Myth vs. Reality

In previous issues, we have discussed various aspects of valuing fractional real estate limited partnership interests. We introduced some of the factors that serve to reduce the value of a fractional interest below its proportionate share of the underlying assets of the entity. These factors are referred to as valuation discounts. Now, after having held ourselves out as experts in determining and quantifying valuation discounts, this article sets the record straight. The valuation discount may be a myth!

Outrageous you say? What about all those annual discount studies published by Partnership Profiles, or the Willamette Management Associates study of limited partnership interests which speaks of a median valuation discount of 48%? There is also the Barber Study which reports an average valuation discount for limited partnership interests of 45%, and Kam, Smith and Schroeder who report a mean discount of 38%. When valuing a limited partnership interest, most valuation analysts compute the proportionate hypothetical current sale proceeds to the owner of the interest being valued, then reduce this pro-rata share by the artificially derived "discount" based on these discount studies. In some circumstances, this valuation method is appropriate. These studies, however, have been so "over-used" and quoted by valuation analysts that it appears that it is the discount itself that drives and motivates the sale of limited partnership interests and thus determines the value of the fractional interest. Nothing could be further from the truth.

When was the last time you heard of an astute investor making an investment decision based on a discount from some computed value? An investor does not say to him/herself, "I will invest if I can get a 35% discount from my proportionate share of the assets of the partnership." The investment decision is not based on some arbitrary valuation discount. This is the myth! The typical investor asks "what cash am I going to get back and when am I going to get it?" What is the one thing that will make any investor open his or her check book and write that check to purchase the interest? THE EXPECTED RETURN ON THE INVESTMENT! This is the reality. The investor analyzes the investment, assesses the risks and projected cash flow, and establishes a return rate that is sufficient to induce him/her to commit the capital to acquire that specific interest.

Accordingly, Valuation Services, Inc. ("VSI") typically values real estate limited partnership interests as other income producing investments would be valued, through the use of a discounted cash flow analysis. This analysis projects the cash flow stream produced to the investor. The projected stream of cash flow is then converted to a present value through the use of an internal rate of return ("IRR") which takes into consideration many factors including the inherent risks and rewards of owning the specific partnership interest, other investment alternatives, the lack of marketability and liquidity, the lack of control, and other specific relevant factors. It is the expected rate of return, or IRR on the investment which drives the determination of fair market value. The expected IRR helps to determine the value a willing buyer would pay for the interest.

Projecting a cash flow stream to the owner of the interest is not the most difficult part of the process. The true challenge comes from determining the appropriate IRR which equates the cash flow stream to a present value. Therefore, when valuing a private ownership interest, the valuator must assess the specific risks associated with the interest, and based on these risks, determine the expected IRR and thus the value of the interest. By comparing the net present value of the interest to the interest's pro-rata share of the proceeds from a hypothetical current sale of the real estate, the discount can be identified. The value of the interest is calculated first, based on the appropriate IRR. The resulting discount is a by-product of the valuation process.

The principals of VSI have acquired and sold many fractional limited partnership interests in private partnerships owning various types of real estate. In each of these transactions, cash flow projections were prepared and an expected IRR was determined prior to consummating the sale/purchase. VSI has accumulated a proprietary database of empirical data on the expected IRR on real estate limited partnership interest purchases. Below is a summary of the database of documented purchases by investors acquiring fractional limited partnership interests which own real estate. The table represents 33 different transactions between 1987 and 1997 in which investors expected to earn the stated internal rate of return in exchange for contributing capital for a fractional ownership interest. The majority of the transactions took place from 1994 to 1997.