Economic Obsolescence Measurement Best Practices

(Part III of IV)

Part one of this four-part series discussed the unit principle of property appraisal. Part two discussed the methods of economic obsolescence measurement. This third part recommends best practices responses to the most typical assessment authority objections for economic obsolescence measurements.

Introduction

Valuation analysts (“analysts”) are often asked to develop value for complex industrial and commercial properties for taxation and other purposes. Unit principle appraisals value these complex properties as a single unit operating collectively on a going concern basis. And the analysis of economic obsolescence is an important cost approach component in the unit principle appraisal of special-purpose taxpayer property.

When unit principle appraisals are developed for state and local property tax appeal or litigation purposes, the assessment authorities often challenge the economic obsolescence measurement. Part one of this four-part series discussed the unit principle of property appraisal. Part two discussed the methods of economic obsolescence measurement. This third part recommends best practices responses to the most typical assessment authority objections for economic obsolescence measurements.

Ten Typical Assessor Objections to Economic Obsolescence Measurements

Exhibit 1 presents many of the typical assessment authority objections to unit-level economic obsolescence measurements within a property tax appeal. These objections are not presented in any particular order of priority or importance.

Exhibit 1: Ten Typical Assessor Objections to Economic Obsolescence Measurements

1. Economic obsolescence converts the cost approach into the income approach
2. The capitalization of income loss method (CILM) does not rely on empirical data
3. The CILM is the income shortfall method
4. The selected CILM benchmarks are not achievable
5. The CILM is not the measurement method described in The Appraisal of Real Estate textbook
6. The analyst should identify and quantify the specific causes of the economic obsolescence
7. Economic obsolescence was caused by taxpayer management’s bad decisions
8. Economic obsolescence is already captured in the income approach and the market approach
9. Economic obsolescence is caused by factors external to the taxing jurisdiction
10. The analyst cannot associate the unit-level economic obsolescence with specific real estate or tangible personal property

These typical objections assume that the state or local assessment authority was presented with the unit principle appraisal of the taxpayer’s industrial or commercial property. The unit principle appraisal included a cost approach analysis. And, the cost approach analysis encompassed the identification and quantification of unit-level economic obsolescence with regard to the taxpayer property. A discussion of each of these ten typical objections—and a recommended best practices response to each objection—is presented next.

Objection 1: The Cost Approach Becomes the Income Approach

Assessor Objection

Economic obsolescence converts the appraisal cost approach into the income approach.

Best Practices Response

All valuation professional organization (VPO) literature, professional standards, and professional guidance recognize three generally accepted property appraisal approaches:

• Cost approach
• Market approach
• Income approach

All unit principle appraisal professional literature, professional standards, and professional guidance also recognize three generally accepted unit principle property appraisal approaches:

• Cost approach
• Market approach
• Income approach

All VPO literature, professional standards, and professional guidance recognize three types of appraisal depreciation within the cost approach:

• Physical deterioration
• Functional obsolescence
• External (including economic) obsolescence

There is one economic obsolescence measurement method that does convert the cost approach into the income approach. That method is typically called the income shortfall method. For that reason, the income shortfall method is not considered a generally accepted economic obsolescence measurement method. The income shortfall method is typically applied (or misapplied) as follows:

Step 1

1. Taxpayer unit cost less physical depreciation (PD) less functional obsolescence (FO)

 –         B. Income approach value indication

 =         C. Income shortfall

Step 2

1. Taxpayer unit cost less PD less FO

 –         C. Income shortfall

 =         D. Cost approach value indication

As indicated in the above illustration of the income shortfall method:

• the analyst has to develop an income approach conclusion before completing the cost approach and
• the income shortfall method always forces the cost approach value to exactly equal the income approach value.

Neither the CILM nor any of the other generally accepted economic obsolescence measurement methods have the conceptual flaws of the income shortfall method. In the application of the CILM, the cost approach is independent of the income approach. In fact, the cost approach can be concluded when no income approach is ever developed.

