Best Practices for Bankruptcy-Related Property Appraisals

Part III of IV

This four-part article summarizes what valuation specialists in all property appraisal disciplines (herein called “appraisers”), company managements, and their legal counsel need to know about property appraisals prepared within a bankruptcy environment. For purposes of this discussion, the term property includes real estate and real property, tangible personal property, and intangible personal property. Part one of this article discussed the reasons to conduct the bankruptcy-related property appraisal. Part two of this article discussed (1) the elements of the property appraisal assignment and (2) the appraiser’s due diligence considerations. This third part summarizes the generally accepted bankruptcy-related property appraisal approaches and methods.

Introduction

Several macroeconomic influences have recently converged to negatively impact the financial condition of debtor companies operating in various industry sectors. Accordingly, some industrial and commercial company managements are considering the implications of a bankruptcy filing. Some of these debtor company managements are considering the reorganization opportunities available in a Chapter 11 bankruptcy proceeding. These managements often expect that the debtor company will emerge from bankruptcy protection with a reorganized capital structure and a lower-cost operating expense structure.

Property appraisals are a common element in many commercial bankruptcy proceedings. This four-part article summarizes what valuation specialists in all property appraisal disciplines (herein called “appraisers”), company managements, and their legal counsel need to know about property appraisals prepared within a bankruptcy environment. For purposes of this discussion, the term property includes real estate and real property, tangible personal property, and intangible personal property.

Part one of this article discussed the reasons to conduct the bankruptcy-related property appraisal. Part two of this article discussed (1) the elements of the property appraisal assignment and (2) the appraiser’s due diligence considerations. This third part summarizes the generally accepted bankruptcy-related property appraisal approaches and methods.

Generally Accepted Property Appraisal Approaches and Methods

The three generally accepted property appraisal approaches are the cost approach, the market approach, and the income approach. For both bankruptcy and most other purposes, these property appraisal approaches generally apply to real estate, to tangible personal property, and to intangible personal property.

Appraisers typically consider, and attempt to apply, all three generally accepted property appraisal approaches in each debtor company property appraisal. Practically, due to data constraints, many bankruptcy-related property appraisals are based primarily on the application of only one or two of the property appraisal approaches.

For each industrial or commercial company property appraisal, the appraiser selects the generally accepted approach (or approaches):

• For which there are the greatest quantity and quality of available data,
• For which the appraiser can perform the most comprehensive due diligence procedures,
• That best reflect the actual transactional negotiations of market participants in that industry segment,
• That best fit the characteristics (e.g., use, age, etc.) of the debtor company property, and
• That are most consistent with the professional experience and informed judgment of the appraiser.

Within each property appraisal approach, there are several appraisal methods that the appraiser can select and apply. And, within each appraisal method, there are numerous appraisal procedures that the appraiser can perform. Appraisal procedures are performed within a method to conclude a value indication. The appraiser may develop two or three different appraisal methods within a single appraisal approach.

For example, the appraiser may develop two different income approach methods and reconcile the three value indications to conclude a single income approach value indication.

The appraiser reconciles the various value indications (if more than one approach is used). This synthesis of the various value indications results in a final value conclusion for the debtor company property.

All the cost approach appraisal methods are based on the principle of substitution. That is, the value of the actual property is influenced by the cost to create a substitute property. All cost approach appraisal methods apply a comprehensive definition of cost, including consideration of an opportunity cost component during the property development stage. In addition, the cost of the substitute property should be reduced (or depreciated) to make the substitute property comparable to the actual property.

All market approach appraisal methods are based on the principles of (1) efficient markets and (2) supply and demand. That is, the value of the debtor company property may be estimated by reference to prices paid in the marketplace for the arm’s-length sale, lease, or license of comparable (or guideline) property. Comparable sale data are analyzed in order to extract pricing multiples or other metrics that can be applied to the debtor company property.

All income approach appraisal methods are based on the principle of anticipation. That is, the value of any income-producing property is the present value of the income that the owner/operator expects to receive from owning or operating that property. All income approach appraisal methods involve a projection of some measure of owner/operator income over the property’s expected UEL.

