Volume 4, No. 2, Fall 1999

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Eminent Domain Law and Business Valuation

This article is the first in a two-part series on Eminent Domain Law and its application to Business Valuation. Part I will focus on the history of Eminent Domain Law and the most current reasons for its application within business valuation. Part II (which will appear in our next issue) will discuss the actual valuation approaches used to measure Business Loss.

The Government has the power to take private land for public use. However, this power is mitigated by the requirement that the Government provide just compensation for the property based on its fair market value. If the owner refuses to sell, the Government may begin the process of condemnation. The Court will appoint an appraiser to estimate the fair market value. Depending upon the nature of the condemnation case, the business appraiser should understand how certain legal principles impact the property and/or business being taken and how different appraisal techniques are used. The general legal principles supported by case law are relevant to the business appraiser. First of all, to determine the fair market value of a business in a condemnation proceeding, any competent (reasonable) evidence may be considered, if it legitimately bears upon the market value. The measure of compensation is the amount which a purchaser willing, but not required to buy the business would pay to an owner willing, but not required to sell taking into consideration the best use to which the business can be put. The courts have traditionally used three methods of determining the fair market value of a property taken in eminent domain: (a) market data approach based on comparable sales; (b) income capitalization approach; and (c) reproduction cost, less depreciation. These techniques are neither conclusive nor exclusive, but are factors to consider in arriving at the market value of property to be taken by eminent domain.

The measurement of damages or loss of property rights begins with the Fifth Amendment to the Constitution, which concludes with the mandate: xánor shall private property be taken for public use, without just compensation.à When the Constitution was written over 200 years ago, the focus was on physical takings or occupation of private lands by the Government, not the taking of going-concerns or businesses. Eminent domain doctrine has evolved to create a basis for a taking anytime a property owner physically loses property, as well as when a property owner does not physically lose property. Depending on state law, in some condemnation cases, just compensation has included certain types of regulatory takings and loss of going-concern or business enterprise value.

The history of just compensation for business enterprise takings has its origins in a case involving the Kimball Laundry Company v. United States, 338 U.S. 1 (1949). In this case, the court reviewed a damage award arrived at by considering a decrease in the market value of the property which resulted from significant changes in the market during the time when the Government used the laundry plant. In this long-standing case, the majority of the Supreme Court ruled that when a business is temporarily condemned, the intangible character of a trade route (customer list) does not, of itself, preclude compensation for its destruction; that since the Government, for the period of its occupancy of the plant, had pre-empted the customer list, it must pay compensation for whatever transferrable value their temporary use may have had. In the District Court, the owner was awarded an annual rental, with interest, for damages to the plant and machinery beyond ordinary wear and tear, plus interest on the rental due for the first term from the day on which the Army took possession, and on the rental for one year thereafter from the beginning of the year until paid. No compensation was awarded by the District Court for the diminution in the value of the business due to the destruction of its 'trade routes.'

After reviewing this case, the Supreme Court indicated that the intangible character of going-concern alone does not preclude compensation for it. The Government must pay just compensation for whatever transferrable value the temporary use of the owner's 'trade routes' may have had; the term 'trade routes' serving as a general designation both for the list of customers built by solicitation over the years and the continued hold of the laundry business upon their patronage. In determining the compensation to be paid by the Government for the going-concern value of a business taken for public use, the Court should consider any evidence likely to convince a potential purchaser as to the presence and amount of such going-concern value. This includes, but is not limited to, the records of its past earnings, the expenditures of building up the business and its gross income. Although not capitalized and carried on the books, going-concern may be present even in a business losing money or at any rate not making enough to have any excess income to provide a return above the rate for tangible assets. The Supreme Court ruled that the refusal of the Trial Court to receive competent evidence, in order to prove such values indicated above, is a reversible error. The Court stated that in determining the value of a business, as between buyer and seller, the goodwill and earning power resulting from its effective organization are often more important elements than is tangible property.

The Supreme Court further commented by saying that one index of going-concern value offered by the petitioner is the record of its past earnings. If the earnings were found to be unusually high, in proportion to the investment and physical property, that could be a persuasive indication to an informed purchaser of the business that more than tangible factors are involved. Such a purchaser might well measure the value thus contributed by capitalizing the excess of the probable future return upon investment in the business over a return which would be adequate compensation for the risk of investment in it. This capitalization is at a rate taking into account the elements of risk and the number of years in which these factors would probably have an effect. Upon reviewing the values estimated by both appraisers, the Court implied that it was the task of the appraiser to estimate tangible and intangible values. The Court said it was theoretically possible to arrive at a total value of a business, not by adding the going-concern value obtained by capitalization of excess earnings to a valuation of the physical property, but by capitalization of all income. Nonetheless, it was clear that it was a responsibility of the lower court to hear evidence on this matter from appraisers who are experts in the applications of these valuation principles.

Valuation Principles for Measuring the Taking
Despite its hypothetical nature, the willing buyer-willing seller concept is firmly established in Federal eminent domain law as it is in many other valuation arenas. It is a requirement of condemners to pay a price which assumes a willing seller as well as a willing buyer, in arriving at what would be the likely result of negotiations between them. Fair market value is the basic standard and is thoroughly embedded within the judicial system. When using a fair market value standard, the application of a corollary rule is usually necessary. The corollary rule, referred to here, is known as the unit rule and is designed to reflect actual market conditions. There are two aspects of the unit rule which are applicable. The first aspect of the rule requires that the condemned business be valued initially as a whole rather than as the sum of the values of the various interests into which it may be divided. The proper procedure demanded by this rule is to determine the value of the whole; then, in a later stage of the proceedings, the award is apportioned among those claiming interest in the business.

