Appraising interesting holes in the ground.

ABSTRACT

A show cave is one example of where real estate is so intertwined with a business that the appraiser cannot properly value the real estate without also considering the enterprise. One solution to the real estate appraisal problem is an income residual technique, The capitalization rate applied to the residual income is determined by weighting the required return on and return of the capital for the real property excluding the caverns with the capitalization rate to the enterprise's total invested capital excluding the real estate.

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With most real estate, any typical tenant could replace any other typical tenant. Such is the case for our appraisal firm and the plain-vanilla, Class B office space we rent. We could find other Class B space, and an accountant or manufacturer's rep or almost anyone else could be satisfied with the space we now occupy. In this type of relationship, the renter receives quiet enjoyment and the services provided in the lease, and all the owner can expect is the timely rental payment. Consequently, although the landlord is in the business of renting real property, he or she has no involvement in the renter's business. This is the situation for the vast majority of real estate across most property types and in most market areas.

On the other hand, some real property is uniquely related to a specific enterprise, in which case the value of the real estate is dependent on the economic well-being of that enterprise as a going concern. This is generally true when there is very little adaptive reuse of the improvements because they have been designed to be useful only to the particular business carried out via the premises. It is also the case when some component of the real property itself is a unique attribute of the business. Valuation assignments in these cases involve the market value of the real estate in use or as a going concern. (1)

Show Caves

Show caves are tourist attractions, and they compete for discretionary dollars with amusement parks, water slides, movies, bowling alleys, and other family-oriented amusements. The number of visitors to caverns directly depends on media advertisements, the historical relationship with tour services, the goodwill created from a long exposure to the market, and a large base of satisfied customers. These factors are more important than the natural beauty or locations of the caverns themselves and speak to the importance of competent management of the company operating the cave.

Show Cave Components

The tangible real estate components of a show cave include the following:

* The land within which the cave is located

* The cave

* Cave improvements, such as the walkways, elevators, tunnels, lighting, communications systems, and water pipes, which constitute the difference between a show cave and a wild cave

* Buildings, such as the restaurant, gift shop, sluices for "panning for gold or jewels," climbing walls, slides, and other ancillary improvements

* Site improvements, such as the parking lots, signage, landscaping, waste disposal system, and balance of utilities.

The non-real estate assets of a show cave include the intangibles and the furniture, fixtures, and equipment (FF&E) typical of a retail facility, lunchroom, or in some cases, an amusement park. The intangibles include the following:

* The brand

* The reputation and pool of satisfied former visitors now willing to take their own children to see the cave

* The organized workforce

* The experienced management

Real estate appraisers have sufficient tools to appraise the land as if there were no cave and to appraise the contributory value all of the surface improvements. This article focuses on estimating the contributory value of the developed cave as a part of the overall value of the real estate. As such, the approach described may be helpful when considering other real estate assets that have a contributory value, such as a proven reserve of merchantable minerals in situ or a merchantable, potable water well. The approach also may help in valuing real estate assets that, like caves, are inextricably intertwined with the business that the real property asset makes possible, such as a continuing care retirement community (CCRC) or a fast food restaurant.

Show Cave Business-Real Estate Relationship

There may be no other situation where the value of the business and the value of the real estate are more closely interrelated than with a show cave. The business enterprise is the dominant part of the show cave's business-real estate partnership. However, the relationship between the show cave business and the real estate is similar to that of a convenience store, a hotel, a nursing home, a day care, or other real property for which there is very little adaptive reuse. The cave may enhance the value of the land within which the cave is located, but that enhancement can only be recognized as a function of the receipts from the business of operating the cave.

Suppose, for example, that a show cave has a market real estate rent equal to about 10% of all cave revenues and that the appropriate capitalization (cap) rate for the stream of income to land containing a cave is 15%. That would mean that if there were 100 acres improved with a show cave (and its supporting infrastructure), the real estate market value would be $2,000,000 if the cave generates $3,000,000 in gross sales, i.e., $3,000,000 x 0.10 = $300,000/0.15 = $2,000,000. However, the value would only be $1,000,000 if the show cave sold $1,500,000 in goods and services, i.e., $1,500,000 x 0.10 = $150,000/0.15 = $1,000,000. This means that show caves can be distinguished from most other real estate where the fortunes of the landlord are not as directly tied to the fortunes of the tenant.

