How Should Real Estate be Treated in a Valuation?
When our clients engage us to value a business, a number of different assets need to be taken into consideration. Real estate assets, including manufacturing plants, retail stores and warehouses constitute just a few of the most valuable assets on a balance sheet, especially in a hot real estate market like the Lower Mainland of British Columbia.
Real estate assets might also be integral to the success of the business, particularly if they are used directly in the operations. For example, there might be certain locational or purpose-built design features that give the business a competitive advantage in the market. In other cases, real estate may not be essential to the business and may not even be used in the business (i.e. in the case of a passive real estate investment holding company).
A question that frequently arises is “how should real estate assets be treated in the valuation of an operating business?” More specifically, should they be considered an operating asset or a redundant asset?
WHAT ARE REDUNDANT ASSETS?
In simple terms, redundant assets are those assets that are either not used in, or do not contribute to, the core operations and revenue-generating activities of the company. Common among those are cash and short-term investments, excess working capital and tangible assets not essential for the business to own (i.e. boats, artwork, aircraft, etc.). Redundant assets are also known as non-operating assets. Non-operating assets are added to the value of the business (the operating assets) to derive the total enterprise value.
WHAT ABOUT REAL ESTATE?
If company-owned real estate is not used in the business (i.e. it is held only to generate passive investment income), it’s clear that they constitute redundant assets and should be added to the value of a business in determining the total enterprise value.
However, when it comes to real estate assets that are actually used in the business, things get a little more complicated. Generally speaking, real estate properties are almost always ‘treated as’ redundant assets. The exception is when a company engages in real estate development and sales as part of its core operations. In this case, the company-owned real estate is treated as inventory.
The treatment of real estate as a redundant asset seems counter-intuitive when the property is used in the operations and contributes to profitability (i.e. through savings in rental expense and other benefits). However, there is a rational explanation for this treatment. The reason for this treatment is that it recognizes that real estate is a fundamentally different type of investment than an operating business. It has different risks and returns in comparison to an operating business.
Here are two examples:
- The investment risk associated with real estate is much lower (i.e. cash flows do not fluctuate from period to period, and the tenant can be replaced if rent is not collected etc.)
- The investment return includes both a current return (i.e. rental income/savings), as well as long term capital appreciation
As a result of these investment features, real estate investments tend to appeal to a certain type of investor that may have a lower appetite for risk. These investors are generally willing to accept a much lower rate of return on their real estate investment, especially compared to an investor in an operating business where the risks are much higher.
So, even though the company’s real estate may be used in the business, to get the most accurate measure of total enterprise value, the operating business and the real estate assets are best viewed separately in a valuation.
Having said that, it is possible to get an identical overall result by treating the real estate as an operating asset. This would result from a combination of:
- the cash flows being capitalized are higher (since there is no rental expense);
- the blended capitalization rate used to value the cash flows is lower since the investor is receiving more tangible assets (with real estate included), which reduces the downside investment risk of the company; and
- the benefit realized from a hidden redundancy (i.e. where the property is currently mortgage free, and financing is available).
Although, it would likely be a fluke that you would get the same answer under both approaches (i.e. treating real estate as a redundant asset vs an operating asset).
At a minimum, separating the real estate provides more transparency as to how the overall enterprise value was derived. The added transparency can be very important in special markets like Vancouver, where the real estate prices have risen quickly.
Separating the real estate also provides more useful information to the parties, as it would enable them to consider alternative structures to an acquisition transaction. This might include stripping out the real estate and entering into a long-term lease back arrangement prior to the transaction, which would reduce the amount of capital an investor would have to commit to the transaction.
IMPORTANT ADJUSTMENTS TO CONSIDER
If the real estate is treated as a separate asset by notionally removing it from the business, an important adjustment arises when valuing the business.
A fair market rental fee needs to be deducted from the normalized operating cash flow. This would reduce the value of the business by the amount of the capitalized after-tax rental expense. The amount of annual rental expense would be determined from discussions with the appraiser. The appraiser will have knowledge of what rates of return real estate investors expect from investments in similar properties.
Finally, the appraised market value of the building would be added (together with any other redundant assets, less non-operating liabilities and debt) to the business enterprise value to arrive at the value of the company’s equity.
We understand that there are a number of factors to consider when valuing an operating business that owns real estate and encourage you to get in touch with us if you would like more information on this topic or would like to discuss how we would approach the valuation of your business.