Valuing an Operating Business that Owns Real Estate

This issue has caused many a headache for lawyers, especially when the valuation is in a controversial setting. I recently addressed this issue with a lawyer heading into mediation. The issue was the value of an operating business that happened to also own the real estate out of which it operated. I sought to support my valuation techniques with reference to existing literature available in textbooks and articles. Exist though they do, they all appear, to me, to make certain base assumptions that were left unexplained. When writing for business appraisers, that is ok, but it is important to not take things for granted when explaining issues to a lawyer. 

In that light, this article is intended to lay the practical and theoretical foundation for this issue and highlight the key assumptions that need to be understood. Once this is done, an application section will describe the effects on value. 

Practical and Theoretical Foundations

It will be helpful to understand that an operating business is one that produces products and/or provides services. This is distinct from an investment entity, or asset holding entity, the primary purpose of which is to own and manage tangible assets. The lines between these occasionally get blurred but usually it is fairly easy to tell. A construction company is an operating business. A law firm is an operating business. An entity that owns an apartment complex is an asset holding entity. 

Often real estate, and other assets on a operating corporation’s books, will be categorized as non-operating assets. This phrase, “non-operating assets,” is a term of art and so it must be understood within its context, and all preconceptions disregarded. Non-operating assets fall into two categories. The first are assets that are unrelated to business operations. Examples may include excess working capital or brokerage accounts holding marketable equities and bonds. The second are assets that may be related to business operations but are not necessary thereto. An example here is often real estate. Although real estate is a part of operations in the sense that the business operates out of it, it may not be a core aspect of the operations. Take, for example, a machine shop. There are certain assets that are essential to operations: CNC machines, lathes, etc. The business cannot operate without these assets. Real estate is not one of these; most machine shops lease the building out of which they operate. Even if the machine shop owns the building, it does not follow that it must own the building. It could sell the building and lease it back from the buyer with no impact on its core operations. 

Here are two considerations that impact how analysts will view corporate owned real estate.

Consideration of Required Rates of Return

The first theoretical aspect to discuss is the rate of return. For a business that has an operating component and a real estate investment component, there exists two separate and distinct risk profiles. The first is associated with operations, and the second with real estate. Now, real estate carries less risk relative to equity investments, and this is particularly true for privately held equity investments. It would therefore be inappropriate to apply a real estate rate of return to the entire enterprise, and vice versa an equity rate of return. 

Note the subtle distinction here between the risk profiles of an operating business with real estate and an asset holding entity: whereas the operating business has two risk profiles, the asset holding entity has only one, since its entire business is the ownership and management of the underlying asset.

The business appraiser is taught that there are two options for this: (1) separate the two investment profiles, value them separately and then add them together or (2) value the entity using a blended, or weighted average, risk rate. The former is considered conceptually cleaner and is the preferred approach in the valuation industry. I will show later that the second option is more work, still requires all the same data, and has a mathematical error that some analysts fall for.

Limitations in the underlying data

A practical limitation in valuing entities of this nature is that nearly all of the valuation data available to us is published in silos, pertaining to distinct risk profiles. Equity rates of return for operating business are published separately from returns for real estate holding entities. The same is true for EBITDA multiples, particularly for small- and mid-size privately held enterprises. 

A common valuation metric for the pricing of a privately held enterprise is the application of a multiple to the company’s EBITDA. Now, these multiples carry factual assumptions as to what is included in the multiple and what is excluded. Almost universally, EBITDA multiples are calculated using an after-rent earnings base. I.e., it is not an EBITDA + rent, or EBITDAR, multiple, it is only an EBITDA multiple. 

This can create a disparity between the EBITDA for the subject company, if rent is not being paid, and the factual assumptions embedded in the multiple. I say factual assumptions intentionally here – it is a fact that the multiple is after a rent expense.

This can be visualized as follows: if the EBITDA being multiplied is before a rent deduction, there is an embedded cash flow return within the EBITDA, measured as the cash flow saved by not paying rent. If this cash flow is then multiplied, there will be an implied value to the real estate by virtue of ownership in current operations. However, the implied real estate value will be associated with an operating business multiple, which we noted above is irrelevant due to the different risk profiles. If a real estate value is then added to this, there will result a double counting of a real estate value: the first using the wrong rate of return and the second using an appropriate rate of return.

Often an attorney will point out that the company is, in fact, not paying rent, so it makes no sense to deduct rent. This is a factually accurate statement, and often a point of concern when the lawyer’s client may benefit from a higher value. The counter point is there exists an equally accurate fact that is entirely contradictory to this statement: that the EBITDA multiple assumes rent has been deducted. The former fact is easier to conceptualize – yes, the company is not paying rent – but the latter fact is equally valid. The analyst must therefore use valuation techniques to address this miss-match. 

