30 Sep The Rent Adjustment in Business Valuation

Written By: Jake Wallace

(4-6 minute read)

The rent adjustment is one of the most common EBITDA adjustments in a business valuation. It is typically required in any case where a business does not rent its real estate from an independent third party (arms-length lease). The following scenarios would require the appraiser to adjust the existing rent expense that the business pays to be in line with a fair market rent:

• The business (company) itself owns the real estate
• The owner(s) of the business personally own(s) the real estate (on Schedule E)
• A separate but related real estate holding entity owns the real estate (e.g.: EPC/OC)

The scenarios above indicate a close relationship between the owners of the company and real estate (non-arm’s-length relationship). Due to this close relationship, the business may pay an arbitrary amount of rent, which can be based on tax strategies, existing (and outdated) debt service covenants or any other reason the business owner chooses. Under Fair Market Value, appraisers must assume that a hypothetical buyer of the business will not benefit from the existing close relationship between the business and real estate. By adjusting the rent that the business pays to the fair market rent, the adjusted EBITDA can then be used to determine the fair market value of the business. This also will allow the lender to assess the value of the business, separate from the real estate, for underwriting and financing purposes.

Methods utilized to estimate fair market rent in appraisals with Reliant Business Valuation include real estate appraisals, buyer-seller lease agreements, and online data.

When available, the real estate appraisal is the most accurate method of estimating fair market rent. The specific method used depends on the approaches used to calculate the property value within the appraisal. The following approaches are used in real estate appraisals to determine value:

• Income Capitalization Approach: involves taking the property’s net operating income and dividing it by a market capitalization rate
• Sales Comparison Approach: compares the subject property to similar (size, age, condition) properties that sold recently in the area
• Cost Approach: calculates the cost to rebuild the structure, minus depreciation, plus the value of the land

When the income approach is used, the business appraiser can use the real estate appraiser’s fair market rental rate (rent per square foot or annual rent) to make the rent adjustment. If the income approach is not used, the appraiser can apply an estimated capitalization rate to the market value of the real estate to determine its fair market rent. This approach may be deemed reasonable based on a comparison to industry rent margins or to rental rates from online data, further discussed below.

If a real estate appraisal is not available, the business appraiser would find comparable rents online for similar facility types to the subject company (typically office, retail, industrial), in the same city and state (or surrounding area). If the real estate is not being sold as a part of the proposed transaction, the owner of the real estate may create a new lease (or draft terms) for the owner of the business. As this is the proposed rent moving forward and is assumed to be fair market based on the arm’s length relationship between the parties, the appraiser can utilize the negotiated annual rent for the adjustment. If the agreed upon rent is clearly a non-fair market rent (or the lease is not assumable by a new tenant, which may indicate non-arm’s length), the appraiser should utilize online data.

It is important to note that in each scenario, the appraiser would also have to account for certain property operating expenses depending on the structure of the assumed lease. For gross leases, the tenant is only responsible for paying rent. However, for triple net leases (NNN), the tenant is responsible for paying property taxes, insurance, and maintenance. Depending on the type of lease being assumed and whether the Company is already paying certain property-related expenses, the appraiser would need to perform the appropriate adjustments.

For example, let’s assume that the subject Company is currently expensing rent under a gross lease structure, and the fair market rent is also a gross lease structure. A rent adjustment made by an appraiser would look as follows:

However, if the Company is currently expensing rent under a modified gross lease structure (already accounting for insurance and maintenance, but not property taxes), and the fair market rent is based on a NNN lease structure, then the rent adjustment made by an appraiser would look as follows:

It is worth noting that, even if the buyer of the business is also purchasing the real estate in which the business operates from, a rent adjustment is still required. In theory, owning the building and the business would lead one to believe that the business would not have to pay a fair market rent. However, if this were the case, the economic benefit attributable to the real estate would be reflected in both the business value and the real estate value, which would overstate the combined value. Just as a real estate appraisal does not factor any benefit (net income from business operations) from also owning and operating a business, the business valuation should not factor any benefit (expense elimination) from also owning and operating the real estate.

If the real estate is being sold as a part of the proposed deal, it should be noted that a real estate appraisal is the most accurate way of determining a fair market rent. If a real estate appraisal has been ordered by the client, it is usually in the best interest of the client to wait for the completion of the real estate appraisal before receiving the completed business valuation (unless deemed unnecessary by the business appraiser). If fair market rent is estimated by the business appraiser and the real estate appraisal eventually concludes a different fair market rent than estimated by the business appraiser, an update to the business valuation would be required (Reliant Business Valuation does not charge for this type of update).