Government’s Termination of Lease Pursuant to its Terms is Not a “Taking”

Public agencies own significant amounts of property throughout California and the United States.  Sometimes, those properties are not being put to a public use, and the government acts as a landlord, leasing out property to private entities.  But when the government is ready to put the property to a public use, and it terminates the lease, is there a “taking” of private property triggering the need to pay just compensation?  A recent unpublished Court of Appeal decision, California Cartage Company v. City of Los Angeles, addressed this issue and held that the government’s termination of a lease in accordance with its terms does not trigger inverse condemnation liability.

In California Cartage, the public agency leased property to a private entity since the 1950’s pursuant to a series of fixed-term leases, but then, more recently, as a month-to-month tenancy.  Over the course of 60 years, the tenant constructed extensive physical improvements; its was operating a large business that generated over $65 million in annual revenues and employed hundreds of workers.  In order to make way for a public project, the agency sent the lessee — in accordance with the lease — a 30-day notice to terminate.  The lessee filed an inverse condemnation action, claiming that the termination of its lease was the “substantial equivalent” of a taking.

Both the trial court and Court of Appeal found no liability:

[T]he termination of Plaintiff’s short-term contractual right to occupy the land already owned by the City . . . does not constitute a taking for purposes of eminent domain law.

The Court distinguished situations in which an agency provides a notice of intent to condemn, but then purchases private property under threat of eminent domain and terminates the lease.  In such cases, there is a substantial equivalent of condemnation because the agency acquires the property “not as a result of bargaining in the open market, but rather in the broad exercise of its power to condemn private property for public use.”  In other words, simply having the power to condemn is not sufficient; there must be some actual exercise of that power either by condemnation or the threat of condemnation.

In conclusion, for purposes of takings-liability, public agencies operating in the open market without exercising (or suggesting the potential use of) eminent domain should be treated similarly to other private market participants.  The fact that a public agency’s lease termination was for a public use is irrelevant if there was no taking.  But keep in mind that the agency does not need to condemn to trigger liability; in California Cartage Companythe court concluded that the agency had never even threatened to use its power of eminent domain — a key factor in the court’s finding of no taking.

Note also that this analysis may be different in the context of a claim for relocation reimbursement if a person or business is displaced by a public project, which has a different set of regulations that do not necessarily require a taking of private property.  While the case law is only partially developed, there is a reasonable argument that the standard for qualifying for relocation benefits as a displacee is lower than the standard for proving a taking for inverse condemnation liability.

Valuing Underground Natural Gas Storage in Eminent Domain Proceedings

In California eminent domain proceedings, a property owner is entitled to the “fair market value” of the property being acquired.  Typically, fair market value is determined by analyzing comparable sales or by utilizing an income capitalization approach.  But every once in a while, there is no relevant market data, in which case the law permits determining compensation “by any method of valuation that is just and equitable.”  (Code Civ. Proc., sec. 1263.320.)  A recent court of appeal decision, Central Valley Gas Storage v. Southam, explains when this “just and equitable” valuation approach may be used, and what limits an expert appraiser may face when using such a methodology.

In Southam, Central Valley operated a reservoir for storage and subsequent withdrawal of natural gas.  After obtaining approval from the California Public Utilities Commission, Central Valley commenced an eminent domain action to acquire Southam’s underground gas storage rights in 80 acres of land.  Central Valley’s expert sought to value the storage rights using market data of similar transactions, which he claimed were based on the number of surface acres the landowners hold within the storage boundaries.  Southam, on the other hand, sought to value the storage rights based on the volume of gas in the storage reservoir.

Central Valley filed a motion to exclude any valuation testimony based on the volume of gas in the storage reservoir, claiming that such an approach was improper given the uncertainty and speculative nature of what is lying underneath the ground.  The trial court agreed, and excluded any such valuation testimony.

