Separating the Sale of a Multi-Unit Office Building from a Business Sale | Edison Avenue

By Eric J. Gall, Managing Partner, Edison Avenue
December 28, 2016

Oftentimes business owners would like to sell their commercial property with their business.  A recent "failed" transaction I was involved in on the buy-side involved the sale of a business and commercial property with an additional layer of complexity to the sale:  The Seller's commercial property included several leased office spaces in addition to the Seller's primary business, i.e., there are two very separate and distinct businesses for sale:

1. The Seller's income producing property.
2. The Seller's primary business.

VALUING THE INCOME PRODUCING PROPERTY

The first step in the valuation process is to value the property.

The value of commercial office space is largely derived from an income approach appraisal based on a simple formula for valuing commercial real estate:

Present Market Value = Net Operating Income / Capitalization Rate

NOI (Net Operating Income) is calculated by summing gross rents and other income generated by the property, then subtracting all operating expenses. Operating expenses include required management and upkeep expenses such as:

• Property Management
• Repairs and Maintenance
• Landscaping
• Marketing
• Taxes
• Insurance

Debt service/loan payments are not considered an operating expense. This is because each buyer will choose their own unique debt structures to finance and purchase the property based on their goals, objectives and credit worthiness. This choice influences net cash flow to the buyer, but does not impact the property’s value.

Present Market Value Calculation:

Income:
Seller's business Rent:  $68,000/year
Tenant #1 Rent:  $18,000/year  
Tenant #2 Rent:  $18,000/year 
Tenant #3 Rent:  $18,000/year 
Total Income:  $122,000/year

Expenses:
Property Management:  $1,200/year
Repairs & Maintenance:  $4,800/year
Landscaping:  $4,800/year
Marketing:  $1,200/year
Taxes:  $4,800/year
Insurance:  $3,600/year
Total Expenses:  $20,400/year

NOI (Net Operating Income) = Total Income - Total Expenses = $122,000 - $20,400 = $101,600

The next step is determining a fair capitalization rate (Cap Rate) for the market where the property is located. Commercial real estate lenders, brokers, and appraisers should have this information, especially for markets they service.

A market cap rate is determined by averaging the cap rates for similar properties in the market's geographic region. Each property will have its own cap rate at the time of sale and is calculated using the following formula:

Cap Rate = NOI / Purchase Price. 

Let's say the market's Cap Rate for multi-unit office properties for the example region is 8%.  With this Cap Rate, we can simply to determine the property’s value by taking the NOI and divide it by the cap rate.

Value = Cap Rate / NOI = $101,600 / 8% = $1,270,000

The building's value is $1,270,000.


VALUING THE BUSINESS

Valuing a business can be a very complicated process.  There are many acceptable methods to value a business; however, none are perfect as variables such as size, type, reason for sale, quality of financial statements, owner involvement, etc. all impact the business value.  Typically, a good estimate of business value can be completed by looking at historical sales of similar businesses.  

The first step is to gather your financial statements:  income (P&L), cash flow, and balance sheet. Next, with help of your business broker or CPA, recast the income statement to estimate the Seller's Discretionary Earnings (SDE).  To calculate SDE, net income is supplemented by "adding-back" the non-cash expenses such as depreciation and amortization; personal expenses such as the Seller's interest payments for business loans; the Seller's salary and personal payroll taxes; Seller's health and life insurance; Seller's personal non-business expenses such as an auto, auto insurance and cell phones; and special cause expenses such as purchase of equipment (Section 179 expense).  

KEY ITEMS OF NOTE REGARDING THE PROPERTY AND BUSINESS:
  

1. Rental incomes from the office-units were included in the property valuation.  Rental incomes are not part of the business operations; therefore, they cannot be included in the revenue in the business financial statements.  If they are, they must be subtracted from the business revenue line.
2. Property management and upkeep expenses were included in the property valuation.  These expenses are not part of the business operations; therefore, they cannot be included in the expenses on the business financial statements.  If they are, they must be added-back to calculate SDE.
3. The business is expected to pay a fair market rent.  If the tenants are paying $10/square foot in rent, the Seller's business should be expected to pay $10/square foot in rent.  If the Seller is giving him/herself a rent discount, then the difference between fair market rent and the rent the Seller is paying must be added to the Seller's expenses to create a fair valuation of both the property and the business.

Fair Market Rent Calculation:

Let's assume the Fair Market Rent is $10/square foot and each tenant is expected to pay $10/square foot.

Rent = Fair Market Rent x Square Footage

Hence, 

Square Footage = Rent / Fair Market Rent

Square Footage (Tenant) = $18,000 / $10 = 1,800 square feet.

Square Footage (Seller) = $68,000 / $10 = 6,800 square feet.

Let's say the seller is giving him/herself a discount by only paying $48,000/year in rent, or a $20,000 discount.  We've already used the full $68,000 in the valuation of the property, so no change would need to be made to the property value.  However, the $20,000 in additional fair market rent must be added as an expense and the net income of the business reduced accordingly.  


Calculation of Business revenue and SDE:

Income Statement Including Property:
Revenue including Rent:  $775,000
Expenses including Building:  $665,000
Net Income:  $775,000 - $665,000 = $110,000

Adjustments:
Removal of Rental Income from Business Revenue:  $775,000 - $122,000 = $653,000
Removal of Property Expenses from Business Expense:  $665,000 - 20,400 = 644,600
Business Net Income:  $653,000 - 644,600 = $8,400

The key item of note is the actual business revenue is $653,000, not $775,000.

Add-Backs:
Seller's Salary and Tax Benefits:  $100,000
Seller's interest:  $25,000
Depreciation and Amortization:  $40,000
Seller's Health and Life Insurance:  $25,000
Seller's Other Personal Benefits:  $18,000
Total Add-Backs:  $208,000

Business Net Income:  $8,400
Total Add-Backs:  $208,000
SDE:  $216,400

Let's say that either looking at historical sales of similar businesses or the published industry multiples, we find the revenue multiple is 0.90 times annual revenue and 2.5 times the SDE.  Using these multiples, the valuation calculations would be:

Revenue:  $653,000 x 0.90 = $587,700
SDE:  $216,400 x 2.5 = $541,000

Therefore, the business value would be somewhere around $541,000 to $587,700.  For simplicity, let's assume $562,500.

The total value for the business and property would be (estimated*):

Total Value = Property Value + Business Value = $1,270,000 + $562,500 = $1,832,500.


CONCLUSION:

Separating the property financial statements from the business financial statements is critical to valuing both the property and the business separately and equitably.  Failure to do so creates incorrect valuations, possibly unrealistic expectations from the Seller, and in my most recent case, considerably wasted time on a lost deal by both the buyer and myself.    

* Note:  Valuations are opinions and may very on numerous additional factors not considered in this analysis including quality of assets, quality of financial records, seller involvement and customer concentration among many others.

For additional information regarding Florida business sales, acquisitions and valuations, please contact Eric J. Gall at Eric@EdisonAvenue.com or 239.738.6227. Also, visit our Edison Avenue website at www.EdisonAvenue.com.