Economic Obsolescence Measurement Best Practices

(Part I of IV)

Valuation analysts (“analysts”) are often asked to value special-purpose industrial and commercial property. These analyses may be developed for various purposes, including taxation purposes. This discussion focuses on the identification and measurement of economic obsolescence in the application of the cost approach to value such special-purpose property. This topic is particularly relevant to the unit principle appraisal of integrated and complex properties operating on a going-concern basis. Analysts and tax assessors often apply the unit principle of appraisal to value such complex industrial and commercial properties for state and local ad valorem tax appeal and litigation purposes. This first of a four-part series considers the differences between the unit principle of property appraisal and the summation principle of property appraisal.

Introduction

Valuation analysts (“analysts”) are often asked to value special-purpose industrial and commercial property. These analyses may be developed for various purposes, including taxation purposes. This discussion focuses on the identification and measurement of economic obsolescence in the application of the cost approach to value such special-purpose property. This topic is particularly relevant to the unit principle appraisal of integrated and complex properties operating on a going-concern basis. Analysts and tax assessors often apply the unit principle of appraisal to value such complex industrial and commercial properties for state and local ad valorem tax appeal and litigation purposes.

This first of a four-part series considers the differences between the unit principle of property appraisal and the summation principle of property appraisal. Part two of the series describes and illustrates the generally accepted economic obsolescence measurement methods (with particular emphasis on the capitalization of income loss method). Parts three and four present best practices responses to typical assessment authority objections to the economic obsolescence measurements included in the property tax appeal.

The measurement of economic obsolescence is often a controversial issue in the property tax appeal of complex taxpayer properties. Analysts who develop unit principle appraisals have to be able to (1) identify and distinguish (qualitatively and quantitatively) the various elements (or types) of obsolescence in the cost approach analysis of special-purpose industrial and commercial property, (2) explain and apply the generally accepted economic obsolescence measurements methods, (3) report and defend the economic obsolescence measurement in the unit principle property tax appeal, and (4) respond to typical taxing authority objections related to the proposed economic obsolescence adjustment.

Unit Principle and Summation Principle Appraisal Concepts

This discussion focuses on unit principle property appraisals—in contrast to summation principle property appraisals. The unit principle appraisal is often applied to value complex special-purpose properties that are physically, functionally, and economically integrated. Such complex properties are typically operating as part of a going-concern business enterprise. Examples of such properties include electric generation plants, oil and gas refineries, pipelines, gas distribution systems, cable television systems, marinas, mining operations, sports stadiums, telecom systems, railroads, airlines, and many other types of properties. The unit principle can be applied to complex property appraisals developed for any purpose. However, this discussion focuses on appraisals developed for state and local property tax appeals.

In the property tax appraisal of special-purpose industrial and commercial property, analysts (and assessment authorities) often apply the unit principle to value a bundle of taxpayer property collectively—as “a unit” or a single collection of property. In the vernacular, analysts apply the unit principle to value the total property unit from the “top down.” The generally accepted unit principle property appraisal approaches and methods conclude a single value for the total property bundle.

This total unit value may be allocated to the individual property components within the taxpayer’s total property unit. Such an allocation procedure may be necessary for a taxpayer property that crosses multiple taxing jurisdictions (such as a pipeline or gas distribution system). This allocation process allows the taxpayer (and the taxing authority) to assign a value to the property located in each individual taxing jurisdiction.

In the property tax appraisal of general-purpose commercial property (such as warehouses, hotels, office buildings, apartment buildings, etc.), analysts (and assessment authorities) often apply the summation principle of property appraisal. Analysts (and assessment authorities) apply the summation principle to individually value each component of a bundle of property—as a portfolio of independent properties. In the vernacular, analysts apply the summation principle to value the total property portfolio from the “bottom up.”

The summation principle approaches and methods conclude an individual value for each property in the total property portfolio (e.g., each property in a portfolio of hotels, office buildings, apartment buildings, etc.). Those individual property values may be “summed” to conclude the value of the total property portfolio.

