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Valuation factors regarding deprivation analyses.

A deprivation occurs when the owner of an asset, property or business interest is involuntarily deprived of the ownership (or other legal or economic rights) of his property. A deprivation can result from eminent domain, property damage, infringement, squeeze-out transaction, breach of contract or similar actionable events. As the result of such events, the property owner is typically eligible for compensation for the economic loss suffered from the deprivation. The measurement of the compensation for the economic loss typically requires an appraisal. These appraisals may include the valuation and economic analysis of a variety of properties, such as: business entities and securities, intangible assets and intellectual properties, real estate and real property interests, tangible personal property, etc.

When deprivations occur, accountants are immediately called upon by their employers or clients for assistance, advice and counsel. Accountants are often asked to perform an analysis of, or to assemble and interpret data for an analysis of, the deprivation. Accountants are frequently asked to participate in the selection of independent valuation and economic advisors who specialize in the deprivation appraisal process. And, accountants are always asked to work with the independent valuation and economic advisors -- and legal counsel -- to ensure the aggrieved party receives the full compensation they are entitled to.

This article will discuss the valuation aspects of deprivation appraisals, in particular, the theoretical concepts and practical applications of deprivation appraisals. These concepts and applications affect the purpose and objective of the appraisal, the definitions of value and premises of value used in the appraisal, the actual valuation approaches and methodologies used, and the presentation of the appraisal work product.

Of course, the definitions of value used, the valuation procedures performed, etc. will be directly influenced by the statutory authority, judicial precedent and administrative rulings of the legal or political authority in which the property deprivation occurred.

The valuation fundamentals will also be directly influenced by the type of deprivation that occurred--and by the type of asset, property or business interest that suffered the deprivation. Nonetheless, there are certain valuation principles or standards that are universal with regard to virtually all types of deprivation appraisals. It is these universal deprivation appraisal principles or standards we will discuss.

This article is presented from the perspective of the professional appraiser, valuation analyst or economist. It is not intended to provide legal, accounting or taxation advice.

The Nature of a Deprivation Appraisal

A deprivation appraisal is conducted when a deprivation has occurred or is threatened to occur. In a deprivation, the legal owner of a property is deprived of the ownership of, the possession of, the use of or the economic enjoyment of that property.

Typically, in a deprivation, the party subject to the deprivation loses some portion (or all) of their bundle of legal rights related to the property. The party subject to the deprivation also loses some portion (or all) of the economic value attendant to those legal rights. The party responsible for the deprivation receives some portion (or all) of the total bundle of legal rights related to the property. And, the party responsible for the deprivation receives some portion (or all) of the economic value attendant to those legal rights.

In short, the party subject to the deprivation is economically disadvantaged, and the party responsible for the deprivation is economically advantaged. Typically, the ultimate objective of the deprivation appraisal is to quantify the amount of fair and just compensation to the property owner to compensate the owner for the economic disadvantage associated with the deprivation. Most often, that amount of fair and just compensation is quantified to restore the property owner to the level or amount of economic well being associated with the legal rights (including, but not limited to, property possession, dominion and control) enjoyed just prior to the deprivation.

When we think of property with regard to a deprivation appraisal, we immediately think of real estate (owned land, land improvements and buildings) and real property (legal interests in real estate, such as leases, development rights, mineral and natural resource exploitation rights, etc.). However, with regard to deprivation appraisals, property is broadly defined. In addition to real estate, the term property includes tangible personal property, intangible assets and intellectual properties, business entities, business interests, and direct and derivative security interests.

The Types of Deprivation Appraisals

There are numerous types and circumstances of property deprivations. To compensate the party subject to the deprivation (and to exact compensation from the party responsible for the deprivation), a deprivation valuation or economic analysis may be required.

When examined microscopically, each of these appraisals and analyses are unique and specific to the nature of the deprivation and the type of property deprived. However, when considered macroscopically, all of these types of deprivations -- and, therefore, types of deprivation appraisals -- may be generally grouped into the following five categories:

* eminent domain;

* property damages;

* infringement;

* squeeze-out transactions;

* breach of contract.

Examples of each of these five categories of deprivation circumstances and deprivation appraisals are presented below.

Under the category of eminent domain deprivations, we would include all instances of municipal condemnation, nationalization of property and industry, and expropriation of any type of property. In these instances, a state, municipality or private person asserts dominion over private property on account of public exigency and in the public good. In such instances, the party performing the deprivation has an obligation to provide adequate compensation to the private owner of the realty, personalty or business enterprise subject to the taking.

