Defining and allocating going-concern value components.
SPECIAL-PURPOSE, BUSINESS-ORIENTED PROPERTY
The market value of special-purpose, business-oriented real estate is inextricably tied to the market value of the going-concern of which it is a vital part. Thus, an appraisal of this type of real estate requires, in many cases, an appraisal of the subject going-concern. Conversely, an appraisal of a going-concern in which real estate is a significant asset requires, in many cases, a separate market valuation of the real estate and other assets. These analyses are necessary to determine whether the highest and best use of the subject entity is for continuation as a going-concern, or for liquidation of the underlying assets at their alternative market values. If the highest and best use of a going-concern is for continuance as a going-concern, then the market value of its essential assets is a function of the contributory value of those essential assets to the going-concern. If, however, the highest and best use of a going-concern is for liquidation, then the market value of its assets is a function of their most probable alternative uses. The information presented is useful for analyzing the relationship between going-concern value and the market value of the underlying assets.
Because the various assets of a going-concern have different remaining economic lives and risk levels, prudent debt and equity investors need to be aware of the relative magnitudes of the risk and value components of a going-concern. Thus, in order for an appraiser to emulate or explain rational market behavior, going-concern appraisal assignments may require that all major components of value be identified, classified, and separately measured.
MISCONCEPTIONS OF GOING-CONCERN COMPONENTS
In the business community, there is considerable misunderstanding regarding the concepts of going-concern, going-concern value, business value, and goodwill. Some definitions and explanations of these items are meaningful and others lack specificity and usefulness. Rabianski has pointed out deficiencies in some appraisal definitions and publications, as well as some vital technical differences between real estate appraisal and business appraisal.(1) Gordon Brown, another author, has suggested using a business cash flow valuation model to appraise investment real estate.(2) Kenney presents definitions and differentiates between going-concern value, business value, and goodwill value, and attempts to correlate the concept of "business enterprise value" within the context of these three defined values.(3) All these discussions are very useful to both real estate appraisers and business appraisers, and especially to those involved in a combination of these two disciplines. Other theorists enjoy vacillating amongst the wide array of interactive forces involving large shopping malls and business enterprise value.
From an appraisal perspective, the concepts of going-concern and going-concern value are defined and discussed as follows:
Going-concern value is the value of a proven property operation. It includes the incremental value associated with the business concern, which is distinct from the value of the real estate. Going-concern value includes an intangible enhancement of the value of an operating business enterprise, which is produced by the assemblage of the land, building, labor, equipment, and the marketing operation. This process creates an economically viable business that is expected to continue. Going-concern value refers to the total value of a property, including both real property and intangible personal property attributed to business value. [emphasis added]
Going-concern appraisals are commonly conducted for hotels and motels, restaurants, bowling alleys, industrial enterprises, retail stores, shopping centers, and similar properties. For these types of property, the physical real estate assets are integral parts of an ongoing business. It may be difficult to separate the market value of the land and the building from the total value of the business, but such a division of realty and nonrealty components of value is possible and is often required by federal regulations.(4)
The discussion above is quite specific and very useful to those performing or using going-concern valuations. However, the following definition of going-concern value lacks specificity and appears to be inconsistent with the previous definition:
The value created by a proven property operation; considered as a separate entity to be valued with a specific establishment.(5)
The same source defines business value as:
A value enhancement that results from items of intangible personal property such as marketing and management skill, an assembled work force, working capital, trade names, franchises, patents, trademarks, contracts, leases, and operating agreements.(6)
This definition does not indicate whether goodwill is included in "business value," but clearly goodwill results, in part, from the factors listed. However, this definition appropriately refers to business value as consisting of "intangible personal property." The Dictionary defines goodwill as "a salable business asset based on reputation, not physical assets."(7) This definition is of very limited usefulness to appraisers and users of appraisal services.
