A company (let’s call it … the “Company”!) owns part of an affiliated entity (“Affiliate”!). Affiliate owns real estate used by and leased to Company. Company, by virtue of its part ownership of Affiliate, pays rent to Affiliate and also earns its ownership share of Affiliate net income. (I have TRIED to explain this as well as I can…I apologize if it is unclear.) Let’s keep things simple and assume that Affiliate’s only asset is the real estate and that it has no liabilities, and that we are valuing 100% of Company at fair market value.
How would you value Company’s interest in Affiliate? Specifically, what are the most important questions to ask?
In my opinion, the key questions are: how long will this arrangement last, and are there any plans to sell the real estate, relocate the Company, or change the rental rate from fair market value?
If the answers are: for the foreseeable future, no, no, and no, how would you reflect this in the Company valuation?
I think that, on these facts, the impact of Company’s interest in Affiliate is FULLY CAPTURED on the income statement! This reflects the Company’s actual (fair market) rent expense as reduced by its ownership interest in Affiliate and the income it provides. (We could get into a good discussion about what discount rate or cap rate to apply to the rental income, but that obscures my point, so I will punt on it. The same applies to non-real estate assets and liabilities of Affiliate, which I assumed to be nonexistent, just to keep things simple. They just obscure the main point.) If, as is probable, there is an asset value reported on Company’s balance sheet that reflects the interest in Affiliate, that should be EXCLUDED from the VALUATION, because (1) it is probably at depreciated historical cost or something similar that does not reflect fair market value, and (2) to include the asset value and the rent expense reduction double-counts the value of the partial ownership interest! THAT IS THE CRITICAL POINT. If you use any balance sheet value (say, get the real estate appraised and mark the Company’s interest to fair market value), you could reflect the value there, but then you would effectively be assuming that the interest would be sold, which would eliminate the net rental income that partly offsets the rent expense.