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

July 2011

What is Fair Value?

So, you’ve got a client who needs to put together a Buy-Sell Agreement and wants to make sure that everything is set to Fair Market Value.  Sounds like a relatively simple matter, right?  Be careful! 

Several items must be considered before a decision regarding the appropriateness of using the Fair Market Value Standard should be made:

 1)      How did the partners originally buy into the deal? 

2)     2)   Did everyone pay pro rata based on their individual ownership percentage? 

3)      3)  When the company eventually winds up, are the partners going to expect to be paid their pro rata percentage of the proceeds,
   or will discounts for lack of control and lack of marketability apply?

4)   For the most part, everyone has paid in capital based on their pro rata ownership and will expect to be bought out at the same rate in the end.  The problems begin with the differences between the definition of “Fair Market Value” and “Fair Value”. 

Fair Market Value involves a hypothetical scenario where both potential buyers and sellers take into consideration the various characteristics of the subject interest being appraised, including the lack of control and the lack of marketability typically associated with ownership of a minority (non-controlling) interest in the business. 

Fair Value, for the most part, involves taking a pro rata percentage of the whole and not applying any discounts whatsoever.  Of course, there are States that have determined that one or more discounts may apply under the Standard of Value of Fair Value.

Fair Value is generally the appropriate Standard of Value for shareholder oppression cases, most buy-sell agreements, and in some areas, divorce cases. 

Fair Value is defined differently in every state but the following definitions are commonly used: 

Fair Value is defined by the Revised Model Business Corporation Act as: 

The value of the shares immediately before the effectuation of the corporate action to which the shareholder objects, excluding any appreciation or depreciation in anticipation of the corporate action unless exclusion would be inequitable.[1]

 In 1999, the Model Act was amended and the revised definition of fair value is as follows: 

“Fair value” means the value of the corporation’s shares determined:

(i)                 immediately before the effectuation of the corporate action to which the shareholder objects;

(ii)               using customary and current valuation concepts and techniques generally employed for similar businesses in the context of the transaction requiring appraisal; and

(iii)             without discounting for lack of marketability or minority status except, if appropriate, for amendments to the articles pursuant to section 13.02(a)(5).[2] [bold items highlighted in text by authors]. 

“As of the date this Guide went to press [published January 2003], only Mississippi and West Virginia have adopted the RMBCA’s 1999 version of the definition of fair value.  Several court decisions, however, have quoted the revised RMBCA definition in support of disallowing discounts for minority status and/or lack of marketability.”[3]

The actual “definition” of Fair Value is determined by an attorney (or the court) after a review of appropriate case law in each state as of a specific date.  However, when used in an agreement, such as a buy-sell agreement, many attorneys define the term as they intend it to be used: i.e., fair market value without any discounts for a minority interest such as, but not limited to, discounts for lack of control or lack of marketability.

We are always happy to discuss how an appraiser would typically determine the value of a company, or other investment, using the standard of value you selected, in order to assist you in achieving the goals that you and your client(s) have in mind.

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 2011

Cash is King

Years ago two partners and I owned a chain of 22 Arby’s Roast Beef Restaurants and some other related entities.  We had been expanding too quickly, and as a result were constantly running short on cash.  We were constantly struggling to make sure that we didn’t run totally out of cash.  At the time, we were generating about $250,000 a week in cash sales and had our payables pushed out to close to sixty days, almost thirty days past the “agreed upon” terms.  A few years earlier, we had received a good sized line of credit from our bank, which we had fully drawn down essentially using it as a source of long-term debt even though it was supposed to be cleared each year for thirty days.  Eventually, we were forced to sell the business to a much larger company that had a good cash position.

This scenario is not that unusual, and I have seen witnessed many times in my role as an appraiser.  Many new (or relatively new) firms are undercapitalized and constantly struggle to find needed cash to support their operations.  In economic times such as we have experienced for the last few years, operating losses have squeezed even many very large, formerly very profitable, firms.

