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Property Tax Resources

Dec
02

Beware the Income Approach to Property Tax Assessments

A hotel business relies on much more than the combination of daily room rentals to generate income. Understanding this fact is critical to achieving a fair and accurate property tax assessment, because only the tangible portion of the hotel operation is taxable.

A fundamental issue in virtually every hotel property tax case is the question of how to allocate value among the taxable tangible assets and non-taxable intangible assets. Tangible assets include the land, building, furniture, fixtures and equipment. The intangible assets generally include the hotel brand or franchise, the management team, the assembled work force, contracts with vendors and customers, and any goodwill stemming from the hotel’s operations. The appraisal community has debated how to allocate among these assets for the last 30 years, yet significant divisions remain.

When valuing a hotel for property tax purposes, most assessors will attempt to utilize the income approach: They simply deduct the expenses from the hotel’s revenue and divide the resulting net operating income by a capitalization rate, just as they would if appraising an office building or an apartment complex. The resulting value is meant to mirror what the property would sell for under prevailing market conditions.

The problem with this analysis, of course, is that it fails to recognize the significant portion of hotel income that flows from non-taxable intangible assets. These non­taxable assets are present in nearly every hotel transaction, but should not be incorporated into a property tax assessment.

To understand this misapplication of the income approach, it is helpful to view the relationship between a business’ income and the real estate the business happens to occupy. On one end of the spectrum are office buildings and apartment complexes. These commercial enterprises derive almost 100 percent of revenue from the direct rental of real estate.

On the other end of the range are service oriented businesses like law firms. A law firm’s revenue derives purely from services rendered, and bears almost no relationship to the rent paid to occupy office space. As a result, an appraiser would never determine the value of a law firm’s office space by capitalizing the firm’s net operating income. Yet this is exactly how many assessors value hotels.

This is not to suggest that hotels are pure service businesses like a law firm. Hotels are hybrid businesses that fall somewhere in the middle of the range between these two extremes. While a hotel’s revenue is not limited to rent, there are certainly portions of the income which are directly attributable to the hotel’s real estate and taxable personal property. The key is to differentiate, if possible, how the income is derived from the different classes of assets.

Parsing out the income streams attributable to the taxable and non-taxable assets is an absolute requirement when an assessor applies the income approach to a hotel’s property tax assessment. Tax assessors routinely ignore this task, however. If they recognize the concept of intangibles at all, many simply deduct a standard percentage – say 20 percent – to reflect the hotel’s non-taxable assets.

The taxpayer must demand more. If the assessor is using the same methodology to value your hotel as he or she uses to value an office building, there is a problem. Engage an expert who understands the allocation of intangible assets, and ensure that your hotel’s property tax value is limited to the value of your taxable assets.

Mark_Hutcheson90Mark Hutcheson is a partner with the Austin, Texas law firm of Popp Hutcheson PLLC. The firm devotes its practice to the representation of taxpayers in property tax disputes and is the Texas member of the American Property Tax Counsel (APTC), the national affiliation of property tax attorneys. Mr. Hutcheson can be reached at This email address is being protected from spambots. You need JavaScript enabled to view it..

 

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Oct
23

A Taxing Issue

Have Your Intangible Assets Been Included in Your Property Tax Assessment?

"It is important to identify and remove potential intangible assets in any property tax valuation."

By Mark S. Hutcheson, Esq., CMI, as published by Commercial Property Executive, October 2012

What's the difference between an income tax and a property tax? The answer seems simple, but it is one lost on many assessors when valuing property for ad valorem taxation. Most people understand that income taxes reflect the income a business generates. Property taxes, by contrast, are based on the value of the tangible assets of a business. Some assessors lose that distinction when applying the income valuation approach, however, and fail to identify and properly remove non-taxable intangible assets.

As a general rule, assessors determine property tax value using one or more of three methods: the sales comparison, income and cost approaches. For commercial properties, assessors and appraisers favor the income approach because it mirrors the method buyers most often use in the open market. When this approach is used to determine the value of taxable property, however, the net operating income (NOI) must exclude any income stream attributable to an intangible asset. 

Intangible property includes assets that have value but are nonphysical, including franchises, trademarks, patents, copyrights, goodwill, equities and contracts, according to The Dictionary of Real Estate Appraisal. Intangible value cannot be imputed to any part of the physical property.

Many commercial businesses have franchise agreements, contract interests and goodwill. These intangible assets are separate and distinct from the physical assets of the business and are generally nontaxable, so the assessor must remove them when determining a property's taxable value. The first step toward that end is to identify the specific intangible assets that contribute to business income.

The operation of a hypothetical hotel provides a simple illustration. A hotel's income stream clearly includes the owner's taxable return from the land and building, but it may also include a host of intangible items that must be removed before the NOI is capitalized into a taxable value. These items may include the hotel's brand; the assembled and trained workforce; maid, concierge and security services; food and beverage outlets; and spa services. Just as the building and underlying land of a McDonald's should not be valued based on the number of hamburgers the restaurant sells, the service and brand components of a hotel's income must be excluded from the value of the taxable assets. While hotels and restaurants are clear examples, it is important to identify and remove potential intangible assets in any property tax valuation.

