Control: What Drives Discounts for Real Estate Holding Companies? – Marcum LLP

Valuing an asset holding company requires careful evaluation, and there are special considerations for real estate holding companies in particular. To value asset holding companies, an analyst must determine the appropriate discounts that are applicable based on the particular characteristics of the entity and the subject interest. In this article, we will explore discount for lack of control that is applicable to holding companies that own real estate.

What is control and when is a discount warranted?

Elements of control include the ability to control financial, operational and legal aspects of a business. This control can include selling a business or all of its assets. Generally, control significantly increases the value of an investment.

A discount for lack of control is warranted when determining the fair market value1 of an ownership interest that does not unilaterally control these key aspects of the business (i.e. a non-controlling interest). To determine discounts for lack of control applicable to real estate holding companies, experts often rely on the Survey of Re-Sale Discounts published by Partnership Profiles Inc. (or the PPI Survey). This annual survey reports the discounts from net asset value (NAV)2 at which minority, non-controlling interests in non-publicly traded real estate limited partnerships and real estate investment trusts (REITs) have been purchased in the secondary market.

NAVs are based on a Partnership’s internal and/or a third-party appraiser valuation. Discount (or premium) can then be determined by comparing the NAV per unit of a real estate holding entity to the actual purchase price of an interest in that entity.

What drives discounts?

Liquidation Period

For real estate holding entities, the liquidation period is the length of time it takes an entity to sell its assets. Non-publicly traded partnership and REIT interests are priced to reflect expectations of the time period until the program is liquidated. This is especially true for programs that don’t make distributions and are not expected to do so in the future.

Studies published by PPI indicate that partnerships and REITs that have announced definitive liquidation plans trade at lower-than-average discounts. Discounts reduce even further for such partnerships that make regular operating distributions because investors would still be able to receive distributions even if plans for liquidation fall apart or get delayed. Programs that usually do not make cash distributions until underlying assets (e.g. undeveloped or improved land) are typically priced at a higher discount.

In summary, investors in minority interests command lower discounts for lack of control once liquidation plans have been announced, since there is a relative certainty regarding distribution of proceeds, and such interests are then considered to have increased liquidity.

But what about entities that have not yet announced a liquidation plan? PPI states that the two most important factors considered by secondary market buyers when pricing units of real estate programs that have not announced a definitive liquidation plan are:

  1. the program’s ability to pay operating cash distributions and recent history of actually paying such distributions, and
  2. the degree of debt financing, if any, utilized by the program.

Let’s examine how these two factors affect discounts.

Distributions

Data published by PPI from 2012 through 2022 shows that an entity’s ability to pay operating cash distributions has the biggest influence on discounts: the higher the distributions, the lower the discount. The reported yield-to-NAV and yield-to-price ratios reveal a strong negative correlation with discounts, as presented below:

2012-2021 Correlation with Discount
2017-2021 Correlation with Discount
2021 Correlation with Discount

Degree of Debt Financing

Historically, distributing partnerships with moderate to high debt (75% or more) traded at lower discounts than those with minimal to no debt—the higher the debt, the higher the discount. However, PPI data indicates that this gap between discounts for varying levels of debt has narrowed since 2015. In more recent years, the average discounts for lack of control reported for distributing entities with moderate to high debt have been essentially identical to those with less debt, as presented below:

2012-2021 Discounts and Distribution Yields
2017-2021 Discounts and Distribution Yields by Investment Type
2021 Discounts and Distribution Yields

Notice that in 2012-2021, in Table 1, discounts for the ‘low to no debt’ and ‘moderate to high debt’ categories were further apart. This data also shows the sizable difference between the distributing and non-distributing entities.

In the 2017-2021 period however, the average discounts for these two categories only differ by 2% (Table 2). Examining solely 2021 in Table 3, the average discounts for the two debt categories are nearly identical.

Does program type affect discounts?

Different real estate holding entities have different types of investment structures and underlying assets. Discounts are typically higher for riskier programs. Three types of programs are summarized below to compare their underlying assets, risk profiles and average discounts.

Program Type Triple Net Lease Mortgages Undeveloped Land3
Description

Pursuant to long-term lease agreements: lessees are obligated to pay all insurance, taxes and day-to-day maintenance expenses associated with such properties.

No active management of properties. Investors may receive immediate returns in the form of rent payments.

Programs that invest in commercial real estate debt.

Debt consists of primarily floating-rate mortgage loans secured by various property types.

Programs that invest in undeveloped land.

Does not generate operating cash distributions.

Comparative Risk Profile LOW MEDIUM HIGH
Average Discount (2015-2021)4 19.71% 25.57% 35%5

How did the COVID-19 Pandemic impact discounts?

The COVID-19 pandemic had tremendous economic effects worldwide, and continues to affect many areas of the economy, including real estate holding entities. PPI reported relatively higher discounts in 2020 and 2021, as summarized below:

Survey Year Average Price-to-Value Discount
2012 32%
2013 31%
2014 28%
2015 22%
2016 20%
2017 19%
2018 19%
2019 23%
2020 33%
2021 38%

The higher discounts in 2020 and 2021 can be attributed to the longer anticipated liquidation periods resulting from the uncertainty caused by the pandemic. Another factor affecting discounts in 2020 and 2021 was the higher number of non-distributing partnerships (which usually trade at the highest discounts) in those years—many of these partnerships did not make cash distributions at all due to the negative impact of the pandemic on their operations.

Real Estate Holding Entities and Control

In summary, while discounts may have increased due to the pandemic, and while debt may have been a greater consideration in the past, the most important factor affecting discounts for lack of control for real estate holding entities are its distributions. Level of risk based on the type of partnership should also be given consideration. As PPI emphasizes, distributions and debt are important, but a more nuanced understanding of those two factors helps the savvy analyst better value entities that hold real property.

Sources & Footnotes

  1. Appendix B of SSVS 1 defines fair market value as “The price, expressed in terms of cash equivalents, at which property would change hands between a hypothetical willing and able buyer and a hypothetical willing and able seller, acting at arm’s length in an open and unrestricted market, when neither is under compulsion to buy or sell and when both have reasonable knowledge of the relevant facts.”
  2. NAV is the market value of the assets less liabilities.
  3. There were no programs owning strictly undeveloped land in PPI’s 2021 survey. These programs have become more rare over the years due to liquidations; the 2015 through 2017 surveys featured only one undeveloped land program.
  4. Latest year available.
  5. Average includes 2015 through 2017.

2021 Executive Summary Report on Re-Scale Discounts, Copyright 2021 ©Partnership Profiles Inc.