In previous columns, I’ve written that assessing authorities must employ appraisal methods which eflect adverse market conditions – foreign competition, government regulations, increasing operating costs and the like – to accurately determine the market value of Northwest industrial property for property tax purposes. The income approach is one of only two appraisal approaches that do so, but it’s deceptively simple.

The income approach determines what a potential buyer will pay for a property today for the right to receive income from owning the plant in the future at a rate that reflects the market’s expected rate of return of – and on – the investment over the investment’s life.

The adverse market conditions affecting the industrial property will be reflected in the income the investor can expect to receive in the future. Likewise, the expected rate of return will reflect the risks the market perceives as inherent in that specific industry or in that specific property.

The income approach is deceptively simple because it consist of only two factors – an estimate of the future income from the operation of the property and an estimate of the required rate of return (the discount or capitalization rate).

Unfortunately, assessors who employ the income approach make a number of mistakes in estimating the future income of an industrial property that can result in significant overvaluations.

How the income approach is applied

Investors determine the market value of an industrial plant by analyzing two types of income; the net cash flow from the plant during the life of the investment and the income received when the plant is sold in the future. Think of a rental house you may own. Now only do you receive the rents for a period of years but you receive the appreciation on the house when you sell it. The market value of the rental house reflects the present value of the future cash flow (rents) and the appreciation (terminal value) you can expect to receive when you sell it Both net cash flow and appreciation of an industrial plant must be reasonably estimated to arrive at a valid market value for property tax purposes.

Net cash flow is simply dollars coming in minus the dollars paid out. It’s the dollars you buy beer with at the end of the day. This is different from an accountant’s estimate of net income or operating profit.

To determine net cash flow, noncash items (such as depreciation) are added back to the income stream. Likewise, because investments in industrial plants are long-term, capital expenditures to replace plant and equipment and annual maintenance expenses must be subtracted from the plant’s revenue to arrive at net cash flow.

Assessing authorities are happy to add back depreciation to increase the amount of net cash flow, but they underestimate the amount of future capital expenditures and normal maintenance and repair necessary to keep the plant in operation. Over time, capital expenditures must be at least equal to depreciation. Otherwise, the plant would physically deteriorate and it’s income stream would be reduced.

Predicting the amount of future net cash flow and investor can expect to receive over the life of an investment is fraught with error. Assessing authorities often use the actual net cash flow of the plant on the assessment date as the base year and then increase it from year to year by a percentage growth rate. By assuming an industrial plant’s net cash flow will increase by, say, 2 percent per year for the next 10 years and in some cases, into perpetuity, and assessor can develop a fantastically high value of the industrial plant that bears little relationship to reality.

A better method is to look at either the historical average of net cash flows of the plant over the last five years or the projections made by management in budgets or strategic plans. However, a couple caveats – historical averages are only appropriate if the same factors that resulted in those cash flows are expected to continue in to the future. Likewise, management’s projections must be based upon realistic assumptions about the future, not upon optimistic hopes of a turn around.

Finally, at the end of the life of the investment, an investor receives income from the sale of the industrial plant. This terminal value must be calculated, discounted to present value and added to the present value of the net cash flow to arrive at a final opinion of the market value. Assuming an industrial property is properly maintained and economic conditions continue to allow the property to operate profitably, the terminal value will reflect the present value of its future sale price. On the other hand, if money was not spent over the years to replace worn-out equipment or to perform normal yearly maintenance, or if the plant suffers from economic obsolescence, an industrial property may be worth no more than salvage value at the end of the life of the investment.

The income approach is a powerful tool to measure market value accurately, but only when it’s properly employed. Failure to make consistent and reasonable assumptions in predicting future income can lead to significant errors in the final estimate of the market value of an industrial property.

David L. Canary has specialized in state and local tax litigation for the past 18 years. He has worked for the past 13 years as an owner in the Portland office of Garvey Schubert Barer and prior to that was an assistant attorney general representing the Oregon Department of Revenue. He has the distinction of trying several of the largest tax cases in Oregon’s history. He is the Oregon member of American Property Tax Counsel and an active member of the Association of Oregon Industries’ Fiscal Policy Council.