Traditional Northwest industries such as wood products, paper, and food processing have been in decline due to government regulation (e.g. the Endangered Species Act), foreign competition (globalization), and increasing operating costs (high energy prices, increasing wages and benefits). Consequently, mills and plants in these industries face declining margins that have lead to unprecedented closures. In turn, the market value of the real and personal property of industrial plants remaining in operation has declined. But not their property taxes.

As discussed in an earlier column, property taxes of industrial property have not declined because assessing authorities base their assessment upon the historical investment made in the plant. This cost approach ignores current economic reality. In appraisal terms, the cost approach does not, and cannot, measure economic obsolescence (i.e. regulation, globalization, increased operating expenses) that decreases the market value of industrial property.

Industrial property exists for only one reason – to manufacture goods and products that produce a return to the owner. When that return declines, the value of the plant declines. To reflect current economic reality, industrial plants must be valued by an income approach – utilizing the net income or cash flow from the manufacture and sale of the goods and products the industrial property produces.

Among assessors, the use of the income approach to value industrial property is controversial. Assessors readily accept the income approach to value office buildings, warehouses, and other commercial property because these properties are leased and capitalization rates can be readily determined from market sales. However, industrial properties typically are owner-occupied and are not leased. Unlike commercial property, the operating income from an industrial property is produced by not only the real property (land and buildings); but, also, from the machinery, equipment, personal property, working capital and intangible assets. Despite the fact that the income approach is a better indicator of the current value of an industrial plant because it takes into account economic obsolescence, assessors scorn its use because of the perceived difficulty in separating the value of the real and personal property from the value of the non-assessable and intangible assets. In short, assessors argue the income approach cannot be used to value industrial property because it values the business enterprise and not the assessable real and personal property.

This argument can be easily overcome. The following equation better illustrates the components of business value (BV) measured by the income approach:

BV = CA+ FA + IA = CL + LTD + SE

Where CA = Current Assets
FA = Fixed Assets (real estate, machinery and personal property)
IA = Intangible assets (that are non-assessable)
CL = Current Liabilities
LTD = Long-term debt
SE = Shareholder’s equity

Accountants and CFOs will recognize this equation as a typical balance sheet. The question is how to isolate the market value of the fixed assets in the income approach.

Simple algebra reduces the equation to:

BV = (CA – CL) + FA + IA = LTD + SE
= WC + FA + IA = LTD + SE

Of course, (CA – CL) is the definition of working capital (WC). Working capital is non-assessable in most states. The market value of working capital (cash, receivables, inventories, etc.) can be easily, and accurately, determined -- leaving only the market value of the intangible assets to be eliminated to arrive at the value of the fixed assets.

Intangible property is non-assessable in Oregon and includes software, good will, customer lists, contracts, patents and trademarks, assembled work force and trade secrets. The owner of an industrial property invests in intangible assets in one way or another – e.g. skilled work force by wages and benefits, trade secrets by R&D – in the hopes of a return on that investment above its cost. Because of economic obsolescence, a struggling industrial plant with very low margins enjoys little return on intangible assets. Because the cost of creating and maintaining intangible assets are already reflected in the income stream as costs of doing business, their market value has already been accounted for in the above BV equation.

Thus, after calculating the BV of an industrial plant by the income approach, one has but to subtract the working capital from the equation to arrive at the market value of the fixed assets:

BV – WC = FA

Of course, the devil is in the details. The two components of the income approach – the income stream and the discount, or capitalization, rate must be accurately calculated to arrive at market value. These two components will be discussed in future columns.

For the past 18 years, David L. Canary has specialized in state and local tax litigation. First, as an Assistant Attorney General representing the Oregon Department of Revenue and, for the past 13 years, as an owner in the Portland office of Garvey Schubert Barer. Mr. Canary 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 Association of Oregon Industries’ Fiscal Policy Council.