The proper identification of intangible assets can be more difficult in properties that primarily derive rental income. The tendency is to assume that if a property rents, all of the income is directly attributable to its tangible assets. While this is generally true, there are a few notable exceptions. Above-market leases are properly classified as intangible assets and should be excluded from property tax valuation. An above-market lease creates a contract right that may not be reproducible on the open market.

The Appraisal of Real Estate, published by the Appraisal Institute, provides that "a lease never increases the market value of real property rights to the fee-simple estate. Any potential value increment in excess of a fee-simple estate is attributable to the particular lease contract, and even though the rights may legally 'run with the land,' they constitute contract rather than real estate rights."

This concept can be expanded to other rental-related agreements, like anchor concessions and a shopping center's tenant mix. For example, assume the owner of a shopping center has relationships with several national tenants that rent space in the owner's centers in other locations. If the owner can persuade a few national tenants to rent space in a new center (possibly through concessions or other business agreements), the result is often a synergy that allows for higher overall rents and less vacancy. In this example, the higher rents are attributable to the owner's business relationships, rather than the location or condition of the center, and must be adjusted to remove the intangible enhancements. Intangible assets are generally nontaxable and exist in almost every business. If your property tax assessment is based on the income approach, make sure the income being capitalized is attributable solely to the taxable, tangible assets of the property.

MarkHutcheson150Mark S. Hutcheson is a partner with the Austin law firm of Popp Hutcheson P.L.L.C., which focuses its practice on property tax disputes and is the Texas member of the American Property Tax Counsel, the national afi liation of property tax attorneys. Reach him at This email address is being protected from spambots. You need JavaScript enabled to view it..

 

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Feb
27

Why Inflated Tax Assessments Persist

"Under most states' property tax laws, your assessment should reflect the purchasing power of a typical buyer, not that of an extraordinarily well-capitalized investor..."

By Mark S. Hutcheson, Esq., as published by National Real Estate Investor, January/February 2011

With well-capitalized buyers driving transactions, assessors routinely overstate taxable property values. Real estate investment trusts (REITs) and insurance companies are big buyers of commercial real estate these days, and their advantage in the capital markets is driving up prices. In turn, assessors are using the price data generated from these sales to institutional buyers to produce inflated taxable values for commercial properties owned by less-capitalized investors.

Assessors typically value commercial real estate using a direct capitalization income approach by dividing the property's annual net operating income (NOI) by an overall capitalization rate. The NOI can be based on the trailing 12 months or projected over the next 12 months.

Determining a proper capitalization rate, however, is often more challenging. That's especially true in this economic environment. An overall cap rate reflects the relationship between a single year's net operating income expectancy and the total property price or value.

Crux of the problem
To determine cap rates, assessors usually look to sales of comparable commercial properties. Relatively weak transaction volume since the start of the recession, however, has forced assessors to extrapolate cap rates from the small number of transactions that have occurred.

These sales increasingly involve high-priced properties sold to well-capitalized institutions. Deal volume for assets priced at $25 million or more rose 126% for the first 11 months of 2010 compared with the same period in 2009, says Real Capital Analytics. From this data, assessors will likely derive cap rates that reflect the buying power of well-capitalized buyers and apply those rates to all investment-grade property.

REITs and insurers have access to particularly low-cost capital resources. Their strategy primarily has been to focus on acquisitions of large, core assets in major cities. Low-cost capital enables these investors to achieve greater returns on lower cap rates than average investors.

Insurers also have far lower default and delinquency rates on loans than other lender groups. The 60-day delinquency rate for commercial mortgages originated by life insurance companies was just 0.29% at mid-year 2010, reports the American Council of Life Insurers.

Compare that with loan delinquencies in commercial mortgage-backed securities at greater than 7%, according to credit rating agency Realpoint. Meanwhile, Real Capital Analytics pegs the commercial real estate loan delinquency rate for banks at 4.28%. Low delinquencies mean insurance fund managers are able to focus more on deploying capital and less on working out distressed assets.

Doing the math
Increasing acquisition volume by well-capitalized buyers gives assessors market data to support lower cap rates, as the following hypothetical example illustrates. LRG, a large insurance company, purchases an office building with a $650,000 NOI for $10 million, reflecting a 6.5% cap rate. SML, a small real estate investment firm, seeks to buy a comparable building across the street that also generates NOI of $650,000.

Due to SML's lack of capital and lower credit rating, the firm's debt structure on the deal is approximately 300 basis points higher than that of LRG. SML would need to purchase the property at an 8% cap rate to achieve the same return at 50% loan-to-value.

SML offers to purchase the building for a little more than $8 million. However, because this price is significantly lower than the LRG purchase price across the street, the seller backs out and the transaction never occurs.

Should the assessor use the 6.5% cap rate reflected by the LRG purchase, or adjust the rate to reflect what a more typical investor like SML might offer in the open market? This is the issue confronting assessors and those who represent property owners in ad valorem tax disputes.

Under most states' property tax laws, your assessment should reflect the purchasing power of a typical buyer, not that of an extraordinarily well-capitalized investor. A careful review of how the assessor arrived at both the value and the underlying cap rate is critical to ensure your property is fairly assessed.

MarkHutcheson140Mark S. Hutcheson is a partner with the Austin, Texas, law firm of Popp, Gray & Hutcheson LLP, the Texas member of American Property Tax Counsel. He can be contacted at This email address is being protected from spambots. You need JavaScript enabled to view it..