All economic obsolescence analyses consider “economics.” That is, all economic obsolescence measurements encompass an analysis of some taxpayer income-related data. All market approach analyses also consider some type of taxpayer income-related data (e.g., market-derived pricing multiple x property income metric). However, the consideration of some income-related data do not convert the cost approach—or the market approach—into the income approach.

Objection 2: The CILM is the Income Shortfall Method

Assessor Objection

The income shortfall method is not a generally accepted economic obsolescence measurement method. The CILM is a disguised application of the income shortfall method.

Best Practices Response

The CILM is a generally accepted economic obsolescence measurement method. The CILM is described in the authoritative appraisal literature published by numerous VPOs, including the following:

• American Society of Appraisers
• Appraisal Institute
• American Institute of Certified Public Accountants
• International Association of Assessing Officers
• Other organizations

The income shortfall method is not a generally accepted economic obsolescence measurement method. The income shortfall method is not accepted in the appraisal professional literature, by VPO guidance, or in relevant judicial decisions. The typical application of the income shortfall method is based on the difference between:

1. the income approach unit-level value indication and
2. the cost approach unit-level value indication (before the recognition of economic obsolescence).

The mathematical difference between these two unit-level value indications is the economic obsolescence measurement. The income shortfall method results in the cost approach value being identical to the income approach value. In contrast, the CILM is based on the difference between:

1. the unit’s actual profit margin or return on investment metric (based on the cost approach pre-economic-obsolescence indication) and
2. the unit’s required profit margin or return on investment metric (based on a market participant benchmark or opportunity return metric).

The CILM is not a residual measurement method. The CILM does not equate the cost approach value with the income approach value. The CILM can be developed independently from (and without ever developing) the income approach. The CILM is not the income shortfall method.

Objection 3: CILM Does Not Rely on Empirical Data

Assessor Objection

The CILM does not rely on any market-derived transactional data to measure economic obsolescence.

Best Practices Response

The CILM does not rely on anything other than market-derived empirical data to measure economic obsolescence. The CILM compares:

1. the unit’s actual economic condition to
2. the unit’s required economic condition.

All data related to the unit’s actual economic condition (e.g., profit margin or return on investment or any component there of—such as market share) are empirical data related to the unit’s actual results of operations. All data related to the unit’s required economic condition are based on market participants’ required (or opportunity) profit margin or return on investment economic condition. These market participants required margins or returns are derived from the following:

• Guideline company empirical evidence
• Most comparable company empirical evidence
• Taxpayer industry empirical data
• Taxpayer unit’s cost of capital empirical data
• Taxpayer unit’s historical performance empirical data
• Taxpayer unit’s prospective performance empirical data

Analysts typically cannot extract required rates of return from the actual sales of comparable property units. This is because for special-purpose properties:

• few other property units would be sufficiently comparable to the taxpayer unit,
• comparable property units rarely sell, and
• the comparable property units that do sell rarely disclose their unit-level operating income data.

Nonetheless, the data applied in the typical CILM analysis are all market-derived empirical data. This is because the profit margin or the return on investment data were actually earned by market participants who invested in actual guideline public companies, industry benchmark companies, or the taxpayer company.

Objection 4: CILM Benchmarks Are Not Achievable

Assessor Objection

The benchmark rates of return (or other financial or operational metrics) used in the CILM cannot be achieved by the taxpayer unit.

Best Practices Response

The financial or operational benchmarks included in the CILM analysis are typically based on empirical data related to one or more of the following:

• Actual taxpayer unit or actual taxpayer industry cost of capital data
• Actual public company results of operations
• Actual taxpayer industry (e.g., trade association) results of operations
• Actual taxpayer unit historical results of operations

The benchmark economic metrics are not the taxpayer’s “wishful thinking.” Rather, industry participants (e.g., public competitors, private competitors, the taxpayer unit) actually achieved the benchmark economic metrics. That is how the benchmark metrics became the benchmark metrics. As of the valuation date, the taxpayer unit may not be achieving the benchmark metrics. In fact, that income deficiency (compared to the benchmark) is the indication of economic obsolescence with regard to the taxpayer unit. However, market participants did earn the benchmark returns at alternative investment opportunities. Or, the taxpayer did previously earn the benchmark returns at the subject unit.

