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- Valuation and Damages: Assessing COVID-19’s Economic Impact
Changes in how businesses operate, restrictions on property use and reduced revenues brought on by mandated closures due to COVID-19 have had a major impact on the real estate market and legal proceedings related to it throughout the United States. In this episode of Digging Into Land Use Law, Nossaman’s Eminent Domain & Valuation Group Chair, Brad Kuhn, and Grobstein Teeple LLP Director, Will Thomsen, discuss the current state of the market and approaches to appropriately assess short-term versus long-term impacts.
Transcript: Valuation and Damages: Assessing COVID-19’s Economic Impact
0:00:00.0 Brad Kuhn: Changes in how businesses operate, restrictions on property use, and reduced revenues brought on by mandated closures due to COVID-19 have had a major impact on the real estate market and on legal proceedings. Today, we'll discuss the current state of the market and approaches to appropriately assess short-term versus long-term impacts for purposes of real estate and business valuation issues.
0:00:26.7 S2: Welcome to Digging Into Land Use Law, Nossaman's podcast covering the development of all things in, on, or above the ground.
0:00:42.8 BK: Thanks so much for joining us today. I'm Brad Kuhn, Chair of Nossaman's Eminent Domain & Valuation Group, and I'm joined today by Will Thomsen, a Chartered Financial Analyst and accredited senior appraiser who serves as the Director at Grobstein Teeple, LLP. Today, we're going to be discussing COVID-19's impact on how businesses are valued and how this analysis has been impacted by the upheaval of a global pandemic. Well, thanks so much for joining me today. We're really happy to have you. I'm excited to talk about this challenging and really important topic as it's impacting our industry. As far as what we're going to be covering today, I think we'll start out with kind of a high-level overview of how you've seen COVID-19 impacted the economy, and then we can jump into some more specific business valuation methodologies and how to take COVID-19 into consideration, and then we'll wrap up with some litigation-related scenarios and how we're seeing this play out in the real world. So again, well, thanks so much for being here.
0:01:39.8 Will Thomsen: Thank you.
0:01:40.4 BK: You want to give us a little bit of an overview as to how you've seen COVID-19 impact the economy and the markets?
0:01:48.3 WT: Sure, I'd be glad to. Needless to say that it's had a pretty devastating impact economically, and just as a few statistics of interest, that the US officially went into a recession starting in February of this year, and the US gross domestic product had declined by 5% in the first quarter of 2020. That's through March. And then as of the second quarter, decline by an additional 31.7%, which, of course, is huge. And to you give you an idea of what happened to the unemployment rate, while it was at about 4.4% in March, just prior to the pandemic really hitting, it skyrocketed almost 15% in April, and then it started trending down, so it's about 13% in May, 11% in June, 10% in July, and it's about 8.4 right now as of August, which obviously is an improvement over the spike in April, but it's still the highest that we've had since the Great Recession. And of course, uncertainties continue.
0:03:00.1 BK: Yeah, interesting. We're seeing some improvement here, but it's going to be interesting to see what the future holds. You've touched a bit on some of the economic numbers. What about more from a market perspective, what are you seeing?
0:03:13.7 WT: Well, we had a huge negative impact early on in March, the Dow Jones and just the stock mark in general just plunged. They fell about 30% to 34% from the peak levels in December. So, right now, the stock market indices are pretty much recovered from that plunge, however, recently, in a recent week or so, they've started slipping again, and we think that's due both to fears about the virus in the colder weather that's coming, as well as the political climate and waning prospects for a stimulus bill to actually happen. All that uncertainty makes the markets quite tenuous. Another thing we're seeing is increased market volatility, and this is similar to what we had during the Great Recession. There's a volatility index that measure stock market swings, and in March, it was up just below 83%, and then it went down. It's been trending kind of up and down, but it's down to about 29 in September, but that is still 45% above the long-term average of 20. That means that the market's very nervous.
0:04:30.2 WT: Of course, we've seen decreases in mergers and acquisitions in terms of deal volume and in value, though it also depends on the area of the market, because some industries, as we'll discuss, are doing better than others. And there's been problems, of course, with the real estate. People just can't make payments, so, you're going to see increased vacancies, and we've seen rent concessions and real problems there.