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Oct
15

Mistaken Reform

How Property Tax Caps Increase Your Tax Burden

"Attacks on the property tax continue. Yet as the table indicates, during the past five years, property taxes have risen no more rapidly than the average of the three tax areas.."

By Mark S. Hutcheson, Esq., as published by Commercial Property Executive, October 2010

Complaints about the burden of ever increasing property taxes are a common refrain. Many property tax reform efforts miss the mark, however, and set the stage for greater inequity from misguided attempts to cap valuations.

In New York state, which has seen strong debate over capping property tax growth, the Senate passed a provision to cap property taxes at 4 percent, while several gubernatorial candidates are touting a 2 percent limit. New Jersey recently passed a 2 percent cap on property tax increases. Voters in Colorado, Louisiana and Indiana will consider tax caps or rollbacks this November.

Attacks on the property tax continue. Yet as the table indicates, during the past five years, property taxes have risen no more rapidly than the average of the three tax areas. (Property tax represents 30 percent of all taxes, sales tax 33 percent and personal income tax 22 percent).

Mistaken_Reform_graph

While one of the most popular efforts is to limit or cap increases in taxable property values, this argument diverts attention from more meaningful budget and spending discussions. Texas, for example, has experienced several unsuccessful attempts to restrain value increases as a means of limiting property tax growth.

A report published by the Lincoln Institute of Land Policy in 2008, titled "Property Tax Assessment Limits: Lessons from Thirty Years of Experience," concluded that, "assessment limits are often put forward as a means of combating two problems popularly associated with rapidly appreciating property values: increasing tax bills and the redistribution of tax burdens.

In fact, 30 years of experience suggests that these limits are among the least effective, least equitable and least efficient strategies available for providing tax relief."

Equality of taxation is one of the foundations of a tax system, and sound public policy recognizes that valuation caps are an ineffective limitation on property taxes. The reasons for this are numerous.

Like all artificial limits, a cap creates grossly unequal values within and among different classes of properties. An appraisal cap creates disparities between a property valued at market and another valued with a cap, so that two identical properties are treated unequally. A cap placed on residential shifts the tax burden from residential to commercial property. If both residential and commercial are capped, there will be a long-term shift from commercial to residential, because homes change hands more frequently.

Caps create unfair competitive advantages as well. Properties that lose a value cap—including newly built, purchased or remodeled assets—will be at an economic disadvantage. On the commercial front, where retail and office leasing is highly competitive, new owners that do not benefit from a cap will likely be forced to reduce their profit rather than quote a higher rental rate than competitors. And an investor may decide not to develop in a market where competing properties receive a cap, rather than compete directly with landlords that can charge less rent to make the same profit.

Moreover, caps increase taxes for owners of personal property, and here is why: Caps seldom apply to personal property at manufacturing plants, refineries, chemical plants or utilities, so a cap shifts the tax burden to these types of properties. Typically, local governments raise tax rates to balance the budget shortfall created by the cap on real property. That means personal property taxpayers will pay based on full market value, and at higher tax rates.

There is also a direct effect on land use that can work against personal property taxpayers in a different way. Communities that limit property value increases compete for retail properties that can generate sales tax income. New housing and non-retail properties become undesirable because they provide less tax growth and increase infrastructure demands.

If there is no limit on tax rates, the cap will simply shift the variable in the property tax equation from the property's value to the taxing unit's tax rate. At best, the property owner's tax bill will remain where it was. At worst, the bill will increase significantly if the taxpayer purchases or improves a property, because they will then lose the benefit of the cap and be required to pay at full market value and at a higher tax rate. In 2010, it is painfully clear that a cap impairs a local government's ability to pay for critical services when state and federal revenues wane and local mandates increase. This shifts governmental control from the local level to the state. Caps impair infrastructure development and result in the imposition of a wide number of local fees and charges to replace property tax revenue. Thus, artificial limits on appraised value have unintended negative consequences. Taxpayers and government alike are better served by pursuing more effective and fairer mechanisms for property tax relief.

MarkHutcheson140Mark S. Hutcheson is a partner with the Austin, Texas, law firm of Popp, Gray & Hutcheson L.L.P., which focuses on property tax disputes and is the Texas member of the American Property Tax Counsel. He can be reached at This email address is being protected from spambots. You need JavaScript enabled to view it..

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Apr
24

The Appeal of Tax Appeals

"If there is one saving grace to this downturn, it's that hotel owners can reap big savings by combating their property taxes."

Interview with APTC Members, by Maria Wood - as published by Hotels Interactive - April 2010

The April 15 deadline for filing tax returns has passed. But for savvy hotel owners, an in-depth review—or possibly an appeal—of their property taxes could net a big refund.

As the lodging sector continues to bleed cash, more and more owners are pursuing property tax appeals to lessen what is typically one of a hotel's largest expense items. Yet while the reward in terms of a reduction can be great, the process is not easy, especially with many jurisdictions fighting to hang onto every last dollar of tax revenue during a lingering recession.

Hotel Interactive spoke to a trio of members of the American Property Tax Counsel (APTC), a national affiliation of attorneys that specialize in property tax appeals. All agree they are seeing more hotel owners fighting their property tax assessments.

