Ad Valorem Appraisal of Property-Intensive Businesses and the Properties They Utilize

By James S. "Jim" Bone

When appraising business properties, the property tax appraiser must identify and value the taxable and nontaxable property. The appraiser can use the three classical approaches, and must either isolate the taxable property and value it during the appraisal, or allocate value to the taxable property after the overall value is determined.

Factories, energy-production facilities, hotels, golf courses, and ski resorts present unique challenges to property tax appraisers. Unlike rental properties, where the business tenant can move from one location to another, these businesses essentially use their realty to produce goods and services. Also, sales of these property-intensive businesses almost always involve both the property itself and the business that uses it.

In the past, appraisers allocated all value to the real and personal property, under the assumption that the business simply 'operated' the property in a manner similar to the way office building lessors operate their properties to enable tenants to place the property into economic use. Recently, the appraisal industry has come to recognize that two identifiable classes of property exist - physical property and intangible property.

One class of intangible property is the intangible assets owned by the business, such as money, accounts receivable, prepaid expenses, patents, goodwill, and the company's relationships with its customers, employees, vendors, and other businesses such as banks and competitors. The other class is the value of the business itself, known as the business enterprise value.

Because of the existence of both taxable real property and nontaxable intangible property in these situations, property tax appraisers should analyze each property very carefully before starting the approach portion of the appraisal.

Approaches to Value

All three approaches can be used to value either the property owned by property-intensive businesses, or the businesses themselves including their real property. The key is defining the appraisal unit to be valued by focusing on the nature of the income and the owner.

The typical error appraisers make when applying valuing business properties is to only see the real and tangible personal property of the business. Many appraisers ignore, or are unaware of, the intangible assets and rights owned within the business unit. Every operating business has some intangible assets and rights.

Appraisal Classifications

Classifying property as to income (rents vs. sales) and ownership (lessors vs. users) provides a convenient way to begin appraisal assignments. If the property owner is not the economic user and the income is rent, then the value indicator will represent the value of the real or tangible personal property being appraised.

On the other hand, if the business is the economic user and the income is from sales of goods and/or services after payment of market rent to the property owner, then the value indicator represents the value of the business unit alone. In either case, however, an adjustment will be made if the contract lease rent is not equal to market rent at the date of valuation.

Problems arise when the business owner is also the property owner. In the income approach to valuation, for example, income will be a combination of rent, or income to the property, and business profits, or income to the business. Value indicators from the comparative sales and cost approaches in these types of properties result in similar problems. Each sale will include both taxable property and nontaxable intangible business assets and rights. In some situations, especially where the business is established or not operating at normal levels, the cost approach may not be appropriate, without accounting for the costs necessary to bring the business to its current operating status.

Classification is fairly straightforward: if the income is rent, then the analysis will generate a property value. If the income is from the sale of goods and services, then the analysis will generate a business value, and the appraiser must allocate the final value between property and business.

Appraisal Unit

If the appraisal unit is the taxable property of a property-intensive business, then each approach will isolate the taxable property. In the cost approach, for example, only the costs of reproducing or replacing the taxable property will be estimated. In the comparative sales approach, only taxable property will be used for comparison. In the income approach, only rents, royalties, or profits a prendre from the taxable property would be estimated. Care must be taken to ensure that only the income to the property is be used to derive an indicator of taxable property value for the income approach. The appraiser will reconcile the three indicators of value, and arrive at an estimate of value for the taxable property.

If the appraisal unit is the value of the business, then then the appraiser uses one or more of the three approaches to estimate the value of the entire business, including the nontaxable and taxable property. The appraiser will reconcile the three indicators and arrive at an indicated value for the business and its property. At this point the appraiser will use information developed within one or more of the approaches to estimate the value of the taxable and nontaxable property and assets within the business unit.

Cost Approach

The cost approach is actually a pricing model that assumes a for-profit manufacturer/developer began manufacturing the appraisal unit early enough to have completed it on the appraisal date. The cost approach assumes that the manufacturer did not have a guaranteed sale and assumed normal risks of sale upon completion. The value indicated by this approach is the price the manufacturer would be expected to ask for the property in order to recover all normal direct and indirect costs of the defined project, and a normal markup, or profit, on the sale. This is expected, or projected entrepreneurial profit, which applies to the product itself.

Entrepreneurial profit in a product is not the same as entrepreneurial business value, which applies to the value of the firm that manufactured the product or property identified as the appraisal unit.

