Have you ever wondered why your local tax assessor has such a high opinion of the value of industrial plants in your area? This is particularly perplexing when global competition drives down the price of finished goods, energy prices skyrocket, the plant gets older and justifying further capital investment becomes difficult because of razor-thin margins.
The assessor thinks industrial properties are worth hundreds of millions of dollars because he uses the trended investment cost method to value the plant. The assessor adds up the historical costs invested in the plant over the last 30 years, trends that cost to current dollars and depreciates the result based upon the plant's remaining physical life.
This method is a backwards-looking valuation approach that does not measure the external economic factors that makes industrial property less competitive or even obsolete. The trended investment cost method bears no relationship to the price at which an owner could sell a plant on the open market. Yet, market value is the basis for all property tax assessments.
Industrial property exists for only one reason — to manufacture goods and provide an income for the owner. When income declines due to external factors, the market value of the plant drops. Because the trended cost investment method only looks at past investment, it can't account for the current economic reality.
A preferred valuation method
The only way for industrial plant owners to obtain fair tax assessments is to argue for the use of the income approach to value their plants — the same valuation approach investors use to determine the price they will pay for any investment.
Utilizing either a discounted cash flow or a direct capitalization method, the income approach projects the future income stream of the plant, capitalizes or discounts the income by a market rate of return on invested capital, taking into account current and future expected market conditions, as well as the risks and illiquidity of the investment.
The business value reflects all the factors of production — land, buildings, machinery and equipment, skilled labor, managerial expertise and goodwill. It is incumbent upon owners to show assessors how to separate the value of the real and personal property from the value of the business for assessment purposes.
Bear in mind that all factors of production fall into one of three categories: working capital, intangible assets and fixed assets. Working capital and intangible assets are non-assessable in most states. The market value of working capital — which includes cash, receivables, inventories, less current liabilities — can be easily and accurately determined. Now, only the market value of the intangible assets needs to be eliminated to arrive at the value of the fixed assets.
Why exclude intangibles?
Intangible assets include software, goodwill, customer lists, contracts, patents and trademarks, assembled workforce and trade secrets. The owner of an industrial property invests in intangible assets in one way or another. For example, the owner pays wages to a skilled workforce and invests in R&D, from which benefits and trade secrets result, in the hope the return will exceed its cost.
Because of economic obsolescence, a struggling industrial plant with low margins enjoys little return on intangible assets. And because the cost of creating and maintaining intangible assets is already reflected in the income stream as costs of doing business, their market value has already been accounted for in the business value. Even if intangible assets do have a value above their cost, the assessor will not complain the resulting valuation is too high.
The devil is in the details. The two components of the income approach — the income stream and the discount, or capitalization rate — must be accurately calculated to derive market value. A plant's budget or strategic plan already projects the future income of the plant.
For property tax purposes, it is the expected future debt-free, after-tax cash flow from the industrial plant that is discounted by the weighted average cost of capital. However, this approach must account for the current and expected market risks and illiquidity of owning a single, stand-alone plant, not the cost of capital of a Fortune 500 company.
If the future income stream is realistic and the discount or capitalization rate reflects the inherent risks of investing in a single industrial plant, the resulting value will equal the price an investor will pay to own that industrial property.
There remains only the task of convincing assessing authorities that the income approach results in a far better, and fairer, estimate of the plant's market value than the antiquated trended investment cost method.
David L. Canary is an owner in the Portland office of Garvey Schubert Barer, the Oregon and Washington member of American Property Tax Counsel. He can be reached at [email protected].