Selling The Obsolescence Argument From the Appraiser s Prospective John Ray Director American Appraisal Associates, Inc. Dallas, Texas (214) 459-6408 johnray@american-appraisal.com An independent third-party appraiser can only advocate for their valuation position not for their client. An appraiser cannot negotiate with a taxing jurisdiction but rather only arm their client with the best possible opinion of value. Quantifying obsolescence is the easy part of the argument. Successfully communicating the methodology and the results are a bit more difficult but key to success. As many of you know you can be absolutely correct in your argument; it s what they decide behind those closed doors after the hearing or trial that really matters. A valuation professional can only present a clear and precise argument backed up by established valuation methodology and calculations. In any valuation you must consider all three approaches to value. However, for the purpose of our discussions we are going to focus on the cost approach and the cost approaches functional and obsolescence components. Under the cost approach, the maximum value of the subject property to a knowledgeable buyer is that amount currently required to erect or construct a new plant of equal utility. The current cost new must be reduced to reflect the physical deterioration, functional obsolescence, and economic obsolescence attributable to the property at the appraisal date. A Picture is Worth a Thousand Words It might be a cliché but it is absolutely true. Communicating the deficiencies of the subject property is the first step in successfully presenting an argument for obsolescence. In many cases the subject property may be unique to the respective jurisdiction and the assessor, board, judge or jury may have nothing with to compare the property. It is the responsibility of the appraiser when presenting an argument for functional or economic penalties to clearly articulate the deficiencies in the subject property and the superiority of the comparable property if applicable. 38 th Annual Conference Institute for Professionals in Taxation
Real World Example A food processing plant was built over the course of two decades. It is operating at capacity and is profitable. However, because of the piecemeal way the facility was constructed there are inefficiencies in the process flow resulting in over sixty manufacturing steps from raw material to finished product. The trended or reproduction cost utilizing the State tables is in excess of $200 million for personal property, however the owner of the plant just built a facility with the same capacity in a neighboring jurisdiction for $125 million (replacement cost). To the further detriment of the subject property the operating cost for the new facility are half as much as the older facility due to a more efficient process/material flow, less employees and reduced utility consumption. Construction and operating cost of the new facility were utilized to compare the two facilities. Photographs, process flow diagrams and testimony from the client s engineers was utilized. Any market participant would take these excess capital and operating costs into consideration while contemplating a purchase consideration for the subject property because it handicaps the ability to monetize their investment. Appraiser Assessor Reproduction or Trended Cost 200,000,000 200,000,000 Less Functional Obsolescence due to Excess Capital Costs 75,000,000 0 Equals Cost of Replacement 125,000,000 0 Less Physical Deterioration 65,000,000 65,000,000 Less Functional Obsolescence due to Excess Operating Expenses 5,000,000 0 Less Economic Obsolescence 0 0 Equals Cost Approach Indicator of Value 55,000,000 135,000,000 A huge difference between $55 million and $135 million but with the deficiencies of the subject property clearly outlined and benchmarked with the newly constructed property it was a very compelling argument and a solid opinion of value. Sister Mary Francis Was Right! When presenting and argument for obsolescence you need to be transparent and present the full set of calculations used to derive your obsolescence adjustments. Never give the appearance you are trying to hide something. If you have properly utilized the valuation tools in your opinion then you should have no issues with showing the data and calculations utilized in the analysis. You should even be prepared to walk opposition or reviewing body through your calculations step by step. Sister Mary Francis was right in third grade when she said show your math. Page 2
Real World Example A drinks bottler has an older plant that has suffered utilization issues for the past several years. Utilization has declined, with one exception, for the past five years. The process technology has also changed in the intervening thirty years where the two single fill lines at plant could be replaced with a single dual fill line. Excess Capital Cost Adjustment Given the age of the subject production lines and the technological advances that have occurred in the industry, a prudent purchaser would consider other alternatives to achieve the desired production level. To determine the cost of a modern replacement for the plant, a review and analysis was made of data for a recently constructed bottling facility. The facility was constructed in 2007. Cost data was extracted from fixed asset management software and analyzed. To ensure the data was correct, comprehensive discussions were held with company personnel knowledgeable with the cost data. The costs associated with the newly constructed line included the costs to purchase, install, and test the equipment. The production lines at the new plant utilize dual fill technology whereas the same capacity at the subject facility is contained in two single fill production lines. The functional replacement for the subject facility s two single fill lines would be one dual fill line of the same capacity as the equipment found at the new facility. Functional obsolescence due to excess capital costs is calculated as follows: Reproduction Cost (Trended) of Existing Production Lines Line 1 Line 2 $14,370,185 $12,223,091 Total Reproduction Cost $26,593,276 Replacement Cost of Modern Dual Fill Line Functional Obsolescence Due to Excess Capital Costs $19,864,000 $6,729,276 Based on the analysis, the total facility replacement cost is concluded to be $39,006,489 for the personal property and business fixtures. The difference between the aggregate reproduction cost of Lines 1 and 2 and the replacement cost of a modern dual-fill line, $6,729,276, is considered a form of functional obsolescence due to excess capital costs. Page 3
