Intangibles in Going Concerns Client & Valuation Perspectives

2. Intangibles in Going ConcernsClient & Valuation Perspectives Presenter: Leslie P. Sellers MAI SRA

3. Objectives of Presentation • Review definitions and fundamentals • Show examples of Going Concerns • Identify Clients for this type of appraisal assignments • Assist clients in understanding the requirements • Recognize that controversies exist • Identify where the controversy exist • Bring clarity with facts and personal opinions on the issues • Review of “some” methods with reviews and examples • Provide resources for further study • Provide framework for moving forward

4. Definitions • Going Concern: A going concern is an established and operating business with an indefinite future life. For certain types of property (e.g., hotels and motels, restaurants, bowling alleys, manufacturing enterprises, athletic clubs, land fills), the physical real property assets are integral parts of an on-going business. (The Appraisal of Real Estate, 14th Edition, The Appraisal Institute, Chicago, Illinois, U.S., 2013, page 63) • NOTE: Going Concern is an entity description – not a value (e.g. ‘going concern value’ in NOT an appropriate term)-Market value of a going concern-Market value of total assets of the business-Market value of specified assets of the business (must specify)

5. Definitions • Real Property Characteristics: Items that have been installed or attached to the land or building in a permanent manner. All real estate improvements were once personal property; when attached to the land, they become real estate. Examples:LandBuildingsFixtures e.g. plumbing, lighting, HVAC, etc.(The Appraisal of Real Estate, 14th Edition, The Appraisal Institute, Chicago, Illinois, U.S., 2013, page 7)

6. Definitions • Personal Property Characteristics: Movable items of property that are not permanently affixed to, or part of, the real estate. Personal property is not endowed with the rights of real property ownership.Examples:Furniture and furnishings not built into the structureEquipment installed by the tenant under specific lease terms removable at end of the lease(The Appraisal of Real Estate, 14th Edition, The Appraisal Institute, Chicago, Illinois, U.S., 2013, page 7)

7. Definitions • Intangible Asset Characteristics: Those assets that are not tangible real property, tangible personal property, or financial assets. An intangible is something that is not material, not corporeal, not substantially real. Examples:Franchises and licensesGood willSkilled workforce(The Appraisal of Real Estate, 14th Edition, The Appraisal Institute, Chicago, Illinois, U.S., 2013, page 7)

8. Definitions • Intangible Business Value: Whenever the income to a property includes payments for goods or services other than real property rents, the property potentially includes non-real property assets that needed to be addressed appropriately. The presence of services that generate income over and above rent on the real property may create intangible property value. (The Appraisal of Real Estate, 14th Edition, The Appraisal Institute, Chicago, Illinois, U.S., 2013, page 703) • Nomenclature is abundant in real world: • Intangible Business Value …aka • Intangible Personal Property …aka • Business Enterprise Value …aka • Enterprise Value …aka • Blue Sky …aka (more appropriate for only good will) • Business Value …aka…XXXXXX • Economic Profit …….

9. Definitions Source:(The Appraisal of Real Estate, 14th Edition, The Appraisal Institute, Chicago, Illinois, U.S., 2013, page 705)

10. Examples

11. Examples

12. Typical Clients • Owners of Going Concerns • Buyers of Going Concerns • Accountants and Auditors (VFR) • REITS, Pension Funds, Insurance Companies • Attorneys, Property Assessors • SBA Lenders if a “Qualified Source” • Commercial Banks, Credit Unions (Federally Regulated)

13. Typical Clients • Owners of Going Concerns • Buyers of Going Concerns • Accountants and Auditors (VFR) • REITS, Pension Funds, Insurance Companies • Attorneys, Property Assessors • SBA Lenders if a “Qualified Source” • Commercial Banks, Credit Unions (Federally Regulated)

14. Allocation or Not? Allocation of Value Opinions Standard Rule 1-2(e) requires an appraiser to: • Identify the characteristics of the property that are relevant to the type and definition of value and intended use of the appraisal, including; • Any personal property, trade fixtures, or intangible items that are not real property but are included in the appraisal. Standard Rule 1-4(g) states: • When personal property, trade fixtures, or intangibles are included in the appraisal, the appraiser must analyze the effect on value of such non-real property items. (USPAP 2014-2015, The Appraisal Foundation)

15. Allocation or Not? Scope of Work Rule • First, appraiser must figure out problem to solve • Identify assignment elements (Through Consultation) • Standard Rule 1-2(e) identification of relevant property characteristics (FF&E, Intangible, RE, etc.) • Second, determine appropriate scope of work needed to solve the problem for the intended use and user. • NOTE: The scope of work is the responsibility of the appraiser according to USPAP.

