A VALUATION OF A HOTEL:
DETERMINING THE "FAIR" VALUE OF
INCOME-PRODUCING REAL ESTATE
Law & Valuation
ABSTRACT: This work will attempt to educate the reader on the current methods used to evaluate real estate and why they are impractical and misleading when applied to large commercial income producing real estate with an emphasis on the problems of valuing hotel property. The first part of this work will concentrate on the current valuation methods used to evaluate real estate. The second part of this work will illustrate through case law the particular problems caused by these traditional methods. Lastly this work will conclude with some suggestions to improve the valuation of income producing real estate using hotel property as an illustration.
In any transaction involving real property that Internal Revenue Service requires a quantifiable basis be used to calculate the tax consequences for the transaction. In order to determine a quantifiable basis the IRS determines the "fair market value" of the property involved in the transaction. The tax code defines fair market value as "the price at which the property would change hands between a willing buyer and a willing seller, neither being under any compulsion to buy or sell and both having reasonable knowledge of the relevant facts. In order to arrive at this fair market value the IRS and the tax courts rely heavily on professional appraisers. A real estate appraisal is defined as "an unbiased estimate of the nature, quality, value or utility of an interest in, or aspect of, identified real estate and related personality". While this simplistic approach may be very useful and practical in valuing residential real estate or commercial real estate where the ! property is simply a location for a business, it proves impractical and even misleading when followed to appraise large commercial properties that produce income.
The nature of income producing real estate is similar to non-income producing real estate in that it is a mixed asset composed of non-depreciating land and depreciating improvements. The income produced by that land however is a return on the investment in the land and the improvements. This return on the investment is simply not determined by the investment put into the land and the improvements, but rather a return on the investment into the business or activity that produces the income. Therefore income producing real estate is not simply the land and its improvements, but rather real estate represents the total investment into the activity or business that produces income on the real estate, which may or may not be directly, related to the land upon which the improvements are situated.
The true value of an asset that produces income therefore is not measured by "personality", but rather the value it generates added the original land value and improvements. Thus income producing real estate should be, in part valued based on its ability to generate income. This approach should be the method with which not only the IRS, but also other entities that rely on the work of professional appraisers should regard large income producing real estate. There are many reasons why an entity, including the owner(s) of the property, would need an appraisal of income producing property. Some of the reasons an entity may request an appraisal include the obvious impending property sale or contemplated purchase, but also include mortgage financing, partial or total property condemnation, estate settlement, property-tax assessments, equitable distribution, and general civil litigation, especially in the area of determining damages. These entities such as the bankruptcy! courts and the court system in general and the seller and buyer in a sales transaction of such property may have varying agendas that may disregard the income producing character of the estate. Nevertheless, in order to determine a "fair market value" market the income producing character must be part of the evaluation in order to compensate the owner of the asset for the loss of the income production character of the estate.
This work will attempt to educate the reader on the current methods used to evaluate real estate and why they are impractical and misleading when applied to large commercial income producing real estate with an emphasis on the problems of valuing hotel property. The first part of this work will concentrate on the current valuation methods used to evaluate real estate. The second part of this work will illustrate through case law the particular problems caused by these traditional methods. Lastly this work will conclude with some suggestions to improve the valuation of income producing real estate using hotel property as an illustration.
II. Traditional Valuation Methods Used for Real Estate
Real Estate appraisers usually rely on three different methods for evaluating real estate the sales comparison approach, the cost approach, and the income capitalization approach. These methods are interrelated because each one to some extent relies on the marketplace. Market value is consistently linked to the term "fair market value" defined as "the price at which a seller is ready and willing to sell and a buyer is ready and willing to buy on the open market and in an arm's-length transaction". This definition however suggests the problem with market value. Just because a seller is willing to sell at a stated price and the buyer is willing to sell does that value indicate the true value of an income producing asset? How does either party determine the "fairness" of the stated value of an asset, particularly a large-scale asset that produces income? More importantly how does the marketplace construct of value apply to a transaction where the buyer or seller is f! orced into the transaction such a bankruptcy proceeding, an eminent domain taking, or in even in a case such as the value determination for property taxation?
