Proving Depreciation

Transcription

1 Institute for Professionals in Taxation 40 th Annual Property Tax Symposium Tucson, Arizona Proving Depreciation Presentation Concepts and Content: Kathy G. Spletter, ASA Stancil & Co. Irving, Texas Experience Commentary: Kim Rogers DuCharme, McMillen & Assoc., Inc. Phoenix, Arizona 1

2 Institute for Professionals in Taxation 40 th Annual Property Tax Symposium Tucson, Arizona Proving Depreciation 2

3 Cost Approach Methodology Determine reproduction or replacement cost of the improvements Analyze the depreciation incurred by the improvements due to any cause Physical deterioration Functional or technological obsolescence Economic obsolescence Add the value of the land 3

4 Reproduction Versus Replacement Cost In a case where significant depreciation is present, it is unlikely that a property would be reproduced Replacement cost considers the current utility of the property Capacity or size of replacement may be different than the subject Typically set by current demand/utilization Right-sized replacement does not cure the superadequacy in the subject property 4

5 Superadequacy Excess capacity in the subject property makes it superadequate Labor Costs Energy Costs Cost-to-Cure Differences between the replacement cost and reproduction cost quantifies excess capital cost An element of functional obsolescence Use of an RCN does not address the obsolescence created by: Excess operating costs Investment required to operate at lower rates in the future 5

6 Identification of Superadequacy Superadequacy can exist in any market Newly constructed or older property Inutility as of the valuation date Current owner motivated to maximize economic utilization of property Buyer unlikely to pay for increment of unusable or excess capacity Current and future changes in utilization or occupancy reflect a change in superadequacy Labor Costs Energy Costs Cost-to-Cure 6

7 First Element of Depreciation: Excess Capital Cost The difference between the reproduction cost and the replacement cost is an element of functional obsolescence The superadequacy of the property would not be built into a new property This step is often avoided by starting with a Replacement Cost New (RCN) rather than a reproduction cost Use of a Replacement Cost New does not cure the impact of the superadequacy of the existing property 7

8 Cost Approach Depreciation Methods RCN must be adjusted for all forms of depreciation Three methods of estimating depreciation: 1) The market extraction method 2) The economic age/life method 3) The breakdown method 8

9 Market Extraction Method of Determining Depreciation Relies on sales data to determine total depreciation from all causes in one step Depreciation considers relationship between: sales value age of the property sold, and the RCN of the comparable sales properties Multiple sales for properties with different ages are required... appealing due to simplicity 9

10 Implementation of the Market Extraction Method Sales of properties must have the same physical, functional, and external characteristics as the subject property Data allows correlation between age and total depreciation Determine an annual rate of depreciation Estimate the economic life of a property Assume linear relationships... but the market is rarely linear 10

11 Economic Age/Life Method of Determining Depreciation Also considers depreciation in one step Depreciation calculated using the formula: Effective Age Total Economic Life Simplicity of age/life relationship is appealing x Total Cost = Depreciat ion Effective age defined to include physical wear and tear and loss in value due to functional and external considerations... utilization and technological status impacts the effective age and total economic life of a property... if the utilization or operating efficiency of the subject property is less than design, then either the effective age must be adjusted, or a different method must be used 11

12 Conclusions Regarding Market Extraction and Economic Age/Life Depreciation Methods Simplistic methods introduce error into valuation of properties Straight-line patterns of depreciation do not apply Past is not indicative of the future... valuation of most complex properties requires more rigorous analysis 12

13 Breakdown Method of Determining Depreciation The breakdown method is a more comprehensive method that identifies specific elements of depreciation and treats each element separately. 1 1 Appraisal Institute, The Appraisal of Real Estate, 13h ed., 2008, p

14 Breakdown Method Sequence Estimate physical depreciation Consider actual age of property Useful life of property Remaining life of property Determine functional obsolescence Determine economic or external obsolescence Add land value 14

15 Accurate Determination of Functional and Economic Obsolescence is Challenging Right-sized RCN defined excess capital costs Many aspects of functional obsolescence may exist Highly likely if the property is old, superadequate, or has issues Required investments, poor utilization rates or occupancy, declines in economic rent, etc., indicate additional functional and/or economic obsolescence 15

