Measuring Physical Deterioration in a Cost Approach Analysis to Value Electric Generation Tangible Personal Property

BY CONNOR J. THURMAN, ARCHIBALD CULLEN, AND BRYAN ENDRES

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The following article was prepared by its authors. The opinions expressed in the article represent the authors’ and may not reflect the view and/or opinion of Vallit Advisors and its staff. Views/opinions are based on the specific facts and circumstances of each matter.

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CONNOR J. THURMAN is a manager with Vallit Advisors and can be reached at 443-482-9500, Ext. 114 or cthurman@vallitadvisors.com

ARCHIBALD CULLEN is a senior analyst with Vallit Advisors. He can be reached at 443-482-9500, Ext. 121 or acullen@vallitadvisors.com

BRYAN ENDRES is an analyst with Vallit Advisors, and can be reached at 443-482-9500, Ext. 108 or bendres@vallitadvisors.com

Journal of Property Tax Assessment & Administration | Volume 21, Issue 1

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Abstract

State and local property taxation legal counsel and/or electric generation tangible personal property owners often require tangible personal property appraisers to appraise their tangible personal property. Such tangible personal property may be appraised for numerous purposes but are often appraised in property taxation related disputes. In such instances, appraisers may apply cost approach appraisal methods. As part of these cost approach appraisal methods, the appraiser must consider the physical deterioration component of depreciation. This discussion will focus on the measurement of physical deterioration in a cost approach analysis to value electric generation tangible personal property.

 

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Introduction

State and local property taxation legal counsel (“counsel”) and/or electric generation (“EG”) tangible personal property (“TPP”) owners often require TPP appraisers (“appraisers”) to appraise EG TPP. Such EG TPP may be appraised for numerous purposes but are often appraised in property taxation related disputes.

 

This discussion will focus on the measurement of physical deterioration (“PD”) in a cost approach analysis to value EG TPP.

 

Specifically, this discussion will summarize what EG TPP is, why EG TPP is appraised, and how EG TPP is appraised. This discussion will also present various cost approach appraisal methods that may be applied to appraise EG TPP. Lastly, this discussion will provide specific guidance related to the measurement of PD in an EG TPP appraisal context.

 

The next section of this discussion will briefly describe EG TPP appraisal.

 

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Electric Generation Tangible Personal Property Appraisal

What is Electric Generation Tangible Personal Property?

Broadly, EG TPP is the physical property of an EG company that is not considered real property. Examples of real property are land and buildings, that is, property that is either land or is permanently affixed to the land.

 

Examples of common EG TPP include:

• wind turbines (including blades, nacelles, and more),
• solar panels,
• natural gas (or other fossil fuel) turbines, and
• much more.

 

The classification of property as either TPP or real property often differs from jurisdiction to jurisdiction. Appraisers may consult with counsel in dispute-related assignments where the classification of property is at-issue.

Why Do We Appraise Electric Generation Personal Property?

In some instances, such EG TPP is not subject to property taxation, whether such taxes are levied at the state level (e.g., unit principle taxation) or at the local level (e.g., summation principle taxation). In such instances, appraisers may be retained by counsel or EG TPP owners (or both) to appraise the EG TPP that is not subject to taxation as part of a property tax dispute.

 

In other instances, such EG TPP may be assessed at a level above (or below) what the EG TPP owner (or taxing assessor) may feel is appropriate. In such instances, appraisers may be retained by counsel or EG TPP owners (or both) to appraise the EG TPP as part of the property tax dispute.

 

How Do We Appraise Electric Generation Personal Property?

There are three generally accepted EG TPP appraisal approaches: the market (sales comparison) approach, the income approach, and the cost approach.

 

The market (sales comparison) approach analysis may include the (1) stock and debt method or (2) the comparable sales method. Either method relies on developing supportable and credible market-derived pricing multiples that may be based on metrics such as (1) revenue, (2) EG capacity, (3) actual EG output, or (4) numerous other metrics.

 

The income approach analysis may include the (1) direct capitalization method or (2) the yield capitalization method. Either method relies on developing supportable and credible estimates of cash flow for the EG TPP. Further, either method relies on developing a supportable and credible estimate of an appropriate capitalization rate and/or discount rate.

 

The cost approach analysis may include the historical cost less depreciation (“HCLD”) method, the reproduction cost new less depreciation (“RPCNLD”) method, and the replacement cost new less depreciation (“RCNLD”) method.

 

All of these cost approach methods have two elements in common:

1. They apply a comprehensive definition of cost—that is, the selected cost metric includes all applicable cost components.
2. They include a comprehensive definition of depreciation—that is, the depreciation metric includes all depreciation and obsolescence components.

 

The next section of this discussion will provide a brief overview of these cost approach methods.

