In Further Defense of the "rushmore Approach" to Account for Intangible Property in Real Property Assessments

• Publication year: 2019
• Author: Michael Slattery

In Further Defense of the "Rushmore Approach" to Account For Intangible Property in Real Property Assessments

Michael Slattery¹

Michael Slattery is Of Counsel to Lamb & Kawakami LLP in downtown Los Angeles where he practices property tax law, municipal law, bankruptcy law, and general civil litigation. Over a 37-year career, he has represented both property owners and municipalities in property tax disputes and has worked in both private and governmental law offices. Mike is a past Chair of the Business Law Section Financial Institutions Committee.

California assessors cannot directly tax intangible assets, but may assume the presence of intangibles assets that are necessary to put taxable property to its highest and best use.² For larger hotel properties, the necessary intangible assets are a franchise agreement and a management agreement and the workforce, trade names, reservation system, and advertising that come with those agreements. Assessors often value hotel properties by capitalizing the net income which they can produce under competent management. But some of that income is produced by the hotel's intangible assets. So, the valuation exercise and focus of this article is how best to account for and remove the value attributable to these intangible assets. Two opposing approaches have emerged—the "Rushmore approach" and the "business enterprise approach." This article argues that the Rushmore approach is the better method. The title of this article borrows from Stephen Rushmore's article, In Defense of the 'Rushmore Approach' for Valuing the Real Property Component of a Hotel ("Rushmore").³

I. SUMMARY OF THE COMPETING APPROACHES

The premise of the Rushmore approach is that the deduction of franchise and management fees from the operating income of a hotel results in a valuation which completely removes the value of intangible assets which contribute to that income. The business enterprise approach identifies particular intangible assets—like a trained workforce in place—values them by looking at their cost and a return on that cost, then deducts that value from the value of the operating hotel. "While both the Rushmore approach and the business enterprise approach consider management and franchise fees as income attributed to the business component, the business enterprise approach goes further and allocates additional income to the business component."⁴ This chart compares how the two approaches account for the value of alleged intangible assets.

Value to be deducted from the value of; the hotel as an operating business	Rushmore approach	Business enterprise approach
	Management fee	Management fee
	Franchise fee	Franchise fee
		Return on personal property
		Return on trade/brand name
		Return of and on avoided startup costs

The business enterprise approach calculates the value of the additional intangibles it recognizes by: (1) calculating the annual cost of that item; then (2) assigning a rate of return which reflects the riskiness of that alleged "asset." For example, a franchise agreement may be terminated for the failure of the franchise to meet brand standards or because the franchisor goes out of business. So, the rate of return on that "asset" would be higher than the rate of return on personal property, a less risky asset.

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II. WHAT IS WRONG WITH THE RUSHMORE APPROACH (PER ITS CRITICS)?

The advocates of the business enterprise approach fault the Rushmore approach because, their argument goes, deducting the cost of something does not mean removing its value because its value is recovery of that cost (return "of" investment) plus a profit (return "on" investment). Therefore, an assessor's deduction of the cost of management and franchise contracts does not remove their full value.

The concept of return on investment:

illustrates why the value of an asset such as a franchise, requires recognizing both a return 'of' and 'on' the asset. It explains why the widely held idea that the value is represented by how much one pays to obtain the franchise is incorrect: Because it fails to capture the anticipated return 'on' that asset.⁵

III. THE RUSHMORE APPROACH HAS PLENTY OF SUPPORTERS

Understanding Intangible Assets and Real Estate: A Guide for Real Property Valuation Professionals ("IAAO Guide")⁶ says the Rushmore approach "has been widely accepted by the courts, has been embraced by most assessment jurisdictions, and reflects observable and verifiable market behavior in the transaction market."⁷ The IAAO Guide states: "for lodging properties and casinos, the Rushmore method is the recommended method for excluding intangible value from real property valuations"⁸ and "in this committee's opinion, in valuing real property the Rushmore approach is the most valid approach for excluding intangible assets in an income approach."⁹

Other jurisdictions use the Rushmore method. The IAAO Guide cites case law from other jurisdictions to show Rushmore approach "has been widely embraced by the courts."¹⁰ The acceptance of the Rushmore approach is especially well developed in reported opinions of the New Jersey tax courts which considered how to account for intangible assets in hotel valuations. Chesapeake Hotel, L.P. v. Saddle Brook Township¹¹ is the most detailed opinion, and actually involved Stephen Rushmore and David Lennhoff as opposing experts. California courts may consider decisions by courts in other states.¹²

IV. THE BUSINESS ENTERPRISE APPROACH TURNS ON A FUNDAMENTAL MISUNDERSTANDING OF INCOME APPROACH VALUATION

The argument that deducting the cost of something does not mean removing its value because its value is recovery of that cost (return "of" investment) plus a profit (return "on" investment) is a false syllogism—the income approach does not just deduct expenses from gross income—it removes the capitalized value of those expenses from the overall valuation. The capitalized value reflects a return of and on investment because it is determined with a capitalization rate which provides a return of and on investment.

• "The capitalization rate is based on a hoped for or anticipated rate of return on and of the investment. It is the rate required to attract capital to the investment."¹³
• "An income rate expresses the relationship between a single year's net income and the value of the entire property or a specified component (e.g., the equity or mortgage interest). Income rates are derived from sales and implicitly provide for both the return on and the return on capital."¹⁴
• "Thus, the capitalization rate estimated and applied to value property must reflect or consider a market level of return of and return on the initial investment in one calculation."¹⁵

Assume, for example, that an income approach did not deduct the cost of the management agreement and the franchise agreement. How would that affect the value conclusion? It would increase the valuation result by the capitalized value of those expenses.

Here is an example. Assume the hotel operator pays a management fee specified as a percentage of revenues and that the fee is $500,000 for the year of the valuation. Assume that the appraiser uses an 8% capitalization rate to value the hotel. The appraiser will deduct $500,000 from the operating income the appraiser will capitalize to value the hotel. That deduction removes $6,250,000 ($500,000/.08) from the appraiser's value conclusion. With an income approach valuation, the deduction of any expense amount from revenues removes the capitalized value of that expense from the valuation, not just the out-of-pocket cost of that expense item.

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Cost of management	Capitalization rate	Value removed by deduction of management fee from income
$500,000/year	8%	$6,250,000

Taxpayers may answer that a capitalization rate for a real estate investment does not accurately reflect the expected return on intangibles because they are riskier assets and require a higher rate of return. That argument misses the point. At most, it proves that the capitalization rate should be adjusted upwards to reflect that some of the investment income comes from intangibles. Moreover, if the capitalization rate is derived from actual sales of operating hotel properties, that market-based rate will have already accounted for the higher risk of some part of the income stream.

V. CALIFORNIA LAW IS UNSETTLED

A. SHC Half Moon Bay

Taxpayers' counsel regularly argue that SHC Half Moon Bay v. County of San Mateo¹⁶ rejected the Rushmore approach:

The application of the Rushmore 'Management Fee' method to a major resort hotel was expressly disapproved by the California Court of Appeal in 2014.¹⁷

But SHC Half Moon Bay should be limited to its unusual facts. The opinion did require a deduction for three alleged intangible assets used in the hotel's operations—workforce in place, offsite employee parking, and guest access to a golf course. But the court did not purport to state any rules that would apply to other hotel appeals. The three intangibles were not contested and therefore as a matter of 'law they had to...