1. The Methodology
The sales comparison approach suggests that the determination of whether or not the parties are being treated fairly depends on whether the property is question is being valued at a price relatively similar to the price being offered for similar properties. This approach is widely accepted and generally used to value residential properties. This approach also can and has been used to value income producing property where properties are similar in design and the income generated by the property is also similar. The underlying theory behind this valuation approach is the notion that a buyer would not pay more for one property than he would for a similar property.
2. The question of Market Comparables
This method works fairly well as long as properties are homogeneous, but large income producing properties are often so distinct in their characteristics that a comparison without some adjustment is misleading. This is especially true of hotel properties although such properties are bought and sold everyday. For example even two hotels in the same vicinity and relatively the same size may not be appropriate to use for the sales comparison approach. One hotel may have meeting facilities and the other may not. One may have an indoor pool and the other may have an outdoor pool. In addition even two hotels with identical facilities and room sizes, may not be comparable due to differing services or reputations, purely intangible characteristics, but nevertheless in valuing a hotel such intangibles are as important as the size of the beds.
3. When the Market is Misleading
The second problem with this approach is the current state of the real estate markets especially the commercial real estate market. As economists had predicted in the mid to late nineties the real estate market in the United States hit an all time low. In the 1980s economic, social and demographic forces combined to create a boom in the real estate market. Foreign investment with low cost capital mixed with tax changes in 1986, created devastating overbuilding, especially in hotel and office real estate. By the late 1980s the evidence of overbuilding could be seen however developers continued to build. In 1985 the office vacancy rate had risen to over 20% and remained at that level into the mid-nineties. In the early nineties the construction cranes that had marked the urban landscape in the eighties had been replaced by foreclosure and "space for rent" signs. Foreclosures and bankruptcies eventually moved some of these excess properties out of the market, but have! forced the sale of these properties at "artificially depressed prices". As a result of the depressed prices the sales comparison data for the past decade is misleading. Income producing property sold or appraised based on this data, is bound to result in an unrealistic value.
1. The Methodology
The cost approach is similar to the sales approach in that it is based on comparisons in the market and therefore has some of the same inherent problems. It compares the cost of either the replacement or reproduction of the building and uses that figure to value the cost of the current real estate. The approach uses the prevailing prices in the market for materials and supplies. Using the cost approach property is first valued by determining the highest and best use of the land as if it were vacant. Then the appraiser uses a variety of methods to calculate the cost to construct the property. In applying these methods the appraiser's look at both the replacement and the reproduction costs. Reproduction and replacement cost are often used interchangeably, but they are in fact two separate concepts.
The difference between reproduction and replacement costs is that reproduction costs are based on producing an exact replica of an existing structure using the same or similar materials and workmanship. Replacement costs on the other hand are based on the cost of producing an equivalent structure with the same utility. The value however is then determined using the cost of what a modern design with modern workmanship and material would cost.
Once the appraiser decides to use either the replacement or the reproduction cost then he adds depreciation and deducts that figure from the total cost. An appraiser's definition of depreciation however is very different than that of an accountant. Depreciation is defined by appraisers as the physical deterioration, functional obsolescence, and economic obsolescence that the structure has endured up to the time of the appraisal. This depreciation is a considered a loss of value.
The term structural deterioration is used interchangeably with functional obsolescence and refers to outdated design such as narrow hallways, high ceilings and poor wiring. Physical deterioration is the normal wear and tear inside the building, while external obsolescence is viewed from the environment that exists outside the structure, such as changes in economic conditions or poor land use. In the cost approach some depreciation is "curable". Curable depreciation is the any depreciation that can be replaced or fixed, but at a cost that is equal to or less than the anticipated increase in value due to its cure. When depreciation is curable its cost is still deducted from the value of the property, but using the following method: Replacement Cost $100,000
Total Physical Life New in Years 40
Effective Age in Years 3
Cost to Repair (Physical Curable) $1,500
Accrued Depreciation $5,887.50
Accounting for "curable" depreciation allows for a better value of the property, however external obsolescence is not curable. External obsolescence is not curable because it is based on external environmental factors over which the present owner or future owners have no control. External obsolescence is similar to nuisance and to measure such external obsolescence, including high crime in the neighborhood or proximity to a plant emitting noxious odors, appraisers again revert back to a sales comparison approach. Appraisers in measuring external obsolescence use sales of properties subject to the nuisance effecting the property in question to those free of the problem, to determine the correct amount of depreciation.
