The Unit Valuation Principle for Property Tax Purposes

Issues and Caveats (Part V of V)

This final of a five-article series discusses the application of the unit valuation principle. This installment describes many of the application issues and caveats related to the use of the unit principle to value the unit of taxable property.

Read Part I here. Read Part II here. Read Part III here. Read Part IV here.

Introduction

This is the fifth installment of a five-part series related to the application of the unit valuation principle for property tax compliance, administration, and controversy purposes. Previous installments of the series summarized what analysts need to know about the application fundamentals of the unit valuation principle. Previous installments also summarized what analysts need to know about the development of the unit principle approaches, methods, and procedures to conclude the taxpayer’s property value. This final installment describes many of the application issues and caveats related to the use of the unit principle to value the unit of taxable property.

Adjustments to Conclude the Taxable Unit Value

The question of what type of property is—or is not—subject to property tax in any jurisdiction is a legal question. It is not a valuation question. It is not a matter of the analyst’s judgement. It is a matter of law.

The client—not the analyst—decides the valuation assignment. That is, the client tells the analyst what to value. The analyst does not tell the client what to value. The taxpayer client—or the client’s legal counsel—should specify for the analyst what type (or categories) of property are subject to property taxation in the local jurisdiction. If the client asks the analyst to value its entire unit of property, then the analyst will do just that: value all of the property within the unit. If the client asks the analyst to value the total unit of taxable property, then the client has to specify what property categories qualify as taxable property.

The valuation assignment can be defined by inclusion; for example, the total unit of real estate and tangible personal property. Or the valuation assignment can be defined by exclusion; for example, the total unit of taxpayer property less all (or some specified) intangible personal property. However, the composition of the total unit of taxable property should be defined for the analyst. And to value that total unit of taxable property, the analyst will likely have to adjust the total unit value. The analyst will typically apply those adjustments through the following formula:

• Value of the total unit of property
• Less: value of the property not subject to property tax
• Equals: value of the total unit of taxable property

Of course, in any taxing jurisdiction, only property can be subject to property tax. If the subject unit value includes components of value that do not relate to property, then those components should be adjusted (removed) from the taxable unit value. Depending on the unit valuation methods applied and on the individual valuation variables selected, the concluded total unit value could include PVGO and/or the value of investment attributes not related to property in place.

PVGO represents the value of future tangible and intangible property not yet in existence as of the valuation. Future property (including future tangible property) would not be subject to property taxation, until it is constructed or purchased. Investment attributes include liquidity, limited liability, diversification, and similar investment attributes of publicly traded stocks and bonds. These investment attributes are not intangible property. In fact, these investment attributes are not property at all.

If the values of PVGO and/or the values of investment attributes—or the values of any other non-property elements—are included in the total unit value conclusion, then the analyst should adjust (reduce) the total unit value to conclude the value of the unit of taxable property.

Depending on the statutory definition of taxable property in the local jurisdiction, it is likely that the total unit value will have to be adjusted in order to conclude the value of the unit of taxable property. Depending on the statutory definitions in the local jurisdiction, the following property types (or categories) may not be subject to property taxation:

• Intangible personal property (recall that any financial accounting intangible assets are not necessarily the same as legal intangible property)
• Intangible investment attributes (as mentioned above, while these attributes are not tangible, they are also not property)
• Working capital/financial property (while not considered intangible assets for financial accounting purposes, these accounts are intangible property)
• Non-operating property (these property components may or may not be taxed separately, but they are not part of the unit of operating property)
• Regulatory accounts (like working capital accounts, these long-term financial accounts are also intangible property)
• Pollution control equipment (some jurisdictions permanently or temporarily exempt from taxation this tangible property category)
• Locally assessed property (for taxpayers subject to central assessment, certain general purpose real estate may be taxed outside of the total unit)
• Property taxed other (non-ad valorem) ways (for example, over the road vehicles may be taxed through a license plate taxing regime)

If any of these categories of property tax exemptions apply to the subject taxpayer, then the analyst must identify the exempt property categories, value the exempt property categories, and adjust (reduce) the total unit value for the value of the exempt property categories.

The mathematical mechanics of making these value adjustments is straightforward; and was illustrated above. First, the total unit value is concluded. Then the value of each exempt property category is concluded. Then the total unit value is adjusted (reduced) by the value of each exempt property category. Finally, the residual amount indicates the value of the unit of taxable property. That is, the adjustment process is conducted at the total unit level. Such a total unit value and total exempt property value adjustment process is efficient, effective, and conceptually sound.