When do analysts apply the unit principle (instead of the summation principle)? Particularly with regard to appraisals developed for state and local ad valorem tax purposes, analysts typically apply the unit principle in the following instances:

• When it is required by statute or regulation
• When the individual property components are physically, functionally, and economically integrated
• When financial or operational data for the individual property components are not available
• When the individual property components would be bought or sold collectively—as a “unit”

Property owners (and other interested parties) often ask if there is value impact of applying the unit principle versus the summation principle. The answer is that a unit principle appraisal and a summation principle appraisal should conclude approximately the same value if:

• Both appraisal principles are applied to exactly the same bundle of property,
• Both appraisals apply consistent valuation variables, and
• There are no scope restrictions on either appraisal.

Historically, the unit principle of property appraisal was called the utility principle of property appraisal. That is because the unit principle was developed to appraise public utility property. In fact, the unit principle was developed to appraise rate-based, regulated public utility property. However, today this unit principle is frequently applied by state and local tax assessment authorities to value both regulated utility property and many types of nonregulated property.

Unit Principle Property Appraisal Approaches and Methods

The following list includes the generally accepted unit principle approaches and methods.

• Income approach
  • Discounted cash flow method (also more generally known as the yield capitalization method)
  • Direct capitalization method
• Cost approach
  • Historical cost less depreciation method
  • Original cost less depreciation method
• Market approach
  • Direct sales comparison method
  • Stock and debt method

Analysts typically consider each of these approaches and methods in the unit principle appraisal. Analysts typically apply each approach and method for which there are meaningful empirical data available to develop the component valuation variables. In the selection and application of the approaches and methods, analysts attempt to emulate the pricing considerations of—and the actions of—market participants.

The names of some of these unit principle approaches and methods may sound the same as the names of the corresponding summation principle approaches and methods. However, analysts understand that the valuation procedures and analyses may be quite different between the two appraisal principles. And, the valuation variables applied and data sources used may be quite different between the two appraisal principles.

In a unit principle appraisal, the terms “property” and “assets” are not the same. The term “property” is a legal term, generally defined by Black’s Law Dictionary, but specifically defined by state statutes. The term “asset” is an accounting term, defined by the Financial Accounting Standards Board (FASB) Statement of Financial Accounting Concepts No. 8. Not all property may be recorded as an asset on a balance sheet prepared in compliance with U.S. generally accepted accounting principles (GAAP). And, not every asset recorded under GAAP may be legally protected as property in a particular taxing jurisdiction. For purposes of this discussion only, these two terms may be used interchangeably.

Unit Principle Procedures versus Summation Principle Procedures

There are numerous differences between the unit principle and the summation principle with regard to both:

1. Appraisal procedures performed and
2. Valuation variable data sources applied.

The more significant of these many differences are summarized in Exhibit 1.

Exhibit 1: Differences in Unit Principle Appraisal Procedures and Summation Principle Appraisal Procedures

	Valuation Variables	Unit Principle Appraisal	Summation Principle Appraisal
	Income Approach
	Type of income considered	Business operating income—from the sale of goods and services	Property rental income
	Term of income	Perpetuity	Over the property’s useful economic life
	Asset replacement	Perpetual property replacements	Property retirement after the property’s useful economic life
	Discount rate	Extracted from capital market data	Market participant-required rates
	Long-term growth rate	Business income growth—from all assets in place	Rental income growth—from specific property only
	Direct cap rate	Discount rate minus long-term growth rate	Extracted from sales of comparable properties
	Cost Approach
	Cost metric	Historical/original cost	Replacement/reproduction cost new
	Physical depreciation	Age/life, total based on accounting data	Observed, individually based on effective age/ condition
	Functional obsolescence	Aggregate excess capital costs; capitalized excess operating expense (in perpetuity)	Individual excess capital costs; capitalized excess operating expenses (over useful economic life)
	Economic obsolescence	Actual vs. required business income margins or business income return on investment	Location-specific rental income loss capitalized over property’s useful economic life
	Market Approach
	Comparables selected	Comparable operating businesses sold; stock and debt securities of “comparable” public companies	Comparable individual properties sold
	Adjustments based on	Size, profit margins, return on investment, growth rate	Location and physical characteristics
	Pricing multiples applied	Price/business income metric	Price/physical or operational capacity metric

Without numerous intentional adjustments, the unit principle appraisal and the summation principle appraisal:

1. Will appraise two fundamentally different bundles of property and
2. Will apply two fundamentally different sets of valuation variables/assumptions.

