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Valuation of fractional interests in real estate limited partnerships - another approach.

A fractional interest in a real estate partnership is not a fee simple interest in real estate, but is rather a security interest in a closely held business enterprise. Several factors can lessen the value of a fractional interest relative to a comparable fee simple interest.

When determining the fair market value of a fractional interest in a real estate partnership, most appraisers use the following three-step approach.

1. Determine the fair market value of the underlying asset.

2. Calculate the fractional interest's pro rata share.

3. Apply a "fractional interest discount" to the pro rata share.

While this approach, termed fractional discounting, can produce satisfactory results, an income discounting approach is a much better determinant of fair market value. In the income discounting approach, an appraiser 1) estimates an asset's likely future earnings based on its track record; and 2) calculates the price a reasonable buyer might pay to acquire those future earinings by examining comparable transactions.

This approach offers at least two advantages over the fractional discounting approach. Firts, income discounting more accurately predits the value a fractional interest is likely to have in the current marketplace. Second, the income discounting approach is more consistent with Internal Revenue Service (IRS) guidleines than the fractional discounting approach. In Revenue Ruling 59-60, the IRS notes:

Valuation oif securities is, in essence, a prophesy as to the future and must be based onfacts available at the required date of appraisal. As a generalization, the prices of stocks which are traded in volume in a free and active market by informed persons best reflect the consensus of the investing public as to what the future holds for the corporations and industries represented. When a stock is closely held, is traded infrequently, or is traded in an erratic market, some other measure of value must be used. In many instances, the next best measure may be found in the prices at which the stocks of companies engaged in the same or a similar line of business are selling in a free and open market. (1) (Emphasis added.)

Using comparable transactions to determine the fair market value of a fractional interest (albeit not in a free and open market) is a more credible approach than any other approach, including the fractional discounting method.

Often, however, the income discounting approach is inappropriate, and fractional discounting should be used instead. For instance, if a partnership owns an asset whose primary value lies in a higher and better use than its current use, income discounting should not be used because the partnership's historrical track record is irrelevant. To the extent the market (as demonstrated by comparable sale demostrated) is nonexistent or dated, the findings derived through the income discounting approach become less reliable. Further, when a partnership's historical performance is erratic, when significant litigation is pending against the partnership, or when a partnership's past performance may not indicate future results, fractional discounting is the best approach to use.

In this article, both income discounting and fractional discounting are discussed. In addition, ten factors that determine the extent of a fractional discount are identified, and a case study is presented in which a fractional interest is analyzed using both valuation approaches.

INCOME DISCOUNTING

The income discounting method is used to determine the fair market value of fractional interests in partnerships that have existed long enough to establish a stable track record of operating performance.

The first step of the analysis is to gather and arrange historical data that reveal the past operating performance of the underlying property. In particular, historical partnership data are reviewed to determine the underlying asset's gross income, operating expenses, net income, debt service (including both interest and principal payments), cash flow, and distributions to the limited partners.

The data must then be analyzed to ascertain wheter the most recent year's results are an aberration compared with results from prior years. If significant disparities are noted, an effort should be made to discover reasons for the differences. Such efforts generally include conversations with the general partner and the property manager as well as with the accountants who prepare the relevant financial data.

The third step is to estimate future operating performance. This involves judging the partnership's future gross income growth rate; the future relationship between gross income and net income; the particular rapayment provisions of any debt instrument(s) that encumber partnership assets; likey reserves for repair, replacement, and other capital expenditures; and resulting cash flow and partner distributions.

The fourth step is to estimate the year in which the partnership asset(s) may be liquidated, and to calculate the partnership's net proceeds from such liquidation. Such "break-up" value calculations require that reasonable assumptions be made about the capitalization rate used to determined the sale price. Any charges likely to be levied against the partnership for such items as real estate commissions and transfer taxes must also be estimated.

The limited partner's share of the sale proceeds must next be calculated. This can be either a simple or a complex calculation, depending on the partnership agreement. The simplest case occurs when all cash distributions are split according to each partner's percentage interest. A more complicatied case is one in which a partner is guaranteed a certainlevel of cash flow each year and distributions above that level are split according to some percentage, with the bulk going to limited partners and a portion going to the general partner.

