" A group of eight hotel owners retained Sean Hennessey to explore the valuation of hotel real estate not by extracting business value but by determining what the hotel real estate itself would rent for. The research examined the rental of the hotel property by a non-hotel affiliated owner to a hotel operator similar to the rental of an office or apartment. The results were striking. "
Property taxes remain a major expense for hotel owners and operators. For the first time in many years, exciting developments in the valuation of hotel properties provide optimism for the significant reduction of these expenses. The first development is the increased acceptance of a new valuation methodology that results in increased deductions for the business value portion of the hotel operation. The second is the re-emergence of the use of whole-property leases as an indicator of the real property value of a hotel business.
Hotel owners know that the investment in and operation of a hotel is much different than other types of real estate such as office buildings and apartments. They know that hotel properties contain a business value component in addition to real estate and personal property. Although taxing authorities generally agree that a hotel involves more than just the rental of space, this is apparently the extent of the agreement. There is no agreement over the methodology for the identification and the quantification of business value. Further whatever agreement there is seems to be ever changing and elusive.
A brief history is useful to an understanding of the lack of agreement. In the early 1980's, hotel owners supported a valuation methodology, which accounted for business value through a deduction of franchise fees and management fees. The applicability of this approach was the primary debate between owners and tax authorities. By the mid-90's, tax authorities had generally accepted this approach only to find it rejected by owners. As more study was given to the area, owners argued that management and franchise fees were nothing more than an expense to the owner and did not represent an indicator of return on the business portion of a hotel. Thus owners sought new ways to explain business value and its deduction for property taxes.
By 2000, David Lennhoff and other hotel appraisers developed methods that quantified business value differently than just a deduction for management and franchise fees. Their methodology provided that to arrive at the real estate portion of a hotel going concern, it was necessary to extract the business value as represented by start-up costs and the residual intangibles of the going concern. These concepts were consistent with the Appraisal Institute's textbook, the Appraisal of Real Estate, and Course 800: Separating Real and Personal Property from Intangible Business Assets. Yet acceptance by the tax authorities was slow.
The first exciting development for property owners is not the development of this methodology but its initial acceptance. Recent trials in New Jersey and Tennessee involved a direct comparison between the old method and the new method. In both instances, the court ruled that the new method was preferable for the purpose of extracting out the business value for property tax purposes. This is the possible start of a growing acceptance of this theory.
The second development comes from Texas. A group of eight hotel owners retained Sean Hennessey to explore the valuation of hotel real estate not by extracting business value but by determining what the hotel real estate itself would rent for. The research examined the rental of the hotel property by a non-hotel affiliated owner to a hotel operator similar to the rental of an office or apartment. The results were striking. The results indicated a rental of the real estate for a range of six to thirteen per cent of revenue on an absolute net basis. This correlated closely with the extraction method.
These two developments will provide dramatic opportunities for property tax reductions. The adoption of a valuation methodology by the courts is typically the first step in adoption by the tax authorities. As more courts agree so will more tax authorities. The whole-property lease approach frames the methodology in a context easily understood by tax authorities and lends further support to the business value methodology. Based on the early results, it appears that used in conjunction, hotel owners may experience significant reductions in their property taxes.