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The determination of hotel value components for ad valorem tax assessment.

In many counties and other taxing districts, a trend has developed toward assessing real property using an income approach valuation instead of the more traditional cost approach. While an income analysis is generally considered the most accurate measure of value for income properties, in the valuation of hotels the results of an income analysis can unfairly distort the value of the real property. Though hotels are income properties, they are unique in that real property, personal property, and business interests all contribute to the value of the project. The value of each of these three components must be individually determined to avoid skewing the estimate of real property value. This article outlines, through a case study, a method of evaluating these three components of hotel value.

The authors were recently retained in the appeal of a real property assessment for a hotel in central Florida where a simple income approach was used by the assessor to determine the 1988 ad valorem tax assessment for the hotel. The analysis was intended to isolate the value of the real property to aid the hotel owner in a tax appeal, and was based on operating data provided by the owner of the hotel as well as on information and assumptions used by the county in its assessment process. From the operating information and assumptions, an estimate of value attributable to the real property was isolated from that of the personal property and the intangible value associated with the business entity.

The hotel was constructed in 1986, two years prior to the valuation, for $5,500,000 (the cost of land and improvements). The two-story, all-suite hotel consists of 128 suites in several buildings with a pool area. The project has no restaurant, lounge, retailing, or convention facilities. An operating statement for the year being evaluated was provided along with the assessor's estimates of capitalization rates and personal property assessment.


Because the property assessment is for real property, it is necessary to isolate this value in the analysis of the hotel. As described in Rushmore and Araisi's article, "Adjusting Comparable Sales for Hotel Assessment Appeals," hotels are different from most forms of real property in that special consideration must be given to the components of the property:

A lodging facility is a unique form of real estate which consists of four components: land, improvements, going business, and personal property. When valuing hotels and motels for real property assessment purposes where only the market value of the land and improvements is at issue, the appraiser must break down or subdivide the overall property value into its individual components.(1)

To isolate the value components, the annual net operating incomes (NOIs) attributable to the real property, the personal property, and the business operations were each estimated. Because the method used by the county assessor was an income approach, the authors also used an income approach in the analysis. By segregating the NOI, the value of each component of the enterprise was measured. Table 1 illustrates this procedure, which is discussed in detail in the following section. The line numbers after the section subheadings correspond with lines in Table 1.


Gross income estimates (lines 1-3)

The gross income for the property is derived almost exclusively from the rental of rooms and associated services. Therefore, the income from rentals is applicable to real property, personal property, and the business enterprise. The total income cited, $2,355,473, was based on actual receipts for the year based on an overall occupancy level of about 70% for the 128 units on the property.

Operating expenses (lines 4-15)

Because the operating expenses reported by the owner appeared to be in line with market expectations, they were used in the evaluation. The expenses include the salaries for administrative personnel, but exclude the management contract and franchise costs associated with the particular operator or business. The costs associated with management expense are considered part of the going-concern value (to be addressed separately in the evaluation).

Real property reserves (line 14)

Real property reserves were allocated at $83,200 per year ($650 per unit). The allocation is to cover the periodic replacement of short-lived real property items such as air conditioning units, exterior painting, and roof replacement. (The reserve allocation reflects the multi-building layout of the project versus a single-building structure.) The real property reserves exclude the replacement reserves for hotel furnishings and other personal property. The reserves for these items will be discussed separately.

Total NOI from operations (line 16)

After deduction of expenses and reserves, the NOI from operations of $1,070,487 represents the income attributable to all components of the operation including real property, personal property, and business interest.

Personal property allocation (lines 17-25)

The next step of the analysis is to estimate the portion of net income attributable to personal property. The personal property allocation is composed of two components: reserves for replacement (return of capital) and the yield on the personal property investment.