Under the category of property damages deprivations, we would include tangible damages and intangible damages. Tangible damages would include fire, theft and other actual or constructive larceny. An example of such tangible damages would be the felonious arson and malicious burning of a factory, warehouse or other commercial property. Intangible damages would include slander, libel and other forms of damage to a party's name, reputation and goodwill. For example, the party damaged by actionable defamation may include an individual, a professional practice or a business.

Under the category of infringement deprivations, we would include patent, trademark, copyright and other intellectual property infringement. Prior to the infringement, the legal owner of the intellectual property enjoyed special legal rights and protections -- and the associated economic benefits of such special protection. As the result of an unauthorized use or other encroachment, the infringer deprived the owner of the full rights and economic benefits of his property.

Under the category of squeeze-out transaction deprivations, the deprived party previously owned a common or preferred equity interest, partnership interest or other ownership interest in some business enterprise. The party enjoyed a certain level of legal rights and a certain amount of economic satisfaction associated with ownership interest. As a result of the squeeze-out or freeze-out, the stockholder/partner is involuntarily deprived of his investment property and of his legal rights and the associated economic satisfaction.

Under the category of breach of contract deprivations, the deprived party entered into a contract -- and paid valuable consideration -- in anticipation of the enjoyment of certain legal rights and certain economic benefits. The contract may call for the purchase or sale of an asset, for the consumption or provision of goods and services, etc. In any event, prior to the breach, the party suffering the deprivation enjoyed a quantifiable level of economic satisfaction. As a result of the breach the party was involuntarily deprived of that level of economic satisfaction. The objective of the deprivation appraisal, in this case, is to quantify the amount of compensatory value required to exactly restore the aggrieved party to his pre-deprivation level of economic satisfaction.

Appropriate Definitions of Value

Professional appraisers realize there are numerous alternative definitions of value that can be assigned to the same asset, property or business interest. An elaborate description could be assigned to each different definition of value, but such elaborate descriptions are beyond the scope of this article. What is most important to understand about the different definitions of value is that they each answer the question: value to whom?

A listing of some of the most common alternative definitions of value and an abbreviated descriptions of each definition follows:

* fair market value -- what the hypothetical typical (or average) willing buyer will pay to the hypothetical typical (or average) willing seller for a property (in this common definition of value, the buyers and sellers are both hypothetical and unspecified);

* market value--same hypothetical willing buyer and hypothetical willing seller concept as "fair market value" with a few additional conditions placed upon the arm's length transaction (e.g., that value will be stated in a cash equivalency price and in local currency);

* acquisition value -- what the subject property is worth to a specific, individual buyer (or acquirer);

* use value -- what the subject property is worth in a specific and specified use (which may be different than its current use);

* investment (or investor) value -- what the subject property is worth by reference to its investment return to the property owner (without consideration to what the owner could sell the property for);

* owner value -- what the subject property is worth to its current owner and in its current use (which may be substantially different from what the property may be worth to any other particular buyer, to any other user, or to the marketplace in general);

* insurable value -- what the subject property is worth for insurance purposes (usually based upon some relationship to the replacement cost of tangible and intangible assets);

* collateral value -- what the subject property is worth if it is pledged as collateral for a loan (what a creditor is willing to loan against the value of the property);

* ad valorem value -- what the subject property is worth to a taxing authority which is attempting to allocate a tax burden fairly and objectively in proportion to the value of all of the property within the taxing jurisdiction;

* contributory value -- what the subject property is worth to the specific owner of a specified other property (assuming that the two properties could somehow be operated in conjunction or in concert).

The above list includes 10 commonly used alternative definitions of value. It is not intended to be an exhaustive list. Certainly, none of these definitions of value is objectively "better" than any other definition.

Virtually all of these 10 alternative definitions of value could be estimated for the very same property. The result of such an analysis would be ten different (possibly quite different) and equally valid "values" for the very same property.

In the case of deprivation appraisals, some judicial and statutory authorities require fair market value as the appropriate definition of value. However, it is much more common in deprivation matters for the controlling judicial, statutory or regulatory authority to require fair value as the appropriate definition of value.

While the nature of the deprivation controls the definition of value that the appraiser will follow, fair value is generally considered to result in the most fair and equitable treatment of the property owner in the case of an involuntary transaction, taking or conversion of the property.

The specific definitions of fair value are as numerous as the number of court cases and governmental statutes in which the term is mentioned. However, there are a number of basic tenets universal to the concept of fair value (at least in terms of how they affect the appraisal).

