Our purpose in writing this book is multifaceted. First, this book aims to present a clear understanding of going concern valuations, at the same time resolving the current misrepresentations surrounding the issue. Additionally, this book offers a new set of rules readers can use to determine which property types qualify as going concern valuations and which do not This book presents an understanding that in performing a Going Concern Valuation of properties which are perceived to have a business component, it may not be possible to segregate, allocate, or value the components individually. "For example, when appraising the going concern value of a motel with occupancy of 75% it could be argued and possibly proven that there is a value that can be separated from the overall value, or going concern value, to the business component. On the other hand, however, appraising that same motel with only 40% occupancy presents a completely different set of circumstances that could easily draw completely opposite conclusions. It simply may be a lack of sufficient tools or data to argue and prove that the business component in fact has value separate from the real estate. To do so with authority is tantamount to ignorance or arrogance"
Going Concern Valuation
for Real Estate Appraisers, Lenders, Assessors, and Eminent DomainBy L. DEANE WILSON ROBIN G. WILSONiUniverse, Inc.
Copyright © 2012 L. Deane Wilson
All right reserved.ISBN: 978-1-4620-6563-9 Contents
Acknowledgements...........................................................................................viiIntroduction...............................................................................................ixChapter 1 Similarities & Differences.......................................................................1Chapter 2 Obligations, Relationships, & Applications to USPAP, FIRREA, the SBA, & HUD......................9Chapter 3 Terms, Definitions, Interpretations, & Misinterpretations........................................25Chapter 4 Others' Notions, Thoughts & Ideas................................................................41Chapter 5 Principles & Vice Principles.....................................................................49Chapter 6 Discernment Rules................................................................................59Chapter 7 Historical Valuation Methodologies...............................................................75Chapter 8 Applied Methodologies............................................................................87Chapter 9 What's Included?.................................................................................113Chapter 10 Resource Material...............................................................................137Chapter 11 Understanding Financial Statements, Capitalization Rates and Discount Rates.....................151Chapter 12 Case Studies....................................................................................163About the Authors..........................................................................................189Appendix...................................................................................................191
Chapter One
Similarities & Differences
Real Estate Appraising versus Business Appraising
The concept of a going concern valuation rests heavily on business valuation; therefore, it is vital to present a cursory comparison of business valuation and real estate appraising. Most businesses that real estate appraisers typically consider to be going concerns are categorized as small. Because the techniques for appraising small businesses are reasonably straightforward, experienced real estate appraisers should be able to learn and apply business valuation methodology relatively easily. Our brief presentation of the similarities and differences is not intended to train real estate appraisers to become business appraisers. We strongly recommend that real estate appraisers interested in performing going concern appraisals enroll in business valuation courses to gain the necessary competency.
Assuming there are no real estate assets to the business, what is being appraised in a business differs from that in real estate. The first difference is the concept of the property itself. Theoretically, real estate is static, immobile, and tangible, whereas a business is typically dynamic, mobile, and intangible. The business appraiser develops net operating income differently than does a real estate appraiser. Real estate appraisal typically does not consider non-cash items such as depreciation and amortization in the development of the income stream. Conversely, business valuations do consider these items. The same holds true in the development of cash flow projections.
Looking at the traditional approaches to value, we see prominent similarities in the Income Approaches and the Sales Comparison Approaches. However, there is less similarity found in the Cost Approaches. These similarities are paraphrased in the following tables, based on two primary sources, Valuing a Business and Valuing Small Businesses and Professional Practices.
The concept of future benefits underpins the Income Approach in both business and real estate appraising. Both can use direct capitalization and discounted cash flow techniques, depending on the assignment. The primary difference between the two is in the expenses charged to the income.
The underlying principle of substitution in the Sales Comparison Approach is the same for both business and real estate. This principle states a purchaser would pay no more for the subject property or business than the cost of an equally desirable substitute property or business. Both find comparable sales and use physical and economic elements of comparison to adjust the sales to compare more similarly to the subject.
Business valuation identifies the Cost Approach as the Asset Based Approach, while real estate appraising calls it the Cost Approach. There is a definite difference between the two. Business appraisers seek the value of all the assets, tangible and intangible, less all the liabilities. They are looking for the net worth via this approach. This one approach is unlike that used in real estate appraising.