These benchmark returns represent the “opportunity return” on an alternative investment available to the market participants. Therefore, the market participants will price an investment in the taxpayer unit (i.e., they will apply economic obsolescence to the taxpayer unit cost metric) in order to earn that opportunity rate of return on the taxpayer unit-level value.

The CILM benchmarks were achieved by some industry participants. That is how those margins or returns became the benchmark data. Therefore, market participants expect to earn the benchmark returns on an investment in the taxpayer unit.

Objection 5: The Unit Principle CILM is Not Described in the Appraisal of Real Estate Textbook

Assessor Objection

The CILM applied in the unit principle property appraisal is not exactly the same methodology as illustrated in the Appraisal of Real Estate CILM examples.

Best Practices Response

The Appraisal of Real Estate textbook describes summation principle appraisal procedures—not unit principle appraisal procedures. The Appraisal of Real Estate CILM description considers a deficiency in a single property rental income (i.e., a deficiency compared to the current market comparable property rental income). Unlike a single rental property subject to a summation principle appraisal, the taxpayer unit does not generate rental income. Rather, the taxpayer unit generates business operating income. In a unit principle appraisal, the income loss, if any, would relate to business operating income.

The current market rental income (described in the Appraisal of Real Estate) corresponds to the level of business operating income required to generate a market-derived required rate of return. Instead of the “market” in a summation principle appraisal being comparable rental properties, the “market” in a unit principle appraisal is the return offered to investors by benchmark public companies, by private company competitors (i.e., the taxpayer industry), or by the taxpayer unit itself (historically).

The Appraisal of Real Estate CILM example measures any deficiency in the income earned by operating a single rental property. The unit principle CILM measures any deficiency in the income earned by operating the taxpayer’s total unit of operating property. The unit principle CILM is conceptually identical to the Appraisal of Real Estate summation principle (or single property) CILM. The unit principle CILM is supported by authoritative professional literature related to the unit principle of property appraisal.

Objection 6: Quantify the Individual Causes for Economic Obsolescence

Assessor Objection

The analyst should identify and quantify each individual cause of (or each individual reason for) the economic obsolescence.

Best Practices Response

First, there is no VPO standard, literature, credentialing course, or other guidance that requires—or even recommends—such a causation-identification procedure. All professional guidance indicates that the generally accepted formula for the cost approach follows:

            Cost measure

 –         Physical deterioration

 –         Functional obsolescence

 –         Economic obsolescence

 =         Value indication

No professional guidance indicates that the generally accepted formula for the cost approach is as follows:

            Cost measure

 –         Physical deterioration

 –         Functional obsolescence

 –         Economic obsolescence from cause number 1

 –         Economic obsolescence from cause number 2

 –         Economic obsolescence from cause number 3

 =         Value indication

Second, analysts do not identify and quantify the individual causes for any other type of appraisal depreciation. For example, analysts do not associate specific physical deterioration penalties with individual physical defects at a taxpayer property. In any other property appraisal, analysts do not assign responsibility for the following:

• Who was responsible for not maintaining the taxpayer facility, thereby causing the leaking roof
• Who was responsible for installing too heavy equipment, thereby causing the facility’s cracked floor
• Which lift truck operator ran into the side of the building, thereby causing the facility’s slanted wall
• Which heavy trucks drove to and from the plant, thereby causing cracks in the facility’s driveway

Instead, in any other property appraisal, the analyst concludes total physical depreciation. For example, the physical depreciation analysis for the typical industrial or commercial property may conclude any of the following:

• The actual age of the property is 20 years
• The effective (observed) age of the property is 30 years
• The expected useful economic life (UEL) of the property is 40 years
• The property is in below-average condition for its age
• The property is, therefore, 75 percent (i.e., 30-year effective age ÷ 40-year UEL) depreciated.

Analysts may note any property physical defects in the appraisal report. But, the appraisal report does not assign responsibility for—or individual deprecation penalties to—individual depreciation “causes.”