Income attributable to personal property

It is necessary to adjust the operating income to reflect that personal property has different characteristics than real property and is assessed separately for ad valorem taxation purposes. Rushmore and Araisi point out:


The actual personal property assessment by the county of approximately $700,000 was used to determine the adjustments in this case.

Personal property reserves

The first adjustment for personal property reflects the need for periodic replacement of such items as hotel furnishings. This allocation is the return of capital expended for these items. The reserve allocation was calculated on a straight-line basis, based on an expected life of seven years for these items, as follows:

Annual reserve allocation

= 1 year/7-year life = 14.29%/year

Personal property value

x Annual reserve percentage

= Annual reserve

$700,000 x 14.29% = $100,030

In addition to the return of capital, the reserve allocation is required to ensure that funds are available to refurnish the units and repurchase business equipment at the end of their seven-year economic life.

Personal property return

The second allocation for income to personal property represents the return requirements for the investment in these items. The capital invested at the time of development would obviously be expected to provide a return to the investor in the project (return on capital).

A return rate for personal property can be "pegged" to standard chattel mortgage rates, which are typically two to three points higher than real property mortgage rates. In the fourth quarter of 1988, rates for hotel mortgages ranged from 10.62% to 11.12%.(3) Therefore, for this procedure a rate of 13.5% was used for an appropriate return rate for an investor. The total annual income attributed to personal property is estimated as follows:

Return percentage

x Personal property value

= Personal property income

13.50% x $700,000 = $94,500

Total income attributed to personal property

Based on the analysis, the portion of the income ascribed to personal property is calculated as follows:
Personal property reserves for
replacement $100,030

Annual yield on personal property
investment $ 94,500

Total income to attributed personal
property $194,530

Note: The overall yield to personal property (return on and of
capital) would be about 20% based on this analysis.

Value of going concern (lines 27-37)

By deducting the $194,530 in personal property income from the total net income of the hotel, the remaining income of $875,957 still includes both real property income and income attributable to the business enterprise (going-concern). The next step of the analysis is to isolate the income attributed to the going concern.

In their article "Hotel Enterprise Valuation," Roland D. Nelson, Jay L. Messer, and Laurence G. Allen discuss going concern value as follows:

The management fee is a normal cost of operating an enterprise. It is a return on the management company's expertise and talents but not on the owner's investment in the business. If the management fee is not subtracted, the value includes the value of the hotel enterprise plus the value of the management contract after subtracting the management company's cost and by using an appropriate capitalization rate.(4)

The concept is also described by Anthony Reynolds in his article, "Attributing Hotel Income to Real Estate and to Personalty," in which he notes that, "In remembering that every penny of the management fee is paid to the owners of the hotel management company, and none of it to the owners of the hotel, it is clear that neither return on nor return of investment worth is paid from the management fee to those who provide and replace the tangible and intangible assets in the working capital and goodwill categories."(5) The value of the enterprise to the owner can thus be calculated as the capitalized income stream to the management fees and as a return on and of other business-related capital expenditures.

Management contract

The value of the enterprise's management component is based on the assessor's estimate of the base capitalization rate before taxes of 11% (see capitalization rate discussion to follow). Thus, the overall value of the management component would be:

Annual management fee

@ Base capitalization rate

= Enterprise value

$124,635 @ 11% = $1,133,045

For ad valorem purposes, however, the capitalization rate must be "loaded" to account for the real estate taxes. To reflect the impact on income from this value component in the analysis, the income attributable to the management contract is adjusted to properly reflect the value of the management contract when using the higher capitalization rate employed for the assessment analysis, as follows:

Enterprise value

x Tax = Loaded capitalization rate

= Adjusted management fees

$1,133,045 x 12.54% = $142,084

Such an adjustment is necessary to appropriately measure the economic impact of the difference between the base capitalization rate of 11% for the business enterprise and the loaded capitalization rate of 12.54% used by the assessor for taxation purposes. Without this adjustment, the value of the enterprise would be understated, and the real property value would be overstated.

