We are often asked by our clients why we need to adjust the rent paid by a business in a business valuation; and more specifically why we request a copy of the real estate appraisal (if one has been ordered). If a business rents its real estate from an independent third party (arms-length lease), it is typically not necessary to make any rent adjustments. However, the following scenarios would indicate a close relationship between the owners of the company and real estate (non-arm’s-length relationship):
- The business (company) itself owns the real estate
- The owner(s) of the business personally own(s) the real estate (on Schedule E)
- A separate but related real estate holding entity owns the real estate (e.g.: EPC/OC)
Any of the scenarios above would require the appraiser to adjust the existing rent expense that the business pays to be in line with a fair market rent. Appraisers must assume that a hypothetical buyer of the business will not benefit from the existing close relationship between the business and real estate. Due to this close relationship, the business may pay an arbitrary amount of rent, which can be based on tax strategies, existing (and outdated) debt service covenants or frankly, any other reason the business owner chooses. By adjusting the rent that the business pays to the fair market rent, the adjusted EBITDA can then be used to determine the fair market value of the business. Additionally, the resulting value of the business does not include any cash flow that would be utilized when appraising the real estate – in essence, you are not double counting the rent.
Reliant Business Valuation utilizes the following methods to estimate fair market rental rates:
- Real Estate Appraisal (most accurate method): If the income approach is utilized within the real estate appraisal, the business appraiser is able to use the real estate appraiser’s fair market rental rate (rent per square foot or annual rent) to make a rent adjustment. Alternatively, if the income approach is not utilized, the appraiser can apply a capitalization rate (defined as the potential net operating income produced by real estate, divided by its capital cost) to the market value of the real estate (capital cost) to determine its fair market rent (net operating income). Using the income approach, and assuming a capitalization rate of 10%, the value of commercial real estate with net operating income of $100,000 would be $100,000/10%, or $1,000,000. Therefore, if the estimated value of real estate is $1,000,000 with an estimated 10% capitalization rate, the fair market rental income (triple-net) would be $100,000.
- Estimate with Online data (if available): If a real estate appraisal is not available, the business appraiser would find comparable rents online for similar facility types to the subject company, in the same city and state (or surrounding area). This method is not always applicable, as certain facility types (such as large day care facilities and auto repair shops) are not always readily available for lease.
- Buyer / Seller lease (if real estate is not being sold): If the real estate is not being sold as a part of the proposed transaction, the owner of the real estate will create a new lease (or draft terms) for the owner of the business. As this is the proposed rent moving forward and is assumed to be fair market based on the arm’s length relationship between the parties, the appraiser can utilize the negotiated annual rent for the adjustment. If the agreed upon rent is clearly a non-fair market rent (or the lease is not assumable by a new tenant, which may indicate non-arm’s length), the appraiser should utilize online data, as discussed above.
The tables below depict the difference between an appraiser’s cash flow and a lender’s cash flow, and reflect a scenario in which the buyer of the business will own the real estate under a separate holding company (Eligible Passive Company/Operating Company [EPC/OC] structure). The appraiser must add back all rent paid to the real estate holding company (if any) to the earnings, and then subtract out a fair market rent (based on the methods discussed above). Conversely, the lender adds back all rent paid to the EPC by the OC, as the lender focuses on cash flow available to service debt for the combined EPC/OC project, rather than the fair market value of the business.
For further information on calculating cash flow, read our SBAvalue Newsletter Calculating Cash Flow (appraiser vs. lender). For more information on appraising Special Purpose Properties, read our previous SBAvalue Newsletter Appraising Special Purpose Properties.
If the real estate is being sold as a part of the proposed deal, it should be noted that a real estate appraisal is the most accurate way of determining a fair market rent. If a real estate appraisal has been ordered by the client, it is usually in the best interest of the client to wait for the completion of the real estate appraisal before receiving the completed business valuation (unless deemed unnecessary by the business appraiser). If fair market rent is estimated by the business appraiser and the real estate appraisal eventually concludes a different fair market rent than estimated by the business appraiser, an update to the business valuation would be required (Reliant Business Valuation does not charge for this type of update).