Valuation Strategies (WG&L)
Going Concern Property Transactions: The Necessity of Value Allocations, Valuation
Strategies (WG&L)
The failure to allocate value components of a going concern purchase price generates significant
risk for buyers and sellers, and denies buyers the opportunity to lawfully avoid some tax.
Author: MICHAEL ALLEN AND CUTCHIN POWELL
MICHAEL ALLEN is a principal, and CUTCHIN POWELL is a manager, in the
Arlington, Virginia, office of Ryan, LLC, a tax services firm.
It has long been accepted that the acquisition price of a “going concern” property includes both
the tangible and intangible assets of a combined business operation. While the methodology for
deriving the component values of a going concern has continued to evolve, both the fundamental
necessity of valuing each portion and the underlying, significant financial benefits of value
allocation have remained constant. Buyers and sellers of going concern properties who neglect to
complete partitioned valuations not only risk potential negative tax consequences, but also they
make themselves vulnerable to the corresponding adverse impacts to the profitability of those
assets and investments.
The Evolving Market
The current commercial real estate market is in transition. The bad assets that were purchased in
the “cheap money”-fueled economy between 2005 and early 2008 have not been fully flushed
out, yet again there are the ominous signs of aggressive underwriting and rosy future
assumptions as to increased performance. Investment capital and credit are slowly becoming
more accessible to investors. Real estate investment trusts (REITs) and other publicly funded
entities are awash in cash, as investors seek alternatives to other investments, particularly those
susceptible to increases in inflation. The pressure (and requirement) to invest that capital is back,
even when that investment is based on frothy assumptions that may not be realizable over the
investment's intended holding period. Nowhere is this mixed tide of investor confidence and
pessimism better observed than with going concern properties, including, but not limited to,
hotels.
More Than Just Real Estate
All going concern properties serve as complex platforms for the business purpose and enterprise
of their owners. Going-concern values include a real estate base that is commingled with the
value of the enterprise it supports. Examples include nursing homes, movie theaters, bank
branches, regional malls, hospitals, hotels, resorts, casinos, and golf courses. These properties
all have something in common—they require intensive and ongoing investments in working
capital, management, marketing, staff, and licensing. And in each case, the value of the going
concern is much greater than that of the underlying real estate alone.
This fact may be illustrated by considering two identical buildings: one fully outfitted and
functional as a flagged (i.e., part of a franchise) and operating hotel, the other an unequipped
building without an operating business. Assuming that each of the properties has a uniform
“highest and best use” and other comparative factors that are similar, which property would
demand a higher purchase price? The latter property, with no furniture fixtures and equipment
(FF&E), no staff in place, no “flag,” no reservation system, no frequent flyer alliance with the
major airlines, and no pre-sold or recurring banquet or convention business, among other
potential intangible assets, would obviously not be as valuable to a prudent and knowledgeable
investor. Such a buyer would typically pay a substantial premium for the established and
functioning property over the property that is not stable or performing.
The premium paid for the established property represents the non-real estate components of
value for that going concern. This enterprise premium is comprised of tangible personal property
(TPP), intangible personal property (IPP), and goodwill. The latter two components are
sometimes collectively called “business enterprise value.” They are considered an intangible
benefit or asset that is transferred together with the real and personal property needed to house
and sustain the operation.
Intangible Personal Property
When valuing IPP, prudent investors will expect not only a return of their original capital but also a
profit on their cash outlay. An investor will pay a premium to shortcut the costs associated with
the stabilization, or original startup, of the income stream to be acquired. On a subsequent sale,
the owner who originally incurred those costs will expect a return on that initial investment; more
precisely, the owner will expect to recoup not only his or her original investment but also an
added premium on sale. Just as the original owner will recoup that principal and interest entirely
from the next owner, the secondary owner will seek to recover those amounts from the third
owner, and so on. The same consideration is true not only with each form of IPP but also with
each tangible asset.
A key concept for going concern properties is that rarely, if ever, are the land and building being
purchased alone. Rather, the buyer is usually interested in acquiring the present value of the
future income stream attributable to the business operation. In going concern properties, the
presence and operation of the furniture, fixtures, and expenses (FF&E) and intangibles as a
whole accelerate both the receipt and the quantity of the stabilized overall net operating income
(NOI) being purchased. Further, it enhances the quality of that NOI. For instance, if there are two
hotel properties of similar size located next to each other, one that is flagged and equipped to be
a luxury international flag and the other is an obscure local flag or “mom and pop” operation, the
revenue per available room that each property can generate will be different. As the NOI will vary,
so too will the price at which each will sell. This does not mean that on a per-key basis the latter
flag will be automatically less profitable or that the return on investment (ROI) for that hotel will be
less, but it does mean that the size of the investment and the associated risk will be different.
In each sale of a going concern property, different components of value (in different proportions to
the whole) are commingled and embedded together in the final, combined purchase price. It is
therefore vital to both identify and segregate those individual values for multiple purposes,
including tax, accounting, and financial reporting. Ultimately, the allocations may impact:

