leveraged breakdowns

Understanding the Difference Between Book Value and Market Value

There are a host of real estate private equity skills that you will need in order to be successful in the REPE business. Beginning as an analyst and moving upward in the org chart, your ability to construct a reliable, accurate real estate private equity model is critical. If you haven’t observed this yet, you will soon: accounting skills are also a must.

This post aims to explain the difference between the book value of an asset and market value of that asset. The distinction is largely based on accounting principles.

Market Value

First, the simple and non-accounting concept. Market value, or sometimes Fair Market Value (FMV) is what something is worth under normal market conditions. Both buyer and seller have access to the same information, and arrive at an agreed upon price without any unusual circumstances or duress existing on either side. Unusual circumstances might be a seller’s default on a loan that could trigger a foreclosure, or a buyer running out of time to acquire a property under 1031 exchange rules. When extenuating circumstances or duress are present, the buyer or seller may accept a price that is different than they would under “normal” circumstances.

Appraisals are an attempt to estimate the fair market value of an asset. You may be surprised at first, and annoyed as you gain experience, that an appraisal of a property involved in a sale tends to value the property at the already-negotiated price. The reason is quite simple- if the parties negotiated in good faith and without duress, the property is worth exactly what the seller is willing to sell for, and what the buyer is willing to pay: the negotiated price. Incidentally, every MAI appraisal (Member Appraisal Institute - a top certification of appraisers) has a complete and thorough definition of “Market Value,” and is worth reviewing a few times (see more on things you can learn from an appraisal here).

Book Value

Now we get to the accounting side of the discussion. The book value reflects the value of an asset on the company’s books, or financial statements. Book value is calculated as purchase price plus capital improvements less accumulated depreciation.

If a net leased asset like a single tenant medical office was purchased at the beginning of 2010 for $2,000,000, and that asset is being depreciated over 39 years, the annual depreciation would be $51,282 (ultimately reaching zero by the end of the 39th year). If there have been no capital improvements since it was purchased, the book value at the end of 2018 would be $1,538,462 ($2,000,000 minus 9 years of depreciation, or $461,538). If there were capital improvements, those would be added to the purchase price, and the depreciation of those improvements would gradually be added to the accumulated depreciation.

Why the Distinction?

This is where profits are made (or lost) and taxes are paid. Suppose the same medical office property were to sell at the end of 2018 for $2,250,000. There are two ways of measuring the gain. There is a $250,000 gain between the selling price and the purchase price. Most simple models will incorporate this fact in determining the overall return on investment. A more sophisticated real estate private equity model will incorporate the tax consequences

In our example, we noted that the book value at the end of 2018 was $1,538,462. This means that from an accounting perspective, the financial statements for the asset will reflect a gain on sale of $711,538. That is also the number that Uncle Sam and the IRS will be interested in, because that is the gain that will be taxed. Assuming a long term capital gains tax rate of 20% (whether at the fund level or passed through to the shareholders) the federal tax would be $142,307. This reduces the gain on the sale down to $569,231 ($711,538 minus $142,307).

The tax consequences of a sale can be very important for the investment committee or management to understand when making decisions. Building book and tax calculations into your model will be a very useful real estate private equity skill for you to master.