Holy Grail or Can of Worms?

“If we only had transactions of fractional interests…” is an oft-stated lament from judges and others who need persuasive evidence of fractional interest value but are understandably frustrated by sometimes obscure expert arguments. Fractional interests in real estate are generally valued using proxy methods—applying public limited partnership data, restricted stock studies and the like, since actual transactions of privately-held partnership and common tenancy interests are rare. But the relevance of proxy methods to the fractional interest at hand is not always made clear or persuasive (see Case of Ludwick, T.C. Memo. 2010-104, for example), so it is understandable that the trier of fact would seek evidence that is more intuitively useful.

This idea is probably attractive because the best-understood property type is single-family residential, for which the valuation process is the well-known sales comparison approach. In that approach, the appraiser finds similar properties that have sold, and then applies their value indications to the subject property. If we came up with comparable transactions that could be applied to fractional interests in the same way, it would be like “finding the Holy Grail,” right? Maybe. But more apt idiom would be like “opening a can of worms.”

Methodology

Sales comparison is a real property approach to value in which the appraiser finds comparable properties, adjusts for transactional elements such as nonmarket conditions of sale, price trends and property rights, and then further adjusts for elements of comparison (square footage, site area, design and appeal, location, etc.). The adjusted sale prices are reduced to appropriate value indications (price/square foot, price/unit, total price in the case of single-family residences, and many others) and then applied to the subject property. This process is described in great detail in the Appraisal Institute’s The Appraisal of Real Estate, (15th edition, chapters 20–22), is well-understood by real property appraisers and does indeed produce persuasive and logical evidence for value.

But how would this process work when the interest being valued is not the whole property, but an undivided, fractional interest in the property? The distinction brings up many issues that must be resolved in order for the comparison to produce useful value indications. First, the process of analyzing single transactions lies entirely within the real property appraisal domain; there is no useful parallel in business valuation. Fractional interest valuation is a multidisciplinary practice, requiring that practitioners learn to ask the right questions in the other discipline’s language. Sales comparison is a big deal in this respect.

Data Availability and Reliability

Second, data sources (such as they are) are far smaller in number, far more opaque, and much more difficult to understand than they are for whole property transactions. The latter are publicly recorded, offered for sale in an active, brokered market with multiple listing and other data services. Unusual conditions of sale can be spotted by appraisers, and confirmed with parties to the transactions. Widely available information usually means that buyer and seller are reasonably informed and knowledgeable, with brokers assisting the process. All of which works just fine. However, fractional interest transactions have substantially none of these features, making finding, researching, and extracting their value indications extremely difficult.

Removing Intangibles

Further, even if the researcher can determine the price paid and percentage interest transferred, many possible and even likely conditions affecting value still might have been present and must be confirmed. What exactly were the expectations of buyer and seller? Why did they enter into the transaction? Did the buyer realize any intangible benefits such as access to onsite resources (timber, minerals) or personal usage? Were personal relationships involved? Were there any agreements? Where there buyback or other exit provisions? Any of these ?elements can cause enormous variations in the value indication—the discount from owner’s equity—the appraiser is seeking. It is essential that parties to the transaction be interviewed to answer these questions.

Another problem is that price is just one component of the discount calculation, the other being the underlying equity or net asset value. This means that the valuer must also obtain information regarding the underlying property value as it was understood by buyer and seller at the time of the transaction, as well as any loans and other adjustments to equity. Since this also requires interviewing at least someone who was involved with the transaction, appraisers will often try to determine underlying value on their own. This has the effect of converting primary data (which would be the discount in the mind of each party) into an opinion of the discount. Using the appraiser’s opinion as a market value indication drastically reduces the reliability of the method no matter how good it is. Besides, did the parties even know what the discount would be, or was something else, like yield or another future benefit, more relevant to their price decision?

Conclusions

Fractional interest transactions could conceivably be well enough understood for them to indeed provide useful indications of value. But obtaining the necessary information is far more difficult than it is for whole-property transactions. Unknown benefits or other nonmarket conditions, and especially the underlying property value, can cause wide swings in the discount, making the sale comparison approach much less reliable for fractional interest valuation than it is for single-family residential appraising. This method is in many respects akin to opening a can of worms, and only with great care and analysis does it become the Holy Grail that it might seem. The entire picture, and the key to persuasive valuations, is presented in Valuing Fractional Interests in Real Estate 2.0.