Recordation or transfer taxes.

Initial (and in states that “chase” sales prices, such as California, subsequent) real estate
taxes and personal property taxes.

Sales taxes.

Income taxes.

Fixed-asset accounting and ledgers.

The overall profitability of the investment.
Each of the taxes listed may be levied at rates as high as 10%, with some, such as real estate
and personal property taxes, occurring annually.
This article will identify ways in which prudent investors can ensure that they pay no more than
their fair share of property and transfer taxes associated with the acquisition of going concern
properties, while remaining in full compliance for all other purposes.
Uniqueness of Going Concern Properties
Going concern properties always generate operating income from more than the underlying real
estate that houses the embedded business. Often, such properties are specially designed or
equipped for a particular use (e.g., a bank branch, hotel, golf course, regional mall, nursing home
or hospital, movie theater, or sports complex). In many cases, the right to operate the business
may require qualifying for and receiving a special license, without which the special use will cease
and the real estate will return to a more generic use (i.e., nursing home to apartment building, or
bank branch to drive-through pharmacy). Hospitals, assisted living facilities, surgery centers,
nuclear power plants, and airports are also examples of such properties. For each, if the current
license is not transferred to the new owner, the property's NOI would not justify the premium that
the new buyer would otherwise pay over the more generic use of that real estate and the lesser
income streams that it would generate.
It has been suggested that the difference between “value in use” and “value in exchange” is the
total business value or, perhaps, the value of all of the combined intangibles. Value in use is the
value of property for a specific use, and there will generally be only a limited number of buyers.
Consequently, it is considered a subjective measure of value. On the other hand, value in
exchange is a more generic market value of real estate, in which the real estate is exploited
based on its respective highest and best use. As such, it is a more objective measure of value.
Understanding the nature of the premium being paid for any going concern property is crucial to
identifying, extracting, and adjusting for non-realty values that need to be considered separately.
There are typically four components to value in the acquisition of any going concern property:

Real estate land.

Real estate improvements.

Tangible personal property.

