July 29, 2014

The Other Side of Deadspin’s NBA Financial Analysis

(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.

  • mgbode

    as you stated, it is so much more complex than simply revenue earned. even simplifying it to the team itself, you still need to account for interest paid (many owners have loans they used to acquire the team/arena), equity in the team’s overall value, and tax benefits from operating the team.

    then, the subsiderary benefits of owning a team that helps for these owners other businesses can completely throw things into a loop.

    anyways, let’s all agree that the owners and players have a ton of money to split amongst themselves (initial owner offer was still giving the players $2bil for 2011) and that the people that really get screwed by this lockout are the team staffers that get laid off and the arena crew, etc. who won’t be paid if games are missed (and won’t get any benefits because of the games missed unlike the players/owners). and, of course, the fans.

  • Andrew

    Good analysis. Go Tribe!

  • http://www.brian23.com Brian

    I’ll bet the Clippers books are hilarious. Also I don’t udnerstand how taxes or anything else works – if I have money at the end of the month and my tv keeps getting bigger I am in good shape.

  • http://mcbias.blogspot.com mcbias

    Nice to see some additional financial analysis on the documents. I give DS a lot of credit for getting those documents and the MLB documents too, but I wish they’d get an accountant too to help round out those posts. Craggs does an ok job, but you, as a business person, can add some extra sizzle to the analysis.

  • http://serandez.blogspot.com Ezzie

    Thank you!!!! Finally someone with a bit of a business understanding to explain why it’s rate of return that matters.

    Also, for what it’s worth, I would think that considering the scale of investment, an NBA owner would want a return of well over 10% on average. With $300 million they could open a hedge fund, where desired returns are usually above 10%. That won’t happen every year, but on average that’s where it should even out to.

  • Roosevelt

    Good cerebral analysis. But IMHO, most of this stuff is just too hard to quantify without some detail. If a team makes a 3% return, but also gains value, the way they undoubtedly did when the whole NBA bumped this past year, how is that counted? Another big one – if they barely break even, but the owner and his kid are getting salaries of 10,000,000 for working in the front office, is that a profit?

    Also, a lot of the income might be coming through other entities that directly profit off the team, like TV networks that are owned by the same group.

    At the end of the day, I always assume that the owners are making out like bandits. One doesn’t become a billionaire without understanding EVERY nuance of EVERY deal that one enters into. (pleasepleaseplease don’t bring up the Wilpons). And I can therefore only assume that the owners are not losing money because they’re stupid about contracts, and that in fact, they’re not losing money at all.

  • Chris

    I kind of have a problem with calculating the money made here using the cost of the franchise. I think the more honest way to go would be to calculate gross profit rate. I’ll be forthright in stating that I’m not a CPA, but I do have some accounting in my background. If that $7 million is real, and their income from operations is $95.7 million, that would equate to a GP% of 7.31%.

    To get a real view of whether or not this is acceptable, it would be necessary to measure it up against the industry. In this case, the measuring stick would be the other professional sports teams, which we obviously don’t have access to.

    The main thing to remember about owning a sports team is that you make the meat of your money in equity gained when you go to sell it. You may not make a huge return year over year. This seems to be true as far back as I can go.

    The biggest problem here is that the NBA (and presumably other pro sports) are depreciating their players as they would with their arenas, which is inherently wrong in a million ways. So meanwhile, they are making their millions tax free because they hide behind these archaic tax laws.

    And we get to pay for their arenas.

  • Chris

    @ #6 – “And I can therefore only assume that the owners are not losing money because they’re stupid about contracts…

    As long as Rashard Lewis is the 2nd highest paid player in the NBA, you may be mistaken here.

  • Return of the (Alex) Mack

    Happy Canada day to the (2nd) newest Cav Tristan Thompson

  • http://www.morningjournal.com/content/articles/2011/01/31/sports/doc4d463b0cd062d819200129.jpg Return of the (Alex) Mack

    also Bryan Adams

  • http://cavalierperspective.wordpress.com/ Cavalier Perspective

    It’s certainly not obvious that the rate of return they should expect is positive. You’re comparing owning sports teams to things like stocks and bonds, which is the comparison owners would obviously prefer you to have in mind. But at the other end you have things like yachts where rich people own them for their consumption benefits and don’t expect a positive annual return on their investment. Owner occupied housing is similar. Part of the return you’re getting on either is the imputed rent of getting to live/use the asset. If the consumption value of owning a sports teams is positive (which it most certainly is) then you need to take that into account and subtract it from the expected rate of return to which you think owners are for some reason entitled.

    It’s difficult to place a value on that benefit in isolation — the only information we have is the value owners are willing to pay for the teams themselves — the discounted sum of the annual consumption benefit plus the annual return out infinitely into the future. Given the ever-increasing sales prices of teams despite the constant cries of poverty from team ownership I’d say the market price of the stream of benefits that comes with owning a team must still be looking pretty good. The owners are free to maximize what they can get out of the negotiations with the players, but fans certainly shouldn’t be fooled into thinking owners are getting a bad shake on their investment. If they don’t like what they’re getting they can feel free to sell to someone who actually wants to own a team.

  • http://www.waitingfornextyear.com Craig Lyndall

    So you think owning a pro sports team is more like owning a yacht than an investment property in real estate? Not sure I agree with that.

  • http://cavalierperspective.wordpress.com/ Cavalier Perspective

    Somewhere in between. An investment real estate property provides no benefit to the owner other than the financial return. Owning a team provides perks like getting your own plush suite at every game, access to the team (albeit in a sometimes adversarial relationship) plus the psychic value of owning a freakin’ team. Yeah, I know that a guy like Glen Taylor probably doesn’t even care about the last part, but that doesn’t mean it’s not something that has value. Don’t you think Dan Gilbert or Mark Cuban gain millions of dollars of enjoyment from getting their faces all over the news, having their kids represent the team at the draft lottery, etc.? This isn’t exactly like owning a waste management corporation.