Real Estate Value and Business Value

The unique characteristic of a show cave is that the value of the land is enhanced by the unusual hole in the ground as compared to otherwise similar real estate that does not contain a show cave. From the point of view the business, the real estate must be considered as an expense (a cost of occupancy) in order to separate the value of the tangible assets from the value of the intangible (business) assets. This is true regardless of who owns the land and who owns the business. The risks and returns to these two classes of assets are very different. It is not possible to develop a supportable estimate of the value of the entirety if one does not separate the tangible and intangible assets and value separately the real estate assets and the enterprise assets. Furthermore, this principle holds for all types of quasi-real estate or integrated real estate-business assets, although the full development of this argument is beyond the scope of this article.

Sales Comparison Approach 

A sales comparison approach assumes that the appraiser can obtain sufficient data on a sufficient number of transactions of comparable properties to extract a useful unit of comparison to apply to his or her subject property. Although amusement parks are reasonably comparable business enterprises to show caves, amusement park sales provide a poor real estate analogue. Most of the property value in an amusement park is either in the value of the land as if vacant or in the personalty. Sales of amusement parks as going concerns may help a business appraiser's market approach, but are not much use to the real estate appraiser.

Research of show cave sales data indicates there have been few recent sales of both the business and real estate of show caves; in addition, there are few show caves listed for sale. Unfortunately, the sales data is often convoluted and unique to each transaction. (2) Most sellers are not able to articulate the reasons they used to set the sale price in terms that an appraiser can translate into a unit of comparison. Also, price per square foot or price per acre, which are typical units of comparison, are not useful with a property as unusual as a cavern. Consequently, the sales comparison approach is not a useful tool in determining the market value of the subject.

Cost Approach

The cost approach and its business value counterpart--the adjusted net asset approach--are not very likely to help solve the appraisal problem for show caves. It is very hard to determine the costs associated with developing a cave. Show caves are generally developed using sweat equity and a lot of volunteer labor. Cave explorers assist in mucking out newly discovered rooms in trade for the privilege of exploring the cave. Also, there is a myriad of physical problems associated with providing the access and lighting required to turn a wild cave into a show cave. These problems are unique to the physical characteristics of each cave. Consequently, with caves--as with mines, landfills, wells, convenience stores, fast food restaurants, continuous care retirement communities (CCRCs), hotels and the other properties where the business and real estate are uniquely related to each other-appraisers must primarily rely on the income capitalization approach.

Case Study: Natural Bridge Caverns 

This article presents a case study to illustrate the real estate appraisal problems and solutions for show caves. The case study is based on an actual appraisal of a show cave, Natural Bridge Caverns. (3)

Description

Natural Bridge Caverns is a tourist attraction located between San Antonio and New Braunfels on Natural Bridge Caverns Road about eight miles off I-35. It is within a half-hour drive from San Antonio and in a growing metropolitan area with a population of over 1,500,000. (4) Natural Bridge Caverns is a management-intensive, tourist-oriented business, not essentially different from the other family-recreation facilities in the San Antonio area, such as Six Flags Fiesta Texas, Schlitterbahn, SeaWorld, or the neighboring Natural Bridge Wildlife Ranch. It competes with all of these attractions for discretionary, family-oriented recreational dollars.

The primary developed area of Natural Bridge is the north caverns, where the tourists may see half a mile of beautifully decorated large rooms. (5) The north caverns of Natural Bridge Caverns were discovered in 1960, developed between 1960 and 1964, and opened to visitors in 1964. The south caverns were discovered in 1967 and 1968, and the Jaremy Room was opened to the surface in 1985. Cave tours are guided and generally consist of about 40 visitors per group; and the caverns may host over 2,000 visitors a day during the height of the season. The caverns are open year-round, but most of the visitors come between March and August. During the past several years, Natural Bridge Caverns (NBC) has attracted between 265,000 and 280,000 visitors, making it the largest of the seven show caves in Texas. (6)