Intangible personal property. 1
Each value component must be identified and its value separated depending on the purpose of
the valuation. For example, raw land is not depreciable, and so for accounting and tax purposes it
is important to accurately identify and record the value of raw land. On the other hand,
improvements to and on land are depreciable for tax and accounting purposes. Whether the real
estate improvements consist of buildings or improvements to the land itself, such as site
improvements, they must be correctly identified, their respective useful lives determined, and the
corresponding depreciation computed.
TPP is movable, breakable, and can disappear. It covers literally any assets not nailed down or
permanently attached to the building or improvements. Verifying and valuing all of the TPP
acquired in a transaction is critical to ensure that the buyer gets what he or she bargained for,
and is not paying for any “ghost assets” on the fixed asset ledger. This is an important
consideration, because if a seller's depreciated book values for these assets are corrupted by
nonexistent assets or assets showing salvage values that are not attainable on the open market,
then the values will be ignored for other purposes. Those purposes include preparation and filing
of local business personal property tax returns and calculation of taxes thereon, as well as the
accounting and income tax functions of determining accrued depreciation and useful lives.
Finally, acquired IPP must be identified, at a minimum, on a global basis. If possible, it is also
beneficial for IPP to be divided into assets that are depreciable and assets that are not. For
example, under Financial Accounting Standards Board (FASB) 141/142, there are five
established categories of depreciable intangible assets. Other items, like the value of “staff in
place” and goodwill, however, are not depreciable, and so it is helpful to capitalize the associated
income for each of the depreciable qualifying intangible assets and then assume the balance is
nondepreciable. This will not bind the buyer's accountants or auditors to automatically treat the
value allocations in the same manner for other purposes, but it does give them a road map to
follow when they consider how to treat the assets for other purposes.
Methodology
The valuation of going concern properties requires the individual valuation of each of the four
component assets—real estate land, real estate improvements, TPP, and IPP. First, the TPP is
valued. This value can be derived using several methods. The approach chosen depends on how
accurate and up-to-date the current fixed asset ledger i,s and what the seller is getting from the
buyer as part of due diligence or at closing. If the review indicates that the ledger's depreciated
book value is a reasonable estimate of the TPP's fair market value (FMV), then it can be used to
prepare the TPP bill of sale and to represent the TPP value of the going concern allocation.
Otherwise, an inventory has to be conducted, particularly if there is any concern about “ghost
assets,” if deletions were not previously fully made from the fixed asset ledger, or if additions
were not completely broken down into their constituent parts.
Another method is asset tagging or reconciliation. This permits a new FMV of the TPP to be
established as of the closing date for use in post-closing renditions.
Once TPP values are estimated, the real estate value is calculated separately by one or all of the
three traditional approaches to value (income, cost, or sales comparison). The choice of method
is based on the type of property. For example:
(1) The cost comparison approach is usually not reliable if the buildings and
improvements at issue are old, in poor condition, or subject to many functional or physical
obsolescence issues due to difficulty in estimating accrued depreciation. Also, a lack of
recent and vacant land sales that are similarly sized and zoned, and topographically laid
out with similar permitted development potential (i.e., floor-to-area ratio) to the subject
property makes the cost approach extremely hard to use to extract a credible unit of
comparison.
(2) Similarly, the sales comparison approach does not work if there are insufficient recent
arm's-length sales in the same market as the subject property for comparison purposes.
This approach can be effective only when each transaction is adjusted to reflect
differences between the comparison property and the subject property. If, in the
adjustment process, it is necessary to make many adjustments or a large adjustment, the
extracted unit of comparison will be unreliable and, in this event, it should not be given
any weight.
(3) The income approach is usually the best valuation method for commercial incomeproducing properties. If no actual income is being generated, as in the case of owneroccupied properties, then a pro forma NOI can be estimated. This is done by using a
market-extracted rent for each of the uses at the subject property, less stabilized vacancy
and collection costs, operating expenses, and building reserves. The resulting NOI is
then capitalized into a value estimate using a market-extracted overall capitalization rate
(RO). That base cap rate solves for the combined value of the land and its improvements,
but it may need to be “loaded” with the local real property tax rate if property taxes were
not deducted from the operating expenses to arrive at the stabilized annual NOI.
(4) If multiple value indications are produced by these three methods, they must be
reconciled into a single value. That does not mean that the values must be averaged.
Rather, greater weight is to be placed on the value indication that is the most credible
based on the market data available.
Once the reconciled total real estate value is determined, it must be allocated between land and
improvements. This is generally done by reference to recent and similar arm's-length land sales.
More likely in today's transitional U.S. real estate market, in which sales are infrequent, land
values can be better determined by reference to extraction methods under the income approach.
These techniques are based on the principle that land is indestructible, and as a result, less risk
is associated with land than with improvements, which will all wear out over time.
The lower the risk, the lower the capitalization rate that should be applied to the stabilized annual
NOI. Land capitalization rates are typically 200 to 500 basis points lower than those selected to
value only improvements. By applying different rates to the same overall NOI for either land (RL)
or buildings (RB), the separate values can be extracted and used to isolate their respective
values.
Case Studies
To understand the benefit and use of pre-closing allocation studies, it is best to review how they
are used by parties involved in performing the due diligence and executing the closing of
commercial going concern property. The present authors considered the following three case
studies:

Purchase of a single, full-service flagged hotel.

Purchase of a portfolio of multi-tenant data centers.

