It appears that motel and other accommodation business leases are valued in a way which may not be consistent with general accounting practises. Sometimes potential buyers receive professional advice not to proceed, this is often based on analysis of accounts using the more traditional approach whereby cost of capital, return to management and sometimes depreciation are deducted before assessing profitability.
In recent years this has been less of an issue as more accountants have been involved in assessment of accommodation proposals and have gained a greater understanding of how this particular industry works. It seems fair to suggest that business appraisals should be based on actual evidence of other sales, rather than a theoretical approach.
There are many valuers throughout New Zealand who have specialised experience and knowledge in motel valuation. As with all valuations, assessments are usually made on the basis of comparison with recent sales evidence. While sales figures may be available to most valuers, the detail of comparative sales is not so widely available. This is why it is very important to engage valuers with substantial and preferably recent market experience. With a valuation report prepared by a recognised independent valuer, borrowing from banks to purchase leases is generally not too difficult. For the right proposals lenders may advance up to 40 to 50 percent of the purchase price or valuation, sometimes a little more.
How do we appraise accommodation businesses?
It is beyond the scope of this article to go into detail about the various factors making up a good lease. There are many variables, however for this exercise we are assuming that we are assessing a leasehold business where the lease is sound and the revenue and profitability are sustainable, or have some growth potential.
Value is usually assessed by calculating the earnings before interest, depreciation, drawings and taxation, sometimes referred to as E.B.I.D.T. The profit is then multiplied by a factor consistent with market evidence. This factor is referred to as the capitalisation rate or the profit multiple. The rate or multiple used varies depending on a number of matters, not least the location within New Zealand. (See separate article at www.coffeys.co.nz/News-Articles/What-You-Get-Is-Where-You-Buy/ or link to AMG archives.) Supply and demand in certain regions and their popularity or otherwise will affect the rate of return applied. Generally the rates range between 20 and 25 percent return, or four to five times the profit.
Why add back depreciation?
Most businesses claim depreciation on plant and chattels and this may save or at least defer some tax. In the case of a high tech printing and copying business for example, it is likely that new equipment will need to be purchased quite regularly and that the old equipment will lose a substantial portion of its value in real terms. In this case, depreciation would be a real cost and would need to be allowed for when assessing the actual profit of the business.
The chattels in a motel could be compared to the engine in a car, insofar as they are required for the business to function. If agreement can be reached on the total value of the business based on its earnings, then the sum recorded for the chattels in the Sale & Purchase Agreement, ( as opposed to depreciated or actual value), has more relevance to the tax implications for both buyer and seller.
There is one qualifier for this though. When calculating profitability, it is important that there has been and will be adequate allowance for ongoing repairs, maintenance and replacement of plant as necessary. (How much will depend on the age of the property.) Should an appropriate allowance for chattel repair and replacement have been made, then we would suggest that depreciation on chattels is really a book exercise for tax purposes.
In reality, one of the challenges when negotiating the sale of a lease, is getting the parties to agree on the sum to be recorded as the chattel figure. The purchaser usually wants to have a high chattel figure so as to be in a position to claim depreciation. The vendor on the other hand would like to show the chattel value at the lower end, if possible at book value, so as not to recover depreciation on the chattels. Any figure recorded as the chattel value which is over and above the book value (up to the original cost value) would be depreciation recovered and this would be taxable to the vendor. The total business value should not be affected by the chattel apportionment, except that the “goodwill” or “intangible assets” will need to be adjusted to make up the total purchase price. If a loan application is supported by a registered valuer’s report, lenders are not usually too concerned as to the chattel figure, as long as it is reasonable.
Why remove owner’s remuneration before assessing the profit?
Some valuers prefer to allow for a manager’s salary before arriving at the profit on which the business value is calculated. In this case though, they will usually use a lower rate of return (or higher multiple) on the profit. The valuation result may be similar. Opinions will vary as to the allowance for the owner’s or manager’s salary, so it is usually preferable to use the more consistent approach of applying a multiple of profit before return to management.
Also, reducing profit by deduction for return to management can produce different results depending on the size of the business. For example if two motel businesses were selling at 25 percent return on EBIDT, one for $800,000 with a $200,000 bottom line and the other for $240,000 with a $60,000 profit, the result would be as follows:
A $50,000 return to the manager from the first example, leaves $150,000 profit being 18.75 percent return on purchase price. In the second example, this leaves only $10,000 after removing the owner’s return, suggesting that the business is worth little if anything.
In the case of the low-priced lease, it can be argued that one is only buying a job and to some extent this is true, however it is also a job that can be sold again in the future. Also, a business at this price level can be bought to satisfy the purchaser’s requirements for independence, lifestyle and the benefits of “free living.”
Part two of this article will appear in the next edition of AMG, addressing why the market has settled at these returns and the general feasibility of the leasehold structure.