Separating Personal Property in Hotel Valuations

A hotel’s value can be categorized into real property and personal property. Real property includes the land and improvements. Personal property includes tangible[1] and, sometimes, intangible[2] personal property.  When valuing a hotel for ad valorem tax purposes, it is often necessary to separate the tangible personal property value from the real property value, as most jurisdictions tax the real property separately. This article proposes a methodology for separating the tangible personal property from the real property value of hotels.

Introduction by Example

I recently reviewed a hotel appraisal[3] in which the appraiser, retained by the hotel’s owner, developed an estimate of tangible personal property value as part of a tax appeal case. Using the Income Approach, the appraiser estimated the tangible personal property value to be nearly $37 million. However, earlier in the report, the appraiser had used the Cost Approach to estimate the replacement cost of the hotel’s tangible personal property to be $20 million. This was a red flag, as theoretically the Cost Approach and Income Approach should produce the same value indications, given adequate market information.

Somehow, when the appraiser went from the Cost Approach to the Income Approach, he ended up roughly doubling[4] his opinion of the hotel’s tangible personal property value. Removing this estimate from the combined value conclusion for the hotel’s real property and tangible personal property value, the appraiser then derived a value for just the real property. So, by estimating such a high value for the tangible personal property, the remaining value allocated to real property appeared very low. This may have delighted the hotel owner, who was challenging the hotel’s real property tax assessment.

Return “of” and “on” Pitfall

Let’s take a closer look at one reason why the appraiser’s estimate of income attributable to tangible personal property was so overstated in the example cited. Since the appraiser was valuing the hotel’s combined real and personal property value by using the Income Approach, he removed a portion of the stabilized income stream that he attributed to the tangible personal property. To estimate the size of this income deduction, the appraiser argued that both a return of and return on the tangible personal property needed to be reflected in the deduction. If misapplied, this concept of a return of and return on investment can lead to a common pitfall some appraisers make when valuing hotels for assessment purposes.

In the example cited, the appraiser had estimated the replacement cost for the FF&E was $40,000 per guestroom, or a total of $20 million. After deducting depreciation, the resulting indication of depreciated tangible personal property value was $17.5 million.

To calculate the income representing the return on FF&E, the appraiser applied a 13.0% rate of return requirement, based on interviews, to his estimate of the depreciated FF&E market value. Calculating 13.0% x $17.5 million, the appraiser estimated $2,275,000 as the income deduction representing a return on the FF&E in place.

To calculate the income representing the return of FF&E, the appraiser divided the estimated replacement cost new of the FF&E by its estimated economic life of 8 years. In the example, this was $20.0 million / 8 years = $2,500,000 annually. The appraiser concluded this amount represented the return of FF&E.

Combining these two calculations, the appraiser then deducted $2,275,000 as the return on tangible personal property and $2,500,000 as the return of tangible personal property from projected EBITDA. This was a total deduction from the hotel’s stabilized income stream of $4,775,000 to remove the present value of the tangible personal property. This is much higher than the $2,975,000 deduction we concluded using the recommended methodology. Why?

Both the appraiser’s return of and return on calculations are flawed. When combined, they produce a large inaccuracy.

Firstly, the appraiser selected 13.0% as the return on the FF&E. This return rate may be too high, especially given our research that showed interest rates on hotel FF&E loans are typically much lower than this. Based on recent interviews with specialty lenders that make loans on hotel FF&E, Hotel Appraisers & Advisors determined that market interest rates are currently closer to 8.0% for FF&E loans. So, the income attributable to tangible personal property is likely overstated.

Secondly, the appraiser divided the replacement cost new by the estimated economic life of the FF&E to derive an estimate of the annual expense to replace the existing FF&E in place. While this is a reasonable way to estimate how much it would cost an owner to replace new FF&E perpetually, this is not the same as replacing the existing FF&E just once. So, the appraiser has identified an annual expense that would be worth much more than the depreciated value of the FF&E in place, thus further overstating the income attributable to the tangible personal property.

Differing Economic Life

When calculating a return on investment, appraisers need to be careful in selecting the appropriate rate. The return on any investment is analogous to the interest payment on a mortgage, whereas the return of an investment is analogous to the principal payments on a mortgage.

Furthermore, FF&E loans typically have terms that match the expected useful life of the FF&E collateral. In the example, the appraiser estimated the FF&E had an economic life of 8 years. This is much shorter than the economic life of a typical hotel building, which can often be 50 years[5] or longer.

Collecting an 8.0% interest charge over 8 years would be worth much less than collecting an 8.0% interest charge over 50 years. As we saw previously, this is one reason why the capitalization rates for tangible personal property can be so much higher than capitalization rates for real property.

To illustrate this point, the following figure shows the net present value of an annual payment of $1.0 million paid over 50 years versus 8 years.

[1] A hotel’s tangible personal property is sometimes referred to as its Furniture, Fixtures, and Equipment, or FF&E. I use the terms interchangeably in this article.

[2] A hotel’s intangible personal property is sometimes called Business Value.

[3] Details have been changed for illustration purposes and to protect confidentiality.

[4] The appraiser’s opinion more than doubled because some depreciation was identified during the Cost Approach, resulting in a depreciated value of $17.5 million for the tangible personal property in place.

[5] Marshall Valuation Services estimates the typical economic life ranges from 40 to 60 years for hotels.