In the hotel industry, capital expenses (CapEx) projects are driven by numerous factors, such as improving, maintaining, or repairing a property, or fulfilling the requirements of brand standards. For owners, CapEx are necessary to preserve the property’s competitive edge. But assessors often misunderstand the function of CapEx and see reserves and CapEx as interchangeable when applying adjustments to assessed value.
In the June 2018 edition of Hotel Executive Magazine, we explored the relationship between CapEx and tax assessments from the owner’s perspective. In this article, published in Hotel Executing Magazine’s November 2018 edition, we’ll focus on the assessor’s point of view. Understanding both perspectives is the first step toward reaching consensus on the role of CapEx in valuations and assessments.
Also, download our webinar, 5 Tips on Hotels, Capital Investments, & Taxes, recorded March 2019 with David Chitlik, VP, Altus Group, and Bob Kalchik, SVP, Marriott International for additional insights and stories. Download Webinar
Permits, Property Valuations, and Supplemental Assessments
As a hotel owner or manager, you will have a multiple year plan to spend CapEx on property renovations, repairs, or improvements. In contrast, assessors learn about the scope and cost of your project at the time of the project or even after through one of several means, such as the annual income and expense questionnaires required by jurisdictions, articles in the media, or construction equipment onsite.
However, the most common way assessors are notified is when a building permit is issued for renovations or improvements. The permit process is similar in each of the 8,000 taxing jurisdictions nationwide, but how and when the assessment will be impacted can be vastly different. Assessments of two comparable properties in two jurisdictions only a few miles apart can differ by thousands of dollars, and taxes by as much. So, before you get the permit, make sure you understand the tax implications.
Permits require disclosure of the estimated cost and scope of a project. Many times, this is the only information available to the assessors to determine the impact the project will have on the assessed value. The cost on the permit benchmarks the value that should be deducted from the assessment for the year (or two) prior to project completion. These amounts are estimates and typically understated, so owners should also discuss the actual project with the assessor. This is a two-step process:
- First, alert the assessor of the required deficiencies and total cost to fix them, or “cost to cure.” When the cost to cure is calculated, it reduces the property’s market value, which often triggers assessment appeals.
- Second, once the project is completed, review any supplemental assessment notices to ensure only the portion of the renovation that actually added value is included in the new value. If your jurisdiction does not issue supplemental notices, check the next revaluation carefully. A dollar of CapEx spent at a hotel is rarely equal to an added dollar of market value for the property — it just keeps the hotel competitive and maintains existing income flow.
Owners should keep in mind that taxes often increase during supplemental assessment cycles that are triggered by construction. There are hundreds of cycles: some statewide, some by locality, some random, and many with unique interim assessments and supplemental provisions, which can increase assessments mid-cycle. This can be the most challenging type of assessed value to determine, especially since, as mentioned previously, assessors often do not have all the information. If an owner is not paying attention to the interim or supplemental assessments during construction, they may be overpaying taxes during this period. Sometimes owners aren’t aware they were charged a supplemental tax — another reason to always review assessments.
When the construction project is completed, owners should get sign-off from the jurisdiction. The law allows valuation of property as of a specific date, and when construction is finished, that’s often when the assessors start adding value.
Why Assessors Ignore Brand Standards
Brand standards are considerable drivers of CapEx. So why do they seldom appear on a tax assessor’s radar?
- Lack of knowledge. Many assessors simply don’t know about brand standards. Each brand has a franchise offering disclosure (FOD) that drives its brand standards, influences how much CapEx is spent (which affects property value), and lists the amount owners must spend on CapEx to maintain the property. And there’s something else assessors may not know: the sizable cost differences to maintain full-service, limited-service, or extended-stay hotels
- Reasons to replace aren’t always apparent. Why spend CapEx on an HVAC unit when the existing HVAC is still functioning? Or even more confusing is why replace a carpet in good condition or barely worn fixtures? From the assessor’s perspective, since there’s no obvious need of replacement then is must be a capital improvement. It’s incumbent on the owner to explain when the brand standard may require replacement before the end of a functional lifespan.
