The Sales Comparison Approach Is Often the Most Direct Estimate of Fair Market Value

Posted by Justin M. Hardy on June 13, 2011

apples2oranges.jpgWhen we started this blog, we wrote a post summarizing the three valuation approaches recognized by North Carolina law.  We followed up with a post about the cost approach and another one about the income capitalization approach.  

In brief summary, North Carolina courts have consistently concluded that the cost approach is best suited as a secondary approach.  By inference, that means the primary approaches are the sales comparison approach and the income capitalization approach.  But the income capitalization approach can only be used when the property being valued is one that is rented out by its owner, thereby generating income.  That leaves the sales comparison approach as the primary approach for most properties that are not income producing.

The sales comparison approach determines market value of a particular property by searching for sales of other properties that are reasonably comparable and adjusting those sales prices to account for any substantive differences.  As long as there exist sales of properties close-in-time to the valuation date that are reasonably comparable to the property being valued, the sales comparison approach provides a direct window to market value.

By way of example, if the property to be valued is a single family house with three bedrooms, two bathrooms, and a garage, then the easiest and most accurate way to determine its value is to look for sales of single family houses with three bedrooms, two bathrooms, and a garage.  Assuming you can find such sales, those sale prices serve as a starting point for determining fair market value of the property to be valued.  But they don't serve as an ending point.  A good appraiser will take care to note substantial differences between the property to be valued and the comparable properties.  When were they all built?  Have there been remodels?  Is the square footage similar?  What about the finish?  Is there additional acreage to worry about? If there are differences in these or other factors, the appraiser needs to adjust the sales prices (up if the comparable properties are inferior and down if they are superior) to accurately reflect market value of the property being valued.

As we've said repeatedly, the valuation approach being used is a key element in any property tax appeal.  If your property is an income producing property, then you should make sure that the taxing jurisdiction based its assessment on a market-based income capitalization approach and that your appraiser does the same.  If your property is not income producing, you should make sure that the taxing jurisdiction and your appraiser bases their assessment/appraisal on a reasonable sales comparison approach.  Only where neither the income nor the comparable sales approach can be applied should the assessor and the appraisal resort to the cost approach as their principal method for estimating fair market value.

Image Copyright Mike Johnson of thebusybrain.com.  This work is licensed under the Creative Commons 2.0 Generic License.

Appeal of Target Corporation - Cabarrus County 2008

Posted by Justin M. Hardy on March 21, 2011

Target.jpgIn a previous post, we talked about the general rule that the cost approach is generally the least reliable approach to determine the fair market value of industrial and commercial properties.  The reason is that you are more likely to find functional obsolescence and economic obsolescence in these kinds of properties, and it is extraordinarily difficult to  estimate value loss due to multiple items of obsolescence. 

However, that reason does not apply when dealing with a new industrial or commercial property, because there probably exists no obsolescence.  When it criticized the cost approach in Greens of Pine Glen (.pdf), the Supreme Court was careful to say that the cost approach is well suited for valuing newly developed properties and specialty properties for which the other approaches are impractical.  The Property Tax Commission found occasion to apply this logic in the recently-decided Appeal of Target Corporation from the decision of the Cabarrus County Board of Equalization and Review. 

In 2005, Target spent $1,500,000 to buy a 12.3 acre tract of land in Kannapolis, North Carolina.  By the end of 2006, it had constructed a Target Superstore thereon at a cost of $9,467,390, for a total investment of $10,967,390.  Effective January 1, 2008, Cabarrus County assessed the land underlying the Superstore at $2,250,250 and the store and other improvements at $16,694,300 for a total assessed value of $18,954,550.  In short, Cabarrus County believed that the value of Target's property was 76% higher on January 1, 2008, than Target had actually invested to buy and build the property in 2005 and 2006.

For its appeal, Target hired an appraiser who testified that the value of the property was somewhere in between.  More specifically, the appraiser determined the land to be worth $3,082,100 (over 100% more than its actual cost) and the improvements to be worth $11,396,840 (20% more than their actual cost).  He got there by utilizing the sales comparison approach to value the land, and relying primarily on the cost approach to value the improvements - both because they were new and because the property was designed and built as a specialty property. 

Rarely do the taxpayer and the taxing jurisdiction agree on the most reliable approach to be applied, and even more rarely is the agreed upon approach the cost approach.  But, that is exactly what happened in Target Corporation. 

Like Target's expert, Cabarrus County relied on the cost approach to assess the improvements.  The difference in opinion, however, resulted from Cabarrus County's reliance on its Schedule of Values land value tables to value the land and upon its cost tables for department stores to value the improvements.  Interestingly, the Property Tax Commission decided that the fair market value of the property as of January 1, 2008 was even lower than the opinion of Target's appraiser.  The Commission held that the property was worth $14,000,000.  Why the Commission chose that value is not entirely clear.