Purchase of a resort that includes golf courses, a conference center, and rental
condominiums (but no traditional hotel).
As with all transactions, each of the case studies has a unique fact pattern requiring customized
consideration of the underlying assumptions, properties, and methods of acquisition. When
reviewing each particular fact pattern, it is important to remember that the most common mistake
made by the buyer, seller, or tax assessor is to equate the value of the going concern to that of
tangible real estate. Assessors are typically tasked with discerning the value to the real estate
only (VRE), but with going concern assets, assessors typically mistake the income of the going
concern (IO) with the income of the real estate only (I RE). Therefore, assessors often mistakenly
(and illegally) assess based on the value of the going concern (VO) instead of the VRE.
In each of the following case studies, the present authors determined the VRE for recordation and
real estate tax assessment purposes. In each case, the purchaser and seller recognized the
significant potential benefits of arriving at an agreed-on price for each asset to be recorded.
Case Study 1.
The traded property was a single, full-service hotel in a major urban market, which was
established, built, and operated as a hotel for more than 25 years and had a stabilized income
stream. The property had approximately 500 guest rooms, onsite parking, an onsite “outside”
chain restaurant, more than 75,000 square feet of meeting and conference space, two distinct
buildings with public-space usage rights underneath, an onsite third-party rental car tenant with
reduced rate agreements, existing airline preferred provider booking contacts, and staff in place.
The property also offered various complementary services, such as airport shuttles. The property
was transferred with all TPP and IPP, including a major flag and management agreement, in
place.
Key considerations. The transaction was an indirect acquisition. More specifically, instead of
directly purchasing the going concern, the buyer acquired a 100% share of the stock of the entity
that owned the operation. Specific intangible personal properties that were transferred included
the flag or franchise, management operations, reservation systems, promotional alliances and
agreements, customer lists and advanced bookings, assembled workforce, non-realty contracts,
non-realty leases, start-up costs, and goodwill.
Methodologies used. Never is it more evident that the acquisition of going concern properties
includes significant non-real estate components than when a corporation is acquired (i.e., the
realty is acquired through transfer of stock). A stock transfer is generally valued by the purchaser
differently than a direct transfer of the underlying real estate, but the allocation of the purchase
price will begin with valuation of the real estate.
In this case study, the three traditional approaches to value were considered, but the cost
approach was significantly discounted. Similarly, the sales comparison approach was given little
weight due to a lack of recent, similar, and arm's-length sales in the sale market. The income
approach—including both direct and yield capitalization—was given the greatest weight, using
actual historic and pro forma future NOI. All incurred expenses of the business (including TPP
and short-lived real estate replacement reserves, management and franchise fee, and insurance)
were considered, except real estate taxes. 2
From the resulting NOI, the present authors capitalized the going concern value. Then, the
returns on IPP and TPP, along with the value of required capital improvements, were capitalized
and deducted from the going concern value. The intangible assets had to be more valuable than
their capitalized costs, because a return on those investments was expected. The authors
therefore considered various market sources, management circulars, and actual expenses to
arrive at those values. (It is important to note that capitalization rates for intangible properties are
typically 100 to 250 basis points higher than tangible properties to reflect the perceived additional
risk associated with non-real estate.)
Next, the TPP was valued by considering the seller's fixed asset ledger and prior returns, and
market surveys, ultimately arriving at a replacement cost new less depreciation (RCNLD) value to
be deducted from the going concern value. As a check, each of these three distinct valuations—
real estate, TPP, and IPP—were added and confirmed to reconcile with the entire going concern
value.
Results. Based on the authors' study and its review by the buyer and seller, the going concern
purchase price was determined to include the following allocations: 19% to real estate land, 52%
to real estate improvements, 12% to TPP, and 17% to IPP. These results are of critical
importance, as a combined 29% of the going concern purchase price acquired was determined to
be from non-realty assets. Buyers and sellers not completing such an analysis often erroneously
report the entire going concern value as a real estate (land and improvements) only value,
resulting in flawed bookkeeping and significant overspend for various taxes. As a result, as much
as 29% of the purchase price was not inappropriately taxed, of which 17% was not taxed at all.
In this case, given the sale of stock, the local assessor may well have determined that the
underlying real estate had sold at the full going concern purchase price, and used that as the sole
basis for determining subsequent ad valorem taxation of the real and personal property. Since
