The valuation professions have, until the present time, been working with Fractional Interest Valuation 1.0 when it comes to real estate holding entities and tenancies-in-common. Version 1.0 refers to the body of knowledge that was developed over many decades for operating companies, with real estate holding companies largely an afterthought. Until now, this valuation practice has mostly consisted of adapting marketability discount and other data and thinking for use with real estate. But adaptation has proved difficult, since the reader might need to be convinced, for example, that restricted stock has something to do with common tenancy or partnership interest discounts—not an easy feat by any means. Implementing Version 1.0 has been a real mess, as any reading of tax court cases or discussions with IRS valuers will attest.
The time has come to upgrade to Fractional Interest Valuation 2.0. Version 2.0 is based on the fact that real estate holding companies are not operating companies. They are real estate entities, which means that the risk profile of the property itself must inform nearly all of the components of the valuation. But the components of 1.0 were developed in a securities context, as is appropriate to their business valuation origins. Even the two that are inherently real estate-related—partition and real estate limited partnership secondary market (RELP) trading—are still partly divorced from their real estate elements. The essential characteristics of the underlying property, growth expectations, cash flow potential, risk profile, highest & best use issues, etc., rarely inform either the data or analytical models that use the data.
Version 2.0 is transformative. It still builds on the many decades of the business valuation body of knowledge for marketability discounting, public partnership trading and option pricing models, but it adapts each specifically to real estate entities. Reliance is placed most heavily on income methods using RELP and REIT market returns. The result is a coherent and reasonably easy-to-explain process that supports all of the circumstances that may be faced by real estate entities.
The methods of 2.0 are essentially an engineered approach to fractional interest valuation. The engineer doesn’t introduce anything new per sé, but applies existing scientific knowledge to produce solutions that might not have been thought of before. Version 2.0 is the end product of a long-term effort to engineer a comprehensive solution for a new generation of valuers, and for new generations of property owners as well.