Rental real estate can seem like a very simple business. There is a piece of property. This property gets leased to tenants that pay rent to the property owner. The property owner then pays expenses (taxes, utilities, repairs, etc.), likely pays the bank, and then keeps what is left. Although it seems simple, there are a large number of iterations of this scenario that play out in reality. All of these iterations can go a long way to impact the value of the property and the entity that owns the property. There are a lot of questions that need to be answered. A few that come to mind are:
- Who is the tenant? Are the property owner and tenant related?
- Who is responsible for paying what? Does the tenant pay property taxes or the landlord?
- How is the lease structured? Is it long-term or short-term? Are there rent escalations built in?
All of these items, among many others, are considered when determining the value of a piece of property. There are qualified real estate appraisers that can handle the valuation of the rental property. The methods that real estate appraisers use are similar to that of business valuation experts, however the real estate appraiser focuses solely on real estate, while the business valuation analyst typically appraises operating businesses, securities, and holding companies. The parallels are summarized briefly in the table below:
| Approach | Real Estate Appraiser | Business Valuation Analyst |
|---|---|---|
| Income Approach | Apply a cap rate to Net Operating Income of the property (gross rents minus cash expenses other than interest) | Apply a cap rate or discount rate to a stream of cash flow from the business (typically EBITDA or adjusted cash flow to invested capital) |
| Market Approach | Examine comparable sales of similar properties (location, sq ft, amenities, lease terms, etc.) | Examine comparable sales of similar companies (industry, annual revenue, EBITDA, etc.) and apply a multiple to the subject company |
When there is a holding company situation in which there is (typically) an LLC that owns the rental property, a real estate appraiser and business valuation analyst are both often engaged and operate in conjunction. The real estate appraiser determines the fair market value of the property, and the business valuation analyst determines the fair market value of the specific partnership interest in the LLC that owns the property.
An additional consideration is made at this point for the specific control and marketability characteristics of the partnership interest. It may not be enough to just take a pro-rata ownership of the Company’s equity as calculated by adjusting the balance sheet to fair market value. It often makes sense to adjust the fair market value of the partnership interest for a lack of control. The balance sheet adjusted to fair market value assumes that the balance sheet would be liquidated and the net equity distributed to the partners. However, if a specific partnership interest does not have control over the Company’s operations, a discount is likely warranted.
Valuation issues often arise in entities holding real estate. DKB’s valuation team has a wealth of experience in valuing partnership interests for a wide range of purposes including estate/gift tax, partner buy-ins, and other transactions. Contact a member of TeamDKB’s Valuation Team today to see how we can help.
