Let’s imagine for a moment that you and a friend, but not a close friend, together own all 100 of the shares in a company. When it needs to make an important decision, it does so by a majority vote of the shares, with each share getting one vote. Let’s say that your friend owns 48 shares and you own 52. Whenever the company makes decisions, your friend votes his shares and you vote yours, but you have more shares than he does, so you always have the majority and the company does what you vote to do. That’s fine so far as it goes. You’ve made decent decisions so far and the company is doing well.
Now, your friend has some savings stored up and would like to make an investment for his future. He likes the prospects of the company and asks you to sell him more shares. You could use some extra money so you decide to entertain his request. Together you have the company appraised and at the time it is in whole worth $100,000, or because there are 100 shares, $1,000 per share on average. Now, because he’s your friend you agree to charge him only what the shares are worth. How much should you charge him to sell one of your shares? How about two? How much for three? Keep in mind that when the company votes on important decisions, if you’ve sold him three shares, he’ll have the say about what the company does, and if you’ve sold him two, you’ll have to agree before a decision can be made.
The total amount that the fair value of the second and third share exceed $1,000 per share is called the “control premium”; control premium, in short, is extra over the apparent value of a share that is paid for the authority to control the company. How much is it worth for you to control the company rather than your friend? The answer has a lot less to do with the company itself and more to do with you and your friend. What if you’re a very sophisticated business person and you’re seriously concerned your friend might just run the company into the ground? In that case, you should probably charge as much for the second and third shares as you would for ALL of your shares so that you don’t have anything to lose if your friend can’t be trusted to run the company. On the other hand, maybe your friend is better informed than you are and has a solid plan to double the value of the company by year’s end. In that case, you might let him vote your shares even without charging him to buy them!
Now let’s suppose the company’s business is owning a piece of land. How valuable is the decision about what is done with that piece of land? Well, if a house that would sell for $300,000 could be built on the land for $200,000, then maybe the land would be worth something close to $100,000, the full value of the company. What if someone with a keener eye for architecture and shrewd negotiation skills could build a house that would sell for $400,000 using the same price to build the house ($200,000)? Then the land could have been bought for $200,000. It seems like the decisions that could be made to guide the company to that higher value home would be worth $100,000, as much as the entire existing value of the company! If your friend had something like that in mind, he may pay 2,3 or even 4 times the $1000 apparent value of the shares in order to have control over the decisions.
One of the things that make real estate so wonderful is that for those shrewd negotiators, keen-eyed architects, or other skilled people with vision it is relatively easy to gain control of the property without paying any control premium. Most homes are simply seen as the homes they are, not for what they could be. To be fair, some sellers will know what you plan to do with the property, and will not agree to sell it to you if you don’t give them a share of your likely profits. For the most part, though, sellers are either unaware of what could be done with their property or are happy to let a creative entrepreneur enjoy the fruits of their labor.
This means that there are many, many properties that can be controlled for much less than they are worth to a sophisticated investor. Not only that, but other investors who aren’t as skilled or don’t have the time to do it themselves are often happy to let a more skilled investor pay them for use of their money, allowing the skilled investor to produce even more control premium. If your friend was going to double the value of the company you share, wouldn’t you go out of your way to let him do it? Now imagine you’re in the driver’s seat. How many houses have you seen that are run-down, dirty, were built too small, or are vacant? Could you fix it up, clean it, expand it, or put a tenant in? That value you create can easily be yours, and that’s one of the things that’s so great about real estate.