How To Separate Real Estate From Business Value?

Hey guys, I have a pretty elementary business valuation question.

Imagine you are valuing a private digital marketing firm that owns its own office. How would you deal with the real estate value? Would you first value the business pretending it doesn’t own any office and therefore adding a rent expense to the future cash flows + add the real estate value to the business value? Or only value the business with no market rent expense?

I’ve been educated to go with the second option (because without the office the company wouldn’t be able to generate any cash flow), but I still think the first option brings more value… I have a hard time believing that discounting a rent in perpetuity reduces the value of the business by the same amount as the real estate value.

Any thoughts?

Thanks!

Most people will separate the business and real estate valuations because it will increase the total value due to the lower cap rates (higher multiples) for the real estate. For example, the business may sell at 4 or 5 times cash flow while the real estate may sell at a cap rate of 7 or 8 percent which is a 12-14x multiple.

To do this, you will need to add a pro forma market rent payment as an expense on the income statement. You will then use this pro forma rent to value your real estate, less any capital expenditures required under the proposed lease terms.

Thanks Chad.

I see and understand your point in case I’ll go with a multiples valuation approach. It makes sense.

However, if I have a DCF valuation approach, I think I should not separate the real estate value from the business value. In your example, a 7% cap rate would pay the office in ~14 years (assuming no capex would be needed), therefore, in this case, adding a market rent expense to my cash flows in perpetuity would in fact reduce the value of my business perhaps by an amount higher than the market value of my office.

To illustrate, imagine my business with the real estate asset incorporated is valued at €10m through the DCF method. JLL values my office at €1m. Now, if I sell the office for €1m and then add a market rent payment to my IS and discount my cash flows in perpetuity, the value of my business should be valued at €9m (or even lower, that’s why selling the business with the real estate asset incorporated for €10m would be the better option).

Also, this makes me realize the overall value can be substantially different depending on the valuation approach.

Do you agree?

Thanks!

well youd sell together. because imagine you sell the business. and not the real estate. and the person who buys decides to move the business elsewhere. now ur stuck with a real estate property without a tenant. lol.
anyways you can put an imputed market rent to value the real estate and to affect the valuation of the business as well. but imo the imputed market rent is highly sus. a higher rent payment leads to a higher valuation of the real estate and an overall higehr valaution sicne real estate has a higher valuation than a private digital business. or vice versa depending on if your the buyer or seller of the bizness.