Hotel Executive Magazine: Does Investing in Capital Expenditures Add Value to Property, or Just Increase Taxes?
Some of the key drivers of capital investments in the hospitality arena are brand standards, franchise offerings, and management and franchise agreements – as well as the normal wear and tear of a property. In this article, published in the June 2018 edition of Hotel Executive Magazine, David Chitlik explores the relationship between CapEx and tax assessments from the owner’s perspective. 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
Does Investing in Capital Expenditures Add Value to Property, or Just Increase Taxes?
Real estate tax is one of the top three expenditures for property owners, and it can be the most difficult to understand. Owners know that capital expenditures (Cap Ex) influence property valuation, which in turn can have a big impact on taxes. However, the perceptionof added value can also play a role in the tax assessment.
For example, some renovations don’t increase the value of a property; they simply maintain it. Unfortunately tax assessors may perceive any renovation as increasing a property’s value, which would then justify higher taxes. Ensuring the assessor’s perception of increase is a valid one, therefore, helps ensure that the tax is calculated fairly.
This is the first of two articles that explore the essential, complex relationship between Cap Ex, property value, and tax.
A Primary Driver of Cap Ex: Brand Standards
How much should an owner spend to maintain or upgrade a property? A large part of that decision depends on brand standards, franchise offerings, and management and franchise agreements—as well as the normal wear and tear of a property.
Brand standards are one of the greatest drivers of Cap Ex, and the full-service franchise offering disclosure (FOD) provides guidelines that property owners must follow to keep those standards. The FOD also shows the amount that must be spent on Cap Ex to maintain the property for each brand. In many cases, however, a significant portion of Cap Ex just satisfies brand standards and does not add value.
Similarly, franchise offerings and management or franchise agreements also contain direct or indirect drivers of Cap Ex. The “as per” statements in each contract should clearly outline the owner’s obligations; brand standards are usually included in the contract as well.
Why Business Personal Property (BPP) Lifecycles Matter
Another non-negotiable Cap Ex involves BPP. Each brand has its own replacement schedule for mandatory renovations before the end of the BPP’s economic life. For example, soft goods, such as carpet, usually must be replaced every three to five years. And the rationale is more than aesthetic: BPP drives hotel traffic. Guests notice BPP upgrades, and that can influence which hotel they choose. Perhaps more importantly, guests notice when BPP is worn out and may decide to stay elsewhere. As a result, the argument can be made that Cap Ex related to BPP maintains value, not creates it. Assessors notice BPP replacements, too, and may raise assessments based on the inaccurate assumption that the expenditure has also increased real property value.
Mandatory BPP replacement schedules, however, are only one of the factors that affect actual BPP Cap Ex. An active market or consistently high occupancy shorten the lifespan of furniture, fixtures, and equipment (FF&E) and make keeping up with the competitive set of hotels “expensive” for owners. Records can support whether the FF&E replacement is related to brand standards, sales or marketing, or maintaining revenue per available room (RevPar). Accounting for Cap Ex in these instances will lend support to the owner’s explanation in the event of an unexpected FF&E cost.
For example, if the carpet’s replacement “due date” occurs before the carpet has actually worn out, it’s important that the assessor understands that the replacement was contractually required, so they can make the appropriate evaluation.
The (Tax) Difference Between Value Added and Value Maintained
In a perfect world, assessors would correlate tax assessments to a property’s current market value. Unfortuantely the process is not that simple. A $1 million Cap Ex may eventually add value, but if part of the hotel had to be shut down during renovations, or competitors recently opened hotels nearby, the expenditure likely just maintained value.
Assessors don’t speculate on future property value. They may assume that a $1 million expenditure to renovate a lobby, boosts the property’s worth almost immediately, or believe that a business would not make such a large investment unless it added value. The owner must then make the case for a more reality-based perspective.
Property value is also measured by whether Cap Ex increases or maintains business income. A room renovation simply maintains a room, but when rooms are added, revenue goes up. Adding a ballroom to a large convention center hotel will increase revenue, but will updating the fitness center do the same? Probably not.