On appeal, Southam claimed that its approach was proper and Central Valley’s approach was inappropriate.  Southam pointed out that thirty years ago, in Pacific Gas & Electric Co. v. Zuckerman (1987) 189 Cal.App.3d 1113, the court excluded the exact surface-acre approach Central Valley now used, concluding there were no true “comparables” in dealing with underground storage reservoirs because there were relatively few such properties in the state, and they were substantially different in geographical locations, temporal transactions, and physical characteristics.  As a result, in Zuckerman, the court stated that “latitude must be accorded an expert in valuing such properties, and any approach that is ‘just and equitable’ may be considered.”

Here, however, the circumstances had changed:  a market for natural gas storage leases had developed in California since the decision in Zuckerman was issued, and all of these leases were based on the number of surface acres the landowners hold.  Given the existence of the new market for comparable data, the court found Zuckerman inapplicable.  The court further held that it is inappropriate to admit evidence of a valuation methodology that ignores the developed market for a particular type of property, and an expert’s opinion must take into account only reasonable and credible factors.  Because Southam could not produce a single instance of a natural gas storage lease that based its value on underground volume, it was appropriate to exclude such an approach.

The Southam case serves as a good reminder:  the “just and equitable” valuation methodology cannot ignore evidence of how particular properties are bought and sold, and it likewise must be reasonable, credible, and non-speculative.  It also allows for the valuation of underground rights based on surface-acres given the existence of market data supporting such an approach.

Court Rejects Takings Claim Based on Temporary Prohibition of Mining

As we’ve reported in the past, temporary takings are compensable in California.  But such claims are not easy to prove, particularly when you’re dealing with the federal government imposing temporary regulations preventing use of property.  A recent case, Reoforce v. United States, demonstrates some of the hurdles an impacted property owner may face.

In Reoforce, the plaintiff discovered a mineral deposit called pumicite on federal land in Kern County, California.  Believing the deposit had potential value for paint and fiberglass applications, Reoforce submitted a mining claim in accordance with federal law and applied with the Bureau of Land Management (BLM) to mine approximately 100,000 tons per year.  After obtaining necessary approvals, Reoforce slowly began mining for the mineral, but only sold 5 tons over an eight-year period.

The property was then transferred into a California state park, and the BLM issued new regulations which (i) restricted mining for some types of mining claimants until additional approvals were obtained, but (ii) allowed other mining claimants to continue operating on an interim basis.  It was unclear whether Reoforce could continue to operate, and due to the regulations and turmoil within the company, Reoforce did not undertake any mining for a 13 year period.  Eventually, it was finally once again granted approval to mine.  Reoforce thereafter filed a lawsuit for a temporary taking, alleging that the cessation in mining due to government regulation was a temporary taking of its property rights.  Reoforce sought just compensation under the Fifth Amendment.

The court held that Reoforce had not stated a takings claim because the temporary prohibition on mining did not amount to a taking under the Penn Central test.  That test applies to potential regulatory takings, and requires an analysis of:

  1. the economic impact of the regulation,
  2. the extent to which the regulation has interfered with distinct investment-backed expectations, and
  3. the character of the governmental action.

Here, the court concluded that the temporary government regulation, even if it completely prevented mining, had a minimal impact on Reoforce since it was several years away from ever engaging in commercial production of its mineral deposits.  The court likewise concluded there was no interference with reasonable investment-backed expectations since the mining operation was a heavily regulated industry, which Reoforce was aware of when entering into the operations.  Finally, the court concluded that the character of the governmental action favored a finding of no liability as Reoforce was not singled out or targeted, but instead was subject to a broadly applied regulation along with numerous other claimants within the area.

The Reoforce case is a good reminder of the uphill battle a property owner faces when pursuing a temporary regulatory takings claim.  Each case will continue to be analyzed on a fact-specific basis:  the court will continue to focus on the government’s conduct, and whether a property owner has been singled out and forced to bear a significant economic impact.

SB1: California Transportation Funding the Talk of the Capitol This Week

Most Californians agree that our State’s transportation system is in dire need of additional funding for additional improvements and repair.  The problem has always been where to secure the necessary funding.  In short, it has become more difficult to rely on the federal government, local and regional transportation agencies have become less reliant on the State, the gas tax has not been raised in years, and vehicles have become more fuel efficient, resulting in more miles traveled by more cars without the incremental increase in funding.  This week is a major turning point to potentially provide a solution, as the California legislature is set to vote on SB 1, a proposal to raise approximately $52 billion in funding over the next 10 years specifically for transportation.

