BUSI 352. Review & Discussion Questions: Answer Guide 10. Lesson 10: Valuation of Specialized Interests

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1 BUSI 352 Review & Discussion Questions: Answer Guide 10 Lesson 10: Valuation of Specialized Interests Air Rights 1. CRAs are limited to the appraisal of residential properties with a maximum of four dwelling units. The key determinant is actual or assumed highest and best use. Here, the subject appears to have a commercial highest and best use except for failing the test of legally permissible. Because the heritage house cannot be demolished, the property has a residential highest and best use. Therefore valuation of this property would be within the CRAs scope of practice. However, the subject of the valuation here isn t the property itself, but the development rights associated with the property. These are commercial in nature, in that their value is effectively the incremental value this residential property could fetch if these commercial and mixed-use air rights could be transferred. This would likely be considered out-of-scope the CRA would require an AACI co-signer or would have to decline the assignment. 2. The legal interest in real property being bought and sold for a condominium relates to what is specified in the registered condominium/strata plans. For a bare land strata or townhouse condominium, the fee simple interest relates to a parcel whose dimensions can be drawn on a land map. However, in a high-rise, only the footprint of the building can be shown on the land map. The actual condominium unit is a cube suspended in the sky above this land. The fee simple interest being bought and sold is a legal interest in the air rights above this land. It can be defined in a 3- dimensional map. Right of Ways and Easements 1. Depending on how much frontage is taken, the landowner would likely be looking for a full acquisition in fee simple. If that were the case, the entire parcel would be valued as if unencumbered in order to make the landowner whole. Life Estates A noise attenuating fence in the front yard is another story, and there is no right answer, as the Courts will likely be involved. 1. $300,000 compounded at 2% per year for 21 years = $454,700 $454,700 discounted at 15% for 21 years = $24,159 Personal Property 1. (a) There are four broad categories of personal property assignments: (i) Sale or disposal: often used to determine the price a piece of personal property would obtain in the market. (ii) Insurance value: usually used to assess the amount of an insurance claim based on either the full replacement value or depreciated replacement value. (iii) Taxation: though Canadian taxing jurisdictions generally do not tax personal property, issues do arise in assessment when personal property needs to be excluded in assessing a property s market value. For personal property that forms part of an ongoing business, depreciation for income tax purposes may also be an issue.

2 Guide 10 Page 2 of 7 (iv) Business values and credit applications: Business valuation includes the values of all tangible (real and personal property) and intangible assets (i.e., goodwill, patents, licenses) of that business. Personal property valuations may also arise from credit or loan applications. (b) Liquidation value is used where the personal property is to be removed and located in another place. In practice, a liquidation value is used when market conditions are less favourable to the seller than those set out in the definition of market value (i.e., company is facing bankruptcy and to avoid filing for bankruptcy some assets must be sold off quickly in order to pay down pressing debts). 2. (a) Salvage value is the value generated where the personal property is purchased for its component parts, and usually occurs when the personal property in question is no longer entirely functional or does not meet current performance standards, but the individual components have some value (i.e., selling a vehicle to an automobile salvage yard who then sells off the parts). Scrap value is the valuation used when the personal property has no remaining economic life and is sold for the value of the underlying material (i.e., scrap metal). Salvage value is typically higher than scrap value. (b) Orderly sale/liquidation value is used where the personal property is to be removed and located in another place and usually involves personal property that has a useful remaining economic life and is sold to a purchaser who intends to use the items in a productive capacity. Forced liquidation value is used where the personal property has to be sold in short order and therefore while the items are exposed to the market usually by way of auction sufficient time has not been allotted to satisfy the classic definition of market value. Therefore, in an orderly sale the personal property is on the market for sufficient time to attract the most probable price. In a forced liquidation sale the exposure to the market is limited. (c) Taxation value refers to the taxable value of the personal property as determined by the specific guidelines laid out in the tax legislation applicable in that jurisdiction. This value may be calculated in order to accurately assess a property values by deducting the value of personal property, or this value may need to be calculated for an ongoing business in terms of depreciation for income tax purposes. Disposal value or sale value is used when assessing what a piece of personal property would obtain in the market; the following are examples: fair market value for continued use, orderly sale/liquidation value, forced liquidation value, salvage value, and scrap value. Further, value for tax purposes is typically completed using original costs and set depreciation schedules, whereas disposal value is a reflection of the value of the personal property in the market. 3. The type of information recorded would depend on the purpose/use of the valuation as well as the scope of the report. Once the scope and purpose of the appraisal have been defined, the appraiser begins with identifying and listing all the personal property to be valued. Micro identification is the process of finding the individual characteristics of the assets: brand name, model number, size, serial number (very important), type of power, weight and dimensions (if practical), condition, and age. Macro identification is the process of determining which items need to be included or excluded from a particular bundle of items that are to be assessed. Further, any assumption made regarding the amount of depreciation used should be noted if applicable.

