows little, if anything, about appraisals.  When this occurs, the appraiser becomes a “teacher” and must be able to explain things clearly without “stepping on toes.”  I have taught quite a few IRS Officers in classes over the years for The Institute of Business Appraisers.  I have found most of them to be reasonable and willing to learn, however, there have been a few that refused to consider anything but what they already believed.  The key issue generally seems to not to be “what is the number?” but instead, “can the appraiser explain why the number is right?”   

Currently, we are working on a business valuation case where the business owes the IRS payroll withholding taxes and is trying to negotiate a settlement.  As part of the process, the business had to be appraised.   The IRS’ Settlement Officer in this case has very little understanding of basic business valuation theory.  The following are a few of the questions we were asked and our responses: 

IRS – “The appraisal does not contain audited financial statements; this is a fundamental aspect of an appraisal; the audit statement must be provided by an independent accountant.”

RESPONSE – The company valued has annual revenue of about $1 million, historically with losses or nominal earnings.  Apparently, the IRS Officer does not understand the various types of financial statements typically prepared for small businesses.  It is very rare indeed for a small business to have audited financial statements.  They are simply too expensive.   The vast majority of small businesses do not pay for audited statements, therefore the hypothetical buyer and seller discussed in the definition of Fair Market Value do not consummate transactions based on an analysis of audited financials.  In fact, often the only financials reviewed before a small business is purchased are tax returns, therefore, tax returns are generally sufficient for an appraiser to perform a business appraisal.

IRS – “Generally a 20-30% premium is recognized for control when the Taxpayer own 100% of the stock.”

RESPONSE – This statement is completely false.  Premiums and discounts are only applicable when the level of value desired is different from the data available.  Each of the methods used in our report measured a “controlling” value directly, therefore a control premium was unnecessary. 

IRS – “There are several approaches and methods used in valuing a business.  The standard of value that is acceptable by the IRS is Fair Market Value as stated in Revenue Ruling 59-60.  The Rule-of-Thumb is sometimes used in valuing businesses.”

RESPONSE – We followed Revenue Ruling 59-60 throughout our report and used the Fair Market Value standard of value.  We also used Rules of Thumb as a “sanity check” to verify that our value conclusion was reasonable.  We disagree that rules of thumb are appraisal methods – they are too arbitrary and generally result in a wide range. 

A good example of the arbitrary nature of rules of thumb is one that has been used for accounting firms.  Accounting practices sell between 40% and 125% of annual revenue.

As illustrated by the questions we were asked, it is clear that the assigned IRS reviewer is not very familiar with business appraisals.  We have seen similar problems arise with real estate appraisals as well.  The more thorough and well supported the appraisal, the better chance of it surviving a challenge by the IRS or other reviewers.

Valuations play a part in all strategic transactions, tax, and many litigation matters. For additional information or advice on a current situation, please do not hesitate to call.  We value both real estate and businesses including machinery & equipment.

November 2008

WACCy Problems:  When is the Use of a Weighted Average Cost of Capital (WACC) Appropriate?

I recently had an inquiry from a business appraiser in Puerto Rico (he had heard me speak in several business appraisal conferences) asking how to appraise a business for an SBA loan.  He was trying to figure out what rate to use for the debt portion of the Weighted Average Cost of Capital (WACC).  This question led to the following discussion regarding whether or not the WACC was appropriate for this type of appraisal.

There are a number of methods available to business appraisers to compute the cost of capital when valuing a business.  When valuing equity directly, many appraisers use some type of a build-up method to derive their discount or capitalization rate.  When valuing equity indirectly, i.e. valuing investment capital (the total sales price of the business regardless of how it is funded versus the equity in the business), the appropriate rate to use is the Weighted Average Cost of Capital, often referred to as the WACC.  Equity is typically valued indirectly when the subject business has an atypical capital structure and it is reasonable to expect that a willing buyer would change it.

In simple terms, the WACC is comprised of a cost of equity component and a cost of debt component.  The weighted cost of each of these components at market value is combined to obtain the WACC.  Inherent in the concept is the assumption that the equity owners of the business are not personally responsible for the debt nor are personal assets required to be pledged for the debt.   

There is some debate as to whether or not it is appropriate to assume that a buyer would change the capital structure when valuing a company.  I am not as concerned with this issue as I take into consideration the size and strength of the company being valued.  I believe that many appraisers are using the WACC inappropriately to value the investment capital of very small companies.  Very small companies and small companies rarely have the ability to borrow funds without the owners pledging personal assets, often personal real estate, and providing a personal guarantee of the debt.  If a personal guarantee and pledge of personal assets are required, does the debt component (which is lower than the cost of equity) really represent the actual cost of capital for that portion of the business’s investment capital?  No.  In my opinion, the requirement of a personal guarantee and pledge of personal assets results in the same cost of capital as the equity component.  Some might debate the issue if only a personal guarantee is required, however, what is the difference of borrowing funds personally and contributing them to the business as capital and borrowing funds in the business name and providing a personal guarantee of the debt? 

