Is Your Bank Double Counting Cash Flow?

Franz H. Ross, CBA, CVA, MAI   •   August, 2020

Everything you need to know about the CRE $500,000 evaluation threshold

CES sees a lot of SBA involvement on many appraisal requests lately.  SBA can be an excellent support to banks from a risk management perspective, but there are issues unforeseen by SBA and most bankers for even relatively small transactions.  Furthermore, most of the points made in this brief article are applicable too many non-SBA transactions.

In 2010 Business Valuation Resources published the article, Dual Appraisals:  Real Estate or Business – A Case Study.[i]  An updated version of this article appeared in BVR’s text titled, Valuing Companies With Real Estate, published in 2014.[ii]

The primary theme of both articles was that the U.S. Small Business Administration was allowing for special purpose properties to be appraised, using two appraisers:  a qualified business appraiser for the business assets, as well as a qualified real estate appraiser.  Since very few banks manage real estate appraisals and business valuations under the same area in the org chart, and since there was no requirement that the appraisers work together to create a cohesive product, the risk of appraisal error due to “too many cooks” is huge.  These issues continue in 2020.

Both articles explained, if the business is relatively stable, determination of stabilized cash flow (defined here as EBITDAR) should be determinable within a narrow range.  But the allocations of EBITDAR between real estate and business may cause double counts or omissions.  The resulting appraisal reports may not be misleading when viewed separately, but are misleading when viewed together.  USPAP prohibits appraisers from producing misleading reports, but there is no USPAP violation here, as USPAP does not address the issue of two appraisers valuing separate components of a Going Concern.  (The Appraisal Foundation needs to fix this!)

OCC is virtually silent on the topic of business valuation, not requiring the strictly defined roles for business appraisal order and review that OCC mandates for real estate appraisals.  Banks typically have an SBA processing specialist order the business valuation, and this manager of the bank’s SBA function generally has little or no knowledge of the appraisal function as managed by the bank’s real estate appraisal department.

Many real estate appraisers and bankers objected to the difficulty in following SBA’s requirements for going concern appraisals.  The unsatisfactory alternative was to hire a business appraiser for the business assets of, for example, a restaurant, with a real estate appraiser valuing the real estate. This alternative is both more costly and is likely to result in an inferior combined appraisal of the going concern.  In two of the issued SOPs[iii], the only real estate appraiser who could do a going concern appraisal was a Certified General who also had one of the recognized BV designations.  (There are probably less than 50 such appraisers in the U.S. today).  SBA responded to new dissatisfaction from bankers and real estate appraisers  in 2015 by segmenting appraisals into non-special purpose and special purpose properties.  Beginning with SOP 50 10 5 H, excluding deminimus situations, non-special purpose properties must be valued by two appraisers, if there are real estate and business assets being sold.  The new rule for special purpose properties  was that they had to be appraised with a single appraisal by a Certified General Appraiser who has appraised not less than four of the subject’s property type within the past 3 years.  The real estate appraiser became responsible to value the FF&E and intangible assets for all special purpose properties that sold as going concerns with real estate.

Problem Solved?  No – And Wow, Was I Wrong

SBA has not come out with a revised SOP since prior to COVID-19.  But there are still issues.  SBA defines “Special Purpose Properties” as “a limited-market property with a unique physical design, special construction materials, or a layout that restricts its utility to the specific use for which it was built”.  There is room for plenty of grey-area with this definition.

More importantly, I was wrong to focus my referenced articles on special purpose properties.  The issue is broader than that.  Consider an example.  The risk of a business appraiser adopting a rent of $15.00/ SF for a chiropractor’s 2,000 SF office, while the real estate appraiser adopts $25.00/ SF is real.  Let us assume that the business generates Net EBITDAR of $80,000 after paying a market level salary to the chiropractor, and after subtracting an adequate capital replacements reserve for both FF&E and real estate components.  If the business appraiser adopts a real estate rent of $15/ SF, the net rent is $30,000, and the remaining cash flow to the business assets is $50,000.  If the business appraiser concluded a 30% cap rate for the business assets, they would be worth $167,000.

Meanwhile the real estate appraisal concludes $25/ SF as the market net rent.  For simplicity, we will use a somewhat higher than typical real estate cap rate of 10% (offset by ignoring a small management fee and nominal vacancy). At the 10% cap rate, the $50,000 NOI indicates a value of $500,000.  But unfortunately, the two appraisals don’t work without Net EBITDAR of $100,000, and historic income and expense indicate that Net EBITDAR is just $80,000.  The two values add up to $667,000 from the two appraisals.

Let us assume that both appraisers were not pushing the value for their component assets, but that they both missed on rent by a few dollars per square foot in opposite directions.  It turns out the market rent is truly more like $20/ SF, which would value the real estate income of $40,000 at $400,000, while the business valuation capitalizes the residual business income of $40,000.  The business value is just $133,000 at the 30% cap rate, making the total enterprise value $533,000; its true value. 

Probably nobody will find the cash flow double count until the loan becomes classified when the borrower can’t make the payments.

Will this situation occur? Some might consider the chiropractor’s office as special purpose real estate, but most probably would not.  And it is not realistic to expect that many real estate appraisers will be able to value the chiropractic practice as a going concern.