16. Allocation or Not? • USPAP – FAQ 193 - Question: There are also occasions when the client does not specifically request separate valuations of non-real property assets, even though they may be present. Is the appraiser still required to value those assets separately?

17. Allocation or Not? • Answer: No. This is a scope of work decision to be made by the appraiser; Standards Rule 1-4(g) does not require separate appraisals of these different types of assets. Some appraisers and users of appraisals believe the requirement that the appraiser must analyze the effect on value of such non-real property items in SR 1-4(g) is a requirement for the separate appraisal of those items in all assignments. That is incorrect. Analyzing the effect on value might be appropriately made through the selection of comparable properties used in the sales comparison approach or the deduction of certain line items of expense for management fees, maintenance or replacements in the income approach, for example.

18. Allocation or Not? • Standard Rule 1-4(g) to value versus to identify and analyze is a scope of work issue. • Appraiser must produce a “credible” work product for the intended use.NOTE: USPAP definition of credible is “worthy of belief.” • The key is client communications…

19. Interagency Appraisal Guidelines

20. Interagency Appraisal Guidelines

21. Interagency Appraisal Guidelines

22. SBA Lending Guidelines

23. SBA Lending Guidelines

24. SBA Lending Guidelines

25. Ad valorem Property Assessment(Attorneys and Property Assessors) • An ad valorem tax (Latin for "according to value") is a tax based on the value of real estate or personal property. • “Typically” intangible business value is not a part of it. • (Business tax is a separate tax) • Allocation of real property and personal property is required • Ad valorem property tax rules are on a jurisdiction-by-jurisdiction basis • Intended use and Intended User may affect the value as a result. (Law states what is Real Property and what is not)

26. Ad valorem Property Assessment(Attorneys and Property Assessors)

27. The Controversy • The controversy is notthe valuation of a going concern. • The controversy isin the allocation of the component values in two areas. • Allocation of the total market value (aka - contributing value) • Which method is proper for the allocation

28. The Controversy • When you participate in the discussion of allocation…..

29. The Controversy • Independent market value of component or allocated contributive value of the component to the whole? Some have opinions… • Wilson book “Going Concern Valuation” • Wilson RICS presentation stated the “Value construct”: • The “value construct” states for value to exist there must be: 1. Demand 2. Utility 3. Scarcity 4. Transferability (actual sales) • Wilson conclusion: Therefore, if one of these elements is missingthere is no value.

30. The Controversy • Wilson RICS presentation: • “Far too long we have been duped into believing because the math is correct there must be value.  That is simply not the case. Just because an appraiser can perform a mathematical formula, such as the Excess Earnings Method, they need to understand that if there is no market support for that conclusion then the math becomes a magical mathematical manipulation, and not a representation of market participants. ”

31. The Controversy • My opinion: I disagree with Wilson • (in most cases the scope requires “allocation” or “contribution”) • But, intended use “could” require independent market value • Why disagree? • The “value construct” is for “market value” (independent) • Most cases the values are “allocations or contributing value” • Scope of work and intended use and user are critical • USPAP FAQ-194 – “Analyzing the effect on value might be appropriately made through the selection of comparable properties used in the sales comparison approach or the deduction of certain line items of expense for management fees, maintenance or replacements in the income approach, for example.” (NOTE: does not state comparable sales must exist)

32. The Controversy • Example of accepted theory with no sales: • We value real property interest all the time based on “the present value of future benefits” • What about sub leasehold or sandwich lease position value? • “Although the market values of leased fee and leasehold positions are often said to be “allocated” between the two (or more) interests, each interest must be valued on its own merit. The results can then be compared with the valuation of the fee simple interest. Because a leasehold or a leased fee interest is based on contractrights, appraisers differentiate between lease provisions that are generallyrepresentative of the market and other elements of a contract that arenot typical of the market.” (The Appraisal of Real Estate, 14th Ed, page 441)