A 100-acre tract contains the entrance to the north and south caverns and the natural bridge for which the caverns are named. The property is improved with an entrance arch and drive, and a 10,154-square-foot main building that houses N BC's business offices, and the caverns' ticket booth, snack bar, restrooms, gift shop, and tour staging area. There is also a storage building and a manufactured home that are considered real estate improvements. Some of the other improvements include a covered walkway from the exit tunnel of the north caverns to the visitors' center, a sluice, a gazebo at the entrance to the south caverns, a building that is the staging area for the south caverns tour, a picnic area, and three dinosaurs, including one named Grendel that is the Natural Bridge Caverns trademark that is reproduced on many of the billboards advertising the caverns.

Income Capitalization Approach: Income Residual Model

The overall appraisal model suggested for the case study of the contributory value of the cave is an income residual model. (7)

The first step requires an appraisal of the market value of the subject property's real estate without considering the contribution of the caverns to the overall value of the real estate. In the ease of Natural Bridge Caverns, a real estate appraiser familiar with the local area was retained to appraise the land and improvements. He partitioned his appraisal into the part representing the contributory value of the land as if vacant and the contributory value of the surface improvements (by component), without any consideration of the caverns. It is important to have the separate values for the parts, because the income residual technique requires an estimate of both the required return on the real estate and the return of the wasting assets (i.e., the surface improvements) over their remaining economic life.

Next, the share of the rental income required to provide a market-based return on the land is estimated as well as a market-based return on and return of capital associated with the wasting improvements. Any rent remaining after the required rental income to these traditional components of the real estate is rental income associated with the real estate that constitutes the improved show cave. This is the portion of the real estate income that is applicable to the interesting hole in the ground. It provides the return of and on the cave, walkways, tram, elevators, lighting, water systems, and other real estate improvements that makes a cave into a show cave.

In the example set out in this article, it is postulated that the show cave business has stabilized gross receipts of $5,500,000 and that 10% of gross revenues or $550,000 per year constitutes market rent for the real estate, including the contribution of the improved caves. Assume for the purposes of the case study that the business pays all real estate-related operating expenses and that the $550,000 per year is equal to net operating income (NOI) to the real estate. As shown later, the required return of and return on the land (excluding the contribution of the cave) and the surface improvements require $111,400 of NOI per year. Consequently, the residual real estate NOI associated with the contribution of the improved cave is $258,600. The show cave component of the rent can then be capitalized to estimate the additional contribution of the caverns, which is then added to the contributory value of the other components of the real estate to estimate the market value of all of the real estate, including the contribution of the caverns.

As is the case with any income residual technique, the difficult part is the support for the appraiser's judgment about the required capitalization rate to apply against the residual income. The rate the appraiser is trying to establish is the appropriate rate to apply to the slice of the real estate rental income that is to be associated with the subterranean component of the real estate. Because the component of the rent associated with the caverns is completely dependent on the operation of a tourist business, the appropriate risk rate for the cavern component of the rental income should be at least 50% of the difference between the blended rate for the balance of the real estate and the cap rate for the business. However, as is the case with many components of an appraisal, the judgment of the appropriate risk rate is the responsibility of the appraiser and should be based on the facts and circumstances of the specific property that is the subject of the appraisal. Appraisers must avoid bias and explain the reasoning behind their judgments as to the appropriate rate.

Market Rent

An essential step in the solution to the real estate appraisal problem is to identify a fair market rent for all the real property assets in order to identify the income that can be assigned to the real estate. Research shows that rented show caves generally rent as a percentage of the operating company's gross receipts. (8) Real estate appraisers are familiar with percentage rents, which are a typical part of the rental structure for shopping centers and restaurants. Because the business potential of a show cave is generally an unknown factor when the cave is being developed, percentage rents are the most reasonable means of keeping the rental costs to the operating company low until there is sufficient cash flow to pay substantial sums in rent and stay solvent. At the same time, percentage rents make it possible for the landowner to share in the growth of the attraction if and when it becomes successful. (9) In this example, the market rent for all of the real estate assets is 10% of gross receipts from operations.