It is an error to make value adjustments within the unit valuation analysis. In other words, adjustments are not made at the cost approach, market approach, or income approach level; for any type of exempt property adjustment. Such adjustments within the unit valuation analysis are not efficient, not effective, and not conceptually sound. Making value adjustments within the unit valuation analysis introduces a high probability of application error. That is, there would be a high probability that the value impact of an adjustment would be either understated or overstated.

After the adjustments are appropriately applied at the total unit level and at the total exempt property level, the adjusted unit value should represent the value of the unit of taxable property. Of course, it is important that any exempt property categories be valued using the same standard of value and the same premise of value as was applied to value the total unit. In addition, it is important that consistent valuation variables (not necessarily identical variables, but consistent variables) be applied to value both the total unit and the individual categories of exempt property. If consistent valuation elements are applied, then the concluded unit principle value of taxable property should be about the same as the summation principle value for that same bundle of taxable property.

If the total unit of taxable property crosses over taxing jurisdictions, then that total unit value may have to be allocated among the taxing jurisdictions. That unit value allocation process is discussed next.

Total Unit Value Allocation

The purpose of the unit value allocation process is to take the total value of the property subject to taxation and allocate that total value among the various taxing jurisdictions in which the property is located. If the taxpayer property is centrally assessed, then the total unit value has to be allocated to the various states in which the property is located. If the taxpayer property is locally assessed, then the total unit value also must be allocated to the various counties or appraisal districts in which the property is located.

As with the valuation reconciliation process, the first question related to the unit value allocation process is: Is there a statutory allocation procedure that the taxpayer or the analyst has to comply with? In other words, does the subject taxing jurisdiction require a certain allocation for all unit principle valuations; or for all unit valuations of certain property types; or for all unit valuations of property in the taxpayer’s industry? If the answer is yes, then of course the taxpayer and the analyst must apply that unit value allocation scheme; at least in that taxing jurisdiction. If the answer is no, then the analyst will apply professional judgment to develop and apply a unit value allocation procedure.

Whatever allocation procedure is developed by the analyst, it should be rational, replicable, and consistent. Rational means that the allocation process should make sense, given the type of taxpayer property valued. Replicable means that the allocation process can be mathematically duplicated, and the duplication will result in the same value allocation. Consistent means that the same allocation process can be applied in each taxing jurisdiction in which the taxpayer property is located. Also, the selected allocation scheme should distribute the total unit value in a way that is fair to all of the taxing jurisdictions in which the taxpayer property is located.

Ideally, the selected allocation process would be based on the operating income earned by the property in each jurisdiction compared to the total operating income earned by the total unit of taxable property. After all, directly or indirectly, each of the unit valuation approaches considers the total operating income in the development of its unit value indication. Usually, such an income-based value application process is not feasible. That is because the taxpayer does not record income at the jurisdiction level. Rather, the taxpayer records income at the unit level. If the taxpayer could measure income at the jurisdiction level, it may not be necessary to develop a unit principle valuation. A unit principle valuation—instead of a summation principle valuation—is appropriate when the taxpayer can only measure income at the unit level.

There are several quantitative metrics that are typically used in the development of the unit value allocation. The most typical of these metrics fall into three categories: cost metrics, size metrics, and operational metrics. While the selection of the most appropriate metric will vary based on the type of taxpayer property and the taxpayer industry, the cost-related metrics are the most typically applied.

The cost metrics typically rely on the financial accounting cost data recorded in the taxpayer’s continuing property records. The cost metric used can be historical cost, historical cost less depreciation, or a combination of the two. If the historical cost data are no longer available (because the taxpayer business entity was acquired in a transaction accounted for as a business combination), then the analyst may have to use original cost, original cost less depreciation, or a combination of the two. Of course, these cost data are only relevant if the taxpayer’s continuing property records capture a location code to tell the analyst the taxing jurisdiction in which the property is located.

Alternatively, size metrics can be used as an allocation measurement if property size data are both available and relevant to the subject property type. For example, size-related data could include inch-miles of pipe for an interstate or intrastate pipeline, number of miles of cable for a cable TV system, number of miles of wire for an electric transmission or distribution system, etc. Again, the size-related data are only relevant if the taxpayer’s continuing property records capture a location code to tell the analyst the taxing jurisdiction in which the property is located.

