How do you value minority interests in operating companies owning real estate? Do you ignore the real estate? If not, how do you value (and discount) it?
Consider three alternatives for an operating business and the real estate:
A. It leases real estate at fair market rent.
B. It leases real estate at other than fair market rent.
C. It owns real estate.
The A case is the baseline. We value the enterprise and discount the minority interest normally. Assume the lease cannot be broken and can be renewed perpetually at fair market rent. There is no effect from the fair market value real estate rent.
The B case has a leasehold value that must be included in the value of B’s equity. If the lease is at less than fair market rent, the leasehold value is positive and B’s stock is worth more than A’s. If the lease is at greater than fair market rent, the leasehold value is negative and B’s stock is worth less than A’s. The difference is the leasehold value. It is computed using the Income Approach
(the difference between actual and fair market rent, discounted at something above the risk-free rate but less than the cost of equity capital). I cannot see any differences in the LOCD or LOMD for A versus B because of the assumption that the lease is perpetual and non-breakable. The leasehold value is an addition to or subtraction from A’s equity value.
The C case is the one of interest. I think the way to handle it is to divide C into two parts. One, the operating business, leases the real estate at fair market rent, just like A, and has the same value and discounts. The other owns the real estate, leases it to the operating business at fair market rent, and owes real-estate related debt. (There will be issues about how much debt is real estate-related and which expenses are allocated to the real estate versus the operating business.) Value this “holding entity” as you would a FLP or an LLC using the Asset Approach. Consider the appraised fair market value of the real estate, built-in capital gains, implied net rent income and compute specific discounts for it as if it were a separate entity. Assume that all cash flow is distributed (since in reality it is, accruing to the company). Alternatively, use the Income Approach and capitalize or discount the cash flows. Either way, add the values of the two parts to value the equity of C. This assumes the real estate will be held indefinitely; if case facts dictate otherwise, use only the Income Approach and specify the sale date, proceeds, expenses, capital gains taxes, etc. The Asset Approach does not work as well if there is going to be a (later) sale.
As I see it, this methodology captures all of the relevant cash flows under the Income Approach and the assets and liabilities under the Asset Approach and lets you value them appropriately at the enterprise level and then apply separate, justifiable valuation discounts to the operating and real estate related parts of the business. It is a way of breaking out the real estate from the operating business, whether leased or owned, and separately calculating the impact of leasing versus owning (and debt financing). It could be very helpful to a business owner deciding whether to sell their real estate, buy it (how to finance it), or lease it.
With this framework in mind, we can compare the baseline A case (business leases real estate at fair market rent) with the C case (business owns real estate) and highlight the differences:
C has an additional asset – the real estate, valued at appraised fair market value – and may have an unrealized capital gain (and associated tax liability) or loss (and associated tax savings).
C may have additional debt associated with the real estate.
C has an equity interest (which could be negative if debt exceeds the fair market value) in the real estate.
C has a leasehold interest in the real estate – the difference between fair market rent and real estate ownership costs such as taxes, maintenance, and utilities – that is positive if fair market value rent exceeds ownership costs and negative if it does not.
The first three differences are captured in the Asset Approach and in the Market Approach (where the real estate value is added and debt deducted as non-operating items). If you use earnings in the Market Approach, they have to be restated with rent at fair market value. It is clear from this that the Market and Asset Approaches assume that the real estate will be liquidated immediately: we include the real estate value at current fair market. It is also clear that the Income Approach assumes the real estate will be held indefinitely. If the real estate is going to be sold in the future, you have to use the Income Approach, modeling the timing of the sale, capital gains tax liabilities (or benefits), as well as replacement rent (or purchase).
The fourth difference shows up in the Income Approach. Here, the value of owning the real estate derives from and is included in the leasehold (the present value of rent savings). The real estate is assumed to be held perpetually. This brings me to conclude that you would not add the (fair market) value of the real estate to your value conclusion under this Approach. That would be double-counting it with the value of the rent savings. Stated another way, the value of the real estate is captured “in use” by the rent savings it creates. It is not going to be sold, so you should not add its value when already taking the rent savings into account.