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Valuing the assets of a manufacturing company.

When working as a real estate consultant for a major accounting firm, I frequently appraised the real estate assets of various types of companies assuming ongoing operations. For the majority of these firms, real estate was not the primary business line. They were typically manufacturing firms, retail chains, insurance companies, and various other types of entities. For companies in the real estate investment industry, the valuation of the real estate, though never simple, was generally straightforward. These assignments were typically market value appraisals assuming a willing buyer and seller, etc. When dealing with companies for which real estate investment is not the primary business focus, however, a minefield of potential problems can arise. Valuation of assets under these conditions is the focus of this article.

One of the most misunderstood concepts by professionals outside the real estate appraisal field (and possibly inside as well) is value in use. Most seem to have a basic understanding of concepts such as market value and liquidation value as defined by the Appraisal Institute. However, when dealing with the value of a manufacturing facility to a specific user, the concept of value can become murky. The first question to be answered is, "value to whom?" Is an appraiser talking about value assuming the plant were empty and available for alternative uses (market or possibly liquidation value), or the value assuming an ongoing operation (value in use)? And just what is value in use, and who is qualified to appraise it?

In valuing the assets of corporations, it is extremely important to have the expertise to value assets from several disciplines within the appraisal field, including the appraisal of businesses and intangible assets, machinery and equipment, as well as real estate. It is impossible to appraise the value in use of assets for a manufacturing firm, a retail firm, a hospital, a health maintenance organization (HMO), or any number of other types of firms, assuming ongoing operations without understanding these disciplines and how they interact.

In such assignments, the first step for a qualified valuation team is to identify all the assets to be valued. The value in use, or use value, is "the value a specific property has for a specific use."(1) This implies that a specific property could very well have very different values to different users. A more encompassing definition may be:

Value-in-use (real property) is the market value of a going concern which reflects a value to a particular user. As distinguished from "value-in-exchange," the criteria are as follows:

a. The property is fulfilling an economic demand

b. The property has an economically viable remaining life

c. There is responsible ownership

d. Diversion of the property to an alternate use would not be economically feasible

e. Due consideration has been given to the property's functional utility

f. The net earnings of the business are sufficient to show a fair return on the assets value(2)

This definition highlights several important issues. First is the property must be fulfilling an economic demand. It is important to note that this demand is being generated by an individual user, and not necessarily the local economy or real estate market. Another important point, and one which may differ under a market value, or a value-in-exchange study, is that consideration has to be given to the property's functional utility. While functional utility is always a consideration in a market value study, in this case, functional obsolescence is considered from the perspectives of both market norms and the specific industry with which the property is associated. As an example, while the market standard for manufacturing in a given area may be 16-foot clear ceiling heights, this may be a totally inappropriate standard for a given industry. Lastly, the return to the business must be sufficient to show a fair return on the assets. If the business does not show a fair return, then external obsolescence related to the specific industry or the business itself is present.

So what does this mean? For example, assume that a 100,000-square-foot manufacturing plant in rural Missouri is currently used by a manufacturer and that this plant would be functional for a broad range of uses. This plant, including land and building only, has a replacement cost less physical depreciation of $50 per square foot. Appraisers who have ever valued a 100,000-square-foot manufacturing plant in rural Missouri, or most likely rural anywhere, would suspect that if this plant were vacant and on the market, its market value would be substantially less than $50 per square foot. However, the value in use to that manufacturer may well approach, or equal, $50 per square foot. This is because the return on total investment in the firm could very easily indicate that the full investment in the real estate is well justified. Otherwise, no one would ever build these facilities in small communities. The company must have a physical plant somewhere, and the specific location of the plant may very well offer the firm everything it needs in labor, education, raw material availability, access to transportation, and whatever other intangibles the company's management requires. However, if the return on investment is not sufficient to justify the total investment, the value in use is most likely less than the $50 per square foot. It is also possible, though, that the value in use may be less than the $50 per square foot, but still higher than the market value of the real estate, assuming it is vacant and available for alternative uses.

What if the company is found to have no economic value? Would the value in use of the real estate assets be zero dollars? Possibly, but probably not. The value in use of the real estate can never be less than the market value of the property. If the improvements are so specialized that there is no market for the improved facility, the value in use (as well as market value) would be the market value of the site as vacant and available to be put to its highest and best use minus demolition and whatever cleanup costs might be associated with the improvements. If the demolition and cleanup costs exceed the value of the site, the company would likely abandon the site altogether, and the value in use would be zero.

If an appraiser is assigned to appraise the value in use of the Missouri facility, he or she must first identify all the assets to be appraised. These assets can usually be broken down into three categories: real estate, machinery and equipment, and intangible assets. The first two categories are self-explanatory. The third, intangible assets, can include a wide range of items from accounts receivables, to client lists, to software development, to patents, to non-compete clauses. In addition, if the value of the company exceeds the cumulative value of the assets, an intangible asset - goodwill - exists. It is imperative that the appraiser, or team of appraisers possess the skills necessary to identify and value the assets in these respective categories before accepting a value in use engagement.

