Income Statement Recasting

Rent Adjustments for Businesses with Non-Arm’s Length Leases

Valuing a Business with A Non-Arm’s Length Lease)

If a business rents its facility from an independent third party (i.e., arms-length lease), it is typically not necessary to make any adjustments to rent.  An exception can occur if the business has a binding long-term lease with below market rent (positive add-back).

With the exception of certain kinds of special-use or single-use properties, e.g., golf courses, it is necessary to treat the valuation of a business occupying shareholder-owned facility separately from the real estate.  This is also true for any non-arm’s length lease.  To separate the real estate value from the business value it is necessary to remove from the income statements all expenses associated with property ownership and to substitute a market rent for the premises occupied.  If the “market rent” is based on a triple-net lease, the business would also be responsible for insurance, property taxes as well as repairs & maintenance.  One should also remove all real estate-related balance sheet items such as mortgages, accumulated depreciation, etc.

Why are Businesses and Real Estate Valued Separately?

Businesses and real estate are two different types of investments.  The earnings multiple (1/cap rate) for commercial real estate may be on the order of 10 (i.e., value = net operating income/cap rate).  The operating income for a commercial property is related to the fair market rent to that type of facility, in that location, etc.  The fair market rent for a commercial property is independent of ownership.  It is also independent of whether or not the occupying business actually pays rent.

Using the income approach, and assuming a cap rate of 10%, the value of a commercial property with a net operating income (assume it is equal to fair market rent with a triple-net lease) of $100,000 would be $100,000/0.1 = $1,000,000.

If the business has SDE of $400,000 but doesn’t pay rent because the real estate is owned by the business, or the business’ shareholders, the market rent must be subtracted from SDE.  The adjusted SDE is then $300,000.  If the proper earnings multiple for the business is 3.0, the business value is $900,000.

The value of the real estate plus the business is $1,000,000 + $900,000 = $1,900,000.

If you don’t adjust rent (even if the business doesn’t pay rent) to fair market rent, you are in effect counting the rent twice.  You are counting it once as the income produced by the real estate; and, again as part of the business’ discretionary earnings.

If you don’t adjust SDE to account for market rent, you are in effect valuing the business and real estate together (i.e., you are adding their cash flows together).  The total SDE for the property and the real estate is $400,000.  If you use the earnings multiple for the business, the combination would be priced at $1,200,000 ($700,000 low).  If you use the cap rate for the real estate, the combination would be priced at $4,000,000 ($2,100,000 high).

What Discretionary Earnings Should  Be Shown in the Offering Memorandum?

Most misunderstandings arise between the way rent is treated in a business valuation versus the way it is treated in the Offering Memorandum or listing.  In the Offering Memorandum, the total cash flow of $400,000 would be shown if the real estate is included in the sale.  If the real estate is not included, and the Seller will charge market rent of $100,000, the adjusted cash flow of $300,000 would be shown (assuming there are no other expenses the business would have to pay that it is not already paying).  If the real estate is available, the Offering Memorandum should show the business cash flow of $300,000 if the buyer buys only the business.  In addition, there should be an indication of the total cash flow ($400,000) if the Buyer buys the real estate.