0:04:52.9 BK: My focus has mostly been on the real estate side, and it's interesting that there's obviously some sectors that have been just completely hammered, especially on the retail side, but other areas seem to be completely booming and thriving, the industrial side and the need for warehouse and shipping, and those types of things, it's just... COVID's maybe even had an opposite effect on that, so, it's very interesting. And obviously, we've been through recessions before, this, to me, feels a bit different than what we've experienced in the past. It doesn't have the same sort of kind of historical what we've seen happen before, what are you thinking, and how does it compare to past recessions?
0:05:30.8 WT: Well, in general, it's very different, because this was all spurred on, as we know, not from an economic or financial problem, like a collapse of the sub-prime market or anything like that; it has to do with a health pandemic. So, the underlying economy was basically healthy prior to that striking. So, we've got... What we have is a self-induced downturn basically as a result of government-imposed shutdowns and people just being careful not wanting to get sick. You've had the fastest economic collapse on record, and the impact has been very widespread. It's affected virtually all the sectors, though as you allude to, not equally, and in fact, some sectors have benefited in some ways. Like for example, tech and online have done basically pretty good, but restaurants and travel, the opposite, and retails, had issues.
0:06:26.4 BK: We've seen some signs of life over the last few months, some improvements. If you look into your crystal ball and predicted the future, what are you seeing?
0:06:35.4 WT: Well, yeah, I wish I had polished my crystal ball a little more, but pretty murky. People discuss... The recovery will happen. The question is, when and how and what will it look like? And people discussed various shapes of a recovery, like an L shape, which means that it plunges down and it's a very slow recovery. Or a U, which is more that it's kind of a gradual, but then it comes back up. There's a W. We have a lot of the alphabet to discuss. We got the W, which is basically a double dip decline. And then a V, which is like, it goes down and shoots back up.
0:07:13.3 WT: Well, a recent survey of CEOs, most CEOs are thinking of a U shape. Like it's going to come back gradually. But the quarter of CEOs think it's going to be an L, it's going to take forever. Some believe it's going to be a W, and very few think it's a V, that we're going to shoot right back up. And as far as the duration of the impact of this thing, for some industries, it could be as long as five years before they fully return to the pre-pandemic levels. And of course, this depends on what the recovery looks like, what happens medically. The longer the pandemic affects our daily lives, and as long as the virus remains pretty much out of control, the more long-term damage is occurring to the US economy and the harder it is to climb back.
0:08:00.8 BK: So, we've talked a little bit about some of the businesses that we've seen struggling, particularly in the retail sector, restaurants. I've seen it with some of my clients' fitness companies, and then a lot of the mom-and-pop businesses, and some of them even going through bankruptcy proceedings. Obviously, it has an impact on how businesses are being sold right now and how valuations are determined. What are you seeing in that respect, and I guess even maybe to take a step back and help our listeners, can you briefly walk us through how a business is typically valued, and then we can turn to what we're seeing with the current pandemic?
0:08:39.0 WT: Sure. Sure, of course. Essentially, there are three approaches to value any business or asset. One is called the income approach, where we're looking at things like projected cashflow, or we're looking at earnings or cashflow at a point in time, and we're converting that to a value. Or we look at a market approach, which is where we look at comps. We'll look at either public companies, or we'll look at transactions of private companies, and we'll try to ascertain value by looking at these transactions and prices. And thirdly, there is an asset approach, where you would look at the balance sheet of the company and try to determine value that way, by basically tallying up the assets minus liabilities. And in the eminent domain world, we've got a hybrid approach that's often used called excess earnings. But the basic concept of all these is that we're looking at anticipated earnings. So, that is really the key to valuing most businesses, because they're valued on a going concern basis.
0:09:45.4 BK: Usually, when we're doing the business valuations in our real estate, eminent domain litigation, we're taking a hard look at the business's anticipated growth, some of the perceived risks that you'd see out there, where else can you put your money and get a rate of return, and obviously, the business's cashflow and profits are some of the big areas. So, how does COVID-19 impact some of the valuation figures that you're typically looking at?
0:10:13.0 WT: Well, first, the issue of earnings, as you mentioned. Of course, short-term and long-term, or at least mid to long-term earnings are impacted. We've had companies where they've either lost revenue altogether or they've deferred revenue, because people are just not making the purchases right now. And there's been also price reduction. You got a whole hit on revenues, you've got supply chain disruptions, where you could think of manufacturers that source from China or other places, those supply lines have been disrupted and the increase... There's either unavailability or just the toilet paper [chuckle] and just costs have gone up. And of course, on the employees' safety end, which is a huge issue now, you've had expenses and concern regarding employee and customer safety and cleaning measures.
