HYDE VALUATIONS, INC
We Appraise Both Business and Real Estate
(208) 722-7272
2007 Monthly Newsletters

2007 Monthly Newsletters
December 2007 - How to Select a Professional

We have all heard the joke: What do they call the guy who graduates at the bottom of his medical school class? The answer is: “Doctor.”

Not too many of us would like to be operated on by the doctor that barely made it through school and squeaked through the licensing process. Similarly, if shopping for an attorney or a Certified Public Accountant, do you look for the lowest price? Do you want to have the guy or gal that just got out of school handle your affairs? Sure, new people must start somewhere, however, they should begin their practice under the guidance of an experienced and competent professional.

The same guidelines should apply to appraisers. It is interesting to note that business appraisers are not licensed. Anyone that desires to work as a business appraiser, can do so. Real estate appraisers must obtain a license, however, the license requirements are pretty easy to meet. In my opinion, simply possessing a real estate appraiser license does not mean much.  

When looking for a professional, how should one be chosen? Most of us follow the time tested method of getting a referral from someone we know and trust. I think it is also a good idea to ask for references and to check them. We also offer to provide prospective clients and their advisors a copy of sample work so that the quality of our work product can be reviewed. Stories abound about people who hired the cheapest professional to later find out that the upfront price is often not the most important factor -- quality of the work usually matters.

An Example – How Not to Do It!

We recently received a referral to a new client from a CPA we know well and respect. This client owns a professional practice and desires to sell the practice to another professional already working in the practice as an employee. Unfortunately, the client had chosen a business appraiser based on the sole qualification that they had given presentations at some professional conferences. After waiting for over six months and paying a fee twice what we charge, the business appraisal finally arrived. The client was not impressed. The client’s CPA referred the client to us to review the report. I have reviewed hundreds of valuation reports over the years – this “business valuation” makes the top ten worst reports I have ever seen. 

There were many things wrong with the appraisal, however, the following were the key errors:

1. The appraisers had no appraisal professional designations and listed no specific appraisal education on their professional qualifications. Their only qualification seemed to be their license to practice in another state as Certified Public Accountants

2. They used a weighted average of historical earnings as their income forecast. Any average of historical earnings in times of even modest inflation implies that the future will be worse than the past. This is possible, but if it is the case it should be specifically discussed and supported. Additionally, the appraisers were either not aware or ignored the fact that the street in front of the practice had been torn up for most of the last year and was now back in good shape.  

3. Most significantly, the appraisers used only one appraisal method! The method they chose to use is the Excess Earnings Method, the method the IRS says should be used as a last resort and only in conjunction with other methods. This method can be easily manipulated to produce virtually any value as the rates it uses are difficult to support. The appraisers did not support the rates they used; they appeared to pull them from the air.

Had the client checked out the business appraiser prior to hiring them with their own trusted professionals they would have avoided a lot of heartache and wasted time and money. However, as we all know, taking classes in the school of hard knocks is sometimes the best education. We should all strive to avoid repeating a class, though, if we can help it.

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. 
November 2007 - Why Are Appraisal Reports So Thick?

Why are business appraisal reports typically such thick documents? Is it because appraisers charge by the pound or is there some other sinister reason behind the mounds of pages to read through in order to get to the point of the report; the number? Actually, there are several reasons for the wordiness, the most common explanation is that all those pages are there because the business appraiser’s valuation bible, Revenue Ruling 59-60, requires a business appraiser to discuss a lot of additional topics in addition to the actual number. Below is the list from IRS Revenue Ruling 59-60 showing eight factors that need to be in each report:

Sec. 4. Factors to Consider.

It is advisable to emphasize that in the valuation of the stock of closely held corporations or the stock of corporations where market quotations are either lacking or too scarce to be recognized, all available financial data, as well as all relevant factors affecting the fair market value, should be considered. The following factors, although not all inclusive are fundamental and require careful analysis in each case:

  a. The nature of the business and the history of the enterprise from its inception.
  b. The economic outlook in general and the condition and outlook of the specific industry in particular.
  c. The book value of the stock and the financial condition of the business.
  d. The earning capacity of the company.
  e. The dividend-paying capacity.
  f.  Whether or not the enterprise has goodwill or other intangible value.
  g. Sales of the stock and the size of the block to be valued.
  h. The market price of stocks of corporation engaged in the same or a similar line of business
      having their stocks actively traded in a free and open market, either on an exchange or over-the-counter.

