Owners, beware of ‘management fee theory’ in appraisals
 
Owners, beware of ‘management fee theory’ in appraisals
20 JUNE 2017 7:26 AM

Be careful with hotel appraisers who subscribe to a theory in which if a management fee and franchise fee have been deducted from the income stream, there is no intangible or business value.

Hotel real estate tax assessments have caught up with the market, allowing few opportunities to appeal the local jurisdiction’s most recent opinion of value, even if it doubled or tripled. Assessors are not limited to any amount of reasonable increase—they are only limited by 100% of fair market value of the real estate, not the going concern.

It becomes more important than ever for tax representatives to make the intangibles argument. Because operating hotels are not a simple real estate asset, in order to tax the real estate one must separate the value of the real estate from the going concern. Of course, the value the tangible personal property, or FF&E, must also be accounted for and typically it is, based on the jurisdiction’s assessment for business personal property (if personal property is separately assessed by law).

Because assessments are based on an opinion of value, often third-party appraisals are looked upon to resolve the differences. Unfortunately, the appraisers most often considered the most qualified to appraise hotels subscribe to a theory, based on a “thought” that occurred about 40 years ago by a leading hotel appraiser, described as the “management fee approach,” which claims that if a management fee and franchise fee have been deducted from the income stream, there is no intangible or business value. The “thought” that is the foundation for this theory is predicated on the idea that the business value belongs to the manager.

There are appraisers who do not subscribe to the “management fee theory” and not surprisingly, they usually work for the taxpayer. These appraisers who understand and support the fact that valuing a going concern requires additional work to separate the value of the real estate from the going concern are routinely discredited by the small group of hotel appraisers.

Here’s the big problem: Assessors have fallen victim to this “thought” perpetrated by a small group of hotel appraisers. Assessors like this argument because it allows them to essentially do nothing to address the issue of removing intangible value. Assessors rely on this so-called “management fee theory” and cite this small group of hotel appraisers as the authority. The end result of this is the intangibles, which could constitute as much as 30% of the total value for a flagged property, remain in the value determination and are taxed as real estate.

It is true the management company’s income stream (fees) represent their business—the management business. It is not true that all of the bottom line net operating income that goes to the owner is only real estate. The hotel business is owned by the owner, not the manager. Ownership has all the risk of the business, and certainly by hiring a professional day-to-day manager as well as paying for a flag, ownership expects to be rewarded.

The hotel appraisers’ mantra that management fees and franchise fees remove intangible (business) value means owners essentially get nothing for paying for these services. If that were the case, any rational investor would simply look to get the least expensive management and flag. We have empirical evidence that that is not the case, or Marriott or other major franchisors would have no business. Additionally, the management agreement and franchise agreement are bilateral agreements, meaning both parties expect to benefit from the arrangement.

The Appraisal Institute created a course for real estate appraisers that specifically addresses the ideas and concerns of operating real estate and the need to separate the real estate from the going concern. The hotel appraisers have not only not embraced that course, but openly flout it.

This small group of appraisers has also used a scare tactic to appeal to owners saying that separating out the intangibles would lessen their ability to get loans on their deals. Again trying to paint the picture that all that the owner owns is hard assets, or, alternatively, that all lenders will lend against is hard assets, neither of which is true. If lenders would lend against only the value of real estate, they would need only a deed of trust as collateral and that is not the case. The usual document which secures a hotel loan is titled “Deed of Trust, Security Agreement, Financing Statement, Fixture Filing & Assignment of Leases, Rents, Security Deposits and Hotel Revenue,” which clearly encompasses much more than real estate.

So owners, take note. Beware of the appraisals lenders need for their benefit that typically state in the report that there is no intangible (business) value. My advice to you is to keep them non-discoverable and out of your files. If you have to commission an appraisal by a reputable hotel appraiser for your purposes, which will end up in your files, take care to state in the engagement letter that you want their opinion of the going concern value and that you do not want any language in the report that specifically says there is no intangible (business) value. If these appraisers are not going to attempt to separate it, which means all they are valuing is the going concern, just value the going concern and stay silent on the matter of the intangibles. Your tax representatives will thank you immensely for paying attention to this little detail and you will have a better chance of prevailing on the intangible argument in your tax appeals.

Bernice T. Dowell is the president of Cynsur, LLC and a former senior manager of Paradigm Tax Group. She has focused her career in real estate transfer and property taxes on hospitality assets and the concept of removing the value of intangibles from a going concern. She began this endeavor as an employee in Marriott International’s tax department in 1991. While at Marriott, she was a member of the inaugural class at George Washington University for the masters of science in finance program and focused her senior thesis on the topic of hotel investment analysis and the contributory value of a tradename to a going concern.

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