Our reading of the Commission's decision is that the Commission found Cabarrus County's land value tables to be more trustworthly than both the appraiser's opinion of the land value and the actual 2005 selling price of the land.  Thus, it accepted Cabarrus County's valuation of the land at $2,520,250.  Simultaneously, though, it held that the appraiser's opinion of the improvement value (roughly) was more trustworthy than both Cabarrus County's department store cost tables and the actual 2005-2006 construction cost of the improvements.  Thus it held that the improvement value was $11,479,750.

So what is the takeaway? Certainly, nothing here disturbs the general rule that the cost approach is not the best valuation method to determine the value of industrial or commercial property, unless said property is special or new.  But does Target Corporation tell us anything about how the Commission weighs cost approach evidence when the cost approach is the most relevant approach?  Not really.  It cannot be said that this decision holds a taxing jurisdiction's Schedule of Values to be the most trustworthy data, because the Commission rejected that data in determining the value of improvements.  It also can't be said that expert opinionshould trump, because the Commission rejected that data in determining the value of the land.  Finally, it obviously can't be said that actual cost is the key, because the Commission rejected that data both in determinng the value of the land and the value of the improvements - although that rejection may have been due to the passage of time. 

For now, taxing jurisdictions and appealing taxpayers will have to continue to guess about what the Commission will and will not find pursuasive when the cost approach is the best valuation method.

Niether John Cocklereece, Justin Hardy, nor Bell, Davis & Pitt, P.A. were involved with any phase of the Target Corporation appeal.

Image Copyright Larry Pieniazek. This work is licensed under the Creative Commons Attribution-Share Alike 3.0 Unported Generic License.

The Income Capitalization Approach Is the Optimum Approach for Appraising Income-Producing Properties

Posted by Justin M. Hardy on February 28, 2011

Thumbnail image for Rodeo_drive_street_sign-93.jpgIn a previous post, we talked about the basics of the three approaches to value recognized by North Carolina law as being relevant to determining the fair market value of property for tax purposes.  We followed that up with a post about North Carolina Courts' conclusions that the cost approach is best suited as a secondary (or maybe even tertiary) approach due to its various shortcomings.  By inference, that means the primary approaches are the sales comparison approach and the income capitalization approach.  In this post, we will discuss what North Carolina law says about the income capitalization approach, and why.

North Carolina courts have consistently held that the income capitalization approach should be given primary reliance when valuing income-producing properties.

Examples are the Court of Appeals' decisions of In re: Owens(.pdf) and Belk-Broome(.pdf); and the Supreme Court's decision of Greens of Pine Glen(.pdf).  Those decisions make a lot of sense, considering that North Carolina statute sets the relevant value of property for property tax purposes as the value at which it would change hands between a willing buyer and a willing seller.  By definition, buyers of income-producing properties buy these kinds of properties to rent them, and not to use them for their own use.  In other words, income-producing properties are investments.  And just like any other investment, they are bought and sold based on their ability to generate a return.  The income approach transforms that return to present value by capitalizing the net operating income of the property by an appropriate capitalization rate.  But it only works if the appraiser follows the rules.

The income, vacancy and credit loss, and expenses used to calculate a property's net operating income should be market-based.

In Southern Railway (.pdf), the North Carolina Supreme Court held that an income capitalization approach valuation must be based on market rents, not contractually restricted rents.  This too makes a lot of sense.  Consider the hypothetical shopping center whose manager is less-than-stellar.  Through poor management, the shopping center fails to attract stable tenants and the contract rents steadily fall.  Additionally, the manager is incapable of negotiating market expenses.  The actual net operating income of the property suffers.  But should that affect the value of the land and buildings, leading to bad management providing the property with benefit of lower ad valorem taxes?  Southern Railway says no.  Market data must be used, not actual data.

Like the net operating income, the capitalization rate should be market-based.

In In re: Owens(.pdf), the Court of Appeals said that the capitalization rate should be derived from a comparable sales analysis.  This concept was explained further by Mr. Peter Korpacz when he was called as a witness for Forsyth County before the North Carolina Property Tax Commission during the appeal of Hanes Mall in Winston-Salem, NC in the case that became Winston-Salem Joint Venture(.pdf).  Quoting Korpacz, the Court of Appeals explained that a capitalization rate should be derived by finding sales of comparable properties, acquiring the actual net operating incomes of those properties, and deriving indicated capitalization rates from those sales.  Thus, the capitalization rate to be used for the property being appraised would be market-based.

So, if you are challenging an assessment of an income-producing property in North Carolina, you should be asking whether your taxing jurisdiction used the income capitalization approach to develop the assessment.  If so, did it use market data to develop both the net operating income and the capitalization rate?  Negative answers to either of these questions could prove to be key items of evidence in your case.  On the flip side, it is absolutely essential that your opinion of value (or your appraiser's opinion of value) is based primarily upon an income capitalization approach which is solidly grounded in market data.

Image Copyright Torsten Bolten.  This work is licensed under the Creative Commons Attribution-Share Alike 3.0 Unported license.

