Hotel revenues are entering a post-pandemic rebound, but what about taxable property values? Although revenues are bouncing back, it does not mean hotel values for property tax assessments have reached pre-pandemic levels.

Recovering revenue is only part of the valuation story. To protect themselves from unfair tax bills, hotel owners may need to clarify to assessors how the pandemic's aftermath is affecting their properties. These taxpayers should point out factors that drag down their hotel's bottom line and provide grounds for reduced assessments.

Here are three factors that can offset increased revenue and lower market value. Hotel owners should consider each in preparing arguments for an assessment reduction.

A stabilized expense estimate calculates the ongoing operational costs of the property under typical, sustainable conditions. Obviously, expenses have been anything but typical, due to labor shortages, inflation and supply chain issues.

Operating expenses went through the roof during the pandemic and stayed there. Payrolls increased dramatically, for example, in large part due to the "Great Resignation" that sparked a labor shortage and higher wage demands from current and prospective employees. Historic inflation increased hotel costs for supplies, food and beverages, service delivery and amenity offerings. Utilities and maintenance expenses shot up as well. Taxpayers should show assessors how these swelling costs have lowered margins.

Some short-term pandemic-related measures require special attention. To bolster margins, many hoteliers reduced staff counts, services, and room turnover. It is unclear whether these changes are sustainable in the long term, as consumers demand lost services and amenities. It may be inappropriate to factor short-term cost-cutting methods into a value analysis because they do not reflect stabilized expenses and could distort the hotel property's true market value. In those situations, it may be necessary to use market expenses instead of actual expenses from the profit-and-loss statement.

As a corollary to expenses, consider a hotel's reserves for replacements as the industry emerges from the pandemic. A reserve for replacements is money hotels set aside to cover major capital expenditures beyond normal operating expenses. Recognizing that hoteliers were hurting during the pandemic, many hospitality brands temporarily relaxed property improvement requirements. In turn, hotel operators may have deferred capex for maintenance and renovations due to financial constraints.

Coming out of the pandemic, hotel owners may need to set aside a larger reserve percentage as the industry recovers. Reserves for replacements have historically been between 3 percent and 5 percent of revenue for full-service hotels and 4 percent to 6 percent for select-service hotels.

Depending on the individual property and its brand, it might be appropriate to increase those percentages briefly while the property is brought back up to standards. The increased deduction would lower net operating income, which consequently would lower the market value. If a property has fallen below brand standards, it should be factored into the hotel's valuation and brought to the local tax assessor's attention.

A benchmark for industry risk, cap rates are simply the relationship between NOI and value. When cap rates go up, values go down.

Interest rates have a direct impact on cap rates: As interest rates go up, raising the cost of debt and equity, cap rates climb. The Fed's recent interest rate hikes have driven up cap rates, pressuring down hotel values.

In many cases, the interest hikes have made it unviable to build or buy new hotels and have made hotel ownership riskier altogether. The question becomes, how should cap rates factor into property tax assessments?

There are several ways to derive cap rates for hotels, and taxpayers should consider all the methods to know which provides the most persuasive grounds for value reduction. Many tax assessors derive cap rates through market extraction by looking at the sale of comparable properties. That method ignores interest rate increases and incorporates intangible value, which is generally not taxable and hard to extract from overall value.

The band of investment method is a helpful way to derive cap rates and involves building up separate cap rates for a property's debt and equity components. This can be advantageous because it accounts for interest rate increases, which the market extraction method does not. Tax assessors need to consider the effect of interest rate hikes on cap rates, as it can create a path to lowering a hotel's tax burden.

Recent hotel revenue recovery only tells part of the story for property tax assessments. To control property taxes, hoteliers and asset managers must highlight how growing operating expenses, reserves for replacements and cap rates diminish market values. Each taxing assessor has a unique perspective on valuation, so it is always helpful to engage knowledgeable, local tax professionals to help ensure hotel owners are maximizing tax-saving opportunities.

When the early pandemic sent hotel occupancies plummeting and uncertainty soaring, it also created clear opportunities for many hotel operators to reduce property tax bills by appealing their assessments.