33. The Methods • 60+ different methods and counting… • Many are slight variations of each other • Appendix of Course 830 has listings and sources on all noted • Cost – Cost Extraction • Management Fee • Parsing • Market Participants

34. Cost Extraction Method • Based on the extraction between Cost Approach (fee simple) and the reconciled value from other approaches which is going concern. The extraction is the residual business value. • Particularly useful in situations where sales of total assets of going concerns are the only sales available. • Care must be taken when using this approach because cost is not always equal to market value. • Amount and type of depreciation existing in the asset play a role in the effectiveness of this approach. Source: The Appraisal of Real Estate, 14th edition, Chapter 35.

35. Cost Extraction Method • A six-year-old, 90-bed assisted-living facility has an estimated market value of the going concern equal to $6,750,000. The land value has been estimated at $900,000, and the depreciated value of the improvements is estimated at $5,200,000. The estimated value of FF&E is $450,000. What is the allocated market value of the intangible assets?Source: Course 830 Fundamentals of Separating Real Property, Personal Property, and Intangible Business Assets course materials (Chicago: Appraisal Institute, rev. 2012)

36. Management Fee Method • Based on the theory that once the revenue attributable to intangible assets is deducted, all other remaining income is attributable to the real property and other tangible assets. • By removing management fees and franchise fees from the revenue, appraisers reason that the influence of intangible assets has been eliminated. • Critics state flawed because: • the value of intangible assets and rights cannot be removed by merely deducting the related expenses from the income stream to be capitalized; allowing a deduction for the associated expense does not allow for a return on the capital expenditure. Source: The Appraisal of Real Estate, 14th edition, Chapter 35.

37. Management Fee Method Step 1

38. Management Fee Method Step 2 Source: Adapted from the article, “Why the ‘Rushmore Approach’ is a Better Method for Valuing the Real Property Component of a Hotel” by Stephen Rushmore, A Business Enterprise Value Anthology, 2nd ed., 2011.

39. Parsing Method • Based on the business valuation methodology called the excess earnings method, which was developed by the US Department of Treasury in the 1920s. Parse income and expenses into different asset classes then capitalize • Good applicability for odd property types especially – income always available on going concerns because that is what they generate • Critics state flawed because: • identification of appropriate cap rate difficult • for using a percentage deduction from income to quantify the value of both the franchise and residual intangibles. • the deductions for a return on the various components of the going concern, which create an opportunity for double-counting unless caution is exercised by the appraiser. • Must be careful with parsing “priorities” in the factors of production Source: Critics statements are taken from The Appraisal of Real Estate, 14th edition, Chapter 35 on all but the last bullet point which is added by the author.

40. Parsing Method Step 1 Source: Appraisal Institute Course 830 – Fundamentals of Separating Real Property, Personal Property, and Intangible Business Assets, rev. 2012.

41. Parsing Method Step 2

42. Market Participants Method • Based on the interviews with market participants and, in some cases, regulatory filings may be used to assist in understanding value allocated to intangibles on sales. • Appraisers interview market participants to ascertain how buyers and sellers of those properties value or allocate intangible assets in pricing decisions. Goal is to determine the thinking of market participants on these issues • Critics say flawed because: • survey responses of buyers and sellers may be influenced by tax or financial considerations • Buyers and sellers may not have a need or motivation to allocate • Not really a method at all but only part of normal verification requirements of standards Source: The Appraisal of Real Estate, 14th edition, Chapter 35.

43. Appraisal Institute LumLibrary Valuation Resources

44. Other Sources Valuation Resources

45. Other Sources – Appraisal Institute Course 830 Has 3 Main Goals (Teaching points) Recognize Indicators that BV may exist Recognize how BV changes over time Goes over basic allocation methodologies Valuation Resources

46. Proposed Framework for SolutionsAdvancing with 8 agreed principles • Rights supported by contracts versus real propertygenerally have higher risk (all other being the same) • Investment premise requires return on and return of the investment • Going concern premise means contributing value of the whole versus independent value for each part • Method used for allocation should pass test of reasonableness • Encourage more than one method and reconcile when possible • No black boxes and no rules of thumb (Daubert) • Each property analyzed independently based on merits • Professional responsibility for proper application of the methodology

47. Questions & Answers