How to Save Money by Allocating Prices in Real Estate Transactions
"Federal regulators recognize operations account for a significant component of hotel income and value..."
Commercial real estate investors generally acquire properties based on total cash flow, rather than on the perceived value of the property's individual components generating that cash flow. Increasingly, however, lenders are attempting to underwrite real estate loans through component analyses by breaking down a property into income-generating elements under the theory that separately valuing components reduces risk.
Taxing authorities already generate separate tax bills, often at different rates, for real property, personal property and business licensing fees. A similar approach from lenders, which are under increasing regulatory pressure to reduce risk, may impinge on commercial real estate financing and slow the industry's recovery.
A purchaser often analyzes components of cash flow when evaluating how to improve a property's operational performance and the impact of taxes on potential returns. Common considerations include real estate transfer taxes, allocation of basis for income tax purposes, real and personal property tax assessments, and segregation of readily depreciable or amortizable assets from non-depreciable or non-amortizable assets. Allocation generally involves four components: (i) land (non-depreciable); (ii) buildings or improvements (generally depreciable); (iii) tangible personal property (generally depreciable); and (iv) goodwill or ongoing business value represented by intangible personal property or business enterprise value (BEV).
Hotel properties are prime examples of component analysis, as the analysis is often a major negotiating point. Hotels are generally sold as going concerns—that is, operating businesses with a value distinct the underlying real estate. Integrating a well thought- out allocation into a purchase agreement potentially simplifies recordkeeping yields significant savings on income, property and transfer taxes, sometimes worth tens millions of dollars. The federal Internal Revenue Code applies different depreciation rates and tax calculations to different property types. Commercial businesses with substantial goodwill associated with operations (such as hotels, shopping centers, healthcare facilities and marinas) can significantly benefit from a comprehensive allocation analysis.
For example, much of the value of healthcare facilities rests in operating licenses. These and other intangible assets are generally not subject to ad valorem taxation, and accurately reflecting value will prevent overpaying property taxes due to an incorrect allocation of value. In states where the federal income tax basis is used to calculate property taxes for purchased assets, an allocation analysis is critical. For federal income tax purposes, the tax basis of purchased assets is allocated according to the residual method, which generally allocates a purchase price into classes of assets. Except for land, certain tangible assets are depreciable for federal income tax purposes.
Valuing such assets typically involves obtaining a real estate appraisal, extracting improvement values from land value and valuing tangible personal property such as furniture using the most appropriate methodology for that asset type. Because the federal income tax basis of property is determined at the time of acquisition, allocating the purchase price should be part of due diligence and not put off until after closing. Closing is a great opportunity to establish the various business assets' tax basis, and separate conveyance documents should be prepared for each major asset to document allocated value.
Property Tax Implications
After closing, governments generally separately assess taxes against the real property, tangible personal property and intangible personal property (usually in the form of a business licensing fee).
Tangible personal property, which is subject to a faster depreciation schedule, includes furniture, fixtures, equipment and supplies. Business enterprise value might include startup costs, an assembled workforce, a reservation system and residual intangible assets. The Uniform Standards of Professional Appraisal Practice (USPAP), promulgated by the Appraisal Standards Board of the Appraisal Foundation, require separation of a hotel's business value from other components. However, there is no consensus on the method for calculating BEV.
Some taxing authorities contend BEV is an illusion conjured by disreputable appraisers and property owners seeking to reduce ad valorem taxes, but the Appraisal Institute and federal regulators recognize that the operating business of a hotel, for example, accounts for a significant component of its income and overall value.
Since Oct. 1, 2011, the Small Business Administration has required affiliated lenders to obtain a going-concern appraisal for any real estate involving an ongoing business. Affected property types include hospitality, healthcare facilities, restaurants and nightclubs, entertainment venues, manufacturing firms, office buildings, shopping centers and apartment complexes. SBA lenders must obtain an appraisal valuing the separate components from an appraiser who has taken specified courses in valuing going concerns.
The Office of the Comptroller of the Currency, which regulates commercial banks, simply requires lenders to use a competent appraiser and does not specify course requirements for the appraiser. While OCC appraisals need only comply with USPAP, stricter standards may apply if required by what the OCC calls "principles of safe and sound banking."
USPAP does not specifically require appraisers to value component elements when appraising going-concern properties. Although USPAP Rule 1-4(g) states, "(w)hen personal property, trade fixtures or intangible items are included in the appraisal, the appraiser must analyze the effect on value of such non-real property items," the Appraisal Foundation has made it clear that this standard does not mandate an appraisal of the property's individual components of value. However, "the appraiser may be required to value the individual components because of what the analysis produces and/or the manner in which the analysis was applied." Thus, USPAP implicitly require an appraiser to allocate values under certain circumstances.
The OCC appears to be seeking to require more. The Federal Deposit Insurance Corp. Improvement Act of 1991 imposed additional requirements on institutions subject to OCC regulations, which require each institution to adopt and maintain written real estate lending policies "consistent with principles of safety and soundness and that reflect consideration of the real estate lending guidelines." Exactly what this means is unclear.
A recent article published by the Appraisal Institute contends that appraisals of going concern properties must allocate values. Although not attributable to USPAP requirements, the FDIC, as well as the Financial Institutions Reform, Recovery and Enforcement Act of 1989, may require allocation in order to ensure "safety and soundness." Whether these principles require different interest rates for different components of value remains an open question.
Component analysis makes sense in analyzing operations and in calculating taxes. The ongoing debate over how to calculate BEV, however, illustrates the difficulty of transporting component analysis into transactions and real estate lending. For example, large hotel loans are typically made by a lender's corporate loan department, not the real estate department, and with good reason. Furthermore, incorporating the concept of component analysis into real estate lending seems likely to increase interest rates at a time when available credit is already scarce. That debate is just beginning.