Finally, operational metrics can be used as an allocation measurement if the operational data are both available and relevant to the subject property type. The operational metrics should be somehow related to how the total property unit generates income. An example of such an operational metric would be the number of airport operations for an airline. In the airline industry, an airport operation is either the take-off or the landing of an aircraft. Of course, the operational metric is only relevant if the taxpayer’s data captures the location in which the operational event occurred.

When selecting and applying a unit value allocation scheme, the analyst should consider a number of application issues. The selected allocation process should not allocate less than 100 percent of the total unit value to all the affected taxing jurisdictions. And the selected allocation process should not allocate more than 100 percent of the total unit value to all of the affected taxing jurisdictions. Unfortunately, this type of under- or over-allocation problem can easily occur when different taxing jurisdictions require different allocation procedures for the same taxpayer. Of course, there is a simple mathematical test to see if the selected allocation process is effective. The sum of all the allocated unit values should equal the total value of the unit of taxable property.

It is important to understand that the allocated unit values are just that, allocations of a total unit value. As mentioned above, the allocation scheme should be rational, replicable, and consistent. But the allocated value still represents a reasonable allocation of the total value of the taxpayer’s unit of taxable property. The allocated unit value may not be the same conclusion reached by the development of a summation principle valuation of the specific property components located in a particular taxing jurisdiction.

All unit value allocations should be fair to each affected taxing jurisdiction and to the taxpayer. The conclusion of the process is an allocation of the total unit value of a bundle of physically, functionally, and economically integrated property. The allocation can be made based on various cost, size, or operational factors. But the allocation is not a separate summation valuation of the specific property located in each taxing jurisdiction. If such a separate summation principle valuation was possible, then the analyst would not have needed to develop a unit principle valuation.

Unit Valuation Principle Application Issues

Due to space constraints, the following discussion does not present a comprehensive list of all of the issues—or caveats—related to the application of the unit valuation principle. This discussion does summarize 10 representative application issues. Also, the list is not presented in order of importance or priority.

First, the unit valuation conclusion (before adjustment) typically includes intangible property. If intangible property is not subject to property taxation in the subject jurisdiction, adjustments may need to be made. In addition, the intangible property could include both intangible assets that are recognized for financial accounting purposes and intangible property that may not be recognized for financial accounting purposes. The unit valuation will typically include the value of the taxpayer’s business goodwill. Although goodwill may be recognized for financial accounting purposes, it may not be considered property in the subject jurisdiction. This is because goodwill is often defined as the present value of income that cannot be associated with any identified tangible property or intangible property.

Second, the unit valuation conclusion typically includes the value of intangible investment attributes or influences. Although intangible, these attributes are not intangible property. In fact, they are not property at all. Also, they are not recognized as intangible assets for financial accounting purposes. Whenever the unit valuation considers capital market data (stock or bond prices, rates of return, etc.), the value of these capital market investment influences may be captured in the unit value. As mentioned above, there are numerous investment attributes or influences associated with reliance on capital market data.

Most analysts immediately think of liquidity as such an investment attribute, but liquidity is not the only one. However, the liquidity attribute is easy to understand. Publicly traded stocks and bonds are perfectly liquid. They can be sold immediately at a certain price, and with very little transaction expense. Investors pay a price premium for such liquidity. In contrast, property is illiquid. It cannot be sold immediately at a certain price, and with little transaction expense. Investors demand a price discount for illiquidity.

When relying on capital market data to develop valuation variables, analysts should consider the value influences associated with all of the investment attributes.

Third, analysts should carefully select all growth rate variables applied in all of the unit valuation approaches. Typically, the selected long-term growth rate should not exceed the expected inflation rate plus a unit-specific real growth rate component. This unit-specific real growth rate is the rate that the unit of property in place can achieve. In other words, that growth rate should not be based on assumed expansionary capital expenditures or on mergers and acquisitions. And the analyst should recognize that the property in place probably has a physical capacity limitation. There is likely a volume limit to the income that can be generated by the pipeline, electric lines, railroad rolling stock, aircraft, or other property in place. That physical capacity limitation places a limit on the appropriate expected long-term growth rate applied in the unit valuation.

Fourth, the unit valuation should incorporate the expected long-term growth rate in the unit of property; not the long-term growth rate of the taxpayer property owner or the long-term growth rate in the taxpayer’s industry. The taxpayer business enterprise growth rate and the taxpayer industry growth rate both incorporate investor expectations for expansionary capital expenditures and, likely, for merger and acquisition activity. Therefore, these growth expectations include future property that is not included in the unit in place as of the valuation date. In addition, the unit valuation growth rate should be applicable to the measure of income considered in the valuation analysis; typically net cash flow. That means, it should not be a revenue or volume growth rate; either for the taxpayer’s business or for the taxpayer’s industry.

