Hotel revenues are entering a post-pandemic rebound, but what about taxable property values? Although revenues are bouncing back, it does not mean hotel values for property tax assessments have reached pre-pandemic levels.
Recovering revenue is only part of the valuation story. To protect themselves from unfair tax bills, hotel owners may need to clarify to assessors how the pandemic’s aftermath is affecting their properties. These taxpayers should point out factors that drag down their hotel’s bottom line and provide grounds for reduced assessments.
Here are three factors that can offset increased revenue and lower market value. Hotel owners should consider each in preparing arguments for an assessment reduction.
1. Soaring Stabilized Expenses
Property tax assessments must reflect costs, and hotel expenses have increased across the board. Naturally, expenses are a primary consideration when valuing hotels. The higher the expenses, the lower the net operating income and the lower a hotel’s market value. The complicated step in addressing these costs is determining the property’s stabilized expenses.
A stabilized expense estimate calculates the ongoing operational costs of the property under typical, sustainable conditions. Obviously, expenses have been anything but typical, due to labor shortages, inflation and supply chain issues.
Operating expenses went through the roof during the pandemic and stayed there. Payrolls increased dramatically, for example, in large part due to the “Great Resignation” that sparked a labor shortage and higher wage demands from current and prospective employees. Historic inflation increased hotel costs for supplies, food and beverages, service delivery and amenity offerings. Utilities and maintenance expenses shot up as well. Taxpayers should show assessors how these swelling costs have lowered margins.
Some short-term pandemic-related measures require special attention. To bolster margins, many hoteliers reduced staff counts, services, and room turnover. It is unclear whether these changes are sustainable in the long term, as consumers demand lost services and amenities. It may be inappropriate to factor short-term cost-cutting methods into a value analysis because they do not reflect stabilized expenses and could distort the hotel property’s true market value. In those situations, it may be necessary to use market expenses instead of actual expenses from the profit-and-loss statement.
2. Deferred Capex and Reserves for Replacements
As a corollary to expenses, consider a hotel’s reserves for replacements as the industry emerges from the pandemic. A reserve for replacements is money hotels set aside to cover major capital expenditures beyond normal operating expenses. Recognizing that hoteliers were hurting during the pandemic, many hospitality brands temporarily relaxed property improvement requirements. In turn, hotel operators may have deferred capex for maintenance and renovations due to financial constraints.
Coming out of the pandemic, hotel owners may need to set aside a larger reserve percentage as the industry recovers. Reserves for replacements have historically been between 3 percent and 5 percent of revenue for full-service hotels and 4 percent to 6 percent for select-service hotels.
Depending on the individual property and its brand, it might be appropriate to increase those percentages briefly while the property is brought back up to standards. The increased deduction would lower net operating income, which consequently would lower the market value. If a property has fallen below brand standards, it should be factored into the hotel’s valuation and brought to the local tax assessor’s attention.
3. Climbing Cap Rates
A benchmark for industry risk, cap rates are simply the relationship between NOI and value. When cap rates go up, values go down.
Interest rates have a direct impact on cap rates: As interest rates go up, raising the cost of debt and equity, cap rates climb. The Fed’s recent interest rate hikes have driven up cap rates, pressuring down hotel values.
In many cases, the interest hikes have made it unviable to build or buy new hotels and have made hotel ownership riskier altogether. The question becomes, how should cap rates factor into property tax assessments?
There are several ways to derive cap rates for hotels, and taxpayers should consider all the methods to know which provides the most persuasive grounds for value reduction. Many tax assessors derive cap rates through market extraction by looking at the sale of comparable properties. That method ignores interest rate increases and incorporates intangible value, which is generally not taxable and hard to extract from overall value.
The band of investment method is a helpful way to derive cap rates and involves building up separate cap rates for a property’s debt and equity components. This can be advantageous because it accounts for interest rate increases, which the market extraction method does not. Tax assessors need to consider the effect of interest rate hikes on cap rates, as it can create a path to lowering a hotel’s tax burden.
Recent hotel revenue recovery only tells part of the story for property tax assessments. To control property taxes, hoteliers and asset managers must highlight how growing operating expenses, reserves for replacements and cap rates diminish market values. Each taxing assessor has a unique perspective on valuation, so it is always helpful to engage knowledgeable, local tax professionals to help ensure hotel owners are maximizing tax-saving opportunities.
Andrew Albright is an attorney and manager and Stephen Grant is an attorney at Popp Hutcheson PLLC, the Texas member of American Property Tax Counsel, the national affiliation of property tax attorneys.