16 Common Types of Functional Obsolescence Excess operating costs Technological obsolescence Improvements in technology or efficiency present in a new, replacement property versus the existing property Must consider whether the existing property deficiency can be cured 16

17 Excess Operating Costs Functional Obsolescence Calculating operating obsolescence involves a comparison of the operating characteristics of the subject property to its modern equivalent, the property with which the subject would (hypothetically) be replaced. The existing property or facility and its higher operating expenses are compared to the reduced expenses that could be achieved by the modern replacement facility. 2 Labor Costs Energy Costs Cost-to-Cure 2 American Society of Appraisers, Valuing Machinery and Equipment: The Fundamentals of Appraising Machinery and Technical Assets, 2d ed., 2005, pp

18 Calculation of Excess Operating Costs Compare the operating costs of the existing property to the optimized replacement property Determine the present value of the difference in operating costs Labor Costs Energy Costs Cost-to-Cure Estimate duration and magnitude of excess operating costs Costs continue until inefficiency is cured or assets are no longer in use Projected annual impact is necessary if excess operating costs are likely to change in the future 18

19 Example of Excess Operating Costs Existing industrial building has 24-foot ceilings Market norm is 18-foot ceilings Replacement property considers 18-foot ceilings Existing property costs $5,000 per year more to heat and cool versus the hypothetical replacement If it is not economic to cure the ceiling height, the excess costs will continue through the life of the property Functional obsolescence is the present value of the $5,000 per year excess Simple calculation: capitalize $5,000 Alternative: consider a discrete projection recognizing changes through time and duration 19

20 Other Functional Obsolescence The comparative benchmark used to determine the value of the obsolescence considers: 1) The property as it exists today 2) The property as it would exist but for the obsolescence issue And is there a cure for the obsolescence issue? If it is curable - How much does it cost-to-cure? - Is the present value of the cost-to-cure less than the present value of the obsolescence? (The present value of the cost-to-cure includes the obsolescence during the period it takes to cure the obsolescence) 20

21 Example of Functional Obsolescence Existing net cash flow from the subject property is $100 million per year Estimate the net cash flow with newer technology, better efficiency, or other improvement in new property is $120 million per year Estimated cost to install new technology or improve efficiency to like-new equivalence is $100 million in capital investment Two-year investment period Cash flow and costs inflate at 2% per year 21

22 Example of Functional Obsolescence (Millions of Dollars Per Year) Year 1 Year 2 Year 3 Year 4 Year 5 Change in Net Cash Flow With New Technology Estimated Cash Flow With New Technology (1) Existing Cash Flow (1) Difference Functional Obsolescence = Net Present Value at 12% (2) $ 79 Million Cost-to-Cure by Installing New Technology Investment (3) Lost Cash Flow Until the Obsolescence is Cured (1) Total Cost-to-Cure (3) Functional Obsolescence = Net Present Value at 12% (2) $126 Million Since the Net Present Value of the Cost-to-Cure is greater than the Net Present Value of the ongoing obsolescence penalty, the appropriate functional obsolescence is the present value of the ongoing obsolescence 22

23 Symptoms of Functional Obsolescence Excess operating costs Due to superadequacy or other causes Functional obsolescence is quantified as the difference in operating costs between the efficient property and the subject property Capitalized at a risk-free rate due to the nature of risk associated with a negative cash flow 23

24 Functional Obsolescence Cost-to-cure considerations The remedy to the obsolescence should be reasonable - Alternative existing technology - Defined revamps or remodel of facilities Not necessarily planned by the existing owner - Existing owner may have limited capital - Existing owner may have a higher hurdle rate than the cost of capital used in valuation analysis - Existing owner may not be interested in investment for a number of reasons this does not mean the functional obsolescence does not exist 24

25 Methods of Quantifying Other Functional and Economic Obsolescence Effective remaining life adjustment Relative return on existing property versus marketrequired return Utilization ratio Income shortfall analysis or economic rent consideration... care must be taken to not double-dip with obsolescence previously quantified while fully capturing the impact of obsolescence on value 25

26 Functional Versus Economic? Often indistinguishable Labels are not important What impacts value? What does a buyer care about? How can those impacts be quantified Two useful methods: 1) Utilization or Occupancy Rate 2) Economic rent 26

