loan

subject: Using Teem-work To Extend Your Reach On The Real Estate/business Value Continuum. [print this page]

ABSTRACT
ABSTRACT

This article revisits proposed methodologies for allocating the

value of the going concern to real estate, tangible personal property,

and business enterprise value (BEV). The favored methodology is rooted

in a business appraisal method known as the excess earnings method

(EEM). The current article proposes a simplified EEM model, the total

excess earnings model (TEEM), which generally requires just twelve data

inputs. The proposed model acts as a test of whether BEV is present

within the going concern, and the EEM is shown to follow the same

concepts as residual valuation methods. Also discussed are the Small

Business Administration requirements on allocations and USPAP FAQ 164,

which states that an allocation is synonymous with an appraisal and

bound by applicable USPAP appraisal standards.

**********

The award-winning film The Social Network gives a close-up view of

the birth of the business that now hosts some 700 million Internet users

across the globe. In 2003, Facebook's assets consisted of Mark

Zuckerberg's laptop computer, his passion and creativity, and

little else. The tangible assets were worth perhaps $1,000, with the

value of the intangible assets unknown. On January 21, 2011, Facebook

announced that two private stock offerings raised a combined $1.5

billion. The valuation of 100% of Facebook equity was approximately $50

billion, based on the price paid for the limited offerings. (1) How was

Facebook valued? Underwriter Goldman Sachs's business valuation has

not been made public, but it is likely that its methodology was based on

the income capitalization approach.

The Real Estate/Business Value Continuum

The Appraisal of Real Estate, thirteenth edition, appears to be

referring to more than real property when it states, "All income

capitalization methods, techniques, and procedures attempt to consider

anticipated future benefits and estimate their present value" (2)

Of course, all income capitalization analyses are similar, and all lie

on a line that could be called the tangible/intangible asset continuum,

or the real estate/business value continuum. At one end of the continuum

is land, such as a pad leased to build a new branch bank. The only asset

is the land, and land is generally considered to be as permanent an

asset as there is. At the other end of the continuum are businesses with

few tangible assets. The economic life of intangible assets can vary

widely. All assets that can be valued via the income capitalization

approach fall somewhere in between leased dirt and Facebook. Table 1

represents the real estate/business value continuum, which shows that

the degree of permanence defines the spectrum.

Many real property appraisers have difficulty performing

going-concern valuations of properties where non-real estate assets are

significant. Most types of income properties include at least a small

amount of furniture, fixtures, and equipment (FF&E). The most

commonly appraised income-property type--apartments--generally include

stoves and refrigerators. Property types with more significant amounts

of FF&E include hotels; golf courses and other recreational

properties; assisted-living facilities and nursing homes; convenience

stores; car washes; concrete plants; power plants; pipelines; and real

estate--intensive manufacturing businesses.

Some of these property types also contain a value that exceeds the

cost of the real property plus the equipment (and perhaps inventory).

This frothiest (or least certain) part of the value is referred to by

several names: intangible assets, goodwill, or business enterprise value

(BEV). Valuing the BEV is one of the hardest assignments for any

business appraiser or real estate appraiser. Many of the property types

mentioned (such as hotels and nursing homes) can have BEV present, at

least to a small degree. Additional property types that often have a

high presence of BEV include funeral homes, veterinary practices,

restaurants, and other specially designed properties operated by

owner-users.

There is a point on the real estate/business value continuum where

many real estate appraisers will draw a line and determine that the

property type should not be valued as a going concern by real estate

appraisers. For example, in appraising restaurants, many real estate

appraisers' sole income capitalization method consists of

capitalizing the net operating income remaining from the real estate

rent. Real estate appraisers are not reluctant to appraise a hotel going

concern in part by analyzing the restaurant revenues within a full

service hotel, but for some reason, many cannot or will not make the

leap to appraise a stand-alone restaurant as a going concern.

Conversely, business appraisers will exclude real estate allocations

from their valuations in order to avoid conflicts with the Financial

Institutions Reform, Recovery and Enforcement Act of 1989 (FIRREA).

Where should appraisers draw the line? Or, is it an overly simplistic

position to draw a line when going concerns involve shades of gray, with

little that is black or white?

The goal of this article is to make appraisers cognizant of the

income capitalization approach continuum and to provide a tool to help

real estate appraisers extend their reach along this line. The

recommended tool to help allocate assets within a going concern--the

total excess earnings model (TEEM)--is introduced and explained in this

article.

Value Allocation Requirements

Allocating values to the different assets present is not a

requirement of the Uniform Standards of Professional Appraisal Practice

(USPAP), though many real property appraisers believe that it is (and

some would argue that it should be). In the 2010-2011 "USPAP

Frequently Asked Questions," a new and important statement is FAQ

No. 164, which explains USPAP requirements regarding allocation of value

opinions. (3)

Question 4 in FAQ No. 164 addresses whether appraisers must value

assets separately:

Question: (4.) There are also occasions when the client does not

specifically request separate valuations of non-real property assets,

even though they may be present. Is the appraiser still required to

value those assets separately?

