United States: Energy Property Tax Assessments — Ensuring Positive Cash Flow After The Period Of Economic Growth

Last Updated: October 2 2018
Article by Mark Lansing

Often, when the economy hums along and grows, taxpayers overlook a major operating expense in their cash flow — property taxes (both real and personal). For income producing properties, a good economy often means the property's value increases. The combination of positive cash flows and being a good corporate citizen can lead the taxpayer to not monitor their property's assessment. However, economists have noted that we are in our second longest time period of extended growth, and quickly approaching our longest time-period of such growth. While predicting the cessation of continued economic growth is an impossibility, positioning cash flows for such a possible end is not. Regardless of the industry, assessors and appraisers have also partook of this economic growth, ever cushioning their property assessments and tax bases, causing commercial property taxes to significantly increase. Reviewing energy property assessments is increasingly important, if cash flows are to be positively adjusted for whatever economic revisions may unfold.

Accordingly, energy assets (whether generation plants, transmission or distribution assets (gas or electric) can enhance positive cash flow through aggressive property assessments. For these complex properties, resolutions can take over eighteen months.

When a market exists for property, the valuation should be the manner applied in the market. A “market” can be defined in two manners: (1) a market for the sale (both new and used) of the property (e.g., the sale of generation assets), or (2) a “market” with respect to the direct or intrinsic income generation of the real property (electricity prices, rentals, etc.). If no market exists, the property tends to be labeled “specialty property”; whereupon, the cost approach is normally applied. 1

To ascertain whether a property is over assessed, the taxpayer must keep in mind that: (1) if the property was recently purchased in an arms-length transaction, the purchase price is often considered the best indicator of value; (2) the construction costs of a recently constructed building is often applied (combined with a land value); or (3) the assessor or appraiser is engaged in mass appraisal techniques. 2 For mass appraised properties, the specific property is valued applying general valuation mechanisms that the assessor/appraiser presumably applies to all properties of the same nature. 3 This may result in failure to consider the specific property's condition, location, economics, market place, deferred capital expenditures, or other important adjustments specific to the property.

The energy taxpayer must understand how their property is being valued by the assessor/appraiser. There are three valuation methodologies: (1) Cost Approach; (2) Income Approach; and (3) sales comparison approach. For commercial and industrial properties, the cost approach is often applied. Incredibly, by mass appraisal techniques, retail and office space is valued using the cost approach; the assessor/appraiser often applying outdated cost manuals that are not applicable to the area. As a result, the appraiser attempts to "translate" the cost manual to the locale by applying multiples to the cost manual costs. In some locations, the assessor/appraiser further adjusts the cost approach using an "economic factor" that attempts to compare sales of similar properties to the cost approach costs to further "translate" the costs to "market" conditions.

The Cost Approach requires developing either a reproduction cost new or replacement cost new (some apply the original cost new), then, deducting for three forms of obsolescence (physical, functional and economic depreciation). Assessors/appraisers rarely apply all three forms, requiring (without informing) the taxpayer to come forward and apply for functional and economic depreciation (this is especially harrowing if the assessor/appraiser is using the reproduction cost new and not replacement cost new, as most properties (if not recently built) involve functional obsolescence of some nature). For generating plants, there are clear economic depreciation factors that should be considered, but are not. All lead to over assessment of the properties. Even the costing out of the construction of the facility can result in overstating value by the appraiser choosing the wrong type of building, structure, class type or materials, or replacement facility. Without checking your assessment (or its computation), the energy taxpayer is not informed of the methodology or cost manual applied.

Another valuation approach is the income approach. Here, the assessor/appraiser determines "market" rent, expenses and capitalization rates. 4 Overstating the income (including non-real property income), applying expense ratios that understate the expenses or deriving a capitalization rate that is below the market all contribute to the over statement of the property's assessment. 5

Finally, there is the sales comparison approach, where the assessor/appraiser must identify "comparable" properties and then make adjustments for location, date of sales transaction, size, financing, condition, etc. The failure to make adjustments results in over stating the property's value. With energy properties, the sales comparison approach is of dubious value.

As property taxes can be twenty or more percent of a property's operating expense and assessors use numerous ways to overstate an energy property's value, an immediate and positive impact on cash flow often results from properly managing the property tax. This is particularly true in the Northeast, and those States that rely primarily on property taxes (e.g., Florida, Texas, etc.). A myth has developed that challenging a property's assessment results in negative consideration for non-property tax considerations. That myth is simply wrong.

Only through vigilant review of the assessment(s) of their property(ies) will the taxpayer improve cash flow and ensure it pays only its fair share of the property taxes.

Footnote

1 Babcock, Appraisal Principles and Procedures (Washington, D.C.: American Society of Appraisers, 1980), p. 139; The Appraisal of Real Estate, 9th ed. (Chicago: American Institute of Real Estate Appraisers, 1987), pp. 16–20; The Dictionary of Real Estate Appraisal (Chicago: American Institute of Real Estate Appraisers,1984).

2 Understanding and communicating the nature of a purchase transaction or construction may be important. For example, a recently constructed mixed use facility that went into receivership, had forced stoppage of construction followed by resumed construction, or other such examples of additional costs that would not be included in a "normal" construction may overstate the construction costs, and thereby, the assessment.

3 Although a location had a published manual for valuation of properties of certain nature, the assessor departed from that manual in order to back into a 1031 exchange value; even though, the assessor termed the transaction "non-market".

4 See e.g., Saratoga Harness Racing Inc. v. Williams, 91 N.Y.2d 639, 644 (1998):

Most relevantly here, when this method is utilized for owner-occupied space, it “is usually estimated at market rent levels” (Appraisal Inst., The Appraisal of Real Estate, supra, at 489). The rubric is that “market rent is the rental income that a property would most probably command in the open market” (Appraisal Inst., The Appraisal of Real Estate, supra, at 478-479 [emphasis omitted]). Estimated annual rent, or market rent, should be determined by analysis of the rent paid for other comparable properties and then imputed to the subject property:

The rents of comparable properties can provide a basis for estimating market rent for a subject property once they have been reduced to the same unit basis applied to the subject property. Comparable rents may be adjusted just as the transaction prices of comparable properties are adjusted in the sales comparison approach” (Appraisal Inst., The Appraisal of Real Estate, supra, at 481).

5 In states, such as New York, that require equalization of assessments, the categories involving commercial, industrial or utility property are "found" to be assessed at a higher percentage of market value than residential or vacant land.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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