Having spent the last two days at the Capitol, I can attest that this bill is a major talking point of Governor Jerry Brown and the Legislature:

The roads are broken and they are getting worse and they are not going to get better unless we get a significant injection of money,

Brown told the panel in rare testimony to a legislative committee.  While recognizing the need for transportation funding, there are always concerns with raising taxes.  Here, much of the proposed funding would come through raising gas taxes and vehicle license fees.  Governor Brown acknowledged that the tax increases are difficult:

I know there is a political concern because people don’t like gas taxes, but what do you do,

he said.  As reported in the LA Times, some feel the funds should come from a different source, such as the oil companies.  Others believe that it’s time for a gas tax increase — especially since it hasn’t happened in 23 years.

If approved, the measure would raise the base excise tax on gasoline by 12 cents per gallon, raise diesel taxes, and create a new annual vehicle fee that would average $51 based on the value of the car or truck.  Current estimates suggest the proposal will cost the average motorist $10 per month.

Thursday will be a major turning point to see whether Governor Brown can gather the necessary votes.  If he does not, it may be years before we see another effort to raise funding for transportation.  If the bill passes, then the debate will involve where to spend the funds — repairs or improvements, and on roads, highways, toll/HOV lanes, public transit, bike/pedestrian corridors, mitigation, or something else.  Stay tuned California….

Property Reserve Aftermath: Discovery Available in Right of Entry Cases & Young’s Market Co.

When the California Supreme Court issued its ruling on Property Reserve v. Superior Court, handing a substantial victory to public agencies, we were given three key takeaways:  (1) the “Right of Entry” statutes (CCP §1245.010 et seq.) are constitutional, (2) the activities the Department of Water Resources sought to undertake are covered by the broad scope of these statues, and (3) if the language of a statute doesn’t match your planned opinion, you can always reform it to match the claimed legislative intent of the statute.

To that last point, the Court’s opinion included its reformation of the right of entry procedure to include a jury trial to determine compensation for any losses caused by the entry on property and activities undertaken thereon. Thereafter, the case was remanded back to the appellate court for further proceedings and the happenings on remand have been all but ignored, though were important.  Since the Supreme Court likened the right of entry process to an expeditious condemnation proceeding, it only makes sense that discovery is part of the process as well.

Indeed, on December 16, 2016, as an early Christmas gift, the Court of Appeal gave California public agencies a more complicated and expensive right of entry procedure when it held that a property owner has a right to discovery from the public agency during the process.  In an opinion that was largely a reiteration of the higher court’s ruling on the main constitutional issues, the appellate court held that both Eminent Domain Law and the Civil Discovery Act allow a property owner to conduct discovery, disagreeing with the trial court’s ruling that the right of entry statutes were exempt from discovery.  The petition for entry process is a “condemnation proceeding” and as such, is governed by rules of practice that govern civil actions, which include traditional discovery rules.    (It also made some ruling or other about indispensable parties … see page 15 of the opinion.)

The Fate of Young’s Market Co.

While the Property Reserve remand opinion got very little notice, the higher court opinions on Young’s Market Co. v. San Diego Unified School District were pretty much ignored.  If you recall, the Supreme Court granted review of Young’s Market and tied it to the fate of Property Reserve stating that “Further action in this matter is deferred pending consideration and disposition of related issues in Property Reserve v. Superior Court…”

On October 16, 2016, the Supreme Court remanded the matter to the appellate court and instructed the court to “vacate its decision and to reconsider in light of Property Reserve.”  And on January 17, 2017, in an unpublished decision, the court held that, as it had decided previously, the actions of the school district were authorized by the right of entry statutes and that the activities on the parcel were temporary and did not constitute a permanent, physical occupation of the property.  The appellate court stuck with its prior ruling – that the activities were acceptable – and pretty much left it at that.