If the real cost of the debt, including personal guarantees and pledge of personal assets, is not considered in the valuation of closely held businesses, I believe that we often overvalue the subject business.

The concept of the WACC and valuing investment capital or equity indirectly is theoretically sound and very appropriate when the business is large enough and strong enough to borrow funds from lending institutions without personal guarantees or pledge of personal assets.  I believe this concept is very appropriate for use in valuing large privately owned businesses of the size often called “middle market” companies.  Middle market companies are those with annual revenues in the $20 million and up range, however, sometimes companies with smaller annual revenues are included in this category. 

When valuing small and very small businesses, we must consider the cost of personal guarantees and pledge of personal assets.  The equity in these smaller companies should be valued directly as the use of the WACC in valuing the equity indirectly will typically result in overvaluing them. 

My answer to the appraiser asking what rate to use for the debt in the WACC was to not use the WACC at all.  Instead, I suggested that he value the company using what is called a build-up method to estimate the cost of capital and value the total assets of the business, i.e. the likely selling price, as if it were debt free.  In this way, the value of the business entity is the same whether a buyer pays all cash from his or her pocket or borrows some or most of the purchase price from a bank in conjunction with personal cash.

Valuations play a part in all strategic transactions, tax, and many litigation matters. For additional information or advice on a current situation, please do not hesitate to call.  We value both real estate and businesses including machinery & equipment.

October 2008

Has the Stock Market Value Disappeared OR Are Stocks on a Moonlight Madness Sale?

The current financial panic has the news media and most politicians in an uproar.  Of course, the largest noise is made by those trying to affix blame for the problem.  Who created the mess is of little interest to most Americans.  The reality of there being a mess, on the other hand, is.  I, along with many others, have been expecting this disaster.  Why, you may ask?  Let me give a couple of anecdotal examples of things that convinced me that some lenders would be in trouble:

1.    Several years ago my daughter and son-in-law informed me that they were going to buy a house in South Nampa.  I was surprised because six months earlier they had needed a co-signor to lease an apartment.  I was completely taken back when a few months later, they bought a house in Nampa.  The developer was allowed to pay the closing costs and they “qualified” for a 100% loan.  Neither of them had been working in the same job for a year and they had no savings.  They got the loan and the house.

2.    A couple of years ago I decided to get a line of credit secured by a house that we have converted to an office building.  All of the lenders originally approached refused to do the loan because a business occupied the property and it was still technically zoned residential even though the City of Parma considers the area to be commercial and allows commercial use.  Some lenders told me if I could get an appraiser to state that it was a house and not occupied by a business I could get a loan.  However, that would be lying so I did not do that.  I received an invitation in the mail from Washington Mutual to apply over the phone for a loan.  I thought this was a novel idea.  I applied and while on the phone they used an AVM (Automated Valuation Model) and told me “no problem” as the property was worth 150% of what I knew it to be worth.  They did everything through the mail never having any appraiser actually look at the property.

Both of these examples illustrate part of the problem.  Many worse examples can be found by asking around or from reading the news.  Some lenders did some really stupid things.  Others bought securities secured by horrible loans.  Could and should anyone have seen this coming?  Yes, many of us in the appraisal industry have been expecting the problems.  Some accounting rules dealing with fair value and mark-to-market have contributed to problems.

Now the big question!  Is the economy ruined and will it never recover?  Of course not!  We as a nation have done many stupid things over the years.  All of us remember the dot.com era of not many years ago.  At that time, investors threw money at any business plan that sounded good – never mind if there had never been a profit generated.  Lots of people lost a lot of money.  In 1980s, we had the Savings & Loan crisis caused largely by lenders getting into the development business and losing lots of money.  The economy has always had its ups – and its downs.  Each time we have a “major” problem some people, including the media, lose confidence in our overall system.  Yet, within a year or two things have improved and the losses and problems are all but forgotten.

Most companies in America are doing quite well and will continue to do quite well.  When nervous and foolish people dump their investments at rock bottom prices, knowledgeable investors are perfectly willing to buy.  I still remember a professor who taught the investing course at Brigham Young University talking about a few times when the stock market goes on “Moonlight Madness Sale”!  He gave us several examples of how he and others hugely profited at these times.

