Standards of Value and Appraisal Techniques

Standards of Value and Appraisal Techniques

Making the Appropriate Selection

By: Alan K. Stagg, PG, CMA

ABSTRACT

The appraisal of mineral properties, operations, and companies involves considerably more than a basic understanding of engineering economy and discounted cash flow analysis.  Several standards of value exist, each being appropriate in specific situations.  Similarly, several approaches and techniques may exist in applying a standard of value.  Selecting appropriate standards of value and appraisal techniques is critical to a meaningful appraisal, and the appraiser is responsible for the appropriate selection based on the purpose and intended use of the appraisal.  In this article, several standards of value are reviewed and criteria governing their selection identified.  Representative case studies are provided and problems involving the application of each standard and technique are discussed.

INTRODUCTION

In response to the savings and loan collapse in the 1980s, the Federal Institutions Reform, Recovery, Enforcement Act (“FIRREA”) was passed in 1989.  As a result, the appraisal of real property came under increasingly tighter standards.  States were required to implement educational and licensing requirements and the Uniform Standards of Professional Appraisal Practice (“USPAP”) were developed.  Any appraisal involving real estate for which federal funds were involved was to be performed by a state licensed appraiser in accordance with USPAP.

For a period after the passage of FIRREA, there was a widespread belief that only in transactions involving federal funds was it necessary to use a state-licensed appraiser to conform to USPAP.  What wasn’t recognized, however, was the fact that many states required licensing of all appraisers in valuing any interest in real property.  Similarly, in those states requiring licensing, the appraiser is required to prepare all appraisals in conformance with USPAP, not just those involving federal funds.  To an increasing extent, those requesting appraisals of mineral interests are also requiring conformance with USPAP.

Since the vast majority of appraisals in any state involve what is thought of as “land” as opposed to mineral interests, it is understandable that most legislatures and appraisal boards did not deal specifically with the appraisal of mineral interests.  What is becoming more widely understood, however, is that most state licensing requirements apply to the appraisal of any interest in real property.  This includes ownership of any portion of the mineral estate as well as mineral leases, claims, and royalty interests.

Over the years, the appraisal of mineral interests typically have been conducted outside the realm of formal appraisal practice for “land.”  As a result, a wide variation exists among mineral appraisals, including not only in the quality of appraisals but also in the selection of the standard of value and the techniques used.  Hopefully, this is changing as more mineral appraisers recognize that state licensing requirements often apply and USPAP is eminently applicable to mineral appraisals involving interests in real property.

Similarly, many mineral appraisers did not recognize that differing standards of value, techniques, and approaches to value are applicable when appraising mineral interests in other than real property, such as shares in a corporation, or other form of legal entity, partnership interests, and business enterprises.

This article identifies and discussed the more widely used standards of value, the various techniques by which they can be used, and the importance of selecting the appropriate standard and technique.  Additionally, a number of case studies are presented for illustration.

STANDARDS OF VALUE

Four of the most commonly used standards of value that an appraiser of mineral interests might encounter are investment value, market value, use value, and fair value.

Investment Value

Investment value reflects value to a single, specific investor.  In applying this standard of value, the investor’s financial measurement criteria such as required rates of return, discount rates, and capital costs are used, with the standard reflecting that investor’s perception of future prices and costs, risk, tax implications, and strategic factors such as synergies with existing assets and operations.  This is the most often used and the most applicable standard of value when a company evaluates a prospective acquisition, divestiture, or capital expenditure.

Market Value

The preferred term market value, which is replacing the term fair market value in formal appraisal practice, contrasts with investment value in that it reflects a consensus of many investors’ perception of value.  There are any number of definitions of market value, but one of the more widely used is that cited in the Uniform Standards of Professional Appraisal Practice as being agreed upon by agencies that regulate federal financial institutions in the United States.  Without quoting the entire definition, it is worth noting that the opening sentence states that market value is “The most probable price which a property should bring …” (emphasis supplied).