The Unit Principle Appraisal is Not a Business Valuation

A unit principle property appraisal is not a business valuation! These two valuation analyses apply different sets of generally accepted valuation approaches. The property appraisal cost approach is not a generally accepted business valuation approach. In addition, the asset-based business valuation approach is not a generally accepted property appraisal approach. The unit principle cost approach is not the business valuation asset-based approach!

These two different types of valuation analyses have two fundamentally different objectives. The unit principle appraisal concludes the value of property operating on a value-in-use basis. That means that the valuation premise applied in the analysis is the going-concern premise. The business valuation concludes the value of business debt and equity securities. That is, the valuation subject of the analysis is a going-concern business enterprise.

These two different types of valuation analyses conclude the value of two fundamentally different bundles of assets. These two different bundles of assets are illustrated in Exhibit 2. In Exhibit 2, the acronym PVGO stands for “present value of growth opportunities.” PVGO is the present value of all future tangible property and all future intangible property that do not yet exist on the valuation date. PVGO includes investor expectations for the subject business enterprise with regard to future M&A transactions, future new products and services, future new territories and innovations, and future expansionary capital expenditures.

Exhibit 2: Unit Principle Appraisal Bundle of Assets Appraised Compared to Business Valuation Bundle of Assets Appraised

	Unit Principle Appraisal Assets Appraised		Business Valuation Assets Appraised
	Working capital accounts		Working capital accounts
	Real estate		Real estate
	Tangible personal property		Tangible personal property
	Intangible personal property		Intangible personal property PVGO Intangible investment attributes

After a business acquisition, the PVGO value typically is recorded as goodwill on a GAAP basis balance sheet. The PVGO value should not be subject to property tax. This is because the PVGO “property” does not exist on the property tax assessment date.

The term “intangible investment attributes” includes the following value increments associated with using stock and bond capital market data in the unit principle analysis:

• Value of stock market liquidity (including quick sale, low transaction costs, certain price)
• Value of stock market limited investor liability
• Value of having no capital calls on public securities
• Value of expected investment appreciation (vs. expected investment depreciation)
• Value of having no investment replenishment expenditures (vs. maintenance capital expenditures)
• Value of applying capital gain tax (vs. ordinary income tax on depreciation recapture) on any gain at sale

After a business acquisition, the value of intangible investment attributes typically is recorded as goodwill on a GAAP-basis balance sheet. The value of intangible investment attributes should not be subject to property tax. That is because these intangible investment attributes are not considered to be property.

The typical formula for the unit principle cost approach follows:

                        Historical (may be original) cost
            –          Physical depreciation
            –          Functional obsolescence
            –          Economic obsolescence
            =          Unit value indication

Each of these four cost approach components (one cost metric and three depreciation metrics) are typically developed in the aggregate—or as a “unit.” The data regarding the cost metric and the physical depreciation metric are typically extracted from the property owner’s continuing property record (CPR) or from a similar property accounting data set.

In the unit principle cost approach, functional obsolescence is typically measured in the aggregate—or at the “unit” level. However, it may be possible that the unit-level functional obsolescence may be caused by one or more individual property components within the overall unit (e.g., an inefficiency at one compressor station or one gas processing plant—as a component of the total pipeline unit). In the unit principle cost approach, functional obsolescence typically relates to an inadequacy or a super adequacy within the unit.

In the unit principle cost approach, economic obsolescence is typically measured in the aggregate—or at the “unit” level. Since all property components contribute to the economically integrated unit, all property components share the unit-level economic obsolescence. In the unit principle cost approach, economic obsolescence typically relates to an inadequacy in the unit’s profitability or return on investment. Both metrics can be measured in many different ways.

Functional obsolescence is caused by factors internal to the taxpayer’s property. Functional obsolescence often manifests as an inadequate unit-level return on investment. That inadequate return on investment may be caused by either:

1. Inadequate profit or
2. Super adequate investment.

The inadequate unit-level profit is typically due to excess operating expenses. These excess operating expenses relate to the operation of the taxpayer’s real estate and/or tangible personal property. The excess operating expense is typically measured as the difference between:

1. The actual unit expense category (e.g., fuel expense, maintenance expense, etc.) and
2. The corresponding budgeted/projected expense level, historical expense level, industry average expense level, and other benchmark expense level.

