2010 Monthly Newsletters
October 2010 - Appraisal Discounts

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

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

  • $100,000 in cash
  • $100,000 in IBM common stock
  • $100,000 in a single-family residence in a large city
  • $100,000 in a commercial property in a large city
  • $100,000 in a single-family residence in a small town
  • $100,000 in vacant commercial land in a small town
  • $100,000 in a small, but profitable closely-held business (100% control interest)
  • $100,000 in a ten percent interest in a small, but profitable closely-held business
  • $100,000 in a one percent interest in a family limited partnership with non-income producing real estate assets

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

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

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

Valuations play a part in all strategic transactions, tax, and many litigation matters. For additional information or advice on a current situation, please do not hesitate to call. We value real estate, businesses, machinery & equipment, and livestock.
September 2010 - How Does the Economic Outlook Affect Value?

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

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

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

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

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

Valuations play a part in all strategic transactions, tax, and many litigation matters. For additional information or advice on a current situation, please do not hesitate to call. We value real estate, businesses, machinery & equipment, and livestock.
July 2010 - Is the (Financial) World Coming to an End? 

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

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

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

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

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

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

Valuations play a part in all strategic transactions, tax, and many litigation matters. For additional information or advice on a current situation, please do not hesitate to call. We value real estate, businesses, machinery & equipment, and livestock.
June 2010 - Appraisal ‘Flavor’ Options 

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

Real Estate Appraisal Options








Business Appraisal Options  








Equipment & Personal Property Appraisal Options







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

Real Estate Appraisal Options Chart
Business Appraisal Options Chart
Equipment & Personal Property Appraisal  Options Chart
March 2010 - Does the Appraisal Conclusion Make Sense?

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

Example

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

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

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

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

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

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

Valuations play a part in all strategic transactions, tax, and many litigation matters. For additional information or advice on a current situation, please do not hesitate to call. We value both real estate and businesses including machinery & equipment.
February 2010 - Evaluating Management 

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

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

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

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

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

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

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

A couple of examples will illustrate this point:

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

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

Valuations play a part in all strategic transactions, tax, and many litigation matters. For additional information or advice on a current situation, please do not hesitate to call. We value both real estate and businesses including machinery & equipment.
December 2010 - Known or Knowable

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

Regardless of the reason for the appraisal, the critical aspect to be considered by the appraiser is what information was known or knowable as of the effective date. When the effective date is the date someone passed away, it is not unusual to have an effective date land somewhere in the middle of a month rather than a date conveniently at the months end. Most companies issue financial statements as of the end of a month, the end of a quarter, or annually. So, if the effective date is September 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.
May 2010 - Do All Appraisals Follow the Uniform Standards of Professional Appraisal Practice (USPAP)? 

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

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

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

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

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

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

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

Valuations play a part in all strategic transactions, tax, and many litigation matters. For additional information or advice on a current situation, please do not hesitate to call. We value both real estate and businesses including machinery & equipment.
April 2010 - Appraising Apples & Oranges

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

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

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

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

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

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

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

1. buyer and seller are typically motivated;

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

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

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

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

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

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

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

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

Valuations play a part in all strategic transactions, tax, and many litigation matters. For additional information or advice on a current situation, please do not hesitate to call. We value both real estate and businesses including machinery & equipment
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August 2010 - Useful Life Issues

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

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

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

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

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

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

Valuations play a part in all strategic transactions, tax, and many litigation matters. For additional information or advice on a current situation, please do not hesitate to call. We value real estate, businesses, machinery & equipment, and livestock.
HYDE VALUATIONS, INC
Business, Real Estate, and Machinery & Equipment Appraisals
(208) 674-7272