The reality of any expected or projected entrepreneurial manufacturing profit can only be confirmed by the other approaches to value on the appraisal date, which establish the achievable asking/selling price for the manufacturer. If development was instantaneous, there would be no difference between anticipated entrepreneurial profit and realized entrepreneurial profit, because the manufacturer wouldn't start the process unless the realized entrepreneurial profit was adequate. The differences arise due primarily to the length of the development/manufacturing process and the economic changes that occur between commencement and completion/sale.

The cost approach can be applied to a business unit as well as a unit of real property. For instance, some companies make a business of setting up and selling turn-key dry cleaning businesses; they find locations, design the interior, pay for the improvements and equipment, train the staff, open the facility, and finance the startup for one to two years. At the end of that time, when the business is ‘stabilized,' they sell the business, including the leasehold interest, tangible personal property, and the operating business. The cost approach would accumulate all the costs from the inception of lease acquisition through the sale and anticipate a normal markup or profit for the producer of the business, or appraisal unit.

If the appraiser does not have sufficient information to estimate the replacement cost of the owned intangible assets of a business unit plus an estimate of the value of the going concern above the cost of all components then the cost approach is not a reliable indicator of the value of the business. It may be, however, a reliable indicator of the value of the taxable property within the unit.

Comparative Sales Approach

The comparative sales approach attempts to estimate the price a typical buyer would have paid for the appraisal unit on the appraisal date, using sales of other similar appraisal units that are the most appropriate for comparison purposes. Since the most appropriate appraisal unit is the unit that typically sells in the market, the subject appraisal unit and the comparable sales will typically contain like combinations of land, improvements, tangible personal property, intangible assets and rights, and going concern value.

The primary problem in property taxation is the fact that the appraisal unit and the assessment unit do not coincide in property-intensive businesses. Appraisers must recognize the potential for error and assure that the property being analyzed in each approach matches the property defined at the beginning of the appraisal. Failure to do so will always result in appraisal and/or assessment errors.

If the appraisal unit is defined as the taxable property, then the comparable sales must be adjusted to include only the taxable property included in the sale to arrive at a sales indicator. An alternative would be to arrive at a comparative approach indicator and to isolate taxable property for the theoretical property.

Income Approach

When an appraiser uses the income from property to value property, few intangible assets disputes arise. This is the type of appraisal that is normally used to value commercial and industrial property. Rent, sales price, and cost to reproduce are all known, and the processed and procedures are well understood for generic industrial buildings, retail shopping properties, office buildings, and warehouses.

In property-intensive businesses that sell as a unit, appraisers routinely define ‘the property' as the business unit, rather than the taxable property. This may occur because property rents are not available in the market, and since the unit that sells in the market includes the business, appraisers have been taught to use business revenue to value ‘the property.' However, for property tax purposes ‘the property' normally means the taxable property which leads to a mismatch between the income source and the appraisal unit.

Use of Business Income to Estimate Rent

If the appraisal unit is the taxable property, then the appraiser must either use property income in the form of rents, or use business income to estimate either the rent-paying capacity of the business or to isolate the taxable property value from the income indicator of value.

Reconciliation of Value Indicators

Regardless of the defined appraisal unit, the appraiser reconciles the indicated value for all approaches that have been used into a final indicator of value for the appraisal unit. If the appraisal unit is the taxable property then the value must be allocated among the taxable components. If the appraisal unit is the business unit, then the appraiser allocates the business value among the taxable and nontaxable components including both the owned intangible assets of the business and the going concern value over and above the value of the identified components.

THE SYMBIOTIC RELATIONSHIP BETWEEN PROPERTY AND BUSINESS

The value of property is its capacity to provide property services to users. This capacity is frequently described as ‘beneficial use' which means that the property's highest value is when it is placed into use. However, ‘use' infers ‘user' and it is the relationship between the property and the business that uses it which creates property income in the form of rents, royalties, or profits a prendre.

It is important to recognize that property does not have a right to be used. It only has the capacity to be put to beneficial use. Property is inanimate, and cannot use itself. It takes an enterprise, with the appropriate combination of property, people, and capital in the form of intangible assets and rights to place any business property into use. For that reason, every valuation of business property must, by definition, assume the presence of intangible assets and rights, owned by the enterprise which places the property into economic use, that generate sufficient business income so the entrepreneur can and will pay the rents, royalties, or profits a prendre.