3 Guide 10 Page 3 of 7 4. In evaluating the condition of the personal property, in particular machinery and equipment (M&E), a rating system can be helpful to evaluate and describe physical deterioration. C Very Good: excellent condition, capable of being used to its fully specified capacity based on its design purpose; requires no abnormal maintenance for the foreseeable future. C Good: items subject to modifications or repair and being used on a regular basis, based on their fully specialized utilization. C Fair: items operating below potential capacity due to age or a change in application requiring repairs or replacement in the foreseeable future. C Poor: items in a state of repair that requires extensive repairs or replacement of major components in the immediate future. C Scrap: technologically or functionally obsolete items that have reached the end of their useful life and require considerable expenditures to put them into working order. In practice, particularly with a small inventory, some appraisers will only value the very good and good items of equipment, with the remainder of the equipment valued on a group basis by category. 5. Like real property appraisal, all approaches to value should be considered. However, it is not usual to have the data necessary to complete each of the three approaches, and the appraiser has to decide which approaches can be applied. Direct Comparison Approach Where the necessary sales data is available, values can be established using the direct comparison approach. The approach works the same way with personal property as it does with real property. The values of items are established by comparison to the sales or asking prices of similar items in a similar market on or about the valuation date. The greater the comparability of the items, the more confidence can be placed upon the value conclusions. The typical direct comparison approach involves establishing a point of reference price, then adjusting it for differences, such as condition, age, functionality, location, installation costs, type of sale, and time of sale. These are the same kinds of adjustments that take place in a replacement cost approach, and therefore, except in cases where there is an active market for the specific items, the analysis undertaken in a direct comparison approach is similar to that undertaken in the cost approach. The main difference between the use of the direct comparison approach for real property and personal property is that for personal property, there is generally less market data on comparables. Cost Approach The cost approach for personal property is similar to the cost approach used in real estate valuation. The appraisal begins with the cost of the item as new and then subtracts all depreciation arising from the factors that make the item less desirable to own than if it were new. Depreciation can take the form of physical deterioration, functional obsolescence, and economic obsolescence. Depreciation is one of the most difficult matters to deal with in the cost analysis. Like real property, personal property deteriorates with age and usage, yet, unlike real property, personal property (like machines and equipment) is much more subject to technological change and innovation that may quickly make them obsolete.

4 Guide 10 Page 4 of 7 6. You have been asked to value a four-plex for financing purposes. The monthly rent includes the fridge, stove, dishwasher, washer, and dryer. All appliances were replaced three years ago. The client has requested an appraisal exclusive of personal property: Market Value conclusion including personal property: $245,000 Replacement cost of appliances per suite: $5,000 Expected life of appliances: 10 years Market value $245,000 Less: depreciated value of appliances* (14,000) Value exclusive of personal property $231,000 *Depreciated cost of appliances RCN depreciation = $20,000 - $6,000 $5,000 4 suites = $20,000 $20, = $2,000/year (depreciation expense) $2,000 3 years = $6,000 depreciation expensed to date Business Value 1. For any resi-mercial property, whether the property is within the scope of practice for a CRAdesignated appraiser depends on whether the property s highest and best use involves some form of commercial utilization. (a) In the case of a house with a hair studio, because it is a professional service business that is fundamentally based on the specific owner and when the business is wound-up the space will simply revert back to residential use, a CRA-designated appraiser can likely appraise this property and it will contribute little or nothing to the property value. (b) For a bed and breakfast, under the Local Government Act (formerly knowns as the Municipal Act) in British Columbia when a household lets more than two rooms, a business license may be required. In such cases, it may not be possible for a CRA-designated appraiser to appraise the property. (Refer to the local municipality regulation on bed and breakfasts in the subject property area for clarity). However, if the property s primary use remains residential, then it can be possible for a CRA-designated appraiser to appraise the property. This type of property will undoubtedly have a business value contribution. If the primary use remains residential, then perhaps the direct comparison approach may be the best appraisal method to utilize. (c) For a recreational property, as long as the primary use remains residential (i.e., primarily used by the owners) then renting out dock space would be similar to renting out a basement suite in a residential property. As such, a CRA-designated appraiser should be able to appraise the property. In terms of the most appropriate appraisal technique, that would depend on whether sufficient comparables are available for the direct comparison approach; if not, then the cost approach would be most appropriate. 2. Going concern value is the value of a business that is both conducting operations at a given date, and has every reasonable expectation of doing so for the foreseeable future after that date. In other words, going concern value is not only the value of the assets if liquidated, but also the premium associated with it being an operating business. Value in use is the worth of the business' assets in their current use. This also considers the contribution of the assets to the total business value, which is valued on a going concern basis.