2. The Cost of Income
As stated before the cost approach because it is based on materials, labor and other market factors can be as misleading as the sales comparison approach. However an even bigger problem exists when this approach is applied to income producing. A leading text in real estate valuation states the following about the cost approach method:
In this method of valuation a qualitative analysis is made in real property, and its maximum valuation is set by determining the replacement cost of the property at prevailing prices. This method is applicable only when no earnings are produced by the real estate in a form that permits estimation, or when the income derived from the real estate as a part of the profits of the business conducted in the property is so small a portion of the total profits that its segregation is impossible. From the maximum valuation, deductions are made by plausible but arbitrary means in order to allow for accrued depreciation and obsolescence. In the making of the deductions, the property is studied in terms of its functional aspects.
In that quote it is illustrated that not only is the deduction process arbitrary, but it is also based on the property's "functional aspects" not its financial aspects. In order for the cost approach to be reliable in valuing any property it is important for the appraiser to be able to determine correct valuations for labor and materials. In addition the appraiser must also be able to determine appropriate amount of depreciation to deduct from the total replacement or reproduction cost. The appraiser must then also be able to determine the costs of curable depreciation. This task becomes increasing difficult as the building ages because the depreciation estimates become more critical and the cost to cure increases. Finally, the appraiser is forced to be in the position of a sociologist and environmentalist and must determine the future of the external environment of the property considering every factor from the future land use to the crime rate.
The cost approach therefore is an extremely difficult method of valuation for an appraiser because it requires a level of expertise in construction, business, and environmental and societal issues. Appraisers usually do not have a proficient level of all of this expertise. In addition it is not very cost-effective to hire such professionals and therefore the appraiser often determines values using the cost approach method that are quite speculative.
When dealing with income producing real estate while the lack of accuracy in determining the "functional aspects" produces the same effect as on any other piece of real estate. That is it produces an inaccurate valuation, it does it so with greater detriment, especially when dealing with an income producing property like a hotel. Hotels are very sensitive to external obsolescence the most difficult kind of depreciation to measure. Therefore when applying the value of external obsolescence to the total replacement and reproduction cost it is important to not only pay closer attention to the factors that produce the external obsolescence value. In is also important to view these factors in terms of not only what impact they are going to have on the physical property in question, but on the tourism and business interests in the area.
Hotels unlike most income producing pieces of property are very dependent on the other aspects of their environment to produce income, unless of course the hotel itself is a self contained resort or convention center. The customers of hotels generally do not come to an area to see the hotel but to see the area or work on a project in the area. If the area is not appealing for any reason tourism will drop, and if the business interests decline so will the need for business oriented customers to stay at the hotel. Therefore, an external factor like a bad smell emanating from a new factory in the area may have no impact on an income producing piece of real estate such as a factory or even an office complex, where the workers spend most of their time indoors. The same factor for a hotel however may be devastating, as would the loss of a nearby sports team, convention center, or even a newer facility down the street.
The income capitalization rate is the method used in tax assessment litigation and is usually the method preferred by owners of income producing real estate. The method works in the following manner using the annual net income from the property and the desired rate of return, also known as the capitalization rate. The net income is then divided by the capitalization rate. The following is an example:
Net Income = 100,000
Capitalization Rate = .12
100,000/.12 = 833,333
Using the above example then the net income from the property justifies an investment of $833,333. This market price for the property however is based upon what an investor expects to see as a return, as in the above example the expected rate of return was .12 whereas a different rate of return would have yielded a different market rate.