I am confident that within a relatively short time, the stock market will have recovered and will go on to new heights in the near future.  Whether or not the country enters a recession is a concern, but not something worth worrying about.  Successful businesses and business leaders make whatever adjustments are necessary and move on. 

Should you wish to discuss any of these issues, I would be happy to do so. 

Valuations play a part in all strategic transactions, tax, and many litigation matters. For additional information or advice on a current situation, please do not hesitate to call.  We value both real estate and businesses including machinery & equipment. 

September 2008

Appraisers:  Report the Market or What the Market Should Be?

Appraisers, by their very nature, are opinionated people and they must be able to make decisions and support them.  Appraisers that regularly do assignments for litigation are very opinionated people who must also be very confident and present their position well.  These tendencies are very helpful to appraisers in doing their jobs, however, they can get in the way of doing what they should do in performing an appraisal.  Appraisers MUST remember that it is their job to report the market for the subject of the appraisal, i.e. what a willing buyer would pay and a willing seller accept as of the effective date NOT report what they personally believe the value should be! 

There are many different standards of value that can be used in any given appraisal assignment, however, I have yet to see one that states the appraiser should state his or her opinion of what the value should be.  All of these different standards of value relate to market participants.  The most commonly used standards of value typically involve a hypothetical and knowledgeable willing buyer and seller each acting without any special motivations as of a specific date.  In short, the appraiser’s assignment is to “mirror the market”.

With the help of computers and numerous software programs, appraisers can now apply many sophisticated methods and model innumberable scenarios as part of the appraisal process.  It is not uncommon to see elaborate statistical models and other very complicated programs used to develop value conclusions for business entities or real estate properties.  As programs and appraisal templates have become more complex and detailed, it seems to me that common sense is sometimes lost.  Appraisers need to consider their value conclusions in the light of “does it really make sense”?  I have an advantage that many appraisers do not share – I sold businesses and real estate as a broker for over twenty years.  I have also owned and sold businesses, real estate, and developed real estate.  Dealing with actual buyers and sellers instead of hypothetical individuals is a real awakening.  Appraisers that have not had “real market” experience should consider talking to market participants, i.e. brokers, buyers, sellers, and/or developers to see if what they have concluded to as a value makes sense.  Although I have real market experience, I practice what I preach – I verify my conclusions as it is so easy to impose your own beliefs while making what should be an objective analysis.

Real Estate Appraisal Example

I recently was asked to review a real estate appraisal of a subsidized housing apartment project.  The appraisal assignment required the appraiser to determine numerous conclusions of value under a variety of scenarios.  Of particular interest to my client was the Hypothetical Value “As Is” as if the property were rented to market tenants without benefit of the Government Subsidies versus the Hypothetical Value “As Renovated” as if the property were rented to market tenants without benefit of the Government Subsidies.  Substantial renovations are required by the government entity, however, the property could be operated just fine “as is” if it were outside of the subsidized housing program.  The appraiser concluded a huge difference between these two values by crunching numbers without, in my opinion, considering real market evidence.  Both of these scenarios were hypothetical as they did not exist and would likely never exist thus complicating things.  The underlying questions were “would a market tenant care whether or not the renovations being required by the Government entity providing the subsidy were made or not?  Would the expenses of operating the property really be much different with our without the renovations outside of the subsidy program?”  In my opinion, things really would not be much different in either scenario and thus the values should have been about the same.  I checked with a few brokers in the area that were familiar with the apartment market and they concurred with me.

Business Appraisal Example

There are numerous business appraisal examples where what actual market participants would likely do is ignored.  The best examples are those where minority interests in an operating business are being appraised.  I often see appraisers calculate huge discounts for lack of control and lack of marketability for a minority interest without considering whether or not the willing seller would accept the concluded value.  For example, let’s consider a ten percent interest in an operating company that has been in existence for thirty years, is profitable, but does not distribute any cash to minority shareholders and is not likely to do so.  The ten percent interest will only receive funds when the company is sold which is not considered a likely option for many more years.  If the company is valued at $1,000,000, clearly the ten percent interest is worth less than $100,000.  However, how much less?  Would a “typical willing buyer” pay $50,000 for the interest?  How about $10,000?  Would the “typical willing seller” accept $10,000?  Probably not.  What would the “typical willing seller” accept for the ten percent interest?  The answer is dependent on many factors, all of which should be discussed in the appraisal assignment.

Valuations play a part in all strategic transactions, tax, and many litigation matters. For additional information or advice on a current situation, please do not hesitate to call.  We value both real estate and businesses including machinery & equipment.

