Small business owners have discretion about what gets reported as operating expenses and how they report those expenses. As business appraisers, part of our job is to analyze the reported expenses and decide if any of them should be normalized. (‘Normalized’ means adjusted to reflect what amount of expense best reflects operations under the appropriate standard of value.)
One of the most important normalization adjustments business appraisers consider is that of the rent adjustment. Oftentimes, the owner of the business also owns the real property the business operates out of, but that is not always the case. Several scenarios of real property owners may require an adjustment. Some of them are described below:
- The real property is held within the same ownership entity that holds the business operations.
- The real property is held in a separate entity that is owned by the same owner of the business operations.
- The real property is held in a separate entity that is owned by a different ownership structure that still includes an interest held by the owner of the business operations.
- The real property is held by an independent third-party with no ownership interest in the business operations.
The following assumes Fair Market Value is the appropriate standard of value, the subject is a 100% controlling interest, and that the business appraiser has been provided with the market value rent adjustment by a qualified real estate appraisal or a rent rate survey of appropriate leased properties.
Under scenario number 1 above, the business in question will not pay rent as part of its regular operations, because the real property is an asset owned by that same entity. However, if we do not make the normalization adjustment and include a market rental expense, then our value conclusion for the subject business will be overstated; likely significantly overstated.
Under scenario number 2 above, the business in question will likely be paying rent for the occupancy of the real property. Often, the amount of the rent paid may have some relationship with the amount of principal and interest paid on the mortgage. The reported rent expense may be higher or lower than the market rental rate of a similar property. If we do not consider a normalization adjustment, our value conclusion for the subject business may be over-or understated.
Under scenario number 3 above, the same discussion from scenario number 2 applies. Just because one or more of the owners of the real property may not also have an ownership interest in the business itself, does not mean the actual rental rate used is at the market.
Under scenario number 4 above, if the property owner is a third party, the rental rates are generally deemed to be at market rates, and no adjustment is required. However, there are always exceptions to any rule. The following comments are for the exceptions:
If the rent expense paid by the business is deemed to be higher than market rates, any normalization adjustment made would also mean that the business will likely be moving to a new location. Is a new location even available in the subject’s market? What are the associated costs and risks of moving the business?
If the rent paid under scenario number 4 above is deemed lower than market rates, there are still other factors to consider before making a normalization adjustment. How long will this favorable rental rate last? Is the favorable rent expense protected by a lease agreement with several years left on the term? If so, perhaps the adjustment the business appraiser makes will be to lower the specific company risk rate instead of normalizing the rent expense.
Normalization adjustments are part of a business appraiser’s toolbox for analyzing a business’ Fair Market Value, and each one is made with one goal in mind; to determine the business’ true economic earnings potential. The rent expense is one of the adjustments more often made in an analysis, but it is definitely not the only one.
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