Please notice the emphasized section of the excerpt. The eight factors are not simply required topics of discussion, but have an actual impact on the appraiser’s analysis of the risk, and therefore value, of the operation. Each of these factors point to a facet of a business that differentiates the subject from any other business, and the results of each analysis will impact the appraised value. For example, if the financial condition of the business is leveraged to the hilt; that makes for a more risky investment, which drives down the value of the business. Each factor’s analysis indicates whether or not the selected capitalization rate for the business should be larger or smaller; which directly impacts the end valuation of the company. This is why business valuation reports generally require a large number of pages. Each page of analysis is actually important and does lead to and support the final valuation conclusion. 

Similarly, real estate appraisals have a number of required factors that must be covered. The number of factors to be covered in the report depends on the nature of the assignment as defined in the scope of work.

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.
October 2007 - Is a Site Visit Really Necessary?

It is generally difficult to appraise something you have not seen. However, depending on the assignment and the nature of the subject of the appraisal, occasionally a site visit is not necessary. For example, when valuing an intangible asset such as a patent, a client list, or a trademark what is there to see? When valuing an operating business, machinery & equipment, or most real estate, viewing the subject of the appraisal is generally a very good idea. 

Reasons to view a small business subject include such things as the following:

  • Verification that it exists! As silly as this sounds, it is pretty important. Occasionally, a business is made to look much better on paper than it is in reality.
  • Quality of the plant & equipment or other facilities – you often simply have to see the business to understand how efficiently and well it functions.
  • Estimate the capacity of the facilities, i.e. if the company expects sales to increase by 20% next year, but they are at total capacity in the plant and are running three shifts, some large capital expenditures for plant expansion are going to be required.
  • Interview management – there are always a lot of questions that need to be addressed. It works best in a face to face interview.
  • Determine how close competitors are located to the business and judge their impact on the business.

Reasons to view machinery and equipment include:

  • Verification that it exists – note model and serial numbers for proper identification.
  • Age and condition – is it held together by baling twine and bubble gum or has it been regularly maintained? Although old, it may very well be perfectly fine.
  • In use or in storage – many pieces of machinery or equipment require substantial costs to connect and install. If the equipment is excess or simply in storage, it generally has a different value than if it is used in a manufacturing process.

Reasons to view a real estate subject and its comparable properties include:

  • Property condition – there is simply no substitute for walking the property and looking at the improvements so that you can better compare it to those properties used for comparison.
  • Neighborhood – is the neighborhood improving, stable, declining? 
  • Any obvious defects or other problems – water stains on the ceiling, cracked walls, etc.
  • Any evidence of contamination – old drums laying around, next to an older closed gas station, etc.
  • Quality of construction – looking carefully at the improvements allows the appraiser to determine if the property is excellent quality constructions, good quality construction, average quality construction, low cost construction or a combination of these. 

Some appraisals are done without viewing the subject. If this is the case, it must be disclosed and less weight should be given to the value conclusion. I have seen many “drive by” appraisals (both of real estate and businesses) that are simply wrong! When the appraiser does not see the subject, it is pretty difficult to compare it to sales comparables, to judge the quality of the income stream, or determine its reproduction cost.
September 2007 - Common Appraisal Errors

Over the past several years we’ve been asked to examine various other appraisers’ work product in order to identify errors, if any that are present in the appraisal. We’ve also taught classes for business appraisers to help them identify errors in appraisal reports. Now, it is important to stress here that there is a major difference between an error and a difference of opinion in an appraisal. Appraisals, just like appraisers, are all different, and we all interpret data differently, however there are some common errors that inexperienced and/or rushed appraisers often make that are fairly easy to identify. 