Back to the restaurant business and years ago:  I had one particular experience that drove home the phrase “Cash is King” like no other experience before or since.  I managed to squeeze out some vacation time and left for a week.  While I was gone, our accounts payable clerk ran the weekly checks to pay all of our vendors, had one of my partners sign the checks, and mailed them – only problem was, she goofed when printing the checks.  Instead of printing checks to pay for one week’s bills that were due about three weeks prior (the normal bills we would pay “late” each week), she printed checks to pay all of the payables we owed paying them totally current!  Big oops!  After I returned on Monday, the bank called and let me know that we were overdrawn.  I wasn’t too concerned, because we were usually overdrawn by $15,000 to $20,000 and the bank simply charged us interest.  When I asked the amount we were overdrawn, the bank representative told me $800,000!  After I picked myself up off the floor, I chased around and found out what happened.  I then had to call each vendor and explain that we had screwed up, that they would be getting our check written to them back, and that we were sending them out a new check for a much smaller amount, etc.  This experience was quite traumatic and while I can laugh about it now, it wasn’t very funny at the time.

Recently I have been working with a professional that has been operating a small practice for a number of years with severe cash flow problems.  She has “borrowed” funds from relatives periodically over the years to meet some of her shortfalls.  After investigating the situation, I found that no payroll taxes had been paid and payroll tax returns had not been filed since 2007.  Her one employee was owed a considerable amount of back pay, her rent was several months past due, her car was about to be repossessed, etc. – she was in a bad financial spot.  After some time of discussing her options in hopes of figuring out what had happened, I realized that the primary problem was that this person, essentially a sole practitioner, was sitting around waiting for work to come into the office rather than being proactive and generating business.  Her failure to do this had resulted in woefully inadequate revenue, such that expenses exceeded revenue and the practice was on the verge of bankruptcy.

All successful business people, including professionals, know what amount of revenue must be generated each week or month in order to pay the bills – and they do whatever is necessary, i.e. work more hours, dig up more work, etc. in order to generate the cash necessary to make things work.  Some businesses have lined up a line of credit from a bank to help cover short-term cash shortages, however, when cash comes in, they repay the line.  Many others, especially in today’s lending environment, must build up a cash cushion and self-fund cash shortages.  Regardless of how it is done, if sufficient cash to cover needed payments is not collected by a company, the game is over, toys are picked up, and the players all go home!

When valuing an operating company, one of the first things we check is the company’s historical operating cash flow, its cash position, and its working capital position compared to the industry.  These factors which demonstrate the ability to generate cash in excess of obligations are often the major consideration in the risk factors applied in a valuation.  There are numerous ways that companies find to screw up their cash flow.  Some of the most common include:  a) failure to collect accounts receivable either by loosening up credit terms in order to generate additional sales – usually results in a sales increase and an enormous increase in accounts receivable that is never collected! or by simply not paying close enough attention to the accounts;  b)  a drop in revenue caused by the economy or industry changes and a failure to modify the company’s market strategy or expenses; and c) the owner(s) draw more cash from the company than is generated by the company.

Balancing cash reserves is a delicate game – one where the good players win and the poor players look for alternative means of employment.  When appraising a business we often need to consider how well this balance is controlled when determining the value of a company.  The same issue can also arise in many real estate investments.

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 2011

The Management Interview

So you’ve engaged a business appraiser to develop a supportable opinion of value of your company.  The appraiser has done his homework, analyzed your historical financial records, investigated the current economic picture, and has even developed an awe inspiring forecast that covers every eventuality imaginable … & even some that aren’t!  The finished and polished report gleams softly in the sunlight as it is delivered into your eagerly awaiting hands, and you can’t wait to take it to your accountant, lawyer, potential buyer, or whomever else might be reading the report.

Too bad that this business appraisal report is completely incorrect and cannot be used for anything other than a beautiful (and spendy) coaster for your morning coffee.

“Why?” you ask, “What could possibly be wrong with this report I paid so much money for?”

The problem lies in the management interview, or rather, the lack of one.

During a management interview certain details come to light that should have an impact on the valuation conclusion, but are simply not available from financial statements.

