Friday, August 8, 2014

Real Estate in Business Valuation and Company Value

Why is it important to factor out real estate when valuing a business?

First, let’s limit this discussion to companies whose ownership or use of real estate is incidental to their business activity, not companies for whom real estate ownership is central to their business activity.  This discussion would apply to companies who use office or industrial buildings as opposed to companies that are in the business of leasing property to other companies.

One of the key principles in business valuation is risk: the risk perceived by investors associated with a particular asset or asset type (and the cash flows it produces) will determine the rate of return required by investors to induce them to take on that risk.

Broadly speaking, real estate – as an asset class – generally enjoys a lower perception of risk and a lower required rate of return than a non-public business investment.  What that means in practical terms is this: if you require a lower rate of return from an asset, you will be willing to pay more to acquire its income producing capacity than you would another asset with the same income producing capacity but higher risk.  Therefore, lower risk equals higher value.

The primary reasons real estate is seen as lower risk are intrinsic value and marketability.  Real estate has an intrinsic value, which can be identified regardless of how that real estate is being used at any given time.  Businesses, on the other hand, usually include a component of ‘goodwill’ in their value – often referred to as blue sky – which places the enterprise value higher than the sum of the intrinsic value of the assets used by the business.

Real estate, in part due to its intrinsic nature, also has a well developed market, where values, sellers, and buyers are identifiable.  Businesses have different values to different types of buyers, and have a significantly less developed marketplace.  Therefore business interests are generally considered to be less liquid than real estate.

If we attempt to value a business with the real estate, we are blending two asset types into one valuation, which may result in a portion of the earnings being over valued or under valued.  It would be equally incorrect to value the business with the real estate, and then attempt to subtract the real estate appraisal value from the total value. 

The real estate must be ‘adjusted out’ of the business financials, and appraised separately.  How is this done?  It is very simple to do in most cases.  On the balance sheet, the building (at cost, as well as any associated accumulated depreciation) and land are removed from assets.  Any mortgages associated with the buildings or land are removed from the liabilities.  On the income statement, depreciation from the building is removed from expenses, interest on the mortgage is removed from expenses, and a new deduction for a triple net lease payment is added to expenses.

A triple net lease requires that the tenant pays all expenses related to the building, including utilities, maintenance, insurance, and property taxes.  These leases have historically averaged 9% of the fair market value of the real estate per year.  This is called a capitalization rate, or ‘cap rate.’  In periods of low long term interest rates (such as now) cap rates have averaged 6.5 – 7.5%.  The more specialized the property is, the higher the cap rate will be.  Office and retail space usually has the lowest cap rates (because tenants are easier to replace), while specialized industrial sites will require 10-20% higher than average, depending on the degree of specialization. 

After these adjustments are made, the balance sheet equity and net income will only reflect the results of the business activity, and not any benefit of real estate investment.

I hope this discussion helps you understand why and how we separate the real estate from the business when valuing a business.

Brian Murray CPA/ABV, CVA specializes in business valuations and merger and acquisition consulting, and has served as an expert witness in court.  Please call Murray & Roberts CPA Firm SC at (920) 225-6436 to find out more or visit our website, and click on the BUSINESS VALUATION link.  Go to now for a fast and affordable business valuation report prepared by Brian Murray.

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