GREENE VALUATION ADVISORS, LLC

GREENE VALUATION ADVISORS, LLC 1430 Broadway 6 th floor New York, NY 10018 TEL: 212.244.1800 FAX: 212.869.0209 e-mail: mgreene@greenevalue.com Are minority interest discounts really appropriate in valuing noncontrolling interests in real estate holding companies? By Martin Greene, CPA/ABV ASA Are minority interest discounts really appropriate for valuing noncontrolling interests in real estate holding companies? This question may raise the ire of trust and estate professionals but win praise from the IRS. However, before choosing sides, let s examine this valuation issue a bit more closely. Historically, business appraisers valuing real estate holding companies used Net Asset Value (NAV), which is the total value of the holding company's assets including the appraised value of their real estate, cash and other assets less liabilities. NAV is generally considered to be the net value that could be realized by a controlling interest excluding liquidation cost. 1 When valuing these minority interests, business appraisers have simply applied discounts to the NAV to account for the interest s lack of control and marketability. Real estate limited partnerships (RELPs) trade in the secondary market at discounted prices compared to their NAVs. Business appraisers consider these discounts a proxy for minority interest discounts of closely held real estate holding companies. Business appraisers select discounts from averages of surveys of these publicly traded RELPs or use data from precedent court decisions for similar real estate holdings. While these average discounts may appear appropriate on the surface, the individual discount for each RELP can vary widely. Partnerships Profiles Inc., widely recognized as an authority in compiling RELP data, publishes an annual survey of price-to-nav study discounts based on current RELP transactions. In a recent publication, they reported discounts for the category partnerships with low or no debt ranging from a low of 3% 1 Johnson, Bruce A., et al.., Comprehensive Guide for the Valuation of Family Partnerships 3 rd Ed. Partnership Profiles Inc. Dallas 3

to a high of 34%. Factors affecting price-to-nav discounts can be complex and averages can be misleading. The specific discount factors include time from the transaction date to the expected partnership liquidation date, size and debt structure, distribution policies, and management; all of which might not be evident from survey averages. Court decisions can be even less precise, depending on the specific testimony of the expert and evidence presented at trial. In Mooneyham v. Commissioner (T.C. Memo. 1991-178) the inability of the taxpayer s expert to support a particular discount for a fractional interest in real estate resulted in the Tax Court rejecting the expert s opinion and choosing a lower discount. The Court opined: although claiming to be a real estate appraiser, [he] did not give an opinion of the value of the whole property. His report set out various reasons why a 15 to 30% discount for a fractional interest of property would be appropriate. Neither his report nor his testimony at trial gave any reason for choosing 25% as applied to the property in issue. In the case of Pierre v. Commissioner (T.C. Memo. 2010-106), the Court allowed a 30% marketability discount for a holding company whose portfolio was limited to marketable securities after the IRS challenged the taxpayer s second expert who advocated for a 35% marketability discount. The IRS failed to argue against the original expert s 30% discount when this discount was actually used in the original report. Business appraisers should understand court decisions and the magnitude of previously allowed discounts, which are based on the specific circumstance and context of each case, and should not assume that discounts approved by the Court in one case will be provable in all situations. As elucidated in Berg v. Commissioner (T.C. Memo 1991-279): The fact that the petitioner found several cases which approve discounts approximately equal to those claimed in the instant case is irrelevant. Therefore, in deciding the appropriate discounts in the instant case we will take into account 2

all relevant facts and circumstances of the petitioner's interest and do not consider the amount of discount[s] applied in other cases cited by petitioner as persuasive. The NAV approach has little bearing on how rational investors make investment decisions. Investors in a minority interest make decisions based solely on the risks and the future rewards of ownership. Investors consider expected cash flows and risks relating to liquidation of their interest in the future. Normally, they do not engage real estate appraisers to value the property and select an appropriate discount from these studies or court decisions. A company holding real estate, in essence, is not entirely unlike any operating business, an attorney joining a law firm, or a CPA buying into an accounting practice. The decision is based on expected cash flows and risks affecting ownership of the interest. In the same way, the investment decisions affecting a minority interest holding are not generally based solely on the underlying asset, whether it is real estate or a client relationship; albeit real estate as the underlying asset generally is less risky than goodwill, but it should be reflected in the discount rate and not the selection of the valuation approach. The NAV approach in valuing minority interests in companies holding real estate is expected by many CPAs and attorneys who engage business appraisers and will frequently ask the size of the minority discount. Even the IRS may expect this approach because they ask the size of the minority discount in estate and gift tax returns. It is surprising that many business appraisers who should know better still simply apply the NAV approach and prepare the same old reports. Perhaps professionals are considering the NAV approach lies in the issue of uncertainty regarding alternative approaches. If appraisers are not considering a discount from the NAV as a means to value the interest then what should they consider? Appraisers could focus on cash flow; a model could calculate the cash flows over a discrete term and estimate a terminal value, and then present value both the cash flows and the terminal value. 3