In a real estate appraisal, some of the most common errors are found in the application of the income approach, especially where the subject property involves a significant business component. The problem arises from the nature of risk. The size of the selected cap rates is based on how risky the subject investment is. In other words, how likely it is that the subject income stream will continue. In an investment property where the sole income stream received is the lease to a third party the risk of that income stream continuing can be measured by analyzing other comparable properties and the rents they are charging as compared to the subject. If the rents are close than it is more likely that the income stream will continue than it would be if the rent just down the street were much cheaper. However, if the property is a hotel, or a mini-storage facility, or a landfill, or any other type of business where the real estate is an operating asset of the business the risk of the subject income stream continuing jumps by a considerable margin. The appraiser has to deal with questions like, “How successful is the subject as compared to its industry?” “Are there any specific risk factors that apply to the subject in addition to those generally weighted?” “How is the income stream expected to vary over the next few years?” In short, if an appraiser uses a cap rate in the range usually associated with properties that only have a lease income to value a property that is actually an operating asset of a business, then the property has likely been over valued.

In business appraisals, some of the most common errors we see also have to do with the income approach. In business appraisals, there are several different income based methods that each require a different level of income stream to use. There are also different methods for calculating discount rates. Problems occur when an appraiser calculates an income stream, and a discount rate that were not designed to be used together. For example if a discount rate calculated by use of a build-up method using rates from public markets is applied to a net income, EBITDA, or any pretax income stream, the valuation will be wrong. This method of determining a discount rate requires the appraiser to develop the income stream that best approximates the dividend paying capacity of the company; which is also another error we see frequently. Appraisers often skip a step or two in the calculation of the dividend paying capacity of the subject business generally resulting in an overvaluation of the business.

One difference of opinion that we have with some other appraisers is the applicability of the guideline public company method when used to appraise a small business. Some appraisers think that they can determine multiples from an analysis of Albertson’s, Safeway, and Wal-Mart, and apply these valuation multiples to the community grocery store. They base their reasoning on the fact that all of the comparable companies are in the same industry. Please note that this is a difference of opinion and not an error that can be simply be pointed to in the textbooks and proved to be an error. This is one of those differences of opinion that was mentioned at the beginning of this article. It is our opinion that the size differential, the ability to obtain capital from various sources, and the geographic diversity that these large companies enjoy make them unsuitable as comparable companies for a small grocery store that has only one location, a limited customer base, and very limited capital sources. We have read many reports and seen many appraisers fight about differences of opinion that are not technically errors. It is important to pick one’s battles, and focusing on an error that turns out to not be an error but a difference of opinion can be disastrous for some later arguments. 

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.
August 2007 - Fair Value Update

Fair Value is a less commonly encountered standard of value than fair market value or market value and is typically used in most states in dissenting shareholder and minority shareholder oppression cases.  

In layman’s terms, a dissenting shareholder action typically arises when a controlling shareholder(s) makes some type of major decision that affects the company and a minority shareholder disagrees, usually feeling that it hurts his or her value. A suit is brought under the fair value standard of value basically asking to be bought out at the value before the action to which the shareholder disagreed. Also in layman’s terms, a minority shareholder oppression case is one in which the controlling shareholder is taking advantage of the minority shareholders, for example, taking such a large salary as to eliminate any profits that could have been distributed to minority shareholders. A suit would be brought under the fair value standard of value for basically a pro rata share of the total control value of the company instead of under the fair market value standard of value which generally includes a discount for lack of control and a discount for lack of marketability. The idea being to determine the “fair” amount that a minority should receive for their interest in the company.  

Fair value is defined by statute in each state, however, the historical definition has been rather vague in most states resulting in the need to refer to case law. The primary area of confusion or disagreement has been whether or not fair value included a discount for lack of control (sometimes called a minority discount) and/or a discount for lack of marketability. Some states allow some discounts, others do not. Some states through the case law define the dissenting shareholder fair value standard differently than they do the shareholder oppression fair value standard.  