The Concept of Economic Use

Commercial and industrial real property is placed into economic use by business entities that acquire real property and tangible personal property outright, or the rights to use it via a lease or other agreement. In a similar fashion, businesses acquire the services of employees, management, and service vendors in exchange for compensation. A business owner uses capital to acquire intangible assets and rights, and to incur losses in start-up years that are expected to generate income in future years. The business owner anticipates a return of, and on, all three factors of production. The value of that return on the factors of production is called the going concern value of the business. In the event that the owner is exceptionally successful in creating the business enterprise, and additional value, typically called goodwill, is indicated by the excess income over and above a normal return of and on property, personnel, and all invested capital.

Classifying Activities as Property Ownership or Business Operation

Since the income from property is rent, and income from business operations is sales of goods and services, classification of properties and/or businesses for appraisal purposes is fairly straightforward in most instances. If rent from a user of the property is the income, then ‘the property' is truly taxable property. On the other hand, if the income being considered results from the sale of goods or services, then ‘the property' is a business enterprise and the challenge to the property tax appraiser is to either isolate the real property and appraise it, which is the preferred method, or if necessary appraise the entire business and allocate value among the enterprise's intangible assets and rights and its taxable property.

Certain business activities and property ownerships combine both classes of property. Real property lessors such as apartment owners, for instance, may provide laundry facilities that generate net income to the owner. Commercial property owners may also operate their own management companies. In these instances, the real property appraiser should exclude income and profits attributable to those operations, since the enterprise activities are minor in relation to the property income from rents. On the other end of the spectrum, business enterprises such as hotels frequently rent space to commercial tenants such as retail stores and restaurants. Property tax appraisers should treat those rents as rent, rather than the combining it with the hotel's income from the sale of goods and services.

Identifying the Economic User of Property

Another way of classifying commercial or industrial property is by identification of the individual or business entity that places the property into economic use. Clearly, where a landlord leases a property to a business owner, the business owner places the property into economic use, assumes the risks inherent in that process, retains any business profits that may exist after the payment of rent and other expenses, and the rent paid for the right to use the property is an indicator of the value of the property. Because rent is isolated from the business income, the value of the business that paid the rent does not enter the equation. The method of rent calculation is not germane to the equation in most cases; it is simply a means for calculating the amount of rent and spreading the risk/reward possibilities between the landlord and the tenant.

Many hospitality end entertainment businesses conduct their activities in owned real estate. Hotels, golf courses, ski resorts, and amusement parks have been incorrectly appraised as solely real property because, in the opinion of the appraiser, the customer's payment for the services can be considered as ‘rent' for the use of the space. However, in all the above instances, the business that advertised for customers, hired the employees, and assumed the business risk of placing the property into economic risk is the user of the property, not their customer. The hotel guest, golfer, skier, and roller coaster customer is simply that - a customer of a going concern business.

The same owner vs. user approach can be applied to extractive industry properties. Under California commercial law, an oil producer that sells crude at the wellhead is a seller of goods. In other words, a business. However, assessors and the State Board see no business when they look at the field. They simply see a taxable property. The real property is valued by using the income from the sale of goods, less the business operating costs. No deduction is made for income to the business operator for either return of and on intangible assets, or a normal business profit. The entire value is assessed as taxable property. In reality the lower indicated cap rates for producing fields compared to start-up operations reflect in part the price being paid for the value of the going concern business. Assessors' appraisers use similar procedures for a variety of property-intensive businesses.

For Sale, Lease, or Build-to-suit; "Commodity Properties Available"

Many property owners are ambivalent when it comes to profits - they will sell the property, build a building for a prospective buyer or lessee, or lease the ground to a tenant that will either use the property as is or construct an improvement on it. All of these activities are essentially the same. They all perform the function of transferring all or part of property to another for a price. They do not involve the use of the property by the seller/lessor, and the seller/lessor does not acquire any financial interest (other than that of a creditor) in the buyer/lessee entity.

Revenue from the sale or lease of property is for all or part of the bundle of property rights, in exchange for those rights, and the buyer/lessee is the individual or entity that either places the property into economic use or transfers that function to a subsequent buyer/lessee in a later transaction. In a similar fashion, the fact that the property owner is in the ‘business' of making profits from this type of transaction does not change the analysis. The owner's business is not being sold or leased. Its existence only enhances the probability that the transaction will be manage and completed efficiently, but the value of the business itself does not become a part of the property being transferred. As a result, the net revenue stream for the right to use the property is an indicator of the value of the property.