27 Utilization as an Indication of Obsolescence Asset utilization is a key criteria in determining values Utilization is analogous to vacancy for measuring obsolescence Applies to special purpose properties Applies to hotels, rental property, etc. The income stream from any incomeproducing property is correlated with vacancy or utilization 27

28 Utilization as an Indication of Obsolescence Utilization analysis can be applied to industrial and manufacturing facilities and equipment Applicable in any situation where income is less than expected due to underutilization Compare actual utilization versus design or optimum utilization Design utilization must consider normal or expected vacancy or downtime For example, typically process facilities are only expected to operate at ~95% of design to allow for downtime 28

29 Utilization as an Indication of Obsolescence Utilization obsolescence is typically defined as economic or external obsolescence The impact of decreasing utilization on value is often misunderstood At 80% utilization, the revenues are 20% lower The change in operating costs is not proportional Therefore, the obsolescence is greater than 20% The reduction in net income will be proportionately larger than the reduction in use 29

30 Utilization as an Indication of Obsolescence The rate of change in operating costs is critical in determining the extent of the obsolescence with declining utilization Example of Utilization Impact on Value Utilization No. of Units of Production Design 100% 1,000 Actual 80% 800 Operating Costs (Millions of Dollars Unless Noted) Utilization 100% 80% Production, Units 1, Fixed Costs Variable Costs Total Operating Costs

31 Utilization as an Indication of Obsolescence The obsolescence is determined by comparing the impact on the net cash flow Looking at only the cost per unit at design utilization versus the cost per unit at the current utilization understates the obsolescence Operating Costs (Millions of Dollars Unless Noted) Utilization 100% 80% Production, Units 1, Fixed Costs Variable Costs Total Operating Costs % Utilization = 80% Utilization = Change in Cost Per Unit Operating Costs Per Unit = 200 MM$/Yr 1,000 Units/D 200 MM$/Yr 800 Units/D = 548 $/Unit (Calc 1) = 685 $/Unit (Calc 2) Calc 2 - Calc 1 = Calc = 25% 31

32 Utilization as an Indication of Obsolescence In this case, a 20% reduction in utilization results in 25% higher cost per unit But the change in net cash flow is much greater Simplified Net Cash Flow (Millions of Dollars Per Year Unless Noted) Utilization 100% 80% Economic Obsolescence Based on Change in Net Cash Flow Percent EO = Calc 1 - Calc 2 = = 80% Calc 1 50 Production, Units Per Year 1, Revenues ($0.25 Per Unit) Total Operating Costs Net Cash Flow Calc 1 Calc 2 32

33 Utilization as an Indication of Obsolescence At 80% utilization, this property is barely above breakeven The economic obsolescence is 80% Net cash flow, and therefore value, always decreases at a rate faster than utilization Note: To avoid double-dipping on obsolescence, the operating costs and revenues used for both the existing and full utilization cases should reflect any improvements captured in functional obsolescence calculations considered what if utilization is expected to change? 33

34 Utilization as an Indication of Obsolescence If utilization is expected to change, a multi-period analysis must be considered Compare annual net cash flow at design utilization versus projected utilization Determine the difference in the net present value of the two cases Economic obsolescence is the ratio of the values as shown in the simplistic case 34

35 Utilization as an Indication of Obsolescence Observations: An assumption that economic obsolescence is directly proportional to a decline in utilization or vacancy significantly understates the obsolescence The analysis must consider the net margin The rate of change in economic obsolescence with decreasing utilization is dependent on the relative magnitude of fixed costs versus variable costs An asset with higher fixed costs as a percent of total costs experiences higher economic obsolescence with declining utilization i.e., if costs cannot be reduced as utilization declines The obsolescence is greater The value of the asset is less 35

36 Economic Obsolescence Based on Economic Rent Calculation The Appraisal of Real Estate text explains that external obsolescence can be determined by the capitalization of income lost due to the effect of the externality. This procedure is applied in two steps First, the market is analyzed to quantify the income loss Next, the income loss is capitalized to obtain the value loss affecting the property as a whole If the income loss is anticipated to last for the economic life of the improvements, it can be capitalized by applying either a gross income multiplier to a gross income loss or an overall capitalization rate to a net income loss If the income loss is not anticipated to be long-term, it can be estimated using discounted cash flow analysis. 3 3 Appraisal Institute, The Appraisal of Real Estate, 14th ed., 2013, p