Some of these are as follow:

1.      The real estate is owned by a related entity,

2.      There are non-essential personnel on the payroll (typically family members),

3.      The budget is inflated with discretionary personal expenses,

4.      Management is planning a significant change to operations, and/or

5.      The recent transaction of company stock was not at arm’s length.

 The question thus becomes:  How can these items interfere with (or outright invalidate) a valuation conclusion?  The following is a brief description of problems that could have been avoided if only a management interview had taken place: 

1.      The rental rate could be higher or lower than market rates, which could lead to an under or over-valuation due to the business’ income not having been adjusted to meet the definition of fair market value.

2.      Non-essential personnel are employees who receive full wages, but do not necessarily contribute any labor or expertise to the company.  These should be added back and if they haven’t been, lead to an under-valuation of the company.

3.      We have seen advertising budgets that included a race car, cabins in McCall for employee retreats that are only used by the Owner and his family, and even all personal expenses down to the weekly grocery bill run through a company.  If these expenses are not adjusted for, it leads to a very significant under-valuation of the company.

4.      The value of a business is based on expected future economic benefits, and if the appraiser bases the expectation of future earnings on historical results without taking into consideration planned changes to the operation, the appraiser would not actually have been appraising the subject at all.  Instead he would have been appraising the subject “as if nothing changes” which would be a hypothetical condition and not be reflective of fair market value at all!

5.      A very good indication of the fair market value of a privately held business would be an arm’s length transaction in company stock between knowledgeable parties, neither having any motivation to buy or sell.  However, most of these are between family members, or are fueled by special motivations that can lead to some rather wacky valuation conclusions when used blindly.

 Another complication sometimes occurs when an appraiser is engaged to do an assignment for a party not involved in the management of a company.  The most common occurrence is for a divorce when one spouse is not really involved in the business.  In cases such as this, the appraiser must do the best he/she/it can.  Often this requires management questions to be asked by the attorney during a deposition.  When management simply cannot be interviewed, and questions that need to be asked are not answered or the information is not available for some reason, appraisers typically include an assumption and limiting condition in the appraisal report to make certain the reader is aware of this fact, and that the value could be different if the unavailable information were known.

Now, not all assignments require a formal management interview, and not all assignments include “landmine” information that could drastically alter the appraiser’s opinion of value, but one never knows when one will pop up.

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 2011

Unfair & Biased Appraisals

I recently was asked to review an appraisal of a minority interest in a business enterprise that was made for the purpose of buying out a minority shareholder whose employment had been terminated.  The appraisal was very short, violated a number of appraisal standards, and concluded that the business had no value and therefore the departed minority shareholder was owed nothing for the stock.

This was a fascinating appraisal with a number of very serious problems.  If it did not so adversely affect someone’s life, it would have been funny.

First, the appraisal was done by the company’s accountant – a clear conflict of interest.  The accountant was paid regularly by the company to do its accounting, taxes, etc. and this relationship was expected to continue.  It seems unreasonable to expect that someone with a vested interest in a continuing business relationship could be objective and fair (especially if the majority shareholders expected the concluded value for the minority interest to be nothing).  The appraisal did not even mention that the appraiser was also the company accountant – a violation of the Uniform Standards of Professional Appraisal Practice (USPAP).

Second, the appraiser has no valuation credential and little, if any, valuation training.

Third, the standard of value used in the appraisal was Fair Market Value – this seems unfair as each of the shareholders bought into the company on a pro rata basis, but per the company accountant’s appraisal, the departed minority shareholder was to be bought out on a discounted basis.

Fourth, the appraiser/company accountant used a weighted historical average of earnings to value the company instead of a detailed and well supported income forecast.  According to all of the valuation textbooks with which I am familiar, the economic value of virtually any investment is based on its “anticipated future benefits.”   In other words: the value of an operating company is based on the anticipated future cash flows expected to be received from both its operations and its potential future sale discounted at an appropriate rate based upon the risk of achieving those expected returns.  This company had lower revenue over the last few years, however, its earnings and cash flow had increased rather dramatically over its historical results despite the recent years economic and industry problems.  Its recent financial results were really quite impressive; however, they were totally ignored by the appraiser/company accountant.  