August 2008

Capitalization Rates and Risk

Last month, I discussed the difference between business and real estate capitalization “cap” rates.  As a follow up to the topic of cap rates, I thought it would be useful to discuss cap rates and how they relate to risk.  This is easiest when discussing real estate, but the same principles apply in business cap rates and discount rates.

Again, just what is a cap rate and what does it measure?  A cap rate represents the percentage applied as a divisor to a one-year income stream that is indicative of the value that both a typical buyer and seller would agree upon.  In simple terms, it is the rate that a buyer requires for both the annual income from a property plus the profit, (typically from appreciation), and what the buyer expects from an eventual sale of the property.  It is critically important to realize that the cap rate includes both annual income and anticipated future appreciation!  Cap rates change over time based on overall economic conditions, national and local, and they are particularly influenced by prevailing rates of return on alternative investments as well as the perceived risk associated with the specific real estate property.  

A number of factors should be considered when selecting a cap rate to be applied to a specific property in order to obtain an indication of value.  It is not simply enough to look at cap rates from the sale of other properties in the same category as the property in question, however, this is often all that is done in practice.  In order to understand how this should work, looking at an example will be helpful.  

Let’s assume we are valuing a small neighborhood shopping center with 10,000 square feet of building – five tenants each with 2,000 square feet of space, built last year, and located on a busy street in a nice town across from a Wal-Mart.  The “subject” is fully leased with one national tenant, one national franchise restaurant (local franchisee), and three “mom and pop” local businesses.  Each lease is for five years and is at “market” rent.

The following are a number of “comparable” sales that could be used to extract a capitalization rate that would be considered applicable to our subject:

If these are all of the sales that have occurred in the last year or so, it may be all of the information available.  What is the appropriate cap rate for the subject?  A tough question.

To further complicate things, cap rates that are extracted from sales are based on the income and expenses associated with each sale.  It is important to consider the vacancy rate used and whether or not the expenses used to arrive at each cap rate included all appropriate expenses or whether they may have been higher than normal for a number of reasons.  Often, there are a number of unknowns involved which could result in differences in cap rates derived from sales comparables.

The selected capitalization rate used to value a property is driven by the risk associated with achievement of the expected income stream.  Factors that influence the risk are the quality of tenants, the length of leases, the relationship of rents to current market rents, i.e. are the rents above the market rate? (If so, the tenant may be looking for ways out of the lease).  Are the rents below the market rate?  (If so, how long are the leases?  Are the leases assignable?)  What is happening in the area?   Many more factors are often considered as well. 

Once the capitalization rate has been selected, its suitability can be checked by a technique called the Band of Investment approach.  This methodology involves the use of typical rates of return on equity and available financing for similar properties.  If the indications of a suitable capitalization rate vary significantly from the capitalization rate extracted from the market, it may mean that additional considerations are warranted to see if perhaps the extracted rate should be adjusted.

The capitalization rate is very sensitive.  A small change in the cap rate results in a large difference in the indication of value.  For this reason, it is wise to use both a cost approach and a sales comparison approach to support the value conclusion reached using the income approach.  The appraiser’s judgment and experience greatly influences the quality of virtually all valuation conclusions reached. 

Valuations play a part in all strategic transactions, tax, and many litigation matters. For additional information or advice on a current situation, please do not hesitate to call.  We value both real estate and businesses including machinery & equipment. 

July 2008

Business vs. Real Estate Cap Rates

It is not uncommon to see an inexperienced business appraiser, particularly one who has a real estate background or is familiar with commercial real estate properties, use a real estate capitalization rate to value a business entity.  When this occurs, the business is typically significantly overvalued. 

For many years it seems like the capitalization rate (cap rate) that was used for many real estate commercial properties was ten percent.  It is still used as a “rule of thumb” by many real estate brokers and property owners.  Over the last few years, we have seen cap rates in many real estate appraisals drop significantly from this old bench mark resulting in higher values.  Now as real estate financing has tightened up, cap rates are rising resulting in somewhat lower values as investors are demanding higher returns.  

Just what is a cap rate and what does it measure?  A cap rate represents the percentage applied as a divisor to a one-year income stream that is indicative of the value that both a typical buyer and seller would agree upon.  In simple terms, it is the rate that a buyer requires for both the annual income from a property plus the profit, (typically from appreciation), and what the buyer expects from an eventual sale of the property.  It is critically important to realize that the cap rate includes both annual income and anticipated future appreciation!  Cap rates change over time based on overall economic conditions, national and local, and they are particularly influenced by prevailing rates of return on alternative investments as well as the perceived risk associated with the specific real estate property.  