- All costs do not add value. An assessor’s perspective of CapEx is usually simple: the owner spends $1 million on the property and the assessment increases by $1 million. Of course, this belief is not true, but it occurs often enough that it’s worth emphasizing: not all capital expenses add value to a property. CapEx spent on brand standards are not negotiable, nor value-adds. Owners can help assessors understand why.
Assessors Often Share Misconceptions
Tax assessments are affected by assumptions, and some are inaccurate for reasons we’ve covered in this pair of articles. Following are the most common areas of friction.
- Lack of trust. Let’s face it: some assessors approach each appeal with skepticism. They’re reluctant to accept the owner’s word that repairs are necessary, cost estimates are accurate, and the value should be reduced based on the “anticipation” of a future renovation, even when every potential hotel purchaser will deduct anticipated costs from the final purchase price.
Building trust takes time. Owners can help by allowing the assessor to make a physical inspection of the property or by providing certified documentation to show why reducing property value before a renovation is a fair approach.
- Not including the entire cycle of CapEx. Even if an assessor is willing to consider an adjustment for upcoming expenditures, he may be wary of projecting beyond 12 months. But most owners have a CapEx budget of five years or more, and using only one year versus the entire cycle of the CapEx plan shorts the valuation. Owners can provide the data to assure assessors that the expenditures are realistic and well researched.
- Requiring that CapEx is spent before reducing value. Some assessors believe that reserves must be spent before they will deduct any CapEx costs. This violates the valuation timeline, since the loss in value is always prior to an issue being fixed or resolved. The assessors are essentially saying that they do not trust that the CapEx will be spent, so “prove it!” before lowering the valuation. Of course, it makes little sense to place a lower value on a hotel after it has just completed a needed CapEx project, even if that CapEx expenditure does not enhance the property’s income flow.
- Assuming CapEx and reserves for replacement are the same thing. Reserves for replacement is an accounting function that creates a sinking fund for future capital expenditures for short-lived items. Reserves are used for the periodic replacement of the property’s furniture, fixtures, and equipment, as well as certain short-lived building components.
CapEx are not reserves. They are major expenses that may not be included in the operating statement, but affect the owner’s cash flow and physical plant and are capitalized over a period of time (one to ten years, depending on the expense). CapEx are the actual dollars spent to fix or replace high-value, short-lived items (e.g., carpeting, air conditioning units, roofs) and on major renovations and repairs that improve the efficiency of the property. Assessors may believe that reserves cover all CapEx, but they rarely do. Reserves are usually exhausted on one CapEx project and funds are rebuilt over time for the next.
Why Should You Consider Equalization
Assessors apply valuation when calculating property tax, but they don’t always apply equalization. Equalization is a ratio that’s calculated by measuring the total assessed value of all properties in a given district or jurisdiction against the real market value of those properties. Equalization extends beyond CapEx, and should be considered in the states that apply it.
There are two types of equalization: equalization of process, which uses the same formula for everyone, and equalization of result, which is how the final value of the property compares with similar properties. Equalization of result can indicate how fairly your property is assessed when compared to the overall market values in that area.
Often, hotel properties are actually under-assessed, but owners may still be valued more than their competitors. Of the cases involving assessments heard by the U.S. Supreme Court, all of them were equalization based. So even if your property is under-assessed, owners — and assessors — should consider the equalization aspect.
The Takeaway (for Owners)
Everyone wants a fair assessment, but it’s usually the property owners who initiate the changes that make the greatest impact. So if you’re an owner or manager, where do you start?
Start by helping assessors understand your CapEx. When questions arise, offer certified documentation and open your property to inspections.
Get to know your jurisdiction. Most assessors are elected and are often responsible for generating revenue to fund fire departments, schools, and other local services. Reducing property taxes will reduce revenue. If your hotel is a top tax generator, that could factor into your assessment.
When owners are proactive, they can help assessors determine fair market value and reduce appeals. And in the end, that’s ultimate goal — for everyone involved.
Republished from the Hotel Business Review with permission from www.HotelExecutive.com. This is the eighth in David’s series on hospitality property tax issues published by Hotel Executive Magazine.