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

By James S. "Jim" Bone

When appraising properties that are operated as a business unit, the property tax appraiser must identify and value the taxable and nontaxable property. The appraiser can use any of 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. An understanding of the relationship between the business and the property it uses is vital to the process of property tax valuations.

APPRAISAL OF PROPERTY-INTENSIVE BUSINESSES

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

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

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 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

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 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

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

Reconciliation of Value Indicators

THE SYMBIOTIC RELATIONSHIP BETWEEN PROPERTY AND BUSINESS

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

Classifying Activities as Property Ownership or Business Operation

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

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"

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.