Appraisal of Industrial Properties Needs to Factor in Globalization

By David L. Canary, Esq., As published by Real Estate Forum, April 2006

"Most assessors recognize the impact of external obsolescence because they see owners close unprofitable facilities daily." Globalization compels companies to compete around the world and subjects them to the international forces of supply and demand. Some US businesses have felt these effects dramatically. Take, for example, the American semiconductor industry, where globalization reduced semiconductor chip prices from $3.29 per megabit to three cents due to competition from Korean and Taiwanese firms. Or, consider the fruit and vegetable processors in the Northwest who have closed their plants because they cannot sell canned or frozen vegetables at prices competitive with products imported from China or Mexico.
Appraisers of industrial plants refer to globalization as external obsolescence, or the decrease in the market value of real and personal property caused by negative external economic factors. Older US industrial plants have experienced external obsolescence because of competition from overseas facilities that enjoy one or more of the following: lower labor and raw material costs; cheaper or subsidized energy costs; newer state-of-the-art technology; or relaxed government regulations. This significantly reduces the return for investment in these aging plants. The proof of this lies in an analysis of recent sales prices of US semiconductor fabrication plants, food processing facilities, steel mills and sawmills. They now sell at discounts of 80% to 90% of their construction cost.
In most states, property taxes are based on the market value of a plant's real and tangible personal property. Since an industrial facility affected by external obsolescence suffers a loss in market value, its property tax assessment would be expected to decline as well. Unfortunately, this hasn't happened because assessing authorities rely on the trended investment cost method (TICM) to determine the market value of industrial facilities. TICM is a backward-looking appraisal method. It calls for the assessor to first total up the amount historically spent on land, buildings and equipment, then calculate the present value of those costs and depreciate them based only on their age. TICM gives no consideration to the external obsolescence factors.
Despite their actions, most assessors recognize the impact of external obsolescence because they see owners close unprofitable properties on a daily basis. The problem relates to owners who fail to contest their taxes and demonstrate to assessors the actual amount by which obsolescence impacts the market value of their property.
Of the several appraisal methods available to owners for demonstrating external obsolescence, three offer simple methodologies. The first measure deals with the concept that every industrial plant is designed and engineered for a certain level of production capacity. Achieving that level of capacity requires a given amount of capital investment. If globalization causes the plant to operate substantially below capacity, a large portion of the capital asset is underutilized and the return on investment is significantly less than when the plant is operated at, or near, its capacity.
Another method involves analyzing prices for which comparable industrial buildings sold. Comparing the replacement cost of each facility with the price at which it sold and subtracting the value of the land yields a measurement of the plant's accrued depreciation, including external obsolescence. Courts and tax tribunals across the US have embraced this market-derived method of quantifying accrued depreciation and the methodology appears in standard appraisal texts.
The third way employs the income approach to valuation. Capitalizing the plant's net operating income indicates the value of the company's tangible assets, intangible property and working capital. If the value of the company's assets using the income approach is greater than its worth as calculated by TICM, the difference is most likely the value of a company's intangible assets. Of course, working capital and land value must be subtracted from the capitalized value before comparing the differences. However, if the income approach produces lower asset values than TICM, very little or no intangible value exists. Thus, the difference typically represents a measurement of external obsolescence.
In this era of globalization, industrial properties will be assessed at fair market values only when assessors use appraisal methods based on current conditions.
The views expressed here are those of the author and not of Real Estate Media or its publications.