The excess operating expense is typically capitalized as an annuity in perpetuity in order to measure the unit-level functional obsolescence. The super adequate investment typically relates to excess capital costs. These excess capital costs relate to the taxpayer unit having more (or having the most costly) real estate and/or tangible personal property than it needs in order to operate at its current volume. This functional obsolescence super adequacy is typically measured as the difference between:

1. The actual investment in the actual property and
2. The investment needed to buy/build the ideal property (e.g., smaller diameter pipeline, fewer/smaller compressor stations, etc.).

A unit can experience both excess operating expenses and excess capital costs. However, the analyst should be diligent to not double-count the amount of functional obsolescence.

In a unit principle appraisal, an inutility analysis is sometimes applied to measure functional obsolescence. This is because inutility measures the amount of the property’s capacity that is not needed for the current volume of business operations.

Economic obsolescence is caused by factors external to the taxpayer’s property. Economic obsolescence often manifests as an inadequate unit-level (1) profit margin or (2) return on investment. These economic metrics can be measured many different ways. For example, the unit-level profit margin can be measured in any of the following ways:

• Before or after taxes
• Before or after debt service
• Before or after depreciation expense
• Based on changes in revenue (selling price and/or volume)
• Based on changes in material, labor, or overhead expenses

For example, the return on investment can be measured in any of the following ways:

• Before or after tax
• Before or after debt service
• Before or after depreciation expense
• Based on gross or net investment
• Based on historical investment or current value indication
• Based on changes in expected growth rate

Economic obsolescence can be caused by any factor that is external to the taxpayer’s real estate or tangible personal property, including the following:

• Changes in technology
• Changes in industry conditions
• Competitor actions
• Property owner management actions
• Regulatory factors
• Income tax rate changes
• Interest rate changes
• Many other factors

The economic obsolescence is typically measured as either:

1. The amount of economic deficiency capitalized as an annuity in perpetuity or
2. The percentage difference between the unit’s actual profit/return metric and a market-required profit/return metric.

External Obsolescence versus Economic Obsolescence

The term external obsolescence includes two specific types of obsolescence:

• Locational obsolescence
• Economic obsolescence

Locational obsolescence is a decrease in property value due to location-related or “neighborhood” factors. Some examples of locational obsolescence follow:

• A new structure is built blocking a high-rise apartment’s view of the waterfront
• A budget motel is built next to a luxury hotel
• A trailer park is built next to a country club

Locational obsolescence is typically a consideration in a summation principle appraisal and not in a unit principle appraisal. Locational obsolescence is typically measured as the capitalization of rental income loss—over the property’s useful economic life.

Economic obsolescence is a decrease in property value due to any external factors other than location or change in “neighborhood.” Economic obsolescence is typically a consideration in a unit principle appraisal but may also be a factor in a summation principle appraisal. Economic obsolescence is one subset or component of external obsolescence. Accordingly, the terms economic obsolescence and external obsolescence are not exactly synonyms.

Economic Obsolescence Measurement Principles

There is a difference between (1) identifying the existence of economic obsolescence and (2) measuring the unit-specific amount of economic obsolescence. Analysts often identify the existence of economic obsolescence in the taxpayer’s industry by developing preliminary analyses, analyses of industry-wide data, or analyses of unit data not involving some investment metric.

Economic obsolescence is typically measured on a comparative basis. The economic obsolescence measurement comparison is often simplified as follows: What you have versus what you want. The “what you have” metric is typically the taxpayer’s actual economic metric. The “what you want” metric is typically the market participants’ required or benchmark level of the same economic metric. The market participants’ required or benchmark economic metric should be based on empirical data. That is, it should be derived from industry, public company, or taxpayer historical or prospective data.

The difference between the “what you have” or the actual economic metric and the “what you want” or benchmark economic metric can be calculated as a percentage. That percentage difference can be applied as the economic obsolescence measurement. The difference between the “what you have” or the actual economic metric and the “what you want” or benchmark economic metric can also be converted into a dollar-based economic deficiency. That economic deficiency can be capitalized as an annuity in perpetuity in order to conclude an economic obsolescence dollar measurement.