After identifying the assets to be valued, the next step is to value the assets by the most appropriate approach, ignoring for the moment the economics of the company itself. For the real estate, this can be done using either one or all three of the traditional approaches to value. In valuing retail stores associated with a retail chain that could serve a variety of retailers in a market, it may be appropriate to use all three approaches to value. If an appraiser is valuing nonspecialized manufacturing facilities in active markets, it may be most appropriate to use only the cost and sales comparison approaches. If the sales comparison approach is used, however, he or she must analyze whether external obsolescence from sources other than those associated with the company itself (i.e., poor management or the specific industry) should be recognized. If external obsolescence not associated with the company itself is present in the local market, it would not be appropriate to apply the local external obsolescence to the subject property. An example of this would be a successful manufacturing concern located in a distressed market. If the company uses specialized facilities, or larger facilities in smaller markets, or even functional, marketable properties in economically distressed areas, it may be appropriate to use only the cost approach. When using the cost approach only, it is vital to incorporate only estimates of functional and physical obsolescence at this time. External obsolescence affecting the facility as it relates to ongoing operations will be identified and handled later. The value of the machinery and equipment and identifiable intangible assets, excluding goodwill, are also estimated under the same criteria.

Next, the value of the business as a whole is estimated, again using the appropriate method or methods of valuing a business. In estimating the value of the business, external obsolescence and/or goodwill related to the industry or the company itself will be accounted for. If it appears that the economics of the business do not support the value in use of the assets before external obsolescence, it may also be necessary at this time to estimate the market value, or value in exchange, of the assets if this was not done in conjunction with the previous step.

For illustrative purposes, assume the following:

1. The subject real estate is a large manufacturing facility located in a small rural community, and values in use for before external obsolescence in all asset classes have been estimated using the cost approach to value only.

2. Market value (value in exchange) has been estimated using the appropriate approaches to value.

3. Value in use assuming ongoing operations before external obsolescence entails real estate, $4 million; machinery and equipment, $4 million; and intangible assets, $2 million.

4. Market value (value in exchange) entails real estate, $1 million; machinery and equipment, $1 million; and intangible asset, $1 million.

In one scenario, the estimated value of the business assuming ongoing operations is $10 million. The question at hand is, "What is the value in use of the various classes of assets?" The value of the business is equal to the value in use estimates before external obsolescence issues ($4 million [real estate] + $4 million [machinery and equipment] + $2 million [intangible assets] = $10 million). Therefore, no external obsolescence or goodwill exists, and the value in use would be equal to the estimated value of the assets estimated by the cost approach to value. If the value of the business had been $12 million, the value in use of the assets would again have been equal to the value in use before any external obsolescence considerations, but there would also have been $2 million in goodwill.

In another scenario, the estimated value of the business assuming ongoing operations is $6 million. The value of the business assuming ongoing operations is less than the estimated value in use before external obsolescence, but more than the market value (value in exchange) of the individual assets combined. This means that unless an alternative use more economically viable than the current operation can be found, external obsolescence exists either within the industry as a whole or within the company itself. At this point it may be necessary to evaluate the individual assets to explore whether the obsolescence is attributable to an individual asset, class of asset, or all the assets across the board. However, functional obsolescence was accounted for in the cost approach. Therefore, unless the obsolescence can be attributed to the performance of specific individuals or departments, it is most likely that the obsolescence can be applied equally across the asset classes. Assuming this is the case, the value in use of the assets under scenario two would be $2.4 million (real estate), $2.4 million (machinery and equipment), and $1.2 million (intangible assets). In this example, external obsolescence of 40% ([$10 million - $6 million]/$10 million) has been applied to all asset classes.

In yet another scenario, the estimated value of the business assuming ongoing operations is $2 million. The value of the business as a going concern is less than the market value (value in exchange) of the individual assets combined. The underlying economics of the industry or the business itself does not warrant continued operations of the business, and the most economical use of the assets is for liquidation. The value in use is, therefore, equal to the combined market value of the individual assets, or $3 million, as follows: $1.0 million (real estate), $1.0 million (machinery and equipment), and $1.0 million (intangible assets).

The preceding examples have been simplified, but they serve to illustrate the complexity involved in appraising the value in use of the assets of a company. It is imperative for an appraiser to understand fully the nature of the business being analyzed and possess the expertise to appraise a wide range of asset types, as well as a business entity. While value in use is often thought of as a simple exercise - often by appraisers applying only the cost approach to value - in reality it may be one of the most complex of all valuation exercises.

1. Appraisal Institute, The Dictionary of Real Estate Appraisal, 3d ed. (Chicago: Appraisal Institute, 1993), 383.

2. John L. Gadd, "Defining Value in Use," ASA Valuation (February 1987): 2.

Richard M. Schmidt, MAI, is senior vice president of Property Counselors, Inc., Chicago. He has served as real estate valuation coordinator for numerous value in use appraisals. He earned a BA in accounting from Southwest Missouri State University, Springfield, Missouri.
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Author:Schmidt, Richard M.
Publication:Appraisal Journal
Date:Apr 1, 1997
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