First, a willing buyer/willing seller transaction is not contemplated. Most deprivation appraisals do not involve a "willing" seller. Generally, the party subject to the appraisal had no intention to -- and does not currently want to -- sell the property. The deprivation is clearly involuntary; and other than the party responsible for the deprivation, there may not be a willing buyer for the subject property.

Second, the objective of this valuation analysis is not to estimate the likely activity of a hypothetical marketplace; the objective is to restore the property owner to his economic status before the deprivation occurs. As the word "fair" implies, fair value quantifies the (fair and) just compensation to the property owner who was involuntarily deprived of the economic enjoyment of the property.

There is another definition of value not as widely used in judicial decisions or in the valuation literature but more descriptive of the purpose and objective of deprivation appraisals: compensatory value.

In most respects, compensatory value is analogous to fair value. However, the term compensatory value is more eloquently expository of the reason for conducting the appraisal and of the answer of the basic definition of value question: value to whom?

Compensatory value is clearly the value of the subject property to the property owner, that is, the party subject to the taking, the expropriation, the economic damage or some other involuntary conversion. The general interpretation of compensatory value is: the value that will result in a fair and reasonable compensation for the deprived property and that will restore the property owner to the level of economic satisfaction enjoyed just prior to the deprivation. Such a definition of value is intuitively the proper measure of compensation in deprivation appraisals.

Appropriate Premises of Value

In a deprivation (or any other type of) appraisal, the appraiser does not have to judgmentally decide the appropriate definition of value, description of property subject to appraisal or valuation date. These fundamentals are already decided by the appraisal assignment.

However, for any type of appraisal, one of the first valuation fundamentals the appraiser must judgmentally decide is what premise of value to apply to the subject property. There are four alternative fundamental premises of value from which appraisers may select.

Virtually any type of asset, property or business can be appraised under each of these four alternative premises of value:

* value in continued use, as part of a mass assemblage of assets and as part of a going concern enterprise;

* value in place, as part of a mass assemblage of assets, but not in current use as part of a going concern enterprise;

* value in exchange, on piecemeal basis (not part of a mass assemblage of assets), as part of an orderly disposition; and

* value in exchange, on a piecemeal basis (not part of a mass assemblage of assets), as part of a forced liquidation.

While virtually any type of property can be appraised under each of these four alternative fundamental premises, the value conclusions reached under each premise, for the same property, may be dramatically different.

The appraiser will select the appropriate premise of value based upon the purpose and objective of the appraisal and based upon the actual physical and functional status of the subject property.

In the case of deprivation appraisals, it is universally accepted the appraiser should apply the premise of value that would have been appropriate on the day before the deprivation occurred. For example, if the property was (or was part of) a going concern business enterprise just prior to the appraisal, then it should be appraised under the fundamental premise of value in continued use. It is possible (and, often, likely) the act of the deprivation could change the functional status of the property.

To illustrate this point, let's assume that a hotel property was a going concern business just prior to an eminent domain condemnation. At the moment after the condemnation, the hotel property ceased its hospitality operations. Clearly, in this example, the subject property should be appraised under the premise of value in continued use (as part of a going concern business) since that was the functional status of the property just prior to the deprivation.

To appraise the hypothetical hotel property under any other premise of value would unfairly economically disadvantage the property owner, in this example. To appraise the property under any other premise of value could unfairly economically advantage the taker, in this example. This is because the taker could restore the hotel to its operational status and enjoy the value increment without having paid for it.

In a deprivation appraisal, applying a premise of value other than that appropriate prior to the deprivation would not achieve a fair value (meaning equitable to the property owner) or a compensatory value (meaning just compensation to the property owner).

Special Valuation Factors to Consider in a Deprivation Appraisal

As implied above, there are a number of special considerations the appraiser should be mindful of when preparing a deprivation appraisal. Of course, various judicial decisions have articulated different factors, based upon the specifics of each individual case. Various statutes have also specified (or implied) their lists of special valuation factors to consider, based upon the type of deprivation contemplated. And, various scholars have postulated special valuation factors to consider, based upon the type of property subject to the deprivation.

The following list represents a consensus of several special valuation factors that should be considered in virtually all deprivation appraisals. These valuation factors are general in nature so as to apply to the appraisal of various types of property and to various types of deprivation situations.

