Property

The principles of valuation

The sale of an existing management rights business is generally the sale of the business and associated real estate.

Collectively the business and real estate are known as a “going concern” because both assets are required for the business to be operational. This is not dissimilar from other going concerns such as hotels, motels, child care centres and service stations. In these examples the real estate component is required for the continued operation of the business.

Relevance to market – As a valuer we always make relativity to market and will review sales that have occurred in the market place. Valuers have a number of approaches. One approach is the direct comparison methodology and it is used by most residential valuers and this approach is intuitively undertaken by most purchasers in the market place when buying a residential property. Another approach is the capitalisation of net income.

Capitalisation and the year’s purchase factor – The traditional method for valuing income producing properties is the capitalisation of the net income. This is based on the simple tenet that the income is at market. The principle with the capitalisation approach is that the market income is capitalised by a market capitalisation rate. The key point here is the word “market”. The capitalisation rate simply represents the return on the investment (or the yield). In other words it is the income divided by the value/purchase price expressed as a percentage.

The year’s purchase (or multiplier as it is referred to in the management rights industry) is the inverse of the capitalisation rate. This can be best seen in the following workings. Consider a typical management rights business, such as the following:

Net operating profit of $85,000 pa and a purchase price of $395,000
The years purchase = $395,000/$85,000
  = 4.647
The capitalisation rate = $85,000/$395,000 x 100%
  = 21.519%
Also inverse of 4.647 (ie 1/4.647) = 21.519%

The above example is a simplistic approach but gives the foundations of the valuation process. There are a number of assumptions with such a process and two critical assumptions are;

  • Net operating Profit is defined as earnings before interest wages and tax.
  • The Net Operating Profit of the previous year will be sustainable into the future.

The above are two critical assumptions of the valuation and purchasing process, however, they are often not given sufficient consideration. A purchaser should fully understand these fundamentals before going into a purchasing contract. They should consult with their accountant, lawyer and valuer to get such an understanding of such principles, and understand what is the impact is should these variables change.

Commercial property perspective – The fundamentals of a business valuation are similar to commercial property. The value of a typical commercial property is assessed by the capitalisation of a sustainable net market income, at a capitalisation rate evidenced through market sales. As we are aware the market rises and the market falls. Therefore if the rent is considered too high or too low, a market rental is adopted with adjustments made for the difference until the income falls back in line with market rates. These principles will apply to business valuations as well.
Take for example a 1,000 m² office building leased two years ago for $300/m² with a seven-year lease term. Consider an identical 1000 m² building with a five-year lease term in the current market where the market rental is $200/ m². Both properties have the same length of lease tenure.
To value the properties, quite clearly the income of both should not be capitalised at the same rate. Using the same capitalisation rates, the following calculations would apply:

Building A $300/m² x 
1000 m²
= $300,000 Capitalise 
@ 9%
= $3,333,333
Building B $200/m² x 
1000 m²
= $200,000 Capitalise 
@ 9%
= $2,222,222

The calculations for Building A should take into account the profit rental above the market level for the period of the lease term. Therefore the calculations are as follows:

Building A $200/m² x 
1000 m²
= $200,000 Capitalise 
@ 9%
= $2,222,222
Add profit rental $100/m² x 
1000 m²
Present value for 5 years 1 = $388,965

1 Present Value of $100,000 over 5 years discounted at 9%.

The passing yield is 9% but the equated yield for building A is rather 11.49% (ie $200,000/ $2,611,187).

Management rights with non-market income streams should be valued utilising a similar approach.

Management rights application – It is convention in management rights to use the past 12 months of income to determine the net operating profit of the business. With motels it is considered prudent to consider the past three years. It is widely accepted that the valuer is to arrive at an opinion of the past three years and not merely apply an average. A key reason for this is that the letting pool can vary with a management rights whereas the motel’s room inventory is stable. Another reason is that permanent rental management rights are not subject to seasonality where motels and holiday letting businesses generally are.

