Income Rules of Thumb - Investing 1 for 3

[Terrel L. Shields]

Seems I have run across this gross income multiplier thing in so many different owner-operated businesses...Some buyers explicitly use it, and some are seemingly unawares that they are doing it.

Namely, the GIM is 3, maybe slightly less for riskier ventures, more for really stable ones.

The saw goes, If I invest $1, I want a RETURN OF my investment ($1), a RETURN ON the investment ($1); and, a TIME RISK cushion ($1). So if the annual GROSS income is $60,000, the most I will pay is $180,000. In the oil business this is almost always called payout in years. But it applies to carwashes, laundrymats, auto detailing shops, oil change shops, etc. Likewise, the buyer often assumes a 50/50 expense ratio. 50% of the gross is spent on expenses.

Likewise, I find it difficult to extract the "Goodwill" from such sales. Usually these sales are reported as 100% REAL estate but my own opinion is that they are invariably a combination of Real and BE Value.

Anyone else use this as a Rule of Thumb?

Ter

 

[Steve Owen]

I have heard this before. It may be okay as a rule of thumb, but I prefer doing it by the old, tried and true appraisal methods, considering the local market.

My last experience with this from a borrower standpoint was a car wash where the owner told me that "these things sell at a percentage of gross revenue and I have the data to prove it." I did the appraisal in the usual fashion and came in slightly below his idea from gross revenue. He wasn't happy, but never gave my any definitive data to show that his idea was valid. (How about some examples of sales paired with the gross revenue?)

My previous experience with this theory was in a campground. The owner said that they always sell as a percentage of gross revenue and that the parent franchise company had lots of data on previous sales that could back him up. I started work, but put it on the back burner, waiting for the promised set of sales and revenue/expense data. They wanted to tell me that such and such sold for "$x" and had gross income of "$y." But, they didn't want to provide any specifics; not even contacts for verifying the sales. That appraisal was never completed because, after stringing me along for several weeks, they decided they need it immediately and I told them I would have to start researching the market for sales since they had not provided the promised information. I got paid for time spent, paid off my assistant, and wrote off the theory.

I might be something of an old fogey, but it seems to me like everytime some promoter tries to start pushing some rule of thumb it is for the purpose of getting their property at a higher value than it will appraise.

 

[Paul Ness MAI]

A GIM general rule of thumb for any and all businesses is dangerous. As Steve said, use regular appraisal methods. If you want to use a GIM, be industry specific and talk with a lot of players in the industry. But you still need to look at competition, expenses, deferred maintenance and any extraordinary issues pertaining to your subject. If you capitalize net business income, you better not be using the same cap rate as if you were appraising the real estate (I have seen many appraisers do this). There is additional business risk that needs to be addressed.

Problem with the sales approach is as you said, stated considerations of comps are usually an allocation of a portion of the going-concern to the real estate, and the allocation is usually low-balled to save on recording taxes. The sales approach is not very good for these types of properties for this reason.

If you are appraising a going-conern, the cost approach will obviously not include intangible assets, so one of the simplest ways to estimate intangible assets is to take the difference between the income approach (going-concern) and the cost approach (real estate and FF&E).

If you are appraising the going-concern, USPAP requires your addressing the impact of non-realty items on the value (FF&E and intangible assets). For FF&E, if you're not comfortable estimating their value, bring in an expert. There are various ways to segregate intangible assets (patents, copyrights, customer lists, franchises, a popular chef, workforce in place, etc.). Most appraisers underestimate the value of intangible assets. The AI introduced an excellent course last year titled "Separating Real and Personal Property from Intangible Business Assets" and the reason for its creation was to develop some uniformity in valuing going-concerns. As a review appraiser, I have seen numerous different home-grown methods for appraising these types of properties, but most appraisers do not adequately identify the fact that they are appraising the going-concern (if in fact they are) and they do not do a great job adhering to USPAP's requirement of itemizing non-realty items.

