Applicable to Real Estate Holding Companies (Part I of II)
In this two-part series, the author discusses real estate holding companies and describes the use of minority discounts (also known as the discount for lack of control [DLOC]) in the valuation of partial, non-controlling interests in entities holding real estate as their primary and most valuable asset. Part II will address the use of the discount for lack of marketability (DLOM) and certain other discounts applicable to interests in real estate holding companies.
In this two-part series, I will discuss real estate holding companies and describe the use of minority discounts (also known as the discount for lack of control [DLOC]) in the valuation of partial, non-controlling interests in entities holding real estate as their primary and most valuable asset. Part II will address the use of the discount for lack of marketability (DLOM) and certain other discounts applicable to interests in real estate holding companies.
The Role of the Valuation Specialist
Valuation specialists conduct an in-depth review of the organizational structure of the real estate organization before performing the number crunching. We are engaged for a variety of valuation assignments that involve real estate assets, including family-owned or private partnerships, limited liability companies that own and operate real estate, real estate companies engaged in development, leasing, property management services, and passively held private funds and portfolios holding various classes of real estate. For real estate holding companies, the most frequently used ownership structure is the Delaware limited liability company, followed by Delaware limited partnerships, both of which typically directly hold every type of property class (i.e., residential, commercial, retail, vacant land) and virtually all sizes. This is the case for a simple real estate holding company.
A more complex real estate organization may be a multi-tiered entity. Certain real estate organizations may be structured with several intervening layers of ownership that emerged as the business grew over several family generations, ownership changed, and assets diversified. There may be hundreds of interrelated entities with several layers of complex ownership in place. In general, the upper-tier entity provides a mechanism to centralize and roll-up holdings of partial interests in various entities involved in diverse real estate projects. Thus, there is an additional layer of ownership between a minority interest investor in an upper-tier company and a minority interest investor in the real estate holding company. Therefore, an additional layer of valuation discounts may be warranted
While the purpose of the valuations we perform varies, we are often engaged to perform valuations for: gift and estate tax filing purposes, transactional purposes such as partner redemptions and buyouts; estate administration and distribution; shareholder disputes; estate litigation; marital dissolution; IRS audits; and other advisory purposes. It is important to remember that valuations are performed for the ownership interest(s) in real estate holding companies, not the underlying real estate. In order to remain objective and unbiased, an independent real estate appraiser performs the appraisal of the underlying real estate. We then use the real estate appraisal in performing our valuation of certain ownership interests in the holding company.
Applying Minority Discounts for Partial Interests
The starting point for valuation is the entityâ€™s net asset value (NAV). NAV is defined as the market value of the real estate plus any other assets, less liabilities. The use of the asset approach in determining the value of an entity usually results in a value that reflects a controlling interest in the company, since the approach assumes that to receive the value of the assets, one must be able to execute an order to liquidate and receive value for the assets.
For partial interests that are not actually imbued with this level of control, an adjustment must be made to account for the fact that a prudent buyer would not be able to manage the assets or control investment decisions. This adjustment is typically made in the form of a minority discount or DLOC, which is calculated based upon a predetermined control premium. The control premium used in the calculation is derived from various sources, including the studies conducted by FactSet Mergerstat LLC.
To be able to apply a minority discount, a critical first step is to assess the provisions of an operating agreement or partnership agreement to ensure that provisions are in place that restrict owners of minority interests. The restrictions exist in order to centralize the management of the entity and preserve the operation of the business for the long-term. Following are a few of the prerogatives that are often not exercisable by a minority interest investor, which is a common scenario in all types of private investment partnerships, and particularly prevalent in the real estate industry:
- Control the day-to-day operations of the company;
- Change the companyâ€™s by-laws or amend the operating agreement;
- Set the general direction and investment policy of the company;
- Sell any or all of the underlying assets of the company;
- Liquidate the company;
- Borrow funds on behalf of the company;
- Determine the timing and amount of distributions;
- Appoint, replace, or remove management; and
- Hire and fire
Next, we defer to empirical data for the sale of non-controlling interests in real estate entities. We estimate and quantify the minority discount based on transactions of limited partnership units in publicly registered real estate limited partnerships (RELPs) published by Partnership Profiles, Inc., which publishes data on the pricing multiples paid in exchange for non-controlling interests in real estate entities, in armâ€™s length transactions. We also refer to real estate closed-end funds (CEFs). This empirical data from the capital markets is evidence of how investors regularly price minority interests in real estate holding entities or real estate funds.
We perform our analysis by searching for RELPs (or CEFs) that have attributes similar to the subject entity based on certain parameters such as: 1) type of property (i.e., commercial, hotel, land, multifamily, mobile home, triple net lease, mini-warehouse, etc.); 2) the yield/NAV ratio; 3) the debt/NAV ratio; and 4) whether the RELP is distributing or non-distributing.
Generally speaking, RELPs or CEFs trade at discounts to NAV. Such discounts vary in a wide range and may be correlated to factors such as cash flow, distributions, and leverage, among others. Not only does the discount reflect market realities, but it is built on the conceptual basis that investors will not pay nearly as much for an interest that lacks control over underlying assets and the entityâ€™s business affairs than an interest that has control. From the sample of RELPs or CEFs comparable to the subject entity, we calculate the median discount to NAV to arrive at a preliminary lack of control discount. For instance, if the median discount to NAV of similar RELPs is 15%, it is generally thought that for RELPs, 90% of this is due to lack of control, therefore, the 15% is adjusted to 13.5%.
While the minority discount estimate is based on objective evidence, such as the empirical studies, there are also subjective elements that deserve consideration. These subjective elements are generally evaluated based on our judgment and interpretation of specific prerogatives of control vested in the owner of the partial interest as outlined in the operating agreement mentioned above. For instance, based on the specific prerogatives of control of the interest as outlined in the operating agreement, an additional lack of control discount of 1% is applied to the 13.5% we initially determined, for a total 15% minority discount (rounded). Minority interest discounts in the real estate sector typically range from 10% to 25%, depending on the investment characteristics of the entity.
Once we have adjusted for lack of control of the partial ownership interest, a second adjustment is considered to account for the lack of liquidity and lack of marketability. This will be the subject of Part II of this article.
This article was previously published in Marks Panethâ€™s Real Estate Perspectives, May 24, 2019, and is republished here with permission.
Angela Sadang, MBA, CFA, ASA, is a Principal in the Advisory Services group at Marks Paneth LLP. Ms. Sadang specializes in business valuations and the valuation of intangible assets and has nearly 20 years’ experience providing corporate financial consulting services and performing valuations. She serves both publicly traded and closely held companies in a wide range of industries that also involves various asset classes.