Until 1999, the Model Business Corporation Act defined fair value as “the value of the shares immediately before effectuation of the corporate action to which the dissenter objects, excluding any appreciation or depreciation in anticipation of the corporate action unless exclusion would be inequitable.” The old definition simply did not address either minority discounts or discounts for lack of marketability. The 1999 amendments to the Model Business Corporation Act included provisions disallowing consideration of minority and marketability discounts in fair value valuations. Currently, seven states have adopted these amendments including Connecticut , Idaho , Iowa , Maine , Mississippi , Virginia and West Virginia . Florida has adopted a variation.  

Another problem area is not covered by either the new Model Business Corporation Act or, up until recently, none of the state courts had considered whether the new fair value definition includes a control premium when applicable. Several appraisal methods, most commonly the guideline public company method and sometimes the discounted cash flow method when using an income stream available to minority interests, require a control premium in order to adjust the value indications to value a control interest in a company. The guideline public company method uses the publicly traded stock closing price for companies in the same or similar industry to provide an indication of value for a larger privately held company. The method is very involved and time consuming, but valuable when appraising a privately held company that is essentially large enough that it could be publicly traded. The problem with the method is that stock in publicly traded companies consists of a minority interest, not a controlling interest! There is typically considerable value associated with a controlling interest in a company versus a non-controlling (minority) interest. In other words, investors are generally willing to pay more, often a lot more, for control of a company than they are for a non-controlling interest. In order to equate a value indication from a minority interest, such as from the guideline public company method or from an income method that used an income stream available to minority interests, an adjustment must be made to the value indication to account for the benefit of control for a controlling interest in the privately held company being value. A control premium accounts for this difference.

Essentially, the only place to find a control premium is to look to data from corporate mergers using information before and after announcements of the acquisition. The problem with this data is that virtually everyone agrees that synergies are often involved, but the amount due to control versus the amounts due to synergies are really unknown. A bunch of articles have been written and some research done trying to quantify the amounts due to control versus synergy, but it still comes down to the appraiser’s opinion as to the appropriate magnitude of a control premium.

According to a case update service dealing with valuation issues, the following case deals specifically with the issue of whether or not fair value should include a control premium:

Northwest Investment Corp. v. Wallace, 2007 Iowa Sup. LEXIS 87 (July 13, 2007)

This case deals with a bank holding company effectively squeezing out three minority shareholders in a reverse stock split. The bank’s appraiser came up with a value of $33.23 per share and the minority shareholder’s appraiser came up with a value of $64 per share. The bank’s appraiser went back and reviewed things revising his appraisal to $48 per share. The minority shareholders filed suit and the case went to trial.

The bank’s appraiser used an income approach giving it a 90% weight and the guideline public company method giving it a 10% weight to reach his final conclusion. He applied a 15% control premium to his guideline public company method, but no control premium to his income method. The minority shareholder’s appraiser used an income approach, sales of controlling interests and the guideline public company method. He applied a 40% control premium to both the income approach and the guideline public company method.

The court adopted what it called the “more credible” fair value appraisal done by the minority stockholder’s expert including his use of the control premium. On appeal the Iowa Supreme Court looked at the official drafters’ comments to the 1999 Model Business Corporation Act and stated that the intent was …”to adopt a more modern view that appraisal should generally award a shareholder his or her proportional interest in the corporation after valuing the corporation as a whole, rather than the value of the shareholder’s shares when valued alone.” They concluded with the opinion that “if an appraiser is valuing the corporation as a whole, then a control premium is certainly proper.”

The bank argued that the control premium was “inflated with synergistic value because the market data upon which it is based included corporate mergers.” The court concluded that “there is nothing wrong with basing his opinion, in part, on the aggregations of actual sales data involving mergers and acquisitions as this evidence reflected the market place.” They went on to comment that appraisers must be aware of synergies included in the underlying data and adjust accordingly.

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. 
June 2007 - Canned Computer Valuation Programs

Wouldn’t it be wonderful if difficult processes could be made drop dead easy by a computer software program?  