While the above method is not very complicated to understand it is like the other traditional methods of real estate valuation and is not without its problems. This approach is very similar to determining the rates of return on other investments like stocks and bonds. It views the property as an investment that produces a series of cash flows, with a reversion or rather the expected return on the investment through sale or realization. However real estate is not like any other security that is easily exchanged in the marketplace. This approach is an attempt to take the same market concepts that are used for stocks and bonds and compare those concepts with the same concepts in income-producing real estate. Therefore the approach takes a series of irregular cash flows and adds this to a reversion to produce a single present value for a piece of real estate, similar to the process used to determine the prices of stocks and bonds. Real Estate is not like a stock or bon! d.
The problems with the income capitalization method are based upon the two factors that are used to determine the market value, the net income and the capitalization rate. The first problem is that the net income amount is based on a stabilized amount of income. The appraiser derives this amount from analyzing property and lease data for the subject in question and other comparable properties. While this may seem entirely logical in does not take into account the variable real estate market over the past two decades. As discussed earlier the boom of the eighties followed by the recession in the nineties in the real estate market has led to interesting data filled with sharp increases and decreases in net income. This data however is not an accurate predictor of future performance because it is based on a unique period of history for the real estate market. This is particularly true when this approach is applied to a hotel's net income. The boom and bust in the commercia! l real estate market, as discussed earlier resulted in too many hotels and not enough renters, therefore hotel rents were drastically reduced in the mid-nineties to compensate for a saturated market with too much supply and not enough demand. The reduction of room rents therefore were an attempt by hotel owners to stay afloat in a market that was overflowing with excess.
Another problem is the capitalization rate is also derived from comparable sales in the marketplace. Appraisers usually arrive at capitalization rates by dividing the stabilized net income of the comparable property by its cash adjusted sales price. As discussed above the concept of stabilized net income is not a reliable measure to use in the real estate market especially in the commercial real estate market. Added to that unreliable measure is the previously discussed method of comparable sales. Therefore the income approach method is not a perfect method for valuing income producing real estate, especially hotel property.
The Reynolds case illustrates the use of all three of the traditional real estate valuation methods to value a hotel in Chicago. The case is tremendously useful to illustrate the arguments outlined above because the court considers each approach on its own merits to value the hotel. In the Reynolds case the court was reviewing the trial court's decision in a partnership dispute. The trial court in a bench trial awarded the plaintiffs $953,465 for their respective shares for their partnership interest in a piece of real estate known as the Whitehall Hotel.
The Whitehall Hotel is located at 105 and 111 East Delaware Place in Chicago. The Whitehall is located near four other hotels in the same area the Drake, the Mayfair Regent, the Ritz Carlton, and the Inn of Chicago. The building was built in 1928 and is 21 stories with a brick face finish. In the basement there is heating equipment, boilers and a laundry facility that is used for the hotel operations. The "Whitehall Club" is located on the first floor of the hotel. The Whitehall Club is a 125-seat restaurant that is reserved for its members and the hotel's guests only. Also on the first floor is small lobby with a bar. The hotel has three elevators and 223 guestrooms.
In 1970 John Coleman entered into an agreement with Lex Hotels, an English Corporation to finance his purchase of the Whitehall. The original agreement stated that Coleman would supply $6 million dollars to the purchase and renovate the Whitehall while Lex Hotels renovated and operated the hotel. The Lex Hotel would then pay Coleman $660,000 in rent. That agreement was later amended in 1973 with Lex Hotel paying $1,100,000 in rent. In 1975 Thomas Reynolds and Kenneth Pigott, both attorneys who had assisted Coleman with his purchase of the Whitehall, entered into an agreement whereby Coleman retained a 95% interest in the hotel while Reynolds and Pigott each held a 2 1/2% interest in the hotel. In 1980 Coleman purchased the operations of the hotel for 2.2 million. Then in 1984 "sold" the legal title to the hotel for 42 million, although he retained the rights of management and could use the hotel as an asset for collateral. Although not clearly stated by the court thi! s deal resulted in a substantial tax loss for both Reynolds and Pigott . The deal went sour and Reynolds and Pigott sued for their interests, in essence dissolving the partnership.