Response: No. This is a scope of work decision to be made by the

appraiser; Standards Rule 1-4(g) does not require separate appraisals of

these different types of assets. SR 1-4 (g) states: "When personal

property, trade fixtures, or intangible items are included in the

appraisal, the appraiser must analyze the effect on value of such

non-real property items."

The responses in FAQ 164 also make clear that an allocation of

value is synonymous with performing an appraisal. The Question 2

response in FAQ 164 states, "Once it is understood that performing

this separation of value is synonymous with performing this appraisal,

compliance with the applicable Standards Rules is required, as is

appropriate competency." (4) This statement places a burden on

appraisers to make accurate allocations, as all of the applicable

standards of an appraisal apply to allocations. Allocations are

therefore objective opinions of value that are developed based on

appraisal standards and must be communicated in a manner that is not

misleading.

While USPAP does not require the breakout of asset components, the

appraiser is required to analyze the effect on value of the non-real

property items. (5) USPAP does not explain how an appraiser can analyze

the effect of non-real property on value in a meaningful way, without

quantifying the allocations. Appraisers not wishing to make allocations

may be able to find a narrow path to compliance with USPAP, but they are

providing a less useful appraisal.

In many situations, allocations are required in order to meet the

needs of the client. It is necessary for bank loan appraisals to contain

asset allocations for banks to comply with both internal loan policies

and mandated regulations (particularly FIRREA) regarding loan-to-value

ratios on real estate. A significant subset of commercial loans is

guaranteed by the US Small Business Administration (SBA). The SBA has

changed its policies numerous times regarding the identification of

assets by appraisers, and most recently the SBA is requiring detailed

asset allocations for going-concern appraisals. The SBA requires

appraisers to allocate values to land, building, equipment, and

intangible assets for special-purpose properties. (6) It has also

increased its deal sizes in recent years, making this a more significant

appraisal practice area.

Where a business valuation is required by the SBA, its requirements

give real property appraisers the authority to include the required

business valuation within a real estate appraisal when the SBA loan is

being used to purchase a special-purpose property. SBA policy states

that the appraiser must be experienced in the particular industry. (7)

These SBA requirements oblige real estate appraisers to become more

competent in going-concern analysis, but this need exists for all bank

financing of special-purpose properties. Before describing a methodology

(EEM) that can be helpful to real estate appraisers, a summary of this

controversial topic's history is reviewed.

Asset Allocations--Where Have We Been, Where Are We Today?

Probably the first effort at formulating a methodology for the

identification and valuation of intangible assets was the Treasury

Method, named for its origin with the US Treasury Department. This

method is today known as the excess earnings method. According to

Valuing a Business, (8) the excess earnings method dates to a 1920 US

Treasury publication, predating most business valuation theory. The

method was first used to estimate the impact of prohibition on

intangible values of breweries and distilleries. The excess earnings

method (EEM) recognizes that each type of asset can be valued by

capitalizing the earnings applicable to that asset. A central theme of

the method is that intangible assets are present when there are excess

earnings, with these excess earnings representing a frothier (or less

certain) level of earnings. Excess earnings represent a return that is

in excess of the return on the tangible assets present.

It is apparent that the EEM involves a methodology very similar to

the land residual method. Real estate appraisers have been allocating

the income from an improved property into a return on land and a return

on the building for many years.

In 1988, Miller, Jones, and Roulac (9) used the land residual

method as evidence that for retail properties essentially all residual

income not applicable to the building improvements should be applied to

the land. Their article's title makes clear their position on BEV:

"In Defense of the Land Residual Theory and the Absence of a

Business Value Component for Retail Property." (10) Their article

references K. Wicksell as contributing to the development of the land

residual method at least as far back as 1955. (11)

Stephen Rushmore demonstrated the allocation of net operating

income between real estate, personal property, and business in his April

1984 article on hotel appraisal. Interestingly, he used capitalization

rates of 12.6% each for the real property and business, with a 12.5%

capitalization rate for personal property (essentially using the same

capitalization rate for all asset classes). (12)

The first presentation of the EEM in a real estate journal is

believed to be an article by T. Alvin Mobley, III, in his October 1997

article, "Defining and Allocating Going-Concern Value

Components." (13) Mobley introduces the excess earnings method,

noting its history as a business valuation methodology. He presents a

strong case for the use of this methodology for allocating the component

assets of a going concern.

Long before Mobley's article, the US Department of Housing and

Urban Development (HUD) wrestled with the concept of asset allocations.

Policy leadership with HUD was convinced that nursing homes consisted of

real estate, FF&E (defined as "major moveable equipment"),

and BEV (named "proprietary earnings" by HUD). It is unclear

when HUD began its policy of allocating a portion of the net operating

income and of the going-concern value to proprietary earnings, but James

K. Tellatin, an authority on the appraisal of senior facilities, stated

in an interview with the author that this policy dated to the 1970s if

not earlier: Also, HUD required as a jurisdictional exception that

appraisers allocate 15% to 25% of the going-concern's net operating

income to the proprietary earnings of a nursing home. This method

reduced appraised values since the net operating income of the going

concern was being separated into two income streams, with the

proprietary earnings capitalized at a higher rate. For many years, HUD

would only insure real estate secured debt, and this methodology was

instituted to counterbalance inflated appraisals.