Another source presents two distinct definitions of going-concern value, as follows:
1. The value of an enterprise, or an interest therein, as a going-concern.
2. 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.(8)
The first of these conforms to the first definition presented (this includes both tangible and intangible assets), and the second appears to be referring only to what was previously defined as "business value" (intangible assets only). These two definitions apparently result from differing concepts of going-concern value as derived in various court cases and used by various legal jurisdictions around the country. Appraisers should be aware of these varying definitions and adjust their work accordingly.
Common legal definitions of going-concern value are:
The value of a firm, assuming that the firm's organization and assets remain intact and are used to generate future income and cash flows. The value which inheres in a company where its business is established, as distinguished from one which has yet to establish its business.
The value of the assets of a business as an operating, active concern, rather than merely as items of property (book value of property alone) which would be the case in a liquidation sale. Such value includes goodwill.(9)
The same source contains a very useful and lengthy definition of goodwill, from which some relevant excerpts are presented below:
Property of an intangible nature, commonly defined as the expectation of continued public patronage. [emphasis added]
The excess of cost of an acquired firm or operating unit over the current or fair market value of net assets of the acquired unit. Informally used to indicate the value of good customer relations, high employee morale, a well-respected business name, etc., which are expected to result in greater than normal earning power.
The ability of a business to generate income in excess of normal rate on assets, due to superior managerial skills, market position, new product technology, etc.
The capacity to earn profits in excess of a normal rate of return due to the establishment of a favorable community reputation and consumer identification of the business name.(10)
ABOUT THE DEFINITIONS
For the purposes of this article, going-concern value denotes the operational value of the total enterprise, including tangible assets (land, improvements, and personal property) and intangible assets (including goodwill, if any). Business value or business operation value denotes all intangible assets except goodwill. Goodwill value denotes the capitalized value of excess net income.
An important distinction between business value and goodwill value is that business value is a direct result of specific costs for intangible items required to create the going-concern, whereas goodwill value is not directly associated with any particular initial costs. Further, goodwill value (as evidenced by excess income) is not essential in order for a going-concern to be economically feasible, that is, to provide a reasonable return on and return of the invested capital (including the costs to create the required intangibles). Goodwill does result from a combination of the tangible and other intangible assets of the going-concern, but the incurrence of the required initial costs to create these tangible and intangible assets does not imply an economic requirement that goodwill value should exist, as in the case of the other asset types.
RECOMMENDED INCOME ALLOCATION TECHNIQUE
This technique is an extension of the excess earnings method commonly used by business appraisers for valuing closely held companies, the roots of which can be traced back to a 1920 publication by the U.S. Treasury Department. In the excess earnings method, a single value estimate for tangible assets is multiplied by a single capitalization rate and this net income allocation to tangible assets then is subtracted from total net income, and any remaining (excess) income is considered attributable to goodwill and is capitalized at an excess earnings capitalization rate.(11) The model presented here treats several asset categories separately in order to identify explicitly and analyze the risk and value components of the going-concern.
The recommended model and its variants can be used for the following purposes: highest and best use analysis and market valuation of a going-concern, a test of reasonableness for going-concern capitalization rates extracted directly from market data, allocation of going-concern value into its tangible and intangible components (in certain cases), identification and measurement of goodwill value in a going-concern, and identification only of functional and/or external obsolescence in special-purpose, business-oriented real estate. (Note, however, that this model cannot measure any identified obsolescence.)
Definition of Income
The term "net income," as used here, may apply to what real estate appraisers commonly refer to as "net operating income" or, in some cases, to what business appraisers refer to as "net cash flow to invested capital." It is intended to mean net income before debt service. For purposes of brevity and clarity of presentation, the issue of going-concern income taxes is not addressed here.
The recommended allocation technique consists of the following steps: (Note that this technique is appropriate only for normalized or stabilized net income.)
1. Estimate the normalized expected annual net income for the going-concern by reviewing historical subject and market trends, current market conditions, and market expectations of the future regarding gross income and expenses.
2. On a preliminary basis, separately value each of the going-concern assets (except goodwill), using appropriate cost less depreciation, sales comparison, or income capitalization techniques. (In some cases, it may be untenable to separate business value from goodwill value.)
3. Estimate appropriate capitalization rates for each of the going-concern assets, using the available market data and considering the expected value change and estimated remaining useful life of each asset.
