The Unit of Valuation Principle for Property Tax Purposes: Applications

(Part I of V)

This is the first article of a five-installment discussion that will summarize the application of the unit valuation principle. As will be described, a unit principle valuation is not a business valuation. However, business valuation analysts are often more comfortable with the development of unit principle valuations than are real estate or personal property appraisers.

Introduction

This five-installment discussion will summarize the application of the unit valuation principle. As will be described, a unit principle valuation is not a business valuation. However, business valuation analysts (hereinafter “analysts”) are often more comfortable with the development of unit principle valuations than are real estate or personal property appraisers (hereinafter “property appraisers”). This is because property appraisers are typically trained in—and experienced with—the development of summation valuation principle property appraisals.

While the unit valuation principle is most frequently applied in the valuation of industrial and commercial property for ad valorem property taxation purposes, it may be applied to the valuation of any assemblage (or unit) of property developed for just about any purpose. Some analysts believe that the unit principle is only applied to property that is centrally assessed for property tax purposes. That belief is not correct. The unit principle can be (and is) applied to the property that is locally assessed as well as to property that is centrally assessed. As will be described below, the application of the unit principle is not a function of the jurisdiction that assesses the taxpayer property. Rather, the application of the unit principle is more a function of the type of taxpayer property. That is, whether it is centrally assessed or locally assessed, an assemblage or collection of property that is physically, functionally, and economically integrated is a candidate for the unit valuation principle.

The unit valuation principle is often called the unit principle of property appraisal. In the valuation profession, and in this discussion, those terms are synonyms. And, in the vernacular, the unit valuation principle is often abbreviated as the unit principle. The unit valuation principle is also often referred to as the unitary valuation principle. All these terms are synonymous. The unit principle was originally called the utility valuation principle. That is because the unit principle was originally developed—over a century ago—to value the property of public utilities. At that time, just about all electric industry, railroad, communications, interstate pipeline, and similar properties were public utilities. In fact, they were regulated public utilities. However, very few of those industries are still public utilities (regulated or unregulated) today. As described below, the unit principle is particularly applicable to “utility-type” properties. Utility-type properties are not necessarily owned by public utilities. Rather, they are physically, functionally, and economically integrated bundles of property; typically operating together as part of a going concern business.

As mentioned above, this discussion will be presented in five installments. The overall discussion will encompass the following topics:

• What constitutes a unit principle valuation
• The conceptual and practical bases for the application of the unit principle
• The differences between a unit principle valuation and a summation principle valuation
• When to (and when not to) apply the unit valuation principle
• Generally accepted unit valuation approaches, methods, and procedures
• Reconciling the various unit value indications
• Adjusting the unit value conclusion to indicate the value of taxable property
• Allocating the unit value among taxing jurisdictions
• Application strengths and weaknesses of the unit valuation principle

This discussion installment will focus on the first two of the above-mentioned topics.

Due to space and scope limitations, this discussion will not present a comprehensive description of the development of unit valuation approaches, methods, and procedures. Such a description deserves a more comprehensive discussion. Such discussions are available in some property appraisal textbooks. And such discussions are available in some property appraisal professional standards. Analysts seeking more comprehensive guidance should be cautioned, however. Many property appraisal textbooks and many property appraisal professional standards focus principally (if not exclusively) on the summation valuation principle. Such guidance may have limited application to (and, in fact, may be inapplicable to) unit principle valuations.

It is also noteworthy that this discussion is limited to the application of the unit valuation principle for property tax compliance, administration, and controversy purposes. Property taxation, like any taxation, is fundamentally a legal matter. This discussion will provide valuation guidance. This discussion will not provide legal guidance. The following questions (and others) may involve legal issues: When is the unit principle applicable for property tax purposes? Which industries may (or must) be subject to the application of the unit principle for property tax purposes? What components of the unit are (and are not) taxable in a certain jurisdiction? What is the appropriate valuation date, standard of value, and premise of value for the property valuation? Which generally accepted property valuation approaches and methods may (or may not) be applied in the unit valuation developed for property tax purposes? How should the various value indications developed in the unit valuation be reconciled to develop the overall value synthesis and conclusion?

The answers to the above questions (and others) may be taxing jurisdiction-specific. Accordingly, analysts and other property tax practitioners may need to consider the applicable statutory authority, judicial precedent, and administrative rulings.

Definitions

This discussion will benefit from a common and clearly defined vocabulary. The following terms will be used in this discussion, and they are defined within the context of this unit valuation discussion only. That is, these terms are not necessarily defined in strict compliance with either generally accepted valuation principles or generally accepted accounting principles. However, these terms and these definitions are intended to be generally consistent with the official definitions of the relevant valuation standards and accounting standards.

These terms are defined as they are used in this particular topical discussion. As with most technical jargon, the following terms may have alternative meanings; based on the context in which they are used.