Such income measures may relate to:

• The income earned from operating the property in the owner/operator business enterprise, and/or
• The income earned from leasing or licensing the property from the owner/licensor to an operator lessor/license that will pay a lease payment or a royalty (or some other fee) for the use of the property.

This income projection is converted to a present value by the use of a risk-adjusted present value discount rate (or an annuity direct capitalization rate).

Cost approach appraisal methods may be particularly applicable to the appraisal of a recently developed debtor company property. In the case of relatively new property, the debtor company development cost and development effort data may be available (or may be subject to accurate estimation).

In addition, cost approach appraisal methods may be applicable to the appraisal of in-process property, special purpose property, or noncommercialized property.

In all cases, the appraiser should realize that the debtor company property value is not derived from the cost measure alone. Rather, the property value is derived from the cost measure (however defined) less appropriate allowances for all forms of depreciation and obsolescence.

Market approach appraisal methods may be applicable when there is enough comparable (almost identical) or guideline (similar from an investment risk and expected return perspective) property transaction data. These transactions may relate to either sale, lease, or license transactions.

The appraiser attempts to extract market-derived valuation pricing indications (e.g., pricing multiples or other metrics) from these comparable transaction data to apply to the corresponding metrics of the subject property.

Income approach appraisal methods may be applicable in situations where the debtor company property is used to generate a measurable amount of income. This income can either be:

• Operating income (when the property is used in the owner’s business operations), or
• Ownership income (when the property is leased or licensed from the owner/licensor to an operator/licensee) to produce rental or royalty income.

Income approach appraisal methods may be applied when the owner/operator has elected to not currently commercialize the property. An example may be when this forbearance of use is for the purpose of protecting the income that is produced by the owner/operator’s other property.

For Further Reference

The following discussion summarizes the generally accepted property appraisal approaches and methods. This discussion is intended to be general and to apply to all debtor company property categories. There exist both professional literature and valuation professional organization (VPO) professional standards related to the appraisal of the individual categories of debtor company property.

For example, for a more comprehensive discussion of real estate appraisal approaches, methods, and procedures, readers are referred to The Appraisal of Real Estate, 15^th edition, published by the Appraisal Institute in 2020.

For a more comprehensive discussion of tangible personal property appraisal approaches, methods, and procedures, readers are referred to Valuing Machinery and Equipment: The Fundamentals of Appraising Machinery and Technical Assets, 4^th edition, published by the American Society of Appraisers in 2020.

And, for a more comprehensive discussion of intangible personal property appraisal approaches, methods, and procedures, readers are referred to Guide to Intangible Asset Valuation, revised edition, published by the American Institute of Certified Public Accountants in 2014.

Cost Approach Appraisal Methods

There are several generally accepted property appraisal methods within the cost approach. Each of the appraisal methods applies a particular definition of cost.

These definitions of cost include the following:

• Reproduction cost new (RPCN)
• Replacement cost new (RCN)
• Historical cost or original cost (HC or OC)

RPCN is the total cost, at current prices, to develop an exact duplicate of the actual property. RCN is the total cost, at current prices, to develop an asset having the same functionality or utility as the actual property.

Functionality is an engineering concept that means the ability of the property to perform the task for which it was designed. Utility is an economics concept that means the ability of the property to provide an equivalent amount of satisfaction.

Historical cost is less frequently applied in cost approach property appraisals. However, it is sometimes applied in the development of unit principle property appraisals developed for property tax and some other purposes. And historical cost is sometimes applied in the appraisal of public utility or other regulated-industry property. Historical cost considers the cost of the subject property when it was originally purchased, constructed, or developed.

In contrast, original cost considers the cost of the subject property when it was purchased, constructed, or developed by the current property owner. So, historical cost considers the price paid by the very first property owner—when the property was first placed in service. Original cost considers the price paid by the current owner to the previous property owner. In a business combination (e.g., a merger or acquisition transaction), the original cost of the property may be influenced by the transaction purchase price allocation.

There are other cost definitions that may be applicable to a cost approach property appraisal. Some appraisers consider a measure of cost avoidance as a cost approach method. This method quantifies either historical or prospective costs that are avoided because the debtor company actually owns (and does not have to lease or license) its own property.

