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Bed and Breakfast Industry Trends |
Wednesday January 7th, 2009 |
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Management Fee Method Causes Hotel Over Assessment - By David C. Lennhoff, MAI, CRE, FRICS |
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The most popular valuation method employed by assessors to determine the taxable value of hotels is the 'management fee' method of appraisal. When taxpayers review their property tax assessments, understanding how the assessor determines the property's value is critically important. |
In nearly every state, the law requires property taxes to be based on the value of the tangible assets, rather than the going business concern. Understanding the flaws in the assessor's methodology allows owners to better challenge the assessed value.
The 'management fee' method has been around for a long time and seems to exist because its ease of use. Many assessment officials continue to use it to remove the business value component from the total assets of the hotel business. However, this method actually fails to remove any intangibles from the total asset income stream and results in an assessment that is inappropriate and unlawful as the basis for establishing the real estate taxes for a hotel.
Hotel owners and managers must recognize when such a technique is being used and be prepared to explain that it results in an over-assessment of the real property, often quite a large one. No way exists to defend it as an appropriate methodology for assessment purposes
Why the Management Fee Method Fails
As most owners know, hotels are rarely built speculatively to be rented to an operator. Therefore, legitimate, arm's length leases of real estate from which to develop an estimate of market rent do not exist. As a result, the appraiser uses the 'income capitalization' approach to value. The appraiser begins with the income generated by the total assets of the hotel business (or 'going concern'), and then deducts that portion of the income that represents tangible and intangible personal property. The result of this calculation represents the rent to the real estate, and it can be capitalized into an indicated value by dividing it by an overall capitalization rate.
The management fee method purports to identify the intangibles and then remove them from the net income. It begins with an estimate of the annual net income produced by the total assets of the hotel business, and then deducts a management fee and a franchise fee to account for the hotel business component. The residual is supposed to be the real estate 'rent', which is capitalized into assessed value. This method implies that when an owner obtains a franchise and hires a management company, he no longer has an interest in the business and simply becomes a passive investor who only benefits from the real estate proceeds.
However the assumption that a deduction from income for management and franchise fees sufficiently identifies the intangible property misses the point. Investors invest in real estate in anticipation of receiving a return of and a return on their investment. When franchising a hotel, owners expect that the money they have to pay the hotel company will be returned to them along with a return on that investment, usually through higher revPAR. If they thought the only benefit of a franchise was the money they pay the franchisor, they wouldn't do it. To suggest that a franchisee gets no return on the investment made in the franchise is just plain wrong. Similarly, to propose that the money paid to a management company represents the entire business contribution from that company is equally incorrect.
How to Identify All the Intangible Assets
Both the franchise fee and the management fee are appropriate expenses and need to be deducted from the income stream. However, by doing so the appraiser has removed only expenses. The appraiser must also recognize the 'return' on these investments accruing from such contributions as the flag, assembled and trained work force, and business start up costs. Until these additional items of income are accounted for and deducted from the net income, along with any others that might derive from the various profit centers at the hotel, the assessor will be taxing elements of the hotel that are not real estate.
Conclusion:
Hotel owners must be vigilant when it comes to their real estate taxes. Many assessors are not equipped with the knowledge to properly develop real estate values for hotel businesses with a real estate component. The 'management fee' method remains popular and has managed to survive so long because it is easy to apply.
However, it fails as a legitimate method of separating the intangibles of a hotel business from the real property. It results in a 'real estate' assessment that can greatly exceed the value of the real estate component and is tantamount to taxing the business.
Armed with the proper methodology for separating the real estate value from the going concern value of your hotel business, you will be in position to realize significant property tax savings on your next assessment.
David Lennhoff is President of PGH Consulting, LLC, a property tax counseling firm with offices in Austin, Texas and Rockville, Maryland. The firm provides property tax counseling, valuation and appraisal services across the country. PGH Consulting serves real estate and corporate clients who own hotels, complex industrial property, retail, multifamily and office properties. David Lennhoff can be reached at: DLennhoff@pghusa.com.
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