Fifth and so on…  Well there were numerous other appraisal issue problems in the appraisal report.  Basically, it appeared to come down to the fact that the remaining shareholders wanted to get rid of a shareholder that they no longer got along with and didn’t want to pay the shareholder anything when that person was forced out.  It looks like they asked their buddy, the firm’s CPA, to prepare an “appraisal” showing that the company wasn’t worth anything so that they could get rid of this individual with no cost to them.

Standard rules aside, from a common sense point of view, there was also another serious problem.  The company was purchased by this shareholder group about 18 months prior to the force out.  The departing shareholder was not even offered a return of his original cash investment.  The company has paid its acquisition debt down more rapidly than scheduled during the time of ownership indicating that they were doing pretty well and were likely financially capable of offering at least a refund of the cash invested. 

The whole deal appears to be unfair and unreasonable – and supported by an unfair and biased appraisal.

In my opinion, this story points out yet again the basic reasoning for using an independent and well qualified appraiser when it becomes necessary to value an investment.

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 2011

Why Rules of Thumb are Dangerous

Rules of thumb have been developed over the years in order to provide people with a quick and easy way to get a general idea as to the value of a business.  These rules of thumb were designed to give a “ball park” estimate only, but it should be mentioned that as such, there are many problems associated with using them as the sole means of valuing a business enterprise (as many factors influence the actual value of what a “willing buyer” would pay and a “willing seller” would accept).  Also, there are typically multiple rules of thumb for most business types; each of which yields a different conclusion… sometimes a radically different conclusion.

This topic came to mind as I have been working periodically over the last several years with a father and son operated medical practice.  Dad owns the practice and both the son and dad have worked together in the practice for a number of years.  Dad wants to sell the practice to the son and the son wants to buy it – however, dad’s accountant believes that the value should be based entirely on a rule of thumb.  I quote:  “the business brokers / valuation experts that I have dealt with during acquisition engagements, use a guideline of 45% to 55% of annual gross revenue for calculating the purchase price / goodwill of a practice.”  Of course, the dad’s CPA is using the high end of this scale – 55% to determine the sales price.  In order to see the obvious problem of using this rule of thumb, I have provided the following income and expense summary and an income valuation approach to the practice.

The following is the reported income and expenses for the medical practice.

Here is the indicated value of the practice using the income approach and the reported income and expenses of the practice (no adjustments):

As is clearly evident, if the reported income and expenses were representative of the market rates for doctor compensation and rental rates for the real estate, the value would be considerably higher than the rules of thumb.

Unfortunately, the reported income and expenses included only a small annual salary of $60,000 for the owner-doctor and no rent expense was paid for the building owned by the doctor by the business.  In a sale of the practice, the owner-doctor’s salary would be adjusted to $175,000 and the rent to market rent of $50,000 as if leased from an independent third party.   After these adjustments, the practice income and expenses is shown below:

Here is the revised indicated value of the practice using the income approach using the actual market income and expenses of the practice (after adjustments):

This value of $200,000 represents the “actual” value of the practice – based on its specific income and expenses.

The following purchase justification tests show what would happen to a purchaser if the practice were bought at indicated value using the 55% of gross revenue rule of thumb and the adjusted income and expenses of the practice:

As shown by the purchase justification test summary, a purchase of the practice for $200,000 results in the buyer being able to receive a small annual positive cash flow – sufficient to warrant the risk of purchasing a practice.  If the practice were purchased for the $600,000 indicated by the 55% of gross annual revenue, the buyer would need to inject an annual payment of $40,000 in order to stay afloat; clearly not representative of what a fair market value buyer would do!

A rule of thumb, particularly one tied to gross revenue, ignores the specifics of a practice or business.  In the case of medical practices, prices being paid over the last few years have dropped significantly as a percentage of gross revenue.  The expenses of operating a medical practice have increased and reimbursement rates (i.e. gross revenue) from Medicare and insurance companies have been squeezed downward dramatically.  As a result of the medical industry reforms currently underway, gross margins are expected to be squeezed even further, resulting in less profit from medical practices.  All of these factors, and many more, are being taken into consideration by potential buyers of practices.  Some of the gross revenue rules of thumb may have been more accurate in the 1990s, but they certainly are not very useful today without careful consideration.

