Lesson 19 – Valuation of Leased Personal Property (The Income Approach to Value)

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The income approach is valid for more than real property; it can be used to value anything that produces an income stream, such as business or personal property. This lesson provides guidance on the valuation of personal property using the income approach.

In many situations, personal property may be similar to real property, in that investors purchase the personal property in order to lease it to others, and, in return, receive an income stream. In other words, the personal property is purchased with the anticipation of receiving income from the rental of the personal property. Therefore, the income approach to value can be used to value personal property as readily as it can be applied to the valuation of land and buildings. However, there are several aspects of valuing personal property that may differ from those encountered in the valuation of real property.

Article XIII A of the California Constitution, added by constitutional amendment "Proposition 13", adopted June 6^th, 1978, only places specific limitations on the valuation of real property. Taxable personal property is not subject to the tax limitations of Proposition 13, or to supplement assessment provisions, and is valued annually as of the lien date. Equipment (1) may be exempt from taxation under the business inventory exemption, (2) is not subject to special assessments, and (3) may be subject to the trade level concept.

Business inventories are exempt pursuant to Revenue and Taxation Code section 219; Property Tax Rule 133 states, in part, that business inventories "… include all tangible personal property, whether raw materials, work in process or finished goods, which will become a part of or are themselves items of personalty held for sale or lease in the ordinary course of business."

The trade level concept recognizes that property normally increases in value as it progresses through production and distribution channels. Property Tax Rule 10 states, in part, "In appraising tangible personal property, the assessor shall give recognition to the trade level at which the property is situated … Such property normally attains its maximum value as it reaches the consumer level."

The Legislature has wide authority concerning the taxation, and exemption, or personal property. The tangible personal property of insurance companies, banks, and financial corporations is exempt from local ad valorem property taxation. Except for certain properties acquired for the California Pollution Control financing Authority, there are no taxable possessory interests in personal property. Though it does not affect valuation, the tax rate for personal property on the unsecured roll is the rate for the prior year’s secured roll.

Tangible personal property in the hands of a person who holds it for consumption shall be valued by the replacement cost approach, sales comparison approach, or the income approach to value. If, however, the personal property is leased for less than six months, it is considered to be in the hands of the retail merchant or wholesale merchant, and it is valued at the amount for which it would transfer to other retailers or wholesalers of like property.

Other factors that must be considered in the valuation of personal property by using the income approach to value include:

• It must be verified that the income is truly income from the property. In many cases, the "rental" or "leased" income is significantly influenced by selling skills, business activity, personal services, sales or services directly related to the rental property (the rental amount could be artificially high or artificially low), or other non-property factors. In such cases, the income approach may not accurately measure the value of the personal property.
• Since personal property usually has a much shorter economic life than real property, an error in the estimate of remaining economic life has a greater impact than it will for real property.
• It is more difficult to find direct market evidence for capitalization rates for personal property as compared to real property.

Despite the above problems, there are many situations where reliable incomes, capitalization rates, and economic life estimates are available. Where such reliable data are available, the income approach is equally valid for personal property as it is for real property.

Both direct capitalization methods and yield capitalization methods may be utilized to value personal property. Yield capitalization is the preferred method because information is readily available and the life span of the property is usually short. In addition, the income steam produced by personal property usually involves a reversion income, the selling of the salvaged item at the end of the economic life.

The components that make up the value of personal property are the cost of manufacturing the item, transportation of the item, installation of the item, and profit markups. Additionally, a sales tax or a use tax component must be added.

The components of the value of personal property may be borne by either the lessor or the lessee. Payments of expenses by the lessee do not diminish the value of the personal property. The terms of the lease agreement or rental contract should be carefully analyzed to insure that all costs are included in the valuation process. When the costs are borne by the lessee, these costs must be determined and included in the value of the personal property.

When the lessee pays for the cost of transportation or installation, the economic income may have to be adjusted to include a charge for these expenditures. Alternatively, the economic income without these expenditures may be capitalized. Then the costs are added as a lump sum to the capitalized earning ability of the income stream. However, it is done, it must be insured that all proper expenditures have been property identified and included in the value of the leased equipment.

Processing the Income Stream

The steps for processing the rental income stream for personal property are the same steps that are used for processing real property income. The steps for processing personal property income stream are as follows:

As with real property, the personal property anticipated income stream is processed when deriving income multipliers and rates. The personal property market income stream is processed when valuing the personal property. In the valuation of personal property, the income stream cannot be processed below NIBT.

Vacancy and Collection Losses

Personal property that is held for lease or sale by a retailer or wholesaler on the lien date may be exempt from taxation. The exemption is for the entire tax year. If the item is leased as of the lien date, it is taxable for the entire year. Because these items are exempt from taxation for the entire year, it can be said that it is improper to allow for vacancy and collection losses. However, it is just as reasonable to argue that an item may be out on lease on the lien date, and therefore taxable, but may be returned to the retailer or wholesaler prior to the expiration of the lease period. Consequently, the retailer or wholesaler may very well suffer a loss of income because of vacancy or collection loss. Whether an allowance is made for vacancy and collection loss should be based on the typical actions of the market place.

