September 2003

Business Valuation, Real Estate Appraisal or Both?

A business valuation methodology that generates stand-alone business and real estate
appraisals may prove beneficial and provide a more accurate assessment of total value

In many cases, the value of a business is intricately intertwined with that of its underlying real estate assets. The business and real estate components of value are particularly connected if the real estate is a special-purpose property and a major asset of the business. Convenience and gas stations, hotels, casinos, lube centers, auto dealerships, car washes, bowling alleys, marinas, cemeteries, theaters, restaurants and mobile home parks are just a few of the many types of businesses that rely heavily on their underlying real estate.

In these situation, a business valuation methodology that generates stand-alone business and real estate appraisals may prove beneficial and provide a more accurate assessment of total value. Real estate valuation methodologies have been designed to generate “stand alone” realty value conclusions. In other words, the real estate appraisal values the property assuming an unrelated tenant. Similarly, business valuations typically assume a hypothetical buyer of the business and, therefore, must assume that the real property utilized by the business is leased from an independent third-party. Overlap between realty and business valuation will occur whenever the subject company’s operations and the realty used by that enterprise are owned by the same person.

Apportioning Real Estate and Business Values

The key to effectively apportioning real estate value and business value is an imputation of a fair market rent associated with the business’s real property. This imputed rent, which serves as a reduction of cash flows for purposes of generating a business value, also is the basis for determining the realty value.
Determining separate stand-alone real estate and business values through this method will usually result in a more meaningful value conclusion. In this manner, an evaluation can determine how effectively management is utilizing the underlying real estate assets to generate additional business value. Additionally, real property assets may not be utilized to their “highest and best use,” a revelation made possible through separate appraisals of the business and real estate.

Applications

To help determine the appropriate valuation requirement for any given purpose, the following is a brief overview of the types of assets that require business valuations, those that require real estate appraisals, and those that require both.

Business valuation. A business valuation will typically be required if the subject business:

• derives revenues from producing goods and services, and it rents its facility from an unrelated third party;

• engages in an economic activity in which the location of the economic activity’s real estate is not a key factor;

• has a value that depends more on industry conditions than on real estate market fluctuations;

• primarily uses machinery, equipment, employee skills or other assets (rather than real estate) in generating goods and services;

• uses intangible assets such as patents, trademarks, copyrights and customer lists to generate earnings;

• is a commercial, industrial or service organization engaged in an activity other than the sole operation of real estate;

• is an equity, fractional or minority interest, or is difficult to split up because the owners do not have a direct claim on the assets; or

• has substantial assets that can be moved from one location to another.

Real estate appraisal. A real estate appraisal will typically be required if the subject business:

• is a residential or commercial property, such as a single-family residence, apartment or office building;

• is a whole or partial interest in real estate, such as tenant in common or joint tenancy;

• engages in an activity whose primary value component is the location of the real estate;

• has a value that fluctuates primarily with the real estate market;

• derives revenues from the use or leasing of real estate;

• uses real estate as its primary asset;

• has real estate assets that cannot be moved;

• has primarily tangible real estate assets that produce economic activity in the form of lease revenue or real estate use; or

• has real estate related operating expenses such as property management and maintenance.

Both business and real estate appraisal. While the specifics of a situation will dictate whether a business valuation or a real estate valuation will be performed, in certain situations, as detailed hereunder, a credible and defensible valuation requires the advice of both a business valuator and a real estate appraiser. The following scenario illustrates the typical manner in which the two work together:

A company requires a valuation and owns several restaurants along with the underlying real estate. The real estate appraiser, through market research and professional judgment, will establish a fair market rent, and this fair market rent will be utilized by the real estate appraiser as one method for estimating the value of the property. Then, the business valuator adjusts downward the restaurant’s cash flows by using the fair market rent figure when valuing the underlying business. The result of imputing the hypothetical rent is to reduce the cash flows generated from the business, thereby lowering the business value. However, the business value is ultimately combined with the real estate value to determine the total enterprise value of the company.

Conclusion

This scenario demonstrates a situation in which the subject entity’s value is at least partly driven by the value of the entity’s real estate. It is important to note that, in these circumstances, both a real property appraisal and a business value may be required to properly determine the total enterprise value of the subject entity.

By correctly separating the two from another, it is easier to estimate an entity value conclusion that is specific and that takes full consideration of all sources of value. ■