Capitalization Rate Differences—In addition to the similarities and differences in the approaches to value, there are differences in developing capitalization rates. According to the book Valuing Small Businesses:
"Pretax income streams from the direct investment in real estate tend to be capitalized at lower rates of return than comparably defined pretax income streams from investments in non-real estate oriented businesses."
There are several reasons for these differences. Real estate typically has income tax advantages not necessarily enjoyed by businesses, which can create higher after-tax income. Real estate also has lesser-perceived risk than businesses. Prior to this recent economic downturn, most real estate investments included an assumption of property appreciation during ownership, and thus, investors were willing to accept a lower initial rate of return. Furthermore, in a balanced market, land has always been considered a non-depreciating asset. In contrast, most businesses have assets such as furniture, fixtures, and equipment that eventually become worthless. Businesses also have other intangible assets that become obsolete in a shorter time than real estate. Much more discussion could be stated on this subject; however, Going Concern Valuation for Real Estate Appraisers assumes its readers have an advanced knowledge of the valuation of real estate and in particular real estate as an investment. It also assumes that its readers become educated on the subject of small business valuation.
Other Comparisons
Value Drivers are unique to business valuation. Value Drivers are factors that influence or "drive" the values of different types and sizes of small businesses. These are distinctive to businesses. While both real estate and business are attractive as investments, smaller businesses are often purchased for reasons other than strictly a return on and of the capital expenditure. Examples of these motivations include:
1. To buy a job.
"These are often small retail or service businesses ... these businesses will reflect little profit ... the purchaser for this type of business is primarily interested in buying a job, and not buying the business as an investment."
2. To realize certain nonfinancial benefits (e.g., involvement with something of personal interest). Many purchases of the local neighborhood bar could be examples.
3. To realize a desired rate of return. This is the same idea for both real estate and small businesses.
4. To achieve a targeted market position (e.g., eliminate the competition). This applies to small businesses as well as larger businesses.
5. To achieve critical mass (for cost savings, access to capital, or many other reasons). Businesses purchased with this motivation are typically much larger than most under consideration as going concerns.
6. To liquidate the business. This is not applicable for our purpose.
Several of these motivations are not generally applicable to many of the businesses we present in this text. They are presented to illustrate that the motivations of business purchasers can be quite different from the motivations of those buying and selling real estate.
In addition to value drivers, there are elements that influence value drivers. Several are similar to elements in real estate. We have cited a few that refer to business valuation below:
Size
Business size is the first element that influences value drivers. According to Valuing Small Businesses and Professional Practices,
"... the larger the business, the more it is viewed as an investment, with return on investment being a major value driver."
This makes sense and holds true for real estate holdings and investments as well. On the other hand, it would make sense that personal motivations drive values for smaller businesses.
Customer Base
In real estate, consumers can be categorized as destinational or fortuitous. Destinational consumers are those that leave home with the intention of going to a specific store or office such as a dentist. Consumers do not drive by a dentist office and decide to pull in and have their teeth examined. Fortuitous consumers, on the other hand, can drive by a store, such as a convenience store or a coffee shop, and decide to stop at a moment's notice. In business, a similar concept is considered and identified as Persistence of Customer Base. Also included in the consideration of a business are Suppliers and Employee Base. The more predictable the consumer/ customer, supplier and employment base, the more stable the business.
Entry—Ease of Entry asks the questions: How much cash do I need to start this business? Or, how much inventory is needed? The easier it is to enter a business, the larger its tangible assets value driver will be; and hence the larger its value.
Competition—Very similar to locational influences in real estate, competition in business considers how many other such businesses are competing for the same customer/consumer.
Licenses, Franchise Agreements, or Permits—There are some similarities to these items in real estate, such as Conditional Use Permits (CUP). However, more items pertain to businesses such as a liquor license, for example, or a franchise agreement for a motel operation.
