In SBA 7(a) business acquisition transactions involving both a business and its real estate, distinguishing between the business enterprise and real property valuations is critical. This white paper addresses the misconception that rent can be excluded from business valuation cash flows when real estate is purchased or owned by the company, a practice that conflicts with fair market value (FMV) standards and SBA SOP. The capitalization of earnings method, preferred for SBA 7(a) valuations, requires normalized rent to ensure accurate cash flows and compliance.

Why Rent Must Be Included in Business Valuation

Valuation of the Business as a Standalone Economic Unit

Business valuations under FMV reflect cash flows of the business as a going concern, assuming a hypothetical buyer and seller, neither under compulsion, with reasonable knowledge. Rent, a recurring operating expense, is essential for nearly all businesses:

• If the business doesn’t own the real estate, it pays market rent, even to related parties.
• Rent must be normalized to market rates, reflecting what an unrelated landlord would charge.
• Excluding rent assumes rent-free operations, inflating cash flows unrealistically.

Separation of Real Estate and Business Valuation

When acquiring both business and real estate, separate appraisals are required:

• Business Appraisal: Reflects cash flows with market rent as an expense, using the capitalization of earnings method.
• Real Estate Appraisal: Uses market rent as income in the income approach, valuing the property independently.

Excluding rent from the business valuation and including real estate value double-counts the location’s value, violating FMV principles.

SBA SOP Reference: “Determining the value of a business (not including real estate which is separately valued through a real estate appraisal)…”

Impact on Valuation and SBA 7(a) Lending

Excluding rent from the business appraisal:

• Overstates free cash flow (FCF), inflating enterprise value.
• Risks underwriting errors, misrepresenting debt service capacity.

Example: A business with $200,000 FCF excluding $50,000 market rent overstates FCF to $250,000, inflating valuation by $500,000 (assuming a 10% capitalization rate).

Including market rent:

• Aligns with FMV, ensuring accurate FCF via capitalization of earnings.
• Supports consistent business and real estate appraisals.

Best Practice: Two-Appraisal Approach with Normalized Rent

To comply with SBA 7(a) guidelines:

• Include market rent as a normalized expense in the business valuation when using capitalization of earnings or other income approaches.
• Conduct a separate real estate appraisal, using the same market rent for income.
• Clearly delineate business and real estate cash flows for lenders.

This approach prevents double-counting, ensuring FMV and sound underwriting.

Conclusion

Rent must be included as a normalized expense in SBA 7(a) business valuations, even when real estate is acquired, to reflect FMV and comply with the SOP. Excluding rent inflates cash flows, risks double-counting, and undermines underwriting. The capitalization of earnings method with market rent, paired with a separate real estate appraisal, ensures accurate, compliant valuations for SBA 7(a) loans.