Land Risk

Rent represents the landlord's return on and return of the real estate. If the tenant is responsible for all of the property expenses, including property taxes, insurance, maintenance, and capital improvements (as is the case with most caverns), then the cash flow from rent is generally equivalent to the landlord's NOI. If the real estate owner is responsible for some real estate-related expenses, gross rent must be adjusted accordingly.

In the case study, the research of long-term ground leases indicates that 8% to 10% of market value represents a reasonable return on land in the market. Since land does not waste, 10% represents the return on the real estate, with the reversion constituting the expected return of the capital represented by the value of the land. In this case, the local appraiser valued the surface land at $400,000. Therefore, the component of the NOI required to support a value of $400,000 at a 10% rate of return is $40,000 per year.

Improved Property Risk: Return of Capital

Improvements have a fixed life, and a percentage of the remaining value of the improvements must be recaptured annually in order to return the investor's capital. For example, if a building had an economic life of 50 years, the investor must receive 2% of the value of the building annually to recapture the investment by the end of the 50 years. The appraiser should calculate a weighted-average remaining useful life for all of the improvements (including site improvements like the parking lot surfaces and short-lived replaceable capital items like the roof and HVAC compressors), recognizing that all of the capital tied up in the improvements must be recaptured in this remaining life estimate. If everything is new, 2% per year may be a reasonable recovery rate. If there is about 20 years left in effective life, then 5% per year of the contributory value of the tangible improvements is needed to recapture the investment in these assets.

In the example here, all the remaining lives for the wasting assets are at 20 years. However, in a real-world assignment all of the major real property wasting assets would be classified and each would have its own claim against the rental income stream associated with that asset. (10)

Improved Property Risk: Return on Capital

If the return (or yield) on the real estate improvements should be about the same as the return on the land, or about 10%, (11) and a 20-year weighted remaining life is assumed, or 5% per year to recover the capital investments, then the appropriate yield on the improved property would be 15% (10% return on plus 5% return of).

In the case study, the local appraiser valued the surface improvements at $476,000. The 5% per year required to cover the return of these assets amounts to $23,800 per year of the NOI. At a 10% return on real estate another $47,600 of the NOI is required, for a total of $61,400 out of the NOI for the surface improvements. In total, $111,400 of the $350,000 NOI is required for the surface real estate, leaving $238,600 NOI associated with the subsurface real estate. The blended rate for the surface component of the real estate is $111,400 NOI associated with $876,000 value, or a blended cap rate of 12.7%.

Estimating the Appropriate Risk Rate for the Business

Estimating an appropriate capitalization rate for an enterprise is generally within the purview of the business appraiser rather than the real estate appraiser, and the Competency Rule does not go away just because some client is willing to pay your fee. (12) Consequently, if you have an assignment wherein the value of the real estate is inextricably intertwined with the value of the business it may be best to affiliate with a qualified business appraiser. (13)

One of the standard techniques taught by the business valuation professional associations is the build-up method to estimate an appropriate direct cap rate for the intangible (enterprise). (14) The real estate appraiser generally capitalizes net operating income, which is a before-debt measure of cash flow. However, the business appraiser generally (but not always) capitalizes cash flow to total invested capital (both equity capital and debt capital).

This next section illustrates the way a business appraiser develops a cap rate and illustrates why the appropriate business cap rate in the case study is 22%.

Business Appraiser Methodology for Developing Business Cap Rate

Much of the data with which a business appraiser works, such as the safe rate based on U.S. Treasuries and the total return on publicly traded equities, reflects total yield on equities or yield capitalization. The real estate cap rates previously developed in the example are single-period capitalization rates. Consequently, the business appraiser must first estimate an appropriate equity yield rate, adjust it to a single-period equity capitalization rate, and then make an adjustment to account for expected or market-based debt capital in order to estimate an appropriate cap rate for total invested capital for the enterprise.