The sixth step is to estimate the price a reasonable buyer would pay to purchase the partnership interest's future earnings. Generally, the riskier the partnership, the higher the return a reasonable buyer will require.

When the considering the price a buyer would pay for a fractional interest in a limited partnership, it is wise to be aware that buyers are few and far between. The limited partnership secondary market exhibits all of the features of a classic buyer's market. Accordingly, investors typically expect to earn an internal rate of return (IRR) of 20% on each dollar invested in an average-risk real estate limited partnership.

To ascertain the market for a partnership interest, an appraiser requires information about recent comparable transactions. This presents a problem, because available data describing recent transactions in the limited partnership secondary market are scarce and frequently are not helpful.

The two best sources for recent trade data are Secondary Spectrum, a newsletter that tracks recent trades among approximately 200 of the largest public partnerships, and Investment Advisor magazine. (2) Unfortunately, these publications simply report trade prices and provide to information about the characteristics of the underlying assets. To determine whether a reported trade is comparable to the partnership being appraised, the appraiser must obtain and review financial data about the traded partnership form other sources--either the partnership itself or the Securities and Exchange Commission.

What prices will buyers pay for partnership interests? Of course, generalizations should not be relied on for specific transaction. Nevertheless, one sampling shows that the real estate partnership IRRs demanded by buyers in mid-1991 range from 17% for the most stable and conservative partnerships, to 25% for partnerships that generate positive cash flow but are making no cash distributions.

A partnership that owns a relatively low-leveraged, nontrophy property making regular cash distributions to the partner might be expected to trade for a price that enables the buyer to obtain a 20% IRR on the investment. A partnership owning a property that is losing money after financial expenses is unlikely to find any buyer at all. (3) The case study presented later in this article describes these six steps in greater detail.

FRACTIONAL

DISCOUNTING

When the income discounting method is considered inappropriate, the fractional discounting approach may be used to determine an interest's fair market value. This approach should include the following steps, as mentioned earlier.

* Determination of the fair market value of the underlying asset.

* Calculation of the fractional interest's pro rata share.

* Application of a fractional interest discount to the pro rata share.

The customarily accepted range of a fractional interest discount is approximately 20% to 40%. This range has been sustained in a number of tax court memorandum. (4)

The market value of a fractional interest depends on the following ten characteristics of both the partnership itself and the fractional interest.

Factors that affect the partnership itself

1. Relative risk of the partnership's asset(s)

2. Historical consistency of partnership distributions

3. Condition of the partnership asset(s)

4. Partnership market's growth potential

5. Degree of portfolio diversification

6. Strength of the partnership's management

Factors tat affect the fractional interest

7. Magnitude of the fractional interest

8. Liquidity of the interest

9. Ability of the interest to influence management

10. Ease of asset analysis

No formulation has yet been created that blends these factors in an equation to produce the appropriate fractional interest discount. Appraisers could benefit if such guidelines, however imperfect, were available. An attemp to quantify some of the deliberations required to determine an appropriate discount follows. The discounts suggested are based on the current market for fractional interests in limited partnerships.

The degree to which a fractional interest may be discounted is determined by assigning a discount to each feature within the given ranges. The six factors that affect the partnership itself should be considered.

Relative risk of the

partnership's assets

The relative riskness of an asset within its asset class is an important consideration. For example, a partnership that owns an office building triple-net leased to a Fortune 500 company is less risky than one whose sole asset is predevelopment land.

Some guidelines for analysis of this factor are that low-risk property types (e.g., triple-net leased buildings with highly creditworthy tenants) should be discounted 3%. High-risk property types (e.g., predevelopment land) should be discounted 10%, while average-risk properties should be discounted 7%.

Historical consistency of

distributions

A track record of earnings and distributions is one of the most favorable attributes a partnership can exhibit. The existence of such a historical record enhances the market value of the interest, while its absence lessens the interest's market value.

A partnership that demonstrates years of steady earnings and distribution growth should be discounted only 3%. However, highly inconsistent partnerships--in which earnings fluctuate 50% or more from year to year, or which have suffered an operating deficit within the past three years--should be discounted 9%. An average performance should be discounted 6%.

Condition of the partnership

asset(s)

The older the asset, the more likely it is that the partnership will have to budget larger amounts for repair, maintenance, and capital improvements. Because the nature of these expenses is difficult to quantify in advance, an aging asset is considered riskier--and therefore less attractive--than newer assets.