The question arises when the level of the net operating profit varies from one year to the next. The mining perspective in Queensland and Western Australia has lead to differing levels of net operating profit, with 2011 often being an above average year. We have seen some businesses where the RevPar was 50% higher in 2011. In these occasions it is difficult to arrive at a figure but we must reflect that we are capitalising the market level of income and a market rate. One needs to re-ask “how is the market approaching these businesses?”. In these situations we would usually find that most purchasers were not “wood ducks” and would discount (and sometimes totally disregard) the above normal trading year. The sales analysis would often represent a much softer yield/capitalisation rate.

There is no simple answer to the mining regions, for if the occupancies and room rates have been high for a 10-year period, then there is a lot of merit to say that that is the market level of income. Likewise the market may, and often does apply a greater risk rating to these locations, and this is often the case for non-coastal, inland and mining regions.

In early 2014 we have witnessed an improving 2013 in most leisure based destinations (eg Gold Coast and Sunshine Coast) with many operators anecdotally experiencing room rates 10% higher and occupancies 10% higher. It has been evident that the net operating profit for 2013 was often higher than 2012, and most leisure based properties we have seen are experiencing a rise above 2013 in average room rates and RevPar in 2014.
In leisure based properties the changes in the quantum of the net operating profit will present new and future challenges to purchasers and valuers. Is the net operating profit benchmark the 2013 level, or will it be the 2014 year, or 2015 year. Are the year’s purchases/multipliers being paid by the market reflective of the improvement in 2014 trading figures and anticipated 2015 figures? We would say so. If the holiday market was softening, we would likely see an accompanying softening of the multiplier/years purchase.

The above commercial property example of the adjusted calculation can be applied to management rights, especially when the former years income is not a reflection of the future years income in perpetuity.
Another factor that is relevant is the available term on the agreements. Consider two similar management rights buildings with the same number of units, and the same design. The only differences being the length of time on the agreements.

For example, building C has around 10 years to run on the caretaking agreement, whereas the other (building D) has 20 plus years tenure. Do the two management rights buildings/businesses have the same value? This is a baited question, because there are other variables which will always interplay. But clearly the year’s purchase factor will not be the same. It is also for this reason that financiers treat shorter term agreements differently and seek a more rapid amortisation of the loan.

Analysing the income – Just as we have seen some reasons why the year’s purchase will vary, the income will also vary as well. Reverting back to the office building scenario, the net income of the office building is the rental less the building expenses. Such expenses can be rates, operating expenses, common area air conditioning and cleaning, lift maintenance, etc.

With management rights the income medium is net operating profit. The net operating profit is defined as the net profit before interest wages and tax. Whilst it is convention to include some items, and exclude others, one needs to determine the assessed net income of the business. Therefore the income (or net operating profit in this case) to be capitalised is what would typically be achieved under typical market conditions, and with typical prudent management. A “verification report” is often as the name suggests, is a verification of the income earned over a particular period, often it is not a reflection of the incomes which could be expected to be earned in the forthcoming year. But put more simply “the past does not equal the future”. The verification report should include a comment on the sustainability of the income.

Market changes – Over time there can be changes to the market and the composition of the rental pool. To give an example to the above, consider the following scenario:

Complex A has had a shrinking letting pool. For simplicity, say each letting unit contributed $3000 pa from commissions only. If the letting pool was dropped by 10 units in the last six months, then by simple deduction, the income would have reduced by $30,000 pa.

Therefore it can be seen that if one totally relies on a verification of income for the past 12 months, the income will be overstated. This causes us as valuers to reflect back on paragraph 3 and the discussion of relevance to the market. As a valuer we are to provide our opinion of the market level of income, and not necessarily quote the passing 12 months level of income if it is not considered appropriate. The valuer is required to further investigate and analyse to determine the sustainability of the cashflow.
If the valuer believes the verified level of income is not at market, then they would comment and make adjustments if considered necessary.

