If you own the Real Estate (RE) where you operate the business, you’ll have to decide if you are including it in the sale, or want to retain the RE as a rental income. RE often blurs the value of the business. The owner may have completely paid off the RE and the business is not paying any rent; or the owner may be charging the business a lower rate than the rent he would expect to receive as a landlord.
Oftentimes, a RE appraiser will use market comparables (comps) to provide an estimate to the owner of the RE value. The problem with this approach is that it’s likely that at least a portion of the business value is included in the comps. When selling a business with RE, allocations will be made by the seller’s accountant to minimize taxes and return the best yield to the seller.
So, just looking at sold auto repair property comps, for example, we would not have any idea if that value included the business and how much should be attributed to business value, and how much to assign to the RE.
The proper way to value a business with RE is to separate the business and RE evaluation. The business valuation should include a fair market rent for the business in determining the expected income (SDE) for the owner. Rental cost directly impacts the business bottom line and hence the value to the buyer. When we counsel our clients, we advise them the Fair Market Rent is not determined by comparable rentals, but is their decision; if they want to retain ownership of the RE and collect rent, the more rental income they require, the less the business is worth.
Further, we advise, that for any business the rent should represent in the range of 6 to 10% of gross sales; e.g., a business with gross sales of $2,000,000 would have a rent expense of between $120,000 to $200,000. Obviously, a business with a rent expense of $120,000 would be worth more to a buyer (higher net) than a business with a rent expense of $200,000 a year. The seller must realize, he cannot have it both ways; in essence, he will either collect a higher rent for the property, or a higher value for his business.
Typically, income properties are based on the property’s Net Operating Income (NOI) divided by a cap rate. While a RE appraisal will consider the highest and best use of the property and value the property on this basis, the present use may not support this valuation. As an example, let us consider a restaurant with revenues of $2,000,000. Without considering growth, most buyers would expect to pay a rent expense of no more than $200,000 and with a cap rate of 7 the property (on an income approach) would indicate a value of no more than $2,900,000.
Using the Income Approach the RE value is NOI divided by the cap rate, where NOI is rental income less taxes, insurance, etc. While it’s possible that another business type (bank, franchise operator) may be able to pay more for the property, another restaurant owner would not.
Here again, the business owner cannot have it both ways. If the thinks he can sell the RE for say $6,000,000 to a bank looking for a new branch site, then he should consider first moving his business to another location, or satisfy himself that this is the value of his business, including the RE.
We will present various scenarios to you and review your options as part of our business valuation before being engaged.