Valuing Companies That Have Experienced Large Holding Gains
The Residential Real Estate Industry’s Far-Reaching Impact

By Jeffrey W. Lippitt, Nicholas J. Mastracchio Jr., and Eric Lewis

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FEBRUARY 2008 - The housing industry experienced dramatic increases in real estate prices and frantic activity levels, but is now faced with declining activity and declining prices. The current environment presents unique challenges in the valuation of residential housing construction companies, and it requires adjustments to typical methodology.

While the market was soaring, many speculative buyers purchased residences in which they never intended to live and assumed they could sell those homes at a profit once the residences were near completion. The aftermath of the slowdown is an industry plagued by an extraordinary number of contract cancellations and competition from a large inventory of homes for sale, including resales of homes in ongoing developments. The five biggest U.S. homebuilders—D.R. Horton Inc., Pulte Homes Inc., Lennar Corp., Centex Corp., and Toll Brothers Inc.—reported that plummeting land prices cost them a combined $1.47 billion in the fourth quarter of 2006 (Ottawa Citizen, Feb. 9, 2007).

Developing a home community can take five years, and if there is a series of communities in a master plan, completing that may take 10 years. The companies are required to evaluate the possibility of impairment on their land holdings. Nevertheless, the impairment test still leaves the potential for distortions in the valuation of these companies. In addition, smaller developers may not have complied with GAAP and may not have written down their land values.

Impact on the Income Approach to Valuation

For many companies in the homebuilding industry, particularly those holding significant amounts of real estate, the purchase of their land holdings during different portions of the business cycle can make assumptions about earnings very difficult. For example, holdings that were purchased prior to the boom in real property prices and that are now being sold can create the appearance of a very high earnings base. That creates the illusion of a very high company value under the earnings-capitalization model if adjustments are not made.

The earnings-capitalization model estimates the value of a company by “capitalizing” the company’s base earnings. Base earnings are generally calculated by taking an average of adjusted accounting earnings. In this application, historical earnings are of interest only to the extent that they are representative of expected future earnings. Adjusted accounting earnings or normalized earnings are used to predict the future benefits that will accrue to the owners of the company. If historical earnings do not approximate future earnings, then an adjustment is necessary to arrive at a satisfactory estimate of future earnings.

A discounted cash flow method might also be used. Typically, projections are made for a few years, then a terminal value is calculated. However, the distortions resulting from the purchase of land at different times in the business cycle and the timing of future increases in land values can lead to similar problems in forecasting and in distinguishing holding gains. With proper adjustments, using these two methods can give the valuator a corroboration of the estimated value.

Comparing the recent past to the expected future of the residential construction industry suggests that significant adjustments are necessary. Separate adjustments are necessary for each of the following:

  • Removal from the earnings base of the effect of realized holding gains due to the dramatic increase in the value of real estate in the past few years.
  • Recognition of deferred tax liabilities for unrealized holding gains on assets held where their fair market value is in excess of their tax basis.
  • Building in the potential of future price declines and consequent holding losses until there is a market bottom.

Removal of Realized Holding Gains or Losses

To the extent that a company holds inventory during a period of significant change in the value of that inventory, the reported earnings of the entity are likely to include both operating earnings and realized holding gains or losses. The realized holding gains and losses result from the sale of inventory with a replacement cost above or below its book value. The sale will contribute “operating income” to the extent that the selling price is above the replacement cost of the item, and a “holding gain or loss” to the extent that the replacement cost is above or below the historical cost of the item. After a period of sharply rising prices, where price increases are not expected to persist, the earnings-capitalization model will produce errors in the estimated value of a firm unless appropriate adjustments are made for unrealized holding gains included in earnings.

The appropriate adjustment depends on the nature of the expectations for future holding gains. If future holding gains are expected to be different from past holding gains, then past holding gains must be replaced by expected future holding gains. If no reasonable expectation of future holding gains can be established, then past holding gains should be eliminated and the value of the company should be estimated by capitalizing the operating earnings without any holding gains. The actual circumstances of the individual company when it purchased the land will determine the adjustment. The uncertainty of the future of the market may well lead the valuation expert to increase the capitalization rate to reflect the uncertainty with respect to future holding gains.

Holding Gains

The influence of holding gains can be illustrated with a simple example. Consider a company that operates in the home-building industry and holds significant amounts of land as inventory. Assume that Company 1 was created with an investment of $150,000 from the owners. The company purchased three parcels of land for $50,000 each. During the year, before any sales took place, the replacement cost of each parcel increased from $50,000 to $100,000. Subsequent to the price increase, the company sold two subdivided parcels for $150,000 each and held one parcel in its ending inventory of land.

The earnings of the company would reflect $120,000 in income after taxes (assuming a 40% tax rate) resulting from the sales of $300,000 and a cost of sales of $100,000. The balance sheet would reflect $270,000 in assets and $270,000 in equity. If a reasonable capitalization rate in this industry was 15%, these results would yield an estimated value of $800,000, implying goodwill of $530,000. The validity of this estimate depends on the income of $120,000 expected to continue into the future.

Sales                          $300,000
Cost of sales              $100,000
Income before taxes   $200,000
Income taxes              $ 80,000
Net income                $120,000

Cash                          $220,000
Land                          $ 50,000
Equity                        $270,000

If reasonable expectations are that the price of land will remain stable in the future, and that sales of two parcels per year for a total of $150,000 can be expected to continue, it is necessary to isolate the realized holding gain included in income and remove it from the earnings base:

Replacement cost of parcels sold    $200,000
Cost of sales                                  $100,000
Realized holding gain
(net of taxes)                                  $ 60,000

Net income                                    $120,000
Realized holding gain
(net of taxes)                                  $ 60,000
Operating income                           $ 60,000

Capitalizing the operating income of $60,000 yields an estimated value of $400,000, implying goodwill of only $130,000. The unrealized gain remaining in the third parcel still in inventory would be added to the value after subtracting the tax effect of the holding gain.