4. Estimate the net income to be allocated to each going-concern asset by multiplying each of the estimated asset values by the corresponding capitalization rate.
5. Successively subtract the allocated net income for each asset from the total going-concern net income; any residual (excess) income is attributable to goodwill unless business value was not estimated separately, in which case the residual income would be attributable to the combination of business value and goodwill value (if any).
If goodwill value exists in a going-concern, it is not likely (although not impossible) that functional and/or external obsolescence is present in the going-concern and its components. If, on the other hand, there is insufficient income to provide a reasonable return on and return of the preliminary estimates of value for the identified cost-related assets (land, improvements, personal property, and business value), then functional and/or external obsolescence exists in the going-concern and in all of its assets except the land. The model presented is not capable of measuring this obsolescence.
CAPITALIZATION RATE ANALYSIS AND INCOME ALLOCATION
Analyses of capitalization rates for each of the assets should consider the lender's perspective on the going-concern and on each of the major asset categories. Depending on the nature of the business (and the underlying assets) and credit conditions in the subject market, it may be appropriate either to consider lending criteria for the assets individually or consider lending criteria for the business as a whole. Other vital considerations for estimating the appropriate overall capitalization rate for each asset include the estimated remaining economic life of each asset, and the suitability of each asset for alternative uses and the economic magnitude of those alternative uses.
Income Allocation to Land
Two input variables are required for this step: a value estimate of the land as though vacant and an estimated land capitalization rate. The land value estimate is performed, preferably using the sales comparison technique or another acceptable method if comparable land sales are not available. If possible, the land capitalization rate should also be based on market data such as comparable land lease rates (annual ground rent expressed as a percentage of land value). Land capitalization rates generally tend to vary inversely, other factors held constant, with the expected rate of growth in local land values. Multiplying the estimated land value by the appropriate land capitalization rate equals the income allocated to the land asset.
Income Allocation to Improvements
Improvements value can be estimated by any of the three approaches if reliable and comparable data are available. However, in many cases, only the cost less depreciation approach is suitable because sufficient data are not available for the sales comparison or income capitalization approaches. In many cases involving special-purpose assets, preliminary value estimates for real property by the cost less depreciation approach would consider only physical deterioration, since the existence of other depreciation types likely would not be revealed until the last step in the net income allocation process.
The appropriate capitalization rate for improvements (buildings and site improvements) will vary for business-oriented real estate based on the suitability and difficulty of conversion to alternative uses. For example, a typical restaurant building with a flexible floor plan can be adapted more easily for alternative uses or users than a restaurant building specifically designed for a unique concept, and this lower risk profile should be reflected in a lower building capitalization rate. As the dependence of the utility of improvements on a specific type of use increases, the direct correlation between the business risk and the associated risk of owning the improvements increases as well. One method of estimating this capitalization rate would be to calculate a sinking fund recapture rate (using the appropriate overall yield rate for improvements and the estimated remaining economic life of improvements) and adding this recapture rate to the overall yield rate for improvements.
Income Allocation to Personal Property
Personal property value can be estimated by any of the three approaches, if reliable and comparable data are available. However, in many cases, only the cost less depreciation approach is suitable because sufficient data are not available for the sales comparison or income capitalization approaches. In many cases involving personal property, preliminary value estimates by the cost less depreciation approach would consider only physical deterioration, since the existence of other depreciation types would not likely be revealed until the last step in the net income allocation process.
The appropriate capitalization rate for personal property (furniture, fixtures, and equipment) will vary based on the suitability for alternative users. There is a direct correlation between the degree of limitation of personal property for alternative uses and the risk of owning this personal property. One method of estimating this capitalization rate would be to calculate a sinking fund recapture rate (using the appropriate overall yield rate for the personal property and the estimated remaining economic life of the property) and adding this recapture rate to the overall yield rate for the personal property. Equipment lease rates may be a source of capitalization rates for personal property as well.