Fifth, analysts should be careful when developing capital expenditure and depreciation expense projections. Analysts should carefully consider the relationship between capital expenditures and depreciation expense. The unit valuation typically includes the value of the property in place, and direct replacement property when the subject property wears out. Therefore, unit valuation typically considers maintenance capital expenditures only. Capital expenditure projections that exceed depreciation expense projections will result in a valuation conclusion that includes property not yet in place as of the valuation date.

Sixth, the unit valuation conclusion (before adjustment) will likely include the value of property other than the taxpayer’s real estate and tangible personal property. The inclusion of intangible property value was summarized in a previous caveat. In addition to intangible property, the unit valuation conclusion will likely include the value of working capital accounts, regulatory asset accounts, non-operating property, investments in non-consolidated investments, and of types of financial property. Even in jurisdictions where intangible personal property is taxed along with real estate and tangible personal property, the analyst may have to adjust (reduce) the unit value conclusion for these other financial property components.

Seventh, in some cases, the taxpayer property owner may own other business units that are not part of the subject unit of taxable property. This is often the case when the taxpayer is a diversified public corporation. In such cases, the taxpayer company may own the unit of utility-type property and other business units of unrelated property. This situation may occur, for example, with publicly traded railroads, airlines, pipeline companies, energy companies, etc. In such cases, the analyst should be careful when using consolidated financial statements, consolidated financial projections, taxpayer stock prices or pricing multiples, and taxpayer stock rates of return in the subject unit valuation. The use of such public taxpayer data could affect the unit valuation by importing components of non-unit value into the valuation.

Eighth, sometimes analysts consider comparable company merger and acquisition pricing data and transaction multiples in the development of the unit valuation. When such transactional data are considered, the analyst should understand the transaction structure of each comparable sale relied upon. That is, was each transaction a stock for stock, stock for assets, cash for stock, or cash for assets transaction? Obviously, the deal structure will impact the transaction pricing multiples. And pricing multiples from different transaction structures will have to be adjusted to a consistent deal structure before such data can be considered in the unit valuation.

In addition, the analyst will have to consider, and adjust for, if necessary, any liabilities assumed in each comparable sale transaction. Also, the analyst will have to understand, and adjust the transaction price, if necessary, for any comparable sale transaction earnout provisions, seller noncompete payments, or other transaction-specific deal provisions. Reliance on comparable sale transactions in a unit valuation requires a very comprehensive analysis.

Ninth, sometimes analysts consider comparable sale transaction allocation of purchase price data in the development of the unit appraisal. Of course, the analyst should consider all the transaction structure considerations mentioned previously. In addition, the analyst should be aware that allocations of purchase price are based on financial accounting guidance and reflect fair value measurements. The financial accounting guidance may not be consistent with the typical property appraisal guidance. And the fair value measurement conclusions may not be the same as market value appraisal conclusions. Accordingly, such comparable transaction allocations of purchase price may or may not be useful regarding the development of the subject unit valuation.

Tenth, as mentioned above, a unit principle valuation is not a business valuation. Compared to the unit valuation, a business valuation typically includes additional value components. A unit property valuation may not necessarily conclude the public stock price for a publicly traded taxpayer. Again, the public stock price typically includes additional value components. The public stock price will include the PVGO of the taxpayer business enterprise. A unit property valuation may not conclude with the acquisition price of the taxpayer business enterprise. The acquisition price typically includes additional value components. And corporate acquirers often pay an acquisition price premium based on buyer-specific expected synergies and economies of scale. Those acquisition price premium components do not necessarily reflect the market value of the taxpayer’s business; no less the market value of the taxpayer’s unit of property.

The above list of issues or caveats does not imply that a unit valuation should not be developed for property tax purposes. In many cases, the unit valuation is required by statute or regulation. In other cases, the unit valuation is appropriate based on the type of property owned by the taxpayer or based on the taxpayer’s industry. Rather, the conclusion is that analysts should be aware of these issues and caveats. Analysts should make appropriate adjustments to the unit valuation conclusion, when necessary. And analysts should discuss any applicable issue or caveat in the unit valuation report. That way, the party relying on the unit valuation conclusion is aware of any applicable issues or concerns. Then, that party can factor those issues or concerns (if any) into its understanding and reliance on the unit valuation conclusion.

