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Goodwill Hunting

Daily Journal
By: Bradford B. Kuhn, Rick E. Rayl
01/02/09

After years of little attention, business goodwill recently seems to be a hot topic for the appellate courts. Cases such as Redevelopment Agency of the City of San Diego v. Mesdaq, 154 Cal.App.4th 1111 (2007), and Inglewood Redevelopment Agency v. Aklilu, 153 Cal.App.4th 1095 (2007), have received considerable attention in the past few years. Mesdaq, which received more attention for its holding on date of value, also contained important language about the proper methodologies for valuing business goodwill. And, in Aklilu, the Court of Appeal approved, for the first time, the use of a cost-to-create approach to value business goodwill in eminent domain actions.

On Dec. 5, 2008, the court in City and County of San Francisco v. Coyne, 2008 DJDAR 17947, issued another business goodwill decision or, more accurately, issued an opinion rejecting a creative and highly expansive theory on what qualified as business goodwill. The Coyne decision contains two key prongs. First, the court confirmed that only "ongoing" businesses operating on the property being condemned can recover business-goodwill losses. Second, the court confirmed that developers of raw land cannot recover anticipated future development profits by characterizing those profits as goodwill losses. In this second prong, the court equated the "business" owners' theory to the traditionally disapproved "developer's approach" to valuing real estate.

In Coyne, the city and county of San Francisco sought to condemn a parcel of raw land for open space. The owners planned to construct a mixed-use development on the property. In the condemnation action, the developers sought to recover not only the fair market value of the property, but also the future profits they projected upon completion of their proposed development. The developers claimed that their anticipated future profits fit within the definition of business goodwill. The Court of Appeal rejected this claim, finding that: the developers did not operate an "ongoing" business on the property, a threshold requirement for recovering business goodwill; the developers' anticipated future profits were encompassed in their recovery of the fair market value of the real estate; and the developers' appraiser's attempt to re-coup these "losses" through the label of "goodwill" amounted to a back-door attempt to recover profits through the disallowed developer's approach to valuation.

In Coyne, real estate developers were in the process of developing a multi-unit residential and commercial complex. They were substantially through the entitlement process when the city and county of San Francisco decided the property was better utilized as open space. The city and county filed an eminent domain action to condemn the property.

In addition to seeking recovery for the property taken, the developers crafted a creative argument that they were also entitled to "business goodwill" losses. In particular, the developers claimed that because business goodwill is based on the present value of anticipated future profits, the developers' anticipated future profits from leasing the residential and commercial units constituted goodwill. In valuing the "goodwill losses," the developers' appraiser first determined the anticipated revenue that would be generated from the development. Then, the appraiser subtracted out commissions, project costs, the fair market value of the land and an expected rate of return. The residual value, according to the developers' appraiser, constituted business goodwill. The developers' appraiser calculated these goodwill losses at more than $2 million.

While allowing the goodwill testimony to be presented to the jury, the trial court ultimately rejected the developers' right to compensation for goodwill losses, finding that because no units were ever marketed or sold, the developers were not the owners "of a business conducted on the property taken."

The Court of Appeal upheld the trial court's decision, holding that the developers could not recover goodwill losses because the developers did not have an "ongoing business" located on the property taken. The Court of Appeal also explained that the developers' "goodwill" theory amounted to little more than a creative attempt to circumvent California's longstanding preclusion of valuation theories predicated on the so-called "developer's approach." Finally, the court concluded that allowing the developers' approach would result in a duplicative recovery, as the anticipation of future profits was already built into the fair market value of the land.

Recovering Goodwill

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." See Code of Civil Procedure Section 1263.510 (b). Because goodwill usually represents the present value of the anticipated future profits of the business, the developers here argued that the anticipated future profits of their condo development were goodwill. Specifically, the developers argued that developing a piece of property was a business in and of itself, and therefore they should be able to recover the fair market value of their land, plus any additional recovery for the loss of their anticipated future profits (which they labeled as "goodwill"). The court rejected the argument. explaining that, "at the time of the taking [the developers] lacked not only customers, but a product or service as well; they had no ongoing business conducted on the property."

The court found important that the developers did not conduct their development business on the property: "they had no office, no telephone or fax machine, no mail delivery, and no business records located at that site at the time of the taking." Thus, the court confirmed that even if a business depends on a certain location that is condemned, if it is not conducting business at that location, it cannot recover goodwill losses.

The Developer's Approach

The developer's approach values raw land based on a specific plan of development, where the costs of improving the land, laying out streets and paying taxes and interest until the units are sold are each subtracted out from the ultimate money the development would generate. Courts have found this approach too speculative to compute the value of raw land. See Contra Costa Water District v. Bar-C Properties, 5 Cal.App.4th 652 (1992). For example, in the Bar-C Properties case, raw land was in the process of being developed as a residential subdivision. The owner had just obtained subdivision map approval when a water district commenced a condemnation action to acquire a portion of the property. The developer's appraiser valued the property utilizing the developer's approach, where he assumed a completed subdivision, and deducted out development expenses, costs of completion and expected profit to reach a residual land value for each individual lot anticipated to be sold, and then added these lot values together to arrive at the fair market value for the entire property. The developer's opinion of value was excluded, as the court concluded it was improper and speculative to determine value based on a project specific plan of development.

In Coyne, the developers attempted to get around this barrier by using a developer's approach, but claiming that it was being used to value "goodwill losses," not real property losses. The Court of Appeal found this argument "novel," but flawed, explaining that the developers were attempting to double-dip and receive compensation for lost profits when those losses should be part of the developers' recovery for the real estate. The court went on to explain that permitting the developers to recover anticipated future profits through goodwill valuation would be "allow[ing] developers of raw land to achieve through the back door precisely what California case law has long denied them at the front, a recovery rooted in a specific development plan."

The court also confirmed that this situation was similar to that in Mesdaq, where a different Court of Appeal prohibited the recovery of goodwill based on a "hypothetical" business. Here, the developers' appraiser's goodwill valuation "was based on a hypothetical multi-unit commercial and residential complex, rather than any actual business." Thus, the developers erroneously approached the valuation of [their] business "as a laboratory exercise rather than as an empirical measure of what actually existed."

Thus, while the developers scored points for creativity, their effort to convert real property into business goodwill fell flat. Notably, the developers' approach may have cost them actual compensation dollars, in that there may have been other ways to capture some or all of the "future profits" they sought by characterizing the claim differently than the ill-fated "business goodwill" theory. Specifically, by focusing on this novel approach, they may have ignored a more traditional avenue for approaching the same value. The concept of "fair market value" is broad, and permits appraisers to look not just to the value of the property based on its existing use, but also on how the market treats anticipated future uses.

Where, as in Coyne, the developers had largely secured entitlements to build their project, the market will have already built substantial value into the real property as a result of those entitlements.

If the developers had focused their creative efforts on finding ways to maximize the real property value based on these more traditional concepts - as opposed to manufacturing a new type of goodwill claim - they may have obtained a better result.

Bradford B. Kuhn and Rick E. Rayl are attorneys in the eminent domain and valuation practice group in Nossaman's Orange County office.
     
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