0:11:17.3 WT: And then if we go into that area of employees and HR, certainly, you've got issues regarding absence, severance costs, re-hiring costs, IT expenses to accommodate working remotely and making sure it works. And of course, we've seen cybersecurity issues, with everyone working remotely. You've got more outsourced professional service costs for a lot of firms. And you've got expenses, as you are well aware, relating to the termination of leases and other operating contracts. And some of this stuff is short-term and some of this stuff will reflect a change in business model. So, not all of it's bad, but it's certainly disruptive.
0:12:05.0 BK: When we go about our business valuation disputes, usually, there's at least some level of certainty that's going into this analysis, we can rely a little bit heavier on path, performance, and results. Gosh, it's so hard right now, with the level of risk that's out there and the perceived uncertainty of what the future holds. How does that come into play, and how does it make your job harder when you're trying to predict anticipated earnings or profits?
0:12:33.5 WT: Well, it's very difficult now, because we know that the past certainly is not prologued right now. So, we've got an issue where the businesses are... Either they're not earning anything or they're just losing money, and the question is, for how long a time is this going to happen? We've got growth prospects that have been impaired, although for some businesses, maybe they'll catch up once the economy reopens sufficiently. We certainly have higher risk, which results in lower values, and how to quantify that is a good question. Appraisers differ how to do this. Do we increase our discount rate and lower our multiples, or do we simply forecast more conservatively because we're just not confident that the businesses are going to recover like they think they will or hope they will?
0:13:27.2 WT: And of course, you've got... A lot of this relates to both internal and external risks of the business. Internal, meaning, you could have a business that is positioned where they've got a high concentration of customers and maybe it's key supplier dependents, maybe key personal risk, all that stuff could be really impacted by COVID in certain circumstances. And then you got... Some businesses are just in an industry like hospitality or retail where it's really been rough. Not long ago, I looked at a business that basically manufactured exhibit booths for trade shows. You can imagine, that business has basically been shut down for the time being, and they're just slowly coming back depending on how the re-opening happens.
0:14:16.3 WT: In valuing, essentially, an income approach has become more relevant, a multiple-period income approach, because we can't just look at one period and say, "That's what's going to happen." We're looking at more of a forecast, we're looking at scenarios. Often, maybe we'll look at a base case or an optimistic scenario, and then when things don't quite open up as we anticipate, for example, if there is a big wave, we hope not, but if there's a wave of infection in fall/winter, what is that going to do? All these are things to consider. And then on the other end, there's... The marketability of business has been impaired because there's a lack of buyers, lack of... Everyone's under financial stress. And finally, as I mentioned before, it's very much industry and geographic-specific, and maybe time-specific, too. I think the northeast has gone through their thing. It all has to be taken into account.
0:15:23.2 BK: So, when we're doing real estate and business valuation disputes in my eminent domain proceedings or other sorts of litigation, it's pretty common that they have a business or a piece of real estate that has a one-off situation with a non-recurring expense or a non-recurring income, and sometimes we'll just completely disregard that for purposes of valuation and say, "Look, that was a one-time expense," or "That was a one-time revenue, and we're not going to predict that going forward into the future." You could see something like that even now with a forgivable PPP loan or something where a business got a couple of million dollars that it wouldn't otherwise get. Is it something that you would say... Can you do that with the COVID situation right now and say, "I'm going to essentially disregard this last year of 2020 and pretend it essentially doesn't exist," for purposes of valuing a business going forward, or is that just... Is it going to be really situation-specific?
0:16:19.6 WT: So generally speaking, I would say no, it doesn't make sense to do that, but we would have to look at it from a case-by-case basis. Certainly, a fundamental exercise that we do in all our valuations is to look at the historical earnings, as you mentioned, and adjust them. And typically, we do adjust for non-recurring items that we think are not going to continue, for discretionary or non-business purpose expenses and that type of thing, and for accounting inconsistencies. Those are the big three we typically adjust for. Now, as far as COVID goes, if you think that the business is not going to be impacted in the future and it's all in the rear-view mirror, then yeah, I suppose you could do that, but I don't think anyone is thinking that right now.