Summary and Conclusion

A unit principle valuation is not a business valuation. However, business valuation analysts are often more comfortable with developing unit principle valuations than are property appraisers. Property appraisers are trained in—and experienced with—the development of summation principle valuations.

This five-installment discussion considered the following unit valuation principle topics: a definition of a unit of property, a comparison of the unit valuation principle and the summation valuation principle, the criteria for when to apply each valuation principle, a summary of the unit valuation approaches and methods, a summary of the summation principle valuation approaches and methods, a review of what property components are included in the unit value, a summary of unit valuation procedures, the reconciliation of unit value indications, unit value adjustments to conclude the value of taxable property, and unit valuation application issues and caveats.

This five-part discussion also considered the applicable property valuation jargon. Some valuation terms are used as synonyms. For example, a valuation is the same as an appraisal. A valuation synthesis is the same as a valuation reconciliation. And a unit valuation is the same as a unitary valuation. However, most valuation terms have specific meanings. Sometimes, those meanings are specific to the unit valuation principle or to the summation valuation principle. For example, a principle is not an approach, and an approach is not a method. So, the unit principle is not the same thing as the unit approach or the unit method. A principle (such as the unit valuation principle) is a fundamental and comprehensive set of doctrines, rules, or truths.

Some property tax practitioners may believe that strict adherence to professional jargon is just a matter of semantics or esoterica. Experienced analysts would disagree. Patients would be very uncomfortable with a physician who uses medical jargon inaccurately and inconsistently. Clients would have little confidence in an attorney who uses legal jargon inaccurately and inconsistently. Parties who rely on valuation analyses and valuation reports should have little confidence in analysts who have a casual relationship with professional jargon.

A unit valuation is not the same as a summation valuation of a large bundle of property. Unit principle valuations are based on unique, principle-specific procedures and analyses. Experienced analysts understand the differences between a unit principle valuation and a summation principle valuation. Property tax administrators and parties that rely on valuation should understand these differences as well.

Most property appraisals are developed using the summation valuation principle. Even regarding industrial and commercial property, most property types subject to valuation are stand-alone and relatively simple properties. Therefore, most of the professional property appraisal literature and professional property appraisal standards relate to summation principle valuations. However, professional literature and those professional standards have limited application to the development and reporting of a unit principle valuation.

Unit principle valuations are appropriate for complex properties that are physically, functionally, and economically integrated. Unit principle valuations are appropriate based on the nature of the subject property. Unit principle valuations may be appropriate based on data constraints. That is, if property component-specific financial and operational data are not available—but unit-level financial and operational data are available—then a unit principle valuation may be appropriate. Unit principle valuations are also appropriate for property that cross over several taxing jurisdictions. And unit principle valuations are appropriate for properties that move (such as airline or railroad property).

Most importantly, the market will tell the analyst when a unit principle valuation is appropriate. When the subject bundle of property would be bought and sold in the marketplace as a single unit, then a unit principle valuation is appropriate. When market participants apply unit principle valuation analyses in their property purchase or sale pricing decisions, then a unit principle valuation is appropriate.

Unit principle valuations are developed to value property. The conclusion of a unit valuation is a property value. Since property is not always the same thing as assets, a property valuation should be developed to value property. The term assets is a financial accounting term. Some elements of property are reported as assets on a taxpayer’s balance sheet; some are not. Some assets that are recorded as assets on a taxpayer’s balance sheet are property; some are not. Therefore, there is not necessarily an equivalence of property (recognized for property tax purposes) and assets (recognized for financial accounting purposes).

A unit principle valuation is not a taxpayer business valuation. The value of the taxpayer’s property in place on the valuation date is not necessarily the value of the taxpayer’s business enterprise on the valuation date. If market participants expect the taxpayer’s business to growth through expansionary capital expenditures—or through mergers and acquisitions, or to experience PVGO—then the taxpayer’s business value may be greater than the taxpayer’s unit value.

In conclusion, this five-installment discussion focused on what analysts need to know about the unit valuation principle for property tax compliance, administration, and controversy purposes. In such an application, a unit valuation is not only intended to value just any property, but also to value the property subject to property taxation in the subject taxing jurisdiction. Depending on what property categories are (or are not) subject to property taxation, the unit value may have to be adjusted (reduced) for any value components that are not taxed in the subject jurisdiction. In addition, the adjusted unit value may have to be allocated among several different taxing jurisdictions. A unit principle valuation developed for property tax purposes is not complete until all adjustments are made to conclude the value of the unit of property subject to property taxation.

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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.