Conclusion

We have yet to see how public agencies and property owners will utilize the Property Reserve opinion to their own advantage, whereas owners may try to drag out the petition proceedings and game the system for increased compensation and leverage – delays in testing can lead to delays in environmental documents, which can lead to delays in project approvals, which can lead to delays in construction timing (resulting in delay damages to the contractor), which can lead to increased project costs and compensation to owners, etc., agencies may try to increase the character, intensity or duration of activities they seek to carry out on private property – as long as owners get their day in court in a condemnation proceeding, we should be allowed to do whatever testing we want.  Only time will tell how this will play out but needless to say, the owners winning on the discovery issue pales in comparison to the slam dunk handed to public agencies in Property Reserve.

Have We Seen the Last Dance for Quantitative Before Condition Goodwill Valuations?

When a business is taken as a result of a public improvement, the business is entitled to seek compensation for, among other things, loss of business goodwill. Typically, this loss is calculated by measuring the business’ “before-condition” value and comparing to its “after-condition” value.  This traditional methodology was the cornerstone for business goodwill appraisers to determine just compensation.  Yet late last year, the California Court of Appeal issued a ruling in People ex rel. Dep’t of Transp. v. Presidio Performing Arts Found. (2016) 5 Cal. App.5th 190 which may have changed the law in eminent domain actions by arguably all but eliminating the need to quantify pre-taking — or “before condition” — goodwill value.

Background

The Presidio Performing Arts Foundation (the “Foundation”), a non-profit founded in 1998, is an acclaimed non-profit dance theatre serving the San Francisco Bay Area youth. In 2009, the California Department of Transportation (“Caltrans”) undertook a highway project which impacted the building from which the Foundation operated.  The Foundation was displaced from its location and relocated to another facility.  The relocation site resulted in increased rent as well as a less functional space, and the Foundation made a claim for loss of business goodwill.

In January of 2015, the court held a bench trial to determine whether the Foundation could establish entitlement to goodwill. The Foundation’s expert identified indicators concerning the Foundation’s location, its reputation, its workers and its quality, and concluded there was the “presence of goodwill at the Foundation” before the impact of the project. The Foundation’s expert then opined that these indicators had changed along with the Foundation’s revenues.  Using the discounted cash flow methodology, he determined the Foundation’s before condition cash flow to be approximately negative $14,000 and the after condition cash flow to be approximately negative $77,000.  He attributed the $63,000 shortfall to loss of goodwill.  Capitalizing the lost cash flow, the Foundation’s expert concluded that the Foundation had lost $781,000 in goodwill and opined that the Foundation must have had at least that much in goodwill before the taking.  In other words, the Foundation’s expert did not value the Foundation’s entire business in the “before condition”, subtract the value of tangible assets, and determine whether there was in fact goodwill remaining, before concluding to whether there was a loss in the “after condition”.

Caltrans sought to exclude the business appraiser’s testimony since the appraiser did not establish the business had goodwill in the first place. The trial court agreed with Caltrans and concluded that although the taking may have caused the Foundation to suffer a loss due to change in location, reputation, etc., the Foundation had failed to meet its burden under Code of Civil Procedure §1263.510(a)(1) because it “failed to prove the quantitative … loss of goodwill.”  The trial court relied on City of San Diego v. Sobke (1998) 65 Cal.App.4th 379 (Sobke) indicating that a business must have quantifiable goodwill in the before condition, before the loss of such goodwill can be calculated – a principal which was also affirmed in People ex rel. Dep’t of Transp. v. Dry Canyon Enters., LLC, 211 Cal.App.4th 486, 149 Cal.Rptr.3d 601 (Cal. App., 2012).

Court of Appeal Decision

The Court of Appeal disagreed. The Court began its analysis by looking at the definition of “goodwill” under the statute.  Subdivision (b) of 1263.510 states: “[w]ithin the meaning of this article, ‘goodwill’ consists of the benefits that accrue to a business as a result of its location, reputation for dependability, skill or quality, and any other circumstances resulting in probable retention of old or acquisition of new patronage.”

