Management Fee Method Leads To Over Assessment

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Management Fee Method Leads To Over Assessment
David C. Lennhoff, MAI, CRE, FRICS as published by Hotel News Resource, July 2008

Introduction

When reviewing your property tax assessment, it is important that you understand how the assessor determined your value, since property taxes should be based on the value of the tangible assets rather than the going business concern. Understanding the assessor's flaws in methodology will allow you to better challenge the assessed value.

Many assessment offices continue to use the "management fee" method as the way to remove the business value component from the total assets of the 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 a 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.

The "management fee" concept has been around for a long time and seems to exist because it is easy to use. There is no way it can be defended as an appropriate methodology for assessment purposes. Here is how it works.

Management Fee Method

As most owners know, hotels are usually not built speculatively and then rented to an operator. Therefore, it is usually not possible to find legitimate, arm's length leases of real estate from which to develop an estimate of market rent. As a result, the appraiser must begin with the income to the total assets of the business, and then deduct the portion that represents tangible and intangible personal property. The residual obtained is 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 do just that. It begins with an estimate of the annual net income to the total assets of the hotel business, and then deducts a management fee and a franchise fee to account for the business component. The residual is supposed to be the real estate rent, which is capitalized into assessed value. The idea behind this method is that, by obtaining a franchise and hiring a management company, the owner no longer has an interest in the business and simply becomes a passive investor who only benefits from the real estate proceeds. This, of course, is patently ridiculous. If it were true, why would anyone do it?

Economics 101: Why this doesn't work

Investors invest in real estate in anticipation of receiving a return of and a return on their investment. When they franchise a hotel they 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, why would they do it? To suggest such a thing is to suggest that a franchisee gets no return on the investment he makes in the franchise. Similarly, to suggest that the money paid to a management company represents the entire business contribution from it is equally incorrect.

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. He has not removed the return on these investments accruing from such contributions as the flag, assembled and trained work force or business start up costs. Until these additional items are accounted for and deducted, 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.

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. They are attracted to the "management fee" method because it has managed to survive so long and because it is easy to apply. It is not, however, a legitimate way to separate 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.

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 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.

FOUR BARTON SKYWAY 1301 S MOPAC, STE 430 AUSTIN, TX 78746 MAPS & DIRECTIONS		512.473.2661 800.473.2661 FAX: 512.479.8013 E-MAIL
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Management Fee Method Leads To Over Assessment David C. Lennhoff, MAI, CRE, FRICS as published by Hotel News Resource, July 2008 Introduction When reviewing your property tax assessment, it is important that you understand how the assessor determined your value, since property taxes should be based on the value of the tangible assets rather than the going business concern. Understanding the assessor's flaws in methodology will allow you to better challenge the assessed value. Many assessment offices continue to use the "management fee" method as the way to remove the business value component from the total assets of the 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 a 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. The "management fee" concept has been around for a long time and seems to exist because it is easy to use. There is no way it can be defended as an appropriate methodology for assessment purposes. Here is how it works. Management Fee Method As most owners know, hotels are usually not built speculatively and then rented to an operator. Therefore, it is usually not possible to find legitimate, arm's length leases of real estate from which to develop an estimate of market rent. As a result, the appraiser must begin with the income to the total assets of the business, and then deduct the portion that represents tangible and intangible personal property. The residual obtained is 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 do just that. It begins with an estimate of the annual net income to the total assets of the hotel business, and then deducts a management fee and a franchise fee to account for the business component. The residual is supposed to be the real estate rent, which is capitalized into assessed value. The idea behind this method is that, by obtaining a franchise and hiring a management company, the owner no longer has an interest in the business and simply becomes a passive investor who only benefits from the real estate proceeds. This, of course, is patently ridiculous. If it were true, why would anyone do it? Economics 101: Why this doesn't work Investors invest in real estate in anticipation of receiving a return of and a return on their investment. When they franchise a hotel they 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, why would they do it? To suggest such a thing is to suggest that a franchisee gets no return on the investment he makes in the franchise. Similarly, to suggest that the money paid to a management company represents the entire business contribution from it is equally incorrect. 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. He has not removed the return on these investments accruing from such contributions as the flag, assembled and trained work force or business start up costs. Until these additional items are accounted for and deducted, 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. 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. They are attracted to the "management fee" method because it has managed to survive so long and because it is easy to apply. It is not, however, a legitimate way to separate 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. 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 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.