A 2005 article by Tellatin, Short, and Hansen, "Proprietary

Earnings of Assisted Living and Nursing Facilities under HUD Valuation

Guidelines," (14) shows how to properly allocate values between

tangible and intangible assets in senior facilities, as well as common

errors in appraisal methodology. The methods shown are relatively

similar to the EEM. HUD has changed its policy within the last couple of

years, however, and now HUD will support loans that are based on the

value of both the tangible and intangible value components. (HUD has

moved away from asset allocations).

While USPAP and now HUD do not require asset allocations, it is

logical that if appraisers are to provide the best possible services for

their clients, such allocations should be provided, even if there is

permission in some cases to omit this analysis.

Over the years, articles published by The Appraisal Journal and

other publications have examined appraisal of special-purpose

properties, and some of these articles also have addressed how to

estimate BEV. The analyses in most of these articles are specific to one

property type. Authors of articles on the topic of allocations have

expressed hope for a single methodology for allocating values to the

appropriate assets. Only a few of the articles in the first edition of

the Appraisal Institute's A Business Enterprise Value Anthology

(15) mention Mobley's 1997 article. Perhaps some the authors were

not aware of this important article.

Stephen Clark and John Knight took their turn at proposing a

universal method for estimating BEV in their 2002 article,

"Business Enterprise Value in Special Purpose Properties."

(16) That article contains a discounted cash flow methodology that

involves estimating the present value of the operating cost (or losses)

until reaching stabilized occupancy and the net operating income for a

new facility. The present value of the sum of the losses incurred until

achieving stabilization is considered an estimate of BEV. While this

methodology may be accurate in some cases, there are pitfalls. A

cost-based approach is probably the best method for estimating the real

property component of a going concern, but a cost-based (or loss-based)

approach may not be appropriate for valuing its intangible assets.

Another issue with this method is that estimating theoretical absorption

rates and incurred operating losses involves very complex analyses.

Clark and Knight recognize the concept of a real estate/business

value continuum, similar to what is proposed in this article. They

state,

There is a continuous scale that reflects varying degrees

of business enterprise value in going concerns that

depend on stabilized occupancy. (17)

More recently, Robert Owens attempted to bring the appraisal

profession up to date with his 2006 article, "Contemplating the

Future of Business Enterprise Valuation." (18) The article contains

a generalized critique of the methods that have been promulgated. While

there is certainly room to criticize the EEM, this article fails to

reference the EEM or Mobley's article, though EEM may be included

in Owens' generalized critique of methodologies.

How Prevalent Is BEV?

The theory that BEV is present in some properties is almost

universally accepted today, though the issues of The Appraisal Journal

from the 1990s indicate that this was then a controversial topic. (19)

The debate over the existence of BEV has quieted since the 1990s, when

knowledgeable appraisers gave strong reasons for why the value in a

shopping center resided exclusively in land and buildings. Evidence of

the strength in their arguments can be found when reviewing assessed

values of such high uses of real estate.

One of the reasons there has been such strenuous disagreement

between BEV proponents and naysayers is probably because each group is

partly right. By its nature, BEV is present to more than a nominal

degree only in the more profitable special-purpose properties. It is

likely that some naysayers feel that if they give an inch on recognizing

BEV, then attorneys and appraisers will find BEV present in virtually

all special-purpose properties, particularly when the issue is property

taxation.

When real estate prices get frothy, there is greater likelihood of

the presence of BEV. This concept is illustrated by the variability of

the stock market. When stock prices crashed in late 2008 and early 2009,

many stocks were trading below book value, or said another way, below

cost. Such stocks included no intangible value. The stock market has

recovered to near premeltdown levels, and today few stocks are trading

below book value. Intangible assets (not on the balance sheet) are

present in the value of such stocks trading above book value.

Special-purpose real estate has recovered from the crisis too, but it is

also evident that in many markets, special-purpose properties are often

selling near cost. This would indicate that, in many cases, BEV is not

present.

Those arguing against the existence of BEV would have difficulty

explaining the value of a long-established funeral home. A funeral home

is physically similar to an office building, except that it has fewer

walls, and it has some modest particular requirements. The argument can

be made that development of a shopping center costing tens of millions

has unusually high (synergistic) real estate value, but what special

value is there in the real estate of a funeral home? There is very

little that is special about such real estate, and yet prices paid for

such going concerns can dwarf the value of the real estate plus the

other (net) tangible assets present. (20)

Business enterprise value is only present when there are excess

earnings. With the cost of developing real estate today, and considering

consumers' careful spending habits, a property (such as a hotel)

needs spectacular profitability in order to have a large BEV component.

One of the challenges to appraising properties such as res

by: Howard x Elliott

welcome to loan (http://www.yloan.com/)