Unlike the progeny of cases that have preceded Presidio and have looked for a quantitative “before condition” goodwill value, the Appellate Court was interested in whether the Foundation offered sufficient evidence of the factors listed in the statutory definition of goodwill, i.e. “benefits that accrue…as a result of its location, reputation….”, to establish the existence of goodwill.  The Foundation, through witnesses and its expert had produced evidence that it had a favorable location and a great reputation prior to its relocation.  Moreover, since the Foundation had also shown evidence that it had experienced a reduction in patronage and that there were disadvantages to its new location, the Court drew the reasonable inference that the Foundation had goodwill prior to being displaced and of course suffered some loss of the benefits when it relocated.  In other words, the Foundation had goodwill based on the qualities set forth in the statute – and that was sufficient.

The Court reasoned that for purposes of the threshold determination of entitlement to compensation, a party must establish that the taking caused some amount of loss of goodwill due to the taking, but need not quantify the loss in a specified manner. In contrast to Sobke, the court in Presidio concludes:

…we are not convinced … that the only way to quantify lost goodwill is by establishing pre-taking goodwill value and subtracting post-taking goodwill value. Nowhere in the statutory language is there a precondition that this [goodwill] compensation is available only to a business that, before the taking, had a total business value in excess of its tangible assets, or profits in excess of a fair rate of return on its total assets.

Conclusion

So is Presidio the demise of the before-condition valuation on the threshold issue of entitlement to goodwill, or is it limited to its facts?  Would the Court have decided this case differently if the business wasn’t a non-profit?  The Court does go out of its way to distinguish Presidio from Sobke and Dry Canyon; nevertheless, the decision is likely to have broad implications on future goodwill claims and certainly leaves room for arguments by business owners and agencies alike.

California to Consider Significant Change to Eminent Domain Law Regarding a Condemnee’s Right to Recover Litigation Expenses

On February 9, 2017, California Assembly Member Phillip Chen (a Republican from the 55th district) introduced Assembly Bill 408 (AB 408).  You can find a copy of the bill here.  AB 408 is styled as an “act to amend Section 1250.410 of the Code of Civil Procedure relating to eminent domain.”  There is very little history available on AB 408 and it appears that the next action is for it to be heard in committee on March 12, 2017.  If AB 408 is ultimately approved in its current form, it would radically change the standards by which courts decide whether or not to award litigation expenses in eminent domain actions.  This, in turn, could drastically impact public projects in California because property owners may have less incentive to settle pre-litigation or during early litigation.  This could lead to increased costs, more trials, less judicial discretion, and more opportunity for mischief.  Fundamentally, it could cause right-of-way costs to go up dramatically and projects may take longer to build.

I wrote a detailed analysis of AB 408 that was published by Nossaman as an e-alert this afternoon. You can find a copy of the e-alert here.  If you are involved directly or indirectly with eminent domain in California, I encourage you to read it.

Trump’s Border Wall: Will Eminent Domain Be National News Again?

Border Wall

There has been a lot of news lately concerning President Trump’s desire to build a border wall. Many of the articles focus on the efficacy, costs and practical challenges of building the wall.  But the discussions are also starting to move into our world of eminent domain.  An Op Ed piece in the Washington Post  talks about “Donald Trump’s Great Wall of Eminent Domain” and mentions that 67 percent of the nearly 2,000 border miles constitute private and state-owned lands. The Daily Beast published an article called “The Great Wall of Trump Would Be the Ultimate Eminent Domain Horror Show,” which describes 480 acquisitions occurring in 2008 when 370 miles of pedestrian fencing along the border was built.  If we assume a comparable number for the estimated 1,000+ miles of right-of-way that must be acquired for Trump’s Border Wall, there would be well over 1,200 acquisitions.  The article discussed grim stories of how Native American burial grounds were impacted and how construction pursuant to the earlier Secure Fence Act left human remains hanging off of machinery used to build the wall.

In other words, eminent domain will almost certainly feature more and more prominently in the nation’s consciousness should President Trump’s border wall move forward. The last time I recall this occurring was in 2005 when the United States Supreme Court held in Kelo v. City of New London 545 U.S. 469 (2005) that generating more tax revenues was a valid public purpose that enabled the government to take private property for private redevelopment. Trump’s Border Wall appears to be far more polarizing in many different ways, so we will undoubtedly see a tremendous amount of political and legal challenges in the days ahead, and eminent domain will be an inevitable part of it.

