Going Concerns

Much of what passes for real estate is not real estate at all. It is business. Real estate is bricks and timbers, dirt and rocks. Business is labor relations and risk management. Business is business. Real estate is real estate.

The occasion for confusion of the two arises when a business is closely tied to the real estate from which it operates. A gas station is part land and building, but it is also non-real estate equipment such as pumps and tanks in the ground as well as the permits that allow it to operate and the goodwill in its clientele. In theory, the business can move. But what does that mean? That the owner digs up the tanks and carries them on a truck across the street? Not likely. More often, the components of real estate, personal property, and goodwill are part of one package. All contribute to value. Their combination is the "going concern."

Where a substantial portion of the value of a business asset is in the real estate, real estate apraisers are increasingly called upon for valuation of going concerns. Real estate valuation today is characterized by volumes of data for generic property transactions. The state of the art of valuation for closely held going concerns in 1997, however, is much like what it was for real estate in an earlier age, when data were scarce.

The Appraisal of Real Estate defines "going concern value" as "the value of a proven property operation." A simple and relatively raw method for the valuation of going concerns is by application of rules of thumb. One is multiples. A fast food restaurant business (excluding the real estate), for instance, may be worth from 25% to 50% of annual net revenue, a car dealership up to 100%, or a gas station 200% to 300% of annual cash flow. A cost analysis may be useful in the valuation of a new business of which a component is real estate when the business lacks a history of operation. Sales comparison can be useful when comparable business transaction data are publicly available, as in the case of heavily regulated enterprises, such as nursing homes.

Typically, however, the value of a going concern rests on the income it is able to generate. Often, the analyst is able to reduce gross receipts to a stabilized net income attributable to two components: the business and the real estate. The income to the business can be separated by deducting the income necessary to produce a market rate of return to the real estate. The income to the business can then be capitalized at an appropriate rate to produce the business' value. This amount coupled with the value of the real estate is the value of the going concern.

Robert W. Hartmann details some of the pitfalls for lenders and investors that can result from confusion of business value with real estate value in "Valuation for Loans on Restaurants" (The Appraisal Journal, October, 1996). With restaurants, one may be double the other. The time to explore the difference is before funds are committed rather than after, when people who have loaned money on what they thought was real estate are left to wonder where the value went. To know that the source of value is in a "hard" thing like real estate rather than something more intangible like a business can help a lender or an investor define the level of risk.

Eric T. Reenstierna, MAI