There is a continuing disagreement in the mineral appraisal community over the appropriate technique to use in valuing an undeveloped mineral property when using the Income Approach to Value, with the alternatives being the use of a royalty income or an operating-based income. As background, it is noted that a lease of mineral rights creates two new estates in a property—the Lease Fee and the Leasehold. In those instances in which a lease exists for an undeveloped mineral property, the appropriate approach will be reflective of which of these two estates is being valued. For properties that are not under lease at the date of the appraisal but for which the Income Approach to Value is being used, the issue becomes which of the two estates should be the basis for the appraisal. In the author’s experience,this decision is best approached as part of the Highest and Best Use analysis. Support for this concept and a hypothetical example are provided in this presentation.
Although not always applicable, the Income Approach to Value can be used in appraising an undeveloped mineral property under certain circumstances. For those mineral properties that are not under lease at the date of the appraisal, the issue then becomes whether to value a royalty income or an operating-based income. Even though an entity capable of developing and operating the property is the owner or potential purchaser, it does not necessarily follow that an operating-based income is appropriate.
LEASED FEE VERSUS LEASEHOLD ESTATES
It is noted as background that a lease of mineral rights creates two new estates in a property—the Leased Fee, held by the Lessor, and the Leasehold, held by the Lessee. In appraising the Leased Fee Estate, it is appropriate to utilize the Income Approach based on the income to be received from the lease, which could include annual minimums, fixed amounts per unit of product, percentage of selling price, net smelter returns, and similar terms.
In appraising the Leasehold Estate, it is appropriate to use the Income Approach based on operating income, recognizing that the mineral estate is but one of the contributors to that income.
In appraising the mineral estate in an undeveloped and unleased property that is owned by or could be purchased by an entity capable of developing and operating a mine on the property, one’s first reaction may be to base the appraisal on the assumption the owner of the mineral estate would be the developer and operator. In this instance, the mineral estate would not be split and the operator would benefit not only from the net revenue generated from the operation, but also from not having a royalty expense. This is not necessarily the appropriate assumption, however, and it may be appropriate to appraise what would be the Leased Fee estate.
This is illustrated in the hypothetical example presented below.
THE APPRAISAL PROBLEM
ABC Coal Company (“ABC”) owns the fee simple interest in a 1,000-acre property underlain at depth by a four-foot thick coal bed that is suitable for use as a metallurgical blending coal (the “SubjectProperty”). Several coal producers are operating in the area, some of which control coal rights and mine the same coal bed as that on the Subject Property on adjacent properties.
ABC requires an appraisal of the Subject Property, which is to be used as collateral for a lending facility. In discussions with the appraiser, the company is pushing for the use of operating income in valuing the property, using operating costs at its other operations and/or operating costs of area producers.
The appraiser, of necessity, should consider the appropriate approach or approaches to value through the eyes of market participants, that is, purchasers of undeveloped coal properties. As a general premise, it would be reasonable to assume that potential purchasers of the property could comprise both potential operators of the property and passive investors in the property. In establishing the appropriate approach to value and the appropriate technique, each of these classes of potential purchasers should be considered.
The use of the Income Approach as an analytic tool in arriving at an opinion of value is justified in the author’s opinion, recognizing that this constitutes a Hypothetical Condition under USPAP. Such an analysis arguably should be used in conjunction with the Sales Comparison Approach.
The appraisal problem thus becomes whether to base the Income Approach on a royalty income to a passive investor or an operating income to a potential developer. In the author’s experience, this determination is best made using the Highest and Best Use analysis.
HIGHEST AND BEST USE
The Appraisal Institute defines Highest and Best Use as:
The reasonably probable use of a property that results in the highest value. The four criteria that the highest and best use must meet are legal permissibility, physical possibility, financial feasibility, and maximum productivity. The use of an asset that maximizes its potential and is possible, legally permissible, and financially feasible. The highest and best use may be for continuation of an asset’s existing use or for some alternative use. This is determined by the use that a market participant would have in mind for the asset when formulating the price that it would be willing to bid. The highest and most profitable use for which the property is adaptable and needed or likely to be needed is the reasonably near future.
(The Dictionary of Real Estate Appraisal, Sixth Edition; Appraisal Institute, 2015, Page 109)
In estimating Highest and Best Use, the four criteria are to be analyzed sequentially, as follows.
· Legally permissible use –
What uses are permitted by zoning and deed and/or lease restrictions on the site in question?
· Physicallly possible use –
What uses are physically possible?
· Financially feasible use –
Which possible and permissible use(s) will produce a net return to the owner of the site?
· Maximally productive use –
Among the feasible uses, which will produce the highest net return of the present worth, or which use will be maximally productive?
HIGHEST AND BEST USE ANALYSIS – SUBJECT PROPERTY
As noted above, the appraisal problem in this circumstance is to determine whether to base the Income Approach to Value on royalty income or operation-based income.
As is typical, the first step in the analysis is to establish whether mining is a legally permissible use. In our hypothetical case, the appraiser determines that it is.
The second step in the analysis is to determine whether mining is physically feasible. Although the coal bed lies at some depth in the subsurface, it can be accessed by one of two means—mining progressing from an adjoining property or the construction of a slope and/or shaft on the Subject Property. In our hypothetical case, either is physically feasible.
The third step in the analysis is to determine whether mining is financially feasible. In considering this, the appraiser develops three basic alternatives, as follows:
· Alternative 1 – Property owner constructs a slope and erects a preparation plant on the property and intends to sell the coal on a clean basis to an operator in the area with a rail loadout. At a reasonable production rate, the life of the mine would be in the range of three to five years.
· Alternative 2 – Property owner constructs a slope and intends to sell the coal on a raw, run-of-mine basis to an area operator with a preparation plant and loadout.
· Alternative 3 – The property owner leases the coal to the operator of an adjoining property.
Value in Alternatives 1 and 2 would be based on operating income with value in Alternative 3 based on royalty income.
As with any operating case, a capital budget and forecasts of development and operating costs would be required to construct a discounted cash flow model for Alternatives 1 and 2. Forecasts of annual production and selling prices would be required for each of the three alternatives, with the establishment of a market royalty rate required for Alternative 3.
Let us assume in our hypothetical case that the Highest and Best Use analysis results in the following conclusions.
· Alternative 1 – Construct Slope/Prep Plant
Results in a negative cash flow for the life of the proposed mine and does not return the capital investment.
· Alternative 2 – Construct Slope
Returns capital investment but results in marginally positive cash flow and extremely low net present value.
· Alternative 3 – Lease Coal
Provides generally consistent positive cash flow and a relatively high net present value.
The final step in the Highest and Best Use analysis is to determine which of the financially feasible uses will be maximally productive and provide the highest net return. In this hypothetical case, it has been determined that Alternatives 2 and 3 are financially feasible, with Alternative3 clearly providing the highest net return and thus maximally productive.
Based on the application of the Highest and Best Use Analysis, the appraiser is well-supported to base the Income Approach to Value in this example on royalty income.