The feverish pace of hotel acquisitions over the past two years has driven sale prices to record levels. Assessors tend to use high sale prices as the basis for property tax calculations. Thus, recent buyers of hotel properties must understand that their newly purchased properties may see property tax bills that exceed pre-acquisition estimates of income and expense budgets.

Most buyers use these planning budgets to assist with pricing decisions. These projections rely on assumptions about income and variable and fixed costs, including property taxes. All too often, the property tax estimates are based on last year's property taxes growing at expected inflation rates. The disastrous impact of such estimates comes when the hotel fails to achieve the forecasted budget because real estate taxes have greatly increased.

To avoid property tax surprises, hotel buyers' due diligence checklist should include the following three items:

  1. Utilize proper methodology: Property taxes represent a significant deduction from a hotel's bottom line, so accurately estimating future property taxes in the planning stage becomes critical. Savvy hospitality investors can make reasonable estimates of income and expenses. However, they find it difficult to accurately project property taxes because these taxes are local, not standardized in all jurisdictions, and, most importantly, they are based on an opinion of value.

    A hypothetical example illustrates the effects of inaccurately projecting property taxes prior to purchasing. Let's say an operating hotel sells for $100 million. The real estate component amounts to $70 million. Last year the hotel received a $50 million real estate tax assessment, and, based on a 2% effective tax rate, its property tax bill was $1 million. The reassessment cycle in the jurisdiction is annual.

    The first column of the table (at right) shows the result of a typical accounting pro forma treatment for projecting the current million-dollar property tax on the hotel at 3% inflation — the wrong method. The second column portrays the figures from a more sophisticated methodology, which utilizes the $70 million real estate purchase price, the 2% effective tax rate and 3% inflation rate to compute the property taxes across time — the right method. Employing the wrong methodology causes the buyer to underestimate taxes nearly $400,000 each year.

  2. At closing, properly record the transaction in the land records: Once a deal is inked, buyers must insist that the transfer documents are filed correctly. Most states impose a realty transfer tax based on the price paid for real estate. This value shouldn't include amounts paid for all personal property. For example, accurate recording would show the total consideration for the property as $100 million with a deduction of $30 million for the value of personal property. The resulting real estate valuation would be $70 million.

    The $30 million of personal property consists of $10 million for the tangible personal property and $20 million representing the price of the intangible asset.

    Typically, buyers tend to separate only the tangible personal property value, the effect of which is to overstate the value of the real estate. Were this the case in the above example, the transfer tax form would overstate the value of the real estate by $20 million. The transfer tax overpayment would amount to $400,000, or 2% multiplied by $20 million. The assessor then has written proof that the price paid for the real estate was $90 million, not $70 million. Future assessments will reflect the erroneously recorded price.

  3. Keep records of closing documents: In a tax appeal, the onus resides with the owner to support his position with proper documentation. The transfer tax return is a sworn document and a representation of the real estate's price. Should assessors attempt to revalue property at something higher than what was paid, the buyer's documentation stands as a bulwark against such revaluation. A buyer who didn't pay attention to completing the transfer tax return has little recourse other than paying the higher property tax.

Property tax due diligence becomes a hotel buyer's best friend because it enables the acquirer to control a significant fixed cost, property taxes. Only a serious due diligence process provides buyers with reduced exposure to property tax increases and, ultimately, optimization of profits.

COMPARISON OF RIGHT AND WRONG METHODOLOGIES

The table illustrates that the wrong forecasting method used by owners can substantially underestimate the property tax expense annually on a hypothetical purchase of a $100 million hotel property.

  Wrong method Right method Underestimated taxes
Year 1 $1,030,000 $1,400,000 $370,000
Year 2 $1,060,000 $1,442,000 $382,000
Year 3 $1,090,727 $1,485,260 $394,533
Year 4 $1,125,508 $1,529,817 $404,309
Year 5 $1,159,274 $1,575,711 $416,437
Source: Popp, Gray & Hutcheson

Bernice Dowell is national director of hotel valuation with the Austin law firm of Popp, Gray & Hutcheson, the Texas member of the American Property Tax Counsel. She can be reached at Bernice@property-tax.com.