04 Sep 2013
Words Tim Admin

Multiple v Return on Investment

It’s pretty much accepted wisdom in the management rights industry that the value of the business is assessed on the basis of a multiple on net profit. Some people call this the years times earnings multiple and it’s essentially the verified net profit for sale purposes times a number. When the number is referred to as a year’s times earnings that’s simply the number of years it will take to earn back the amount paid for the business. Of course, in nearly all cases, you don’t just buy a business when you purchase a management rights. There’s usually a unit attached and an obligation to own that unit will be reflected the caretaking and letting agreements. Indeed, it is the exclusive right to operate the business that attaches to the manager’s lot that gives the business its security and the lenders their confidence. I know virtually everyone who reads this column already knows how the multiple works but the underlying premise is worth summarizing because I think to some degree it’s past its use by date. If the multiple is used to arrive at a business value and individual values are assessed by comparison with other properties (recent sales) then how can the obligation to purchase the manager’s lot be ignored ? Put simply, the total capital required to acquire the typical management rights includes both business and unit value. The viability of many management rights is directly related to the relationship between the rights and unit value. The higher the proportion of unit value to the total purchase then the less viable the business is likely to be. The reasons for this are simple. The managers unit does not generate an income per se and thus is essentially a non income producing purchase. However, there is an obligation to purchase the lot in order to access the management rights business and hence income streams. No unit, no business! If the industry continues to compare relative business value via multiples of net profit then the real return on capital and comparative investment returns cannot be readily assessed. The simple solution is to compare buildings via return on investment. A simple calculation of net verified profit as a percentage of the total purchase price (unit and rights) will reveal much when used to compare buildings. Take the simple example of two buildings each with a 5 times multiple netting netting $300K per annum. In isolation that’s a 20% ROI on a $1.5M rights purchase. Now let’s throw in a $500K unit for rights # 1 and an $800K for rights #2. The ROI is now 15% on rights #1 and 13% on rights #2. All things being equal it would seem that the better business is rights #1. Clearly a comparison of multiples in isolation would not have revealed the underlying ROI numbers. The second consideration is that the lower the RIO the less debt a building can carry and hence the less a potential purchaser can borrow. In my experience this will ultimately lead to a lower demand for rights #2 and a possible need to either find a purchaser with a high deposit or discount the total price to attract a suitable buyer. It’s interesting to note that the industry average ROI in management rights is around 14% on the total purchase price. Of course, the ratio of unit to rights value ultimately drives the ROI so the lower the percentage of unit value the higher the ROI. In my opinion 60% rights : 40% unit (or better) is the sweet spot with anything approaching 50:50 being cause for concern. In the increasingly investment dollar competitive motel sector ROI is the benchmark when reviewing asset values. Interestingly enough motel freehold ROI averages stand at around 14% while leaseholds are running to 30% ROI averages. While very different businesses motels and management rights have a certain cross over among operators and investors so I think the adoption of ROI benchmarks across sectors makes good sense. Now, before all you industry experts tell me that there’s more to value and market acceptance than a simple return calculation….I know there is. Some people just have to live in a penthouse while others can put up with the outhouse. All I’m saying is that the outhouse resident will make more money and enjoy a better return on the capital employed. And don’t tell me capital gain on the unit compensates for a lower ROI……….we all saw what real estate capital growth did to unit / business ratios at the top of the property boom and it wasn’t pretty. If you want to speculate in real estate management rights is not the way to do so.