Use Value

The term use value is defined as “the value a specific property has for a specific use.”  This standard of value is frequently used in appraising personal property such as machinery and equipment, in which replacement cost less depreciation is the approach used.  It is also applicable to mineral interests, particularly as a derivation of the Income Approach to Value.

Fair Value

The term fair value has different meanings in different contexts.  In the appraisal of real property, the term is frequently used interchangeably with the term fair market value or market value.  In business appraisals, however, the term is a legal standard of value applying to specific circumstances, one of which involves dissenting shareholders’ appraisal rights.  In such a circumstance, the dissenting shareholder typically has a statutory right to have his/her shares appraised and to receive fair value in cash.

However, in the case of the dissenting shareholders’ rights, the definition of the term varies between states, being dependent on the statutory requirements and on case law.  In some states, fair value is held to be equivalent to market value, and in these instances premiums and/or discounts are applicable for control or lack of control and for liquidity.  In other states, fair value is considered to be the full value of the shares without any premiums or discounts being applied.

INTENDED USE AND PURPOSE

In selecting the appropriate standard of value and appraisal technique, it is incumbent upon the appraiser to first establish the intended use and purpose of the appraisal.  Each should be stated in the appraisal report.  A typical statement of intended use is as follows:  “The intended use of the appraisal presented herein is to assist the XYZ Bank in financing arrangements involving the subject property.”

Once the intended use of the appraisal has been established, the appraiser can then select the appropriate standard of value.  The standard of value defines the type of value being sought.  In my opinion, this is one, if not the most, critical aspects of the appraisal process.  The selection of an inappropriate standard of value can effectively negate the integrity of the appraisal.  

The standard of value selected becomes the purpose of the appraisal.  A typical statement of purpose is as follows:  “The purpose of the Appraisal is to provide the Appraiser’s best estimate of the market value of the leased fee estate in the subject property as of the effective date.”

APPROACHES TO VALUE

Traditionally, appraisers have used three approachs to value.  These are the Cost Approach, the Sales Comparison Approach, and the Income Approach.

The Cost Approach is an appraisal technique that involves reproducing or replicating the subject property.  It can also involve replacing the property with a property that has the same utility but different construction materials.  The Cost Approach is based on the principle of substitution.  This principle affirms that no prudent investor would pay more for a property than the cost to acquire the site and construct improvements of equal desirability and utility without undue delay.  Since depleting assets such as mineral rights cannot be reproduced or replaced at their location, buyers and sellers of mineral interests would not use this approach in establishing value.

The Sales Comparison Approach is an appraisal technique in which an estimate of market value is based on market prices in actual transactions.  The technique consists of collecting market data on comparable assets.  After studying the market consensus, the appraiser makes value adjustments for comparability differences.  The process is essentially that of comparison and correlation to the subject property.

The Income Approach is an appraisal technique that capitalizes the anticipated income stream from the appraised assets.  This approach is predicated on developing either cash flow or income projections that are then discounted for the time value of money and associated risk.  This approach is appropriate in appraising mineral interests when the underlying property is in production or when there is a reasonable expectation that production will commence within a determinable period of time.

In performing the appraisal, the appraiser considers, but may not use, all three approaches.  For a particular property or type of property, the value indication from one approach (or two) may be most significant.  When possible, the appraiser uses any of the applicable approaches as a check against the other.  There are appraisal problems, however, in which certain approaches cannot be applied.

APPRAISED INTERESTS

Although there are any number of interests that a mineral appraiser might be called upon to value, the following are among those most likely to be encountered.

Fee Simple Estate – Absolute ownership unencumbered by any other interest or estate, subject only to the limitations imposed by the governmental powers of taxation, eminent domain, police power, and escheat.

Mineral Estate (Subsurface Rights) – The rights to the use and profits of the underground portion of a designated property, the title to which may be severed from the estate.

Leased Fee Estate – An ownership interest held by a landlord with the rights of use and occupancy conveyed by lease to others.

Leasehold Estate – The interest held by the lessee through a lease conveying the rights of use and occupancy for a stated term under certain conditions.

