Part I of this article discussed what goes into valuing a real estate agent’s business, including discretionary earnings, add backs, cost savings and revenue enhancers.
We’ve determined what the profit was, done our deductions and add backs, established any cost savings or revenue enhancements, reviewed the balance sheet, and taken a look at any documents the seller has that are relevant to the sale. What do we do now?
Industry practice has determined that the most dependable way to set the valuation of a real estate business is to have the discretionary earnings applied to a multiplier to get the enterprise value of the business.
What facts inform us as to what number to use as the multiplier?
- Size of the business: The general rule is that the larger the team discretionary earnings, the larger the multiplier. This is because larger teams have access to capital, resources and efficiencies of scale that smaller teams and single agents do not.
- Industry specifics: If there are barriers to entry in the area the seller functions in (cost, education, skill set, etc.) and less competition, these lend toward a higher multiple. A recent high growth rate in the seller’s area of focus is also good. For example, the seller may specialize in soliciting medical recruiters for relocating doctors in a city with new hospitals coming online. This would provide a dependable source of continuing business.
- Customer concentration vs. one trick pony: An obstacle to the sale could be that a healthy percentage of the seller’s business may be trapped in two to three investors, the defection of which may threaten or be fatal to the business.
- Key person/ego: Where the seller is the face of the business, has all of the relationships, and makes the decisions (read: micromanager), it will take an extended period of time for the goodwill of the business to transfer over to the buyer, and the multiplier will go down.
- Smart growth: I included the word “smart” here because all growth is not created equal. To show 100% growth in revenue over the past three years while showing a 150% increase in expenses is not growth a buyer wants to see.
- Recurring clients: The buyer doesn’t want to see a lot of concentration, but if a lot of the same clients are coming back over and over to the seller, that’s a good thing. This is essentially an annuity that the seller has set up that buyer is now purchasing. Any routine buyer of businesses will tell you that they love buying annuities because they’re usually easy to value.
- Operating margin/profit: Agent businesses with higher profit margins and more profit (discretionary earnings) will get higher multipliers than those with lower margins and profit. This is because the buyer can see that they will make a higher return for every dollar invested into the company.
Many commercially sophisticated people involved in the sales of real estate brokerages in the United States would say that when the market is “normal,” they would likely see a multiplier in the range of 3x to 3.5x for the brokerage. When using a multiplier, a buyer is trying to back down to present value a certain amount of a future income stream.
Because a medium- to large-sized team is essentially a small brokerage, the multiplier should be no different. However, the buyer will let any number of factors inform their decision on what multiplier they think is proper in the case of a particular seller’s business. That range would have been lower during the 2008-2012 time period, when every real estate business was struggling to keep the lights on.
From the foregoing then, if we’re considering the purchase of a team that generates $500,000 in annual discretionary earnings, and based on our analysis we think the team is an above average candidate to acquire, we may peg a 3.4x multiplier to the transaction. This would establish an enterprise value of the team at $1.7 million ($500,000 x 3.4). Great! What do we do now?
Sale structure
Assuming there will be no SBA (Small Business Administration) financing involved [I always assume there will be none], it is likely that the buyer will ask the seller to do some private financing after putting a specific amount of cash down – which would usually be 10-20%. While these are generalities that can be negotiated, we could see the following as a result of our $500,000 in earnings hypothetical above:
Discretionary Earnings: $500,000
Multiplier: 3.4x
Enterprise Value: $1,700,000
Cash Down: $300,000
Amount Financed: $1,400,000
Term of Note 48 months
Interest Rate: 5%
Monthly Payment (P&I): $32,241
A reason to like the foregoing sale structure for the seller is that the financing is not for an extended period. From the buyer’s side, the average monthly discretionary earnings are $41,667 ($500,000/12 months), so there is a margin of error of over $9,000 per month between the earnings ($41,667/month) and the note payment ($32,241/month). This math assumes that the buyer will keep the business operating at least at the same profit level as the seller before them.
This should make the buyer feel secure that even in the event of a bad month or a speed bump in the market, the debt service will be covered. Understand that the foregoing $41,667 number is an average and not adjusted for seasonality, of which there will be some.
In any event, the buyer should be coming to the table with an already-profitable business in their own right that supplies them with enough cash to cover all necessary expenses for their life already. Here, the buyer is simply biding their time, knowing that they will have a nominal monthly income from the seller’s business for the next four years, but after the note payment is complete, there is a business that should be producing at least $500,000 per year in earnings.
Security
Sometimes things go sideways. Maybe the buyer needs a temporary or permanent loan modification due to the market not generating income sufficient to cover the note, or the buyer’s spouse has a temporary but serious medical issue that diverts the buyer’s attention away from the business. The seller should try every avenue possible to resolve the issues.
Since a promissory note is being issued and tangible and intangible assets are being sold, the seller will usually take a security interest in the business assets and file documents with the appropriate government agency to memorialize the relationship. Think of this in the context of a note and mortgage against a home.
Here, the seller would effectively get the business back – the database, the chairs, the desks, everything. There is always the question of whether the seller would want all of that back, to then re-engage in the business, and have to sell it (again) to another buyer. The buyer in our hypothetical has already parted with $300,000 that they aren’t getting back, so they have an incentive to make a resolution on the debt work.
Before the buyer or seller engage in the process of buying or selling an agent business, they should consult with their accountant and a business broker, who can and should advise on how the business should be valued.
In addition, for tax reasons, the accountant may recommend a separation of costs of physical assets from the goodwill of the business in the purchase documents. Although the valuation is based upon the foregoing and additional factors, at the end of the day, the buyer should be able to get a sense of the seller’s truthfulness in the course of dealing on the due diligence items. This will weigh heavy into the buyer getting a “feel” if the valuation is too high.
The next article in this series will review transitioning the business to the buyer.
Hank Sorensen is the Area Manager for Pinellas County for RE/MAX Realtec Group in Palm Harbor, FL. He can be reached at gogetalisting@gmail.com.
This content should not be considered accounting or legal advice. You should consult your local tax or legal professional in your state for appropriate strategies.