"You are seeing significant drops in RevPAR, ADR and all the metrics that hoteliers look at," relates Mark S. Hutcheson, a partner at Popp, Gray & Hutcheson L.L.P. in Austin, TX. "That, combined with assessing communities seeking to maintain their tax base, means you are necessarily going to come to a head."

No income-producing property sector has escaped unscathed from the economic maelstrom. But hotels may have been hit hardest and therefore, owners are battling more aggressively now.

"What we are finding is that more hotel properties are actually litigating their values now than in the past," Hutcheson says. "The reason why is because hotels—of all the different property types—have probably experienced the greatest decline in value, which is directly related to their drops in revenue."

In fact, Fitch Ratings predicts that hotel property values may recede as much as 50% from their peak in 2007.

But just how do you value a hotel in a flat or declining market? The historical measurement of comparable property sales, which gives a snapshot of current cap rates, is of little value when few hotels are being sold these days. And to look back at sales completed at the height of the market distorts the present value of a lodging asset.

According to the APTC attorneys, there are myriad methods to value a hotel in a stagnant market, and they typically revolve around the all-important issue of what is an appropriate cap rate for a specific hotel in today's marketplace.

Stewart L. Mandell, a partner at Honigman Miller Schwartz and Cohn, L.L.P. in Detroit, says that he has used what is known as the income approach with great success in resolving valuation disputes between a taxpayer and a taxing authority.

According to Mandell, among the tools that use income and cash flows to determine a property's value are the direct capitalization and discounted cash flow methods.

In the direct capitalization method, a hotel's value is calculated by dividing the property's net operating income by an appropriate capitalization rate. In a discounted cash flow model, the net cash flow for each year during a given period is determined. Then, Mandell explains, the present value of each year's cash flow is added along with the current value of the property at the end of the period.

One point of contention between taxpayer and taxing jurisdiction is what revenue stream to use when valuing a property. According to Hutcheson, tax assessors may argue that 2009's poor showing was an aberration and that a property's stabilized income should be greater, more in the range of 2000-08 levels.

Conversely, taxpayers maintain that market conditions have changed dramatically for hotels and 2009 may end up being more of the norm than the peaks experienced in 2007 and 2008, Hutcheson says.

Due to the lack of meaningful sale transactions, Hutcheson's firm has recently applied the band of investment approach for determining cap rate. This formula usually yields hotel cap rates in the 10 to 12 percent range.

In that methodology, several factors are considered, such as the cost of debt and equity as well as what current loan-to-value ratios look like. However, Hutcheson points out that one of the disadvantages to the band of investment approach is the lack of market data for the equity dividend rate, or the return an investor would require on a down payment after debt services.

At the heart of that equation is whether a buyer thinks there is upside potential in a prospective acquisition.

"If, for example, the investor looks at a trailing 12-month income stream and thinks the property is going to do significantly better, then you'll end having a lower cap rate," Hutcheson says. "The same is true if the assessor for 2009 were looking at a trailing 12-month income stream over the last 12 months of 2008. There would probably be downside potential in that cap rate, because going forward there was an expected decline.

"What most taxpayers are having struggles with now is how to develop a cap rate when there aren't any transactions, when the surveys [of cap rates] have very large spreads between buyers and sellers and where it's very difficult to relate that cap rate to whether there is upside or downside potential in the income stream," Hutcheson continues.

As if that weren't enough to make valuing a hotel in today's environment more of a hair-pulling exercise, there is also the question of how to separate the worth of the tangible and intangible personal property from the actual value of the bricks and mortar.

Tangible and intangible personal property includes everything from a liquor license and the furnishings in a hotel to the estimated value of a management contract and brand affiliation.

"In some states, such as Michigan, personal property is taxed, so there is a calculation that the assessor comes up with in terms of valuing the personal property," Mandell says. "That one, at least in Michigan, can be pretty easily agreed upon by the parties. But sometimes in those valuation issues, the analysis needs to be pretty sophisticated to give you some confidence that it's given you a number in the ballpark."

In a down market, the issue of how to assess the business value of those tangible and intangible assets becomes particularly thorny, Hutchenson says. "The taxing jurisdictions will seek to allocate as much of the overall value as possible to the taxable value," he says. "Of course, the taxpayers or the hoteliers will seek to allocate [out] as much as possible to mitigate their tax liability."

In many instances, assessors use a cost approach to valuation by calculating the cost to build new and deducting physical depreciation, according to Mandell. A proper cost approach, however, requires also deducting any functional obsolescence (room types that are no longer desirable) and external obsolescence caused by the current economic downturn.

"Especially in a recessionary period, it's the economic obsolescence that causes so much of the loss in value," Mandell explains. "If you look across the board at all sorts of properties, it's the economy that has driven the property values lower. Here in Michigan, we have such properties under appeal, virtually brand new hotels. They are built exactly to be what the market wants today, yet they're performing poorly because of the economy. So if an assessor values that property based on what it costs, less a little bit of physical depreciation, that property is going to be egregiously overvalued."

So what can an owner do if he feels his property, as Mandell states, is egregiously overvalued? What can he expect to recoup if he decides to pursue an appeal? And how much of a pushback will he encounter from a taxing authority?

Much depends on the particular jurisdiction. Some will battle tooth and nail for every last dollar of tax revenue; others may be more open to negotiation.