Equity Discount Rate

The enterprise equity discount (yield) rate includes three elements: (1) a market-derived, risk-free rate of return; (2) a general (equity) risk premium derived from the public equity markets; and (3) a company-specific risk adjustment. Two of these components of the judgment of risk are derived directly from the public markets. The safe or risk-free rate is generally agreed to be the rate for a twenty-year U.S. Treasury as reported in the Federal Reserve's H.15 Report. (15) The equity risk premium is reported in the Ibbotson Stocks, Bonds, Bills and Inflation (SBBI) Yearbook. (16) Only the specific company risk is the result of the appraiser's judgment about the additional risk associated with the subject company over and above the other risks. In the example here, the components used are as follows:

* A risk-free rate of 5.85% to 5.95%

* A general market equity premium of 7.30%

* A 10th-decile premium of 5.20%

Thus, the estimated base equity premium, before considering any company-specific risk, is 18.55% to 18.45%. Table 1 presents the development of the equity discount rate for the cave's business enterprise using the build-up approach.

The unsystematic risk, also referred to as company-specific risk, is a function of the appraiser's judgment about characteristics in the industry and the specific company relative to the stock market as a whole. The company-specific risk for the case study show cave takes into consideration the key drivers for the tourism and recreation industry, the financial performance of the company, and the dependence of the company's performance on its family-oriented management team; the company's specific risk is estimated to be 6.50%-9.50%.

The company-specific risk component of the equity yield rate for this business is based on the appraiser's judgment, which is one of the weaknesses of the income approach in business valuation. In this case, between 1/3 and 1/4 of the total yield rate is based on appraiser judgment, rather than on a rate extracted from the markets. (17) In summary, the equity discount rate for the tourist cave enterprise developed under the build-up approach is within the range of 25%-28%, say 26.5%.

Converting Discount Rate to Cap Rate

The equity rate estimated to this point is a discount rate, not a single-period capitalization rate. Most business appraisers adopt the Gordon Growth Model (18) convention to convert a discount rate to a single-period cap rate, which is intellectually the same as that used in real estate appraisal: R = Y - Change (or delta). In this case, the long-term rate of growth for this enterprise is estimated at 2%. Consequently, the estimate for the equity, single-period cap rate for the business is 24.50%.

Weighted Average Cost of Capital

The risk rate for a business needs to reflect its capital structure (both debt and equity). The weighted average cost of capital (WACC) is a blended rate that reflects the costs of the company's financial sources in its capital structure (i.e., the cost of debt and cost of equity). (19) Table 2 presents the detailed calculations for the WACC.

As Table 2 shows, the equity rate developed under the build-up approach is 24.5%, while the nominal cost of debt is the market rate at which the business could obtain external financing. It is assumed that the company could obtain about 15% debt financing at a nominal interest rate of 9% to improve its capital structure. (20) The nominal rate for debt capital must be adjusted for the fact that the interest component of the cost of debt is tax exempt and the resulting cap rate is applied to an after-corporate-tax stream of income. In this example, the nominal cost of capital was reduced by 40% for the tax effect of the expected corporate taxes. The subject is a C-corporation facing a 40% combined federal and state income tax on earnings. The debt component of the WACC rate should be adjusted to reflect the level of tax that the company expects.

The WACC shown in this example is 85% equity capital at an equity cap rate of 24.5% to contribute 20.825% to the overall cost of capital, plus 15% x (9% nominal interest rate x 0.60 (1 - 0.40 combined corporate tax rate)) = 0.81% for a total of 21.6% WACC. Therefore, a 22% WACC (rounded) is used in the valuation analysis of the show cave enterprise under the premise of going concern.

Calculating the Contributory Value of the Cave

Since it has been determined that the appropriate single-period cap rate for the business is 22%, this rate can be used to calibrate the appropriate rate to be applied to the $238,600 of residual real estate NOI associated with the subsurface real estate.

There are 930 basis points of difference between the 12.7% cap rate for the surface real estate and the 22% cap rate for the business. Of this difference, 50% or 465 basis points is assigned as additional real estate risk for the subsurface real estate or a cap rate of 17.4% (0.1272 + 0.0465 = 0.1756). Capitalizing $258,600 at 17.4% indicates a contributory value of $1,571,264 for the subsurface real estate as improved, and the total real estate value is $2,247,264 ($876,000 + $1,571,264 = $2,247,264) or $2,250,000, rounded. With an income of $550,000 and a value of $2,250,000, the overall capitalization rate for the real property is 15.6%. Table 3 shows the calculation of the excess rent and the contributory value of the cave.