Some appraisers consider either historical cost or trended historical cost as a cost measure. In the trended historical cost method, historical development costs are identified and trended to the valuation date by an inflation-based index factor.

Regardless of the specific cost definition applied, all cost approach appraisal methods include a comprehensive definition of cost. The cost measurement (whether RCN, RPCN, or some other cost measure) typically include the following four cost components:

• Direct costs (e.g., materials)
• Indirect costs (e.g., engineering and design labor)
• The property developer’s profit (on the direct cost and indirect cost investment)
• An opportunity cost/entrepreneurial incentive (to motivate the property development process)

The material, labor, and overhead costs related to the property or development may be easy to identify and quantify. The developer’s profit may be estimated using several procedures. It is often estimated as a percentage profit margin on the developer’s investment in the material, labor, and overhead costs.

The entrepreneurial incentive may be measured as the lost profits during the replacement property development period. Alternatively, entrepreneurial incentive is sometimes measured as a fair rate of return on investment during the duration of the property development process.

For example, let’s assume it would take two years for the debtor company owner/operator to develop a replacement property. If the buyer buys the debtor company’s actual property, then that buyer can start earning income (either operating income or license income) immediately. In contrast, the buyer will have to wait two years to generate any income from the to-be-constructed replacement property.

To illustrate entrepreneurial incentive, let’s consider the development of a replacement property. If the property buyer “builds” its own hypothetical replacement property, then the property buyer will not earn any income (operating or license) during the two-year development period.

The two years of lost profits during the hypothetical property development period represents the opportunity cost (to the buyer) of developing a new replacement property—compared to buying the debtor company’s actual property.

All four cost components—that is, direct costs, indirect costs, developer’s profit, and entrepreneurial incentive (or opportunity cost)—should be considered in the cost approach analysis. While the cost approach is a different set of analyses from the income approach, there are economic analyses included in the cost approach.

These cost approach economic analyses provide indications of both:

• The appropriate levels of opportunity cost (if any), and
• The appropriate amount of economic obsolescence (if any).

The current cost metric (however measured) should be adjusted for losses in value due to:

• Physical deterioration,
• Functional obsolescence, and
• External obsolescence.

Physical deterioration is the reduction in property value due to physical wear and tear. It is unlikely that a debtor company intangible property will experience physical deterioration. Nonetheless, this type of appraisal depreciation should be considered in every debtor company property appraisal.

Functional obsolescence is the reduction in property value due to the property’s inability to perform the function (or yield the periodic utility) for which it was originally designed. The technological component of functional obsolescence is a decrease in property value due to improvements in technology that make the actual property less than the ideal replacement for itself.

External obsolescence relates to a decrease in property value due to influences external to (or outside of) the subject property. The economic obsolescence component of external obsolescence is a reduction in property value because events or conditions that are external to—and not controlled by—the property’s current use or condition.

The impact of economic obsolescence is typically beyond the control of the debtor company.

In any cost approach analysis, the appraiser typically estimates the amounts (if any) of the property physical deterioration, functional obsolescence, and economic obsolescence. In this estimation, the appraiser typically considers the property’s actual age—and its expected UEL.

Appraisers sometimes apply the following cost approach formula to quantify RCN: RPCN – curable functional obsolescence = RCN.

To estimate the debtor company property value, appraisers often apply the following cost approach formula: RCN – physical deterioration – economic obsolescence – incurable functional obsolescence = property value.

In summary, in the application of the cost approach to value debtor company property within a bankruptcy context, the appraiser should recognize the following first principles regarding the cost approach:

1. The cost approach value indication does not equal accounting net book value (and the cost approach does not include the so-called “net book value” method).
2. The cost approach to property appraisal is not the same as the asset-based approach to business valuation.
3. The cost approach only considers future costs. That is, the cost approach considers the costs that would be measured on the valuation date to replace or reproduce the subject property. The cost approach is not a backward-looking analysis.
4. The so-called cost savings method is an income approach appraisal method, not a cost approach appraisal method.
5. The cost approach considers capitalizable expenditures, and not current period expenses.
6. The cost approach should consider an opportunity cost component (as part of the entrepreneurial incentive cost component).
7. The cost approach should consider all forms of obsolescence.
8. The cost approach does not typically consider any income tax considerations. That is, the cost approach is a “before tax” or tax neutral analysis.