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 2011

Highest & Best Use

Why is it so important to determine the highest and best use of a property? 

Imagine the subject of an appraisal is a sixty acre farm with a single-family residence and various outbuildings constructed on it.  Obviously we need to find comparable properties that are also small farms with similar improvements, right?  The correct answer to that question is the all too familiar: “It depends”. 

The selection of comparable properties depends largely upon what the highest and best use of the subject property is:  In this case a sixty acre farm with some improvements.  One could choose between other small farms, perhaps some potential residential subdivisions, or how about a large commercial parcel that Home Depot is looking to build on?  Any one of these sales may be completely valid to use as comparables, though each would support an entirely different value conclusion. 

Determining which of these comparables is the most appropriate to use depends on what the subject’s highest and best use is.

So, how than does one go about determining this mysterious condition known as “highest and best use” of a specific property?  One determines the highest and best use by simply performing a series of analyses that distinguish between pertinent aspects of the property.  Some of these steps are shown below:

·         Analyze the physical characteristics of the property

o   If the property is irregular in shape and not very flat, than perhaps a commercial application would be inadvisable.

o   If the property is rectangular in shape and completely flat, than it could be used for a variety of purposes.

·         Analyze the legal characteristics of the property

o   Zoning tells a lot about what kind of comparable properties should be used.

o   Agricultural zoned properties are generally not real comparable to properties zoned commercial.

·         Analyze the locational characteristics of the property

o   What types of properties are in the immediate vicinity of the subject?  If there are residential subdivisions being devloped adjacent to the subject, than it is a good bet that the subject’s highest and best use might be development as a subdivision.

o   If there are commercial and/or industrial use properties adjacent to the subject, than perhaps farming is an interim use.

Determining the highest and best use of a property, is one of the key steps in developing a supportable opinion of value for real estate.

Additionally, the concept of highest and best use applies to businesses as well.  Occasionally, the highest and best use of a business entity is liquidation rather than continuance as an ongoing entity.  For example, the plant owned and operated by a long-term family business might be sitting on very valuable land – the possibility that the land could be sold for more than the value of the operating business is an example of highest and best use.

The concept of highest and best use is sometimes the most difficult part of an appraisal assignment – in all cases, it is a concept that must be considered carefully by the appraiser.

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 2011

Why Do People Buy a Small Business?

Small businesses play a very important role in the U.S. economy.  According to a recent report issued by the Small Business Administration, approximately one-half of the private sector jobs in the U.S. are attributed to small businesses and the other half to large businesses.  The government often defines a small business as one that has fewer than 500 employees.  About 90% of U.S. businesses have less than 20 employees.

Approximately 95% of business closures are very small businesses (those with less than 20 employees).  Many very small businesses open and close within only a few years.  Yet, quite a few of those very small businesses that survive for at least five years, operate successfully for many years and make up the pool of potential small businesses that are eventually sold.

There are some very large risk differences between starting a new business from ‘scratch’ and buying an existing successful business.  I believe that a relatively small number of people in the country have the temperament, ability, and guts to start a new business -- particularly as a full-time employment endeavor.  These entrepreneurs must have considerable self-confidence and drive in order to succeed especially since most of these very small businesses are started with insufficient capital.  Development of a new business plan, whether formal or not, that leads to success in a very competitive market place requires some skill and probably a lot of luck.  Generally people that purchase a small business do so because they want to avoid the pitfalls, risk of failure associated with starting a small business and they typically want to be able to start drawing an income large enough to meet their family needs from the business immediately.

Some people refer to those that purchase a small business as “buying a job.”  This, I believe, denigrates the small business owner and the importance of small businesses in our economy.  There are many small business owners that have chosen to purchase or start a small business rather than continue to work for big corporate America.  Most people that I have seen purchase a business did so while working for a big business or did so after being laid off instead of pursuing another job with a large company.

There are many reasons why people purchase a small business.  Based on my experience for many years as a business broker and discussions with other business brokers, the following appear to be the major reasons:

 “So I can be my own boss.”  -- Many people simply want to control their own destiny and not be worried about what their boss or company management might do that could cause them to lose their job.

