How to Ensure Just Compensation for Business and Goodwill
Retail Petroleum Consultants (RPC) specializes in complex valuations of gas station and car wash properties throughout the United States. These property types are often found at major intersections and along well travelled arterial roadways. As such, they are frequently involved in road widening and related Right of Way (ROW), projects causing the property owner to forfeit real property and business assets. Local State Departments of Transportation (DOT) have the right to condemn property by means of eminent domain but must pay the owner just compensation (Fifth Amendment Constitution). States must follow due process when acquiring private property (Fourteenth Amendment Constitution).
In most States Business Goodwill value is not compensable in eminent domain. States that recognize Business Goodwill as being compensable include California, Delaware, Florida, Louisiana, Iowa, Idaho, Vermont, Virginia, Wisconsin, and Wyoming. Although most states reimburse business relocation costs, many businesses such as gas stations and car washes simply cannot be effectively relocated. This article will address proper appraisal methodology for gas station and car wash valuations where both real property and Business Goodwill are impacted. For simplicity purposes we will assume a full take where the entire property is condemned or taken and that the business cannot be relocated as would be the case with gas stations or car washes that typically trade as a going-concern.
Going-Concern Value – Is defined as the value created by a proven property operation; it includes the incremental value associated with the business concern, which is distinct from the value of the real estate. Going-Concern value includes an intangible enhancement of value of an operating business enterprise, which is produced by the assemblage of the land, building, labor, equipment, and marketing operation. This assemblage creates an economically viable business that is expected to continue.
It is the property owner’s right to obtain an independent appraisal in an eminent domain proceeding. In most cases the condemnor pays up to $5,000 towards appraisal fees. The condemnor is subject to the Uniform Act (Uniform Relocation Assistance and Real Property Acquisition Policies Act of 1970, Amended 1987) and must comply to their regulations and the Uniform Standards of Professional Appraisal Practice (USPAP) unless there is a jurisdictional exception. The Real Estate Acquisition Guide for Local Public Agencies states:
“The Uniform Act provides benefits and protection for persons whose real property is acquired or who are displaced from acquired property because of a project or program that uses Federal Funds or receives Federal financial assistance. The Constitution requires payment of just compensation for real property which is acquired and, when a project results in displacement, the Uniform Act requires services and payments be provided for displaced persons. A displaced person may be an individual, family, business, farm, or non-profit organization.”
Key to the above statement is that a displaced person can be a business. Some specific terms to understand as defined within the Uniform Act include the following:
Fair Market Value – Is market value that has been adjusted to reflect constitutional and other legal requirements for public acquisition. This is determined by State law but generally includes the following:
- Buyer and seller are typically motivated
- Both parties are well informed or well advised, each acting in what he or she considers his or her own best interest;
- A reasonable time is allowed for exposure in the open market;
- Payment is made in terms of U.S. dollars or in terms of financial arrangements comparable thereto; and
- The price represents the normal consideration for the property sold unaffected by special or creative financing or sales concessions granted by anyone associated with the sale.
Just Compensation – Is the price an agency must pay to acquire real property. An agency official must make the estimate of just compensation to be offered to you for the property needed. That amount may not be less than the amount established in the approved appraisal report as the fair market value for your property. If you and the agency cannot agree on the amount of just compensation to be paid for the property needed, and it becomes necessary for the agency to use the condemnation process, the amount determined by the court will be the just compensation for your property. (Note this definition does not address Business Goodwill).
Appraisal – An appraisal is a written statement independently and impartially prepared by a qualified appraiser setting forth an opinion of defined value of an adequately described property as of a specific date, supported by the presentation and analysis of relevant market information.
Condemnation – Is the legal process of acquiring private property for public used or purpose through the agency’s power of eminent domain. Condemnation is usually not used until all attempts to reach a mutually satisfactory agreement through negotiations have failed. An agency then goes to court to acquire the needed property.
Eminent Domain – Is the right of government to take probate property for public use. In the U.S., just compensation must be paid for private property acquired for federally-funded programs or projects.
Goodwill – consists of the benefits that accrue to a business as a result of its location, reputation for dependability, skill or quality, and any other circumstances resulting in probable retention of old or acquisition of new patronage.
The Appraisal Institute (AI) defines Goodwill as the intangible asset that arises as a result of a name, reputation, customer patronage, location, products, and similar factors that have not been separately identified and/or valued but that generate economic benefits.
The Uniform Act does not define business. The AI defines Business Value as the term applied to the concept of the value contribution of the total intangible assets of a continuing business enterprise such as marketing and management skill, an assembled work force, working capital, trade names, franchises, patents, trademarks, contracts, leases, and operating agreements.