The income stream used in real estate valuations is net operating income – a pre-tax income stream.  The income stream used in business valuations is net cash flow – an after-tax income stream that is also adjusted for non-cash expenses, capital expenditures, changes in working capital and changes in long-term debt.  Cap rates applied to value real estate and those applied to business income streams are very different.  They simply cannot be used interchangeably at all.  However, often we see a real estate appraiser or someone familiar with real estate appraisals try to value a business using a real estate cap rate.  When a business appraiser tries to value a real estate property, the cap rate is, of course, generally ten percent.

Business and real estate cap rates also come from different places.  A real estate cap rate is often “extracted from the market” meaning real estate appraisers collect a number of sales for which income information is known so that cap rates can be calculated.  Using a number of similar property sales, the “market” cap rate can be extracted.  The only problem with this approach is that it essentially guarantees that the sales comparison approach and the income approach are going to match because the same data is used for both – this could be either good or bad.  What it does mean is that when the same data is used to develop both approaches, the approaches do not “check” each other – they give you the same answer.  We generally use another method called the band of investment approach to “check” our data to see if it is reasonable.  The band of investment techniques use equity and mortgage investment rates to estimate a cap rate for a property.  This tool also has a problem:  it is extremely sensitive to small adjustments and thus answers can easily be skewed if the appraiser is not careful.  Business cap rates are typically “built-up” using a risk free rate, a rate for the overall stock market as a whole, a size premium for smaller publicly traded stocks, and then a subjective specific company risk premium estimated by the appraiser.  This methodology is also extremely sensitive to small adjustments.  This is why other business appraisal methods must be used to support conclusions reached using a cap rate.

If this discussion makes you uncomfortable, it has accomplished its purpose.  A valuation constructed using only one approach is often difficult to support.  This is why generally three approaches to value:  the market or sales comparison approach, the cost or asset approach, and the income approach are used to estimate the value of a property or a business interest.  Often, a lender requests a “best single approach” valuation to save money – I think that this is a mistake as one approach has no checks to make sure it is accurate.  This is similar to trying to identify a line with a single point – no one knows if it is correct or not.  As we were all taught in geometry class, it takes at least two points to identify a line.  More than one approach should be used to value real estate or a business interest unless the required data is simply not available. 

The following examples illustrate simple applications of cap rates for both a business and an income generating commercial real estate property:

In this example, both the commercial property and the business have the same value of $700,000.  The cap rates are very different numbers and they are applied to different income streams, yet the values are the same.  Does this mean that an investor would look at these two investments as identical?  Certainly not!  Although the indicated value is the same, they would each very likely have completely different risks and potential benefits associated with them.

It is important to understand where a cap rate comes from and its applicability to the income stream to which it is applied.  If the process is not understood and applied correctly, value conclusions will not be meaningful.

Valuations play a part in all strategic transactions, tax, and many litigation matters. For additional information or advice on a current situation, please do not hesitate to call.  We value both real estate and businesses including machinery & equipment. 

June 2008

Business Exit Strategy Planning

Business owners often spend years building up a successful business without giving much, if any, thought as to what will happen to the business when the time comes for them to exit.  Events such as personal or family member illness or death in addition to voluntary retirement can result in a need to exit the business.  Business owners need to develop a plan that will work for them.  Business Exit Strategy Planning is best done early – well before an event occurs that makes an exit necessary.  I believe that it is very important to have the business owner’s professional advisors involved, particularly the firm’s attorney and CPA, in the process as a number of legal and tax issues must be examined and important decisions made.  It is generally necessary to have the business appraised as part of the planning process.

The typical methods for exiting a successful business include the following:

·         Children take over the business

·         Sell to partner (Buy-Sell Agreements)

·         Sell to key employee(s)

·         Sell to all employees (ESOP)

·         Sell to outside, independent third party

·         Keep the business – hire professional management

·         Take the company public (Initial Public Offering or IPO)

·         Liquidate the business

Each of these options has some advantages and disadvantages.  The following are brief comments to consider about each of the typical exit options:

Children take over the business

This option has several issues that must be considered.  Are the children interested in running the business?  Are they capable of doing so?  If more than one child is involved in the business, who will be in charge?  How will compensation between them be determined?  If some children will take over the business and others will not, how will that be worked out to be fair to all children?

Sell to partner (Buy-Sell Agreements)

Is the sale mandatory?  How will it be funded?  How is the price set?  Is the price updated regularly as the business changes?  If done with a formula, will the formula work over time?  Will the formula be challenged by heirs or a spouse as unfair?

Sell to key employee(s)

Do the key employees have the financial ability to buy the business?  If the sale is done with little or no down payment, what will keep the buying employees from walking away if the business develops problems?  Will the seller’s family members agree that the price was fair?  Will the key employees walk away without paying the full price and open a competing business?