The assets have been overvalued by 25% in this example. What is the solution? 

  • Had both appraisers been engaged to appraise their respective components of the going concern in a co-ordinated manner, as stated in well written engagement letters, they would have discussed their rent findings, and probably would have agreed to meet in the middle at $20/ SF, keeping this grievous error from occurring.
  • Had the two appraisers worked in their respective silos, unaware of what the other appraiser was doing, a competent review appraiser reviewing both reports would have identified the contradictions of the two reports, and the reviewer would have made the two appraisers aware of the issues, with the required revised reports resolving the issue.

Other Issues

Going Concerns are Special:  Owner-occupied properties with successful businesses are less risky than either rental real estate or a business owning only a medium term leasehold interest.  In the owner-occupied situation, there is less risk of vacancy at the real estate end, and the business owner does not have to wonder if he or she will be given the opportunity to renew when the current lease nears its end.  The risk of the tenant having to re-invest in new leasehold improvements is decreased substantially. At CES, we consider the value of the Going Concern, not just the separate values of the real estate and business.

All Owner-Occupied Properties Are Going Concerns:  Virtually all commercial real estate (whether office, retail, or industrial) has specialized leasehold improvements built for the nature of the business and for its human resources.  Therefore, all are going concerns, at least to a degree.  The issue identified here regarding how easy it can be to double count (or omit) cash flows is also an issue for any owner-occupied property.

Does This Issue Go Away for Leased Properties? Recognize that non-arms-length leases between related parties are disregarded.  But in a situation where there were three unrelated parties (business seller, business buyer, and landlord), and where the real estate and business were both being valued, double counts could occur.  If a property is under a medium to long term arms-length lease, the contract rent will be used in both the real estate appraisal and business valuation, so there would rarely be an issue regarding EBITDAR double counts (or omissions).  But if the lease agreement is for a short term, there could be conflicting opinions by a business appraiser and real estate appraiser regarding future market rent.  Double counts (or omissions) of cash flows can occur even for a leased property, though this is likely to be an issue of smaller magnitude.

If the Real Estate Appraisal Does Not Use the Income Approach, The Issue Goes Away, Right?  Wrong. The concluded value using only a sales comparison approach (or cost approach) must indicate a reasonable rent similar to the rent used in the business valuation.

Cost Approach Issues:  Most of this article discusses the income approach for both the business and real estate.  Double counts (or omissions) can occur in the cost approach.  A dust collection and air filtration system in an industrial property might be considered as equipment by one appraiser while the other appraiser might feel that it is sufficiently attached to be considered part of the real estate.  Who is right? I have no idea.  But if both appraisals add value for the dust collection system, there has been a double count, or conversely, both appraisals may omit the dust collection system as being an asset for the other appraisal. This issue is readily solved by the two appraisers communicating and agreeing which appraisal it should be included in.

Conclusions

CES can perform business valuations for your SBA transactions.  We can assure you the cash flow double count will not occur if we are provider for the business valuation. 

Since COVID-19, many assets need to be revalued.  While many properties have declined in value, some are having record breaking years. Successful owner-occupied properties can be analyzed with a greater degree of accuracy than appraising a leased restaurant where the appraiser only has a general idea of how successful the underlying business is.  Lenders should recognize the superiority of successful going concern properties, and should build the bank’s portfolio with these less risky properties.  With our expertise in the analysis of Going Concerns, CES can help your bank book safer loans.

For those properties, including many hotels, having a poor year, a limited scope appraisal may support a deferment of principal or potentially principal and interest, using a discounted cash flow analysis, recognizing it will take time to return to normalcy.  In making cases, a principal deferment could be a profit center for the bank, as a fee can be charged for those seasoned loans where LTV is shown to still be reasonably strong.

So why choose Collateral Evaluation Services for our Commercial Evaluations?

Here at CES, we have been at the forefront of best in class evaluations for over a decade and continue to offer reliable, credible, and meaningful insight to our clients regarding all aspects of compliance with safe and sound banking practices.

At CES, “Your Virtual Appraisal Department™,” we want you to be able to take full advantage of your opportunities to remain competitive and cost effective; but not at the cost of safe and sound lending. CES offers the best Evaluations being performed above todays industry standard. In fact, regulators use CES Evaluation Reports as an example of what Evaluation Reports should look like. Also, our own clients have told us: “CES Evaluations are as good, if not better than most of the appraisals we are receiving from appraisers in our marketplace.”

Still unsure if it’s time for your financial institution to take advantage of this exciting new threshold for CRE Evaluations?  We’re here to help! Get all your questions answered right here or call us today at 678-580-6250.

[i] Dual Appraisals:  Real Estate or Business – A Case Study, by Franz H. Ross, Business Valuation Resources Update, August 2010.

[ii] How Too Many Cooks Can Spoil the Broth, By Franz H. Ross, an article in Valuing Companies with Real Estate, published by Business Valuation Resources, 2014.

[iii] SBA SOP 50 10 5 F (effective January 1, 2014) and SBA SOP 50 10 5 G (effective October 1, 2014)