Reserves for Replacement: An Overlooked Tax Deduction
The unfortunate truth is that if reserves for replacement costs were not a contractual requirement, some owners would not have them. However neglecting reserves is a risky business practice. If a new roof costs $10 million, and there’s only $5 million in reserves, the owner must come up with the shortage elsewhere. Even with careful planning, a property’s cost requirements often exceed its reserves.
There’s another reason for owners to show reserves for replacement on their income statements: it’s a significant additional expense in calculating NOI. Using the earlier example, if the owner shows the assessor that she needs an additional $5 million deduction for a roof replacement, she can receive a tax benefit for it.
Budgets, Feasibility, and Market Downturns
What goes up, must come down—but when the market has been up for a long time, property owners rarely plan for the down cycle. Market trends correlate closely with taxes and hotel operations, and a downturn has a big impact on Cap Ex, budget, and feasibility. When trying to maintain expenses in a down market, keep in mind that assessors value property based on historical data, so if prior years were consistently profitable, owners must budget accordingly.
BPP should also be part of a budget/feasibility review. Cap Ex to replace FF&E may have no impact on real estate value, but can increase BPP value when filing tax returns.
Of course, budgets change over time, and expenses may also be higher than anticipated if owners try to maintain brand standards without a significant redo. Utilities, housekeeping, and other expenses can increase as the property degrades and becomes less efficient. Unanticipated Cap Ex will inevitably affect feasibility analysis and erode budgets.
Federal Tax Reform
Although property taxes are not part of the Federal Tax Code, the changes will have an affect on property taxes. It is a simple proposition that with less money going into Washington, less money will be going to the States and more pressure will shift to State and Local Taxes to fund required services. With property tax rates inevitably increasing, every dollar of assessed value that an owner gets reduced translates to increased savings.
Decision Time: Repair, Rebrand, Tear Down?
Depending on where a property is in the real estate life cycle, owners will make different choices under the same circumstances. However, the key question remains the same: what’s the best use for this property? Should it stay as it is, be converted to something else, or be torn down? Each choice has pros, cons, and unique tax considerations.
- Repair: An owner knows that property repairs are expensive. So where will they get the funds if the Cap Ex for maintaining the physical structure aren’t available? What happens if the hotel is underperforming? Usually repairs will simply maintain the hotel so it doesn’t lose advantage on the RevPar.
- Rebrand: Converting a property can save operational and maintenance costs as well as tax. A struggling hotel may consider rebranding to a lesser brand; costs involved in rebranding are usually short term. Keep in mind, however, that negotiations between the manager and the owner can be tedious.
- Tear down: When a structure reaches the end of its economic life or a natural disaster causes catastrophic damage, tearing it down may be the best decision for the owner. In those cases, the property value is only the land, so the tax will be lower.
Acquisitions and future renovations
Most property purchases are made with an expectation of future Cap Ex expenditures. These upcoming costs and the resulting increase in property taxes are a critical part of the pre-acquisition feasibility analysis and if the taxes are overstated, a good deal could be overlooked.
For most owners, planning means looking into the crystal ball and trying to predict the future. Success may rest on predicting what profit a new hotel will bring or what extra revenue an extensive renovation would generate. These feasibility analyses incorporate numerous variables related to potential income and probable expenses and may look 5 to 10 years into the future. As discussed, property tax is one of the largest expenses and therefore carries a significant amount of weight within this process. If an owner predicts too high a cost for a renovation, it could “kill” a deal and a potentially profitable endeavor may be lost. Determining how much future costs will add to the assessed value (and corresponding taxes), allows an owner to more accurately predict future net income resulting in an appropriate current cost.
It is common for newly acquired properties to be assessed at the purchase price even though that price usually includes many future considerations. Ensuring the assessor is informed and understanding how these considerations will impact the assessment will put the property owner in the best position for a fair and equitable tax assessment.
Bridging Two Perspectives: Owner and Assessor
Assessors and owners won’t agree on every issue related to property tax. But the next article will show that a better understanding of the assessor’s perspective not only benefits both parties, it may also save owners money they didn’t even know they were spending.
Republished from the Hotel Business Review with permission from www.HotelExecutive.com. This is the seventh in David’s series on hospitality property tax issues published by Hotel Executive Magazine.
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Last updated on September 4th, 2019 at 05:03 pm