Business Enterprise – An industrial, commercial, or service organization pursuing an economic activity.

Stock (Equity) in Closely-held Companies – The ownership shares of a company or corporation, in this instance one that is not publicly traded.

The first four of these comprise interests in real property.

SALES COMPARISON APPROACH

There are a number of schools of thought regarding the use of the Sales Comparison Approach in valuing mineral interests.  On the one hand there are those who maintain the approach cannot be used under any circumstances and who rely solely on the Income Approach.

Moving somewhat from that position are those who maintain that this approach can be used only in appraising undeveloped and/or non-producing mineral interests.  At the other end of the spectrum are those who believe this approach to be useful in valuing both undeveloped or non-producing mineral interests and producing mineral interests.  The reality is that this approach is useful in each of these instances.

Interests in Real Property – The Sales Comparison Approach is used routinely in appraising Fee Simple and Mineral Estates.  However, there are two requisites when using this approach.  The first is to conduct adequate research in identifying sales of similar properties and the second is to assure that the selling price in each instance is expressed on the basis of the appropriate unit of comparability.

For example, if one is appraising the mineral estate in a property that may have unconfirmed economic potential and which lies in an area or region of similar properties, it is likely that mineral rights will be bought and sold on the basis of a price per acre.  In this circumstance, an acre is the appropriate unit to use when comparing sales.

For resource-bearing properties in areas or regions in which there is a history of mining, and in which sales are routinely made on the basis of the known resource potential of the property, the appropriate unit of comparison is that by which the resource is typically denominated.  These include such measurements as cubic yards, ounces per ton, pounds, or tons.  It is this requirement that frequently leads appraisers to the conclusion that comparability cannot be established.

This is simply not the case, however.  What is required is a thorough assessment of the resource potential of both the subject property and the potential sales comparisons, taking into account tonnage, mining type, grade or bed thickness and composition, quality, and other relevant factors.  Clearly the appraiser in this instance must have technical knowledge of the resource being appraised and the techniques used in its estimation.

Although the Sales Comparison Approach is most frequently used in appraising undeveloped and/or non-producing properties, it can be used when a property is in production and generating an income stream.

When the purchaser in such sales is buying only an interest in the property and not the mining operation itself, as a land company or individual would do, value is a function of the anticipated royalty stream from the property.  The amount and timing of this royalty stream is specific to the subject property and thus the value that it yields on a per-ton basis cannot be applied directly to another property that likely will yield a different royalty stream.  Nevertheless, it is possible to use the Sales Comparison Approach in conjunction with the Income Approach for producing properties in instances when buyers appear to be discounting values derived from the Income Approach.

Business Enterprise and Equity Interests – Business appraisers typically use the term Market Approach rather than Sales Comparison Approach, although the application is the same.

With the Market Approach, the subject company is compared to publicly held companies whose stock is traded.  A value indication is determined from the various multiples developed from the comparable companies, which are frequently referred to as Guideline Companies.  These multiples are normally based on earnings of companies in similar lines of business and include consideration of other relevant factors such as capital structure, growth prospects, and risk.

The Market Approach is based on the observation that companies tend to trade as groups, therefore, market multiples such as price/earnings ratios of industry groups tend to be closely distributed.  A logical extension of this observation is that a closely held corporation, if taken public, would trade at a price/earnings multiple that was based in part on the multiples of the companies in the industry group, barring unusual circumstances.

Because of substantial differences between companies, debt levels, and associated interest payments, it is common practice to compare debt-free or interest-free market multiples.  Rather than analyzing price/earnings multiples, invested capital is compared to both earnings and revenues.  Earnings can be operating earnings (Earnings Before Interest and Taxes, or “EBIT”) or cash-based earnings such as Earnings Before Interest, Taxs, Depreciation, and Amortization (“EBITDA”).  The primary criteria for selecting comparable companies include similar lines of business, growth prospects, risk, size, and markets.

Because market data are the fundamental data used in the Sales Comparison Approach, only Market Value and, in some instances, Fair Value can be estimated.