 

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Cost Approach Appraisal Methods

The cost approach yields the value of a property as the cost (based on current dollar expenditures) necessary to create a property with equal utility and functionality as the subject property. The following cost components are typically considered in a cost approach valuation: direct costs, indirect costs, developer’s profit, and entrepreneurial incentive.

 

The cost approach valuation may also consider the various forms of depreciation if the replacement property is superior to the subject property. The various forms of depreciation, besides physical deterioration (“PD”), are functional (including technological) obsolescence, and external (including economic) obsolescence (“EO”).

 

This discussion will focus on the measurement of PD in the cost approach analysis as it relates to EG TPP.

 

As previously mentioned, the cost approach starts with some measure (or metric) of cost. The common types of cost that may be used in an EG TPP cost approach appraisal include the following:

1. Historical cost (“HC”) as part of an HCLD method analysis,
2. Reproduction cost new (“RPCN”) as part of an RPCNLD method analysis, or
3. Replacement cost new (“RCN”) as part of an RCNLD method analysis.

 

The HC represents the cost to create a subject property, based on the applicable historical prices. The RPCN represents the cost to create an exact replica of the property (i.e., “reproduced property”) at current prices. The RPCN relates to the cost to create the functionality and utility of the original property, in a form that is identical to the original property. The RCN represents the cost to create the functionality and utility of the original property, but in a form that may be different from the original property (i.e., “replacement property”).

 

The methods which these various cost metrics may be applied are described next.

 

Historical Cost Less Depreciation Method

The first procedure in an HCLD method analysis is to estimate the HC. Typically, the HC of a property can be obtained from the continuing property record of the property owner. This continuing property record should indicate when such historical costs were incurred and what those costs related to. The result of this procedure is the HC.

 

Historical costs ordinarily include consideration for:

1. a developer’s profit component related to the property development/construction,
2. an entrepreneurial incentive component for the property development/construction,
3. direct costs (e.g., salaries), and
4. indirect costs, (e.g., overhead, employment taxes and benefits).

 

The second procedure in an HCLD method analysis is to consider and measure all relevant forms of depreciation. The forms of depreciation considered in an HCLD method analysis are (1) PD, (2) FO, and (3) EO.

 

PD represents the diminution in value of assets due to wear and tear and all physical aspects that may diminish life and serviceability.

 

FO represents the diminution in value of assets due to an inability of the asset to sufficiently perform the function for which it is used. FO typically relates to asset super-adequacies, asset inadequacies, excess operating costs, and excess capital costs.

 

EO represents the diminution in value of assets due to external factors. Examples of these factors may include supply/demand changes, changes in law, industry conditions, economic conditions and other external factors. Typically, EO is not considered on an asset-by-asset basis but rather on a total entity basis. That is, EO is typically considered as one overall adjustment that is allocated to each company asset.

 

The third and final procedure in an HCLD method analysis is to apply the various depreciation adjustments to the HC to estimate the HCLD of the property.

 

Reproduction Cost New Less Depreciation Method

The first procedure in an RPCNLD method analysis is to estimate the RPCN. One accepted model for estimating RPCN is by applying a trend factor adjustment to historical costs (i.e., trended historical cost). A trended historical cost adjusts the actual historical costs of creating the property by an appropriate cost adjustment trend factor. The result of this model is the RPCN.

 

As previously mentioned, historical costs ordinarily include consideration for developer’s profit, entrepreneurial incentive, direct costs, and indirect costs.

 

The second procedure in an RPCNLD method analysis is to consider and measure all relevant forms of depreciation, that is, PD, FO, and EO.

 

It is important to note that the amount of PD, FO, and EO measured depends (in part) on the cost metric applied.

 

The third and final procedure in an RPCNLD method analysis is to apply the various depreciation adjustments to the RPCN to estimate the RPCNLD of the property.

 

Replacement Cost New Less Depreciation Method

The RCNLD method may be applied to estimate the value of the property. The RCNLD method relies on the RCN cost metric and considers the same forms of depreciation as are considered in the HCLD and RPCNLD methods (and discussed previously).

 

In some situations, the RCN cost metric may also equal the RPCN cost metric (or even the HC cost metric in some circumstances). This situation is common when the property to analysis is relatively new and, therefore, was developed/constructed using current technology, tools, and practices.

 

The formula for arriving at RCN, based on RPCN is as follows:

RPCN Less: Excess Capital Costs Equals: RCN

 

If the property owner can provide detailed information that can isolate excess capital costs related to the property development/construction, say costs related to the property that was never used in the end-product, the subtraction of those costs can result in the RCN.

 

Regardless of which model is used to estimate RCN, the next procedure is the consideration and measurement of all relevant forms of depreciation. The forms of depreciation considered in an RCNLD method analysis are PD, FO, and EO.