An asset in excellent condition should thus be discounted 2%, one in poor repair should be discounted 5%, and a partnership asset in average condition should be discounted 3%.

Partnership market's growth

potential

The future value of a real estate partnership is affected by the gorwth potential of its local and regional market. While markets are subject to cycles, certain markets have demonstrated consistent growth above the national average, while others have shown below-average growth. An asset located in a historically strong market is perceived to offer relatively greater appreciation potential than if it were located in a weak market.

Assets in historically strong growth markets, such as southern California, should be discounted 2%, while those located in no- growth or slow-growth markets such as Bismark, North Dakota, should be discounted 4%. An average market rates a 3% discount.

Portfolio diversification

Clearly, a well-diversified portfolio is more resilient to market weakness than is an undiversified one.

A well-diversified portfolio of properties according to both geographic region and asset type should be discounted 1%, as should an average portfolio. A single-asset portfolio should be discounted 2%.

Strength of the partnership's

management

The capabilities and track records of management are important factors in determining the prospects for any partnership. The most useful measure of management's capabilities is a record of successful operating results.

A management team that has compiled an excellent track record should be discounted 1%, as should an average management tesm. However, when a team with a poor record, a new team, or no management team exists, the asset should be discounted 2%.

In addition, the following four factors that affect the fractional interest should be considered.

Magnitude of the fractional

interest

When the market of potential investors is considered, a fractional interest can be uneconomically small, unattractively large, or appropriately sized.

Real estate securities traded in generally recognized markets (e.g., real estate investment trusts [REITs] and master limited partnerships) have access to the largest investor market and the highest trading volume. Many institutional investors and thousands of individual investors actively invest in these securities. Virtually no interest is too large or too small to find buyers in this category.

Public partnerships, which are not traded in generally recognized markets but are infrequently traded by approximately 15 to 20 small firms active in the "secondary market," have access to a smaller market of investors and modest trading volume. Financial information about public partnerships is relatively easy to find because such partnerships are required to file quarterly, audited annual reports that are available to the public.

Institutional investors have shown only modest interest in this market, however, and investment demand arises primarily from individual investors seeking to invest a few thousand dollars at a time. While virtually no interest is too small to find buyers in this category, an interest worth over $300,000 will find a sharply diminished market of potential buyers.

Private partnerships, which are neither traded in generally recognized markets nor traded by most of the secondary market firms, have the smallest market of all and are rarely traded. Financial data about private partnerships frequently are not available at all. Because data are not provided, potential investors must undertake their own due diligence efforts at substantial expense--often costing $4,000 or more per partnership. For this reason, virtually no institutional investors participate in this market, leaving the field to a small group of relatively sophisticated individual investors. An interest worth less than about $20,000 may be difficult to sell because the due diligence expences become disproportionately high. An interest worth over $500,000 may be difficult to dispose of at all.

If the indicated market value of the fractional interest under considerations is appropriately sized, it should be discounted 3%. If it is so large that the pool of possible buyers is reduced, or so small that the due diligence costs become disproportionately great, the interest should be discounted 7%. The average discount should be 4%.

Liquidity of the interest

The relative liquidity of a fractional interest should be determined by comparison with other real estate-based securities traded in generally recognized markets (e.g., REITs and master limited partnerships) as well as by comparison with public and private limited partnerships, which are not traded in generally recognized markets.

Partnership securities listed on exchanges (e.g., REITs and master limited partnerships) are liquid. Public partnerships held by thousands of investors and traded by one or more secondary market firms are less liquid, while private partnerships are least liquid of all.

A highly liquid fractional interest should be discounted 2%, a highly illiquid interest should be discounted 6%, and an interst of average liquidity should be discounted 4%.

Ability to influence

management

The ability to control or influence the management of an investment has value. As an owner of a fractional interest, a partner may be unable to exercise any meaningful control over the asset. In most partnership situations, for example, a limited partner who exercises any management function loses his or her limited liability protection.

A fractional interest capable of influencing management of the asset, whether as a result of a large percentage interest owned or a familial or other noneconomic rleationship to management, should be discounted 0%. An interest with no control should be discounted 1%, as should an average interest.

