By Tim Sauer
I recently attended a presentation where the presenter used a hamburger as an analogy for a cost-segregation study. While most people just see a hamburger, he sees a beef patty, lettuce, tomato, cheese, and a bun. That is to say, he doesn’t see a single piece of real estate, but numerous smaller assets that comprise the larger asset. The same can be said of a purchase price allocation (PPA).
Introduction to Purchase Price Allocations
As the name implies, the objective of a purchase price allocation is to allocate the purchase price of an asset to its component parts. Unlike a cost-segregation study, which allocates cost for tax purposes, PPAs allocate fair value for financial reporting purposes. More specifically, PPAs are performed for companies complying with Accounting Standards Codification Topic 805, Business Combinations (ASC 805) under US GAAP. Unlike appraisals for financing purposes, which are governed by the Financial Institutions Reform, Recovery, and Enforcement Act of 1989 (FIRREA), PPAs are performed in accordance with the Accounting Standards Codification (ASC) promulgated by The Financial Accounting Standards Board (FASB); therefore, PPAs have intended uses and intended users that are distinct from financing appraisals.
The fundamental objective of a PPA is to allocate the entity’s purchase price to its tangible and intangible components for US GAAP basis reporting (not income tax reporting). The acquiring company will use the PPA to place the acquired assets on their US GAAP basis fixed asset register and balance sheet. With the exception of land, which does not depreciate, the allocated tangible and intangible asset values will serve as the basis of the assets’ depreciation schedules for US GAAP reporting.
Before the allocation can begin, the appraisers must determine whether the purchase price is consistent with fair value. If the purchase price is below the entity’s fair value, then the sale is classified as a “bargain purchase,” which FASB describes as an unusual and infrequent event. Assuming that the purchase price is consistent with fair value, the next step is to determine the fair value of each of the entity’s tangible and intangible components.
The Finer Points
For some hotels, the purchase price can simply be allocated to tangible assets, such as land, personal property, and real property improvements. These assets can be valued using the sales comparison approach, income capitalization approach, and cost approach, as applicable. Land can be valued using the sales comparison approach or ground-rent capitalization approach, depending on market norms. Due to a dearth of comparable “dark” hotel sales, the real property improvement value is often ascribed based upon the depreciated replacement cost new (DRCN). Likewise, the personal property is often valued using the DCRN.
For more complex hospitality assets, additional tangible or intangible asset (or liability) allocations may be necessary. These additional assets and liabilities might include in-place leases, favorable/unfavorable leases, advanced bookings, assumed debt, and goodwill.
If a portion of a hotel is leased to third party, such as a restaurant or retail shop, that agreement should be analyzed. Lease agreements can create an asset, in the case of an above‐market lease rate, or a liability, in the case of a below‐market lease rate. Additionally, a lease that is in place at the time of the acquisition can have an intangible value to the buyer because that space produces a cash flow immediately, and there is no loss of rent or expense reimbursements while a tenant is found. Unamortized leasing commissions and tenant improvement allowances associated with tenant leases should also be analyzed. Additionally, if the hotel is situated on a ground lease, that lease agreement must be analyzed to determine if it is favorable (an asset) or unfavorable (a liability) to hotel ownership.
The hotel’s advanced bookings, management agreement, and franchise agreement should also be analyzed to determine whether these agreements are material to the acquisition, thereby creating an identifiable intangible asset or liability. For example, if the hotel has an agreement to host a large meeting on a long-term recurring basis, it might be necessary to ascribe value to that agreement. Similarly, the hotel’s management agreement might create an asset or liability if the management fee results in an operating expense that is above or below the market norm. When the management agreement is terminable upon sale, there is neither an asset or liability. While the existing franchise agreement should be examined, the franchisor needs to approve the buyer upon a sale, and if the buyer is approved, a new agreement will be written between the buyer and the franchisor at the franchisor's current fee structure.
Goodwill arises when the total fair value of the hotel exceeds the total value of identifiable tangible and intangible assets and liabilities. Goodwill is only observed in rare cases for hotels, primarily in situations where a hotel has an iconic status that results in an outsized purchase price. In addition to the tangible and intangible assets discussed in the preceding paragraphs, other potential assets or liabilities are evaluated on a case-by-case basis.
Given the unique nature of both hospitality assets and ASC 805 PPAs, it is important to engage a valuation firm with experience in both areas. No two hotels, or PPAs, are identical; therefore, HVS professionals are happy to discuss the intricacies of a potential hotel PPA project with both the client and their audit partner. Additionally, HVS can often complete the PPA in tandem with the financing appraisal, creating a more streamlined closing process for the buyer because there is only one data request and one site inspection.