Specific Adjustments to Consider 

We noted in the introduction that there are two approaches to address this issue. The first was to separate the two components (operating and real estate holding), value them separately, then add the values together. This section provides insights on the specific adjustments that may be necessary to restate the financials.

To provide a framework, the starting point is to restate the company’s financials to remove all data associated with real estate ownership, and restate it as if it was renting the real estate from a third party. 

Balance Sheet Adjustments

The adjustments on the balance sheet are to remove the assets and debts associated with the real estate. This usually includes:

• The real estate asset(s).
• Associated depreciation; and
• Any associated debts, e.g., the mortgage. 

The result will be a restated balance sheet that considers only the operating components of the corporation.

Income Statement Adjustments

The first adjustment to consider on the income statement is a rent deduction. This deduction should equal fair market rent for the facilities. Often, it is necessary to retain a real estate expert to opine on what fair market rent would be for this facility, but reliance on management’s opinion is a viable option as well.

Other adjustments to consider include:

• Insurance attributable to real estate ownership
• Property taxes
• Interest on the mortgage
• Repairs and maintenance, and
• Any rental incomes

It is critically important that any adjustment made corresponds to the assumptions in the rent expense adjustment. By this I mean that the real estate appraiser, in assessing fair market rent, will have assumed certain cash flow items be borne by either the landlord or the tenant. For example, if it is the landlord’s responsibility to carry insurance on the property, then any rent expense for such insurance on the corporation’s books must be adjusted. Below is a table that shows how a failure to do this could result in a double counting of this cash flow item.

This highlights the importance of reconciling the assumptions made by the real estate appraiser in assessing fair market rent with the cash flow adjustments made in the valuation model. 

Using a Blended Discount/Capitalization Rate

The above assumes we are valuing the entity using a sum of the parts approach. But I noted earlier we could actually use a blended capitalization rate. This can be done by weighting each capitalization rate (or discount rate if this is a DCF model) by the relative proportion of the two values to the whole. 

I have read valuation literature on this topic that states you weigh the discount/capitalization rate with earnings as the denominator. This is actually mathematically incorrect. 

The analyst must weigh the rates of return with relation to the Company’s total value as the denominator. Thus, before you can ever use this calculation, you must already have valued the company. This makes one wonder why this method would ever be used. 

A proof is included below.

Example Calculation Using a Blended Rate

Let’s start by noting that the value of this business, per the calculation supra, is the sum of the real estate and operating components, or $1,000,000 + $2,666,667 = $3,666,667. 

The table below derives an equivalent value using these inputs. Note that using this blended rate does not alleviate an expert or lawyer from obtaining a value of the real estate and a fair market rent amount.

	Operations	Real Estate	Total
Value	$2,666,667	$1,000,000	$3,666,667
% of Total	72.73%	27.27%
Capitalization Rate	15%	5.5%
Weighted Capitalization Rate	10.9091%	1.5%	12.4091%
Total incomes	$400,000	$55,000	$455,000
Incomes / Cap Rate = Value			$3,666,664
			(note slight error from rounding the cap rate)

Note that it is irrelevant whether one may disagree with the final value as long as the assumptions are in agreement and consistently applied throughout. 

Erroneous Calculation that the Author has seen in some Valuation Literature

I noted above that I have read literature that proposes weighing the capitalization rate using total earnings as the denominator, rather than total value. This has a logical ring to it but it is in fact a mathematical error, no way around it. To avoid a discussion of mathematical rules, I will instead show a quick example using the same table above, with adjustments are necessary.

Assuming that we need to derive a value equal to the above ~$3.67 million:

	Operations	Real Estate	Total
Cash Flow	$400,000	$55,000	$455,000
% of Total	72.73%	27.27%
Capitalization Rate	15%	5.5%
Weighted Capitalization Rate	13.19%	0.66%	13.85%
Incomes / Cap Rate			$3,284,808
Difference from correct value			$381,859

So, you can see that if you weighted your rate using cash flows, instead of value, you would derive a value that is $381,859 lower than the correct value. This kind of mistake would not look good on the witness stand!

Wrapping Things Up

I hope that you can walk away from this article knowing that:

1. Real estate is usually considered a non-operating asset when the real estate is not critical to operations. You can test this by asking whether there are two separate risk profiles associated with the company’s operations.
2. The best approach to valuing an entity of this nature is to separate the operating business segment from the real estate segment, valuing each individually, and then adding the sums together. 
3. To affect #2, one must be cognizant of the assumptions in the real estate appraisal and the rent expense adjustment so as to not double count any items.
4. If, rather than a sum of the parts analysis, a blended rate is used, the rate must be weighed by using the value of the real estate relative to the total company value. It cannot be done using cash flows as a denominator. 

I stress once again the importance of recognizing the different risk profiles in a business of this nature. They each must be valued independently of one another if an appraiser is to appropriately consider these risk profiles. The independent values can then be added together to derive a single value indication.