The Unit of Valuation Principle for Property Tax Purposes

When to Apply

This second of a five-article installment discusses the application of the unit valuation principle. Guidance is provided for when to apply the unit of valuation principle.

Read Part I here.

Introduction

This discussion is the second installment of a five-part series related to unit principle valuations prepared for property tax compliance, administration, and controversy purposes. As was introduced in the first installment, the unit principle is often applied to collectively value a large assemblage (or a unit) of taxpayer property. This principle is typically applied to value complex, utility-type property that is physically, functionally, and economically integrated.

Unit Valuation Principle and Summation Valuation Principle

Unit valuation approaches, methods, and procedures are applied to conclude a value for a total unit of property. The unit valuation principle concludes with a total value for a total unit of property. Summation valuation approaches, methods, and procedures are applied to conclude a value for individual pieces, components, or elements of property. That property can be real property or personal property. And that property can be tangible property or intangible property. The summation valuation principle concludes with a separate value for each individual piece of property. To conclude a total value for a bundle (or unit) of various pieces of property through the summation principle, first, each individual piece is appraised separately. And second, all the individual values are added (or summed) to conclude the value of the total unit of property.

As mentioned previously, the names of these unit principle and summation principle approaches, methods, and procedures may sound similar. However, the application of the two sets of approaches, methods, and procedures (i.e., the actual valuation mechanics and mathematics) may be materially different.

It is important to note that the unit principle and the summation principle should conclude the same total value for the same bundle of property. However, that statement is only true if all elements of the two valuations are the same. The elements of the valuation include: the standard (or definition) of value sought, the premise of value applied, the valuation date used, and (importantly) the exact same bundle of property is valued. However, the values concluded by these two valuation principles are not always the same. Almost invariably, this is because the two appraisals valued different bundles of property.

Often, the summation valuation will analyze and value a specified list of real estate and tangible personal property. In contrast, the unit valuation may be applied to analyze and appraise that same bundle of tangible property plus some associated intangible property; and even some non-property intangible investment attributes of the property owner’s business.

The point is that the selection and application of the unit principle or the summation principle should not be based on the objective of concluding a higher value or a lower value for the subject property. If the same bundle of property is analyzed, there is no directional bias in a unit valuation compared to a summation valuation. For the same bundle (or unit) of property, neither valuation principle should conclude a higher value—or a lower value—than the other. Therefore, the selection and application of the unit principle versus the summation principle should be based on which valuation principle will be more effective and efficient in developing the property valuation. That selection and application should not be based on concluding a directionally desired value.

Typically, most property appraisers are inclined to select the summation valuation principle and to develop a summation principle appraisal. That is, unless the unit valuation is required by statute or regulation, most property appraisers gravitate towards the development of a summation principle appraisal. However, where the summation valuation principle is not practical (or not possible) for the subject complex property, property appraisers will select and apply the unit valuation principle. Like the summation valuation principle, the unit valuation principle can be applied to conclude just about any standard of value appropriate to the subject taxing jurisdiction. That is, both valuation principles can be applied to conclude market value, fair market value, true cash value, or any other standard of value required by the relevant statutory authority.

Most property appraisers and most users of appraisals (including market participants, financing lenders, attorneys, property tax administrators, and others) are more familiar with the summation principle than with the unit principle. That is because most property appraisals are developed using the summation valuation principle. And that is because most properties (certainly most simple properties) can be effectively and efficiently appraised through the application of the summation valuation principle.

For example, most residential properties are typically appraised using the summation principle. Such properties include single family residences, multiple family condominium properties, multiple family rental properties, etc. Even simple commercial properties are often appraised using the summation principle. Such properties include strip shopping centers, standalone retail stores, standalone warehouses, etc. However, the summation valuation principle is not typically effective or efficient in the appraisal of more complex industrial and commercial properties; and particularly of complex utility-type properties.

Because summation principle appraisals are more common, there is more professional literature guidance, more valuation professional standards guidance, and more judicial precedent guidance regarding the development of summation appraisals. However, that professional guidance is not always applicable to the development and reporting of unit valuations. For example, The Appraisal of Real Estate (published by the Appraisal Institute) is authoritative literature regarding the summation appraisal of real estate. However, that authoritative textbook provides little or no guidance regarding unit principle valuations. Similarly, the Valuation of Machinery and Equipment (published by the American Society of Appraisers) is authoritative literature regarding the summation appraisal of tangible personal property. Again, that authoritative textbook provides little or no guidance regarding unit principle valuations.

As with the professional valuation literature, valuation professional standards provide limited guidance regarding the development and reporting of unit valuations. The Uniform Standards of Professional Appraisal Practice (USPAP [promulgated by The Appraisal Foundation]) provide authoritative standards regarding summation principle valuations. In fact, USPAP provides professional standards regarding the summation appraisal of real estate, tangible personal property, and intangible personal property. But USPAP provides precious little guidance regarding the development and reporting of unit principle valuations.