Just yesterday, I was contacted by a local radio station (KNX 1070) and interviewed concerning Trump’s Border Wall and whether it could be built as quickly as President Trump claims.  The producer of the news program had done her own research and asked me whether a 1907 proclamation by President Theodore Roosevelt called the “Roosevelt Reservation” meant the federal government already owned all the right of way it needs along the U.S. / Mexico border.  This was news to me, so I found a copy of it online.  I ultimately explained to the producer that the Roosevelt Reservation was limited to California, Arizona, and New Mexico, exempted properties that were privately owned, and really only permitted highway use.  While it proved not to be a panacea for President Trump’s right-of-way needs and ultimately was not part of my interview, it certainly demonstrates the creative thinking people may use to fast-track the project.

As I sat down to write this post, I read one additional informative article that touches on many issues surrounding the Border Wall.   One item from the article that I found of particular note was the Real ID Act of 2005 which allows the Department of Homeland Security to waive 37 federal laws to construct border fencing, including the Endangered Species Act. In other words, it’s possible that President Trump could build the wall without the usual analysis of environmental impacts.  Because a wall would impose a physical barrier not only for two-legged animals (albeit, with questionable long-term efficacy), but also migratory wildlife, this could be a significant concern to environmental groups.  But it may theoretically eliminate one significant obstacle in President Trump’s desire to fast-track the Border Wall’s construction.

Whether you support or oppose President Trump’s Border Wall, it will almost certainly bring to the forefront the work we eminent domain practitioners do.

A Condemnation Action is Looming — What are a Landlord’s Disclosure Obligations to Potential Lessees?

commercial-tenant-build-outBefore an eminent domain action is filed, public infrastructure projects involve years of planning, environmental approvals, design, and property negotiations.  During this time, property owners and real estate agents/brokers are often faced with deciding what to disclose about the potential condemnation to prospective tenants when attempting to lease out space.  It is a difficult position to be in, as (i) disclosing too much makes it extraordinarily difficult to find a tenant willing to pay market rents with the looming “cloud” of condemnation, and (ii) disclosing too little exposes the landlord or broker to a potential concealment or fraud claim.  This situation recently played out with a commercial property owner facing Caltrans’ I-5 freeway widening project, and a Court of Appeal decision in DNI Food Service v. Kim (2017) Cal. App. Unpub. LEXIS 199 provides some guidance to landlords.

In DNI Food Service, the owner of a multi-tenant retail building received a notice from Caltrans that its property would be impacted by an upcoming project.  After Caltrans sent a “Notice of Decision to Appraise,” identified the permanent and temporary construction easements to be acquired, and had its appraiser inspect the property, the landlord proceeded to lease space to a restaurant without disclosing the upcoming project.  Shortly thereafter, Caltrans filed an eminent domain action, which was the first time the restaurant tenant received notice about Caltrans’ taking.  In the condemnation action, the tenant filed a cross-complaint against the owner and the real estate agents, claiming they should have disclosed information related to Caltrans’ planned freeway expansion that would affect the property.  The tenant asserted that had the proper disclosure been made, it would have never leased the space or spent time and resources remodeling and equipping the restaurant.

In analyzing the tenant’s claims, the court explained:

a property owner is under a duty to disclose material facts affecting the value or desirability of the property, if it is known that such facts are not known to or within the reach of the diligent attention and observation of a buyer. . . .  When the seller’s real estate agent or broker is also aware of such facts, “he [or she] is under the same duty of disclosure.”

The court went on to explain that “a fact is material if it has an effect on the value or desirability of the property.”

Here, the property owner and agents knew about the planned Caltrans taking and failed to disclose that fact while simultaneously touting the property’s excellent location and convenient proximity to the freeway.  Sounds like a slam dunk concealment case, right?  Surprisingly, the court denied the tenant’s claim, concluding that the scope of Caltrans’ acquisition — which primarily involved a small piece of landscaping at the opposite end of the commercial development — had such a minimal impact on the value of the lease that it was not a material fact giving rise to a duty to disclose.