Start-up costs

In addition to the value associated with the management of the business, the initial start-up costs associated with the property, including initial losses from the business, must be recaptured by an owner/investor. These costs include the organizational costs of assembling the management and administration team, the initial franchise fees of the business entity, and losses during the initial start-up and training period. As with the personal property return, the cost of funds for these items has been used as a basis to determine the annual return requirements for these items.

Start-up costs, a one-time expenditure realized during the opening years of a project, benefit the project over the long-term. A conservative allocation of annual income for this item is through amortization of the costs over the life of the property. For this analysis, we have estimated an economic life of 40 years. The overall yield rate for the business interest has been allocated at 12.5% (10% return on(6) + 2.5% recapture). The annual constant for the income allocation based on the economic life and the yield rate is 12.61%. The annual allocation is therefore calculated as follows:
Organizational costs $170,000
Franchise fees $ 38,400
Initial business losses $188,000

Total business start-up related
capital $396,400
Amortization constant x 12.61%

Income attributed to start-up capital $ 49,986

The total net income attributable to the business entity would therefore be calculated as follows:
Adjusted income for management
capital $142,084
Income attributed to start-up capital $ 49,986

Total income attributable to business $192,070

Real property valuation (lines 39-45)

After deducting the income attributed to personal property ($194,530) and business concerns ($192,070), the remainder of the NOI ($683,887) is applicable to the real property. To formulate a value of the real property, the income is capitalized by an overall capitalization rate--in this case, the given capitalization rates used by the county assessor:
Base capitalization rate (market) 11.00%
Tax rate loaded 1.54%

Loaded overall capitalization rate 12.54%

Therefore the value of the real property was calculated as follows:

Real property net income $683,887 / Overall capital rate 12.54% = $5,454,000 (rounded)

The overall value estimate is in line with the actual cost plus land value for the real property (approximately $5,500,000), and in our opinion is representative of the real property value of the property as of December 31, 1988.


Because hotels represent a unique form of real property investment, a simple income analysis using direct capitalization may overstate the value of the real property component of the investment. While such commingling of values is less a problem for appraisals, in the valuation of hotels for ad valorem taxation care must be taken to isolate real property values. In many jurisdictions owners are taxed separately for real property, personal property, and intangible values (business interests). Hotel owners thus may be taxed doubly or triply for the same investment unless the interests are properly identified and isolated. By allocating the income attributable to each value component of a project for an income approach, appropriate values for each part of the investment can be achieved.

1. Stephen Rushmore and Thomas Araisi, "Adjusting Comparable Sales for Hotel Assessment Appeals," The Appraisal Journal (July 1986): 356.

2. Ibid., 358.

3. American Inst. of Real Estate Appraisers, "Financial Indicators," The Appraiser (January 1989): 14.

4. Roland D. Nelson, Jay L. Messer, and Laurence G. Allen, "Hotel Enterprise Valuation," The Appraisal Journal (April 1988): 164.

5. Anthony Reynolds, "Attributing Hotel Income to Real Estate and to Personalty," The Appraisal Journal (October 1986): 615-617.

6. An estimated return rate based on alternative yields with similar risk/return periods. The derivation of this rate is only incidental to the analysis and has not been discussed in detail as part of this case study.

Daniel R. DeRango, MAI, is vice president/partner with Matonis, MacDermott, DeRango, Sorich & Company in Orlando. He received a BBA in finance from Stetson University in Deland, Florida.

Stephen J. Matonis, MAI, is president of Matonis, MacDermott, DeRango, Sorich & Co. in Orlando, Florida. He received a BBA in real estate from Florida Atlantic University in Boca Raton, Florida.
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Author:Matonis, Stephen J.; DeRango, Daniel R.
Publication:Appraisal Journal
Date:Jul 1, 1993
Previous Article:The valuation of income property in overbuilt markets.
Next Article:Considerations in the valuation of hotels.

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