Today, however, it can be difficult to know whether appealing an assessment still makes sense. Record selling prices are being reported on a macro level despite increasing interest rates, rapid inflation and ongoing unpredictability in many markets. This gives taxpayers a potentially confusing array of mixed messages affecting valuation.

Hotel operators should heed the real estate adage that "all properties are unique," a saying that certainly rings true in the current hospitality market. To really understand hotel values, it has become essential to delve into what drives demand at each property.

Value Judgments

I recently heard an appraiser sum up the hotel market recovery as follows: "At the beginning of the pandemic, we thought it was going to take five years [for hotels to recover], but it turned out it was more like two to three," he said. "And if a property isn't recovering by now, then it's probably not going to."

This was, admittedly, an oversimplification, but it seems to reflect the reality in many places.

Laurel Keller, an EVP at of Newmark Valuation & Advisory's gaming and leisure division, observed that the recovery has been uneven across different markets and hotel types. "I've seen a range of recoveries, from midscale hotels that recorded their best top-line revenue and profit margins ever last year, to full-service hotels still performing at levels below pre-pandemic," Keller said. "In most instances, average rate growth has been substantial over the past 18-plus months, though occupancy recovery has been slower."

So, how can an owner or operator know if their hotel is fairly assessed?

For property tax purposes, most states recognize that hospitality properties are operating businesses (also called going concerns) of which real estate is only one value component. The other components are the furniture, fixtures and equipment, and the intangible business value.

To reduce property taxes, an owner must challenge the assessor's property value assessment, and that value pertains only to the real estate component. Failing to prove the proper allocation of overall value among the going concern components can result in an owner paying taxes on non-taxable property.

Two Approaches

There is widespread agreement that a lodging operation carries a business value that must be separated from the real estate to determine taxable property value. However, for the past two decades there has been debate about how to tease out those separate values. This ongoing discussion is dominated by two generally accepted valuation methods. The more conservative of the two assumes that the removal of management and franchise fees from the income stream offsets the hotel's business value. That approach gained favor in many jurisdictions in the early 2000s for its straightforward and simplistic nature.

Several prominent court decisions in recent years have endorsed a more robust analysis, however, to ensure that all non-taxable assets are removed from the real estate assessment. This more detailed approach considers the values associated with intangible items such as a trained workforce, reservation systems and brand goodwill.

One expert witness recently described post-pandemic hotel analysis as "granular," and noted that seemingly minor differences between properties have become more important than ever. As an example, he pointed to two properties in his market with the same flag which would have been considered comparable three years ago, but subtle differences in their locations relative to office submarkets, sporting facilities, and hospitals could now make a big difference in performance and valuation. Despite appearing similar on the surface, each property has unique demand factors.

In a similar vein, an owner of hotels throughout the United States used the term "hyperlocal" to describe property performance in 2022. As an example, the owner cited two upscale hotels about a mile apart from each other in the same submarket, just outside of a large metropolitan area. Pre-pandemic performance at both properties was similar and relatively predictable. Today, the property slightly closer to the airport is thriving while the other struggles to get back to 2019 performance levels.

It also can be difficult to make sense of the news around recent acquisitions. Even as billions of dollars are pouring into the extended-stay sector nationwide, owners in some markets are looking to convert their extended-stay properties to apartments. Similarly, 2022 has seen significant investment in hotels along interstate highways despite indications that occupancy may be starting to decline in that subsector.

"Pandemic recovery has varied widely from property to property and market to market and been far more protracted for some hotel assets," Keller said. "More surprisingly, we are now seeing performance decreases at some hotels that experienced a surge in leisure-oriented travel last year. So, the recovery is ongoing, and perceived rapid recovery at some hotels may have been slightly misleading."

Perhaps the key takeaway from all this is that the reported "recovery" in the industry doesn't equate to a recovery for every hotel.

Just as all properties are unique, all taxing jurisdictions have their own rules and idiosyncrasies. Understanding the intersection between accepted appraisal practices and a jurisdiction's particular laws around the assessment of going concern properties is essential to ascertaining whether a particular hotel is fairly assessed.

Operators seeking assistance in evaluating their property tax assessments should lean toward qualified appraisers and tax counsel with local knowledge, which can help identify opportunities to right-size taxes and articulate the narrative behind each property in question.