"You are finding more taxing authorities challenging the appraisals to their assessments," Hutcheson says. "But by and large, most jurisdictions recognize that hotels have been hit hard. The issue is not that there is a decline, the issue is what the magnitude of that decline is. Most assessors and taxing units are obviously trying to hedge as much as possible to maintain their tax base. The issue boils down to negotiation."

For example, Hutcheson can present a cap rate of 11.5 percent using the band of investment approach based on a trailing 12-month income stream for a particular property. Meanwhile, the assessor might counter with a 9.5 percent cap rate, but based on a forecast.

Ultimately, settling on an agreeable value is more important than whatever method is used, Hutcheson finds.

Likewise, Kiernan Jennings, a partner with Siegel Siegel Johnson & Jennings Co. L.P.A. in Cleveland, says that a less adversarial stance may work best and get the taxpayer a resolution sooner. It's not uncommon for tax appeals to drag on for several years.

"When the taxing authorities are looking to hold onto their money longer because of their own circumstances, you need to find win/win solutions to the real estate tax problem," he says. "We've found that by working with the taxing jurisdiction we can come to a settlement that helps both the district and the taxpayer. You need to be creative and understand where [the taxing agencies] are coming from and vice versa. That speeds up the process."

In some instances, the taxing district may be willing to accept a lower assessment for tax purposes in future years in exchange for no break in payments due to a tax dispute. "By reducing the assessment for future years and possibly taking a credit on the reduction for the past year, you can help the tax district even out their budgetary constraints due to overall falling assessments," Jennings says. "If there is a wave of tax reductions coming, and you are able to get to a resolution sooner, you are actually helping the tax district."

Jennings estimates that a successful tax appeal can cut an owner's tax liability by at third of what it was several years earlier.

"If values have fallen by 30 percent and you were properly assessed previously, then you could expect you could reduce your taxes by about 30 percent," he maintains.

Mandell agrees owners can reap a hefty savings on their tax bills, but the exact percentage is hard to pin down.

"The vast majority of hotels that we are seeing need to be appealed because they are excessively taxed," he says. "But whether [the reduction] is 10, 20, 30 or even 50 percent, which we sometimes do see, it varies depending upon the profile of the property and in particular, the income."

Many hotel owners routinely review their property assessments. But all can benefit from hiring an appraiser or property tax attorney, even if the upfront cost is great. "In many jurisdictions, once you establish a value that value carries forward for future years," Hutcheson says. "So it could be the investment that keeps on giving if properly made now. And this is probably the best time to have a thorough, detailed analysis done simply because values are likely to be as low now as they have ever been, or at least over the past five or six years."

Since property tax laws vary from state to state, Mandell advises hiring an attorney that practices in the state where the hotel is located. Moreover, that attorney should be a skilled and experienced trial lawyer.

Equally as important as a skilled lawyer, an owner should find an appraiser who truly understands lodging real estate, Hutcheson adds.

But whatever assessment method is used or whomever the hotel owner hires as his attorney, undertaking, or at least considering, a tax appeal is simply good business.

"Especially these days, when everybody is very focused on the bottom line, it's imperative that people look at their property taxes," Mandell says. "To not appeal excessive property taxation is to throw money away. There is no difference. If you have a property that is excessively valued and excessively taxed, if a property owner doesn't appeal that, it's the same as throwing money away."

 

Hut_Man_Jenn

Stewart L. Mandell is a partner with the Detroit law firm of Honigman Miller Schwartz and Cohn LLP, Michigan member of American Property Tax Counsel (APTC). He can be reached at This email address is being protected from spambots. You need JavaScript enabled to view it..

J. Kieran Jennings is a partner with the Clevland law firm of Siegel Siegel Johnson & Jennings, Ohio and Western Pennsylvania member of American Property Tax Counsel, the national affiliation of property tax attorneys. He can be reached at This email address is being protected from spambots. You need JavaScript enabled to view it..

Mark S. Hutcheson is a partner with the Austin law firm of Popp, Gray & Hutcheson, Texas member of the American Property Tax Counsel (APTC), the national affiliation of property tax attorneys. He can be reached at: This email address is being protected from spambots. You need JavaScript enabled to view it..

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Sep
07

Tax Assessments in Flux in New Market

"During times of market transition, especially from an up market to a down one, taxpayers should spend extra time to carefully analyze their tax assessments."

By Mark S. Hutcheson, Esq., as published by Hotel Journal, September 2008

The hotel market was booming during the past three years. Purchase prices broke records and set historically low capitalization rates. Across this period, investors in more traditional real estate holdings moved into the hospitality segment, seeking to maximize the anticipated bounce following the post 9/11 downturn. While market conditions were great for investors, both asset managers and property tax professionals faced uphill battles at local assessment offices.

In response to the market upswing, assessors lowered cap rates in their valuation models to match those implied from sales prices. Now, with the crisis in the credit markets prompting a market downturn, taxpayers must ensure that their assessments reflect current economic conditions, which indicate relatively flat income projections. The key to fair property tax assessments lies in deriving a proper cap rate—one that does not assume significant upside potential.

Cap rates and upside potential

Generally a lag exists between hotel assessments and current market conditions. The lag is caused by valuation methods that focus on trailing income and expense as well as the use of cap rates from prior-year sales surveys. These factors provide great benefits for owners when the market is going up, but do not bode well for them when the market peaks and starts to turn down.