In reading between the lines, it appears the tenant’s business was failing regardless of Caltrans’ acquisition.  The court further concluded that even if there was a duty to disclose, the restaurant tenant failed to demonstrate causation and damages, as the restaurant shut down within months of learning of the eminent domain proceeding, but before any construction had started.  This may have been an underlying driving factor in the court’s decision.

While the property owner and real estate agents/brokers were let off the hook in this particular case due to Caltrans’ taking being deemed “immaterial,” it is a good reminder on landlord disclosure obligations with a future acquisition looming.  Landlords should not leave it up to chance to determine what is and what is not material, and should instead take the cautious approach and disclose.  If the landlord is worried about not being able to find a tenant or accepting below market rent due to the pending project, one suggestion is to consider entering into a lost rents agreement with the public agency.  This has the benefit of putting rent in the landlord’s pocket, while keeping the space vacant and avoiding a large goodwill or relocation claim for the public agency.

Value Trends of Gas Stations and Car Washes

gas-stationIn a previous post, “What is ‘Just Compensation’ For Gas Station Acquisitions,” we explored various methods for valuing gas stations and car washes in an eminent domain action, including a recommendation by a gas station appraisal firm, Retail Petroleum Consultants, to approach such valuation assignments as “special use properties”.  Retail Petroleum has issued another useful article, “Value Trends in Gas Stations and Car Washes,” which examines recent trends driving the valuation of such properties in California.

Retail Petroleum explains that because gas stations are typically special-use properties sold based on a going-concern value, there are two primary valuation metrics buyers and sellers use in the market:  (i) the Gross Profit Multiplier method, which measures value based on the gross profit generated by the property, and (ii) the Capitalization Rate approach, which measures value based on the net operating income generated.  The article concludes that the vast majority of gas stations are run by small businesses, meaning operating expenses can vary dramatically from property to property, and therefore the Gross Profit Multiplier may be a more reliable method for valuation.  However, the article explores certain nuances that should be considered with each approach, depending on the particular gas station being valued:

  1. Gross Profit Multiplier Mirrors Real Estate Market Trends:  Based on statistical data, the Gross Profit Multiplier valuation method has trended more consistently with the real estate market, whereas capitalization rates showed an opposite trend through the recent recession (i.e., capitalization rate trends indicated increasing gas station values during the recession and falling values after the beginning of the recovery, which clearly did not occur).  This needs to be taken into consideration when deciding what “cap rate” to utilize for purposes of valuation.
  2. Capitalization Rate Approach Considers Risk:  Post-recession, most stations saw an increase in cash flow with improved fuel margins, higher convenience store sales, and heightened sales at car washes and quick-serve restaurants.   However, a higher net income generally results in increased risk to a buyer (there is a greater risk of continuing that above-market income stream into the foreseeable future), and capitalization rates are therefore impacted.  This risk may not be as fully recognized by simply looking at gross income, and the size of the gas station’s income therefore needs to be taken into consideration when deciding what multiplier or cap rate to utilize.
  3. Capitalization Rate Approach Recognizes Pool of Buyers:  Properties with a higher net operating income will generally be higher-priced and will therefore have a smaller pool of buyers, which would also impact capitalization rates.  For properties with lower net operating income, many more potential buyers can bid on the property, thus pushing capitalization rates into a lower and more constant range.  As a result, for gas station and car wash going-concerns, an appraiser must consider the relationship between the property’s income and the appropriate capitalization rate to be applied.

Retail Petroleum concludes that both methodologies should be carried out in any appraisal of a gas station, c-store, or car wash:

They can both provide useful insight into how buyers, sellers, and other market participants value these property types, which can be quite complex. Differing locations, improvements configuration and condition, profit centers, underlying land values, and a multitude of other factors can influence values.

However, value indications from a gross profit multiplier may be more consistent because of the more consistent market data available, whereas capitalization rates will tend to be somewhat less reliable due to the nature of accounting for operational expenses within small businesses.

For a detailed analysis of the two approaches and current statistical trends, take a look at Retail Petroleum’s article.

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