The Unit Valuation Principle for Property Tax Purposes

Valuation Procedures

This fourth of a five-article series discusses the application of the unit valuation principle. This installment summarizes the generally accepted unit valuation procedures. But first, this discussion describes the generally accepted summation valuation approaches and methods as a comparison to the unit valuation approaches and methods.

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

Introduction

This is the fourth installment of a five-part series regarding the development of unit principle valuations for property tax compliance, administration, and controversy purposes. Previous installments described when and why to develop a unit principle valuation—instead of a summation principle valuation—particularly for utility-type properties and industries. The last article summarized the generally accepted unit valuation approaches and methods.

This installment summarizes the generally accepted unit valuation procedures. But first, this discussion describes the generally accepted summation valuation approaches and methods as a comparison to the unit valuation approaches and methods.

Summation Valuation Principle Approaches and Methods

The summation valuation principle may be easier to understand than the unit valuation principle. And the summation principle may be more familiar to analysts, to property appraisers, and to parties who rely on property appraisals. However, the development of a summation principle valuation just may not be applicable to the valuation of complex, utility-type properties.

The following three generally accepted property appraisal approaches are also applicable to the summation principle valuation: the cost approach, the market approach, and the income approach. However, the development of these three approaches is different for a summation valuation than it is for a unit valuation.

There are several valuation methods within the summation principle cost approach. These methods include the following:

• The reproduction cost new less depreciation method
• The replacement cost new less depreciation method

In the summation principle, reproduction cost new is also defined as the current cost to recreate an exact duplicate of the subject property. It is typical for property appraisers to trend historical costs by property type-specific trend factors to estimate reproduction costs. It is also typical for property appraisers to estimate the current construction or purchase costs to install the exact duplicate property. A reproduction cost estimate is developed for each individual property component in the assemblage of properties.

Replacement cost new is likewise defined as the current cost to recreate (through construction or purchase) the utility and functionality of the subject property. The replacement property is created with modern materials and modern design. Therefore, the replacement property will duplicate the utility and functionality of the subject property, but not the appearance of the subject property. Applying this method, a replacement cost estimate is developed for each individual property component in the assemblage of properties.

Unlike in the unit principle, the historical cost less depreciation method is rarely developed in a summation principle valuation. It may be applicable in the valuation of recently constructed or very new property.

In each summation principle cost approach method, three forms or types of appraisal depreciation are analyzed and applied. These three forms of depreciation are as follows:

• Physical depreciation
• Functional obsolescence
• External obsolescence

These three types of depreciation are defined the same way that they are defined in the development of a unit principle valuation. Unlike in a unit principle valuation, each type of depreciation is separately quantified for each individual property component in the assemblage of properties.

As with the unit principle valuation, each cost approach method should indicate about the same value for the same property in a summation valuation. While each cost approach method starts with a different measure of cost, the three depreciation measurements should adjust to that cost measurement. Therefore, the final property value indication should be about the same; regardless of the cost approach method applied.

There are fewer valuation methods within the summation principle market approach. Most property appraisers apply the direct sales comparison method in a summation principle market approach analysis. There is no equivalent to the stock and debt method in the summation valuation principle.

In the direct sales comparison method, the property appraiser searches for and selects sales of comparable properties. The property appraiser documents and applies specific comparability criteria in the search process. The property appraiser looks for arm’s length sales of properties that are directly comparable to the subject property. The procedure of searching for and relying on sales of guideline properties is not typically applied in a summation principle valuation. And the property appraiser searches for and analyzes sales of individual properties; and nor sales of large bundles of properties as in a unit principle valuation.

The property appraiser calculates pricing multiples for each comparable sale. The pricing multiple could be based on a financial metric, such as price compared to rental income. More typically, the pricing multiple is based on an operational metric, such as price to size, capacity, or some other volumetric measure. The property appraiser compares each comparable sale property to the subject property. Based on that comparison, the property appraiser selects a subject property-specific valuation multiple. The property appraiser applies the selected pricing multiple to the subject property’s operational fundamental in order to develop an individual property value indication.

There are several valuation methods within the summation principle income approach. Those valuation methods include the following:

• The direct capitalization method
• The yield capitalization method

The mechanics of the two income approach methods are pretty much the same in a summation principle valuation as they are in a unit principle valuation. However, the individual valuation variables used in each analysis will be materially different.