INCOME APPROACH

Many mineral appraisers are most comfortable using the Income Approach to Value simply because it is so widely used, which is a self-reinforcing concept.  It should be noted that many courts are hesitant to accept this approach, primarily because it requires so many assumptions and thus is considered to be not only speculative in large part but also particularly conducive to manipulation by the appraiser.

Interests in Real Property

As a general rule, if an appraisal assignment involves interests in real property the Income Approach is suitable only if there is production from the mineral interests or if it can be demonstrated that production will occur within a reasonable period.

In order to demonstrate that production is likely to occur, it is typical to require that the necessary permits and/or zoning are in place or in the process of being acquired and/or that specific plans for development exist within realistic time frames.  The practice of applying the Income Approach to undeveloped properties for which there is no evidence that development will occur within a reasonable period has caused many to view mineral appraisers as nothing more than shills for developers and property owners.

Because the demand for a given natural resource is not infinite, every mineral property cannot be developed in the foreseeable future.  Accordingly, the indiscriminate use of the Income Approach for undeveloped properties would lead to the absurd conclusion that the total value of the properties containing such abundant resources as stone, sand and gravel, clay, and coal is in the gazillions of dollars.

The mineral appraiser will do well to remember that in estimating market value, the true test of the estimate of value derived is to ask oneself if that is a price someone would be willing to pay for the interest at the date of the estimate.  The designation of this standard of value contains the word market for a reason.

In appraising Fee Simple Estates, Mineral Estates, and Leased Fee Estates, income is based on the royalty to be received by the landowner, while for the Leasehold Estate income is based on the difference, if any, between the contract royalty rate and market royalty rate.

In using this approach, a relatively simple discounted cash flow model is developed, incorporating the following: appropriate time period; sales volume; sales price; royalty rate; administrative expenses; depletion allowance; state and federal tax rates; and discount rate.

In those instances in which the royalty rate is a flat amount per unit rather than a percentage of the selling price, selling price is not needed in the model.When applying this methodology to the Leasehold Estate, the royalty stream used is the difference between the contract royalty and market royalty.  Using the Income Approach in this fashion yields an estimate of Market Value for each of the three estates.

If the landowner happens to be the operator of the property, a technique termed Relief from Royalty is used.  Although on first glance it may appear that the same model as that used in estimating value of the Fee Simple, Mineral, and Leased Fee Estates is appropriate, it is desirable when possible to develop an operating model and derive the Business Enterprise Value (“BEV”).  This model is then run on two bases – without a royalty rate and with a market royalty rate.  The difference between the two is the value of ownership to the operator.  This constitutes Use Value.

It is important to note that the lack of liquidity in an investment in a real property interest must be taken into account when deriving an estimate of value.  There are several ways in which this can be accomplished, one of which is to add a number of percentage points to the discount rate.  The amount depends on the appraiser’s experience and knowledge in this regard.  A second way, which is discussed subsequently in this article, is to use the results of marketability studies.

Business Enterprise and Equity Interests

In using the Income Approach to value these interests, an operating model is constructed in which forecasts of revenues and costs are developed over an appropriate period of time for the enterprise being valued.  Annual cash flows are forecast after accounting for depreciation, depletion, and amortization and for taxes.  These forecast cash flows are then discounted to a present value using an appropriate discount rate.  The model constructed incorporates the following:  An appropriate time period; sales volumes; selling price; production costs; capital expenditures; depletion allowance; state and federal tax rates; working capital; and discount rate.

A model such as this can be used with all four standards of value discussed in this article.  When used to estimate Investment Value, it is important that assumptions reflect those of a specific investor rather than a consensus of the market.  Conversely, in estimating Market Value, the assumptions should reflect a consensus of the market rather than those of a specific investor.

In estimating Use Value, a technique termed the Residual Technique of Reserve Valuation historically was widely accepted.  In recent years, this technique has been replaced by the Multi-Period Excess Earnings Method which will be fully covered in a subsequent article.