Market Approach Appraisal Methods

Appraisers often attempt to apply market approach appraisal methods first in the debtor company property appraisal process. This is because the market—that is, the economic environment where arm’s-length transactions between unrelated market participants occur—often provides the best indicator of value.

However, the market approach will only provide meaningful valuation pricing evidence when the actual (i.e., the debtor’s) property is sufficiently similar to the guideline properties that are transacting (by sale, lease, or license) in the marketplace. In that case, the guideline transaction (sale or license) prices may provide market-derived evidence of the expected price for the debtor company’s property.

The generally accepted market approach property appraisal methods include the following:

1. The comparable transaction (or comparable sales) method (principally applied to tangible property).
2. The relief from royalty method (principally applied to intangible property).

In the comparable transaction method, the appraiser searches for arm’s-length sales, leases, or licenses of either comparable or guideline property.

For example, in the intangible property relief from royalty (RFR) appraisal method, the appraiser recognizes that the debtor company in fact owns the subject intangible property. However, the appraiser assumes that, if the debtor company did not actually own the intangible property, then the debtor would have to inbound license the use of that property from a third-party licensor.

Therefore, because the debtor company does own the actual property, the debtor is “relieved” from having to pay a royalty payment on the inbound license of the property. The appraiser values the subject intangible property as the present value of the license royalty payment that the debtor company is “relieved” from paying.

In the application of the comparable transaction method, the appraiser often relies on comparable or guideline sale transactions related to real estate or tangible personal property. This is because third-party sales of tangible property are more typical than third-party sales of intangible property.

In the comparable transaction method, first, the appraiser researches the appropriate exchange markets to obtain information about sale transactions, involving either guideline (i.e., similar from an investment risk and expected return perspective) or comparable (i.e., almost identical) property that may be compared to the debtor company’s property.

Some of the comparison attributes may include characteristics such as property type, property use, industry in which the property operates, date of sale, and so on.

Second, to the extent possible, the appraiser verifies the transactional information by confirming that (1) the transactional data are factually accurate and (2) the sale exchange transactions actually reflect arm’s-length market considerations.

If the guideline sale or license transaction was not at arm’s-length market conditions, then adjustments to the transactional data may be necessary.

This verification procedure may also elicit additional information about the current market conditions related to the potential sale of the actual debtor company property.

Third, the appraiser typically selects relevant units of comparison (e.g., income pricing multiples or dollars per unit—such as “per horsepower” or “per square foot”). And, the appraiser develops a comparative analysis for each selected unit of comparison.

Fourth, the appraiser compares the selected guideline or comparable property sale or license transactions with the debtor company’s actual property, using the selected elements of comparison.

Then, the appraiser adjusts the sale price of each guideline transaction for any differences between (1) the guideline property and (2) the actual property. If such comparative adjustments cannot be measured, then the appraiser may eliminate the sale transaction as a guideline for future appraisal consideration.

Fifth, the appraiser selects pricing metrics to apply to the actual property from the range of pricing metrics indicated from the guideline or comparable transactions.

The appraiser may select pricing multiples at the low end, midpoint, or high end of the range of pricing metrics indicated by the transactional sale data. The appraiser selects the subject-specific pricing metrics based on the appraiser’s comparison of the actual property to the guideline property.

Sixth, the appraiser applies the selected subject-specific pricing metrics to the debtor company’s financial or operational fundamentals (e.g., revenue, income, amount of motor horsepower, amount of building square feet, etc.). This procedure typically results in several market-derived value indications for the debtor company’s property.

Seventh, the appraiser reconciles the various value indications produced from the analysis of the guideline sale transactions into a single market approach value indication. In this final reconciliation procedure, the appraiser summarizes and reviews (1) the transactional data and (2) the quantitative analyses (i.e., various pricing multiples) that resulted in each value indication.

Finally, the appraiser resolves these multiple value indications into a single market approach value indication.