With a market in transition, assessors commonly err by using cap rates implied from prior sales in the rising market to capitalize current income streams, which show no upside potential. The math is best understood through an example. To keep the example simple, no intangibles are removed from the sale (but they should always be excluded in a proper assessment). Assume a hotel, which was on the market in early 2007, had a prior-year net income of $1 million and sold for $15 million. By dividing the income by the sales price, the transaction implies a low cap rate of 6.6%. At the time of the sale, however, the buyer estimated that the net income would increase by 30% over the following year to $1.3 million. Thus, the cap rate of 6.6% would be adjusted up to the "real" cap rate of 8.6% once the buyer's anticipated upside is taken into consideration.

Utilizing the stabilized cap rate

Now assume the same property is being assessed for tax year 2008. The assessor knows of the prior sale and has calculated the 6.6% cap rate, which he intends to use to value the property. Over the course of 2007, the buyer's expectations were exceeded and the property's net income grew to $1.4 million. The assessor plugs the income information into his valuation model and calculates a whopping $21.2 million for the hotel ($1.4 million divided by .066).

As a result of the changing market conditions, however, the income projections are flat. If the lack of upside potential reflected in the market is considered, the assessor should have used the stabilized 8.6% cap rate, which would have resulted in a value of $16.3 million, approximately a $5 million difference in assessed value.

Losses from sub-prime mortgage holdings have profoundly affected the availability of commercial credit. Lenders with holdings tied to sub-prime mortgages are now scrambling for cash, as investors flee to other sectors of the market. This lack of cash has restricted funds for commercial lending and changed the playing field for hotel transactions. Greater underwriting scrutiny and more risk recognition in interest rates have increased the cost of capital, making deals more difficult to justify.

Unreliability of market extraction

The impact of the current credit crisis is abundantly evident in the market. For example, the share price for one large independent commercial lender dropped from more than $61 last June to around $10 in March, and the lender recently announced it will sell assets to address concerns about a cash shortage.

When interest rates increase because of the lack of commercial credit and with tighter underwriting standards, cap rates must go up to reflect these market conditions. Evidence of this increase however, may be difficult to establish. Assessors typically use the "market extraction" method, which derives cap rates by dividing net income by the sales prices of transactions in the local market.

When the volume of sales transactions declines, the market extraction method becomes less reliable because there are fewer transactions from which to develop an appropriate market cap rate. One alternative is to build up the cap rate through a band -of-investment analysis, wherein a return of and on the debt and equity components can be independently established.

This analysis requires greater knowledge of valuation principles, but may be the best alternative during a time of market transition.

Ensure the assessment matches market

During times of market transition, especially from an up market to a down one, taxpayers should spend extra time to carefully analyze their tax assessments. The underlying valuation methodology and the cap rate applied may not reflect current market conditions concerning income growth and the availability and cost of capital. As the market continues its cycle, the tax dollar saved today will pay dividends tomorrow.

MarkHutcheson140Mark S. Hutcheson is a partner with the Austin, Texas law firm of Popp, Gray & Hutcheson. The firm devotes its practice to the representation of taxpayers in property tax disputes and is the Texas member of the American Property Tax Counsel (APTC), the national affiliation of property tax attorneys. Mr. Hutcheson can be reached at This email address is being protected from spambots. You need JavaScript enabled to view it..

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Apr
08

Improper Use of Cap Rates Proves Costly

"In developing property tax assessments, assessors too often rely on the extraction method and its simple math to generate what they see as a correct cap rate. In fact, the proper extraction and application of a cap rate is a complex calculation that takes into account many factors to provide taxpayers with fair and equitable valuations of their properties."

By Mark S. Hutcheson, Esq., as published by National Real Estate Investor, April 2008

Developing a capitalization rate for tax assessment purposes seems like a relatively simple task. Using the market extraction approach, the one most commonly employed by assessors and appraisers, a property's net operating income (NOI) is divided by the sale price to extract a cap rate. Sounds simple, right? While the math offers no challenge, the proper application of this method for tax assessment purposes presents a quite complex problem.

Property tax assessors and appraisers usually take a few recent comparable sales and do the quick math to establish an applicable cap rate for a property. However, just because the comparable sales look and function similarly to the appraised property does not necessarily mean they are financially similar. This is where the extraction method's complexity comes into play.

What's so complicated?

When using the extraction method, assessors seldom, if ever, consider three critical issues. First and foremost, there must be reliable and sufficient data on the comparable sales. The data should reveal the property's anticipated net income, operating expense ratio, financing terms, lease structure, the relevant market conditions and whether the property was part of a larger transaction.

Second, the NOI must be calculated or estimated using the same factors the assessor plans to apply to the assessed property. For instance, if the assessed property reports net income based on trailing 12-month financial statements, the comparables must report on the same basis.

Effects of improper methods

The following example shows how an assessor's failure to properly utilize the extraction method can cause taxpayers to pay unwarranted property taxes. Let's assume your local property tax assessor in Texas develops a cap rate to value your office building using the market extraction method. In your jurisdiction, the property tax law dictates that an assessor must value the property at market value, based on prevailing market conditions as of a specific date, usually Jan. 1.