Conclusion

There is a substantial amount of real estate that shares a common characteristic with the show caves in that there is an increment of real estate value based on the earning capacity of the enterprise that the real property makes possible. This is the case for timberland, land with merchantable minerals in situ, landfills, wells, mines, convenience stores, fast food restaurants, hotels, regional malls, hospitals, nursing homes, day-care facilities, and CCRCs, among others.

An appraiser must pay attention to the risks that drive value for the business in order to understand the value of the real estate when the business and the real estate are integrally interconnected with each other. Each of these property types is in a unique relationship with its business. Each has its own peculiarities, but the conceptual approach to the appraisal is generally the same:

* First, appraise the traditional components of the real property assets using whatever approaches and methods apply.

* Second, determine the cash flow (rent) that the market determines that the enterprise should pay for all of the real estate assets based on the gross receipts of the enterprise. Real estate appraisers have no difficulty with this concept when they apply a percentage rent in the valuation of a fine dining restaurant, for example. Even if analogues (like the substitution of an amusement park for a show cave) are not particularly useful in a sales comparison approach, they may be very useful in determining the appropriate percentage rent.

* Third, apply the appropriate cap rate to recover both return of and return on the capital represented by each component of the real property to which a value has been assigned. The residual income from the percentage rent is associated with the contributory value of the unique component of the subject's real estate.

* Fourth, select an appropriate cap rate for this residual stream of income. This article suggests that an appropriate rate is about 50% of the difference between the aggregate risk rate for the real property components already valued and the risk rate for the enterprise upon which the percentage real estate rent depends, although a case can be made for other percentages of that difference.

* Finally, add the value estimates for all of the components of the real estate to value the subject real estate including the contribution of the unique asset.

The approach presented here has been successfully applied for caves and other unusual property types. A variant of this approach has been applied to the valuation of convenience stores, fast food restaurants, hotels and residential facilities like a continuing care retirement community. Appraising these types of real estate adds a great deal of fun to the business of making supportable real estate value judgments, and provides a valuable service to property owners of these unusual assets when appraisals are required for eminent domain, mergers and acquisitions, lending, buy-sell agreements, divorce proceedings, or any of the myriad of other reasons that owners require appraisals.

(1.) Ben Wilcox, CBA, MAI, describes these types of properties as interdependent properties; Ben Wilcox, "Complexities in the Use of Real Estate Appraisals," Business Appraisal Practice (Spring 2008): 27-36.

(2.) Cave sales researched include the sales of Fantastic Caverns in Missouri (the only Class C cave in this small inventory of sales), Diamond Caverns in Kentucky, Cave Without A Name in Texas, Cosmic Caverns in Kentucky, and Bull Shoals Cave and Mountain Village in Missouri. Details of this information are available on request.

(3.) The author obtained permission from the cave owners to use his work on their property as an example; however, dollar amounts may have been changed to meet the purpose of the discussion, and readers should not assume that the numbers within the examples represent the actual figures.

(4.) Russell Gurnee and Jeanne Gurnee, American Caves (Closter, N.J.: R. H. Gurnee, Inc., 1990), 251; U.S. Bureau of the Census, 1998 population estimate 1,538,338.

(5.) The caverns are limestone formations and are very moist. Over 98% of the caverns are living caves, meaning that the formations are still active. The cave decorations consist of stalactites, stalagmites, pillars, drapery, rimstone pools, flowstone, helictites, soda straws, and other unusual crystal formations.

(6.) Other show caves in the area are Cascade Caverns in Boerne, about 14 miles from San Antonio; Cave Without A Name, about 11 miles north of Boerne; and Wonder World in San Marcos. The most isolated of the Texas show caves, and one of the most decorated of any in the United States, is the Caverns of Sonora in Sonora, about 3.20 miles from any of the metro areas. The other Texas show caves are Longhorn Caverns between Burner and Marble Falls, and Inner Space in Georgetown near Austin; American Caves, 246-255.

