Not many published court opinions give meaningful guidance on determining the discount rate in economic damages case (see BVWire #92-5). A new decision concerning lost profits for the breach of a franchise lease finds the plaintiff’s BV analyst going against a real estate appraiser, with the win going to—wait for it . . . the one that used better industry data and research.
The plaintiff’s expert actually prepared two reports. The first relied on the mitigating rental income from a substitute tenant on the same premises. Because this represented the “best case” stream of income without accounting for vacancies, he used a discount rate of 4.5%, based on the risk-free rate. After the substitute tenant defaulted, however, and given the unstable market, the BV expert revised his rate, beginning with the risk-free rate (4.8% on 20-year U.S. Treasury securities as of Feb. 2010). He also considered the 10.4% used by the plaintiff’s real estate appraiser, and settled on a figure halfway between the two, for a final discount rate of 7.5%.
The defendants’ MAI-certified appraiser criticized the approach. Blending or averaging the risk-free rate with the cap rate was not appropriate, he said. Moreover, the risk-free rate does not accurately reflect the risk associated with a real estate investment. Instead, the MAI expert relied on industry reports and transaction data, which showed average cap rates of 8.5% and average discount rates ranging from 9.58% and 10.10%, with an average spread between the two of about 1.3%. Based this data, the defendants’ expert believed that buyers of restaurant properties would discount franchisee cash flows by 10.3% (or only 0.1% off the rate used by plaintiff’s real property appraiser).
The court adopted this rate as more credible, citing the MAI expert’s “extensive research of numerous databases.” It rejected the BV expert’s rate, finding it “too speculative” and his reasoning “unclear.” Read the complete digest of Navigato v. SJ Restaurants, LLC, 2011 WL 69099 (D. Kan.)(Jan. 10, 2011) in the April 2011 Business Valuation Update; the court’s decision will be posted soon at BVLaw.