Hotel owner jolted by new method used to determine real estate value

Did your hotel business value “check out” this morning? For a hotel owner in Austin, Texas, it did. The following is a true story and should raise concern among hotel owners and property tax professionals across the country. If it can happen in this sophisticated taxing jurisdiction, it can happen anywhere.

A full-service Marriott hotel recently sold for $48 million. Historically, the tax assessor would have valued the hotel for property tax purposes following normal procedures. He would start with the sales price as an indication of a going concern value and deduct a furniture, fixtures and equipment (FF&E) value and a business value to arrive at the hotel's real estate value. This also was the approach the tax assessor's nationally known hotel appraiser had used in previous property tax trials in the city. The tax assessor and taxpayer then debated the amount of business value deduction, which typically ranged from 20% to 50%.

This year, however, the business value of the hotel apparently “checked out” the night before because the system the tax assessor used found that value to be virtually zero. Using a different approach, he started with the hotel's purchase price and deducted a FF&E of $4 million. Next, he determined that the entire business value contribution to the going concern equaled about 10%. From this business value contribution, he deducted the franchise and management fees. The final total business value contribution of the hotel was only $500,000, or 1% of the purchase price. Based on his assessment, the hotel had a real estate value of $43.5 million.

An eye-opener for hotel owners

This story is significant for hotel owners for several reasons. The city had a sophisticated property tax system, and in the past had followed traditional hotel property tax appraisal methodology. It used a well-known hospitality valuation expert as a witness, as well as in-house Members of the Appraisal Institute (MAIs) for guidance. Finally, and perhaps most importantly, the different approach came at a time when taxpayers and appraisers have expanded the historical understanding of business value and have advocated even greater deductions for property tax purposes.

Traditionally, appraisers have determined the going concern value of a hotel by calculating not only its tangible assets, but the value of its intangible assets, such as reservation systems and trained workforce, as well. They have then deducted the FF&E and the business value to arrive at the real estate value.

The business value generally was estimated by deducting the expense of the franchise fee and the management fee from the going concern income stream. This approach was first advocated by taxpayers, accepted by tax assessors and then again refined and rejected by taxpayers.

Taxpayers rejected this approach primarily because the use of franchise fees and management fees results in an understatement of business value. These fees are nothing more than an expense to an owner of a hotel and do not fully represent a return on the business portion of the property. As a taxpayer recently testified, “If I wanted a return only from real estate, I would have purchased an office building, but since I wanted a return from real estate and from a business, I purchased a hotel.”

In contrast to the traditional approach, the new refined methodology advocating a higher business deduction in hotel appraisal has been supported by such appraisers as David Lennhoff of Delta Associates, Alexandria, Va., and Peter Gloodt of Chicago Hospitality Consulting Services, and by property tax lawyers. The new method identifies elements of the hotel business that create value beyond a flag and management expertise. In addition, The Appraisal Foundation, the licensing and regulatory body of MAI appraisers, has expanded its discussion of business enterprise value in its textbook, The Appraisal of Real Estate.

Practical tips for taxpayers

Taxpayers should consider the following in evaluating a hotel real estate value for property tax purposes:

  • Determine the revenue generated by the flag over and above the typical hotel. The hotel name, reputation, reservation system, marketing and sales services may increase room revenue and occupancy above a typical hotel. One method of adjustment is by a reduction in the actual income stream to a market income stream.

  • Determine the revenue generated by the intangible elements common to all hotels, such as assembled work force, working capital, typical management skills, contracts, leases, licenses and operating agreements. One method of adjustment is to estimate the difference in cash flow associated with a stabilized hotel compared to a start-up hotel.

  • Determine the revenue created by service profit centers such as food and beverages, health clubs and business centers. The profit may be capitalized at a business capitalization rate to make an appropriate deduction. This approach may help prevent your hotel business value from “checking out” as an appropriate property tax deduction.

Jim Popp is a partner in the Austin, Texas, law firm of Popp & Ikard. The firm is the Texas member of the American Property Tax Counsel.

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