(7.) Appraisal Institute, The Appraisal of Real Estate, 13th ed. (Chicago: Appraisal Institute, 2008), 508-516.

(8.) The National Caves Association (NCA) classifies show caves by number of visitors, with Class C being the larger caves, like the subject, that have 100,000 or more visitors per year. The research here included a nationwide search and visits to most of the larger, privately owned show caves from California to New York. The caves visited included Moaning Caverns in California; Cave of the Winds in Colorado; Mark Twain Caverns, Meramec Caverns, and Fantastic Caverns in Missouri; Diamond Caverns and Hidden River Cave in Kentucky; Ruby Falls in Tennessee; Luray Caverns in Virginia; and Howe Caverns in New York as well as the show caves in Texas.

(9.) This analysis assumes good and competent company management, similar to the real estate appraiser's general assumptions about real property management. The forecast of the business gross receipts is a part of the business appraiser's judgment about normalized operations for the business to be appraised. The judgment about the competence, adequacy, and depth of management is a component of the business appraiser's judgment about the company-specific risk component of the build-up rate.

(10.) Most of the time the depreciable components of the personality associated with the enterprise are wrapped up in the business appraisal and are not a major concern for the real estate appraiser. If this is not the case, the real estate appraiser can associate with a qualified personal property appraiser and/or asset allocation specialist.

(11.) As in all appraisal assignments, the estimate of the required return on capital is a part of the appraiser's judgment about the requirements of the market and expected changes in the market over time.

(12.) See Standard 9, "Business Appraisal, Development," Standard 10, "Business Appraisal, Reporting," and the Competency Rule in Appraisal Standards Board, Uniform Standards of Professional Appraisal Practice, 2008-2009 ed. (Washington, D.C.: The Appraisal Foundation, 2008).

(13.) The Institute of Business Appraisers offers the CBA designation, the American Society of Appraisers offers the ASA designation, the American Institute of Certified Public Accountants offers the ABV accreditation, and the National Association of Certified Valuation Analysts offers the CVA designation, all of which are generally recognized indications of appraisal competence for intangible assets.

(14.) The business appraiser may use the build-up method of developing a cap rate. The resultant equity rate component, however, needs to be reasonably supported. The business appraiser usually encounters difficulty in obtaining capitalization rate data from the national marketplace of private company transactions, although there are now private business-transaction databases, like the IBA database or Pratt's Stats, that contain data on several thousand transactions of various types of business over a multiyear period. Real estate appraisers have access to public records of the sales transactions of real estate, and they often are able to extract cap rates based on actual contemporaneous transactions of reasonably comparable properties. However, business appraisers seldom have sufficient data about private company transactions to generate reliable estimates of the relationship between income and value. Consequently, business appraisers use the build-up method because it has many market-driven components, such as the trades of equities in the public marketplace and the market-driven cost of debt capital. For a reliable exposition of the build-up method see Shannon P. Pratt and Alina V. Niculita, Valuing a Business, 5th ed. (McGraw Hill Library of Investment and Finance, 2007), 198-204.

(15.) The appropriate rate for any Federal Reserve instrument for 1993 or later may be found at http://www.federalreserve.gov/releases/h15/data/Business_day/ H15_TCMNOM_Y20.txt.

(16.) The Ibbotson SBBI Valuation Yearbook is published by Morningstar, Inc. and is available at http://www.ibbotson.com.

(17.) This reflects what a business appraiser thinks about as he or she builds a rate.

(18.) Valuing a Business, 238, 242-243

(19.) The weighted average cost of capital in finance is similar to the band-of-investment concept.

