Enterprise component allocation: methodology discussion.(INSIDER'S PERSPECTIVE)

BUSINESS ENTERPRISE VALUE (BEV) HAS FOR MANY YEARS eluded a universally accepted method of appraisal. It has been the subject of much discussion, writing and even litigation. By definition intangible, BEV is difficult to pin down. This article reviews various methodologies for estimating BEV, and discusses how it relates to various types of real estate.

Business enterprise value is a component of going-concern value, which is defined in The Dictionary of Real Estate Appraisal, Fourth Edition, as:

1. The market value of all the tangible and intangible assets of an established and operating business with an indefinite life, as if sold in aggregate; also called value of the going concern;

2. Tangible and intangible elements of value in a business enterprise resulting from factors such as having a trained work force, an operational plant, and the necessary licenses, systems, and procedures in place;

3. The value of an operating business enterprise. Goodwill may be separately measured but is an integral component of going-concern value.

Going-concern value was originally defined by the United States Supreme Court in a 1933 case involving a public utility (Los Angeles Gas & Elec. Corp. v. Railroad Com'n, 289 U.S. 287), as follows: "This court has declared it to be self evident that there is an element of value in an assembled and established plant, doing business and earning money, over one not thus advanced, and that this element of value is a property right which should be considered in determining the value of the property on which the owner has a right to make a fair return."

A counselor or appraiser may be requested to isolate the BEV, which is defined in The Dictionary of Real Estate Appraisal, Fourth Edition, as follows: "A term applied to the concept of the value contribution of the total intangible assets of a continuing business enterprise such as marketing and management skill, an assembled work force, working capital, trade names, franchises, patents, trademarks, contracts, leases, and operating agreements." Reasons to separate BEV components of a going concern include: 1) benefits to the ownership of the after-income-tax cash flow; 2) property tax purposes; 3) mortgage lending allocations; and 4) general property analysis. Identifiable real estate entities that have basic earmarks of enterprise components include: restaurants, gasoline service stations, hotels, marinas, shopping centers, bowling alleys and nursing homes.

Real property is sometimes valued and subtracted from the going-concern value to isolate the BEV. Conversely, one can value each non-real estate component, separate these items from the value of the going concern, and thus isolate the value of the real estate. Also, BEV components could be identified by employing a discounted cash flow (DCF) analysis. The difference between the value of the property as currently in operation and the same property if vacant and available could well be the business enterprise value.

In any type of analysis, the appraiser should first research the market for items that are the easiest to identify and isolate. By elimination, the components of the BEV can be narrowed down to the more difficult items to value.

Generally, when the market declines on volatile, relatively short-lived enterprises, the last item of value remaining is the BEV, including licenses, operational expertise, supplies, etc. An operation that no longer supports the land and/or improvements will finally he closed, at which time the highest and best use of the real estate is greater than the current non-performing use; hence there is no BEV.

This author is in general agreement with most articles and valuation analyses regarding valuations of BEV, but concludes that there are no perfect or superior methods. Appraisers have spent considerable time and effort on various thoughts and methods, and most agree that more than one method can be applicable.

There is another component of real estate enterprise and BEV that needs to be defined, that being goodwill, defined in The Dictionary of Real Estate Appraisal, Fourth Edition as:

1. An intangible asset category usually composed of elements such as name or franchise reputation, customer patronage, location, products and similar factors;

2. The intangible asset that arises as the result of name, customer patronage, location, products, and similar factors that have not been separately identified or valued but that generate economic benefits.

Under IRS Section 197, goodwill is to be amortized over a 15-year period for income tax purposes.

The aim of many investors is to seek "tax shelters" in real estate-oriented properties for after-tax cash flow returns. Historically (prior to 1992), when enterprises were sold, the general tendency was to minimize land value, allocate everything possible to depreciable tangible improvements, and ignore business value. Currently, for income tax purposes, the depreciable real estate improvements are amortized over 39 years.

Is it appropriate to depreciate old, worn-out real estate improvements in economically depressed locations that may have a ten-year remaining economic life, but for income tax purposes, the investor is required to depreciate the improvements over the next 20 years remaining of the 39 years of depreciation? (If built after May 1993, or a 31.5-year period of depreciation is applicable if put in service after 1986 and before 1993.)

Today, many lenders are looking for the vacant-and-available value of property being mortgaged, as these institutions are basing loans on collateral value of the real property, whether an owner-occupied office building, industrial plant, commercial building, etc. What would mortgage loan terms be on commercial property without personal liability on the mortgage indebtedness? Could the difference be something other than real estate value, and/or could the difference be depreciated for IRS purposes as a business value? These interesting concepts are based on common logic and valuation procedures.

The assessor should be looking at the vacant-and-avail-able status of all property for tax assessment purposes in states that assess on a fee simple, market value basis (as required, e.g., by the Michigan Constitution). Generally, value of recently leased commercial buildings could be greater than that of similar vacant buildings, which could take time to lease up and incur expenses during vacancy, including rent loss, leasing fees, management, insurance, debt service, property taxes, maintenance, security, utilities, etc. An assessor should not penalize a landlord of a vacant building by placing an assessed value equal to that of a similar occupied building; and the owner of leased property should not be required to pay taxes on property subject to existing occupancy (BEV). This analysis is applicable to the real estate investor's maximizing his/her after-tax cash flow position.

For some time, counselors and appraisers have used the DCF method to analyze and value property, including enterprises (BEV), that have not achieved market stabilization, as well as for properties that have contracted variable income streams. Investors/lenders often require various value estimates for a project, i.e., as is, as if complete and as if stabilized. These indicate a possible--and very probable--BEV allocation. Assume there are two physically and functionally similar apartment buildings in similar economic locations. Assume one is vacant and one is in a stabilized operating condition. In good times it is easier and less time-consuming to fill up the vacant building, than in economic down times. This is indicative of a possible greater BEV in some properties that are in poor economic areas versus in good economic areas. The lease-up costs are generally not considered real estate and could reasonably be depreciable for income tax purposes.

These old residual techniques for land and buildings were developed in the mid- to late-1930s. Some articles analyze successful enterprises by applying residual techniques to the stabilized net income, and reasonably suggest that the difference between the net income necessary to justify the improvements and the projected pro-forma net income is the net income (value) that accrues to the non-realty components.

There are allocation methods based upon various formulas involving franchise value percentages and business portion allocations. An overall capitalization rate applicable to business-oriented real estate, such as a hotel, should be higher than a capitalization rate that is appropriate for a leased, high-profile fast food franchise.

In general, these approaches are reasonable. However, can these approaches be applicable to an economically marginal BEV property? A marginal BEV property could be any business-type of property located in an area where new competition or changing economics have limited the property's economic future. In a marginal operation, an interest rate on the land alone might require all of the net income from the enterprise to satisfy the demands of the land.

However, a marginal enterprise could have some BEV. The BEV could be the last component of value remaining, short of salvage value (furniture, carpeting, elevator cables, etc.). Not every BEV will represent enough net operating income to cover the depreciated value of all of the improvements, including land. This author's article, "Valuation of a Pari-Mutuel Race Track," Appraisal Journal, April 1989, states that in the valuation of a successful operation:

The valuator should always go to the market when valuing the components of a BEV. If one can't find it in the market, one probably should not use it in an analysis. Find out how enterprises are put together, i.e., identify their components. The net operating income produced in an income approach must support all aspects within a going concern by providing a return on all components, such as land, building, licenses, inventories, startup/organizational costs, etc.

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