(Note: This was written before Deadspin corrected their post. It largely remains accurate except that it now relies largely on some arbitrary numbers that Deadspin originally stated. Still, conceptually it should work and the conclusions should be the same.)
Yesterday, Deadspin scored a coup when they obtained some financial records for the New Jersey Nets. The title of that article is pretty eye opening. “Exclusive: How (And Why) An NBA Team Makes A $7 Million Profit Look Like A $28 Million Loss.”
It is a good article with a lot of interesting takeaways about how NBA financials work on the ownership end of things. It turns out that there are some arcane tax laws that have been in place for a long, long time that allow NBA owners to claim giant losses on paper even as they make some money. In the case of the New Jersey Nets from five years ago, it was a $7 million gain that was made to look like a $28 million loss. That number apparently wasn’t totally correct, but let’s assume it is. What we aren’t getting into here, is what kind of money an NBA owner should realistically expect to make from the investment. That’s what I wanted to look at here.
In order to determine the value of an asset, it is important to look at the revenues. In an ideal world, each and every business will stand alone and make money on its own. We know that isn’t always the case. Tommy Craggs makes some very good points about how some NBA teams are used as leverage in property deals like the Nets probably are/were for someone who wanted to develop in Brooklyn. I am going to go ahead and remove that element as well even though it is a very good point.
In the case of Dan Gilbert, the Cavaliers are worth a certain amount of money, but they would be a certain amount in losses assuming his casino development goes through. There is no denying that. But let’s assume for a second that the asset value of the franchise was tied directly to the revenue stream and the owner should be able to expect a reasonable rate of return. What would be a fair amount of return for an NBA owner?
The answer is different depending on the value of the franchise. In real estate the pros will use a capitalization rate. A building is valued based on the expected net operating income from the leases of the tenants. Quite frequently, in commercial property circuits, freestanding drug store buildings are sold with advertised cap rates in the range of 7-10%. That means if a building is creating net operating income of $100,000 per year and has a cap rate of 7% then the building is allegedly worth $1.429 million (100k / 0.07.)
In the case of the New Jersey Nets, let’s say that Deadspin is right that they had a $7 million profit. Sounds awesome to you and me because $7 million is a lot of money! But let’s look at it in terms of capitalization rates. If you were out to buy that team and you wanted a really great annual return on your money of 10% then what would that $7 million in income be worth? $7 million divided by 10% capitalization means that the New Jersey Nets would be worth $70 million dollars. Meanwhile, Ratner purchased the team for $300 million.
So maybe 10% is a little ambitious. Finding an investment that pays 10% per year isn’t exactly easy in this day and age. Let’s do a countdown. At 9% cap rate, the team is worth $77.78 million dollars. At 5% the team is worth $140 million. At $300 million, Ratner’s $7 million surplus is only a 2.33% capitalization rate. That is better than a money market account, but certainly not what you would hope for as a rich guy who has $300 million invested in an asset.
Say what you want about sports owners, they deserve to make money. The league will be at its healthiest when owners can make even a decent rate of return. Assuming a $300 million team value that means on the high end it should be reasonable for an owner to make between 15-$30 million per year at cap rates between 5-10%.
Common sense tells me that owners of thriving teams should at least be able to make as much per year as a max player in the league every single year, right? Profit and contract values aren’t dirty words for players and it shouldn’t be dirty for an NBA owner either. And right now, despite whatever other investments the New Jersey Nets help prop up, as a standalone investment they aren’t worth anywhere near the approximately $300 million valuation just by looking at the income.
So strap in folks. Whether you agree with my conclusions or not, you can be sure that at least a few of the NBA owners out there will be thinking like this. It could be a long road until any kind of compromise is reached with the players who are looking to protect their current way of life.