As a reasonableness test, consider a company that enters the same industry on the same scale, but after the increase in the price of the land. The owners must invest $300,000 into Company 2 in order to purchase three parcels of land for $100,000 each. Assume that before the end of the year they sell two units for $150,000 each and hold one unit in inventory at the end of the year:

Sales                           $300,000
Cost of sales               $200,000
Income before taxes    $100,000
Income taxes               $ 40,000
Net income                  $ 60,000

Cash                            $260,000
Land                            $100,000
Equity                           $360,000

Because Company 2 entered the industry after the price increase, its earnings do not include a holding gain component; its net income is all operating income. Capitalizing its income at 15% yields an estimated value of $400,000 and implies goodwill of only $40,000.

Deferred Tax Liability

The observation of equal capitalized earnings values for the two companies discussed above is reasonable in the sense that their prospects for future economic income are the same. There is, however, reason to believe that the first company is worth less than the second, because reported accounting income and taxable income for the two companies will be different. Because Company 1 has a parcel of land that has a book value and tax basis below its fair market value, Company 1 has a “built-in” tax obligation that Company 2 does not. Given the same future pretax economic earnings, but higher expected future tax payments, Company 1 is less valuable than Company 2 by the amount of this deferred tax liability:

Fair value of ending land        $100,000
Cost of ending land                $50,000
Unrealized holding gain           $50,000
Tax rate                                   40%
Deferred tax liability               $20,000

Although Company 1 will experience higher accounting income because its ending inventory of land is understated in value, it will have the same expected economic income as Company 2, but a higher tax obligation, and consequently a lower value. A reasonable estimate of value for Company 2 would be the $400,000 capitalized value of operating income less the $20,000 deferred tax liability, or $380,000. It should be noted, however, that the investment in Company 1 is only $150,000, compared to an investment of $300,000 in Company 2.

The Effect of a Deflating Real Estate Bubble

With an extended period of increasing prices, or any period of dramatic price increases, it is possible, if not probable, that replacement costs of land that has been developed will exceed its original costs. As noted earlier, in the residential real estate industry, developers often purchase large tracts of land and hold them for considerable periods before selling them in smaller parcels as they are developed. This can lead to the realization of large holding gains even during periods of declining land values. In the current real estate market, some of the anticipated decline in land values may still lie ahead, so builders may be experiencing holding gains with the expectation that future holding gains will be smaller, or that future holding losses will be incurred.

Holding Losses

The influence of holding losses on the value estimate can also be illustrated with a simple example. Consider another company that operates in the homebuilding industry and holds significant land as inventory.

Assume that Company 3 was created with an initial investment of $150,000 from the owners. It then purchased two parcels of land for $50,000 each. During the year, before any sales took place, the replacement cost of each parcel decreased from $50,000 to $30,000. Subsequent to the price decrease, the company sold two subdivided parcels for $90,000 each and purchased one additional parcel for $30,000, which remained in its ending inventory of land.

Company 3’s earnings would reflect $48,000 in income after taxes, assuming a 40% tax rate, resulting from the sales of $180,000 and a cost of sales of $100,000. The balance sheet would reflect $210,000 in assets and $210,000 in equity. If a reasonable capitalization rate in this industry was 15%, these results would yield an estimated value of $320,000, implying goodwill of $90,000. The validity of this estimate depends on the income of $48,000 expected to continue into the future:

Sales                             $ 180,000
Cost of sales                  $ 100,000
Income before taxes       $ 80,000
Income taxes                  $ 32,000
Net income                     $ 48,000
Cash                               $ 200,000
Land                               $ 30,000
Equity                              $ 230,000

If reasonable expectations are that the price of land will remain stable in the future, and that sales of two parcels per year at $90,000 each can be expected to continue, it is necessary to isolate the realized holding loss included in income and remove it from the earnings base:

Replacement cost of parcels sold     $ 60,000
Cost of sales                                   $100,000
Realized holding loss
(net of taxes)                                   $ 24,000

Net income                                     $ 48,000
Realized holding loss
(net of taxes)                                  $ 24,000
Operating income                           $ 72,000

Capitalizing the operating income of $72,000 yields an estimated value of $480,000, implying goodwill of $250,000. A failure to properly adjust reported earnings for the holding losses would result in an estimate that undervalues the company by the $160,000 difference in the valuation results shown above.

Valuation Professionals Must Pay Attention to the Details

Business valuation models that are based on measures of income or cash flows depend on how the valuation professional adjusts historical earnings in order to reflect expectations about future benefits that will accrue to the owners. In any industry where assets for sale are held for extended periods of time, the prospect exists of significant holding gains or losses on those assets at the time of sale. These gains and losses depend on underlying cycles in the markets for these assets; they are not part of the value added by the business that develops them for future sale. The residential building industry is perhaps an extreme example of this type of business. Companies purchase land that may be held for many years before their development and sale are completed. The impact on valuation, however, applies to any industry with similar attributes.

Valuation experts must recognize these holding gains and losses as components of value that are separate from the normal and expected earnings stream of the business, and they should adjust expected earnings to reflect this recognition. Careful attention to this detail of the valuation process will yield results that more closely reflect future economic expectations for the business.


Jeffrey W. Lippitt, PhD, is an associate professor of accounting at Ithaca College, Ithaca, N.Y.
Nicholas J. Mastracchio Jr., PhD, CPA, is a member of the accounting faculty at the University of South Florida, Tampa, Fla., and a member of
The CPA Journal Editorial Board.
Eric Lewis, PhD, is an associate professor at Ithaca College, Ithaca, N.Y.

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 



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