2009 Monthly Newsletters
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 22nd, is it appropriate to use a September 30th financial statement or must the August 31st financial be used? What if the company is small and prepares statements only quarterly? Would it then be appropriate to use the September 30th statement or should the June 30th statement be used? If statements are only prepared annually, or only tax returns are prepared, should the December 31st 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 22nd, 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.

In the specific instance previously described, continuation of the existing use was not a realistic option. The company had gone out of business and the likelihood of finding another similar user willing to pay full market value for the property was remote. The nature of the existing improvements did not lend themselves to conversion to another use. Likewise, renovation of the existing improvements or additions to them did not make sense. The only realistic option, the one that would likely return the highest rate to the land, is demolition of the existing structures and redevelopment of the site.  
After discussing the Highest and Best Use with the Assessor’s office appraiser, they understood my point, though they felt that surely the improvements should have some value “just because they are there and could be rented to somebody for something.” I pointed out that the client had been able to rent the premises after a considerable amount of time with it sitting vacant – it was finally leased to a trailer manufacturer from Texas at a rate that worked out to less than the land was worth. The rental rate essentially means that the improvements had no value, other than being in place did eventually facilitate the rent of the land as an interim use, i.e. until such time as market conditions warrant redevelopment of the property for another use.

Finding and supporting the Highest and Best Use conclusion for a property is sometimes the most difficult part of an appraisal – it is also often the most important part. 

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 Appraisal Institute. The Appraisal of Real Estate. Twelfth Edition. (Chicago: The Appraisal Institute, 2001), p. 305.

[2] The Appraisal Institute. The Appraisal of Real Estate. Twelfth Edition. (Chicago: The Appraisal Institute, 2001), p. 307.
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.
Horse Appraisal Example Chart
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: 
Multi-Year Income Producing Real Estate Example Chart
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:
In this example, the annual discount rate is 25% with a 22% capitalization rate (discount rate less a long-term sustainable growth rate of 3%) used to estimate the terminal value (expected sales price) at the end of year seven. The calculated capitalization rate of 16.7% would also have been next to impossible to estimate in year one due to the expected changes in future net cash flow. It should be noted that the present value of the reversion is approximately one-third of the total indicated value of the business.

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 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.
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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%

 The real estate appraiser included the value of the furniture, fixtures, certificate of need, and enterprise value in his total value conclusion. He reached the value conclusion largely based on sales of other assisted living facilities in the general area using price per bed for the comparison. He made adjustments to each of the sales comparables based on factors he thought made sense. He also used an income approach forecasting revenue in similar amount to what was used by the business appraiser, however, instead of analyzing the specific company’s historical expenses and profits, he used “typical” expenses and operating profits for the industry. His forecasted earnings were significantly higher than the specific company had ever achieved – an operating profit of 9.3% versus 3.8%. The real estate appraiser used a capitalization rate of 10% applied to the net profit before taxes. Most of the comparable properties used by the real estate appraiser were the same for both his sales comparison approach and his income approach – no surprise that the value conclusions from both approaches were similar.
The business appraiser analyzed the historical income and expenses for the entity and capitalized the net cash flow to invested capital at 12.2% using a weighted average cost of capital (WACC). This was based on an equity discount rate of 18% and a debt cost of 7.5%. He did not use any type of sales comparison approach and did not properly account for the value of the real estate. He was also not licensed to value real estate – another problem.
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]

If you bought the 10% interest in company number two, absent some agreement specifying permitted and prohibited actions reached through some negotiations, would you be able to prevent the 90% owner of the business from raising his or her salary and thus cutting the expected annual return paid to you significantly? Would you be able to dictate when the business would be sold so that you could get your investment back? Could you prevent the 90% owner from changing the business operations to enter a more risky field of endeavor? Could you prevent the 90% owner from entering into deals with other firms owned by him at less than market deals? Perhaps you might be able to pursue some type of shareholder oppression suit if things were really egregious, however, for the most part, the control owner can do what they like and you, the minority owner are stuck with it.
The value of a 10% minority interest in a company is often the subject of a business appraisal assignment. Under a fair market value standard of value, the value of a minority interest is rarely the pro rata of the total value of the company. Due to the lack of control nature of a minority interest in a privately held company, investors view such interests much less favorably than control interests. Accordingly, investors generally would demand some discount from the pro rata amount to account for the risk and extra illiquidity involved with owning a minority interest in a privately held company. There are two issues that need to be addressed when valuing minority interests in privately held companies:

1) lack of control with the interest

2) extra lack of liquidity associated with the interest above and beyond the lack of liquidity due to being a privately held company, i.e. the lack of liquidity due to the difficulty associated with selling a minority interest in any privately held company

Accordingly, depending on the appraisal methodology employed, a discount for lack of control and a discount for lack of marketability must often be used in valuing a non-controlling or minority interest in a privately held company. Determining the magnitude of each of these discounts is another issue. This is an important part of many of our appraisal 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.

[1] Shannon P. Pratt, Robert F. Reilly, and Robert P. Schweihs. Valuing a Business: The Analysis and Appraisal of Closely Held Companies. Fourth Edition. (New York: McGraw-Hill, 2000), p. 365-366.
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.  

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: 

Multi-Year Business Income Example Chart
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? 


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:

  • Use of the hypothetical condition is clearly required for legal purposes, for purposes of reasonable analysis, or for purposes of comparison;
  • Use of the hypothetical conditions results in a credible analysis; and 
  • The appraiser complies with the disclosure requirements set forth in USPAP (Uniform Standards of Professional Appraisal Practice) for hypothetical conditions.[1]

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:

  • It is required to properly develop credible opinions and conclusions;
  • The appraiser has a reasonable basis for the extraordinary assumption;
  • Use of the extraordinary assumption results in a credible analysis; and
  • The appraiser complies with the disclosure requirements set forth in USPAP (Uniform Standards of Professional Appraisal Practice) for extraordinary assumptions.

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.

Business, Real Estate, and Machinery & Equipment Appraisals
(208) 674-7272