Accountants have seen Turbo Tax make income tax reporting “so easy you no longer need a C.P.A” and all sorts of accounting software programs. Yet, C.P.A.s continue to do income taxes and deal with numerous accounting problems. Attorneys have seen numerous “do it yourself _____ (fill in the blank)” software programs for everything from wills to all types of contracts and agreements. There seems to be no shortage of legal work for attorneys either.  

Likewise, appraisers have seen multitudes of ‘simple drop in the numbers out comes the value’ software programs. I recently decided to get a line of credit secured by an office building my wife and I own. I was amazed when the lender said all they needed was an “instant” appraisal done by their computer program. I’ve got a pretty good idea of the value of the office building, but the lender’s computer valuation program said it was worth 1.5 times the value – all determined in a minute or two from a location out of state. I couldn’t help but wonder what the lender will do with the building if I were to default on the loan -- I believe they would be seriously under water.

As part of my appraisal practice, I regularly review a wide variety of both business and real estate appraisals. When I see a report that includes obvious data from one of the many software valuation programs readily available to appraisers, I am rarely surprised by the poor quality of the work, the lack of understanding of appraisal concepts and procedures, and by the outlandish and silly valuation conclusion.

I have found that good quality work requires a professional that is well educated, experienced, and that pays attention to detail. Obviously, some tools professionals use exist, including software programs for routine things, however, difficult and complex problems cannot be dropped into canned software programs with good results. In the valuation arena, complex problems require some serious thought and planning combined with good research for successful resolution. I’m sure that problem cases both C.P.A.s and attorneys face require the same things in order to properly solve clients’ various problems.

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. 
May 2007 - Precision vs. Accuracy

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

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

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

I cannot help but laugh when I see an appraisal conclusion stated something like the following:May 2007

Precision vs. Accuracy

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

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

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

I cannot help but laugh when I see an appraisal conclusion stated something like the following:
Nineteen Million Seven Hundred Eight-Six Thousand Seven Hundred Thirty-Six Dollars and 22 Cents

$19,786,736.22

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

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

Nineteen Million Eight Hundred Thousand Dollars

$19,800,000

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

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

Valuations play a part in all strategic transactions, tax, and many litigation matters. For additional information or advice on a current situation, please do not hesitate to call.
April 2007 - Risk vs. Reward

We have all heard the term “Risk versus Reward” but, I often wonder if this concept is really understood. Everyone looks at the risk of an investment a little differently depending on individual circumstances. There appears to be quite a difference between how a multi-millionaire and a low income earner view the investment of $1,000 in a specific stock. To the individual with large amount of funds to invest and regular substantial earnings, a $1,000 investment in highly speculative stock with the possibility of a huge return versus the likelihood of a total loss may not be a big deal. However, to the person whose total savings it may represent, it would be viewed a huge risk.

Appraisers must attempt to view the ‘investment’ they are appraising “as if” it were contemplated by a “typical” investor. Generally, the standard of value used dictates the view of the hypothetical seller and buyer we consider as we prepare the appraisal.  

Let’s consider the following possible scenarios illustrating risk vs. returns. What these scenarios indicate is that a “typical” investor would be equally comfortable with $1,000 in one year as the amount shown as “Amount Now” in cash – based on the described risk: 
Amount Now Chart
The risk rates illustrated in this table include the differences in liquidity of the funds as part of the risk. Also included in the risk is the possibility that the return will not be received at all as well as the risk that the principal may be lost as well.  

Another factor that must be considered in the appraisal of specific business or real estate interests is the likelihood of future price appreciation and the likely holding period of the investment. Each of these criteria can and does affect the risk versus return.

The result of an appraisal of anything should be the point where the buyer and seller would just as soon take the investment described or the amount of cash shown as the value. They should be ambivalent as to which they would take.  

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.  
March 2007 - Business vs. Real Estate Cap Rates

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

Just what is a cap rate and what does it measure? A cap rate represents the percentage applied as a divisor to a one-year income stream that is indicative of the value that both a typical buyer and seller would agree upon. In simple terms, it is the rate that a buyer requires for both the annual income from a property plus the profit, (typically from appreciation), that the buyer expects from an eventual sale of the property. It is critically important to realize that the cap rate includes both annual income and anticipated future appreciation!  