First, the appraiser should ignore the deprivation itself and all its effects in the appraisal. The property should first be appraised as if the deprivation (and any resulting decrement in property value) had not occurred. This assumption (that the deprivation had not occurred) may be the basis upon which the appraiser can make a comparative analysis for purposes of quantifying one measure of compensatory value -- i.e., the fair value of the property before the deprivation less the fair value of the property after the deprivation.

Second, the appraiser should ignore all subsequent events after the occurrence of the deprivation (i.e., after the valuation date). This normal appraisal practice should go without saying. However, in the case of deprivation appraisals, it is often difficult (but necessary) to ignore the substantial economic effects of time and the deprivation act itself on the subject property.

Third, the appraiser should ignore the deprivation event itself (and the associated effects of the deprivation) during the selection of the appropriate premise of value. Generally speaking, the selection of the appropriate premise of value is a threshold test. If a property is a going concern business, then it should be appraised under the premise of value in continued use.

For example, if our illustrative hotel is open for business, then it should be appraised on a value in continued use basis, even if it has lower occupancy and less profits than it had historically or compared to industry benchmarks, etc. It is still a going concern business, even if it may be worth less than it was historically.

Fourth, the appraiser should ignore the actions of the party responsible for the deprivation, both before and after an actual deprivation event (if one specific event occurred). In the case of a condemnation, for example, the state may have performed certain actions prior to the issuance of the actual condemnation notice that would have a decremental effect on the value of the property.

Using our hypothetical hotel to illustrate, such actions may include closing down most access roads to the subject hotel, changing the zoning of the subject property, starting major highway construction directly adjacent to the subject hotel, etc. The appraisers should factor out all of these effects from the deprivation appraisal and essentially value the subject property on the date before any detrimental deprivation activities occurred.

Fifth, the appraiser should not consider many of the valuation discounts that would normally apply in a willing buyer/willing seller market value appraisal. To illustrate, let's assume our exemplary hotel is a closely held corporation, with a number of shareholders. Let's also assume the hotel is subject to a condemnation deprivation and one of the four equal shareholder owners is seeking compensation for the deprivation.

Normally, the appraiser would discount the overall value of the closely held corporation due to its illiquidity. Normally, the appraiser would also discount the owner's pro rata value of the corporation due to the lack of marketability of blocks of stock in close corporations. Normally, the appraiser would discount the owner's pro rata value due to the minority ownership nature of the interest (i.e., lack of control of the hotel operations). And, normally, the appraiser would discount the owner's pro rata value due to any other restrictions on the transferability of the shares (e.g., for buy/sell agreements, etc.).

However, in a deprivation appraisal, none of these discounts may apply to our hotel shareholder. These discounts may apply in appraising the hotel business interest under a willing buyer/willing seller definition -- but our shareholder is not a willing seller. He was perfectly content to own his 25% of the hotel. He had no intention of selling his ownership interest. Instead, he was involuntarily deprived of his interest.

If these valuation discounts were applied in the deprivation appraisal, then the four owners would collectively receive much less than the total market value of the hotel. Accordingly, they would be economically disadvantaged. And, the state (i.e., the party responsible for the deprivation) would be economically advantaged. This is because they were able to "buy" the hotel for much less than its total market value.

Conclusion

Before performing a deprivation appraisal, the appraiser should understand the purpose and objective of the appraisal (within the deprivation context), the nature of the deprivation action and the type of property subject to the deprivation.

The appraiser should consider the appropriate definition of value and the appropriate premise of value in order to conclude the compensatory value of the subject property. Such a definition of value (and the corresponding appraisal approaches and methodologies) will be different than the traditional hypothetical willing buyer/hypothetical willing seller concept. Rather, since the deprivation appraisal relates to an involuntary transaction, the appraisal should conclude an economic value that represents a fair and just proper measure of compensation for the economic damage suffered by the deprived property owner.

This article was intended to provide accountants with an overview of the key factors related to deprivation appraisals. With this overview, accountants may better serve their employers or clients who have experienced a deprivation. By providing informed advice and counsel, accountants can ensure that the aggrieved party receives the maximum compensation they are entitled to.

Robert F. Reilly, ASA, CREA, is a managing director of Willamette Management Associates. He has considerable experience performing deprivation appraisals and other economic analyses for litigation support and dispute resolution purposes.
COPYRIGHT 1992 National Society of Public Accountants
No portion of this article can be reproduced without the express written permission from the copyright holder.
Copyright 1992 Gale, Cengage Learning. All rights reserved.

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Author:Reilly, Robert F.
Publication:The National Public Accountant
Date:Nov 1, 1992
Words:3719
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