Undivided Interests in Real Estate, Part 3

THE RESOLUTION – VICTORY!

While we were able to score a victory for our client, questions still linger regarding the valuation methodology of an undivided interest in real estate.   This article wraps up a three part discussion of a complex case I have been involved in since January of this year.  Our client is happy with the positive result.  For us, I wish that our valuation methodology would have been verified.

Is it or Isn’t It?

The issues in the case were varied and interesting. First, there was a question as to whether or not the interest in question was a real property interest or a security.  If the interest was determined to be a real property interest, as a business valuation expert, I would not be qualified to value the interest or to testify. I believe the interest is a security, and the comments I received universally supported that position (the IRS argued that the interest was a real property interest).  One of our readers previously pointed out that in Florida a real estate broker cannot accept a commission on the sale of a TIC interest, perhaps implying that Florida law also views it as a security.  I was permitted to testify because I have vast experience valuing similar interests, but the court did not address the underlying question of the nature of the interest.

What Method Should Be Used to Value an Undivided Interest?  The Conflict

The next question was how such an interest should be valued.  All parties agreed that the interest could be worth less than the pro-rata value of the whole, which had been determined by an appraisal of the underlying real estate.  The IRS argued that the pro-rata value should be determined by subtracting the cost to partition the real estate.  My position is that the interest should be valued on its own, rather than by applying some discount to the pro-rata value.  Further, I testified that in order to understand the value of the undivided interest, one must consider the rate of return that would be expected by an investor, given the non-controlling, non-marketable nature of the interest.  In order to understand the required rate of return for the interest, I looked to the most similar interests for which there is an active and public market.

We Were Winning the Argument

My opinion is that publicly-traded limited partnerships holding similar underlying real estate provide the best available data for comparison, after adjustment for the differences in marketability.  After lengthy testimony, I was able to provide the Court with a framework for the analysis of the interest that was both well-reasoned and reasonable.  Upon cross-examination, it was clear that my position had merit, and that process followed in my determination of analysis was reasonable.  At that point, the cross-examination changed from attacking the framework and the process to attacking the assumptions about rate of return.  Again, after lengthy questioning (some from the Court), it was all-but-obvious that the Court understood my analysis, had no reasonable alternative analysis, and would likely decide favorably for my client, vis-à-vis the methodology.  The last question, of course, was what the actual value should be.

Fortunately for my client, in post-trial filings the IRS has conceded the value we submitted.  But disappointingly for the valuation community the questions of whether the interest is a security and what methodology is appropriate for valuation will not be decided in this case.  As much as I would love to be the expert who helps to establish a consistent and cogent process for this type of valuation through case-law, I hope that none of my current or future clients dealing with the same type of interest will have to be the test case.  For now, I’m perfectly content to have won.

Read Part 1 and Part 2 of the discussion here:

Undivided Interests in Real Estate – Part 1

Undivided Interests in Real Estate – Part 2

If you have comments or questions about this article, or would like more information on this subject matter, please contact us.
Robert Buchanan

Valuation | ESOP
rbuchanan@pcecompanies.com
Orlando Office

407-621-2100 (main)
407-621-2120 (direct)
407-621-2199 (fax)