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

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

If this discussion makes you uncomfortable, it has accomplished its purpose. A valuation constructed using only one approach is often difficult to support. This is why generally three approaches to value: the market or sales comparison approach, the cost or asset approach, and the income approach are used to estimate the value of a property or a business interest.

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

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

Valuations play a part in all strategic transactions, tax, and many litigation matters. For additional information or advice on a current situation, please do not hesitate to call.
February 2007 - Goodwill: What is it?

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.”  

In my former professional life as a business broker, periodically I would get a call from a prospective client who would tell me about their wonderful business, how everyone loved it, how many repeat customers they enjoyed, etc. When they finally got around to talking about earnings, they would disclose that the business was losing $8,000 per month and they would ask me how much I thought they could get for the “goodwill.” My answer typically did not please them. Without earnings, goodwill does NOT exist. It is possible to have some intangible value without earnings, for example, a patent, a customer list, or a proprietary process. These intangible assets might have value and perhaps could be sold separately from the business, however, if the business is losing money consistently without much chance of a reversal, there is no goodwill.

Goodwill, when it does exist, comes in two flavors: personal and commercial. Personal goodwill is what is attached to a specific individual rather than to the business. Commercial goodwill is the intangible value of a business that is not due to some specific intangible asset such as a patent, a customer list, or a proprietary process, etc.

The best example I have heard of personal goodwill is that of a neonatal neurosurgery practice. This professional practice was operated by two neurosurgeons that specialized in the really tough cases involving infants. All of their business came from referrals from other neurosurgeons around the country. The business came to them specifically due to their personal reputation and contacts. If they were not there, the business had no earning power and thus, no commercial goodwill. An interesting side note for this practice is that they owned two Lamborghini automobiles – the stated reason being that the docs had to get to the hospital fast in an emergency. That didn’t fly with the IRS!

In a divorce, whether or not personal goodwill (sometimes called professional goodwill) is considered by the court to be a marital asset is a major issue. This varies from state to state. The following two examples have been obtained from Gary Trugman’s excellent book Understanding Business Valuation: A Practical Guide to Valuing Small to Medium-Sized Businesses. One of the most widely cited cases that detailed factors to be considered is a California case called Lopez v. Lopez (113 Cal. Rptr. 58 [38 Cal App. 3d 1044 (1974)]. The factors to be considered included:

  • The age and health of the professional
  • The professional’s demonstrated past earning power
  • The professional’s reputation in the community for judgment, skill, and knowledge
  • The professional’s comparative professional success
  • The nature and duration of the professional’s practice, either as a sole proprietor or as a contributing member of a partnership or professional corporation

In a Florida case, Williams v. Willams (No. 95-00577, 1996 WL 47675 (Fla. Dist. Ct. App Feb 7, 1996), the trial court ruled that Mr. Williams accounting practice included $43,200 in practice goodwill. This was overturned on appeal. The appellate court stated:

"The goodwill of a professional practice can be a marital asset subject to division in a dissolution proceeding, if it exists and if it was developed during the marriage…. However, …for goodwill to be a marital asset, it must exist separate and apart from the reputation or continued presence of the marital litigant….When attempting to determine whether goodwill exists in a practice such as this, the evidence should show recent actual sales of a similarly situated practice, or expert testimony as to the existence of goodwill in a similar practice in the relevant market….Moreover, the husband’s expert, who testified the practice had no goodwill, stated that no one would buy the practice without a non-compete clause. This is telling evidence of a lack of goodwill."

Other courts have found just the opposite. Some courts have stated that goodwill is to be differentiated from earnings capacity. Others have found that even an individual practice, whether or not a professional corporation, can have goodwill that is transferable. The variability of court conclusions in different jurisdictions make both the appraiser’s and attorney’s jobs more interesting.  

An example of commercial goodwill is a profitable local retail store. As long as the business earnings exceed the typical return on the required business assets, goodwill exists.