there was no deed or bill of sale recorded, refuting such an aggressive valuation would have
been difficult and costly but for the authors' report and allocation of values.
Case Study 2.
The property included a portfolio of data centers located in various cities and states. Some of
these properties were established (i.e., built and operated in their current use for three to eight
years), and had stabilized income streams. Other properties were currently used as commercial
office or warehouse space and were in process of being converted to their highest and best use
as data center space.
The average site was a single structure having between 50,000 and 175,000 square feet of gross
rentable area. Some sites included significant added land, however, which was intended for
future expansion or was in the process of being expanded at the time of sale. The properties also
offered various complementary services, such as engineering and IT support, as well as
additional for-hire services. Most sites included electrical substations with contracts in place
allowing for power sharing with the local community. The properties were transferred with all TPP
and IPP in place.
Key considerations. The transaction was a direct acquisition of the going concern and
underlying real property. As the portfolio being acquired included both industry and site name
brands that were inseparable from the specific properties, the residual value of those intangible
assets had to be considered even though this was not a stock acquisition.
Methodologies used. The allocation process began with valuation of the underlying real estate.
As in Case Study #1, the three traditional approaches to value were considered. The cost
approach was significantly discounted for the established property, but it was used as a key
indicator for property under construction. The sales approach was not used, because the sales
were found to be unhelpful. The income approach—including both direct and yield
capitalization—was given the greatest weight, using actual historic and pro forma future NOI.
All incurred expenses of the business (including TPP and short-lived real estate replacement
reserves, equipment rental, power generation, and insurance) were considered, excluding real
estate taxes. From the resulting NOI, the present authors capitalized the going concern value.
Returns on the IPP and TPP and the value of required capital improvements were capitalized and
deducted from the going concern value. The intangible assets had to be more valuable than their
capitalized costs because a return on those investments was expected.
The authors considered various market sources and actual expenses to arrive at those values.
Specifically, estimated hours and income from service contracts, and the expense and anticipated
return on staff in place, were considered. (As noted earlier, capitalization rates for intangible
properties are typically 100 to 250 basis points higher than tangible properties.) Next, the authors
valued the TPP by considering the seller's fixed asset ledger and prior returns, and market
surveys, and ultimately arrived at a RCNLD value to be deducted from the going concern value.
Finally, each of these three distinct valuations—real estate, TPP, and IPP—were added and
confirmed to reconcile with the entire going concern value.
Results. Based on these independent valuations for each location, the combined going concern
purchase price was determined to include the following (rounded) allocations: 6% to real estate
land, 80% to real estate improvements, 1% to TPP, and 13% to IPP. These results are of critical
importance, as a combined 14% of the going concern purchase price acquired was determined to
be for non-realty assets. Separate allocations for each location were made, and the bulk sale was
broken down into its constituent parts.
A buyer or seller not completing this analysis might have erroneously reported the entire going
concern value as real estate (land or improvements), resulting in flawed bookkeeping and higher
taxes than required. As a result, as much as 14% of the purchase price was not inappropriately
taxed, and 13% was not taxed at all. Of course, the allocations varied by location, but as is readily
apparent from the base allocations, the risk of potential over-taxation prior to this allocation was
significant.
Case Study 3.
The subject property was a resort with a conference center, golf courses, and rental
condominiums in a suburban area with significant tourism draw. While select condominiums have
been razed or built over the years, the primary property was established, built, and operated in its
current use for 20 years and had a stabilized income stream. The site was encumbered by partial
external ownership of some golf facilities and most condominiums by multiple third parties.
Further, development rights of the significant excess land were restricted by the homeowners'
association. The property also received unrelated income from off-site catering, videography and
photography, and landscaping businesses. The property was transferred with all TPP and IPP in
place.
Key considerations. The transaction was a direct acquisition. The purchase included a
significant name-brand acquisition, as well as the off-site businesses in place, along with
intangible assets. Development rights were encumbered by easements and contracted
association (and other third-party) agreements that were in place. As the resort boasted a myriad
of property types, uses, and businesses, varied assumptions had to be considered for each
business type and ultimately consolidated and reconciled with the combined going concern
purchase price.
