Typically, when performing a business valuation for SBA 7(a) purposes, the prospective buyer is seeking to purchase both the business and its underlying real estate from the seller. In these instances, it is important to ensure the relationship between the company and the real estate is addressed correctly. Otherwise, the business valuation may provide an unreliable conclusion.
Related party rent payments are generally among the more significant and impactful normalization adjustments appraisers must make to determine the normalized cash flows produced by business operations.
The Need for a Fair Market Rent Adjustment
Owners controlling the business and its real estate may set rent above or below market rates or even waive rent entirely. This may lead to reported net income, which is unreliable for business valuation or debt service coverage purposes. In such cases, the valuator must establish fair market rent and adjust historical and projected rent expenses accordingly. Failing to do so could lead to significant over or undervaluation of the business.
Which Entity Owns the Real Estate?
When the business and real estate are owned within the same legal entity, in addition to the rent expense being adjusted to fair market value, the real estate’s fair market value, as determined by a qualified real estate appraiser, should be reflected on the company’s balance sheet. The business valuation should specifically note that its concluded value includes the real estate as a nonoperating asset to ensure the lender does not double count the appraised real estate value.
More commonly, for numerous tax and legal reasons, the real estate will be held in a separate legal entity. Under these circumstances, the operating business may or may not have made rent and associated triple-net payments to the entity that owns the real estate. As such, it is crucial to identify which entity historically covered real estate-related expenses like property insurance, taxes, and maintenance. If the business valuation professional calculates fair market rent on a triple-net basis, where the tenant covers such expenses, any historical allocation of these expenses paid by the real estate holding company should be transferred to the business’s adjusted operating expenses. Conversely, if rent expense is estimated on a gross basis, the business’s adjusted income statement should exclude these building-related expenses, as they are the landlord’s responsibility. To accurately account for these adjustments, the appraiser should ask for the real estate holding entity’s tax returns or request the historical amounts for real estate insurance, taxes, and maintenance. The following table shows how failing to account for triple-net (NNN) expenses can result in an overstated business value.
| Seller’s Discretionary Earnings (SDE) | SDE Multiple | Business Value | |
|---|---|---|---|
| Including NNN Expenses | $200,000 | 3.0x | $600,000 |
| Not Including NNN | $220,000 | 3.0x | $660,000 |
Fair Market Value
Under the fair market value standard, appraisers must determine the value of a business irrespective of who owns the real estate. For instance, a restaurant owner who also owns the real estate property might receive a higher cash flow stream than if they paid rent to a landlord. However, fair market value requires the appraiser to consider the economic cost of the company’s real estate when determining the value a hypothetical buyer would receive from owning the business. Simply put, a restaurant needs physical real estate to function, and the cost of that space – the rental payments – must be accounted for when evaluating the restaurant’s profitability.
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Calculating Fair Market Rent
Once it has been determined that a business owns the real estate it operates from or leases its facility from a related party, several methods exist to calculate a fair market rent expense. Suppose the real estate is also being transferred to the buyer of the business and a real estate appraisal is being conducted. In that case, the income approach from the real estate appraisal report will provide the most accurate rent calculation. If the real estate appraiser did not use an income approach, a fair market rent could still be calculated by applying a capitalization rate (the expected return on similar types of real estate) to the overall value of the real estate. On the other hand, if the seller of a business is retaining the real estate and no real estate appraisal is performed, then the proposed lease rate between the buyer and seller can be used as a fair market rent expense.
How We Can Help
At Withum, we provide a comprehensive range of SBA-compliant valuation services, including business and real estate appraisals. We strongly advise lenders to consult qualified appraisers to determine the necessity of such appraisals. Our lender clients can benefit from our complimentary review process, helping them evaluate deal feasibility and the scope of valuation engagements.
Author: Tim Gbur | [email protected]
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For more information on this topic, please contact a member of Withum’s SBA Business Valuations Team.
