Hotel Owner Jolted by New Method Used to Determine Real Estate Value

— As published in National Real Estate Investor, December 2001, By Jim Popp, Esq.

Did your hotel business value “check out” this morning? For a hotel owner in Austin, Texas, it did. The following is, as they say, a true story and should raise concern among hotel owners and property tax professionals throughout the country. If it can happen in this previously sophisticated taxing jurisdiction, it can happen anywhere.

A full-service Marriott hotel recently sold for $48 million. Historically, the tax-assessor would have valued the hotel for property tax purposes following normal procedures. He would start with the sales price as an indication of a going concern value and deduct a Furniture, Fixtures and Equipment (FF&E) value and a business value to arrive at a real estate value. This was also the approach used by the tax-assessor’s nationally known hotel appraiser in previous property tax trials in this city. The tax-assessor and the taxpayer would then debate the amount of business value deduction ranging typically from 20 to 50 percent.

This year, however, the business value apparently had “checked out” the night before because the system the tax assessor used found that value to be virtually zero. Using a different approach, he started with the hotel’s purchase price and deducted a FF&E of $4 million. Next, he determined that the entire business value contribution to the going concern equaled about 10%. From this business value contribution, he deducted the franchise and management fees. The final total business value contribution was surprisingly only $500,000, or 1% of the purchase price. Based on his assessment, the hotel had a real estate value of $43.5 million.

An Eye Opener for Hotel Owners
This story is significant for hotel owners for several reasons. This city has a sophisticated property tax system, and in the past had followed traditional hotel property tax appraisal methodology. It used a well-known hospitality valuation expert as a witness, as well as in-house Members of the Appraisal Institute (MAIs) for guidance. Finally, and perhaps most significantly, this different approach comes at a time when taxpayers and appraisers have expanded the historical understanding of business value and have advocated even greater deductions for property tax purposes.

Traditionally, appraisers have determined the going concern value of the hotel business by calculating not only its tangible assets, but the value of its intangible assets, such as reservation systems and trained workforce, as well. They have then deducted the FF&E and the business value to arrive at the real estate value.

The business value was generally estimated by deducting the expense of the franchise fee and the management fee from the going concern income stream. This approach was first advocated by taxpayers, accepted by tax-assessors, and then again, refined and rejected by taxpayers.

Taxpayers rejected this approach primarily because the use of franchise fees and management fees results in an understatement of business value. These fees are nothing more than an expense to an owner of a hotel and do not fully represent a return on the business portion of the property. As a taxpayer recently testified, “If I wanted a return only from real estate, I would have purchased an office building, but since I wanted a return from real estate and from a business, I purchased a hotel.”

The newer, refined approaches in hotel appraisal methodology have been advocated by such appraisers as David Lennhoff of Delta Associates, Alexandria, VA., and Peter Gloodt of Chicago Hospitality Consulting Services, and by property tax lawyers. The new method identifies elements of the hotel business that create value beyond a flag and management expertise. In addition, The Appraisal Foundation, the licensing and regulatory body of MAI appraisers, has expanded its discussion of business enterprise value in its textbook, The Appraisal of Real Estate.

Practical Tips for Taxpayers
Taxpayers should consider the following in evaluating a hotel real estate value for property tax purposes:

  • Determine the revenue generated by the flag over and above the typical hotel. The hotel name, reputation, reservation system, marketing, and sales services may increase room revenue and occupancy above a typical hotel. One method of adjustment is by a reduction in the actual income stream to a market income stream.
  • Determine the revenue generated by the intangible elements common to all hotels, such as assembled work force, working capital, typical management skills, contracts, leases, licenses, and operating agreements. One method of adjustment is to estimate the difference in cash flow associated with a stabilized hotel compared to a start up hotel.
  • Determine the revenue created by service profit centers such as food and beverage, health club, telephone, parking, laundry, and business center. The profit may be capitalized at a business capitalization rate to make an appropriate deduction. This approach may help prevent your hotel business value from “checking-out” as an appropriate property tax deduction.

Jim Popp is a partner in the Austin, Texas, law firm of Popp Gray & Hutcheson. Popp Gray & Hutcheson. The firm is the Texas member of American Property Tax Counsel (APTC).