Income Allocation to Business Operation/License
The capital costs required to obtain any necessary licenses or permits to operate the business and to start the business enterprise (training management and employees, establishing working capital, creating record management systems, etc.) are deserving of a return on and return of the invested capital. In the case of a hotel going-concern, income attributable to the business operation often is represented by a management fee and/or franchise fee.(12) In other cases, the cost to create the business operation can be obtained from historical audited financial statements, and then can be adjusted to the present, using the historical rate of inflation. Depending on the nature of the specifically identified intangible assets of the business operation and on the data available in each case, one or more of the three traditional valuation approaches may be used to estimate the market value of these intangible assets.(13)
Once again, the overall yield rate (derived in consideration of the costs of debt and equity capital) and the average remaining economic life of the business assets should be primary considerations in estimating the appropriate overall capitalization rate for the business operation component. Also, the marketability and/or transferability of the intangible business assets for alternative users should be considered as risk factors. Market-extracted overall capitalization rates for these intangible assets probably will be difficult to obtain. Estimating these rates is quite challenging and may require the use of strong professional judgment preceded by careful consideration of the many factors involved in each case.
Capitalization Rate for Goodwill
Goodwill is identified by the existence of excess income. All of the other increments of business income described before can be directly associated with specific capital investments or costs (land, improvements, personal property, and business startup/license costs) required to produce this going-concern income. Thus, any business net income remaining after allocation of net income to these specifically identified capital investments is considered to reflect an excess increment of value, or goodwill. Pratt et al. discuss some relevant considerations in estimating an appropriate overall capitalization rate for goodwill:
Net tangible assets provide a measure of safety that, if earnings fail to materialize as expected, then the assets usually can be liquidated for something. Goodwill, on the other hand (as well as most other intangible assets), has no liquidation value in the absence of earnings, since its economic value depends on its ability to generate economic income. Therefore, the risk attached to the intangible portion of the assets would seem to be greater and demand a higher rate of return.
Furthermore, a case can be made that the tangible assets have a more persistent and predictable life than goodwill or other intangible assets in many cases.
In general, investors are not willing to pay cash up front for more than one to five years' worth of earnings from commercial goodwill, sometimes even less. The length of expected future earnings from goodwill for which investors are willing to pay depends primarily on the perceived persistence of those earnings in the future, independent of further investment of time and effort to perpetuate them.
One way to estimate a capitalization rate to apply to excess earnings is to think in terms of converting the number of years' worth of expected future excess earnings the investor would be willing to pay for in terms of cash up front into an implied capitalization rate. The implied capitalization rate in this scenario is simply the reciprocal of the number of years' expected excess earnings for which the investor would be willing to pay cash up front. For example, if the typical investor would pay cash equivalent to four years' excess earnings, the calculation would be: 1/4 = 0.25.(14)
Estimating the appropriate capitalization rate for goodwill (excess) income is the most difficult step in this analysis. One useful method is to interview knowledgeable market participants (buyers, prospective buyers, etc.) to determine the appropriate excess income multiplier. In addition, it is possible to extract a goodwill rate from comparable sales if adequate data is available.
INCOME ALLOCATION MODEL
Table 1 presents two scenarios using the model described. In scenario 1A, the stabilized going-concern net income is estimated at $1 million. Based on the method described before, a portion of this $1 million is allocated to each asset. The asset values and capitalization rates shown are hypothetical. The remaining excess income ($107,000) indicates the existence of goodwill, which is capitalized at a hypothetical rate in scenario lB. Scenario 1C contains the estimated going-concern value and the implied overall capitalization rate (OAR) for the going-concern.
The inputs for Scenario 2 differ from Scenario 1 only in that the estimated going-concern net income is $1.5 million. In Scenario 2, the residual excess income is $607,000, and the implied OAR is 300 basis points higher than in Scenario 1. To illustrate a potential error from not using the recommended allocation [TABULAR DATA FOR TABLE 1 OMITTED] model, assume that Scenario 1 is typical for a set of comparable sales but the income-generating characteristics of the going-concern under appraisal are represented by Scenario 2. An uninformed appraiser could easily reconcile to a market-extracted overall rate based on Scenario 1 comparables and apply it to a Scenario 2 subject, resulting in a value indication of $9,986,684 and an implied goodwill capitalization rate of 16.46%. This value is much higher than the value indicated by the income allocation method and would result in a major valuation error Also, the implied goodwill capitalization rate would be much lower than appropriate. Thus, the recommended method is very useful for going-concern valuations and for testing the reasonableness of going-concern capitalization rates extracted directly from market data.
