A business valuation takes into account all assets. On the balance sheet, one of the most expensive assets is usually the real estate assets – manufacturing plants, physical stores and warehouses, etc. These assets would usually fetch a higher asset value especially in a hot real estate market like in Singapore.
When real estate assets are engaged in the actual business, they become an essential component for its success. For instance, a business might have a competitive edge due to its space’s location or aesthetics or distinctive attributes. On the other end of the spectrum, real estate can also be excluded from a business and hence play an insignificant role or even none at all in its success. Such can be the case of a passive real estate investment holding company.
Regardless, it is vital to do a check-in on real estate assets while valuing a business.
Then the important question is: should real estate be treated as operating assets or redundant assets?
What Are Redundant Assets?
These assets are not used in the business at all; or they do not support the primary business or the income-generating activities of an organisation. Hence they are also called the non-operating assets.
Typical examples include cash, short-term investments, excess working capital and non-essential tangible assets. Still, redundant assets are included during valuation to calculate the overall value of a business.
What Are Operating Assets?
They are completely opposite to the nature of redundant assets, being essential to the business and its operations, or support the organisation’s income-generating activities.
Are Real Estate Redundant Or Operating Assets?
To simplify things, we start with the standard that all real estate properties are considered redundant assets.
This is easy to accept when the said real estate is fundamentally a non-operating asset.
Things become less straightforward when they take on the role of an operating asset.
In the case of an organisation selling and/or developing real estates, the owned real estate then becomes an inventory.
For all other cases, where the real estate is used directly in the business operations and helped to generate profits through cost-saving means (i.e. no need to pay rent) and other advantages, the real estate will still be accounted as a redundant asset.
Why is this so?
Real estate has risks and profits unlike that of an operating business so treating it as a redundant asset essentially identifies it as an investment rather than an operating business.
Consider the following examples:
- With real estate, cash flows do not fluctuate across two consecutive periods; and tenants can be easily replaced. Hence the investment risk is lower.
- With real estate, profits are recent, such as the case of rental income or savings; and there is long-term capital appreciation. Hence there is investment return.
Based on the two examples above, investors who prefer investments of lower risks, and are aware of the higher risks in operating business, would be attracted to real estate, and more likely to accept lower rates of profits.
With this crucial difference between operating business and investment, it is thus important to consider real estate assets separately from the operating business for valuation. This would increase the accuracy of the overall business value.
But what if we wanted to treat real estate assets as an operating asset?
It is still possible, and you may still get the same overall business value – only when the following happens simultaneously:
- there is zero rental expenses
- the capitalised cash flow is higher
- a lower blended capitalization rate is used to value the cash flows as there is now more tangible assets (since real estate is in this category), which then lowers the organisation’s downside risk of investment
- there are benefits from a hidden redundancy like a property that is mortgage free or available for financing
Even so, the chances of getting the exact same value is almost close to zero. So the possibility is still unlikely.
Considering real estate as an investment instead of an operating business also allows more transparency in the derivation of the overall business value. This is critical in markets with ever-changing real estate prices like in Singapore.
Moreover, treating real estate separately further supplements information to help parties involved in an acquisition transaction take on alternative structures to safeguard their interests. One common strategy involves removing the real estate and then going into a long-term lease back arrangement before the transaction – this allows a lower capital for the investor.
Important Adjustments For Treating Real Estate As Redundant Assets
When removing real estate from the operating business to account it as a non-operating asset for valuation, a fair market rental fee must be subtracted from the normalised operating cash flow. This reasonably lowers the business value by the amount equal to the capitalised after-tax rental expenses, which is derived from the annual rental expenses.
Such expenses can be ascertained appropriately with an appraiser who has the expertise to advise investors on the expected return rates based on comparable investments and properties.
Next, the appraised market value of the buildings related to the real estate must also be considered in the valuation, as with all the other redundant assets, less non-operating liabilities and debt. This will help give an appropriate representative figure of the organisation’s equity.
Real estate, as long as owned by the organisation, will have to be accounted for in the overall business value even though it is not used in the business, or it may only be generating passive investment income for the business.
Speak with a Qualified and Experienced Valuer.