For example, both summation principle methods typically capitalize the property rental income (i.e., the income earned by the property owner from the rental of the property to an independent operator [lessee]). In contrast, both summation principle methods capitalize the property business operating income (i.e., the income earned by the property owner by operating the property as part of a going concern business operation). Both summation principle methods typically derive their capitalization rates from the sale of individual property components (i.e., the comparable property sale price compared to its rental income). In contrast, both unit valuation methods derive their capitalization rates from public company stock and bond market rates of return. Both summation principle methods typically assume a limited remaining useful life for the income stream associated with each property component. In contrast, both unit valuation methods assume a perpetual remaining useful life for the property unit income stream.

So, while the descriptions of the direct capitalization and the yield capitalization methods sound the same under both valuation principles, the mathematical development of the income approach methods is quite different under the two valuation principles.

After developing one or more valuation approaches, the property appraiser will synthesize the various value indications into a final summation value conclusion. As with the unit principle, that reconciliation process involves the property appraiser assigning either a quantitative or a qualitative weighting to each value indication. Because the data sources and the selected valuation variables differ between the two valuation principles, the property appraiser would likely assign different weight to the different appraisal approach value indications under the summation principle versus under the unit principle.

Unit Valuation Procedures

The scope of this discussion does not allow for a detailed description of each valuation procedure within each method within each approach of a unit principle valuation. Rather this discussion will focus on an illustrative list of the differences in valuation procedures between the unit principle and the summation principle. Due to space constraints, this list of differences is not exhaustive. And the list focuses on comparative differences. For example, there is no corresponding summation principle valuation method to the unit principle stock and debt method. Therefore, there is no procedural difference to discuss.

The order of the following list of procedural differences is not intended to indicate relative importance or priority.

• Property appraised: The unit valuation procedures estimate the value of the total bundle of property included in the taxpayer’s operating unit. The summation valuation procedures estimate the value of the individual property components specifically identified as the valuation subject.
• Analyst due diligence: In the unit valuation, the analyst typically inspects a small sample of the unit property to confirm existence and condition; the analyst primarily relies on the owner’s continuing property records. In the summation valuation, the property appraiser typically inspects most of the subject property to assess the condition of each property; the property appraiser often creates (or confirms) a physical inventory listing of the subject property.
• Comparability criteria: In the unit valuation, the comparability criteria are primarily based on investment risk and return considerations (since the comparable properties are compared to a diversified portfolio of unit property). In the summation valuation, the comparability criteria are more based on physical and functional considerations (since the individual comparable properties are compared to an individual subject property).
• Cost metrics: In the unit valuation, historical cost is the primary property cost metric; trended historical cost is the secondary cost metric. In the summation valuation, replacement cost new is the primary property cost metric.
• Depreciation: In the unit valuation, all depreciation components are typically quantified on an aggregate unit-level basis; in particular, economic obsolescence is typically measured on a unit basis. In a summation valuation, all depreciation components are typically quantified on an individual property-level basis; in particular, economic obsolescence is typically measured on a property component-specific basis.
• Economic income loss: In the unit valuation, economic obsolescence is often measured through the capitalization of income loss method; the income metric typically analyzed is the total operating income of the total unit. In the summation valuation, economic obsolescence can be measured by applying several alternative measurement methods; when the capitalization of income loss method is applied, the income metric typically analyzed is property-specific rental income.
• Income metric: In the unit valuation, all approaches and methods include consideration of unit-level business operating income; this business-level income impacts all cost approach (through economic obsolescence), market approach, and income approach methods. In the summation valuation, all approaches and methods include consideration of individual property-level rental income; this property rental income impacts all cost approach (through economic obsolescence), market approach, and income approach methods.
• Capitalization rate: In the unit valuation, all capitalization rates (both direct and yield rates) components are extracted from capital market data sources; so those rates import the value attributes of liquidity and other publicly traded security investment attributes. In the summation valuation, all capitalization rate (both direct and yield rates) components are extracted from the sales of comparable individual properties; so those rates are appropriate to apply to property-level income.
• Income life: The unit valuation approaches and methods incorporate the assumption of a perpetuity projection period; this perpetual remaining useful life assumption concludes the value of all property in place (plus the perpetual replacement of all property in place). The summation valuation approaches and methods incorporate the assumption of a finite projection period; this finite remaining useful life assumption concludes the value of the subject property in place only.
• Capital expenditures: When the unit valuation includes the assumption that capital expenditures exceed depreciation expense, the valuation concludes the value of the property in place plus the value of expansionary future property not in existence on the valuation date. When the summation valuation includes the assumption that capital expenditures are less than depreciation expense, the valuation assumes maintenance expenditures only to conclude the value of current property in place; but no incremental or expansionary property.

This discussion provided a partial listing of the many procedural differences between the development of a unit principle valuation and the development of a summation principle valuation. This listing should imply to any analyst, to any property appraiser, or to any parties relying on property appraisals that these two valuation principles have both conceptual and practical differences.