The appraiser may confer with the debtor company management to explore whether the debtor itself has entered into any property sale agreements. These debtor company agreements may relate to the sale of operating property or surplus property—either before or during the bankruptcy proceedings.

The RFR appraisal method also relies on arm’s-length transactional data—in this case, the inbound or outbound license of comparable or guideline intangible property. Some appraisers consider the RFR method to be an income approach appraisal method. This is because a projected royalty expense savings is capitalized in order to reach a value indication.

Other appraisers consider the RFR method to be a cost approach appraisal method. This is because the “cost” of the royalty (i.e., the expense of the license payment) is avoided because rights associated with the intangible property is owned by the debtor owner/operator.

However, this intangible property appraisal method is typically considered to be a market approach method. This is because the RFR method relies on market-derived, empirical transaction data.

In applying the RFR method, the appraiser assumes that the debtor company does not own the actual intangible property. Without this ownership, the debtor company would have to license the intangible property from a hypothetical licensor.

So, the debtor company becomes a hypothetical licensee that licenses the intangible property from a hypothetical third-party licensor. In that scenario, the debtor company or licensee would have to pay a royalty payment to the hypothetical owner or licensor. The royalty payment would be for a use license to use the intangible property in the debtor’s business operations.

The debtor company does own the intangible property. Because of that ownership, the debtor company avoids the cost of having to pay a use license royalty payment to a third-party licensor. Therefore, the debtor’s intangible property can be valued by reference to this hypothetical royalty payment that the debtor is relieved from making.

The hypothetical royalty payment is often calculated as a market-derived royalty rate multiplied by the debtor company’s revenue. So the application of this appraisal method requires:

1. An analysis of comparable property license royalty rates, and
2. A projection of the debtor entity revenue related to the use of the actual intangible property.

In this appraisal method, the revenue expected to be generated by the intangible property (from all sources) during its UEL is multiplied by the selected royalty rate. The product of the multiplication is a projection of the royalty expense that the owner/operator is relieved from paying because of its ownership of that intangible property.

This projected royalty expense is capitalized over the intangible property’s UEL. The result of this capitalization process is the intangible property value indication.

Although the projected royalty expense is typically based on a royalty rate multiplied by the debtor company’s revenue, it could also be based on a royalty rate multiplied by gross profit, net income, number of units produced, number of units sold, or some other owner/operator metric.

The royalty expense should be the amount of the net royalty expense that the debtor company is relieved from paying. Therefore, if the debtor company would have to pay for intangible property development, maintenance, promotion, or legal protection expenses (as part of its licenses agreement), then these expenses should be subtracted from the royalty expense projection.

The objective of the analysis is to measure the net benefit to the debtor company from not having to inbound license the intangible property. So when analyzing the transactional data, the appraiser should consider which party would be responsible for these intangible property maintenance expenses: the actual owner or licensee or the hypothetical owner or licensor.

In the application of the RFR appraisal method, the appraiser typically develops the following procedures:

1. Select and document the criteria to be used for selecting the comparable license agreements; such criteria could include the type of intangible property, the type of owner/operator, the industry in which the property is used, the size of the market in which the property is used, and the dates and terms of the license agreements.
2. Assess the terms of each selected intangible license agreement with consideration of:

• • The description of the bundle of legal rights for the licensed comparable property,
  • The description of any maintenance or other expenditures required for the comparable property (for example, product development, advertising, product promotion, or legal protection),
  • The effective date of the comparable license agreement,
  • The termination date of the comparable license agreement, and
  • The degree of exclusivity of the comparable license agreement.

3. Assess the status of the industry and the associated relevant market and prospective trends.
4. Estimate an appropriate market-derived capitalization rate for the royalty expense projection; the capitalization rate considers the risk of the royalty expense projection and the UEL of the intangible property.
5. Apply the market-derived capitalization rate to the royalty expense avoidance projection to conclude a value indication.

The RFR method has application for the type of intangible property that is typically licensed between licensors and licensees. This appraisal method is also applicable when there are a sufficient number of comparable license agreements related to sufficiently similar intangible property.

The RFR method may be especially applicable when the intended standard of value is fair value or fair market value. That is because this appraisal method is based on actual arm’s-length transactions (licenses) between independent parties.