The court heard from appraisers on both sides. Coleman appraisers looked at all three methods. In looking at the cost approach the Whitehall was valued at 17 million. To reach this figure the appraiser took the land that the Whitehall sits on and valued that land at $5 million using a rate of $250-$300 per square foot. The appraisers for Coleman then valued the reproduction of the hotel at a cost of $20 million while the replacement cost was estimated to be about $16 million based on a replacement cost of $115 per square foot times the 140,000 square foot area of the building. The appraisers then added the lesser replacement cost of $16 million to the cost of the land $5 million for a total of $21 million. The appraiser's then discounted this value for physical depreciation and functional obsolescence and came up with a figure of 17 million.
The appraisers for Coleman also used the sales comparison method. In using the hotels in the vicinity mentioned earlier the appraisers looked at sales data that ranged from a modest $3.25 million for a 450 room hotel in 1977 to a high of $27.7 million for a 657 room hotel in 1979. Each of the comparable hotels were similar only in location, however using this data the appraiser's reached a figure of $17 million, or a value of $76,233 per room.
Coleman's appraisers reached the lowest figure for the Whitehall by using the income capitalization approach. Using the income capitalization approach Coleman's appraiser's came up with a value for the Whitehall of $11.9 million using a capitalization rate of 11% and depreciated the total to account for the age and condition of the building.
While Coleman's appraisers using all three methods concluded that Whitehall was worth somewhere between $11.9 million and $20 million, Reynolds appraisers using the same methods came up with an estimate for the Whitehall of $49 million.
The Reynolds appraisers originally valued the Whitehall at $45.5 million by using a 15 year income and future valuation approach and reducing that figure to its present value of $17.1 million (this is essentially the income capitalization approach). The appraisers then added $28.4 million to the $17.1 million figure because they argued that that amount represented the projected current value of Whitehall's business over the next 15 years. After adding $28.4 million and $17.1 million the appraisers then threw in a value of $3.5 million for the land resulting in a total price tag of $49 million dollars.
The $49 million sales figure was then compared against comparable hotel sales to ensure that it was a fair estimate. The appraisers for Reynolds then looked at several hotel sales including the sale of a 306 room hotel in Denver that sold for 24.2 million in 1983, a 770 room hotel that sold for $62.5 million, and a number of other hotels around the country that were better located and had better facilities than the Whitehall.
Despite the figures presented by the Reynolds appraisers being less than accurate the trial court accepted their numbers based on testimony from another witness from the company that "bought" the property from Coleman in 1984 for $42 million. The trial court had used this $42 million figure and added in the value of the land, which they valued at $6,619,000 for a total of $48,619,000. The Illinois Appeals Court however reversed the trial court's valuation based on the fact that the Reynolds appraiser's used future income predications to estimate the purchase price of the property.
The Illinois Appeals Court held that using future predictions of income to estimate the purchase price of property was too speculative. The court reiterated a holding in a prior case People v. Stevens. The case, which was decided in 1934 held that:
"In civil cases the rule is that fair cash market value of property on the date under inquiry is its value for the highest and best use for which it is adapted, and evidence tending to show profits from the operation or volume of business, or contingencies of future profits, is too speculative and remote to be considered."
The court thus excepted the numbers of the Reynolds appraisers without any attention placed on the income the Whitehall would be able to generate. The court took the sales comparison and cost approach to determine the value of Reynolds and Pigott partnership interest.
IV. A Better Way to Determine Value
In reviewing the Reynolds v. Coleman case above it becomes obvious that some courts simply ignore the income producing nature of income producing real estate. As this work has attempted to convey such a method of valuing property results in a poor valuation. Depending on the circumstance such a method results in either a valuation that is too low or one that is too high. For example in a depressed economy, property that is valued without taking into account the loss of profits from external factors results in an elevated value for the property. On the other hand when a very profitable establishment is valued without any consideration to the income it produces the result is a severely depressed value.
How do we then value income-producing properties? The perfect method does not exist however in valuing income-producing property, the entity that requests the valuation whether it be the government or a buyer or seller, must not overlook the income producing nature of the property. To do so is to dismiss the true value of the property.