For the purpose of this article, the term Business Goodwill includes all intangible assets and excludes real estate, personal property, and equipment. The five states listed below do not cap or limit just compensation for Business Goodwill and are somewhat consistent in their definitions.
It is expected that the condemning agency uses competent appraisers and reviewers to render just compensation when private property (or Business Goodwill) is taken. The condemning agency must abide by the Uniform Act as well as USPAP unless a jurisdictional exception applies. Given adherence to USPAP and recognized appraisal procedures for special use properties one would expect similar methodologies be employed by both the taking agency and condemnee appraisers, but this is often not the case, especially when it comes to Business Goodwill.
California Code section 1263.510 states the owner of a business conducted on the property taken, or on the remainder if the property is part of a larger parcel, shall be compensated for loss of goodwill if the owner proves all of the following:
- The loss is caused by the taking of the property or the injury to the remainder.
- The loss cannot reasonably be prevented by a relocation of the business or by taking steps and adopting procedures that a reasonably prudent person would take and adopt in preserving the goodwill.
- Compensation for the loss will not be duplicated in the compensation otherwise awarded to the owner.
It’s clear to see that with a full take of a gas station or car wash the above conditions are met warranting just compensation for Goodwill Business. Let’s look at a typical DOT agency as an example. DOT has regularly paid just compensation for gas station and car wash businesses involved in eminent domain. However, their methodology for doing so appears flawed, shows lack of appraiser competency, and is not considered USPAP compliant.
The Uniform Act advises the condemning agency to employ sound appraisal procedures using verified market data, appraisers that are competent for the specific property type and business being taken, and to follow USPAP standards. Based on our experience with DOT and related eminent domain appraisals, rarely are credible appraisal reports are not used to determine just compensation for special use properties that are owner occupied like gas stations and car washes. What is DOT doing wrong?
DOT employs faulty methodology and does not use competent special use property appraisers. Their appraisal methodology is generally to have two separate appraisals performed; one for real estate, and the other for Business Goodwill. We call this the “two appraiser approach”. USPAP warns about appraising individual components of a property and then adding them together. To begin with, gas station and car washes are purchased based on their cash flow potential, not physical units of comparisons such as price per square foot, as may be appropriate for most commercial real estate properties. Buyers of fee simple gas stations and car washes do not separately purchase going-concern assets, i.e.; Business Goodwill, equipment, and real property. Rather, they pay an agreed price for the entire going-concern based on the cash flow potential of the business. The purchase price is often allocated between real estate, equipment, and Business Goodwill, though this is generally for estate planning, lenders, and tax purposes and is not considered to be a market supported allocation. For these reasons a buyer’s or seller’s allocation of a going-concern purchase price should not be relied on as standalone values for real property, equipment and Business Goodwill.
The two appraiser approach is complicated by the fact that real estate has different value if severed from an operating business (closed or dark), verses being part of a going-concern where real estate is assembled with an operating business and related equipment. This is evident in the sale of a closed gas station or car wash where buyers discount the real estate given stabilization costs and risk to successfully open and cash flow the business.
The market pays more for same real estate if assembled with an operating business than if closed. So how does the DOT appraiser address the valuation of real estate only? They treat is as many generalist appraisers do who are not adequately trained in going-concern valuation. Common real estate only valuation procedures used by DOT appraisers include:
- Cost Approach Only
- Comparable Sales Analysis Using Leased Fee Real Estate Sales
- Comparable Sales Analysis Using Going-Concern Sales
- Estimate Real Estate Rent and Capitalize Leased Fee Income
Each of the above valuation procedures are flawed. If an appraiser performs only the Cost Approach, they have not proven the gas station or car wash is the highest and best use, violating USPAP and Uniform Act requirements. Without properly analyzing business operations the appraiser cannot determine if cash flow supports the real estate and whether or not the gas station or car wash represents the highest and best use.
Appraisers must make apples to apples comparisons when selecting market sale comparables. Comparing real estate that is owned leased fee to fee simple real estate unencumbered by lease is not sound appraisal methodology. Leased fee properties trade based on projected rental income at the time of sale. They should not be compared to fee simple properties where cash flow is based on the owners operating business. It is important that the appraiser is consistent when matching the ownership interest of the appraised property to the sale comparables. We have witnessed DOT appraisers doing just this, overvaluing real estate because they are using going-concern sales that include non-real estate assets. In this case the Business Goodwill appraiser may be double counting assets included in the real estate appraisal.
A going-concern sale includes real estate, Business Goodwill, and equipment and should not be compared to real estate only. As stated earlier buyers and sellers allocations are generally not market based but driven by their motivation to reduce tax liability or get a loan. It is often these allocations made by buyer and seller that end up on the assessors roll, further complicating the analyses given appraiser’s reliance on assessor’s record. It is problematic to value real estate only without considering the effect an operating business may have on it.