Chapter Two
Obligations, Relationships, & Applications to USPAP, FIRREA, the SBA, & HUD
Before we get into any in-depth discussion regarding terminology and methodology of estimating a going concern value, it is important to understand exactly what is required by Uniform Standards of Professional Appraisal Practice (USPAP) and Financial Institutions Reform, Recovery, and Enforcement Act (FIRREA). We will also review the SBA's current position regarding going concern appraisals. Let us start with the Uniform Standards, of course with the caveat of what is required at the current time. Given that USPAP changes every year, or every other year, the conclusions drawn at this time need to be monitored with each new edition of USPAP. We will reference the current 2010-2011 edition of USPAP as well as previous editions, which in our opinion helped cause some of the confusion.
As with any appraisal assignment, the first order of business is to define the problem. The appraiser's first action should be to determine exactly what the client wants. From that determination, you as the appraiser can decide exactly what you can provide. It is extremely important to know up front what the client expects, if for no other reason than to charge an adequate fee. Interestingly, it has been our experience that, many clients are not sure of what they want (or need) in the way of an appraisal. Unfortunately, this is especially true when it comes to USPAP requirements. While appraisers are required to take educational courses on USPAP, clients, such as lenders, are not. USPAP expects appraisers to perform at a certain level, not the client. Therefore, you as the appraiser want to make sure you understand what you are appraising and what USPAP requires you to do. This is especially critical when looking at a potential going concern property. The questions should be obvious, such as:
• What is the purpose of the appraisal?
• Is it for lending purposes, tax consequences, or perhaps eminent domain?
• What value are you seeking?
• A basic question should always be, "Is it the real estate only?"
• Does the client want a separate value of any of the personal property, furniture, fixtures, equipment, and/or intangible items?
• Should you be the one to make the proper decision?
• Is the client asking you to appraise the going concern value?
Currently, USPAP does not require real estate appraisers to value the different elements integrated in an appraisal of the going concern value. In addition, most real estate appraisal assignments do not have these elements to consider in the appraisal. However, USPAP directs appraisers to "analyze the effect on value" of such non real property items, "when personal property, trade fixtures, or intangible items are included in the appraisal." Analyze the effect is not a mandate to value such items. In fact, a recent Q&A from the Appraisal Foundation actually states,
'Some appraisers and users of appraisals believe the requirement that the appraiser must analyze the effect on value of such non-real property items is a requirement for the separate appraisal of those items in all assignment. That is incorrect. Analyzing the effect on value might be appropriately made through the selection of comparable properties used in the sale comparison approach or the deduction of certain line items of expense for management fees, maintenance or replacements in the income approach, for example."
Therefore, even USPAP agrees with our position that analyzing is not the same as valuing. However, several major points need to be understood regarding the term "analyze" when appraising a property with these elements. Although there is a difference between analyzing and valuing, if the analysis is performed thoroughly, the appraiser may be required to value the individual components because of what the analysis produces and/or the manner in which the analysis was applied. Because by nature, a going concern has several parts, and because USPAP does not define the term analyze, we will take a side bar here to define the term, and how it works in real estate appraising, especially appraising going concerns.
Side Bar
To analyze means to separate the subject under study into parts or basic principles to determine the nature of the whole; to examine methodically. In appraising, four types of analysis are applicable to the appraisal process. These are Procedural, Structural, Operational, and Causal.
• Procedural Analysis simply analyzes the process of some activity in a chronological order or systematic method. It explains how to do something, such as the appraisal process itself.
• Structural Analysis analyzes the structure or organization of something. A good example of structural analysis in appraising is describing the components in a house, such as the building materials.
• Operational Analysis analyzes how something works, such as the operation of a business enterprise.
• Causal Analysis analyzes the causes of some effect, the reason why something happened. For example, causal analysis is evident in the sale data we use, which is the cause of our value conclusion.
When we consider the basic definition of analyze we realize that it requires us to separate the individual components when appraising a going concern. While it is true that we separate the components in name only, how does that benefit the user of our report? How does knowing the definitions of the types of analysis influence appraisers pondering an appraisal of a going concern? If appraisers adhere to the definition of analysis, they must at a minimum identify and consider various elements as they define the problem, contemplate the assignment, and develop the scope of work. If for no other reason, familiarity with the definition of analysis will allow the real estate appraiser to write an engagement letter in a manner that excludes personal property and intangible elements if the client does not want a going concern appraisal and requests just the real estate. Additionally, because of the recent Q&A from The Appraisal Foundation, "There are occasions when the client does not specifically require a separate valuation of non-real property assets, even though they may be present. Is the appraiser still required to value those assets separately?" The answer is no. It is critical for the appraiser to understand that it is the Appraisal
Foundation's opinion that "separating" and "allocating" is "synonymous with an appraisal." Inherent in the previous statement is the assumption that if the appraiser separates or allocates the components, that is the same thing as performing an appraisal. We do not think it was the Foundation's intent to start parsing words; however, it is of key importance as to who separates or who allocates the components. Moreover, if the appraiser does the allocation, the process or conduct was used to separate or allocate the components is extremely critical.