Sell to all employees (ESOP)

An Employee Stock Ownership Plan (ESOP) can be very attractive as laws establishing them provide some great tax incentives involving a deferral of the sales price if the business qualifies.  ESOPs generally result in increased employee productivity and can be a great benefit to employees.  However, ESOPs are expensive and the company must have enough employees to make it worthwhile.  The process is generally too expensive for firms with less than fifty or so employees.

Sell to outside, independent third party

The company must have good financial records and have the ability to transfer management to a buyer.  It is generally important to keep any potential sale confidential so that employees, customers, and competitors do not cause the business difficulties.  A good, well qualified business broker is generally very helpful in locating qualified buyers and in maintaining confidentiality.  

Keep the business – hire professional management

If the business is large enough, this can be a good option.  However, finding, monitoring, and retaining professional management can create issues. 

Take the company public (Initial Public Offering or IPO)

This is only an option for fairly large companies and is very expensive as audited financial statements are required and large fees must be paid to an underwriter.  Most companies will not qualify for this as an option.

Liquidate the business

Occasionally, this is the best option as some businesses are worth more dead than alive.  A business appraisal will reveal whether or not this should be considered.

Each of these options require a lot of thought and planning.  Coordination with the firm’s professional advisors is also critical.

Valuations play a part in all strategic transactions, tax, and many litigation matters. For additional information or advice on a current situation, please do not hesitate to call.  We value both real estate and businesses including machinery & equipment. 

May 2008

Precision vs. Accuracy

The purpose of an appraisal is generally to determine the “value” of something using some specified standard of value typically “as if” the subject of the appraisal changed hands often between a willing and able buyer and a willing and able seller in terms of cash equivalency.  An appraiser uses his or her special knowledge, experience, and training together with data gathered regarding the subject and comparables to develop an estimate of the subject’s worth as of the specified date following the selected standard of value.  Inherent in this process are typically numerous assumptions and often a number of subjective decisions and judgments.  When possible, appraisers use a cost approach, a market approach, and an income approach.  Sometimes, multiple methods within one or more of these approaches are applied.  Each of the indicated values generated by the methods used must then be reconciled into a final value conclusion.

Appraisals, by their very nature, can be accurate or inaccurate, but they cannot be very precise.  The definition of precise that I am talking about, according to Webster’s Dictionary is “minutely exact”.  According to the Appraisal Institute, precision is defined as “how finely something is measured.  The more digits, the more precise the measurement is.  For example, a distance that is measured to the nearest tenth of a foot is more precise than one measured to the nearest foot.”  What I mean by accurate is “free from error” or “reliable”.  The Appraisal Institute defines accuracy as “how close the specified number is to reality.  The digits are meaningful.  In the previous example, if the measuring tape was properly manufactured and has not shrunk or stretched, the numbers “2”, “3”, and “4” from the tape are all meaningful because they convey accurate information.  If the tape has stretched by one-half percent, the number “3” is precise because it was read off of the tape, but it is not meaningful because it is incorrect.”

It is virtually impossible to measure anything with perfect accuracy.  An infinite number of digits can exist to the right of the decimal point for each measurement.  The same principal applies to value indications derived in an appraisal.  The accuracy of any indication of value is totally dependent on each component that went into the process.  If a side of a building is measured at 33 feet, two and 5/8 inches, what is the appropriate number to use?  I would typically round the measurement to the nearest foot or on smaller measurements, perhaps the nearest half-foot.  Suppose a simple building is measured at 33 feet, two and 5/8 inches by 93 feet, seven and 3/8 inches.  What should the stated square footage be?  I would call it 3,102 square feet having rounded the measurements to 33 feet by 94 feet.  However, it could also be called 3,100 square feet or 398.625 inches by 1,123.375 inches or 3,109.75944 square feet. Later on, after applying all of the data gathered, this square footage would be used to help determine estimates of value.  During this process, typically a number of subjective decisions are made each of which lessens the precision of the process, however, as it is the appraiser’s job to “mirror the market” meaning to determine value according to how market participants would view it.

I cannot help but laugh when I see an appraisal conclusion stated something like the following:

Nineteen Million Seven Hundred Eight-Six Thousand Seven Hundred Thirty-Six Dollars and 22 Cents
$19,786,736.22

Knowing all of the subjective decisions that went into the appraisal process, a conclusion stated with this much precision is ludicrous and misleading.  An appraisal conclusion simply cannot be accurately stated to this level of precision.  Instead, rounding to what is determined to be “significant digit” should be employed.  A “Significant Digit” is a digit “that is believed to contribute accuracy, not simply precision, to a measurement.  