0:17:05.8 WT: What's interesting is that there is a controversy about this as... A typical measure or earnings that we see is EBITDA, earnings before interest, taxes, depreciation, and amortization, and that's usually... It's very commonly used for deals and valuation. A new measure is coming up called EBITDAC, and what's the C? That's Coronavirus. So essentially, it's earnings before Coronavirus. Some companies are putting that forth as a measure, basically, "Hey, this is what we did in the prior years," and using that as a basis for loans and for financial reporting. And it's been met with a lot of skepticism, frankly, because first of all, it's not a real number; it's a speculative number. And the real question is, sure, we need to identify the impact of COVID-19, because those are likely to change over time. So we don't want to just look at the unadjusted numbers and not understand why the sales and profits are down right now, but to completely adjust them out and just pretend it didn't happen, in most cases, wouldn't make any sense.
0:18:18.8 BK: Got it. I think I mentioned my practice, and I know you do a lot, too, my practice primarily involves around real estate and business litigation, particularly disputes on valuation issues, like inverse condemnation, eminent domain, landlord-tenant disputes, and purchase agreements, other things like that, and I think factoring COVID-19 into these cases are going to present some real challenges, and we'll touch on that a little bit, but what other types of valuation litigation are you involved with, or where might you see COVID-19 have an impact?
0:18:51.5 WT: In addition to the areas you mentioned, we are seeing valuation and dispute issues in such areas as in the banking and finance world, certainly, you see loan defaults. There are also... There's litigation related to unfair or alleged unfair or biased PPP lending that's coming out. Of course, one of the big elephants in the room is business interruption. There's a lot of claims that have been made on that. The jury is still out as to how that's going to pan out. I think there's been some success by business owners in getting some relief, but generally speaking, right now, the insurers are succeeding in saying that this is not covered by their policies. But business interruption is obviously a big issue. There's breach of contract, we see that litigation coming up, and you feel your inability to fulfill an obligation, and that, of course, does relate to real estate, like in your area, the real estate, the landlord-tenant disputes, foreclosures, work outs, all that is a fallout of COVID-19.
0:20:03.7 WT: On the employment side, we're seeing litigation related to things like wage and hour disputes, where people... Maybe their time hasn't been tracked properly since working remotely. Or health and safety issues, folks that are going back to work and getting sick and suing the company. There are issues related to mergers and acquisitions for deals that just have either broken or impaired, and whether it's a result of COVID-19, or is it a result of the parties simply backing out? And there's also an interesting area of security fraud and auditor liability, where if a company has failed to disclose information, or they made misleading statements, or there's inadequate due diligence, there's a fallout for that, too, if that's not reported properly.
0:20:54.5 BK: Yeah. There's just a whole lot to take on there. I think I did recently see one of the first successful business interruption insurance coverage cases that came out recently, so, there might be some headway in that area. On the real estate side, too, it's been really interesting seeing how the landlord-tenant disputes are falling out, and the purchase agreements that people are trying to get out of due to financial difficulties and just changes in their projected forecasts and making the deal not as profitable or it doesn't make sense financially anymore, so...
0:21:23.7 WT: And maybe just to add one other item, is that overlaying this is that the courts have been closed generally. So, that must impact what remedies you seek.
0:21:38.1 BK: Yeah, absolutely. We're a lot of times dealing with a variety of different valuation issues. Are you working mostly on things that are dealing with damages or lost profits, lost business goodwill, or is it something else?
0:21:50.8 WT: It's a mix. I've been doing all of the above. There's some work that's non-related to litigation as well, such as estate and gift tax work, where now is a great time if you have the wherewithal to make gifts, because assets are depressed.
0:22:13.9 BK: I'm thinking of the issues that I'm seeing pop up in the valuation world, and obviously, a huge one for what I'm doing, in a domain or other sorts of business valuation issues, is what's the cause or the reason for the loss? Was it due to the public project, or was it due to the economy, or was it actually due to COVID-19 or something else, and being able to separate out those issues? What are you thinking are the biggest disputes as it pertains to COVID-19 as it pertains to business valuation experts?
0:22:47.4 WT: Well, a big issue down the line is going to be causation. The date of valuation is one big issue there. Certainly, if you're valuing a business as of say, December, or even maybe early February of this year, you probably can get away with attributing... At that point in time, not attributing COVID-19 in your valuation, because it was really not known and knowable to the extent that it subsequently became. So, certainly, after... This is why a timeline of COVID-19 and how it impacted the financial markets and people is so important. As of March of 2020, I think that's when the stock market basically crashed, and that's when the shutdowns occurred and people started really getting sick, then you've got an absolute issue as to the impact on value. As far as lost profits and diminution of value, the question, of course, will become, "Well, what part of it's caused by COVID, if it was, and what part was because of, say, the actions of a party that did a wrong thing?"