Because of the Foundation's position, appraisers should employ the utmost care when analyzing a going concern and in particular, when analyzing the components' effect on value. Much more discussion is needed to fully clarify this confusing issue regarding the words separate and allocate, and expected conduct of the appraiser.
Without performing an actual appraisal, there are only a couple of ways an appraiser might be aware of the individual components' values. One way is to have the property owner or their representative, identify the elements and place a value on them. If the appraiser reports that value, he has not performed a separation or allocation, nor has he valued the components. However, the appraiser cannot state whether he agrees with the owner's value, or whether it is high or low.
Another way an appraiser may learn the individual components' values is through the sales comparison approach. If the appraiser has sale data that includes the business or personal property component, and other sale data that does not, then the user of the appraisal report can infer a value for the components, and/or separate or allocate the individual values. Once again, the appraiser cannot render an opinion regarding the value of the components, only what consequence they have on value. These two examples produce a separate or allocated value to the components, without the appraiser performing that function. Thus, the appraiser complies with USPAP.
This confusion partially stems from how earlier USPAP editions handled the issue. Furthermore, we continue to deliberate on the verbiage in an effort to resolve the current confusion.
The 2004 version of USPAP required appraisers to allocate the different elements. Since then USPAP has changed its wording and eliminated the word allocate. This is a change in the right direction.
Turning back to the current edition of USPAP, the first reference informing appraisers of their responsibility is in Standards Rule 1-2 which states:
"In developing a real property appraisal, an appraiser must:
(e) identify the characteristics of the property that are relevant to the purpose and intended use of the appraisal, including: ..."
The word used as a foundation for this standard is quite clear. The word is identify. Identify the characteristics does not mean value the characteristics. Valuing these characteristics is dependent upon the assignment. More importantly however, the characteristics referred to by this standard, as stated in Advisory Opinion 23 (AO-23), include fee simple interest, leased fee interest, leasehold interest, partial and/or fractional interests, and physical items such as land or improvements. AO-23 does not refer to personal property, trade fixtures, or intangible items. Therefore, if appraising one or more of these characteristics, the obvious first step is to verify what characteristic (as explained by AO-23) is relevant for your assignment.
While AO-23 does not refer to the characteristics associated with a going concern valuation, Standards Rule 1-2(e) does, and continues as follows:
(i) its location and physical, legal, and economic attributes; and
(ii) any personal property, trade fixtures, or intangible items that are not real property but are included in the appraisal."
Let us first look at the term economic attributes. We were unable to uncover any published definition for the term economic attributes. We found similar terms, such as economic influences and economic considerations, which relate to the financial capacity of a market's occupants and their ability to rent or own property. However, we found no reference regarding appraising. Therefore, we choose not to comment on the term economic attributes. Out lack of commentary does not affect the purpose or intent of this book in any way.
Now we will look at the remaining terms of personal property, trade fixtures, and intangible items. Personal property can be objects like automotive hoists in an auto shop or classical paintings in a hotel lobby. Additionally, personal property (the automotive hoists, for example) can also be classified as trade fixtures, depending on their design and their method of attachment. Intangible items on the other hand, are more involved. USPAP defines intangible items (intangible property) as,
"Nonphysical assets, including but not limited to franchises, trademarks, patents, copyrights, goodwill, equities, securities, and contracts, as distinguished from physical assets such as facilities and equipment."
(Continues...)
Excerpted from Going Concern Valuationby L. DEANE WILSON ROBIN G. WILSON Copyright © 2012 by L. Deane Wilson. Excerpted by permission of iUniverse, Inc.. All rights reserved. No part of this excerpt may be reproduced or reprinted without permission in writing from the publisher.
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