Marital Assets

These types of businesses operate with the real estate, or land plus building improvements, as special purpose businesses that often attract customers because of location. This special-purpose property may be the major asset of the business in which your client holds equity.

Different Business Methods

Generally, the interaction of real estate assets and an operating business will occur in one of three ways:

1. The business rents (leases) real estate from an arm's length party. Without any evidence of collusion, the rent paid is probably OK. However, rent could be less than normal market demand because of a quid pro quo arrangement with another business. Also, long-term leases might be set to expire, and absent renewal at the same rate, rent would likely increase in the future. In addition, any significant changes in the real estate market prior to a renewal should be considered, which would likely require the assistance of a real estate appraiser.

Consider the expense structure for both the contract rent and the market rent. Expense structure refers to the responsibility between the lessor and lessee for the payment of real estate operating expenses, such as real estate taxes, building insurance, repairs and maintenance, utilities, janitorial services, etc. It is important for the market rent to assume the same expense structure as the contract rent. If not, it must be considered in any adjustments to the business rent. In some instances, such as for some restaurant tenants, a lease may contain a percentage rent clause that requires additional rent to be paid based on the tenant's business revenues. If the real estate appraiser reflects this additional income, then the business appraiser must be careful not to also reflect it within the business valuation. Investigate these areas to ensure that the rent paid is reasonable at a market-rate-based level and that the future will reflect the same consistency.

2. Real estate is held within a separate corporate wrapper, such as an S-Corporation, partnership or LLC that is owned by the same owners of the business, and rented/leased to the operating company. Actually, the opportunity for misrepresentation in these circumstances is significant. The owner of both entities could charge excessive rents from the operating company to avoid certain taxes, or for other reasons. Conversely, rent could be “waived” if the operating business is in trouble. At times, an operating business may suffer from cash flow problems, and rent may be reduced or not paid at all in order to conserve cash in the business.

In a divorce, both real estate and operating business equity should be appraised. Most of the time, the accountant will accrue the rent owed as a liability. However, you may find sloppy accounting where the actual rent payment is hidden or not recorded properly. If the real estate appraisal utilizes the Income Capitalization Approach, a market rent may be provided in the appraisal. In addition, a real estate appraiser can be engaged to perform a separate assignment ' to estimate the market rent. In either case, compare the market rent to the rent that is actually paid by the business. However, if the marital asset is a minority interest, it still may not be appropriate to make adjustments for any differences between market rent and contract rent: Minority shareholders cannot force management decisions. Generally, you should not be looking for an accounting adjustment, but merely a sanity check that the rent paid is not grossly inflated or minimized.

3. Real estate is held within the business entity itself. No rent is paid and the accounting records show no occupancy costs. This situation is perhaps the most dangerous for a business appraiser because with no imputed rent, the real estate becomes an operating asset. In income and market methods, operating assets are not added back to calculated value. However, the business transaction databases, such as Pratt's Stats and Bizcomps, specifically exclude real estate value in calculating multiples. But unless the appraiser reads the comments in Pratt's Stats or calls the broker submitting the Bizcomps data, inaccuracies may arise. You may find situations where Business A (which holds real estate outside of the operating company and pays rent), is valued less than identical Business B (which owns its own real estate and pays no rent) because the apparent cash flow is higher in “B” than in “A.” Business appraisers could adjust expenses for market rent, and add back the real estate as a separate asset.

Understand the Mechanics

In an asset (or cost) methodology, the property should be independently appraised by a qualified real estate appraiser. However, without a viable and profitable going concern operation utilizing the special-use real estate property, the real estate improvements may have minimal value, if any. These results should be adjusted into the accounting balance sheet along with other estimates of intangible assets on a going-concern basis. Ensure that you understand the steps in the appraisal inquiry, because of lapse of appraisal (and legal) judgment could cost your client money, leading to unhappiness and more.

Recommendations

• With these types of marital equities, communicate with a local real estate appraiser to help to determine the appropriate rent. You could ask the real estate appraiser to either appraise only the underlying land value or provide an allocation of the market value between the land and the improvements. Be sure to compare contract rent and its estimated market rent on the same consistent expense structure.
• Ensure that your business appraiser is talking to a competent real estate appraiser (or broker) to understand the nuances of the business and reasons for customer patronage. A site visit is a must!
• Where your subject equity is a controlling ownership position, not a minority one, the real estate may be in a notably desirable location that could generate a substantially higher value than the carrying value in the operating business itself. Think of key corner property held by a troubled and shrinking restaurant business, with increasing traffic counts that other owners would covet. In some cases, the highest and best use of the real property may require the demolition of the existing improvements if the real estate appraiser concludes that the highest best of the real property is as vacant land. If so, be prepared to argue for liquidation of the business (with liquidation costs) and sell the real estate!
• A real estate appraiser should consider the property's functional obsolescense, particularly if machinery and equipment are involved. Functional obsolescence occurs when property is poorly maintained or loses its utility, and therefore a deduction must be made. The real estate appraiser should also consider the potential for both functional and external obsolescence in the context of the real estate. Make sure that the real estate appraiser and the business appraiser don't both pick up the value of the embedded equipment or other personal property.

Conclusion

The next time your client presents a marital asset that includes a going-concern real estate centered business, your antennae should stick up! No formula or magic wand will give you a quick answer of value. Do your homework and beware of missed assets or double-counted assets.

Rob Schlegel, FASA, MCBA, a member of this newsletter's Board of Editors, and Ethan Buchman are with Houlihan Valuation Advisors in Indiana. Wayne Baer, MAI, CPA, ABV, is an independent real estate appraiser in Indiana.