Special Adjustments to Facility Occupancy Costs in SME Business Valuation

When evaluating a small business, one of the critical components often overlooked or misunderstood is the treatment of facility occupancy costs. These costs, which pertain to the expenses associated with the space in which the business operates, can significantly impact the valuation of the business. Whether the business owner leases or owns the real property, special adjustments to these costs are often necessary to arrive at an accurate valuation. This blog will explore the intricacies of facility occupancy costs and the adjustments required to ensure a precise and fair business valuation.

The Importance of Accurate Facility Occupancy Costs in Valuation

Facility occupancy costs are a significant expense for most businesses, and how these costs are treated can have a considerable impact on the valuation of the business. Inaccurate or improperly adjusted facility costs can lead to a distorted picture of the business's financial health, potentially leading to overvaluation or undervaluation.

For businesses that lease their premises, the treatment of occupancy costs is relatively straightforward—unless there are unusual circumstances related to the lease. However, when the business owner also owns the real estate, special adjustments are almost always necessary. These modifications are crucial because the method of valuing a business typically excludes any real estate that the business owns. Instead, the business is valued under the assumption that it leases its operating premises, with the real estate valued separately.

Leasing vs. Owning: Different Approaches to Adjustments

Leased Property: Adjustments for Lease Terms

If the business owner leases the facility, the lease expense is generally carried over directly into the recast profit and loss statements (P&Ls) used for valuation purposes. However, there are situations where adjustments may be necessary:

• Automatic Rent Escalation Clauses: If the sale of the business triggers an automatic increase in rent, this anticipated cost should be reflected in the recast P&Ls. Failing to account for such a clause could lead to an overstatement of the business’s profitability and, consequently, its valuation.
• Lease Term Near Expiration: If the lease is near the end of its term and the landlord is expected to increase the rent significantly for the next term, an adjustment should be made to reflect this higher future expense. This adjustment ensures that the valuation accurately reflects the business’s future financial obligations.

Owned Property: The Need for Phantom Rent and Other Adjustments

When the business owner also owns the real estate, the approach to adjustments becomes more complex:

• Separate Entity Ownership: If the real estate is owned by a separate entity controlled by the business owner, and the business pays rent to this entity, the rent that the owner intends to charge the buyer should be substituted in the recast P&Ls. This adjustment is necessary to reflect the future financial realities that the buyer will face.
• Same Entity Ownership: If the real estate is owned within the same legal entity as the business, and no rent expense is shown on the P&L, a phantom rent expense must be added. This phantom rent is typically based on the fair market value rent that the owner would charge a third party. In addition to adding the phantom rent, all building-related expenses, such as depreciation and debt service on any real property purchase loans, must be removed from the recast P&Ls. This is because the valuation of the business is done under the assumption that it leases its premises, making these real estate-related expenses irrelevant to the business valuation.

Why Real Property Is Valued Separately

In business valuation, the real estate and the operating business are valued separately for several reasons:

1. Different Capitalization Rates and Multiples: The capitalization rates, discount rates, and earnings multiples applied to an operating business are substantially different from those used in real estate valuation. Businesses are often valued based on their earnings potential, while real estate is typically valued based on rental income and property appreciation potential.
2. Clarity and Precision: By separating the real estate from the business in the valuation process, the appraiser can provide a clearer and more precise valuation for each asset. This separation also allows for more accurate application of industry-specific valuation methods and ensures that the buyer and seller have a clear understanding of the value of each component.
3. Transaction Flexibility: Separating the real estate from the business valuation allows for more flexible transaction structures. For instance, a buyer may be interested in purchasing the business but leasing the property, or they may want to purchase both. Having separate valuations for the business and the real estate facilitates these types of negotiations.

The Role of Triple-Net Leases in Adjustments

When the business owner owns the property, another important consideration is the treatment of building maintenance and repair costs, insurance, and property taxes. The simplest and most effective way to address these expenses is by applying a fair market value triple-net (NNN) rent expense in the recast P&Ls.

A triple-net lease requires the tenant to pay all costs associated with the property, including maintenance, insurance, and taxes. By substituting the actual costs with a fair market value triple-net rent, the recast P&Ls reflect the typical expenses a buyer would incur if they were leasing the property under standard commercial terms.

Practical Example: How Business Valuation Advisors Helped a Client Navigate Facility Occupancy Adjustments

A recent engagement at Business Valuation Advisors illustrates the importance of making the proper adjustments to facility occupancy costs during the business valuation process. Our client, a long-time owner of a successful manufacturing business, was preparing to sell the company and its associated real estate. The business operated out of a facility owned by the same legal entity as the business, meaning that no rent expense was listed on the profit and loss statements.

The Situation:The initial profit and loss statements showed healthy profits, with no rent expense included, as the owner had not been charging the business rent. Additionally, the P&Ls included depreciation and interest expenses related to the building's mortgage. The business owner, unaware of the need for adjustments, assumed that these financial statements provided an accurate reflection of the business’s profitability.

The Challenge:Upon reviewing the financials, Business Valuation Advisors identified the need to adjust for the lack of rent expense and the inclusion of real estate-related costs in the P&Ls. We recognized that these adjustments were crucial to accurately valuing both the business and the real estate separately, as potential buyers would need to understand the true financial commitments they would be taking on.

The Adjustments:

1. Phantom Rent Expense: We added a phantom rent expense to the recast P&Ls, calculated based on the fair market value rent that a third party would pay to lease the facility. This adjustment reflected the actual cost that a buyer would incur to operate the business in the current location.
2. Removal of Depreciation and Mortgage Interest: We removed the building’s depreciation and mortgage interest from the P&Ls, as these expenses were related to the ownership of the real estate, not the operation of the business. This adjustment ensured that the business valuation reflected only the operating costs relevant to the business itself.
3. Separate Valuation of Real Estate: With the adjusted P&Ls in place, we conducted a separate valuation of the real estate based on its potential rental income. This allowed the seller to present the business and the real estate as two distinct assets, each with its own valuation.

The Outcome:Thanks to these adjustments, the client was able to present a clear and accurate financial picture to potential buyers. The business was valued at a fair market price, reflecting the adjusted profitability after accounting for the phantom rent expense. The real estate was also valued separately, allowing for flexible negotiation options. Ultimately, this led to a successful sale where the buyer had a clear understanding of the financial obligations associated with both the business and the property, and the seller maximized the value of their assets.

Conclusion: The Necessity of Facility Occupancy Adjustments

In business valuation, particularly for small businesses where the owner also owns the property, making the appropriate adjustments to facility occupancy costs is crucial. These adjustments ensure that the business is valued accurately, reflecting the financial realities that a new owner will face. By adding phantom rent, removing irrelevant real estate expenses, and applying a fair market value triple-net rent, the appraiser can provide a valuation that is both precise and reflective of the true economic conditions of the business.

For business owners and buyers alike, understanding these adjustments is essential to making informed decisions during the sale or purchase of a business. Ignoring or misunderstanding these factors can lead to significant discrepancies in valuation, potentially resulting in overpayment or underpayment for the business.

At the end of the day, the goal of any business valuation is to provide a clear, accurate, and fair assessment of the business’s worth. Facility occupancy costs, when properly adjusted, play a key role in achieving this goal, ensuring that both buyers and sellers have a solid foundation on which to base their negotiations and final transaction terms.

At Business Valuation Advisors, we specialize in helping clients navigate these complex adjustments, ensuring that both the business and its associated real estate are accurately valued. Our expertise allows clients to approach negotiations with confidence, knowing they have a clear understanding of the true financial picture.

To learn more or for valuation services, visit us at www.valuationadvisor.com