It may be applicable when the appraiser has access to the debtor’s financial projections, especially debtor revenue projections. It may also be applicable when the appraiser has developed an estimate of the intangible property’s UEL.

The RFR method may be less applicable in the following circumstances:

• In the analysis of intangible property that is not typically licensed between a licensor and a licensee.
• When there is not a sufficient quantity of comparable license agreements or if the licensed intangible property is not sufficiently similar to the actual intangible property.
• When the appraiser does not have access to management-prepared financial projections or cannot estimate the subject intangible property’s UEL.
• When the appraiser does not have sufficient information about which comparable transaction party (licensor or licenses) is responsible for the intangible property maintenance and protection expenses.

Income Approach Appraisal Methods

In the application of the income approach, value is estimated as the present value of the future income from the ownership/operation of the debtor company’s property.

The present value calculation has three principal components:

1. An estimate of the duration of the income projection period, typically measured as the debtor property’s UEL.
2. An estimate of the property–related income for each period in the UEL projection, typically measured as either (a) owner income (e.g., lease rent or license royalty income), (b) operator income (e.g., some portion of the total business enterprise income), or (c) both.
3. An estimate of the appropriate present value discount rate or direct capitalization rate, typically measured as the required rate of return on an investment in the debtor’s property.

For purposes of the income approach, the property’s UEL relates to the period of time over which the debtor company expects to receive the income metric related to the subject property:

• Lease,
• License,
• Operational use, or
• Forbearance of operational use.

In addition to the term (i.e., duration) of the UEL, the appraiser may also be interested in the shape of the UEL curve. That is, the appraiser may be interested in the annual rate of decay of the debtor property’s expected future income.

For purposes of the income approach analysis, many different income measures may be relevant. If properly applied, these different income measures can all be applied in the income approach analysis to conclude a value indication.

Some of the different income measures that may be applied in the income approach analysis include the following:

• Gross or net revenue
• Gross income (or gross profit)
• Net operating income
• Net income before tax
• Net income after tax
• Operating cash flow
• Net cash flow
• Incremental income
• Differential income
• Rent or royalty income
• Excess earnings income
• Several others

Because there are different income measures that may be applied in the income approach, it is important for the capitalization rate (either the present value discount rate or the direct capitalization rate) to be derived on a basis consistent with the level of income measure applied in the appraisals.

Regardless of the measure of income considered in the income approach, there are several categories of appraisal methods that may be applied to value the debtor company’s property:

1. Appraisal methods that quantify an incremental level of property income—that is, the debtor company may expect a greater level of revenue (however measured) by owning/operating the property as compared to not owning/operating the property.

a. Alternatively, the debtor company may expect a lower level of costs—such as capital costs, investment costs, or operating costs (expenses)—by owning/operating the property as compared to not owning/operating the property.

2. Appraisal methods that estimate the present value of actual or hypothetical lease or rent license royalty income—that is, these methods estimate the amount of actual or hypothetical lease or royalty income that the entity company (as licensor) would generate from the outbound license of the use of the subject property.

3. Appraisal methods that estimate a residual measure of property income—that is, these methods typically start with the debtor company overall business enterprise income. Next, the appraiser identifies all of the tangible property and routine intangible property (other than the subject property) that are used in the debtor company’s overall business.

a. These other properties are typically called “contributory assets.” The appraiser then multiples a fair rate of return times the value of each of the contributory assets. The product of this multiplication is the fair return on all of the contributory assets.
b. The appraiser then subtracts the fair return on the contributory assets from the debtor business enterprise total income. This residual (or excess) income is the income related to the subject property.

4. Appraisal methods that rely on a so-called profit split—that is, these methods typically also start with the debtor company’s business enterprise total income.

a. Typically applied to the appraisal of intangible property, the appraiser then allocates or “splits” this total income between (a) the company’s tangible property and routine intangible property and (b) the subject property.
b. The profit split percent (e.g., 20%, 25%, etc.) to the subject property is typically based on the appraiser’s functional analysis of the debtor company’s business operations. As it contributes to the production of the debtor company’s business total income, this functional analysis identifies the relative importance of:

i. The subject property, and

ii. The routine (or contributory) assets.