Expenses

As with real property, all lessor-borne expenses that are necessary to maintain the income stream may be deducted as an operating expense. If the lessee pays for the expenses, they are not deductible from the income stream.

Maintenance is often a major expense. If the lessor is responsible for maintenance, the rent will reflect this expense. If the lessee pays the maintenance charges, the lessor will generally charge a lesser rent, and the appraiser does not deduct expenses when reconstructing the operating statement.

Particular care must be given to analyzing expenses. The lessor's books may show an expense for maintenance. If the lessee has purchased a maintenance contract from the lessor, the price of the contract must be added to the rental fees before processing the income stream. If the price of the contract is not added to the rental fees before processing the income stream, then the expenses for maintaining the item are not deducted as an expense.

Valuation Methodology

When yield capitalization methods are used to value an item of personal property, the present worth of each year's income and the reversion are computed as a separate income stream. The present value is the algebraic sum of the present worth of each income.

Personal property is often valued using the property reversion method. The rental income is capitalized using direct capitalization techniques. This income is usually constant terminal income and is often called an annuity. The reversion income is capitalized using the same procedure that is used in yield capitalization. The present value is the sum of the indicated values. The formula for the valuation of a level annuity income stream and the reversion income is as follows:

SFF is the Sinking Fund Factor, based on an appropriate yield rate, the effective tax rate, annual compounding, and the estimated remaining economic life of the personal property.

SFF is the Sinking Fund Factor, based on an appropriate yield rate, the effective tax rate, annual compounding, and the estimated remaining economic life of the personal property.

(Future Value of Reversion) × PW1_{{"Col 4" @ (YO + ETR), Ann, for REL}} = Present Value of Reversion

The reversion income is usually the salvage value, the net amount of money the owner expects to obtain when disposing of the personal property. The reversion is usually positive, but it can be a negative amount. PW1 is the Present Worth of 1, based on the yield rate plus the effective tax rate, annual compounding, and the estimated remaining economic life of the item.

The total value of the personal property is as follows:

Alternative Methods of Valuing the Level Terminal Income Stream

In the Self-Paced Online Learning Session, Time Value of Money – Six Functions of a Dollar, and again in Lesson 4, Time Value of Money, you studied the relationships between the factors in compound interest and annuity tables, such as the AH 505. In particular,

• i + SFF = PR, i.e., the interest rate plus Column 3 equals Column 6, and
• 1 ÷ PW1/P = PR, i.e., Column 5 and Column 6 are reciprocals of each other.

When the property tax appraiser uses this technique, the NIBT is used and the factor is found at a rate that includes both the Yield rate and the Effective Tax Rate. For example:

or

A Summary of Differences between Personal Property and Real Property

Although taxed at the same maximum percentage of market value as real property, personal property is treated differently in many other respects.

• Special assessments are levied on real property only.
• The Legislature has wide authority pursuant to article XIII, section 2, of the Constitution concerning the taxation and/or exemption of personal property.
• Tangible personal property cannot be assessed to insurance companies, banks, and financial corporations.
• Locally assessed real property is governed by article XIII A, while personal property is appraised at market value annually.
• Unless otherwise provided by the Legislature, the tax on State and national banks shall be according to or measured by the net income and shall be in lieu of all other taxes and license fees upon banks or their shares, except taxes upon real property and vehicle registration and license fees. ……… Section 27 of article XIII of the California Constitution]
• There is no taxable possessory interest in personal property, except as provided for in section 201.5.
• The tax rate on the unsecured roll is the rate of the prior year's secured roll.
  ……… California State Constitution, article XIII, section 12

Summary of the Income Approach in the Valuation of Personal Property

The income approach can be applied to leased equipment or other personal property appraisal units that independently produce income, because it converts expected rental income to a present value estimate. However, it is normally not applicable to most types of personal property – personal property, in general, is not purchased to produce income independent of other property that may be under the same ownership; the furniture and other personal property in a hotel, for instance, add to the income of the hotel operation. It is often difficult to assign or estimate an expected income to the furniture or other personal property. The examples above help illustrate how the income approach to value can be used in the appraisal of personal property. In practice, though, each situation is different, and this should be taken into consideration by the auditor-appraiser.

Summary

The lesson you just completed explained the use the income approach to value in the valuation of personal property, and, in particular, the use of the Property Reversion technique for the valuation of leased equipment. The next lesson summarizes what we have covered in this Self Paced Online Learning Session on the income approach to value.

Note: Before proceeding on to the next lesson, be sure to complete the exercises for this lesson.