Ease of asset analysis

Clearly, an asset that is easier to analyze is more marketable. A partnership that owns several assets is thus more difficult to analyze than a partnership that owns one asset.

A fractional interest with ample and complete data available for analysis should be discounted 0%, as should an average interest, while an interest for which only the basic data (i.e., tax returns) are available should be discounted 1%.

Table 1 summarizes the appropriate discounts a fractional interest should be assigned with respect to each of these factors. As indicated in Table 1, a fractional interest in a partnership that is superior in every respect should be discounted only 16% from fee simple value. This is somewhat less than the 20% discount recent case law shows as the lower end of the discount range; by using the system described here, however, an appraiser should have ample grounds for justifying the relatively modest discount.

Similarly, a fractional interest in a partnership that is weak according to every criterion should be discounted 47% as opposed to fee simple value. While this is somewhat greater than the 40% discount recent case law defines as the upper end of the discount range, it is also justifiable under the circumstances.

An average fractional interest will be discounted 30% according to this system, which is precisely at the mid-point of the range recent case law suggests is appropriate.

CASE STUDY

The following case study demonstrates how both the income discounting and the fractional discounting approaches are properly used to derive an accurate valuation conclusion.

The appraisal taks is to determine the fair market value of a 22.5% fractional interest in an actual limited partnership as of December 31, 1990 (the "valuation date"). To preserve the anonymity of the partnership and the limited partners, the author has agreed not to use the name of the partnership or of the underlying property.

Description of the partnership

Asset

The limited partnership owns an 80,200-square-foot neighborhood strip shopping center a fourt of a mile from an interstate highway in a major Eastern seaboard city. Primary tenants include a major retailer, a national auto parts store, a gas station, and a major bank. The property is in excellent condition.

According to traffic counts, approximately 40,500 vehicles pass the property every day. A national home improvement retailer is located opposite the property, separated by a major arterial highway that extends the length of the property. A fast-food restaurant is immediately adjacent to the center. Several [TABULAR DATA OMMITTED]

strip commercial centers have been built along this highway within three miles of the property over the past five years.

Althoug 100% of the property was leased on the valuation date, two stores that encompass 9,460 square feet (11.8%) are vacant even while continuing to pay rent. All tenants other than the national retailer and the gas station pay percentage rents--even the bank. Rents average $6.95 per square foot. The property was developed in 1972, and has been managed since that time by the developer.

Long-term debt on the property consists of an 8% mortgage that will be fully pain on July 1, 1999. On the valuation date the loan balance was $1,319,666. A summary of key operating performance measures for the last three years is shown in Table 2.

[TABLE DATA OMMITTED]

Valuation method 1: income

discounting

This partnership appears to be better than average. Of particular interest is the fact that the property has a lenghty and relatively stable operating history as well as a relatively low level of debt that is being extinguished at a rapid rate. Accordingly, it can be concluded that a prudent investor would accept an internal rate of return of somewhat less than 20%; in this case 18% seems justifiable and appropriate.

Table 3 sets forth an analysis that uses the income discounting approach. The analysis shows that a sale of the 22.5% fractional interest for $560,000 would enable the new buyer to earn an 18% internal rate of return, after an up-front 9% fee paid to the agent/broker is included.

[TABLE DATA OMMITTED]

Valuation method 2: fractional

discounting

To verify the income discounting approach, the fractional discounting method can be used.

Determine the fair market value of the underlying asset The fair market value of the underlying asset may be ascertained in a number of ways. In this case a capitalization-rate approach is used to analyze a hypothetical sale of the partnership asset on the valuation date.

Gross sale proceeds are calculated by dividing the property's 1990 net operating income (NOI) of $526,567 by the assumed capitalization rate of 11%, indicating a gross sale price for the property of $4,786,972. The gross proceeds are reduced by 6% transaction costs of $287,218 and outstanding liabilities of $1,319,666. The partnership cash balance of $164,585 is added back. The net sale proceeds to the partnership thus total $3,344,673. Limited partners keep 99% of that, or $3,311,227.

Calculate the fractional interest's pro rata share The fractional interest is entitled to 22.5% of these proceeds, or $745,026.

Apply a fractional interest discount to the pro rata share Next, the partnership and the fractional interest are assessed with respect to each of the ten factors as follows.