The Cost Approach Often Fails to Reflect Market Conditions

Posted by Justin M. Hardy on February 18, 2011

obsolescence.jpgIn a previous post, we talked about the basics of the cost approach and mentioned that it is one of the three approaches accepted by North Carolina courts as being relevant to determining the fair market value of real property and business personal property for property tax purposes. If you are back for an appraisal theorist’s breakdown of each element, you’ve come to the wrong place.  What we will try to do is discuss who uses the cost approach and what North Carolina law says about it.

The usual suspects for using the cost approach are the taxing jurisdictions.  By both statute and necessity, taxing jurisdictions conduct mass appraisals.  G.S. 105-317(b)(1) requires each taxing jurisdiction to create and adopt a “Uniform schedule of values, standards, and rules” to use in its mass appraisal. While some taxing jurisdictions commit resources to developing mass data tables based in income and expense data or sales data, all taxing jurisdictions spend most of their time gathering mounds of cost data and boiling it down into cost and depreciation tables for various property types.  The ultimate results are assessments based largely on the cost-approach. 

This is not a problem for the large percentage of properties.  Most cost data available is for residential properties, and the taxing jurisdictions therefore do an admirable job estimating the values of residential properties.  This shows when the taxing jurisdictions test random assessments against actual sales that have occurred close in time to the relevant valuation date in what are known as "sales ratio studies."

A problem tends to arise, however, when taxing jurisdictions attempt to utilize the cost approach to value industrial and commercial properties.

In commercial and industrial properties, you are more likely to find functional obsolescence (technology, industry or social norms, or legal evolutions require different building features) and economic obsolescence (production of product has moved overseas, demand for product has declined, the property no longer fits the use of the neighborhood, etc.).  The cost approach becomes decreasingly accurate when these factors are in play, because it is extraordinary difficult to estimate the value loss due to multiple items of obsolescence.  This is particularly so when trying to do it on a mass appraisal basis.  The Courts have taken note.  More specifically, the Supreme Court recognized this shortfall in Greens of Pine Glen (.pdf), in which it held that the cost approach is “better suited for valuing specialty property or newly developed property and is often used when no other method will yield a realistic result.”  Likewise, in Belk-Broome (.pdf), the Court of Appeals recognized that:

“the modern appraisal practice is to use the cost approach as a secondary approach because cost may not effectively reflect market conditions.”

The issue of which valuation approach is most appropriate for valuing a specific property continuously presents itself in property tax appeals.  Those challenging assessments in North Carolina should be asking their taxing jurisdictions which approach was used to develop the assessment.  If it can be shown that the approach was contrary to the cornerstone cases above, and those discussed in upcoming posts about the income capitalization approach and the sales comparison approach, that could go a long way to winning the case.

Image Copyright Willie Duffin. This work is licensed under the Creative Commons Attribution-Share Alike 2.0 Generic License.

The Three Valuation Approaches Recognized in North Carolina

Posted by Justin M. Hardy on February 11, 2011

In North Carolina, taxing jurisdictions determine the amount tax that must be paid on real property and business personal property based on the “true value” of that property.  The taxing jurisdictions are generally counties and cities, each of which set the property tax rate to be applied to the “true values” of taxable property within their boundaries.  The term “true value” is defined by statute as market value, which is the price at which the property would be sold by a willing seller to a willng and financially able buyer if neither were under any compulsion to buy or sell and if both had reasonable knowledge of all the potential uses for the property.  So, the concept of calculating taxes is simple. 

  1. Set the tax rate.
  2. Determine market value of the property to be taxed. 
  3. Apply the tax rate to the determined market value.  

In practice though, it all gets bogged down at Step 2 when the taxing jurisdictions try to determine the market value of property.   

There are only three valuation approaches recognized by North Carolina courts.  In no particular order, they are the cost approach, the income capitalization approach, and the sales comparison approach. 

The Cost Approach:  The cost approach determines market value by estimating the value of land (typically using the sales comparison approach), and then estimating the value of any improvements on that land (like buildings or paving) by starting with the replacement cost or reproduction cost of each improvement and then depreciating that cost to account for physical deterioration, functional obsolescence, and economic obsolescence suffered by the improvement. The idea is that buyers in the market will not pay more for a property than it would costs to build, taking account for all forms of depreciation existing.

The Income Capitalization Approach:  The income capitalization approach determines market value by capitalizing the net operating income of a particular income producing property by dividing it by an appropriate capitalization rate.  The idea is that buyers of income producing properties are investors who won’t pay more for a property than they estimate they will make by owning that property over a standard ownership period.  Similarly, sellers of income producing properties will not sell a property for less than they stand to make by continuing their ownership. 

The Sales Comparison Approach:  The sales comparison approach determines market value of a particular property by searching for sales of other properties that are reasonably comparable and adjusting their sales prices to account for any substantive differences.  The idea is that buyers won’t pay more for a property than they would need to pay to buy a comparable property, and sellers won’t sell a property for less than comparable properties are selling for.

More often than not, a property tax appeal has as one of its issues whether the most appropriate approach was used by the taxing jurisdiction to value the property or whether the taxpayer is relying on the most appropriate approach to develop its opinion of value. Look for future posts about the strengths, shortfalls, and appropriate applications of each recognized approach.