Economic obsolescence can be measured as a deficiency in profit margin or as a deficiency in rate of return (including in the long-term growth rate component of return on investment). The unit’s profit margin deficiency can be influenced by any factors causing a deficiency in the unit-level profits (however measured) and a deficiency in the unit-level revenue (or in related utilization or inutility). The unit’s rate of return deficiency can be influenced by any factors causing a deficiency in the unit-level profits (however measured) and an excess in the unit-level amount of (or the value of) investment (however measured).

The causes of (or the reasons for) the economic obsolescence should be external to the taxpayer’s real estate or tangible personal property. However, the causes of (or the reasons for) the economic obsolescence are not necessarily external to the taxpayer’s business enterprise. As a fundamental principle of both summation principle appraisals and unit principle appraisals, cost is not equal to value. Cost is not an indication of value. Rather, cost less all forms of depreciation provides an indication of value. Economic obsolescence is not an adjustment from the unit value:

• Economic obsolescence is not subtracted from the unit value
• Economic obsolescence is adjusted from the unit cost metric
• Economic obsolescence is not an adjustment from a final cost approach value
• Economic obsolescence is an adjustment in order to get to a final cost approach value

The economic obsolescence measurement typically involves economic data and economic analyses. Analysts should be aware of the following observations:

• Income data are analyzed in all economic analyses
• The analysis of income data does not convert the cost approach into the income approach
• The economic analysis measurement can be developed when no income approach is developed and no income approach value is concluded
• The income approach—and the cost approach—and the market approach—all consider some measures of income data

Summary

Analysts are often asked to value units (or bundles) of complex industrial and commercial property for various reasons—including state and local property tax appeals and litigation. Analysts often apply the cost approach in the property tax appraisal of such complex, special-purpose property. This discussion focused on the development of, and the reporting of, economic obsolescence measurements as a component of a cost approach appraisal of industrial and commercial property operating on a going-concern basis.

The cost approach is a generally accepted approach that is often applied to develop a unit principle appraisal of industrial or commercial property prepared for any purpose. In particular, the costs approach is typically the primary approach applied in the unit principle appraisal of special-purpose industrial or commercial property for property tax purposes.

This first of this four-part series focused on the unit principle of appraisal—in contrast to the summation principle of appraisal. This first discussion described the general concepts of economic obsolescence within the cost approach. The next article in this series focuses on the generally accepted economic obsolescence measurement methods.  

The opinions and materials contained herein do not necessarily reflect the opinions and beliefs of the author’s employer. In authoring this discussion, neither the author nor Willamette Management Associates, a Citizens Company, is undertaking to provide any legal, accounting or tax advice in connection with this discussion. Any party receiving this discussion must rely on its own legal counsel, accountants, and other similar expert advisors for legal, accounting, tax, and other similar advice relating to the subject matter of this discussion.

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Robert Reilly, CPA, ASA, ABV, CVA, CFF, CMA, is a Managing Director in the Chicago office of Willamette Management Associates, a Citizens company. His practice includes valuation analysis, damages analysis, and transfer price analysis.

Mr. Reilly has performed the following types of valuation and economic analyses: economic event analyses, merger and acquisition valuations, divestiture and spin-off valuations, solvency and insolvency analyses, fairness and adequacy opinions, reasonably equivalent value analyses, ESOP formation and adequate consideration analyses, private inurement/excess benefit/intermediate sanctions opinions, acquisition purchase accounting allocations, reasonableness of compensation analyses, restructuring and reorganization analyses, tangible property/intangible property intercompany transfer price analyses, and lost profits/reasonable royalty/cost to cure economic damages analyses.

Mr. Reilly has prepared these valuation and economic analyses for the following purposes: transaction pricing and structuring (merger, acquisition, liquidation, and divestiture); taxation planning and compliance (federal income, gift, estate, and generation-skipping tax; state and local property tax; transfer tax); financing securitization and collateralization; employee corporate ownership (ESOP employer stock transaction and compliance valuations); forensic analysis and dispute resolution; strategic planning and management information; bankruptcy and reorganization (recapitalization, reorganization, restructuring); financial accounting and public reporting; and regulatory compliance and corporate governance.

Mr. Reilly can be contacted at (773) 399-4318 or by e-mail to RFReilly@Willamette.com.