Likewise, most state and local property tax-related judicial precedent relate to the summation valuation of relatively simple properties. Accordingly, that judicial commentary related to valuation data sources, methodology, reporting requirements, etc., often provides limited guidance related to the development and reporting of the unit principle valuations of complex, utility-type properties.

There is relatively little professional guidance related to the most significant difference between summation valuations and unit valuations. That difference relates to the data sources, analysis, selection, and application of the specific valuation variables that go into the valuation approaches, methods, and procedures. The term valuation variables is the jargon related to the actual numbers that go into the analysis.

Typical examples of valuation variables include: the property income metric, the market-derived direct or yield capitalization rate, the rate of change of the property income, the relationship between operating income and net cash flow, the property cost metric, the property depreciation metric (particularly with regard to the economic obsolescence component), the market-derived pricing multiples applied, and the measure of property income that the market-derived pricing multiples are applied to. Each of these valuation variables can be sourced, analyzed, and concluded differently between a summation valuation and a unit valuation.

One reason why these valuation variables are derived from different data sources, are analyzed differently, and are concluded differently relates to the term “market-derived”. The “market” is typically different in a summation valuation and a unit valuation. In a summation valuation, the market participants are assumed to be buying and selling individual properties (whether real or personal). In a unit valuation, the market participants are assumed to be buying and selling total bundles of property (including both real and personal). And that total bundle of property is assumed to be working together to generate unit-level income.

In fact, in the unit principle, many of the valuation variables relate to going concern businesses and to capital market data sources. The use of such valuation variables can import business enterprise value into the property appraisal. Therefore, as discussed below, the concluded value for the total unit of property may have to be adjusted to conclude the value of the unit of taxable property.

When to Apply the Unit Valuation Principle

Since most property appraisals apply the summation valuation principle, it is reasonable to explore when it is appropriate for an analyst to apply the unit valuation principle. Within the context of this discussion, this question is particularly relevant regarding property valuations developed for ad valorem taxation purposes. There are three categories of reasons to apply the unit valuation principle: legal compliance reasons, valuation best practices reasons, and practical application reasons.

Of course, the legal compliance reasons involve complying with the law. If the application of the unit principle is required by statute or by administrative ruling, then the appraiser will develop a unit principle valuation of the subject property. Such statutes and rulings typically apply to property that is centrally assessed for property tax purposes. For example, a state statute (or a state department of revenue administrative ruling) may state that all railroads or all interstate pipelines or all mining properties must be appraised by application of the unit valuation principle. Of course, analysts—and taxpayers—will comply with that legal requirement.

The valuation best practices simply relate to when it is a best practice, in the analyst’s professional judgment, to apply the unit valuation principle. Some of these best practices reasons to apply the unit principle include the following:

• When the various components of the subject bundle of property are physically, functionally, and economically integrated.
• When the subject property financial and operational data (historical and/or prospective) are only available at the unit level (and not at the individual property component level).
• When the subject property would sell as (or has sold as) a single unit (rather than as individual property components).
• When the only measure of property income available for analysis is business operating income (rather than individual property rental income).

The practical application reasons relate to whether it is only practical (or only possible) to apply the unit valuation principle to effectively value the subject property. Some of these practical application reasons include the following:

• When the subject unit is real estate-dependent; that is, when the subject business operations cannot be practically separated from the individual real estate parcels.
• When the subject property physically moves over time.
• When the subject property crosses over multiple taxing jurisdictions.
• When the subject property is simply too big or too complex to efficiently appraise by the application of the summation valuation principle.

The above listing of reasons is intended to be representative; it is not intended to be a comprehensive listing of reasons.

The following listing presents some of the types of properties—and some of the industries—that are typically valued by the application of the unit valuation principle:

• Airlines
• Railroads
• Telecommunications property
• Electric generation, transmission, and distribution property
• Pipelines, interstate, and intrastate
• Cable TV systems
• Water and wastewater distribution systems
• Racetracks
• Marinas
• Sports stadiums and other entertainment venues
• Hospitals and nursing homes
• Mines and mineral production facilities
• Oil and gas refineries
• Natural gas distribution systems
• Oil and gas gathering systems
• Golf courses and country clubs

The above listing of property types and industries is intended to be representative; it is not intended to be a comprehensive listing. Although few (if any) of the above industries are still considered to be public utilities, these properties are typically considered to be utility-type properties; at least for valuation purposes.

Conclusion

This discussion summarized what analysts need to know about the application of the unit valuation principle for property tax compliance, administration, and controversy purposes. The next installment of this five-part series will summarize what analysts need to know about the generally accepted unit valuation approaches and methods that may be applied to value the above-mentioned utility-type property types.

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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.