Second, related to the measurement of economic obsolescence in the unit principle appraisal, analysts are not required to identify and quantify the following:

• Which competitor was taking market share from the taxpayer unit
• Which purchasing executive signed the unfavorable supply contract, causing increased raw materials costs to the taxpayer unit
• Which financial executive signed the financing agreement, allowing for increased interest rates to the taxpayer unit
• Which taxpayer executive decided to expand the plant capacity during a period that ultimately became an industry downturn

Third, a property appraisal (whether a summation appraisal or a unit appraisal) is not a blame game. A property appraisal concludes value, not responsibility, liability, or causation. These are legal concepts that may determine who should pay damages to a damaged party. These legal concepts are not appraisal concepts related to determining who or what caused the unit-level economic obsolescence.

Fourth, the economic obsolescence measurement itself identifies the economic causes for the obsolescence. Compared to the benchmark economic condition, the taxpayer unit is actually experiencing the following:

• Decreased revenue (e.g., decreased price, volume, or market share)
• Increased operating or financing expenses
• Decreased profitability or growth rate
• Increased capital investment

These economic variables are the “cause” or the “explanation” for the unit-level economic obsolescence.

Objection 7: Poor Management Causes Poor Performance

Assessor Objection

If economic obsolescence does exist at the unit, it was caused by the taxpayer management’s bad decision making.

Best Practices Response

The first inference of this assessor objection is that the taxpayer management deliberately decreased the value of the unit property in order to decrease the property tax expense. The illogical conclusion of this objection is that the management would prefer to run a less profitable business operation than to pay property tax expense.

The second inference of this assessor objection is that the taxpayer owners would allow incompetent management to continue to inefficiently operate the unit’s business operations. Of course, the fact is that whether the unit is owned by a public company or a private company, the owners will quickly replace incompetent managers with competent managers.

It is also noteworthy that all unit-level business decisions should be evaluated when they were made—not in hindsight. It is easy for an assessor (or any other party) to look back years after the fact and second-guess the management’s investment and operational decisions. But, of course, management decisions can only be evaluated in light of the known competitive and economic conditions that existed at the time that those management decisions were made. Managers are not expected to make perfect investment or operational decisions every time. In defense of shareholder litigation claims, company directors are typically protected by what is called “the business judgment rule.” In the case of unit principle appraisals, management decisions should be evaluated by reference to a similar business judgment rule.

Unit managers often cannot control the outcomes of their investment or operational decisions. In regulated industries, management decisions are strongly influenced by regulatory authorities. And, in nonregulated industries, the outcomes of management decisions are strongly influenced by competitors’ actions, customer preferences, general economic conditions, and general capital market conditions.

All that said, so-called “bad” management decisions still result in economic obsolescence with respect to the taxpayer property. Economic obsolescence is due to factors outside of the taxpayer property—NOT outside of the property owner. A unit principle appraisal is a property appraisal—and NOT a property owner appraisal. The decisions of the taxpayer management are external to the unit’s physical property itself. If the reason for the unit’s inadequate economic condition (e.g., profit margin, return on investment, growth rate) are not due to the age, condition, inadequacy, or superadequacy of the physical property, then the inadequate economic condition indicates the existence of unit-level economic obsolescence.

Objection 8: Economic Obsolescence is Already Considered in the Income Approach and the Market Approach

Assessor Objection

Any unit-level economic obsolescence is already captured in the income approach and the market approach analyses. Economic obsolescence does not have to also be considered in the cost approach.

Best Practices Response

The cost approach is exactly where economic obsolescence should be considered. Like all forms of appraisal depreciation, economic obsolescence is specifically a cost approach concept. A well-developed income approach analysis and market approach analysis will both implicitly consider the taxpayer unit’s economic obsolescence. However, the cost approach explicitly considers the taxpayer economic obsolescence. The cost approach is where all forms of appraisal depreciation—including economic obsolescence—are specifically identified and separately quantified.

