If a store block is worth a million dollars, what is a 10% share in it worth?  Let’s say that ten sisters and brothers own equal shares.  What is each one’s share worth?  The simple answer is 10% of a million dollars. But the simple answer is not necessarily the accurate answer.  Because, if the question is, what would that 10% share sell for if it were put on the market, the answer might not be $100,000.  It might be difficult to sell the 10% share.  As a result, it might sell for less.  If that is the case, its owner has experienced what in accounting circles is termed a “minority discount.”  The 10% interest is a minority, and its value is a discount from the face value of 10%. 

A sizable industry has grown up to apply discounts in the valuation of minority interests.  In the valuation of the assets of an estate, for instance, it is important that a taxpayer’s heirs not be forced to pay taxes on more than what the estate is really worth.  Minority discounts were originally applied to small, fractional interests for which there might be only a tiny market of buyers.  But over the years the practice of applying minority discounts has grown to the point where the “minority” may be a 50% owner – say, the husband in a husband-and-wife ownership of an asset like a house.  Until recently, no one thought of a half interest like that as having less than 50% of the whole value.  Now, many advisors do.  And when they do, the practice of applying a minority discount begins to fly in the face of our common understanding of what a share is worth.
The logic of minority discounts is sound.  Often, the minority interest is a 1/100th share or less.  A general partner, not the minority owner, makes decisions as to whether to upgrade the property, convert it to condominiums, or sell.  The minority owner has no voice and no control.  A partnership may operate under rules that penalize shareholders when they sell their interests to outsiders, limiting their market to only a small group.  With issues of lack of control and lack of marketability of this kind, the logical conclusion is that the minority share suffers a discount.
The problem for appraisers is the lack of direct proof.  Appraisers experience considerable discomfort when market data are unavailable to back up even the most logical assertion.  The “proof” of minority discounts and of the rate of discount that it is appropriate to apply comes from data involving resales of shares in a small group of real estate partnerships formed in the 1980s.  The analysis of the data, including the calculation of the discount rate, is by a third party, not the appraiser making use of it.  To the extent that the data are derived from trades of very small fractional shares in very large properties, the data may be less than relevant to the valuation of a 50% interest in the store block owned by a husband and wife.  Without good-quality, comparable, hard data, the appraiser is without an anchor.  Any value conclusion is as good as any other, because no good real-world proof is at hand.
The method of valuing a minority interest by applying a discount to its face value is a method devised by a different profession.  It has been adopted by appraisers for long enough for appraisers to have discovered its flaws.  Appraisers are not generally content to do things only one way.  Appraisers have traditionally sought multiple methods to estimate value.
One alternate method of valuation of a minority interest is to examine its history of cash flows.  If a 1/100th share of a group of apartment buildings has a history of consistently throwing off (and looks like it will continue to throw off) an annual dividend of $200, if 99 other shareholders are available as potential buyers of the 1/100th share, and if 5% represents a reasonable rate of return, we could apply the standard appraisal logic of the Income Capitalization Approach to conclude that the value of the share is $4,000 ($200/.05 = $4,000).
But the method of valuation that appraisers most prefer is the Sales Comparison Approach.  It is a second alternate method.  If something has sold in an arm’s-length transfer, isn’t that price the strongest proof of what an identical thing is worth?  If we have an abundance of data from sales of small shares in hundred million dollar assets and if we are confident in the computations that show a minority discount, then the minority discount method may be acceptable.  On the other hand, if the comparable sales are of small shares in big assets and the thing we are valuing is a half interest in a three-decker – a large share in a small asset – we have a mismatch, and we need to look for better comparable sales.
When we look for comparable sales for quarter or half interests, we come up empty.  Call a commercial broker’s office and ask whether anyone has a half interest or a quarter interest in something for sale, and the broker will draw a blank.  Go to Ebay or to Craigslist.  Look for the same thing.  You will find little or nothing.  Brokered sales of half, quarter, or 10% interests very seldom occur.
Four people form a partnership to acquire a small office building.  Five years later, one dies.  What happens to that partner’s share?  Typically, the matter is settled internally.  The estate may have the property valued, and the three survivors re-finance and buy out the estate’s interest, at face value.  Or, the survivors find a new fourth partner, who buys out the estate – again, at face value.  The estate has no interest in selling at a discount.  The survivors have no interest in taking on a stranger as a fourth partner.  So the share is never exposed to the market.  An arranged sale at face value is what occurs.
To provide better answers to what minority interests are worth, appraisers need better data.  Sales of quarter interests and half interests are not handled through brokers.  They are not publicly reported.  They are not compiled as data.  Without comparable sales, appraisers are on uncomfortable ground.  The demand for the data exists.  Minority interests and sales of them, in fact, are as common as mustard seeds.  They happen every time an internal, arranged sale occurs.  In the valuation of minority interests, billions of dollars are at stake.  Given the pent-up demand for data to tell us the prices at which minority interests have been bought out in the internal transactions that occur all the time, we can expect that, in time, the information will become available for appraisers to use.

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Eric Reenstierna Associates LLC is a real estate appraisal firm taking on valuation and consultation assignments in Greater Boston, Massachusetts and New England. Eric Reenstierna, MAI, is the office's principal and is a commercial real estate appraiser.


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