I have been involved with a number of restaurant acquisitions and refinances over the years and one of the most frustrating events in those transactions is when the banks do their appraisals. I have seen similar restaurant appraisals for properties located in the same area, within close timeframes of each other, vary by over $125 per square foot. Why does this occur?
An appraisal is not an exact science. It is a set of assumptions based on previous sales and rental information found by the appraiser and appraisal company at a certain point in time. Therefore, an appraisal is the value estimated at the date of the appraisal. Also, appraisals are a laggard in estimating value. What does that mean?
Real estate appraisals must utilize previous sales or executed leases with a third party landlord (not your own real estate holding company) within the last six months to one year. Therefore, in a rapidly rising or falling real estate market, the information can be misleading.
But the biggest impact to the value of land & building in a real estate appraisal is the allocation of price in a contract of sale in a viable, operating restaurant on prior sales that are utilized in the appraisals as “comparable sales”. I say “viable and operating” versus a bank foreclosure sale, which will always have a negative impact on any appraisal for any form of real estate. The allocation of price on the sale of a restaurant is broken down into 1.) Land & Building, 2.) Fixed Assets, 3.) Goodwill. Goodwill is the asset category that includes the value of the liquor license and/or business sales.
In the State of New Jersey there is a “real estate millionaire’s tax” for any sales that exceeds $1,000,000. The tax is 10% of the sales price; therefore a sale of $1,000,000 will cost the seller $10,000 in state tax at time of closing. Most sellers want to limit their tax exposures i.e. allocate a lower amount on the sale of real estate.
In an effort to limit tax implications from the sale of real estate, a Seller and Buyer speak with their accountants and attorneys prior to executing a contract of sale. The agreement of the total purchase price of the real estate, fixed assets and goodwill need to be properly defined and allocated prior to closing.
I have seen a number of appraisals where the comparable property used in that appraisal has an allocated sales price of $999,000. That is a red flag when I am reviewing an appraisal. I have had many a discussions with appraisers concerning that event and in some cases appraisers will adjust the value when reconciling all their comparables. This also occurs with sales recorded over $1,000,000. Remember every $100,000 is an additional $1,000 in taxes owed.
When the economy was very good (circa 2007) I saw appraisals at $300-$500 per square foot. I now see appraisals at $150-$350 per square foot. When reviewing an appraisal, I do not only look at the overall value of the property, but what the value is per square foot. That is the commonality every restaurant shares in an appraisal, and sometimes is overlooked by the buyer/borrower.
So what should a buyer/borrower do prior to an appraisal? Whether buying or refinancing an existing restaurant, an accurate square footage of the restaurant is very important. The square footage defined by the bank and appraisal company is the operating space, i.e. the dining room(s), bar(s), kitchen(s) (above grade). It does not include storage in any area below grade or attics. I have had restaurateurs miscalculate square footage by over 1,000 square feet! Hard to believe, but that information was supported by a written appraisal performed for another bank in a prior financing. That almost ended all efforts to refinance this property.
I would also recommend retaining your own appraisal prior to applying for a bank loan. The cost will be $2,500-$5,000, but in some cases it is important information to know. Why? If you receive either a Letter of Intent, or Commitment Letter from a bank they will ask for a non-refundable fee to move forward on your request. If the appraisal comes in for much less than is necessary to secure the loan, you will not be able to close for the amount requested or at all. An ounce of prevention is worth a pound of cure.
Finally, although not part of the appraisal process, but just as important, is the Environmental Inspection. In most cases this is a report that is requested by the bank at time of approval, but as a future owner, this is something you need to understand. If there are any issues in an environmental report it needs to be addressed and remedied prior to closing. Remember, once you own it, it’s your problem. That is also important when executing a lease on a restaurant. Most leases offer the lessee the right to an environmental inspection on the restaurant prior to possession with the landlord stating there is no environmental issues to the best of his/her knowledge. If you have an option on your lease to purchase the land & building and you did not have an environmental inspection prior to possession, that clause can come back to haunt you when you are exercising your option.
In the banking environment that now permeates all lending decisions, the value of the underlying collateral, now is more carefully analyzed with stricter guidelines as to whether a loan is granted.
The new mantra is “the restaurant is worth what can be financed” has never been truer.