Methodologies used. The allocation began with valuation of the underlying real estate using the
three approaches to value and significantly discounting the cost approach for this established
property. The cost approach was considered, however, for a single family residence, for select
land, and for other non-income generating real estate. The sale comparison approach was also
discounted due to the unique nature of the business operation and the absence of a suitable
sample size. The income approach—including both direct and yield capitalization—was given the
greatest weight, using actual historic and pro forma future NOI.
All incurred expenses of the business (including TPP and short-lived real estate replacement
reserves, management fees, and insurance) were considered, except real estate taxes. 3 From
the resulting NOI to the going concern, the present authors capitalized the going concern value
for each underlying business. Then, returns on the IPP and TPP, along with the value of required
capital improvements, were capitalized and deducted from the going concern value. Again, the
intangible assets had to be more valuable than their capitalized costs because a return on those
investments was expected. Therefore, the authors considered various market sources and actual
expenses to arrive at the values. Next, the TPP was valued by considering the seller's fixed asset
ledger and prior returns, and market surveys, ultimately arriving at a RCNLD value to be
deducted from the going concern value. Finally, each of the three distinct valuations—real estate,
TPP, and IPP—were added and confirmed to reconcile with the entire going concern value.
Results. Based on these independent valuations for each location, it was determined that the
combined going concern purchase price included the following (rounded) allocations: 17% to real
estate land, 44% to real estate improvements, 10% to TPP, and 27% to IPP. That is, a combined
37% of the going concern purchase price acquired was determined to be for non-realty assets. As
a result, as much as 37% of the purchase price was not inappropriately taxed, and 27% was not
taxed at all.
Conclusion
Many buyers of going concern properties lament the lost opportunity they could have realized had
they carefully considered pre-closing allocation of asset values. Months or years later, when they
finally find time to address the myriad of governmental, legal, and tax accounting and auditor
issues following the purchase, they find that they let their chance to lawfully reduce their tax
liability pass. Simply put, buyers often wish that some value or asset classification had been
made clearer or had been better supported when they find themselves responding to questions
posed by an assessor, other government agent, or even their own accountants long after the
acquisition is completed. By this time, attempts to reconstruct past assumptions and underwriting
are difficult, if not impossible, as the buyer realizes that informed personnel have left, documents
have been lost or misfiled, or the acquisition team handed the matter off to the operations team
without a full briefing of the closing.
Further, despite intensive due diligence, a buyer rarely gets from the seller all of the books,
records, and supporting materials needed to prove every number on subsequent tax returns, the
allocated assessment valuation, or accounting books and records. An allocation study is a useful
tool to focus buyers and sellers on addressing and documenting the underlying valuation of the
various interconnected assets while the deal is still being struck and the parties still have a joint
motivation to memorialize the underlying elements of the total purchase price.
Without this certainty, taxing authorities are much more likely to apply their subjective valuations
for the different purposes and functions that they perform. More often than not, this will result in
multiple valuations and allocations, each different from the other, with no rationale to explain the
differences. Rarely does this result in a buyer paying less tax.
Further, although pre-closing allocations are important for all buyers and sellers of going concern
properties, they are particularly important for REITs. REITs are encumbered by a requirement
and condition for their special income tax status to ensure that no more than 15% of revenue, or
25% of value, is derived from non-realty assets. Failure to respect these restrictions may result in
the REIT losing its privileged tax status, which allows its shareholders to avoid double taxation.
Accordingly, REITs must appropriately consider value allocations before closing to ensure
compliance. If they are going to replace or enhance any non-realty after acquisition, it is
especially important to empty the glass first before trying to refill, so as not to violate the REIT
rules.
Memorializing these buyer- and seller-agreed asset values and allocations within the closing
documents, incorporating them into all filings, and using them as the basis from which taxes are
computed, will ensure that the buyer and seller are not taken advantage of. It will also ensure that
ad valorem-based tax of real or personal assets will not be distorted or inflated because nonrealty assets are included in those assessments. In short, pre-closing allocation saves time and
money, by allowing buyers to avoid challenging these ongoing values in post-closing years.
1
Goodwill is included in IPP.
2
Real estate taxes were accounted for by “loading” the capitalization rate.
3
As with the other case studies, this expense was accounted for by “loading” the capitalization
rate.
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