A recent decision by the Oregon Tax Court reaffirmed that functional obsolescence has enormous tax-saving potential for owners of older industrial, commercial or utility properties. The court held that functional obsolescence due to excess operating costs must be deducted as depreciation from the replacement cost using the cost approach.

While this holding is not earth-shattering, the court's determination of the appropriate discount rate to calculate the after-tax present value of the excess operating costs merits attention. In Les Schwab et al. vs. Dept. of Revenue, we appealed the Oregon Department of Revenue's valuation of improvements to a 1.7 million sq. ft. tire distribution facility. The facility had added buildings as needed from the 1950s until 1997. By then, the facility consisted of a variety of over 20 distribution warehouses, offices, shops and production centers. The appraisers for both parties agreed that a replacement facility would consist of five or six buildings, to lower the company's operating costs. Such a replacement facility would employ less workers and vehicles due to the efficiencies resulting from a smaller number of buildings. Additionally, there would be savings due to reduced heating and cooling costs, as well as lower insurance costs.

The court accepted testimony of the parties' appraisers that functional obsolescence from excess capital costs in constructing over 20 separate buildings should be removed from the valuation of the property. This was accomplished by estimating replacement cost of a new, modern facility with a more efficient layout and design. The court accepted the physical depreciation calculated by the taxpayer's appraiser. Then, the court focused on the three categories of functional obsolescence due to excess operating costs: excess utility and insurance due to excess building costs; excess labor costs due to the large number of buildings in the complex; and excess equipment costs due to duplication of equipment.

The net amount of the annual excess operating costs was then discounted for a period of time to find the present value of those costs. The parties agreed that the appropriate discount period would be 20 years. There was, however, disagreement on the appropriate discount rate.

Testimony by the Oregon Department of Revenue's appraiser indicated that the appropriate discount rate should be the taxpayer's weighted average cost of capital, the typical industry cost-of-debt. Conflicting testimony from the taxpayer's appraiser demonstrated that a risk-free rate should be used, one close to treasury notes. The court agreed with the taxpayer's appraiser and set a 6.6% discount rate.

The court determined the present value of the annual net excess operating costs for a 20-year period to be $3.9 million. Accounting for functional obsolescence, the court found the value for the Les Schwab facility to be $20 million, a reduction of $16 million from the assessed value of $36 million.

In this case, the court adopted and validated the appraisal methodology for calculating functional obsolescence due to excess operating costs. At the same time, it opined that the correct discount rate to determine the present value of the excess operating costs is substantially lower (a riskless rate) then is typically employed by assessing authorities. The use of a substantially lower discount rate greatly increases the amount of functional obsolescence to be deducted in the cost approach. The effect is to substantially lower the assessed value of the property for ad valorem tax purposes.

In the Les Schwab case, the difference in the discount rate accounted for about a $1 million difference in value. For large industrial properties such as paper mills, automobile manufacturing plants, utilities, etc., the deduction for the amount of functional obsolescence can be enormous.

When contesting the property tax assessments of industrial property, you have two critical elements in your defense. Fully analyze and present the three components of functional obsolescence due to excess operating costs, excess utility and insurance costs, excess labor costs and excess equipment costs. Then determine the correct discount rate for valuing the excess operating cost. Efforts to understand and clearly present these elements can provide a bulwark in defense against unwarrantedly high assessments.