The assessor pulls comparable sales data in your competitive market area and corresponding NOI for each sale. Next, he simply divides the NOI by the sales price and determines that 9% represents a market cap rate for your property. This cap rate is then divided into your property's $1.25 million NOI, resulting in an assessed value of $13.9 million. This seems like a simple exercise, but the devil is in the details.

In your review of the assessor's comparable sales, it becomes apparent that the sales transactions he used to generate a cap rate contained below-market rental rates and short-term leases. As a result, the 9% cap rate developed by the assessor to set your $13.9 million value represents a cap rate for properties with significant upside potential.

Your property, on the other hand, has above-market rental rates and long-term leases with national tenants who have outstanding credit. As you investigate the 9% cap rate, you discover that one of the assessor's comparables sold for $5 million and produced $450,000 NOI. The assessor divided that income by the sales price and derived a cap rate of 9%.

Additional research, however, reveals that the property had below-market leases that were about to expire. Further, when you adjust the property leases to market rates, the comparable creates at least a $500,000 NOI. This $500,000 is divided by the $5 million sales price, yielding a 10% cap rate, rather than the 9% rate developed by the assessor.

By applying the 10% cap rate to your property's income of $1.25 million, the assessed value would be $12.5 million. As the accompanying chart shows, you'd cut your property tax assessment by just over $1.4 million.

In developing property tax assessments, assessors too often rely on the extraction method and its simple math to generate what they see as a correct cap rate. In fact, the proper extraction and application of a cap rate is a complex calculation that takes into account many factors to provide taxpayers with fair and equitable valuations of their properties.

By understanding all the factors used in developing your cap rate, you can avoid excessive property taxes.

Mark_Hutcheson90Mark S. Hutcheson is a partner with the Austin, Texas law firm of Popp, Gray & Hutcheson. The firm devotes its practice to the representation of taxpayers in property tax disputes and is the Texas member of the American Property Tax Counsel (APTC), the national affiliation of property tax attorneys. Mr. Hutcheson can be reached at This email address is being protected from spambots. You need JavaScript enabled to view it..

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Mar
11

Mass Appraisals May Lead to High Taxes

"Hotel owners and managers should resist attempts by the taxing authority to use short-cut methods to derive their valuation for property tax purposes."

By Mark S. Hutcheson, Esq., as published by Hotel News Resource, March 11th, 2008

Every year, most assessors across the nation face the daunting task of determining market value for every property in their jurisdiction. By virtue of necessity, they are required to use 'mass appraisal' techniques to value thousands of properties within a very short time frame.

When these mass appraisal short-cuts are used to value hotels, however, the results often yield widely inaccurate valuations for property tax purposes.

Wide-spread agreement exists within the appraisal industry that determining the tangible (taxable) value of a hotel is one of the most difficult tasks. The best minds in the appraisal community differ greatly on the proper way to segregate non-taxable intangibles in hotel valuations.

  • Capitalizing the trailing 12-months net income, but subtracting management and franchise fees as expenses.
  • Capitalizing net income and subtracting a percentage, usually between 20% and 30%, for 'business value.'
  • Applying a standard gross room revenue multiplier (GRRM) for each hotel type.
  • And, most simplistically, taking the year-end RevPar multiplied by 1,000, multiplied by the room count.

If these approaches yield a proper assessment, it is just by coincidence. Applying a standard adjustment for business value or a GRRM may yield acceptable values. But, an owner who accepts this kind of short-cut method in one year may face totally unacceptable values in future years when market conditions change.

Hotel owners and managers should resist attempts by the taxing authority to use short-cut methods to derive their valuation for property tax purposes. This calls for owners to perform an independent analysis every year by using market income, adjusting for the return on and of start-up costs and business personal property and employing appropriately determined capitalization rates. Such an analysis provides owners with the necessary data to begin discussions with the assessor for more accurate and equitable tax assessments on their hotels.

MarkHutcheson140Mark S. Hutcheson is a partner with the Austin, Texas law firm of Popp, Gray & Hutcheson. The firm devotes its practice to the representation of taxpayers in property tax disputes and is the Texas member of the American Property Tax Counsel (APTC), the national affiliation of property tax attorneys. Mr. Hutcheson can be reached at This email address is being protected from spambots. You need JavaScript enabled to view it..

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Nov
01

Reduce Property Taxes By Using the Cost Approach

"The use of the income approach in the face of increasing sales prices generated considerable push-back from tax assessors because of their discomfort with the resulting allocation of ever increasing amounts to the business enterprise portion of the going concern."

By Mark S. Hutcheson, Esq., as published by Hotel News Resource, November 1st, 2007

The valuation of hotels for property taxes has always been a difficult process. The increasing sales prices of hotel properties and increasing hotel REVPARs over the past several years have made the process even more difficult. The tax assessor response to these increases has resulted in ever increasing value for property taxes purposes and, thus, ever increasing tax bills. Hotel owners traditionally addressed property tax valuations through the use of the income approach. This calls for capitalizing the net income produced by the operating property and then allocating the value among the real estate, personal property and business enterprise components. The use of the income approach in the face of increasing sales prices generated considerable push-back from tax assessors because of their discomfort with the resulting allocation of ever increasing amounts to the business enterprise portion of the going concern.

