Inside vs Outside — Combining BV and RP Worldviews in Partnership Valuations, Part 2

Multidisciplinary valuations can be hazardous undertakings, because they require cross-professional knowledge that is not normally within the educational scope of either discipline. Partnership interest valuations are multidisciplinary and quite common, and errors resulting from knowledge gaps have very much degraded the public’s trust in valuers’ opinions over many decades. Even otherwise highly qualified and experienced valuers can produce valuations that are confused, confusing and just plain wrong. Understanding the differences in the worldviews of the business valuation and real estate appraisal professions can go a long way toward filling in the knowledge gaps, and should result in valuations that are as trusted by the public as conventional business valuations and real estate appraisals.

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.

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. The two realities might be very similar but can also be wildly different. If key facts and important circumstances 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 real estate is more than a number

The idea that the real estate appraisal has a single thing that is of use to the partnership’s business valuer—its concluded value—is dangerously myopic.

Most partnership interest valuations rely on NAV methods, which look at conditions at a single point in time and then compare that with market data for lack of control (say, public limited partnership transactions) and lack of marketability (various liquidity impairment methods). But single point models can embed assumptions about growth, future changed use, leverage and cash flow that may have little to do with the market data. Such embedded assumptions are dangerous because they are largely unseen and cannot be easily accounted for.

In Part 1, we looked at ways that an outside market view of the real estate value itself can be a poor representation of a partnership’s more realistic inside value, making the NAV method either misleading or impossible. Here, we will identify a number of critical variables that can be easily unhidden by using the income approach. A good multidisciplinary valuation will first recognize these variables, adjust for outside/inside differences, make them explicit in a present value model, and conclude a credible value in a transparent process.

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:

This particular figure shows a constant value and cash flow growth for simplicity but is still similar to the more commonly used discounted cash flow model. Its key variables are value and value growth, cash flow rate and cash flow growth, time, and the yield rate(s) used to discount future cash flow back to the present. Growth values from the “outside” real estate appraisal need to be modified by the conditions “inside” the partnership. Some of the more important outside/inside differences are described as follows:

• Cash flow: revenues. Revenues reported in the real estate appraisal are based on current leases but adjusted to market on expiration or renewal. Inside revenues may be different based on the ability of management to increase rents, or its long-term relationships with tenants, for example.
• Cash flow: net operating income. NOI is projected in the real estate appraisal based on management by a typical market participant. While many line items are the same whether inside or outside (utilities or future maintenance costs, for example), others are likely to differ based on actual management capabilities. These include professional management fees, insurance, property taxes in some jurisdictions (California at least), and all kinds of administrative expenses.
• Cash flow: entity charges. The real estate appraiser will have selected which line items to include in the market value analysis, but there will be other line items attributable only to partnership operations. These normally include some administrative costs, salaries, entity taxes and the like. Future capital expenditures might be assumed by the real estate appraiser to be covered with an annual replacement allowance, especially if the market includes properties with similar replacement needs. But the business valuer will still need to consider any specific capital costs expected to occur during the holding period, and whether they will need to be covered by the partners or from cash flow. (Covering re-tenanting, roofing, and some other costs can be an enormous challenge for the partners, and would necessitate an analysis of working capital adequacy and needed accumulations.)
• Value growth. If the current property use is the same as the appraiser’s concluded highest & best use, then the real estate value growth figure may be usable. But if its use is different, then inside growth can easily be different as well, and must be adjusted for; see Part 1 of this article.

The effects of value growth are very often missed, which can affect the discount for lack of marketability. This second discount uses the minority-marketable value as a starting point. If value growth for the real estate was 3% annually, then a 25% discount for lack of control will increase the growth rate from 3.0% to 6.0% over a 10-year period, or from 3.0% to 9.1% over a five-year period. In either situation, the discount for lack of marketability can be hugely overstated by using the unadjusted 3.0%.

These are just a few of the more prominent examples of inside/outside differences that will affect the valuer’s concluded value for a noncontrolling interest. Net asset value issues can also have big effects, as discussed in Part 1. The income approach, allowing as it does for explicit analysis of the above variables, is far more likely to deliver a persuasive story of value and a credible conclusion than other methods that simply embed it all. Other related topics will be explored in subsequent articles. I hope you have found this multidisciplinary perspective useful.

Best Regards,

Dennis Webb

The inside and outside perspectives in this article were taken primarily from Chapters 2-5 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.