Inside vs Outside — Combining BV and RP Worldviews in Partnership Valuations, Part 1

We don’t think too much about specific differences between the various valuation professions because we each have our domains of expertise, which have been highly developed over many decades to credibly value specific assets, entities and so on. This is fine as far as it goes, but what happens when the work from both professions is combined in a multidisciplinary assignment, as it is when valuing partnership interests, for example?

Inside and outside

When valuing an entity, it is fairly common for the business valuer to simply enter the real estate appraiser’s conclusion on the partnership’s normalized balance sheet and then forge ahead with the valuation. But there is a whole shopping list of valuation elements that can look entirely different depending on whether they are viewed by the business valuer or the real estate appraiser. If these differences are not understood and accounted for, then the overall valuation can be anywhere between mildly wrong and a misleading catastrophe. Fortunately, these important elements are easy to see once you know where to look.

The fundamental difference in viewpoints is that real property markets exist “outside” the partnership, while its business operations are “inside” the partnership. The two realities might be very similar but can also be wildly different. The real estate appraiser lives in the outside, market-based world for the real estate assets. The business appraiser lives in the inside, personal world of partnership operations, as well as the market world for the partnership interest being valued. Any overlap between asset analysis and partnership analysis is mostly an abyss, into which may fall key facts and important circumstances, thus damaging the credibility of the valuation report.

When net asset value stops working

The outside market is about the entire property, presuming operation under typical market conditions by a typical market participant with typical (or no) financing. But the outside market’s version of?"typical" operations is almost certainly different from the actual partnership's inside operations, at least in some respects and sometimes in very important ones. It is essential to first recognize that the value being determined—in our example, a noncontrolling interest in a partnership—is required to apply only to the interest being valued, and not to the rest of the partnership’s assets. Yes, the net asset value (NAV) method does require that all assets and liabilities be marked to market, but this method can be misleading because a market value balance sheet can have little or no meaning for the holder of a noncontrolling interest. The method can only be useful if the property is being operated in the same manner as a typical market participant would. If it is not, then the NAV method might end up being completely useless.

Future NAV, on the other hand, is a fundamental expectation of real estate partners. They will eventually receive their pro rata share of the whole. The ending NAV is the important thing, and this is explicitly recognized in the income approach. Even if the partners expect to hold their real estate assets for a very long time, our valuation models must consider a future NAV where inside and outside conditions come together, typically through sale of the property. We then value the partnership as operating in the manner it is expected to for a time—regardless of whether those operations are typical for the market or not—but under market conditions at the end. This arrangement accounts for all the facts and circumstances related to the property and its operations, and best matches partner expectations. The beginning NAV may be nice for calculating discounts, but really has little to do with the value of the subject interest.

Valuing the future

The income approach models cash flows over time, and can more closely match partner expectations, even if such expectations do not match the real estate market. The basic present value analysis is illustrated by the following figure:

Once we realize that the current value of the partnership's assets may have nothing to do with the current value of its noncontrolling interests, seemingly impossible valuation circumstances become just another (fairly simple) valuation problem to solve. The following diagram shows cash flows over time for a partnership that is operating a property whose current use does not match the real estate appraiser’s highest & best use at the date of value. As an example, let's consider an older multitenant industrial park that is immediately in the path of new housing development. A typical outside market participant would scrape the site and develop it with housing. But inside the partnership, the owners are happy with the cash flow they get from the industrial units and are not interested in redevelopment (at least for now). Using the NAV method’s considerably greater value could reward the subject interest-holder with a buyout value that the other partners would not realize for many years. Using the present value of NAV that is realized in the future is a far better match with the actual partnership, and results in a somewhat lower but fair buyout price.

What if NAV is negative, say, if the property’s value has declined and is now exceeded by the partnership’s liabilities? A negative beginning NAV can still get resolved, and often does, through loan forgiveness, foreclosure or improving market conditions. The market change scenario depicted in the figure below is easy to model, and closely matches one possible expectation. The NAV method cannot be used at all.

One more model (below) shows a wasting asset, like a leasehold interest with a fairly near-term expiration. The ground lessee operates the property and improvements during the lease term, but their use reverts to the lessor (the fee holder) at the end. At this time, the real estate leasehold interest is extinguished, bringing the real estate value on the balance sheet to zero. (There may be other assets and liabilities remaining, so there could still be a relatively small ending NAV.) The real estate appraiser will likely use this sort of model anyway, but value growth will be drastically different than it would for (say) the public limited partnerships that are used to develop a discount for lack of control, misstating the discount. Other effects will be discussed in Part 2 of this article.

A useful understanding of NAV is not the only possible casualty of differences between outside and inside views. Others, including risk and growth rates, cash flows and more will be explored in subsequent articles. I hope you have found this multidisciplinary perspective useful.

Best Regards,

Dennis Webb

The figures in this article were taken from Chapter 11 of my book, Valuing Fractional Interests in Real Estate 2.0 (? 2021), the only complete, definitive text on this subject. You can find it at www.primusivs.com.