Considering the Fair Market Value Standard When Evaluating Fractional Interests

Why There is No Such Thing as a Minority Premium

Robert Buchanan of PCE Valuations writes about the application of discounts to fractional interests and argues that some appraisers are mistaken when they assert that certain levels of discounts amount to a “minority premium” for certain non-controlling interests. Here’s the logic behind his thinking.

Be sure to read Mr. Buchanan’s whole argument at HERE. Here are some key points:  

Fractional Interests

A fractional interest, often called an undivided interest, is an ownership interest in a percentage of an asset (generally real estate) that cannot be identified as a specifically defined portion of the asset. So, if there were four equal owners of undivided interests in a four-acre parcel of land, each would own 25% of the whole, but none would own any specific 25%. Therefore, no one owner could sell his one-acre equivalent; an owner does not own one acre, he owns 25% of four acres. In order to sell, everyone must agree, or the owner wishing to sell must seek partition, a judicial remedy. “The ‘minority premium’ theory assumes that the ‘willing seller’ is also a ‘willing buyer’ and is, in fact, a specific buyer willing and able to buy from a specific seller.”  Because of the inability to act in relation to the asset (translate as “inability to sell”), the market has generally recognized some reduced value for such an interest, below the pro-rata value of the whole. This is as true for very large percentage ownership interests as well as for very small interests.

The Theory of the “Minority Premium”

The idea presented at the symposium is that the application of a discount to a large interest should be no larger than the price to buy out a corresponding smaller interest at its “full value” or at some premium. That is, if the discount applied to an interest exceeds the amount to buy out the corresponding smaller interest, the holder of the larger interest would never sell, but would instead use the difference to buy all of the rest of the interests and gain full control. For instance, consider a 99% undivided interest in a $1 million property (pro-rata value of $990,000). Applying a discount of 30% would leave $693,000. The argument is that the owner of the 99% interest ought to be able to buy out the other 1% interest holder (pro-rata value of $10,000) for much less than the applied discount ($297,000). Meaning the larger interest holder would be willing to pay up to $297,000 for the 1% interest. Therefore, the application of the discount creates a “minority premium” for the 1% ownership interest. Clearly, the logic of this makes sense. However, the theory makes certain assumptions that are rarely true, and are never true using the FMV standard.

The Assumptions

The “minority premium” theory assumes that the “willing seller” is also a “willing buyer” and is in fact, a specific buyer willing and able to buy from a specific seller. Both the buyer and seller must be owners of undivided interests in the same asset. In addition, the buyer must be able to gain complete control of the underlying asset, eliminating the fractional nature of the interest, and therefore must be able and willing to buy out all other interest holders. Furthermore, the theory assumes that all other interest holders are willing sellers. Finally, this theory assumes all other interest holders aren’t knowledgeable enough or informed enough to demand all but the last dollar of the discount that would be applicable to the owner of the other interest (the buyer in this scenario). This is what we would call a “strategic transaction.”

The Standard

FMV requires that we consider value from the view of a “hypothetical willing buyer” and a “hypothetical willing seller”. FMV also requires consideration only of the value of interest held. Unfortunately, all of the above assumptions ignore the basic premise of value. The idea behind FMV is that we are to examine the value of the interest in question given a certain set of facts, considering how those facts will be analyzed by the market of buyers, in general. Here, those facts are that the underlying asset cannot be sold by the buyer of the interest being considered (and only the interest being considered) without pursuing a lawsuit for partition against the other interest holders. Aside from the fact market participants rarely seek investments that require litigation, the remedy of partition ignores the economic reality common in these situations that partitioning the underlying asset frequently diminishes value (the underlying asset is frequently worth more as a whole than as separate and distinct pieces).

Even without exploring the empirical market data that suggests fractional interest discounts are very real the “minority premium” theory is only possible by ignoring the FMV standard of value. Once FMV isn’t a concern, it’s easy. Of course, because we can’t ignore the FMV standard, there is no “minority premium” outside of a “strategic transaction.”