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...