 “So I can control my lifestyle – I can live where I want to instead of where my employer tells me I must live.”

“So that I can work the hours I want to work instead of when my employer dictates I will work.”

“So I can’t be laid off or fired.”

“So I can finally be paid what I’m worth.”

 “So I can benefit from my work directly instead of making my employer lots of money.”

“So I can build up equity in a business (create an estate) instead of creating more value for my employer.”

 “So I can employ my family” – usually the children, some of whom may have a difficult time finding other work.

 “Because I’m too old to be hired; I don’t qualify for retirement or health plans, but I’m not ready to stop working.”

 “Because I’m tired of just working for wages.  I want more from my efforts.”

Personally, I have worked for several large businesses, but have been self-employed for many years and love it.  I hope to stay self-employed for the balance of my career.   In fact, my goal is to sign my last appraisal report as the coffin lid is closed at the age of 115 or 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.

December 2010

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.

October 2010

Appraisal Discounts

We often are asked to opine on the value of a small, minority interest in a closely held company -- often a company that owns a mixture of liquid assets and real estate that is owned by a family member or members that are trying to transfer interests to the next generation.  These types of entities are typically referred to as a “Family Limited Partnership” or “FLP”.  However, they may be a limited liability company, a limited liability limited partnership, or some other type of legal entity.  The key issues involved in such an appraisal are as follows: the nature and type of underlying assets and liabilities; the provisions of the operating agreement; the likely holding period of the investment; and the interest being valued. 

Appraisal discounts, and premiums for that matter, exist only because there is insufficient data available to support a valuation conclusion at the desired level.  In order to understand the need for discounts, it is important to realize that there is a large difference between the desirability to most investors of various types of investments.  For example, let’s consider the desirability of the following investments:

I have listed these investments, from top to bottom, in the order in which I would consider them to be the most desirable to the least desirable.  Now, we could adjust things by modifying that the real estate in the small town is a very small town with a declining population that has lost its largest employer.  This would very possibly make the real estate investment less desirable than the 100% interest in the investment in the small business, however, it would probably still be more desirable than the one percent interest in the family limited partnership!  Generally, there is a very limited market for a minority interest in a closely-held family limited partnership.  Also, typically the more illiquid the underlying investments, the less an arm’s-length buyer would pay for the interest.  Since there is such limited actual sales data for sales of non-controlling interests in family limited partnerships, other valuation techniques must be employed and discounts applied and supported to convert the available data conclusions so that it is applicable to what is being appraised.

Consider again the list of above investments – what dollar amount would it take in a one percent interest in a family limited partnership to get you to select it instead of $100,000 in cash?  How about $350,000?  $500,000?  Or, ….  Of course, the decision would depend on the nature of the underlying assets and the terms of the operating agreement.  This is the basis for a business appraisal of this type of entity!

Some people are very concerned about discounts that are applied when valuing minority (non-controlling, non-marketable) interests in family limited partnership entities.  Court cases abound with IRS challenges to discounts taken in many family limited partnership entities, however, the vast majority of these challenges are warranted, generally because the entity was not set up properly and/or not funded as intended and generally the appraiser that valued the interest did not do a proper job explaining and supporting the discounts taken.  Discounts cannot be pulled out of the air – a proper analysis must be made and the conclusions must be well supported.

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.

September 2010

How Does the Economic Outlook Affect Value?

We have been asked many times, “How does the recent “down” economy affect the values of both businesses and real estate investments?”  Most people expected us to reply with something along the lines of, “Well of course values are down, the economy has dropped, so values did too.”  Interestingly enough, this is not always true.  Certain industries and locales have benefited from the economic downturn, while others have suffered.

A good example of counter-recessionary business and an area thriving is the gold mining industry and property values in places like Elko and Carlin, Nevada.  These communities largely depend on the local gold mines to generate jobs – when gold prices drop (usually in times of economic prosperity), the gold mines shut down and lay off their employees.  The effects of these layoffs ripple through the local economy of these communities resulting in a local business and real estate value downturn.  Over the last few years, as the nation and other parts of Nevada have experienced an extended economic downturn and businesses and real estate investments have struggled, businesses and real estate values, (for the most part) have done quite well in Elko and Carlin.