The author's assertion that reasonable going-concern capitalization rates are impacted by the degree of intangible value (especially goodwill value) present in a going-concern is supported by the following:
Properties such as congregate care facilities that include substantial intangible going-concern value generally have higher overall capitalization rates than properties without substantial going-concern value. The higher overall capitalization rate, in part, recognizes the greater risk of going-concern value over that of tangible assets.
The overall capitalization rate for a particular property will be influenced not only by the physical characteristics of the property, but also by the amount of going-concern value included. In general, the higher the going-concern value, the greater the risk and, therefore, the higher the overall capitalization rate.(15)
Author James Brown articulated an important concept, but his well-intentioned attempt at implementation was incomplete. In some cases, the residual excess income will be a negative number, indicating no goodwill value. A negative number means that the going-concern income is not sufficient to provide a reasonable return on and return of the preliminary estimates of value for the cost-based tangible and intangible assets. In these cases, the existence of functional and/or external obsolescence is identified and, if the assignment necessitates, the going-concern value must be reallocated in order to measure the identified obsolescence properly. The recommended reallocation process is reasonably laborious and is a matter for another day.
The foundation of this article is an evaluation of various definitions of going-concern value components. When analyzing these components, the vital first step for appraisers is acquiring a thorough understanding of well-articulated definitions. Current Appraisal Institute publications are lacking in some of these areas. The recommended model presented is intended to provide practitioners with a useful tool for highest and best use analyses and for valuations of going-concerns in which real estate comprises significant assets. This article is also intended to provide practitioners and academicians with a framework for further study and analysis of the important issues involved.
1. Joseph S. Rabianski, "Going-Concern Value, Market Value, and Intangible Value," The Appraisal Journal (April 1996): 183-194.
2. Gordon T. Brown, "'Free Cash Flow' Appraisal...A Better Way?," The Appraisal Journal (April 1996): 171-182.
3. Mark T. Kenney, "Business Enterprise Value: The Debate Continues," The Appraisal Journal (January 1995): 33-40.
4. Appraisal Institute, The Appraisal of Real Estate, 11th ed. (Chicago, Illinois: Appraisal Institute, 1996), 26.
5. Appraisal Institute, The Dictionary of Real Estate Appraisal, 3d ed. (Chicago, Illinois: Appraisal Institute, 1993), 160.
6. Ibid., 44.
7. Ibid., 160.
8. Business Valuation Committee, Business Valuation Standards: Definitions (Washington, D.C.: American Society of Appraisers, January 1994), 16.
9. Henry Campbell Black, Black's Law Dictionary, 6th ed. (St. Paul, Minnesota: West Publishing Company, 1990), 691.
10. Ibid., 694-695.
11. Shannon P. Pratt, Robert F. Reilly, and Robert P. Schweihs, Valuing a Business: The Analysis and Appraisal of Closely Held Companies, 3d ed. (Chicago, Illinois: Irwin Professional Publishing, 1996), 285-297.
12. Stephen Rushmore, Hotels and Motels: A Guide to Market Analysis, Investment Analysis, and Valuations (Chicago, Illinois: Appraisal Institute, 1992), 243.
13. Pratt et al., 557-597.
14. Ibid., 292-293.
Internal Revenue Service. IRS Valuation Guide for Income, Estate and Gift Taxes (Chicago, Illinois: Commerce Clearing House, Inc., 1994).
T. Alvin Mobley, III, MAI, is a consultant specializing in valuation and value allocation of special-purpose, business-oriented property. He received a BBA in finance from Florida International University, Miami, and an MA in real estate and urban analysis from the University of Florida, Gainesville.