Property Tax Counsel Considerations When Choosing a Unit Principle Property Appraisal Analyst (Part IV)

Property Tax Counsel Considerations When Choosing a Unit Principle Property Appraisal Analyst (Part IV)

Connor J. Thurman, ASA, ABV

State and local property taxation legal counsel may become involved in matters related to a dispute surrounding certain taxable properties owned by their corporate clients.  Some of these disputes may involve property that is assessed centrally under the unit principle of property assessment.  In such matters, legal counsel may require the professional assistance of an appraisal analyst experienced in unit principle property appraisal.  In such instances, there are numerous considerations that legal counsel may make when choosing such an appraisal analyst.

This article is the fourth in a four-part series describing considerations that legal counsel may make when choosing an appraisal analyst in a unit principle property appraisal context.  This part of the series focuses on the examples of the unit principle property appraisal approaches and methods.

Generally Accepted Unit Principle Property Appraisal Approaches and Methods

As mentioned previously, the UPP appraisal may contain elements of a business valuation assignment, intangible property appraisal assignment, and tangible property appraisal assignment. Therefore, the analyst should be familiar with (and competent in) the application of the relevant valuation and appraisal approaches and methods.

There are three generally accepted business valuation approaches: the market approach, the income approach, and the asset-based approach.

Moreover, there are three generally accepted intangible and tangible property appraisal approaches: the market (sales comparison) approach, the income approach, and the cost approach.

The appraisal report should discuss that each valuation/appraisal approach and method was considered. And, the appraisal report should discuss which valuation/appraisal approaches and methods were applied. Similarly, the appraisal report should describe why certain valuation/appraisal approaches and methods were not applied.

A detailed description of all the generally accepted valuation and appraisal approaches and methods is beyond the scope of this discussion. For the purposes of this discussion, we will focus on a summary of the tangible property appraisal approaches and methods that are often applied in a UPP appraisal analysis. Further, (when relevant) we will continue with our example of an electric generation power plant as the subject of our UPP appraisal analysis.

Market (sales comparison) Approach

The appraisal of the Subject Property within an electric generation power plant total unit may involve the application of the market (sales comparison) approach. This 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) electric generation capacity, (3) average actual electric generation, or (4) numerous other metrics.

The reasoning for selecting market-derived pricing multiples for the subject electric generation power plant should be clearly described in the appraisal report. The report reader should be able to understand the analyst’s reasoning for selecting certain pricing multiples.

The selection of average or median market-derived pricing multiple, with no support for such a selection, is typically not appropriate.

Rather, subject-specific pricing multiples are typically based on the analyst’s comparison of the appraisal subject to the market-derived guideline comparables (in this case, guideline electric generation power plants) or to the guideline transactions of such electric generation power plants in terms of (1) size, (2) growth rates, (3) profit margins, and (4) returns on investment.

For example, if the value indication based on a multiple of projected electric generation is assigned more (or less) weight than the value indication based on a multiple of latest 12-month electric generation, then the appraisal report should discuss why the analyst assigned that relative weighting.

Income Approach

The appraisal of the Subject Property within an electric generation power plant may involve the application of the income approach. This 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 electric generation power plant. Further, either method relies on developing a supportable and credible estimate of an appropriate capitalization rate.

Cash Flow Estimate

If the direct capitalization method is applied, the analyst should be able to discuss the reasoning behind any normalization adjustments made to the historical financial and operating performance of the electric generation power plant. And, the analyst should be able to describe the rationale for weighting (or not weighting) any income measures that were analyzed (e.g., latest 12-months, historical five-year average, etc.).

If the yield capitalization method is applied, the analyst should be able to discuss the reasoning behind any normalization adjustments made to the projected financial and operating performance of the electric generation power plant. Further, the analyst should be able to describe the rationale for weighting (or not weighting) any income measures that were analyzed (e.g., projected year 1, projected five-year average, etc.).

A discussion of who prepared the financial projections that are incorporated in the UPP appraisal should be included in the appraisal report. The financial projections are often prepared by the taxpayer company management. In certain circumstances, the financial projections may be prepared by the analyst with input from management.

In the instance of management-prepared projections, the appraisal report may describe how the analyst tested the reasonableness of the projections. In every circumstance, the projections relied on in the income approach analysis should be supportable and credible.

Yield Capitalization Rate and Direct Capitalization Rate Estimate

In the income approach analysis, the analyst should provide a discussion of the proper matching of the cash flows utilized and the present value discount rate. For example, if the yield capitalization method is applied, those cash flows should be discounted using the appropriate yield capitalization rate. In the case of a UPP appraisal of an electric generation power plant, the yield capitalization rate is often based on similar data as the taxpayer company’s weighted average cost of capital.

Further, if the cash flow projection is developed on a pretax basis, then the yield capitalization rate should also be developed on a pretax basis. If the cash flow projection is developed on an after-tax basis, then the yield capitalization rate should be developed on an after-tax basis.

The appraisal report should include a discussion of the cost of capital components utilized in the UPP appraisal analysis. In the case of our electric generation power plant, this discussion may include an explanation of how the analyst estimated the cost of equity capital, the cost of debt capital, and the weighting of each of the capital components in the yield capitalization rate calculation.