 

The final procedure in an RCNLD method analysis is to apply the various depreciation adjustments to the RCN to estimate the RCNLD of the property.

 

The next section of this discussion will provide a description of the PD measurement analysis.

 

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Physical Deterioration Measurement

What is Physical Deterioration?

PD is one component of total depreciation that is considered in a cost approach analysis related to EG TPP. PD is sometimes also referred to as “physical depreciation” but the meaning is consistent for both terms. A common definition of PD is as follows:

physical depreciation. Loss in value or usefulness of a property due to the using up or expiration of its useful life caused by wear and tear, deterioration, exposure to various elements, physical stresses, and similar factors.

 

As presented above, PD may be broadly defined as depreciation of property relating to the physical use of the property.

 

PD is typically the first component of depreciation considered in an EG TPP cost approach analysis. Further, PD is often estimated as a percentage of the property’s cost metric (e.g., a brand-new property with an RCN of $1 million may have a PD percentage of 0%).

 

What is Not Physical Deterioration?

As previously mentioned, there are three components of total depreciation: PD, FO, and EO. FO and EO are separate and distinct from PD.

 

A common definition of FO is as follows:

functional obsolescence. A form of depreciation in which the loss in value or usefulness of a property is caused by the inefficiencies or inadequacies of the property itself when compared to a more efficient or less costly replacement property that new technology might now allow.

 

As presented above, FO is depreciation (or obsolescence) that relates to the loss in value due to inefficiencies or inadequacies of the property, often due to technological changes.

 

EO is commonly referred to as economic obsolescence as opposed to external obsolescence. Economic obsolescence is one component of EO, the other being locational obsolescence. However, for the purposes of this discussion, we’ll limit the discussion to the economic obsolescence component of EO.

 

A common definition of economic obsolescence is as follows:

economic obsolescence. A form of depreciation where the loss in value or usefulness of a property is caused by factors external to the property. These may include such things as the economics of the industry; availability of financing; loss of material and/or labor sources; new legislation or ordinances; increased cost of raw material, labor, or utilities without a compensatory increase in product price; reduced demand; increased competition; inflation or high interest rates; or similar factors.

 

As presented above, economic obsolescence is depreciation that relates to the loss in value due to factors that are external to the property. EO typically is equal to economic obsolescence but may exceed economic obsolescence to the extent that locational obsolescence also exists for the property.

 

Accounting Depreciation Is Not Physical Deterioration

It is important to note that PD (nor FO, EO, or the combination of those three components of total depreciation) is the same as accounting depreciation.

 

Depreciation in an appraisal context relates to the estimated loss in value of a property when compared to a new property, that is, appraisal depreciation measures value inferiority caused by PD, FO, and EO.

 

In the United States, accounting depreciation relates to cost allocation (with some exceptions), and it is not a method of valuation. Accounting depreciation is a mathematical procedure to allow property owners to recover the original cost of a property in installments over a specific period.

 

Factors to Consider When Measuring Physical Deterioration

There are certain factors that the appraiser may consider when measuring the PD related to an EG TPP appraisal. Some of these factors are discussed next.

 

Remaining Productive Capacity

The remaining productive capacity of the EG TPP is one factor that the appraiser can consider in the PD measurement analysis.

 

Theoretically, PD can be discretely measured. For example, a solar panel may be able to generate “x” amount of electricity over its physical life. If the necessary data exists, the solar panel has not been reconstructed or mistreated, and all assets of the same type are equivalent, then a ratio of past production to the expected total production would measure the PD.

 

Condition

Further, the physical condition of the EG TPP may be considered in the PD measurement analysis.

 

Broadly, condition is a factor that must be observed, and may be subjective based on who is making the observation. An appraisal report should discuss the condition of the EG TPP and provide adequate explanation of how such a condition was determined. It is often useful to annotate the condition of a property using a matrix like the one that follows.

 

The above matrix is only meant as a guide. Appraisers may use whatever analytical framework for assessing condition that is appropriate given the nature of their assignment.

 

Curable vs. Incurable

Another factor that the appraiser may consider is the curability (or incurability) of the PD inherent in the EG TPP. PD is curable when it is economically viable to remedy (i.e., fix) the deterioration. That is, PD is curable when remedying the deterioration results in an increase in utility and value that exceeds the cost to cure.

 

By contrast, if the cost to cure is higher than the increase in utility and value from the remedy, then that deterioration is considered incurable.

 

The level (or degree) of curable and incurable PD related to the EG TPP may affect the overall measurement of PD in the appraisal analysis.