37 Economic Obsolescence Based on Economic Rent Calculation In actual practice the income lost often considers data for the subject property The Appraisal of Real Estate provides a calculation based on the subject property data, and market rates, to determine an equilibrium rent The concept of equilibrium rent is analogous to the equilibrium cash flow required for any incomeproducing property 37

38 Economic Obsolescence Based on Economic Rent Calculation An important concept in the capitalization of income loss is equilibrium rent, which is the market derived rental rate that would be expected in the market at equilibrium. The equilibrium rent is compared with the actual rent affected by the external factor in the current market, e.g., the lower rents that result from the oversupply of competitive properties in the market. There are two methods of estimating the equilibrium rent: 1) Base the estimate on market rent during a recent period of equilibrium adjusted for inflation. 2) Base the estimate on depreciated replacement cost, similar to feasibility rent but substituting depreciated replacement cost for full replacement cost. 4 4 Ibid, pp

39 Economic Obsolescence Based on Economic Rent Calculation Equilibrium rent is the rent that is calculated based on earning a market return on the depreciated replacement cost The equilibrium rent is used to calculate an Equilibrium Net Operating Income (NOI) The Equilibrium NOI is compared to the Actual NOI to determine the Income Loss Which is then capitalized to determine the economic obsolescence 5 5 Ibid, pp

40 Example of Economic Obsolescence Based on Economic Rent Calculation 1. Calculation of Equilibrium Rent Millions of Dollars Unless Noted Replacement Cost 100 Less Physical Depreciation 30 Less Quantified Functional Obsolescence 10 RCNLD Less FO 60 Plus Value of the Land 5 Total Depreciated Cost Without External Obsolescence 65 Multiplied by Market Capitalization Rate 10% Equilibrium Net Operating Income (NOI) or Equilibrium Rent (MM$/YR) Calculation of Income Loss and External Obsolescence Equilibrium NOI, MM$/YR 6.5 Less the Actual NOI, MM$/YR 4.5 Income Loss, MM$/YR 2.0 Capitalized at Market Rate 10% External Obsolescence Based on Equilibrium Rent 20 40

41 Equilibrium Rent as an Indication of Obsolescence Is economic obsolescence a circular calculation to the Income Approach? Yes only if economic obsolescence is determined by the difference between the Cost Approach and RCNLD less FO No if independently calculated The same property is being valued in both approaches Some of the same data is used in both approaches Any valuation method cannot ignore subject property data Any valuation method must consider the economic attributes of the subject property and the external market implication there is a reason it is called economic or external obsolescence 41

42 Equilibrium Rent as an Indication of Obsolescence If the income loss is temporary, the value of the loss should be calculated using a discounted cash flow analysis Also note that when the equilibrium net operating income is calculated from cost, the value indicated by the cost approach will be the same as the value indicated by the income capitalization approach. 6 6 Ibid, p

43 Economic Obsolescence Economic obsolescence considers comparative measures Actual throughput, utilization, vacancy, margins, or returns Compared to: Design, historical actual, required throughput, utilization 43

44 Reconciliation The three approaches to value should correlate with one another All three approaches are considering the same specific property and the same market The Cost Approach provides another method to parse the data and understand the value attributes of the subject property i.e., why is this property value so high or so low? 44

45 Conclusions An accurate appraisal on a complex property is a challenging undertaking If it was simple, everyone would be an appraiser! 45

46 Sources 1) Appraisal Institute, The Appraisal of Real Estate, 14th ed., 2013, pp ) Ange, Diane M., SRA, CAE. "Is the Cost Approach Reliable in Appraising Income-Producing Properties?" Fair & Equitable (Magazine of the International Association of Assessing Officers). IAAO. Volume 13, Number 12. December 2015, pp ) Crawford, Robert G., PhD, and Gary C. Cornia, PhD. "The Problem of Appraising Specialized Assets." The Appraisal Journal. January 1994, pp ) Reilly, Robert F., and Robert P. Schweihs. Economic Obsolescence Is An Essential Procedure Of A Cost Approach Valuation of Industrial or Commercial Properties. Property Tax Valuation Insights. Spring 2006, pp ) Spletter, Kathy G., Appraising Properties with Declining Utility, published in the International Association of Assessing Officers Journal of Property Tax Assessment & Administration, Vol. 8, Issue 4. 46