Ad valorem taxation—a type of property taxation where the tax is based on the defined value of the taxable property

Appraisal—the act of developing an analysis and concluding a defined value for a property

Appraisal report—any written or oral reporting of the appraisal analysis and the value conclusion

Appraisal approaches—the three generally accepted approaches that may be developed to conclude any property value, generally referred to as the cost approach, the market approach, and the income approach

Appraisal methods—the generally accepted analytical methods within each of the three appraisal approaches; for example, the direct capitalization method and the yield capitalization method are both methods within the income approach

Appraisal procedures—the generally accepted quantitative or qualitative analyses that are developed within an individual appraisal method; for example, the capital asset pricing model is a procedure that may be applied to develop a capitalization rate within an income approach method

Assemblage—a collection or bundle or group of properties, that may include tangible properties and/or intangible properties; an assemblage (or group) of properties is not the same as assemblage value (which is the value increment that is created when various properties are assembled into a bundle)

Asset—something that is owned and will provide its owner with a future economic benefit and that is recognized for financial accounting purposes under U.S. GAAP; accordingly, asset is an accounting term

Business valuation—the development and reporting of the defined value of a going concern business enterprise or of a fractional ownership interest in a going concern business enterprise; also referred to as a business appraisal

GAAP—U.S. generally accepted accounting principles, as promulgated by the Financial Accounting Standards Board and codified in the Accounting Standards Codifications

Intangible property—property that derives its utility and its value from its intangible nature, with its intangible nature generally associated with a bundle of legal rights

Personal property—property that is capable of being physically moved without damaging the property; property that is not permanently attached to the land

Premise of value—in an appraisal, the assumed set of transactional conditions under which an exchange of property takes place; typical premises of value include: value in use, value in place, and value in exchange (under various conditions)

Property—something that is owned, something that may be exchanged (either individually or with other property), something that is protected by either federal or state law; accordingly, property is a legal term

Property taxation—a tax on the ownership or use of property; the tax may be based on the value of the property, the amount of use of the property, a fixed amount per property type, or some other quantifiable basis

PVGO—present value of growth opportunities; in a business valuation, the present value of the expected future income associated with future tangible property and future intangible property that does not yet exist on the valuation date; accordingly, PVGO is typically not considered to be property

Real property—property that is not capable of being moved; property that is permanently affixed to the land

Reconciliation—the process of synthesizing the various value indications developed by several appraisal approaches or methods to reach a final value conclusion; the process of reconciliation may be quantitative (based on mathematical weighting of the value indications) or qualitative (based on analyst judgment)

Standard of value—the definition or the characteristics of the value sought in an appraisal; the standard of value typically answers the question: value to who?

Summation valuation principle—the appraisal of an assemblage or bundle of property where each component of property is appraised individually; the values of each of the individual property components is summed (hence the name summation principle) to conclude the value of the total bundle of property

Tangible property—property that derives its utility and its value from its tangible nature, with its tangible nature generally associated with a bundle of legal rights; tangible property includes both tangible personal property and tangible real property (also referred to as real estate)

Unit of property—an assemblage or collection of property that is typically operating as part of an incoming-producing, going concern business enterprise; a unit of property can include both real and personal property and both tangible and intangible property

Unit valuation principle—the appraisal of an assemblage or bundle of property where all of the components of property are appraised collectively—as a single operating unit (hence the name unit principle)—to conclude the value of the total bundle of property; the total unit value may be allocated to the various property components, if such a value allocation is needed

Valuation date—the “as of” date for which the value conclusion applies to the subject property

As with most professions, there is a body of technical jargon associated with the property tax valuation discipline. Unfortunately, analysts, attorneys, and other professionals associated with property tax administration, compliance, and controversy are not as precise in their use of language as they could be.

The imprecise use of jargon often results in confusion and miscommunication with regard to the development of unit principle valuations. This is because many of the terms used in a unit principle valuation are similar to (or even identical to) the corresponding terms used in a summation principle valuation. However, the meaning of those terms can be subtly (but importantly) different.

As will be explained below, both the unit valuation and the summation valuation involve the application of the cost approach, the market approach, and the income approach. However, the individual valuation methods and valuation procedures applied within the three generally accepted approaches are materially different between a unit valuation and a summation valuation. As an example, in both a unit valuation and a summation valuation, the development of the income approach involves the capitalization of “income”. However, the measurement (or definition) of this “income” is materially between a unit valuation and a summation valuation.

Accordingly, all parties who develop, report, and rely on unit principle valuations for property tax purposes are encouraged to be careful and consistent in their use of technical jargon.

Fundamentals of the Unit Valuation Principle

The unit principle involves the valuation of an assemblage or bundle of numerous properties (that may include numerous property types) as a single “unit”. That is, the collection of properties is valued in the aggregate and as a whole The value of all the subject properties is estimated in the aggregate; as if the collection of properties would sell in the marketplace as one unit.