There is an interesting study from the mid-1990s that indicates cash flow provides a more robust measure than using a price-to-nav. The study summarizes data of 20 income producing RELPs, all with histories of paying distributions and with no announced plans to liquidate. The discount from NAV at which the interests traded varied between 22.0% and 59.3%, much like the annual price-to-nav discount studies cited previously with significant deviations in price; yet the yield-to-price of each RELP was relatively similar with little deviation between the individual partnerships. 2 Another approach, called the market approach, which is based on the theory of substitution, postulates that a rational investor will pay no more for an investment in the subject business than it would have to pay for a similar investment, if available. Therefore, as in valuing a business, the market prices of comparable publicly traded guideline companies data or transactions involving comparable companies are utilized to determine the value of real estate entity. In applying the market approach, several multiples are developed to apply to the subject entity in just the same way as an investor compares investment choices. The market approach, rather than considering the average of price-to-nav studies, involves selecting individual guideline partnerships that should contain attributes similar to the subject holding company. Guideline partnership multiples can be applied to subject holding company s fundamentals. An investor will pay no more than for other similar companies. Conversely, a seller would sell for no less than the price that is comparable to other guideline partnerships or companies. Some of the criteria used to select guideline partnerships can be those with similar the distribution policies, capital structure, and real estate type held. However, outside of the obvious difference that guideline partnerships are publicly traded and the subject company is closely held, some characteristics are unique to privately held entities. 2 Johnson, Bruce A., Park, James R. Limited Partnerships Discounts-Observations from the Secondary Market. I Vol. 16 No. 2 (June 1997) p. 62 4

Frequently, closely held entities tend to have assets with a lower inside cost basis, and real estate held is more fully depreciated, whereas the guideline partnerships can have significant depreciation deductions. In New York City, valuations can include S corporations, which are subject to local corporation taxes not as a rule applicable to guideline partnerships. Merely applying discounts to NAV based on public traded RELPs would not measure the dynamics of these and other specific company factors on value, which would be considered by a potential investor. However, by applying the market approach business appraisers can quantitatively normalize or adjust the guideline companies multiples for these factors. The market approach allows for applying downward adjustments for these multiples, whereas applying the NAV or cost approach may be less transparent; applying any adjustments may be subjective or in effect require developing a market approach application. To summarize under the cost approach, generally only a single multiple is considered: price-to-nav. The multiple is an average of surveyed partnerships, which may have little relationship to the subject entity. There can be a significant variance in the minority discount depending on the selected RELPs in the survey category. Under the market approach, on the other hand, the selection of guideline partnerships is made under very selective criteria regarding the guideline partnerships and the subject company. The number of multiples is not limited, and cash flow (which is considered the most significant) can be evaluated. Partnership Profiles, Inc. advises applying the same approaches described in this article, and while they published the study, they do not believe the NAV approach will necessarily provide the best method for estimating minority interest discounts. In addition, the income approach mirrors the investors thinking as to the cash flow and potential risks of the investment. Real estate appraisal is often an important component in the valuation process, and it would be unwise to advocate eliminating it. A real estate appraisal can provide insight in estimating ongoing revenues and expenses. Because the lives of these entities are not indefinite; liquidation issues arise in business appraisal of these holding companies and real estate appraisals can be used to estimate value at that time. Further, under the 5

income approach, distributions to stakeholders from refinancing of debt may be considered a cash inflow. Real estate appraisals can be used to help measure the potential borrowing of the subject company. The underlying real estate appraisal can further be applied to estimate certain multiples and provide a terminal value in some circumstances. Using the income and market approaches generally will determine the entities values on a minority basis without separately calculating a minority level discount. A minority interest discount still can be determined by comparing the price and other discounts including a marketability discount to the NAV, which can be helpful. On a recent assignment, the calculated minority discount was over 70%. Merely selecting a discount based averages of survey would have significantly underestimated the minority discount. A large variation, whether between individual approaches in the business valuation or differences in the valuation and the real estate appraisal, requires further analyses. Too low a valuation versus an appraised value could prompt the hypothetical selling to hold the property. Regardless of the ultimate disposition, reconciliation of the different approaches and appraisal report will result in a more thorough and comprehensive analysis than merely deducting a fixed rate from the appraised value. 6