0:24:14.5 WT: You also see things like the... You expect discount rates to vary over time, because are we looking at a value... If you're looking at a value of a business versus a value, basically, a lost profit analysis, you're going to have a difference there. Really, there are a lot of things that I think are going to be in dispute. Causation is huge, I think, as it relates to COVID-19. How do we separate it, out if we can? And for how long is COVID going to have an impact on the business? And you go back to your... What we sometimes call it "but for." But for the actions of the... Whether it's an agency or whether it's an individual or whatever it is, what would have happened? And you've got COVID in the middle of all that. So, we've got to be very careful how we figure things out. There's always room for disagreement and different interpretations, but now we have to really be careful.
0:25:18.3 BK: Yeah, and we had a big enough spread between appraisers before COVID, and now, the spread just becomes even bigger. Like you said, figuring out causation and predicting what the future holds is just lots of big question marks. So, it's going to be interesting to see how this plays out. What about how COVID-19's impacting the real estate and business valuation industry generally? Are you going out and doing site inspections and meeting with businesses? How are you seeing business relocations being impacted? We talked about courts being closed, jury trials getting postponed, how it's taking just a lot longer to get to trials. Is this helpful for your valuation and analysis? Talk about the industry generally and what you're seeing.
0:26:01.4 WT: Well, it's... The shutdown itself has made it more difficult to physically access a business to the extent that we need to do that. As far as the damage analysis, in a sense, if there's a delay in the trial, it could actually afford more time to see what an after-condition performance might look like, which, the more you have, the better it is. So, in a sense, you could take that time and have a better understanding of how, for example, COVID or some wrongful action are really impacting a business. The only problem is that we don't know when stabilization is going to happen, so we're not quite in the shock we were in in March, April, May, but we're certainly not at a stable point, either.
0:26:58.2 BK: Yeah, it's interesting that with some of the trials that we've been having, usually, it's not typical to have a lot of after-condition data where you have... If a business has to relocate or lose a bunch of parking, whatever the case may be, what's the actual revenues and expenses of the businesses? And now, you might have some of that [0:27:17.9] ____ so it will be interesting to see how you use that, especially when that data is potentially impacted by COVID and whether it's actually something that's helpful or not. But otherwise, in our industry, generally, it's kind of a mixed bag of results. I've seen a number of public works projects that are being delayed or postponed, but then others that are being expedited, and they're taking advantage of less traffic or less businesses that might not otherwise be open.
0:27:47.8 BK: Another thing that we're handling a lot is business relocations and the criteria for what a relocation site may look like. It's completely changed due to the COVID. We talked about businesses just changing the way they operate. They may downsize, or restaurants may now be looking for more outdoor seating. If the businesses are completely changing the way they operate due to COVID-19, how does that play out in the business valuation scenario? You don't really have a true "apples-to-apples" scenario of a before-condition business and an after-condition business. In some respects, you almost have a completely different type of business in your after-condition due to COVID.
0:28:27.3 WT: Absolutely, and these are complex issues. And I think we do have to look at them pretty much on a case-by-case basis. And it will be interesting to see, as you mentioned, some of these operational changes may be short-term, but there may also be a permanent change, like the example of maybe the brick-and-mortar store that's leaning more toward online now, because that's going to be a permanent state of affairs, that they really want to do that. Other business, it may not be the case.
0:28:58.2 BK: Alright, some really interesting stuff, lots of issues there to unravel and think about. Man, it's going to be interesting to see how this plays out in our real estate and business valuation world. Lots things to strategize on before we're approaching these litigation matters. Will, I really appreciate your time today. It's been a pleasure speaking with you. I know you put together some handouts for this, and so if anyone's interested, feel free to reach out to either one of us. My email is firstname.lastname@example.org, and Will's is wthomsen, which is W-T-H-O-M-S-E-N@gtllp.com.
0:29:39.5 BK: Thanks to all our listeners for joining us for Digging Into Land Use Law. For additional information on this topic or other land use or eminent domain issues, please feel free to visit our website at nossaman.com, and don't forget to subscribe to Digging Into Land Use Law wherever you're listening to your podcast so you don't miss any of our upcoming episodes. Until next time, thank you.
0:30:03.9 S2: Digging Into Land Use Law is presented by Nossaman, LLP and cannot be copied or re-broadcast without consent. Content reflects the personal views and opinions of the participants. The information provided in this podcast is for informational purposes only. It's not intended as legal advice and does not create an attorney-client relationship. Listeners should not act solely upon this information without seeking professional legal counsel.