The following example traces the steps we take in a fair market valuation of a minority ownership interesting in a real estate holding entity (“the Entity”). The summary appraisal is prepared in order to provide the owners of the Entity with an independent valuation opinion in connection with gift and estate tax reporting purposes.
During the course of our valuation analysis, we are provided with financial and operational data regarding the Entity. Additionally, we are typically provided with purchase and sale agreements and/or a real estate appraisal reports regarding the real estate holdings of the Entity.
In conducting an appraisal, we consider the asset approach to valuation.
The asset approach to valuation adjusts the book value of the tangible assets of the company to appraised value at the valuation date. The adjusted book value (or net asset value) method adjusts the subject company’s assets and liabilities to fair value. Each component of the business is valued separately, and then summed up to derive the total value of the enterprise after which discounts or premiums are applied where appropriate to reach the fair market value. The asset approach is particularly useful in companies where there is very little or no goodwill, such as a real estate holding company.
Valuation conclusions reached by the asset-based approach generally only apply to a controlling ownership interest. This is because only a controlling stockholder could decide (1) to replace or liquidate the subject assets or (2) to put the assets to their highest and best use under a going concern assumption. Since the Entity is a holding company, we elect to apply the asset approach to value the subject interest.
Adjustments to Net Asset Value
We adjust the book value of real estate holdings to fair market value of the real estate holdings based on the real estate appraisals and purchase and sales agreements. The Net Asset Value (“NAV”) is before the application of any discounts as discussed later in this article.
Discount for Lack of Control
Majority owners have rights that minority owners do not; the difference in those rights, and how those rights are exercised may cause a disparity in the value of a control ownership block versus a minority ownership block. In practice, the minority interest discount can be quantified by reference to prices paid in the public market for a control position in a corporation whose stocks had previously traded as minority interests.
Control Premium Study
The Mergerstat Control Premium Study (“Mergerstat”) tracks acquisitions and computes the premiums paid for controlling interests in publicly traded companies over the market prices at which the stocks of such companies had previously traded as non-controlling interests. The discount for lack of control is the mathematical inverse of the control premium paid.
During the three months preceding the Valuation Date, Mergerstat reports an average and median Discount for Lack of Control (“DLOC”) of 31.1% and 26.6% for 43 transactions. During the 12 months preceding the Valuation Date, Mergerstat reports an average DLOC of 22.7% and a median DLOC of 22.2% for 191 transactions.
Our analysis also considers transactions during the two years prior to the Valuation Date involving real estate investment trusts (SIC 6798) and operators in non-residential (6512) and residential (6513) buildings. The results includes 9 transactions with the average at 14.3% and median at 15.0%.
A closed-end fund, like a public company, issues a set number of shares in an initial public offering and trades on an exchange. Its share price is determined not by the total value of the assets it holds, but by investor demand for the fund. Thus, closed-end funds often trade at a discount or premium from their net asset values. Closed-end funds are similar to minority interests in holding companies.
When valuing a real estate holding company or an investment company, the most appropriate valuation multiple to use for comparative purposes is the price to net asset value multiple. This value represents what a buyer is willing to pay for an interest compared to the pro-rata market value of the underlying assets. The price to net asset value is equal to one minus the discount for lack of control.
Discount for Lack of Control Summary
The value concluded from the asset approach is indicative of a controlling level of value. Because the Interest we are valuing is non-controlling, a DLOC is warranted. The control premium study for real estate entities results in a weighted average of the median and average discounts of 15.0%. The closed-end funds sample resulted in a median DLOC of 11.0% and a third quartile discount of 14.4%. Based on this sample data, we apply a 13.0% discount for lack of control for an ownership interest in the Company.
Discount for Lack of Marketability
In contrast to shares of stock in public companies that have an active market, ownership interests in closely held entities are not readily marketable. Consequently, it is appropriate to apply a discount to the value of these interests to reflect the reduction in value attributed to the lack of marketability. To determine the magnitude of the discount for lack of marketability (“DLOM”), we review restricted stock studies which computed the average discounts by comparing restricted and unrestricted shares of stocks in the same corporation. Based upon the comparison of the subject company as compared to the financial and liquidity factors of companies in the restricted stock study, we ultimately apply a 10% discount for lack of marketability for an ownership interest in the Entity.
Total Discount reconciliation
To determine the magnitude of the total discount taken, we review market data related to transactions in real estate limited partnerships. We review statistical data published by Partnership Profiles, Inc. (“PPI”) publishes annual surveys that report the level of price-to-value discounts at which non-controlling interests in non-listed real estate limited partnerships and real estate investments trusts are being purchased in the secondary market. The underlying data covers real estate partnerships that represent a cross section of distributing equity partnerships, non-distributing equity partnerships, and triple net lease partnerships.
All of the partnerships are publicly registered with the SEC, but none are publicly traded on any formal exchange. Units of the partnerships change hands in the informal secondary market which is comprised of independent securities brokerage firms that act primarily as intermediaries in matching up buyers and sellers. The results of the study reveal that the two most important factors related to discounts from NAV considered by buyers in pricing units of real estate partnerships are (1) whether the partnership is paying regular cash distributions and (2) the degree of debt financing utilized by the partnership. The price-to-value discounts in the PPI database imply discounts for both lack of control and marketability and are primarily influenced by distributions and leverage.
Total Discount Summary
In this example we assume that the Entity is a real estate holding company that has a history of making distributions. As such, the Entity’s total implied discount would warrant comparison to distributing partnerships. We compare the observed discounts to the total discount for the subject interest of 21.7%, at the selected DLOC and DLOM of 13% and 10%, respectively. Based on the results of the comparison, the combined discount is reasonable as compared with the PPI guideline data points as it falls between the discounts for all partnerships and distributing partnerships.
Our analysis applied the asset approach, using the net asset value method. Based upon the foregoing review and analysis, we applied a combined 21.7% to the NAV of the Entity in order to arrive at the fair market value of the minority interest that is being considered for gift and estate tax purposes.