* Relative risk of the partnership's asset(s)--Range: 3%-10%. A triple-net leased property is among the least risky types of real estate. The fact that two stores are vacant prevents this from being a "best case," but it is still a relatively risk-free property, and should receive a 4% discount.

* Historical consistency of distributions--Range: 3%-9%. The partnership has been consistently profitable, and cash distributions have been growing. As in the category previously mentioned, this partnership performs well in this respect and rates a 4% discount.

* Condition of the partnership's asset(s)--Range: 2%-5%. This property is in excellent condition, having been well maintained and recently upgraded, and should receive a 2% discount.

* Partnership market's growth potential--Range: 2%-4%. The city in which the property is located is an average market and rates a 3% discount.

* Portfolio diversification--Range: 1%-2%. The partnership has only one asset, and is therefore highly undiversified. It thus rates a 2% discount.

* Strength of the partnership's management--Range 1%-2%. The current management team is doing a good job, as is reflected in its successful record, and should receive a 1% discount.

* Magnitude of the fractional interest--Range: 2%-7%. With an indicated value of $560,000 and a consequent purchase price of $610,400, this interest is too large for most investors. The pool of potential investors will likely be somewhat smaller than average, therefore the discount should be 5%.

* Liquidity of the interest--Range: 2%-6%. Interests in private real estate partnerships are less liquid than public partnerships. But real estate partnerships in general continue to be more liquid than other partnership asset groups such as oil and gas, equipment leasing, and cable television. This partnership thus rates a 4% discount.

* Ability to influence management--Range: 0%-1%. Because it holds a 22.5% interest, the limited partner will carry somewhat more clout than one holding, which would rate for example a 1% discount. In this case, the discount should be 0%.

* Ease of asset analysis--Range: 0%-1%. The partnership's information was readily furnished by the general partner, and thus rates a 0% discount.

* Aggregate discount--Range: 16%-47%. The fractional discounting approach indicates a 25% discount is appropriate for this fractional interest. Therefore, a 25% discount to the interest's pro rata share of $745,026 is $558,770.

The $558,770 value derived from the fractional discounting approach corresponds closely with the $560,000 value derived through the income discount approach and provides additional evidence that this valuation conclusion is correct.

CONCLUSION

This article illustrates two approaches useful in determining the degree to which a fractional interest in a real estate limited partnership should be discounted relative to an equivalent fee simple interest in the same asset.

The income discounting approach can be an excellent predictor of fair market value in certain circumstances. Ten factors affect the discount used in the fractional discounting approach, which is favored by most appraisers. Ranges of discounts for each factor are suggested as aids for choosing the appropriate discounts.

Fractional interests in real estate partnerships are inadequately understood. It is important for appraisers to be aware of the issues involved, because such interests are likely to become the subjects of more appraisals in the future. (5)

(1) Internal Revenue Service, Revenue Ruling 59-60, Section 3.03.

(2) Partnership Profiles, Inc., Secondary Spectrum (Dallas: Partnership Profiles, Inc.) monthly newsletter; and Robert A. Stanger Company, Investment Advisor (New Jersey: Robert A. Stanger Company) monthly magazine.

(3) It should be noted that it is common for firms that represent buyers in the secondary market to earn a fee for their efforts; therefore this fee must be taken into consideration by a prospective buyer. One should assume the fee totals 9% of the purchase price, and add these charges to determine the buyer's gross investment.

(4) See three cases the Internal Revenue Service (IRS) frequently cites when arguing the appropriateness of a fractional discount: Estate of Andrews v. Commissioner, 79 TC 983 (1982); Ward v. Commissioner, 87 TC 78 (1986); and Estate of Piper v. Commissioner, 72 TC 1062.

(5) The author welcomes information from readers about other efforts to more rigorously quantify the fractional interest discount.

Brad Davidson is president of Pre-Owned Partnership, Inc., in Annapolis, Maryland. He received his BA from St. John's College in Annapolis, Maryland. Mr. Davidson was a featured speaker at the Regional Appraisal Conference sponsored by the Washington, D.C. Metropolitan Area and Maryland Chapters of the Appraisal Institute on the topic of appraisal of fractional interests.
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Copyright 1992 Gale, Cengage Learning. All rights reserved.

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Author:Davidson, Brad
Publication:Appraisal Journal
Date:Apr 1, 1992
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