As we all know, over the last few years the residential construction industry, and more recently, the commercial construction industry, have been hard hit with housing starts way down and unemployment of construction workers among the highest rates of any industry.  The construction industry collapse has affected a number of other industries as well.  The forest products industry has experienced severe problems in many areas of the country since the demand for lumber has declined significantly.  In many areas the lack of logging has caused lumber mills to close and the resulting loss of jobs in many smaller communities that heavily rely on the mills for an employment base.  In such cases, the local businesses and property values have been devastated.  Yet, some areas of the country continue to be logged and the lumber mills remain busy.  For example, in a western Washington town, the local lumber mill has been expanding and it continues to be very active.  The local businesses and properties that depend on forest products in that area continue to do well.  

A wood pellet manufacturing company with three plants in different areas of the country demonstrates the different ways the economy affects business and property value outlooks.  In two of the three areas, logging has been seriously curtailed resulting in little sawdust for them to process into wood pellets.  Further, the small amount of sawdust now generated in the areas that used to be free, the lumber mills are now able to charge for resulting in gross profit margins being squeezed to the point that at this time wood pellets cannot be profitably manufactured in these plants.  The company’s third plant, in the western Washington area, is doing very well and continues to operate profitably because of the local factors enabling the local lumber mill to continue to operating profitably.

Business and income producing real estate investment values are largely based on their ability to generate income and the risks associated with the expected income streams.  Whether or not the overall economy is suffering may impact the risk of continuing to achieve the expected income stream, but as long as a company or property is making money, and expected to continue to do so, its value may not be adversely affected.  Each case is specific and requires investigation of many factors and circumstances.

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.

August 2010

Useful Life Issues

There are a number of important issues dealing with the useful life of an asset or investment.  A “normal” useful life is the estimated period of time (usually in years) that an asset is expected to be used before it is “retired” from service.  

For example, a good way to think about useful life is to examine life expectancies for various aged individuals using life insurance company prepared tables.  According to one such table, the average life expectancy for a human male is 72 years and for a human female is 79 years.  However, if you look at the remaining life expectancy for a 60 year old man, it is 18 years, six years beyond the average of 72 years.  The remaining life expectancy for a 80 year old woman is nine years – ten years beyond the average of 79 years.  The reason for these differences likely include such things as the tables were constructed including infant mortality rates, teenage drug, alcohol and traffic or crime related deaths.  In similar fashion, many assets can have their useful lives extended, or shortened, depending on a number of factors. 

A typical new residence has an expected useful life of about sixty years (depending on the type of construction and a few other factors).  However, there are many examples in certain parts of this country or in Europe, of some very old residences that are still in use today and look great.  Remodeling or maintaining a property in good repair can extend its useful life.  Conversely, ignoring required maintenance or taking poor care of a property can shorten its useful life.  Appraisers periodically are asked to estimate the remaining useful life of an asset.  They typically do so by gathering and analyzing statistical data from similar assets.

An economic life is the estimated time period that an asset may be profitably used for the purpose for which it was intended.  Some intangible assets of great value may have a very short useful economic life.  For example, in various high-tech industries, some medical fields, etc., technology is changing so rapidly that make a very profitable asset today worth nothing in a few months or a few years.  I remember a few years ago valuing a business in the medical industry that used a very expensive piece of equipment to generate substantial revenues and earnings.  I was challenged on my value conclusion by a few of the owners because they thought my value conclusion was too low.  When I asked them to provide assurances that my useful life estimate for the equipment was too short, given the rapid changes in the medical industry, they saw my point and agreed that my conclusion was reasonable.

The term for a patent is usually seventeen years for technical inventions or fourteen years for design patents.  However, due to technological changes, many patents have a useful life considerably shorter than the term given them.  Estimating a patent’s remaining useful life is very important in the determination of its value.  One of the best ways to value a patent is to use what is called the relief from royalty method.  Essentially, this involves researching royalty rates paid for the use of a similar patent, developing a forecast of revenue associated with the patent, and then determining the present value of the royalty stream to value the patent.