    I have no idea what the market price is for all that stuff. I would guess few owners have the teams just for the pure enjoyment of it. That said, even the teams that are selling at the pit of the recession are going for several hundred million dollars. Part of that is that the buyers are gambling on a favorable CBA-resolution that makes the teams more profitable, but part of it is that even in their current state there’s a lot of people out there who want to buy these things. Some combination of hidden earnings, favorable tax deductions such as those mentioned in the deadspin piece or enjoyment of owning teams has to account for that, unless we think that sports teams are just another asset bubble.

  • http://www.waitingfornextyear.com Craig Lyndall

    Even still, I think I was relatively conservative with my cap rates, so I don’t think it is unreasonable to expect that minimum return plus the enjoyment of owning the franchise and other ancillary benefits.

  • http://cavalierperspective.wordpress.com/ Cavalier Perspective

    First, I do commend you on the analysis and framing the Deadspin piece which I think did lack a framework for understanding what the numbers they uncovered mean. I think you’re also spot on in getting at what the owners are after in terms of how they think about the return on a business venture (and what they’re likely to hold out for in these negotiations.) I guess the disagreement comes in the grey area of what’s fair or reasonable for owners to expect and whether we as fans need to have any particular respect for that. I guess I see an environment in both the NFL and NBA where the leagues are functioning pretty well from the fans’ perspective (we can debate that separately), where few teams are pushing up against the minimum salary, and at least in the NBA where teams are falling head over heels to throw money at marginal players, and where team values are still at historical highs. In both leagues it’s pretty clear the owners are the ones making the big demands — the players would happily coast along on the status quo. If the owners can negotiate a “fair” rate of return without us missing games then I’m on board, but if that starts cutting into the season then I’m not going to have a lot of patience with someone who just paid 400 million dollars for a team and isn’t happy with what they got. If they didn’t think the profit stream was worth it why did they buy it in the first place?

  • jimkanicki

    it’s not like owning a yacht or investment property. it’s exactly like owning a mcdonalds or dunkin donuts. it’s a franchise. and this is where the owner are right to assert themselves.

    a franchise owner gains income and asset appreciation from his local enterprise, but neither occur if the franchise brand does not provide a base level of product consistency among all franchises. if the KFC in miami is the only one using the secret herbs/spices, then it wont be long until the other franchises fail. see where i’m going?

    the players union is the product. if they want to participate on percentage of net income basis, they need to ensure that they provide all franchises with a consistent quality level. sorry NBAPA, but someone has to play in milwaukee and utah and sacto and cleveland.

    if the NBAPA doesn’t like that reality, digs in their heels for ‘player movement,’ then the option is for less franchises and less roster spots. and then we’ll see whether this union represents all their members or just the stars.

    i hate taking sides in these mgt/labor fights because the guaranteed winner is scott boras and the guaranteed loser is the fan.

  • david

    two thoughts – if you are the owner of a terrible team, why do you deserve to make money? in business, if the product you produce doesnt sell, you lose money.

    the second is that maybe owning a team isnt like owning a yacht but it certainly is a privilege. when you buy a professional sports team there are all kinds of rules/regulations. do you think the yankees enjoy giving their profits to the pirates? absolutely not.

  • mike

    its ridiculous. i like reading an interesting article (along with posters) breaking down the financial benefit. we all know these guys make incredible amounts of money, if they did not, no business man (or woman) would be interested in owning a team. teams make a ridiculous amount of money, but they lie on their books. thats why nfl owners do not want the books available. they write off so many family expenses in team profits, its out of this world. again, billionaires fighting millonaires, and the only people hurt are the lower-middle class. i wish we could all boycott if the nfl and nba miss games. nobody will join me though :(

  • http://cavalierperspective.wordpress.com/ Cavalier Perspective

    @Jim

    Agreed that they’re franchises, but it’s not exactly like owning a Dunkin Donuts. If I offered to sell you a (huge 300 million dollar) Dunkin Donuts that makes a 10% return on your investment or a basketball team that makes a 10% return on your investment which would you choose? Obviously you’d choose to own the basketball team. Why? Because owning a basketball team is way more enjoyable. Yes, it’s not purely like a yacht, that I agree with. But there are yacht-like elements that mean that owning a team doesn’t need to return as much as a Dunkin Donuts in order to be worth owning.

    And for what it’s worth I think the players are called “labor” not the “product”. If the owners want to fight over designing a system that ensures quality players in all markets then I’d have more sympathy. Maybe they’ll impress me, but my sense is as the negotiations drag on we’ll see them cave on the things that matter to fans in favor of a couple more percentage points of revenue. And no, I’m not interested in missing a few games so rich guys can make sure they get the return they think they deserve on something they already own.

  • http://twitter.com/dj_2 DJ

    One thing to keep in mind with the Deadspin piece: The numbers were from several years ago, well before the market tanked and we went into a pretty deep recession. That’s why I’m not paying much attention to this. If Craggs had figures from 2009 or 2010 which stated the same thing, then I’d pay more attention.

  • jimkanicki

    @19, the main point i wanted to put forward is this: the nba’s product is ‘competitive sporting event.’ the players are not ‘labor’ and, equally overlooked, they’re not the product. they’re the main ingredient in the product. and in order to have the _competition_ component in the product, the ingredients need to be [somewhat] consistently distributed to all franchises.

    i dont know, but suspect, that the dollars/percentages piece of the contract negotiation is a trojan horse. i hope that stern recognizes that the biggest risk to the league is player movement and the prospect of more miami heats. their main goal should be to come out of this lockout with something like nfl’s franchise tag.