(20.) Debt capital is inherently less expensive than equity capital, and the tax code provides favorable treatment to the interest component of the cost of debt capital, which is why most public companies try to maximize the debt component of their capital structure. Private companies can also benefit from including debt as a part of their capital structure if they are able to borrow funds without relying on recourse debt backed by the financial stability of the owners as individuals. The appraiser should probably not include a WACC as a part of the analysis if non- recourse debt is not available to the company.

by Henry J. Wise, MAI

Henry J. Wise, MAI, CRE, CBA, BVAL, is a commercial real estate appraiser and business appraiser who specialized in litigation support. He recently retired from Pritchett, Bail & Wise, Inc. a multidiscipline appraisal firm that has over a 60-year history and substantial experience in appraising unusual properties. Wise earned a BA at Hiram College, Ohio, an MA at Emory University, and an MS and GCRE at Georgia State University, where he serves as a part-time instructor in the real estate department of the College of Business Administration. He is a member of the Appraisal Institute, The Counselors of Real Estate, The Institute of Business Appraisers, and the Atlanta Economics Club. His articles have been published in The Real Estate Workout Deskbook, the Journal of Applied Real Property Analysis, Valuation Insights & Perspectives, and Business Appraisal Practice as well as other valuation-related publications. Contact: [e-mail]

This article is based on a presentation at the 2006 meeting of the National Caves Association and a seminar for the Atlanta Chapter of the Appraisal Institute in 2007. It grows out of an actual appraisal assignment in which Kari Lazarova, ASA, CFA, was the business appraisal project manager, Martyn C. Glen, MAI, CRE, FRICS, was responsible for the real estate appraisal excluding the contributory value of the caves, and Donald H. Minyard, PhD, CPA/ABV, BVAL, CPD, CFE, assisted in the original appraisal and in the development of the appraisal methodology.

Table 1 Buildup of the Equity Discount Rate

Components of Required      Lower    Higher   Source/ Rationale
  Holding-Period Return

Long-term government         5.85%    5.93%   Federal Reserve
  bond yield-to-maturity                      H.15

                                              Report as of
                                              April 15, 2002

Ibbotson common            + 7.30%    7.30%   See Ibbotson
  stock premium                               SBBI Yearbook
                                              2002 for annual
                                              premium returns

Small cap stock            + 5.20%    5.20%   See Ibbotson
  premium-10th decile                         SBBI Yearbook
                                              2002 for annual
                                              premium returns

Total equity premium
(base holding-period        18.35%   18.43%   Base equity
  required return)                            discount rate

Company-Specific
  Risk Premiums)
Seasonality                + 2.00%    2.50%
Consumer spending          + 1.50%    2.50%
Tourism and travel         + 1.00%    1.50%
  to the area
Competition                + 1.50%    2.00%
Management                 + 0.50%    1.00%

Subtotal, company-         + 6.50%    9.50%
  specific risk
  premium
Total estimated
  range of required
  holding-period returns    24.85%   27.93%
Rounded                        25%      28%

Table 2 Computation of Weighted Average Cost of Capital (WACC)

Cost of Capital                Weight   x   Rate    =     WACC

Cost of equity, target ratio    0.85        24.5%        20.83%
Pre-tax cost of debt                         9.0%
Tax rate                                    40.0%
After-tax cost of debt          0.15         5.4%       + 0.81%
WACC                                                     21.60%
Rounded                                                  22.00%

Table 3 Calculating Excess Rent and Contributory Value of the Cave

Rent Considerations for Natural Bridge Caverns
Expected gross receipts
                                                         $3,500,000
Total NOI
  (real estate rent as percentage of gross                 $350,000
    receipt $3,500,000 x 10%)
Surface real estate value, based on appraisals
    Land                                                   $400,000
  All surface improvements                                +476,000
Total surface real estate value                            $876,000

Required rent
  Return on land                                 10.0%      $40,000
  Return of improvements (20 yrs.)                5.0%       23,800
  Return on improvements                         10.0%     +47,600

Surface real estate NOI
  (rent of 100 acres + surface improvements)               $111,400

Subsurface real estate NOI
  (remainder amount for income-based rent)                 $238,600


Business (intangible) capitalization rate
  (used to index residual rent                   22.0%
    for subsurface real estate)

Land and surface improvements cap rate
  ($111,000/$876,000 = 0.1272)                   12.7%

Cap rate for residual (subsurface real estate)   17.4%
Contributory value of caverns                            $1,371,264
Real estate market value                                 $2,247,264
Rounded                                                  $2,250,000
Overall real estate capitalization rate
  ($350,000/$2,250,000 = 0.1555)                 15.6%