Unit Valuation Synthesis and Conclusion

The valuation synthesis and conclusion process is also called the valuation reconciliation. The process is not fundamentally different between the unit principle and the summation principle. The objective of the process is certainly the same between the two principles. First, the analyst considers each value indication reached by each property valuation approach and method that was developed. Second, the analyst synthesizes (or blends or reconciles) the various value indications into a single value conclusion. As a matter of valuation jargon, the results of the development of each valuation approach or method is called a value indication. The final (reconciled) result of the overall valuation process is called a value conclusion. So, the valuation reconciliation is the process of synthesizing the various value indications into a value conclusion.

As mentioned above, the valuation synthesis can be quantitative (where the analyst assigns a specific percentage weighting to each individual value indication) or qualitative (where the analyst assigns a relative emphasis to each individual value indication). There is no formula or equation to determine how much emphasis (either a specific percentage or a relative weighting) should be assigned to each value indication. However, the analyst generally considers a number of factors, which are summarized below.

First, particularly regarding a property tax valuation, the analyst considers whether there is specific statutory or regulatory guidance (or requirements) with regard to the reconciliation process. For example, some jurisdictions require the analyst to develop a stock and debt method analysis for property in certain industries. The statute or regulation may not require that a minimum weighting be assigned to the stock and debt value indication, but only that a stock and debt method value indication be developed. Alternatively, a statute or regulation may require that, say, the historical cost less depreciation method value indication receive a minimum of a 30 percent weight.

Of course, analysts should follow the law; if there is such a legal requirement. It is noteworthy that such a legal requirement may only apply to property tax assessors; and not to independent analysts or property appraisers. It is also noteworthy that analysts are not lawyers. Analysts typically rely on their clients (i.e., the taxpayer or the taxpayer’s legal counsel) to provide them with any legal instructions.

Second, the analyst typically considers which valuation approach and method is the most conceptually sound regarding the subject property. That is, which approach or method best “fits” the subject property type? This process is repeated for the second best fit, the third best fit, etc.

Third, the analyst typically considers which valuation approach or method is the most conceptually sound regarding the subject industry. That is, which approach or method best “fits” the taxpayer’s industry? This process is repeated for the second best fit, the third best fit, etc.

Fourth, and like the third consideration, the analyst typically considers which valuation approach and method is principally relied on by industry participants. That is, which approach or method do industry participants apply to make unit-level merger and acquisition pricing decisions?

Fifth, the analyst typically considers his or her level of confidence in both the quality and quantity of data relied on in each valuation approach or method. Of course, the more reliable the data sources applied, the more emphasis the analyst will assign to that approach or method.

Sixth, the analyst typically assigns more emphasis to the value indications that are mutually supportive than to an outlier value indication. Of course, value outliers should be investigated. The reasons why one valuation approach or method produces a value outlier should be explored. That investigation may reveal that one valuation analysis was based on valuation variables that are inconsistent with the variables applied in the other valuation analyses. Or the investigation may reveal that one valuation method is analyzing a different unit (or bundle) of property than the other valuation methods are analyzing.

Finally, it is noteworthy that all unit valuation approaches and methods should generally (within a reasonable range) conclude a similar value indication for the same bundle of property. Also, there should not be a directional bias in the value indications produced by any approach or method. That is, no approach or method should be developed (or assigned a greater or lesser emphasis) because that approach or method concludes a higher or lower value indication.

Likewise, a unit principle valuation should conclude about the same value conclusion as a summation principle valuation for the same unit of property. If different unit valuation approaches (or if a unit valuation and a summation valuation) conclude materially different value indications, then the analyst needs to consider two questions. Are inconsistent valuation variables being applied between the different valuation analyses? And are the different valuation analyses really valuing different bundles of property?

When the final unit valuation conclusion includes property types or value attributes that are not subject to property taxation in a particular taxing jurisdiction, then the total unit value may need to be adjusted. The objective of such an adjustment process is to remove nontaxable property or value to conclude the value of the unit of taxable property.

Conclusion

This is part four of a discussion of the unit valuation principle as applied for property tax compliance, administration, and controversy purposes. Previous installments summarized what analysts need to know about the application fundamentals of the unit valuation principle. This installment summarized what analysts need to know about the development of a valuation unit principle valuation. That is, this discussion focused on the unit valuation principle approaches, methods, and procedures applied to conclude the total unit value.

The fifth article of this series will focus on the adjustments necessary to the total unit value to conclude the value of the unit of taxable property. It will also discuss application issues and caveats related to the unit valuation principle for property tax purposes.

---

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.