The second aspect of the unit rule can be stated more briefly: different elements of a business are not to be separately valued and then simply added together. The rule states that the property is to be valued as a whole and its constituent parts are to be considered only in view of their ability to enhance or diminish the value of the whole. Application of these two unit rule principles is an area in which close coordination between the appraiser and the attorney is essential.

In condemnation proceedings, there are generally two types of takings. The first is commonly called a xtotal takingà of the property. It is relatively simple from the appraiser's point of view because there is nothing left of ownership after the taking, thereby requiring the appraiser to only appraise the property xas isà in the before the condemnation state.

The second type of taking is the 'partial taking; when only part of the property and/or business is taken. A partial taking is more complex because the appraiser must not only measure the value of what was taken, but must also evaluate whether there was any damage to the remaining business, known in condemnation law as severance.

Severance damages are a form of compensation paid for a loss of value arising out of the relationship of the part taken to the entire business. This value principle comes into play when the condemner acquires only a part of a business from the whole and the taking lessens the value of the remaining ownership. Often, severance damages occur because a condemning authority does not condemn the whole of a business or going-concern. No problem exists if the part taken is a component of the business entirely separate from the part not taken. However, if the part taken is a portion of a single ownership, a problem arises. For example, if a business consists of two separate locations with a store situated on a piece of property, and only the other piece is being acquired, it is necessary to decide whether the business being appraised consists of both locations. If it is decided that the business taken is a portion of the larger enterprise, then just compensation is held to include damage, if any, to the remainder as a result of the condemned part. This example demonstrates the valuation principle of severance damage. To ascertain whether a business meets the legal test of a single enterprise prior to the taking, three basic criteria are commonly applied: unity of title, unity of use, and contiguity. The first two are essential requirements, whereas the third is a factor to be considered, although it may not be essential. Some courts, however, specify that all three be essential requirements.

Property owners are entitled to abutter's rights, which involve visibility ö the right to see and be seen from the highway and the enjoyment of light and air flow from the highway to the property. The need for valuation of abutter's rights rises from the impairment or taking of these rights, generally as a consequence of street and highway construction. The loss of these rights may have a significant impact on the operation of a business. Changes in traffic control and traffic patterns, grade separations, construction of frontage roads, and construction of controlled accesses often impact businesses adversely. In considering which of these rights is compensable, it is important to distinguish between the Government's power (under eminent domain) to acquire property for public use, upon payment of just compensation, and its right under police power whereby it may control and regulate the use of private property for general welfare, without compensation. In some instances, the law permits businesses to make a claim for damages that come about as a consequence of street and highway construction. A generally accepted method of ascertaining diminution in the business value and the amount of just compensation is to calculate the difference between the market value of the entire business before the taking, and the market value of the remaining business enterprise after the taking. Both the before and after values of the business must be estimated as of the legally established dates of the taking. Excluded in any calculation of damages or benefits are those not allowable under the law, even though they may, in fact, have reduced or enhanced the value of the remaining property in the market. The complexity of the law in establishing what constitutes compensable interference with abutter's rights and loss of access requires close analysis by an attorney. Accordingly, the advice of competent counsel should be sought whenever interpretation of the law becomes complex in its application to business damage in a particular appraisal problem.

In partial taking cases, the matter of special or general benefits to the remainder, resulting from the project for which the part was taken, has proved to be a problem area for appraisers. A special benefit is generally considered to occur when an increase in the value of a particular business or going-concern results directly from the taking or the proposed improvement. If the remaining portion of the business is specially benefitted or enhanced in value by reason of the taking, then the just compensation payable shall be reduced by any special or direct benefit accruing to the business. These special benefits must be direct and peculiar (legal term) to the particular business at issue.

General benefits are those which come from sharing in the common advantage and convenience of increased public facilities and the general advance in the value of a business by reason of the public project. They are enjoyed by the neighborhood or community served by the public project which may be adjacent or in the general vicinity. General benefits are distinguished from special benefits in that they come from the incidental benefits enjoyed to a greater or lesser extent by the lands in the area of the improvement. Special benefits do not become general benefits merely because other lands nearby are similarly benefitted. The fact that the value of other property is increased by the improvement is no reason, under the Fifth Amendment, for excluding the consideration of special benefits to the particular business in determining whether it has been damaged. The Supreme Court and other Federal courts have reaffirmed the offsetting benefits rule so that it must be considered by appraisers in eminent domain cases. Generally, the view of the Court takes into account the offsetting benefits to the remainder as a rule which prohibits charging the public for value created by projects funded from the public purse.

Conclusion
The loss of going-concern value and business damage is an emerging area of eminent domain law throughout the country. As the Government plays a greater role in the development and redevelopment of our communities, the courts are becoming more conscious of private property rights and how they are adversely impacted by public takings. Real estate and business enterprises function in unison more often than not. With the increasing specialization of many industries, the market value of the real estate and business are inseparably linked and require joint analysis by the appraiser. We anticipate that the admissibility, and in turn, the compensability of business loss will draw more attention by the courts in years to come.