The last bullet point identifies appraisers estimating rent for real estate and then capitalizing estimated rent by an estimated overall rate. Given the lack of data for this type of analyses and obvious flaws, fee simple real estate should not be valued in this way.
The DOT tends to use a “generalist real estate” appraiser to value the real estate portion of a gas station or car wash going-concern, then uses a second “business” appraiser to value the Business Goodwill. Severing the business from the going-concern and valuing it separately creates problems as discussed. How does one value a business by itself that does not exist by itself? A gas station or car wash business must have real estate to locate and operate on either through direct ownership or lease. But under DOT methodology the fee simple going-concern is broken up into separate valuations, one of the real estate and the second of just the Business Goodwill.
How does the business appraiser determine the lease rate for the gas station or car wash? They tend to estimate rent based on data extrapolated from the real estate appraisal report. Comparable recently signed arm’s length gas station and car wash leases are not readily available in the marketplace as most gas stations and car washes are owner occupied. When they are leased they are often between related parties; i.e., Major Oil Company or created due to the sale of a business. Even if the business appraiser has data to support rent and resulting business net operating income (NOI), they still have to select an overall capitalization rate (OAR) from market sales of similar type businesses. Data for gas station and car wash business sales are particularly scarce. Most this data lacks specifics regarding lease terms which have a significant effect on what someone pays for the business. As an example, a business with long term renewable below market lease would trade for a lower OAR (higher value) than the same business with short term nonrenewable above market lease. Because of the wide variations in lease terms between comparable business sales, the OAR varies dramatically and can fall anywhere from 10% to 50%. Without knowing specific lease terms to understand and support the spread in OARs, business sale data is of limited use and considered suspect.
Now that we have shown the flaws of many DOT appraisers how should special use fee simple gas stations and car washes be valued? Let’s start with one of the pillars of USPAP – competency. In order to have credible appraisals one must start with a competent appraiser. Because gas stations and car washes are special use properties an appraiser specialist or expert with specific knowledge of this property type and industry is recommended. This person employs recognized valuation procedures used by market participants and has access to confidential proprietary market data necessary for credible appraisals. With gas stations and car washes this proprietary data includes sales volumes, profit and loss statements, expense ratios, fuel margins, car counts, operations by brand, car wash type, as well as cost comparables, going-concern sale comparables, and related data bases. Without these data sources the specialized appraiser cannot interpret market trends and competently employ credible valuation techniques used for special use properties.
A competent appraiser will look to the subject’s specific market to determine appraisal methods most commonly accepted and best suited for the specific property type; i.e., gas stations and car washes. Methodology used or preferred by market participants; i.e., brokers, buyers, and sellers is considered a good place to start. Buyers of fee simple gas stations and car washes do not look to per unit comparisons such as price per square foot or dispenser. There is little if any relationship between the number of dispensers or building size and how much cash flow a gas station generates. Instead market participants base going-concern pricing on cash flow and look at Gross Profit Multiples (GPM) and OARs to convert income to value. These valuation formulas are summarized as follows:
Fee Simple Going-Concern Sales Price = Gross Profit X GPM
Fee Simple Going-Concern Sales Price = NOI ÷ OAR
These formulas render a market value for the gas station or car wash fee simple going-concern and includes real estate, equipment and Business Goodwill. The difficulty here is having access to actual market sales and resulting GPMs and OARs. Most generalist appraisers do not have access to sensitive financial data from car wash and gas station operators on a consistent basis to build these necessary data bases. Most brokers sign non-disclosure agreements making verification and collection of sensitive going-concern sales data particularly difficult. A specialist appraiser has regular interaction with market participants, depth of work, and necessary databases to employ credible valuation techniques that mirror the marketplace.
Market participants buy and sell gas station and car washes based GPM or OAR analyses. What better way to provide just compensation than to base it on how the market would purchase said property. The GPM and OAR approaches render a supportable going-concern value that includes real estate, equipment, and Business Goodwill. Any allocation of going-concern assets is performed after said valuation. Business Goodwill value is typically arrived at through a residual technique by subtracting the Cost Approach (tangible assets) from the concluded Going-Concern Value. A positive residual means there is value to Business Goodwill, a negative value means there is functional and or external obsolescence and the gas station may not represent highest and best use.
Going-Concern Value – Cost Approach = Business Goodwill
Appraisal is often seen more as art than exact science. In reality it’s probably a bit of both. All appraisers have to make subjective decisions based on their knowledge and expertise. Knowing what valuation approaches and techniques are most appropriate for which property type can be difficult, especially with special use properties like gas stations and car washes. A competent specialized appraiser tends to focus on a specific market sector and related properties. These are the appraisers that should be sought for eminent domain appraisals whether it be for the condemnee or for the condemnor.