Adjusting profit when the business rents from the owner

The short answer, expanded

When an owner's family trust, company or super fund owns the premises and leases them to the operating business, the rent is set between related parties. It may be higher than market, lower than market, or not charged at all. Whatever the reason, the rent in the accounts does not necessarily tell a buyer what they would pay to occupy the premises.

So a valuer normalises the rent: it removes the rent actually paid and deducts a market rent instead. Profit rises if the business has been overpaying and falls if it has been underpaying. This is the same idea as normalising a working owner's salary: replacing a related-party arrangement with what an unrelated party would pay for the same thing.

Why the valuer uses market rent

A business valuation usually asks what a hypothetical buyer, dealing at arm's length, would pay for the business. The ATO describes market value in the same terms. That buyer would not inherit a favourable or unfavourable family arrangement; they would expect to pay a market rent, either to the current property owner under a new lease or to another landlord.

Market rent is the rent obtainable in an open market between a willing landlord and a willing tenant at arm's length. For Victorian retail leases, section 37 of the Retail Leases Act 2003 puts it in similar terms for rent reviews, and expressly excludes the value of goodwill created by the tenant and the tenant's fixtures and fittings. That exclusion is a useful reminder: market rent is what the premises command, not a share of what a successful business can afford.

Evidence of market rent

A rental assessment by a property valuer is often the strongest evidence: it comes from someone who inspects the premises, identifies comparable leases and explains the adjustments between them. A valuer of the business will normally rely on that assessment rather than form a property opinion themselves.

A good rental assessment states:

• the premises, lettable area and permitted use
• the lease terms assumed, including term, reviews and who pays outgoings
• whether the rent is gross or net of outgoings, and whether it includes GST
• the comparable leases relied on, and the adjustments made
• the assessment date

Where the property is held by a self-managed super fund, the rent also matters for the fund. The ATO says business real property leased to a related party is an exception to the in-house asset rules, but dealings must still be on arm's length terms, and non-arm's length dealings can give rise to non-arm's length income. That is a question for the fund's adviser, but the same rental evidence is often relevant to both.

A worked example

This example is hypothetical, with round numbers.

A business reports EBITDA of $250,000 after paying $120,000 a year in rent to the owner's family trust. A property valuer assesses market rent at $90,000 a year, on the same basis as the current lease (net of outgoings, which the business pays, and excluding GST).

The adjustment is $30,000 ($120,000 less $90,000), and normalised EBITDA is $280,000 ($250,000 plus $30,000). Both routes give the same answer.

Now reverse the facts. The same business pays only $60,000 rent, so its reported EBITDA is $310,000 ($370,000 less $60,000). Market rent is still $90,000.

The adjustment is a reduction of $30,000 ($90,000 less $60,000). Normalised EBITDA is again $280,000, because the business itself has not changed; only the family arrangement has.

Align the outgoings basis

If the related-party lease is gross (the landlord pays outgoings) but the market rent is assessed net, the two are not comparable. Now suppose a variant of the first example in which the lease is gross and the trust, not the business, pays $15,000 a year of outgoings such as council rates and insurance. On a net market rent of $90,000, a buyer would pay the rent and also bear those outgoings, so normalised EBITDA would be $265,000 ($280,000 less $15,000). Always compare rents on the same basis.

Separating the business and the property

Once the rent is normalised, the business is valued as a tenant paying market rent, and the property is valued as a separate asset, let at market rent. That separation prevents double counting. If the business were valued on profit with no rent deducted, and the property were also valued on its rental income, the same dollars would be counted in both values.

For more on when each valuation is needed, see do you need a business valuation, a property valuation, or both.

Limitations

Normalising to market rent assumes the buyer would obtain a lease at market rent on comparable terms. If a buyer must in fact accept the existing lease at an above-market rent, that is the rent that buyer will pay, and the valuation should reflect it. Likewise, if a binding lease at a below-market rent would pass to the buyer for a fixed term, that benefit may have value for the remaining term. The lease terms themselves also matter; see how the premises lease affects business value. Tax, super and family law consequences of related-party rent are outside this page and need specific advice.

Next steps

• Gather the current lease (or confirm in writing that there is none), the rent and outgoings actually paid for each year being reviewed, and who pays each outgoing.
• Obtain a market rental assessment from a property valuer. For the property itself, APAVAL is the property valuation partner brand of Valuo; ask at the outset whether the rental assessment you need is within scope.
• Record the rent adjustment, with its evidence, in the earnings normalisation worksheet.
• Review other related-party items at the same time, such as non-recurring expenses and owner salaries.

General educational information, not financial, tax or legal advice. Worked examples are hypothetical and do not value a real business. A valuation depends on its purpose, the evidence and the agreed scope.