5. Appraisal methods that quantify comparative income—that is, these methods compare the debtor company’s income to a benchmark measure of income that, presumably, does not benefit from the use of the subject property.

a. Such benchmark income measures typically include: (a) the debtor company’s income before the subject property development, (b) industry average income levels, or (c) selected guideline publicly traded company income levels.

b. One typical measure of income for these comparative analyses is the earnings before interest and taxes (EBIT) margin.

c. When publicly traded companies are used as the comparative income benchmark, the method is sometimes called the comparable profit margin method.

All of these income approach property appraisal methods can be applied using either:

• The direct capitalization procedure, or
• The yield capitalization procedure.

In the direct capitalization procedure, the appraiser:

• Estimates a normalized income measure for one future period (typically, one year), and
• Divides that measure by an appropriate investment rate of return.

The appropriate investment rate of return is called the direct capitalization rate. The direct capitalization rate may be derived for:

• A perpetuity time period, or
• A specified finite time period.

This selection of the capitalization period depends on the appraiser’s estimate of the subject property’s expected UEL.

Typically, the appraiser concludes that the subject property has a finite expected UEL. In that case, the appraiser may use the yield capitalization procedure. Or, the appraiser may use the direct capitalization procedure with a limited life direct capitalization rate.

Mathematically, the limited life capitalization rate is typically based on a present value of annuity factor (PVAF) for the subject property’s expected UEL.

In the yield capitalization procedure, the appraiser projects the appropriate income measure for several future time periods. The discrete time period is typically based on the subject property’s expected UEL. This income projection is converted into a present value using a present value discount rate.

The present value discount rate is the investor’s required rate of return—or yield capitalization rate—over the expected term of the income projection.

The result of either the direct capitalization procedure or the yield capitalization procedure is the income approach value indication for the debtor company’s property.

Summary

Property appraisals are a common element of most commercial bankruptcy proceedings. This four-part series considers what appraisers, parties-in-interest to the bankruptcy, and their legal counsel need to know about the property appraisal process.

This third part summarized the generally accepted property appraisal approaches and methods that are typically considered in a bankruptcy-related property appraisal. The fourth and final part of this series considers (1) the property appraisal synthesis and conclusion process and (2) the development of the bankruptcy-related property appraisal report.

The opinions and materials contained herein do not necessarily reflect the opinions and beliefs of the author’s employer. In authoring this discussion, neither the author nor Willamette Management Associates, a Citizens Company, is undertaking to provide any legal, accounting or tax advice in connection with this discussion. Any party receiving this discussion must rely on its own legal counsel, accountants, and other similar expert advisors for legal, accounting, tax, and other similar advice relating to the subject matter of this discussion.

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Robert Reilly, CPA, ASA, ABV, CVA, CFF, CMA, is a Managing Director in the Chicago office of Willamette Management Associates, a Citizens company. His practice includes valuation analysis, damages analysis, and transfer price analysis.

Mr. Reilly has performed the following types of valuation and economic analyses: economic event analyses, merger and acquisition valuations, divestiture and spin-off valuations, solvency and insolvency analyses, fairness and adequacy opinions, reasonably equivalent value analyses, ESOP formation and adequate consideration analyses, private inurement/excess benefit/intermediate sanctions opinions, acquisition purchase accounting allocations, reasonableness of compensation analyses, restructuring and reorganization analyses, tangible property/intangible property intercompany transfer price analyses, and lost profits/reasonable royalty/cost to cure economic damages analyses.

Mr. Reilly has prepared these valuation and economic analyses for the following purposes: transaction pricing and structuring (merger, acquisition, liquidation, and divestiture); taxation planning and compliance (federal income, gift, estate, and generation-skipping tax; state and local property tax; transfer tax); financing securitization and collateralization; employee corporate ownership (ESOP employer stock transaction and compliance valuations); forensic analysis and dispute resolution; strategic planning and management information; bankruptcy and reorganization (recapitalization, reorganization, restructuring); financial accounting and public reporting; and regulatory compliance and corporate governance.

Mr. Reilly can be contacted at (773) 399-4318 or by e-mail to RFReilly@Willamette.com.