The most common method of valuing the total intangible assets of a business is called the Excess Earnings Method. This method, maligned by some, is very useful when correctly applied. Problems with the Excess Earnings Method primarily arise from its inappropriate use or when its basic required capitalization rates for tangible and intangible assets are not properly supported. If more than one kind of intangible asset exists and each needs to be enumerated, various intangible asset appraisal methods can be employed to identify each.

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.
January 2007 - Real Estate in Business Valuations

When a business owns real estate, the business valuation of a control interest can become more complicated. First, the nature of the real estate asset must be established. Is the real estate an operating asset, is it owned by a related entity and leased to the business at a rate above or below market rents, is it a non-operating asset? If the real estate is leased, the business value is determined after modifying the rent expense to market rent. If the real estate is a non-operating asset, such as a ski condo in Vail, Colorado , it is valued separately from the business and added to the business value to get the value of the total enterprise. If the real estate is an operating asset, more work is involved.

An operating asset is an asset owned by the business that is a required component of the business. Real estate, such as an hotel land and building is a good example of real estate as an operating asset. Without the specific land and building, the hotel business cannot exist. Hotels are typically valued as a combination of the real estate, the fixtures and equipment, and the intangible assets together, however, the individual components must sometimes be valued separately.

In order to determine the value of the business portion only of an entity that owns real estate as an operating entity, the real estate must be valued “as if” it were standing alone without the business. A market rental rate for the real estate can then be estimated. This market rental rate must then be added to the operating expenses of the business as rent expense in order to obtain an income stream that can be used to value the business portion only.

For example, let’s consider a corporation that owns a convenience store together with the associated real estate. The following is a summary income statement for the business:
​ If this entity were valued using a capitalization rate of twenty percent without considering the value of the underlying real estate, the following would result: 
There is a big problem with the methodology illustrated above. Improved commercial real estate is typically considered less risky than a business entity. The above scenario treats both the real estate portion and the business portion “as if” they have the same risk characteristics.

Now, instead, if the underlying real estate were valued separately and then an appropriate market rental rate were used as part of the operating expenses in order to value the business only portion, the value would be significantly different. Two examples follow; one with a market value of $1,000,000 for the underlying real estate, the other with a market value of $500,000 for the underlying real estate.
The market rent expense should be obtained from a commercial real estate appraiser. The real estate appraiser will survey the market for ground and building lease rates and support the concluded rental rate. For simplicity, a rate of ten percent has been used in these examples.

The net cash flow has decreased to $39,000 after deduction of rent expense of $100,000 from a previous amount of $99,000.
In this example, the business portion of the entity has a value of $200,000 with a total value of the entity of $1,200,000 versus the indication of value of $510,000 with the value of the underlying real estate unknown.

If, the value of the underlying real estate were $500,000 instead of $1,000,000, the following would result:
A deduction of $50,000 for market rent expense instead of $100,000 results in a net cash flow of $69,000 instead of $39,000. This would result in a value conclusion for the business only portion and combined entity as shown below:A deduction of $50,000 for market rent expense instead of $100,000 results in a net cash flow of $69,000 instead of $39,000. This would result in a value conclusion for the business only portion and combined entity as shown below:
Summary:

Using the same income stream, we find very different values for the business portion. This illustrates the importance of getting the correct real estate value before attempting to value the business portion. The chart below summarizes the three examples:

Scenario

Indicated Value - Business Portion Only

Combined Total - Business & Real Estate

Combined Real Estate & Business - Incorrect Methodology, value supposedly would include both the business and the real estate

Unknown

  $510,000

Real Estate Valued at $1,000,000

  $200,000

  $1,200,000

Real Estate Valued at $500,000

  $360,000

  $860,000

These examples show the importance of dealing with the value of the underlying real estate properly. The difference in the real estate value changes the market rent expense, which in turn, changes the value of the business only portion. When valuing a business entity with associated real estate, it is critical to get the value of the real estate right. Failure to do so often results in an even larger error in the value of the business entity alone.

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.  
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