Inutility Adjustment A clear indication of the existence of economic obsolescence is inutility. To quantify the magnitude of economic obsolescence inherent in the subject assets, an inutility analysis was developed. Plant capacity on an annual basis is 82.4 million gallons. Capacity is based on one-ten hour shift per day, six days per week. The previous year s production was 45.4 million gallons making a capacity utilization deficit of 37 million gallons. To quantify an inutility penalty, an analysis was made using the subject s historical operations and the typical level of utilization. The inutility penalty is quantified as follows: Scale Factor Inutility = 1 - (Actual Production Rated Production) The scale factor allows for an adjustment between two levels of production in a nonlinear manner. Based on discussions with knowledgeable engineering staff with the responsibility of designing, building and installing new bottling facilities, a scale factor of 0.68 was used to calculate the inutility penalty. To calculate the inutility penalty, the rating of each production line was used as a benchmark and was compared with the actual 2011 production data. The following calculation for Lines 1 and 2 are used to compare the actual 2011 production data with the plant capacity: Inutility = 1 - (Actual 2011 Production 2011 Plant Capacity) Scale Factor = 1 - (45.4 MMgal/Year 82.4 MMgal/Year) 0.68 = 0.333 or 33.3% The inutility analyses resulted in the following economic obsolescence indicator (inutility penalty), based on an analysis of the plant s actual performance against its rated capacity: GALLONS 2011 2011 INUTILITY INUTILITY LINE CAPACITY PRODUCTION PENALTY (%) PENALTY ($) LINE 1 45,795,000 26,846,975 30.5% LINE 2 36,609,375 18,565,246 37.0% TOTAL 82,404,375 45,412,221 33.3% 2,297,069 Page 4
This indicator shows that the subject assets, as of the Valuation Date, have significant overcapacity because the facility does not operate at its designed utilization levels. Accordingly, it is concluded that significant economic obsolescence exists that adversely affects the value of the subject property. Based on the above, a penalty is determined to recognize economic obsolescence inherent in the subject property and is applied to the value indication after deducting physical deterioration from the replacement cost. An example of the cost approach to illustrate the steps followed in the analysis is provided as follows: Subject Asset: Line 2 Bottle Rinser Asset # XXXXX-XXXX Asset Class- XXXXX Normal Useful Life - 12 Years Year Purchased 2005 Chronological Age - 7 Years Effective Age - 7 Years Original Cost 220,096 Trend Factor 1.15 Reproduction Cost (Cost x Trend) 253,110 Less Functional Obsolescence Due to Excess Capital Costs 64,155 Replacement Cost 188,955 Less Physical Deterioration 96,387 Less Economic Obsolescence 32,111 Equals Cost Approach Value Indication $64,276 The Nun, the Farmer and the School Teacher The above discussions are pointless unless you can clearly communicate with the parties who will utilize your valuation and your testimony. As members of a technical profession we often forget that the people we are trying to communicate our valuation issues with are not valuation experts. It is hard to articulate you position with, in many cases, volunteers or Page 5
professionals that typically hear cases that involve a home owner mad that their home s property tax went up, or a small business owner trying to get the value of his office equipment reduced. However, do not confuse a lack of valuation experience with a lack of intelligence. Real World Example One of my very first cases involved a county board comprised of a nun, a farmer and a school teacher. I started off with highly technical, jargon-filled testimony for a very complex mining property. While not unintelligent individuals I quickly realized that the group knew nothing about coal mining or valuation. I quickly had to adjust, backup and explain how coal was mined and prepared or prepped for market. Then I had to give a very detailed explanation of the cost approach walking the board through each step, referencing and making copies of several American Society of Appraisers publications for them. This experience not only made me rethink how I would give testimony in the future but also how I would write future reports. To this day I always include sections in a valuation report that describe the manufacturing process, an detailed explanation of the cost approach and lastly a detailed explanation of how the cost approach was applied. JOHN RAY is a director in the Dallas, Texas office of American Appraisal. Mr. Ray specializes in the valuation of complex personal property. His practice is focused on several industries such as oil & gas, mining, food processing and high tech manufacturing. Mr. Ray has been with American Appraisal for eighteen years and is a third generation appraiser. He attended Georgia State University in Atlanta, Georgia and graduated with a BA. Page 6