In the above example, the value conclusion could be stated accurately a number of ways depending on the data used in the assignment and the level of adjustments required to arrive at the conclusion.  I would typically state such a value conclusion as follows:

Nineteen Million Eight Hundred Thousand Dollars
$19,800,000

This type of statement is accurate, but not so precise as to mislead the reader into thinking that the data available and the processes applied allowed the result to be stated as precisely as shown above.  

Valuations can and should be “accurate” meaning that they should be reliable in that they should fairly represent what market participants would pay or receive for the subject property as of the effective date of the appraisal following the selected standard of value.

Valuations play a part in all strategic transactions, tax, and many litigation matters. For additional information or advice on a current situation, please do not hesitate to call.  We value both real estate and businesses including machinery & equipment. 

April 2008

Lease Issues and Business Value

Many businesses do not own the real estate they occupy.  Instead, the premises are typically leased.  A lease is a written agreement that transfers the right to use and occupy real property for a specified period of time in return for rent.  Leases often include many other provisions, some of which can be quite complicated, that may affect the value of the business occupying the site.    

Business appraisers must carefully consider the implications that the lease has on business value.  There are many.  I have chosen to discuss of few of them in this article.

First, an outrageous, but real example.   A few years ago a retail store located in a regional mall was put up for sale.  It had been in the mall for quite a few years and had been very successful.  Due to large amounts spent for advertising and good business practices, the retail store’s revenue and profits had grown each year and it appeared to be highly desirable as a business purchase.  A buyer was found that made an acceptable offer on the business and both the buyer and seller were happy.  Only one problem existed.  The real estate lease was expiring in less than a year and it turned out that the regional mall had a new jewelry store in mind for the space that was willing to pay a much larger rent.  When the buyer applied to assume the lease and requested a renewal of the lease, the mall told them that the lease would not be renewed.  The pleadings of the seller and references to long-term loyalty including spending lots of dollars to bring customers to the mall were to no avail.  The lease was not renewed, the business relocated outside the mall but it never regained profits anything like what they were while in the mall and it eventually went out of business.  As shown in this example, the failure to be able to renew and transfer the lease eliminated what had appeared to be a significant business value.

Lease issues that must be considered when valuing a business include, but are not limited to, the following:

The remaining term of the lease is usually the easiest potential problem to spot.  Usually, the expiration date of the lease is clearly defined.  Some businesses are easier to move to a new location than others.  The easier it is to relocate a business, the less impact on the value due to the lease.  Conversely, the more difficult to move the business, the greater the impact on the value related to the lease.

Renewal options can be tricky.  Many leases spell out specific formulas or fixed amounts for the rent for each renewal option, however, quite a few leases call for vague and ambiguous rent provisions for the renewal periods.  A clause that calls for an agreement to agree on the future rent is not very worthwhile and cannot typically be relied on to assure renewal of the lease.  A reference to market rent at the time of renewal can also be a problem.  If the business is highly dependent on the location and market rents soar for any number of reasons, the future market rent may be so much higher than current rent as to eliminate all or much of the business profits.  Estimating future market rents five or more years down the road is difficult as well.  Such a renewal option increases the risk of achieving the forecasted business income stream effectively reducing the value of the business.

Transferability issues are relatively obvious.  They can cause huge problems as shown in the example.  Often, the lease calls for landlord approval of transfer of the lease with approval “not to be unreasonably withheld.”  Other times the lease gives the landlord a great deal of discretion regarding transferability of the lease again effectively reducing the value of the business.

Below or above market rent may affect the value of the business substantially.  A long-term lease with below market rent that is clearly transferrable may increase the value of the business, however, should the property be foreclosed upon, the lease may be extinguished eliminating this increased value.  If a business is paying above market rent, the business is often motivated to relocate and thus reduce this expense or may be able to renegotiate the lease if relocation is a strong possibility.  These factors are challenging to deal with in business valuations.

Percentage rent or other participation clauses must be taken into consideration especially when forecasting future revenues.  Some leases, particularly long-term leases for businesses like restaurants, have a clause that requires the tenant to pay a certain percentage of gross revenue if that amount exceeds the basic rent.

Default provisions can create uncertainty especially if a business has difficulty avoiding some provision that could be used by the landlord to get out of the lease.

Ownership of leasehold improvements is generally specified in the lease.  Many businesses include leasehold improvements on their balance sheet, however often at the termination of a real estate lease they become the property of the landlord.  Even if they really do belong to the tenant, are they worth anything if the tenant leaves the location – can they be removed and used elsewhere?  Usually, the leasehold improvements have no value as they cannot be removed and used elsewhere; they are simply on the company’s books and the cost is being recovered by depreciating them.