Everything in life is expected to last only so long.  Based on various factors this number may vary and it is our job to utilize market data to make the appropriate adjustments in any given situation.

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.

July 2010

Is the (Financial) World Coming to an End? 

Over the last few months, I have spoken with a number of people that were pretty discouraged and seemed to believe that the financial world, as we have known it, is coming to an end.  I have given this point of view considerable thought and have the following insights:

·         The financial markets, in particular, the real estate market is cyclical.  When the real estate market is booming, many people seem to forget that periodically, it goes through a correction.  I’m old enough to remember the early 1980s when the Prime rate hit 21.5% and what the real estate market was like at that time.  It was brutal – in my opinion, much worse than it is today!

The real estate market’s growth or decline is largely affected by the availability of real estate loans.  Over the last few years before the real estate “crash”, lenders were giving loans to almost anyone that could sign the loan papers.  Historical qualification criteria were forgotten in the hurry to put more money out secured by the “safest” asset available – residential real estate.  I was amazed at the prices people were paying, especially for high end homes.  Some of these ridiculous prices were only made possible by lenders that appeared to lose whatever sense they previously had.  According to several of my colleagues that work in Southern California, some of the loans granted in that area were particularly troubling.  For example, it was not uncommon for an older small house of less than 2,000 square feet on a small city lot to sell for about $1 million.  Most buyers who would like to live in such a house could not afford to make a payment on a million dollar real estate loan --- to accommodate the “need”, some lenders made negatively amortizing loans, i.e. the monthly payment was less than the interest due on the loan resulting in the amount not paid in interest each month being added to the amount owing on the loan.  This was allowed until the loan balance became 125% of the original amount.  Apparently, the lenders hoped that the market would continue to appreciate and that their borrowers would either be able to refinance or sell in the future (before the loan balance hit the 125%).  Of course, once the market collapsed, these loans, along with many more conventional loans, could not be repaid.

The problem was not restricted to residential real estate.  Over the last few years of real estate expansion, many people began paying higher and higher prices for commercial real estate, land, and other investments as well.  Capitalization (‘cap’) rates dropped significantly reaching lows that were unprecedented.  (The lower the cap rate, the higher the value).  Historical cap rates of 9% to 11% for some types of commercial properties were almost cut in half, resulting in prices being paid by some investors that seemed to indicate many people forgot about all types of risk as well as the concept of risk vs. return expectations.  When the economic downturn finally became obvious, some tenants went out of business, others struggled to pay their rent, consumers cut back on their spending, and things got tough.  A big problem now beginning to surface is many of the loans made to purchase (or refinance) some commercial properties based on very low cap rates have a five year call provision.  As these loans come due, owners are going to experience great difficulty refinancing these very high loan balances as they were based on unrealistic values simply because people were paying very high prices for commercial real estate for a period of time.

Of course, it is the American way to blame someone for the problem.  Often, it is the appraisers that are deemed to be at fault.  I remember that in the early 1980s during the S&L Crisis, the appraisers were blamed for the financial mess.  It is important to remember that the appraiser’s job is to report the market for a property as of a specific point in time.  If people are paying “stupid” prices for similar properties as of the effective date of the appraisal, that is the value that an appraiser is going to report.  Appraisers are typically asked to report “market value” – I have seldom been asked a question like “would you pay that much for this property?”  Market value, by definition, is essentially the amount that a willing buyer would pay and a willing seller would accept as of a specific point in time (with a few more criteria involved).  Nowhere in the definition is the appraiser asked to comment on whether or not he or she thinks the reported value “makes any sense”.

Where do we go from here?  Is the financial world coming to an end?  No, the financial world is not coming to an end.  At some point, the economy will improve to the point where the constant negative news will be about something other than a recession, financial institutions will again lend money in a relatively responsible manner, businesses will expand, consumers will buy, and the real estate market cycle will again expand.  Hopefully, we will all remember that at some point the market will again retract so that we make better investment decisions.  However, I am convinced that after a year or two of a good market, many people will again jump into the market expecting a resumption of the “good times” forgetting our recent concerns and difficulties.  It seems to be the American way.

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.

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 buil