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21 Aug 2015

Valuation of a Real Estate Holding Entities

Single family house on pile of money

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.

Asset Approach

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%.

Closed-End Funds

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.

Valuation conclusion

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.

27 May 2015

Valuation of Finance Receivables

cards_2222752aOur professionals at Brookline Valuation Services (“BVS”) were recently involved in the estimation of fair value of Finance Receivables of a Company, which provides consumers an alternative method of paying for services and products. The valuation was done in accordance with the Financial Accounting Standards Board (FASB) Accounting Standards Codification (ASC) Topic 825, which requires disclosures about the fair value of all financial instruments.

The primary business of the Company is the extension of credit to consumers through merchants (the “Merchants”) participating in the Company’s program throughout the United States. The Company’s network of Merchants include dental and medical markets, eye care, hearing aids, specialty beds, fitness equipment, and other various services and products. The Company extends credit to customers of Merchants using a system whereby the prospective credit applications are screened on an expedited basis. Based upon the consumer credit rating and underlying Merchant agreement, the Company extends or declines credit to an applicant for use at a Merchant on a nonrecourse or recourse basis. When credit is extended on a recourse basis, the Merchants are typically required to maintain a reserve account with the Company to offset any future losses.

The most appropriate valuation methodology was deemed to be the discounted cash flow analysis. In the first step of the analysis, with the help of BVS professionals, the Company developed a set of projected cash flows that are expected to be collected from finance receivables in place as of the Valuation Date.

The cash flows were examined for:

  1. Analysis of historical and expected delinquency and charge-offs rates;
  2. An analysis of the Company’s finance receivable historical performance and how this compares to their projected performance;
  3. Risk factors facing companies within the industry.

Once a benefit stream was determined, the second step in the income approach was determining the discount rate to be applied to the benefit stream.

How do you determine a discount rate for an asset already in place? The projected cash flows of finance receivables already incorporate the risk of delinquency and charge-offs. The majority of the risk is related to the opportunity cost of not having all the receivables collected today, but rather spread over a five year period.

Ultimately, the methodology used to estimate the discount rate was similar to the methodology of developing rate of returns on individual assets in the Purchase Price Allocation under the ASC 805. In other words, the starting point for the development of the discount rate applicable to finance receivables was the estimation of the discount rate applicable to the cash flows of the enterprise.

The development of the discount rate was based on a variety of factors including perceived similar returns available in the marketplace.  The more speculative the benefit stream, the higher the discount rate, and conversely, the more stable the benefit stream, the lower the discount rate.

Eventually, the discount rate applicable to the estimation of Fair Value of Finance Receivables was based on after-tax short term rates, which would have been available to market participants. We gave significant consideration to the mix of debt and equity financing required to fund these Finance Receivables, with the majority of the financing available in the form of debt.

06 Sep 2014

Bargain Purchase Transaction

Great Deal - Arrows Hit in Red Target.

September, 2014

Brookline Valuation Services recently prepared a valuation report that estimated fair values of certain identifiable intangible assets of an acquired company. The valuation was used by the acquirer for financial statement reporting purposes.  The key unique feature of this particular transaction was the presence of negative goodwill.

One of the first steps in the allocation process is to ascertain the reasonableness of the purchase price and implied internal rate of return. This involves considering the value of the acquired business as a whole.  We have utilized a discounted cash flow methodology for this analysis. Management provided revenue, earnings and cash flow projections.

The business enterprise analysis is essentially a calculation to determine the implied internal rate of return (IRR) from the acquisition. The indication of value, as developed from the cash flow projections provided by management should approximate the purchase price. The discount rate is the implied internal rate of return necessary to equate the cash flow stream to the purchase price. Reconciliation of this rate of return with the weighted average cost of capital (WACC) and weighted average return on the assets (WARA) acquired is an important step in determining the reasonableness of the underlying assumptions and indications of value determined in this report.

The implied IRR was significantly higher than the WACC and WARA. If an IRR is higher, oftentimes there is an indication of a bargain purchase situation. In other words, the purchase price, for the expected cash flows, was lower than what a market participant would likely expect to pay for the Company resulting in the higher implied rate of return on the acquisition.

As a result, the purchase price allocation results in negative goodwill.  Goodwill is calculated as the residual difference between the purchase price and the fair value of the tangible and intangible assets acquired and liability assumed. Under ASC 805, negative goodwill is not recorded, but rather, if a bargain purchase is considered, the related gain should be recognized as of the acquisition date.

ASC 805 defines a bargain purchase as a business combination in which the total acquisition-date fair value of the identifiable net assets acquired exceeds the fair value of the consideration transferred plus any non-controlling interest in the acquiree, and it requires the acquirer to recognize that excess in earnings as a gain attributable to the acquirer.

Generally speaking, a bargain purchase is rare. However, for the subject acquisition there were factors that drove down the purchase price, resulting in the bargain purchase and gain recognition.

The seller of the assets had become motivated due to prolonged lapse of time between entering into a plan of divesture the target company and the ultimate sale caused by a previous failed sale transaction with another buyer.

As a result of the unique circumstances surrounding the subject acquisition, and considering the current fair value standard, it appears reasonable a gain would be recognized.

How often do you see bargain purchase especially in the current economic environment?