5 Guide 10 Page 5 of 7 3. The statement is false. In the context of business valuation, price and fair market value are not necessarily equivalent terms. There may be considerable differences between the terms. Fair market value is often determined within the setting of a notional (or hypothetical) market; price is not. Fair market value always presumes that there are equal negotiating strengths between buyers and sellers, which is not necessarily true with regard to the price. In addition, the definition of fair market value presumes that both parties have the same level of knowledge with respect to the business at hand. Again, this is not necessarily true as the seller generally has superior knowledge. Finally, fair market value presumes that neither party is under any compulsion to transact. However, there are situations that may occur that will increase an owner s desire to sell. 4. Mr. Deficit's statement does have validity. The key premise in liquidation value is that the business is not being valued as a going concern since the intention is to sell the subject assets as piecemeal. However, in the case of a manufacturer, for example, or any other company that has a significant inventory of work in progress or component parts, it must be determined whether the inventory would obtain a higher price if it were completed and sold as finished goods or if the items should simply be sold in their existing stage of completion. This is done by liquidation valuation, so in some cases it does apply. 5. A potential problem with using the earnings basis approach of valuation is when there are issues with the quality and objectivity of the financial statements, management projections, and other factors. This could be a result of poor accounting systems, optimistic or pessimistic management projections depending on the purpose of the valuation, and the personal objectives of the owner, e.g., sale or divorce. A potential problem with the asset basis valuation approach is the fact that this approach is limited to start-up businesses, small businesses that are relatively inexpensive to start, and businesses that are totally dependent on a small number of customers that are related in some way, and as such are limited in their application. Furthermore, it is based on the key premise that the business is not being valued as a going concern since the intention is to sell the subject assets piecemeal. However, when assessing a business that is viable as a going concern, this approach may not be the most appropriate. 6. The capitalization rate is an expression of risk. One factor in the selection of the capitalization rate is the degree of security or risk in future earnings. Security is represented, among other things, by the tangible asset backing of the business. In other words, the closer realizable asset value is to earnings value, the greater is the security, because the purchaser may realize on his or her outlay by continuing the operations or by disposing of the assets. 7. Goodwill has value by reference to future earning power. If this earning power cannot be transferred from vendor to purchaser, it is of no interest to the purchaser, and he or she will not pay for it. Examples: (1) A surgeon may be extremely competent and very successful financially. However, the surgical skill would not be available to another surgeon who might wish to buy the former s practice. Paying for goodwill would yield the purchaser nothing because once the vendor surgeon leaves, so would his skill and reputation.

6 Guide 10 Page 6 of 7 (2) An insurance agent, on the other hand, may serve a clientele year after year with a minimum of, or even no, personal contact. Each period, the agent merely sends out an invoice for another renewed term of insurance. A purchaser of this type of business can, and usually must, pay a premium over the tangible asset value of the business. The purchaser can normally expect to retain some portion of the business that was created prior to his taking over, and he or she will thus benefit from the efforts expended by the vendor. 8. It is not correct to assume that intellectual (intangible) assets will have a fair market value of zero if a company is being liquidated. To a large extent, it will depend on the reasons for the liquidation of the company. If the company is being liquidated due to depressed economic conditions, technological obsolescence, or changing consumer preferences, then it is likely that the intellectual assets of the company will have little, if any, value. If, on the other hand, the liquidation is a result of poor financing decisions, or a loss of key management, it is quite possible that the intangible assets of the company still have value to another company, such as a competitor. 9. Case Studies Review the case studies found under Online Readings on the course webpage. Consider how these valuations relate to your real estate valuation experiences. Can you identify the similarities and differences between business types? Muller, Ron Business Valuation Case Studies: C Case Study: Video Store C Case Study: Bike Store C Case Study: Bookkeeping C Case Study: Restaurant Answers to this question will vary, please share your experiences on the forum. 10. The determination of highest and best use is tricky for resi-mercial properties. The question is if the commercial aspect contributes substantially enough to overcome the residential use, or if it is fundamentally residential with some cash flow contribution. If two rooms versus four rooms tipped the balance between residential and commercial, then the appraisal would change substantially. For one, the CRA might be within scope versus not for the commercial property. The valuation approach would likely be direct comparison (residential), not income-based techniques. The cash flow potential would likely be considered as an adjustment within the direct comparison approach. This might be quantified with GIM or capitalization methods. However, the appraiser would have to verify that the market participants do in fact value this cash flow e.g., it isn t just value to the specific owner, but is a part of more general market value.

7 Guide 10 Page 7 of Undoubtedly the review presents some uncertainty surrounding the bed and breakfast; of particular concern is the question of which regulations will apply, the Province of Nova Scotia s or the Town of Lunenburg s. Both permit the use of a bed & breakfast/guest house, however, they differ on imposed limitations. The province s regulations limit the operational area to 25% of the floor area of a home, whereas the Town limits them to a room/unit count (three). It is clear from a comparison of the restrictions that smaller homes benefit from the Town s limitation, whereas larger homes benefit from the provincial regulation. Whichever is eventually enforced after the review, the uncertainty for Ms. Chary is slightly reduced as the Chary s would face one of two situations: (1) the current set-up of three bedrooms will be allowed (as per the Town s by-laws) or (2) the maximum allowable area dedicated to a bed & breakfast will be limited to 750 square feet (3,000ft =750ft 2 ). Therefore, whether this review will affect this future value will depend on whether or not the three rooms are within the maximum allowed 750ft 2 limit imposed by the province, as this would be the worst case scenario following the review. If the three bedrooms are within the limit, then no value adjustment is necessary. However, if the three bedrooms are not within the limit of 750 ft 2 then perhaps a value adjustment may be necessary to account for the uncertainty regarding the final specifications of the bed & breakfast.