Market level of charges – Another common problem we often face is the non-market charges. Sometimes we have found that the selling manager had never increased the rentals for the renewing tenants since they arrived some three to five years earlier. Consequently many tenants were paying rentals significantly below the market rate. A verification report would generally not address the differences in the market rental rates. In such a case a purchaser would pay above the market rate for the year’s purchase/multiplier)

Reletting fees – Another issue we have often found when questioning the vendors is “what do you charge for reletting?” In another complex, the managers elected not to charge a lease renewal fee because they didn’t believe it was warranted. The opposite also occurs with some holiday letting complexes, where the charges are above the industry standard. The verifying accountants and valuers keep industry benchmarks on such services, and often you will find the verifying accountant will make reference to it in their report.

A word of warning – raising charges can often be difficult and it is a lot harder than reducing them. Therefore someone acting as a purchaser should not make an automatic assumption that the charges can be brought up to a market level overnight.

Wages – An issue often faced by the verification accountant is the inclusion of wages. At the end of the day, it comes down to professional opinion, and these will vary depending on the verification accountant. We also draw reference to clause 12 of the standard REIQ contract where it states: “For the purpose of this clause net operating profit shall be calculated by deducting from the gross income of the business for the relevant period the actual expenses of operating the business for that period (in particular excluding depreciation, GST, borrowing expenses, interest on borrowings, and any payment for labour related to work which would normally be performed by a two person resident management team.”

However we do ask the reader to consider the following scenarios; In hypothetical building D in the suburbs, the manager has elected to sell units in the building and employ a gardener. The manager received sales commissions of $120,000 for the year and paid $30,000 for the gardener. The challenge faced by the verifying accountant was – should the gardener’s wages be included as an expense? Clearly the manager has elected to earn $120,000 through sales commissions but it was at his choice to forgo the gardening and pay for outside assistance. Whilst every circumstance is different, we are of the opinion that the gardener’s wages should not be included in the expenses, nor should the sales commission be included in the income.

Food and beverage and other sundry income – It is common to see differential capitalisation rates apply to leisure based management rights where there is food and beverage income. As the food and beverage income is considered more volatile or riskier, then a lower multiplier will often be applied. In such an example one may see the food and beverage component be applied with a 1.5 to 2.0 times multiplier, and the caretaking and letting business sell with a 5.0 times multiplier. This principle also applies to other non-core income streams of management rights businesses.

Reasonable hours – The issue of reasonable hours came up at a large Brisbane Riverside complex some 12 years ago and it does come up with some large townhouse complexes. We have seen some complexes that were so large that the manager often spent in excess of 40 hours per week performing such duties. One again does need to be careful and some of these complexes involved the manager taking on extra duties like courtyard maintenance. When these issues do arise we need to reflect back on what duties can be performed by a typical “husband and wife” operation, and if the current managers are performing in excess of this, then additional staff should be factored into the expense section of the profit and loss.

Another way to view the value proposition – A going concern motel, hotel, or management rights is sold and also analysed on a going concern yield. By this we mean the net operating profit divided by the price of the going concern (real estate and business), and expressed as a percentage. This issue did become more relevant as the value of the real estate component increased to such an extent they neared or exceeded the business value. It also became a problem with the financiers with lending serviceability.

We are finding it have more relevance in today’s market with the target or hurdle rate being 12.5 per cent to 15 per cent. The complexes that net in excess of $300,000 pa generally are towards the 14 per cent to 15 per cent range.

We have also found that the market paradigm has changed with the Asian purchasers representing a much larger percentage of the market. Nowadays we are finding that the Asian market can be between 70 per cent to 90 per cent of the market for permanent letting businesses in the Brisbane market and over 50 per cent on the Gold Coast, and to a lesser extent on the Sunshine Coast.

Due to a focus on the overall return, there is less importance on the size and status of the manager’s residence, and the Asian model often involves employing manager’s to perform the duties.

You will find the purchaser will intuitively make adjustments to the income components and often the valuer will apply a structured analysis to explain and reconcile this process.

A good way to summarise is that the valuer is capitalising market income at market rates, and when the income is not considered to be at market, then the valuer will make adjustments they consider appropriate.

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