Thus, many owners now find it useful to step back and approach the issue from a different valuation perspective. They often employ the cost approach, which has proven to be a useful tool in discussions with tax assessors. Over the last 10 to 15 years, the cost approach fell into disuse for valuing hotels for property taxes. Two factors influenced the decision not to use the cost approach: 1) Investors do not give much consideration to the cost approach in determining the purchase prices of hotel properties and 2) It is difficult to measure economic obsolescence attributable to the real estate. While both of these factors are correct, they do not negate the potential use of the cost approach.

A quick review of basic hotel cost information from Marshall & Swift (a recognized source of cost information for appraisers and tax authorities) may indicate whether the cost approach will be useful. This information shows that construction cost ranges from $84 to $139 per square foot for Class A limited service hotels to $99 to $195 per square foot for Class A full service hotels.

If the preliminary review of Marshall & Swift data reveals a potential for the use of the cost approach, a more detailed cost analysis may be in order. The cost approach is one of the three generally accepted approaches to value.

A traditional cost approach involves the following steps:

  1. Estimate hard and soft costs of the improvements.
  2. Estimate entrepreneurial incentive.
  3. Estimate accrued depreciation involving physical deterioration, functional obsolescence and external obsolescence.
  4. Estimate contributory value of land and site improvements.

These steps result in an estimate of the market value of the real estate portion of the hotel business's total assets. Generally, the cost approach is considered to represent the upper-end of value when appraising real property.

The following example demonstrates the usefulness of the cost approach as provided by a property tax appraisal of a full service convention type hotel. The appraisal valued the total assets of the business at $200 million and the cost prior to depreciation at $150 million. The appraiser ascertained that due to the size and location of the hotel, there were a limited number of potential operators. Consequently, his appraisal determined economic obsolescence at over $50 million. This resulted in significant tax savings for the owner.

Thus, owners should give careful consideration to the use of the cost approach for valuing hotels for property tax purposes. With profits at record levels and sales at historically low cap rates, the income and sales comparison approaches create difficulties for assessors. Since tax authorities are comfortable with the cost approach, which they use regularly on other properties, this approach is very useful, especially because a hotel's profitability is not a consideration under the cost approach and the approach necessarily excludes intangible business value.

MarkHutcheson140Mark S. Hutcheson is a partner with the Austin, Texas law firm of Popp, Gray & Hutcheson. The firm devotes its practice to the representation of taxpayers in property tax disputes and is the Texas member of the American Property Tax Counsel (APTC), the national affiliation of property tax attorneys. Mr. Hutcheson can be reached at This email address is being protected from spambots. You need JavaScript enabled to view it..

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Jun
27

Use Caution When Applying Cap Rates from Sales Surveys

"Surveys may include cap rates based on actual incomes, pro forma incomes, or some combination of the two. As a result, the cap rates shown in the surveys may be artificially low due to the impact of underperforming properties."

By Mark S. Hutcheson, Esq., as published by Hotel News Resource, June 27th, 2007

When assessors use cap rates from national surveys to value a hotel, the taxpayer stands a very good chance that his property will be over assessed. Assessors in most jurisdictions assess hotels by utilizing a direct capitalization approach. This method follows the standard appraisal formula of V=I/R, that is, V = value, I = net income and R represents the capitalization 'cap' rate. For property tax purposes, assessors seek to determine the value of the hotel at a specified point in time (usually January 1st of the tax year). They derive a net income for the property -- through actual year-end performance or published room rates and market data -- then divide that net income by a cap rate. While there are several methods for determining cap rates, most assessors utilize national surveys of indicated cap rates from hotel transactions.

To understand why cap rates from national surveys may result in overstated property tax assessments, it is important to understand the appraisal formula referenced above. Survey participants provide cap rates by dividing the net income by the sales price. For example, a hotel with an annual income of $1 million that sold for $10 million would indicate a 10% cap rate. If at the time of sale, however, the same hotel had an underperforming annual income of only $750,000, the indicated cap rate from the sale would be 7.5%. The disconnect here is that the buyer may have assumed in his pro forma that through better management he could get the income up to market levels at $1 million. As a result, the $10 million sales price made sense to the buyer at a forecasted 10% cap rate, while it might not have at the actual 7.5% rate.

Surveys may include cap rates based on actual incomes, pro forma incomes, or some combination of the two. As a result, the cap rates shown in the surveys may be artificially low due to the impact of underperforming properties. This problem translates into higher property tax assessments when assessors use these survey cap rates to appraise well performing properties. In the above hotel example, if the property were performing well with $1 million in net income and the assessor used a 7.5% cap rate (rather than the 10% the buyer actually forecasted), the resulting assessment would be $13,333,333 - one-third higher than it would have been at a 10% cap rate.

Understanding this relationship and the pitfalls of using survey data becomes critical to the valuation of hotels for property tax purposes. To achieve accurate tax appraisals, you should ensure that the cap rates used to value your property are derived from transactions involving comparable properties with consistent levels of income performance.

MarkHutcheson140Mark S. Hutcheson is a partner with the Austin, Texas law firm of Popp, Gray & Hutcheson. The firm devotes its practice to the representation of taxpayers in property tax disputes and is the Texas member of the American Property Tax Counsel (APTC), the national affiliation of property tax attorneys. Mr. Gray can be reached at This email address is being protected from spambots. You need JavaScript enabled to view it..

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