Regarding the cost of equity capital, analysts often consider the (1) modified capital asset pricing model (“MCAPM”) and the build-up model (“BUM”). Both the MCAPM and BUM include various risk premia components that include (1) the risk-free rate of return, (2) industry-adjusted equity risk premium, (3) size risk-related equity risk premium, and (4) property-specific equity risk premium. The analyst should describe how each risk premia component was considered in the cost of equity capital analysis.

Regarding the cost of debt capital, analysts typically consider (1) the taxpayer company pretax cost of debt capital (often based on the actual market-based debt on the taxpayer company balance sheet) and (2) an estimated effective tax rate. The appraisal report should provide a discussion of each of these components and how the analyst selected them in the UPP appraisal analysis.

Support for a selected residual value (or terminal value) pricing multiple or residual value direct capitalization rate should be included in the appraisal report. In some UPP appraisals, the residual value may represent a significant component of the total fair market value. As a result, the selected residual value pricing multiple, or the residual value direct capitalization rate, often has a material effect on the value conclusion. The analyst’s reasoning for the selected residual value pricing multiple, or the selected long-term growth rate component of the residual value direct capitalization rate, should be adequately explained and supported in the appraisal report.

Cost Approach

The appraisal of the Subject Property within an electric generation power plant may involve the application of the cost approach. For a tangible property appraisal (as part of the UPP appraisal analysis), the generally accepted cost approach appraisal methods include the HCLD method, the RPCNLD method, and the 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.

Cost Metric Estimate

Counsel (and the analyst) should also be aware that the cost approach cost metric analysis should include all applicable cost components.  

For example, in the application of the HCLD method, the cost metric typically includes direct and indirect costs (often material costs and labor costs) from the historical construction of the appraisal subject. These data are often included in the taxpayer company’s financial accounting data.

Further, in the application of the RPCNLD method, the cost metric typically includes direct and indirect costs (often material costs and labor costs) related to the modern construction of an exact replica (or reproduction) of the appraisal subject. These data are often based on a trending (using reliable cost trending data sources) of the historical cost data to the appraisal date.

Finally, in the application of the RCNLD method, the cost metric is the replacement cost new (“RCN”) of the appraisal subject. And, the RCN cost metric should include:

1. Material costs
2. Labor costs
3. Developer’s profit
4. Entrepreneurial incentive

Depreciation Estimate

Counsel (and the analyst) should be aware that the cost approach depreciation analysis should include all types of property depreciation. These depreciation types fall into the following categories:

1. Physical depreciation
2. Functional obsolescence (both due to excess capital costs and excess operating costs)
3. External obsolescence (both locational obsolescence and economic obsolescence)

It is important to note that the above-described forms of depreciation are not equivalent to financial accounting depreciation. Financial accounting (or “book”) depreciation usually encompasses the following:

1. Physical depreciation
2. Some components of functional obsolescence

Book depreciation does not include:

1. all components of functional obsolescence or
2. any external obsolescence.

The UPP appraisal analysis should include the relevant components of depreciation. And, the depreciation components should be separately identified and separately measured in the application of the cost approach. Counsel (and the analyst) should be aware that the cost approach may be applied to estimate the going-concern value of the Subject Property. Said another way, the cost approach (unless specifically applied to conclude such a value) does not conclude liquidation value. Rather, the cost approach typically concludes going-concern value.

Appraisal Analysis Value Synthesis and Conclusion

The appraisal report should include a section that presents (1) a synthesis of all of the value indications and (2) a final value conclusion.

This appraisal report section should include a discussion of how each value indication (from each appraisal approach and method applied) was weighted in the conclusion. Furthermore, an explanation should be given for all of the value indication weightings.

The appraisal report should describe the reconciliation and synthesis procedure performed by the analyst to reach the final value conclusion. The appraisal report should include sufficient information to allow the report reader to recreate the analyst’s mathematical procedure to reach the final value conclusion.

Summary and Final Conclusion

This article is the fourth in a four-part series describing considerations that legal counsel may make when choosing an appraisal analyst in a unit principle property appraisal context. This part of the series focused on the examples of the UPP appraisal approaches and methods. 

Counsel is often involved in the UPP appraisal aspects of property taxation issues for their corporate clients. Counsel may become involved in these UPP appraisal considerations for property tax planning, property tax return compliance, property tax appeal, and property tax litigation purposes. For all of these purposes, counsel may have to retain, instruct, rely on, and defend an analyst and their appraisal report. In these circumstances, counsel may need to retain the services of an analyst who performs UPP appraisal analyses.

This discussion provided practical guidance to counsel involved in such tax planning, compliance, appeal, or litigation matters about selecting and working with such an analyst. This discussion also summarized the development and reporting procedures as well as the professional standards and practices that an analyst would typically apply in the UPP appraisal process.

That is, this discussion presented what counsel may need to consider when choosing a UPP appraisal analyst for tax planning, compliance, appeal, or litigation purposes.

Connor J. Thurman is a Manager with Vallit Advisors, LLC. Connor has over 6 years of experience in business valuation, tangible and intangible asset appraisal, and various other litigation services. He has written numerous articles in professional and peer-reviewed journals covering a variety of topics in his areas of expertise and has presented on these topics via webinars and conferences. He is an Accredited Senior Appraiser (ASA) with the American Society of Appraisers and is Accredited in Business Valuation (ABV) with the American Institute of Certified Public Accountants.

Connor can be reached at 443-482-9500 Ext 114 or cthurman@vallitadvisors.com

The preceding article was prepared by its author. The opinions expressed in the article represent the author’s 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.