How do you determine the value of an undivided interest in real estate? That is the question from numerous readers of my January newsletter (here), besides their seeking insight to the case specifics I discussed. For background purposes, the IRS attempted to disqualify me as an expert in the case because I am not a real estate appraiser. The Court eventually accepted me as an expert based on my experience in valuing similar interests, rather than deciding based on the nature of the interest. I believe valuation should be done as a “security” and the IRS view is one of a “real property interest.”
Everyone from whom I received comments agreed that the valued interest was something other than a real property interest. Interestingly, each person agreed with me for different reasons. This undivided interest represents the right to receive distributions, if distributions are made, but not the right to force distributions. In addition, there is no organized and ready market for such a security as there is for stock of publicly-traded companies. For valuation analysis purposes, the owner of such an interest is in a similar position to an owner of a non-controlling limited partnership (LP) interest.
Therefore, the proper approach revolves around rates of return that are appropriate for investing in non-control, non-marketable securities similar to LP interests, given the risks associated with the underlying investment. In order to accomplish this task, it is important to understand all of the risks and all of the expected future returns, as well as all of the attributes of the underlying assets, and the differences between the subject interest and available alternatives. This approach mimics the process followed by investors (either explicitly or implicitly) in every investment, and is an approach which relies upon market data and supportable assumptions.
Others believe that the proper approach to value is to calculate the diminution of the value of the underlying asset due to the undivided nature of the interest. The first part of this theory is that a buyer would pay the pro-rata portion of the underlying asset, as determined through traditional real estate appraisal techniques (understanding that the interest is undivided). I agree with this part, however, the disagreement comes in the next step. The theory postulates that the diminution in value directly attributable to holding an undivided interest in the asset is the cost of seeking the legal remedy of partition, which in turn suggests that returns are heavily influenced by the ability and willingness of the investor to sue his or her partners. While I believe that the cost to partition may create some floor discount level, hypothetical buyers will ultimately analyze the interest just as they do all other investments, considering the right to partition merely as a component of the overall risk analysis. I have seen no evidence that supports the idea that investors (hypothetical willing buyers) determine prices for anything based on the ability to sue their partners.
Regardless of how we get to the analysis, one thing is clear- the analysis shouldn’t differ from the analysis of similar interests applied by the likely pool of investors. No hypothetical seller would expect anything else.