 

Other Factors

Various other factors may be analyzed by the appraiser in the EG TPP analysis when measuring PD. Some of these factors may be property specific or industry specific. Certain factors may also include the following:

• chronological age (“CA”)—number of years since a property was built or placed into service.
• effective age (“EA”)—apparent age of a property when compared to a new property of its kind; that is, the age indicated by the actual condition of the property. The EA may require consideration of overhauls, rebuilds, refurbishments, level of maintenance, and more. If a property is routinely overhauled, the effective age may be less (possibly significantly so) than its CA.
• normal useful life (“NUL”)—physical life (usually in years) that a property will be used before its retired. NUL is often based on statistical or actuarial data derived from property studies that consider actual operating conditions. A property’s useful life may be longer than its economic life because a property owner may decide not to retire the property at the end of its theoretical economic life.
• remaining useful life (“RUL”)—estimated period during which a property of a certain effective age is expected to be used before retirement. Usually, best estimated based on statistical or actuarial data derived from property studies that consider actual operating conditions. RUL may be approximated by subtracting the property’s EA from its NUL. Appraisers should consider statistical or actuarial data before placing all reliance on this procedure.
• physical life (“PL”)—estimated period (usually measured in years) that a property will physically last before it deteriorates to an unusable condition purely from physical causes. PL does not consider earlier retirement due to FO and EO.
• remaining physical life (“RPL”)—estimated period that a property of a certain EA is expected to physically last before it deteriorates to an unusable condition purely from physical causes. RPL does not consider earlier retirement due to FO and EO.
• economic useful life (“EUL”)—estimated period (usually measured in years) that a new property may be profitably employed for its intended purpose. That is, EUL is the period for which a property owner may use a property before it would economically benefit the owner to replace the property with a new property that provides equivalent (or better) utility. EUL does consider the effects of FO and EO and is often less than the property’s NUL.
• remaining economic life (“REL”)—estimated period that a property of a certain EA is expected to be profitably employed for its intended purpose. REL may be estimated by subtracting the property’s EA from its EUL. Appraisers should consider statistical or actuarial data before placing all reliance on this procedure.

 

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Physical Deterioration Measurement Procedures and Models

There are various procedures and models that may be applied to measure PD. It should be noted that the names of these procedures and models may be referred to in numerous ways within the appraisal profession. For example, differences may exist between the naming convention for real property appraisers and TPP appraisers. While some analytical differences may exist between these two appraisal fields, the underlying concepts are the same. Moreover, these procedures and models may also be referred to as methods in professional literature.

 

For example, The Appraisal of Real Estate identifies the following three methods for estimating depreciation in a real property context:

• market extraction method
• economic age-life method
• breakdown method

 

In comparison, Valuing Machinery and Equipment identifies the (1) observation method, (2) formula ratio method, and (3) direct collar measurement method.

 

The six different methods (or models) mentioned above will be described below.

 

Market Extraction Model

The market extraction model relies on comparable sales of properties for which depreciation can be extracted. Due to various reasons (including lack of data), the market extraction model typically measures total depreciation, and not PD alone.

 

The first procedure in the market extraction model is to identify and analyze sales of comparable properties. For EG TPP, it may be difficult or impossible to find sales of comparable properties since valuable EG TPP (such as solar panels, wind turbines, etc.) rarely sell separately from other related properties or businesses.

 

The second procedure is to adjust the comparable sales data and prices for factors such as: property rights conveyed, recent capital expenditures, financing, etc.

 

The third procedure is to remove any value unassociated with the relevant property type. This could include land, buildings, and more.

 

The fourth procedure is to estimate the cost of the property for each comparable identified. This cost should be consistent across the comparables and the subject property (e.g., all based on RPCN, RCN, etc.).

 

The fifth procedure is to subtract the contributory value of all property from the current cost of the comparables to estimate the total dollar amount of depreciation for the property as of the sale date. This extracted depreciation amount relates to PD, FO, and EO.

 

The sixth procedure is to convert the dollar amount of depreciation into percentages by dividing each dollar amount of depreciation by the current cost of the comparables.

 

If the ages of the comparable sales are relatively similar to the age of the subject property, the total depreciation percentage can be reconciled into an appropriate rate for the subject property. This rate is applied to the subject property’s cost to measure the total depreciation.

 

If the ages of the comparable sales are not relatively similar to the age of the subject property, an annual depreciation rate should be developed based on the calculated percentage of depreciation from the comparables. It should be noted that this procedure relies on an estimate of the EUL of the subject property. Moreover, this procedure may not be reliable by itself since both FO and EO are not necessarily related to the age of a property.

 

Regardless of the age of the subject property and the comparables used, the reader should note that the market extraction model measures total depreciation and not PD, alone. That is, the PD measurement is subsumed into a total depreciation measurement. Figure 1 presents a summary example of the market extraction model.