 

[Terrel L. Shields]

That could be an excellent course...I read a treatise from a buyer seller of numerous carwash and related businesses who worked hand in hand with an appraiser for 20 years. He even explained (for the benefit of other buyers of similar properties) how to choose an appraiser with carefully crafted questions. From his questions he could determine if the appraiser was actually going to appraise the whole business or real estate alone. He recommended strategies to lower property taxes, etc. from these appraisals. And, he claims (and I don't doubt) that he can interview an appraiser and get one that will inflate the value (desirable for loan purposes); deflate it (property tax contesting); or, if he really needs to know what it is worth.
One of his big concerns about appraising using net incomes were the reliability of the numbers. He concluded most people don't skim the take so much as they inflate expenses for tax purposes, such as charging off most of the expense of a car or truck on the business. And, if someone is skimming and cannot show the income on their tax statement...then as a buyer, he will offer the lower indicated value. He claims about the time these people want to sell they realize they have screwed themselves by skimming cash. He refuses to accept their pleas that "you know, it really makes more, and everybody skims a little."
however, it has been my experience that almost every broker of small royalty interests in oil or gas wells use the 3 times annual income approach, and do so exclusively. When it becomes corporation sized acquisitions, then DCF rules, but anything under $10,000 annual can be lead pipe cinch offer of 3 times last years take. This does not even take into account rapidly depleting reserves vs long term reserves. Our family has royalty interests in Carbon Dioxide wells in SW Colorado. THey have produced for 15 years and my calculation indicates the fields will not deplete for another 45 years. annual income has been steady to higher since initial production. This is one of the lowest risk investments you could make in the petroleum related business, yet my mother gets letters every year from people offering a mere 3 times previous years earnings. And for mineral rights I have to do what the market is doing. DCF is overkill for such properties.

Ter

 

[Paul Ness MAI]

I took the course last year when taught by its creators and it was very good. Following is a schedule for it.

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10/11/2002 - 10/12/2002
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02/06/2003 - 02/07/2003
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Location: West Hartford, CT

 

[Terrel L. Shields]

they do not do a great job adhering to USPAP's requirement of itemizing non-realty items.

Amen...difficult but required. Appraising a small restaurant is about as bad as it gets. Mixed age equipment, buildings are often unique or leased. Etc. I have a few appraisals I would not mind having back for another go to make it clearer.

I find many appraisers do gloss over the personal property aspects as well. i.e.- the impact upon value of trade fixtures. Double dipping also occurs.

I have a copy of an appraisal of an oil well lease. The interest appraised was called a leasehold interest, but there was pumping equipment, too. This was described by arm waving. You were not even told if the pumping unit was electric motor or gas engine powered. Nor was the size of the tank battery given. In effect, the appraiser appraised the property as operating, then added the personal property as salvage(as he saw it.) But since the well operated, the minerals should have been valued as time discounted based upon reserve estimates WITH the equipment. The property as salvage would render it inoperable, and valued only for its lease value + salvage....more or less.

I recently was asked to appraise a factory / warehouse type building, 14,000 SF, and came in at $250K. It had appraised as an on-going business 4 years earlier at $750K and a broker said he could sell the property w/ equipment for $400K. We were all likely right. I was asked only to appraise the warehouse and assume the machinery was liquidated. I was not including the machinery. The broker was thinking in terms of equipment AND warehouse, and the other appraiser was appraising an on-going concern which was profitable at that time. They lost their Wal-Mart contract and bit the big wienie.

Ter

 

[Bill_FL]

To get back to the original theme of the post, which was using "rules of thumb", I too have heard these. One, if you talk with some of the "old timer" investors is they want 1% per month on their investment. In our terms, I guess that would be an equity yield of 12%. They want to make 1% per month on the out of pocket cash top buy the investment. We haev fancy names for it, but that is what they looked at when buying the property. Could they make that. Seems to me, we have all these terms and formulas with fancy names, but if you really get into it with some of these investors, they make it pretty simple.

 

[Terrel L. Shields]

Good point. If we as appraisers are not replicating what the market is actually doing, no matter how fancy a formula we use, we are likely to make more mistakes. I read a piece on Hoskold's formula (similar to Inman's)and it is a relatively easy way to calculate a value, but on the other hand, I have never seen nor heard of anyone using it except for some foriegn country using it to calculate the tax on a mine.
ter

 

[Restrain]

The "Rule of 3" is not a bad approach for an operating business. I have seen it along the line of the value of the fixtures, plus 2x income, which on a typical business that has significant equipment will equate to the 3x rule. Conversely, a business like an appraisal company may not be worth more than 1-2x as much of the business is due to the "good will" of the appraiser. I have seen a very profitable commercial firm destroyed within 1 year of purchase by an incompetent appraiser. The seller had to reclaim the business (foreclosed on the note) in order to protect his name as he had sold it with the firm.