Each appraisal approach should be independent of each other appraisal approach. Of course, there is only one set of financial and operational data regarding the taxpayer unit. So, all appraisal approaches draw on a common data set regarding the taxpayer property. But each appraisal approach should be calculated independently and completely from each other appraisal approach. Assigning a greater weight to income approach or market approach value indications in the reconciliation does not correct an incomplete cost approach analysis.

Before any unit value indications are considered in the final value reconciliation, each appraisal approach should be fully supported—and fully completed. And, each appraisal approach should provide a completely developed—and credible—value indication for the taxpayer’s property.

Objection 9: Economic Obsolescence Causes Are External to the Taxing Jurisdiction

Assessor Objection

The factors that cause the taxpayer’s unit to experience economic obsolescence are external to the taxing jurisdiction.

Best Practices Response

Assessment authorities sometimes believe that they are being “blamed” or “punished” for any economic or industry phenomena that are occurring outside of their taxing jurisdiction. However, a unit principle appraisal is not the blame game. No party is blamed for the existence of economic obsolescence—in the taxpayer unit or in the taxpayer’s industry. Economic obsolescence is typically caused by uncontrollable customer, competitor, capital market, microeconomic, and macroeconomic conditions.

Economic obsolescence is always caused by factors that are outside of (or external to) the unit property. Those factors may also be external to the state or local taxing jurisdiction. Those factors that cause the unit’s economic obsolescence may include environmental conditions, weather patterns, foreign and domestic supplier actions, foreign and domestic customer actions, foreign and domestic competitor actions, capital market conditions, government and regulatory actions, etc. There is no appraisal principle that requires (or even implies) that property values can only be influenced by factors constrained by the town, county, or state in which the property is located. Economic obsolescence is caused by factors that are external to the taxpayer property—and not by factors that are external to the taxpayer property AND internal to the taxing jurisdiction.

Assessment authorities are accustomed to residential property values being influenced by Federal Reserve interest rate policy, national inflation and unemployment rates, and other economic factors that are external to the taxing jurisdiction.

Objection 10: Unit Economic Obsolescence Cannot be Isolated to the Property Located in the Taxing Jurisdiction

Assessor Objection

Economic obsolescence is a unit-wide value adjustment. Economic obsolescence is not measured or applied specifically to the local (i.e., within the taxing jurisdiction) real estate or tangible personal property.

Best Practices Response

The statement included in this objection is correct. In a unit principle appraisal, economic obsolescence is typically measured on a total unit-level basis. It is typically not measured separately for each individual taxing jurisdiction in which the taxpayer unit operates. In a unit principle appraisal, most of the valuation variables are measured on a total unit-level basis, including the following:

• Cost trend factors
• Average total life of each property category
• Functional obsolescence (e.g., any capitalized excess operating expense)
• Economic obsolescence (e.g., any CILM analysis variables)

If the valuation variables are measured separately for each individual property location, that analysis is not really a unit principle appraisal. Rather, such an analysis is probably a summation principle appraisal. For taxpayer properties that are physically, functionally, and economically integrated, some valuation variables—such as economic obsolescence—have to be measured on a total unit-level basis. Because of the integrated nature of the unit property components, all property located in all taxing jurisdictions typically experience the same level of economic obsolescence. And, that unit-level economic obsolescence adjustment is typically measured as a percentage adjustment to any cost approach value indication.

It is inconsistent with the unit principle appraisal—and inconsistent with the integrated nature of the operations of the taxpayer property—to assign a different economic obsolescence percentage to properties located in each individual taxing jurisdiction. All integrated property units contribute to the taxpayer unit’s economic obsolescence condition. All integrated property units experience the same influence of the unit-level economic obsolescence. So, for a physically, functionally, and economically integrated unit, all property units are typically assigned to some pro rata economic obsolescence adjustment.

Summary

Part one of this series summarized the concept of the unit principle of property appraisal and the concept of economic obsolescence measurement. Part two summarized the generally accepted economic obsolescence measurement methods. This third part presented recommended responses to the ten most typical assessment authority objections to economic obsolescence measurement. The fourth and final part of this series will present recommended responses to other (but still common) assessment authority objections to economic obsolescence measurements.  

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.