In fact, that is the fundamental principle of unit valuation. The principle is that all the subject properties would be bought and sold together; in one transaction. And that one aggregate transaction price represents the total value of all of the individual properties included in the hypothetical sale transaction.

The theoretical premise of the unit principle is that the use of unit valuation is not determined by a statutory requirement (although such a requirement may exist). The use of unit valuation is not determined by the analyst’s professional judgement (although the analyst may have selected that methodology). And the use of unit valuation is not selected because of each of the applications or because of data constraints (although those factors may have influenced the application of the unit principle). In theory, the use of unit valuation is determined by the marketplace. Buyers and sellers of the various subject properties (i.e., market participants) do not see numerous individual properties. Rather, market participants see—and evaluate and transact on—a single total unit of property.

Applying the unit principle, the subject property is not only valued collectively (in the aggregate), it is typically valued in use. That is, the appropriate premise of value for the unit principle valuation is typically value in use, as part of a going concern. That does not mean that the unit valuation does not conclude an exchange price. It does conclude with an exchange price. But the exchange price assumes that all the subject property sells at one time. All the subject property does not sell separately and individually. And when that bundle of property sells, it sells as a single unit that is being used collectively.

That hypothetical exchange (as an aggregate unit) represents the highest and best use of the subject property.

The unit valuation typically analyzes the hypothetical sale of the total property not only in use, but in use and generating income. That is, the unit is typically assumed to be a part of a going concern. That does not mean that the unit is a going concern business enterprise. A going concern business enterprise is typically the owner of the unit. But the going concern business enterprise is not the unit. As will be explained below, the going concern business enterprise typically includes elements (such as the present value of growth opportunities and investment attributes) that are not part of the property unit.

Accordingly, a unit valuation is not a business valuation. A unit valuation is a property valuation.

A unit valuation involves the valuation of property. A unit valuation does not involve the valuation of the property owner.

These distinctions are particularly important for property tax administration, compliance, and controversy purposes. Property tax is a tax on property. It is not a tax on the owner of the property. Property tax is not a business tax. Property tax is not a business income tax or a business franchise tax.

Property tax is also not an asset tax. It is not a tax on the assets owned by a business. As mentioned in the definitions section above, the term assets is an accounting term. Assets are recorded on a business’s balance sheet prepared in accordance with GAAP. Some assets are recorded on an accounting balance sheet, but they are not property. Some property is not recorded on a balance sheet prepared in accordance with GAAP. Property tax is a tax on property;  not a tax on the accounts recorded on a business’s balance sheet.

The unit valuation should conclude the value of a unit of property;  not the value of a business, of the current owner of the property, of the income generated by the business owner, or of the assets recorded on the business’s balance sheet.

The concept of the unit principle is not new. In fact, it has been around since at least the end of the 19^th century. It was originally developed to appraise the property of rate-based, regulated utilities. Later the application of the unit principle expanded to all regulated utilities (rate-based or not). Later still, the application of the unit principle expanded to all utilities (regulated or not). And now the unit principle is often applied to all utility-type properties. A further description of utility-type properties is provided below.

The concept of the unit principle is consistent with (and, in some cases, required by) generally accepted appraisal standards. While primarily related to summation principle appraisals, the unit valuation principle concept is endorsed in the Uniform Standards of Professional Appraisal Practice (promulgated by The Appraisal Foundation). And the unit valuation principle concept is frequently mentioned in the Uniform Appraisal Standards for Federal Land Acquisitions (promulgated by the Interagency Land Acquisition Conference and published by The Appraisal Foundation). For certain types of physically, functionally, and economically integrated properties, the unit valuation principle is considered a best practice in the valuation profession.

As mentioned, the application of the unit valuation principle is not restricted to public utility properties. As further explained below, the unit valuation principle may be applied to various types of complex properties in many industries. The application of the unit valuation principle is not restricted to centrally assessed taxpayers. The use of the unit principle is common among centrally assessed taxpayers and industries. However, local property assessors often apply the unit principle to value locally assessed utility-type properties. And the application of the unit valuation principle is not restricted to appraisals developed for ad valorem property tax purposes. Of course, property taxation is the focus of this discussion. But the unit valuation principle is often applied to value utility-type properties for transaction, financing, financial accounting, bankruptcy, and many other non-taxation purposes.

Conclusion

This first installment summarized the fundamentals of the unit valuation principle for property tax compliance, administration, and controversy purposes. The next installment of this five-part series will summarize the differences between the unit valuation principle and the summation valuation principle.

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Robert F. Reilly, CPA, ASA, ABV, CVA, CFF, CMA, is a retired professional and former Managing Director of Willamette Management Associates, an independent consultant. He lives in Chicago and in his previous work at Willamette Management, which he is continuing, included business valuations, forensic analysis, and financial opinion services.

Mr. Reilly can be contacted at (847) 207-7210 or by e-mail to robertfreilly.cpa@gmail.com.