Requirements to restore premises to original condition can be particularly onerous depending on the nature of the business and the amount invested.  If some environmental issues are involved and total clean-up is required, the cost of the remediation is sometimes larger than the value of the business enterprise.

Valuations play a part in all strategic transactions, tax, and many litigation matters. For additional information or advice on a current situation, please do not hesitate to call.  We value both real estate and businesses, including machinery & equipment. 

March 2008

S Corp Valuations & Gross v. Commissioner

In the now famous court case entitled Gross v. Commissioner,[1] a very profitable Pepsi Cola distributorship that paid out large amounts as distributions to its shareholders was valued by the taxpayer’s expert using the then standard valuation technique of tax-affecting the income stream “as if” the entity were a ‘C’ corporation.  This technique was disallowed by the court causing an upheaval in the valuation profession.  Since this time, this valuation concept has been studied, reported on, and analyzed by many valuation experts.  Several valuation models have been developed which are now commonly used to value minority interests in ‘S’ corporations especially when the report is prepared for tax purposes.  Tax-affecting the income stream “as if” the entity were a ‘C’ corporation is generally considered perfectly appropriate when valuing a 100% control interest in the entity, but it certainly is not appropriate when valuing a minority interest in an ‘S’ corporation.  

Whether or not a minority interest in an ‘S’ corporation or a ‘C’ corporation is worth a different amount has been the subject of many arguments and articles in the business valuation profession since the Gross v. Commission case was first published.  Since then, several more cases have strengthened the IRS’s resolve to disallow tax-affecting the income stream when valuing minority interests in ‘S’ corporations.  

The basic concept underlying the valuation of a minority interest in an ‘S’ corporation is fairly simple:  “if you have to pay income taxes on the income you receive from an investment, you end up with less in your pocket than if you didn’t have to pay taxes.  Therefore, all things being equal, if one investment has taxes levied on it, and the other does not, an investor would choose the one that does not.”[2]   

‘S’ corporations were originally authorized by congress so that small business corporations that elected this status could be taxed in the same manner as partnerships effectively doing away with the double taxation problem that ‘C’ corporations have, i.e. income is taxed at the corporate level and then dividends paid out to shareholders from after-tax income is taxed again to the shareholders.  The creation of ‘S’ corporations eliminated the dividend tax that the individual shareholder must pay.  In fact, the shareholders of ‘S’ corporations pay the income tax that a ‘C’ corporation would have paid personally on their share of the income, whether or not cash is actually distributed, at personal income tax rates.  Currently, personal and corporate income tax rates are substantially equal so the real benefit to the investor is that the investor does not have to pay dividend tax on any amount distributed to them from an ‘S’ corporation.  

An additional benefit of an ‘S’ corporation when less than 100% of profits are paid out to shareholders is that the earnings not paid out will increase the shareholders basis in their investment and lessen the eventual capital gains tax that will have to be paid when the investment is actually sold.  Some ‘S’ corporation models attempt to quantify this benefit by making a number of subjective assumptions regarding the likely holding period of the investment and generally use a different risk rate to discount this future benefit as the risk of receiving it is much higher than the benefit of not paying dividend taxes.  Unless a transaction is expected in the near future, the present value of this benefit is generally immaterial.  Investors in closely held companies typically have a long investment horizon, often estimated at approximately fifteen to twenty years.  Under the fair market value standard of value, a typical investment holding period is assumed, therefore, this possible benefit is often not given any weight in many valuations.  

Depending on the amount of cash distributions relative to the amount of income tax that must be paid by the shareholder personally, the value of ownership interests in ‘S’ corporations may be worth less than an otherwise similar ‘C’ corporation, may be worth the same, or may be worth more.  For example, some ‘S’ corporations pay out less cash to shareholders than the shareholder will have to pay personally in income taxes for the investment, some pay out just enough to cover the personal income tax liability, and others pay out more than is necessary to pay the personal income tax liability.  

Since the Gross v. Commission case was decided, a number of valuation models have been developed to value minority interests in ‘S’ corporations.  Among these models, the one that we believe best presents the value in an understandable manner is the model developed by Chris Treharne, ASA, MCBA, BVAL in his article entitled “S Corps:  Follow the Cash” presented at the 2006 Institute of Business Appraisers conference and based on the article entitled “Valuation of Minority Interests in Pass-Through-Tax Entities” published in Business Valuation Review in September 2004.[3]  The following tables illustrate how this model works using an example with combined Idaho and Federal tax rates: