Mill Management May Reduce Cost of Property Taxes by Evaluating Mill Assets

by Ronald Bruzek

The 1990s have not been kind to the pulp and paper industry. The decade began with a four-year recession. By 1995, demand was on the rise again, but within the year, even as prices for many products were reaching new highs and customer inventories were building up, prices began to tumble again, and by 1997 the industry as a whole was showing disappointing results. Today, despite substantial gains in many areas, it remains battle-scarred and cautious, buffeted by cyclic forces, major capital costs, and secular market changes.

To add insult to injury, many hard-pressed companies also find themselves paying levels of local real estate taxes, which may be tolerable in flush times but add to the burden of operating their often aging facilities at a reasonable profit. Here, at least, there may be some good news: mills may be able to get relief from at least a portion of their real estate tax bill.

Taxation theory & practice. Valuations of industrial facilities are usually carried out for reasons related to a property acquisition or sale, or for insurance purposes. Ordinarily, the appraisal report is delivered, scanned for the few essential bottom-line figures, and filed away unread. Buried within a properly organized professional valuation report, there can often be found a wealth of information, which may significantly enhance a company’s cash flow and bottom line if properly used.

For example, the acquisition of a company routinely triggers a detailed valuation study for the allocation of the purchase price—i.e., an allocation of the property’s total market value into various assets, tangible and intangible, that together comprise the total price paid. In many cases, by scrutinizing the allocation study in greater depth, it may be possible to equalize and adjust the facility’s tax burden.

Pulp and paper mills, like all manufacturing facilities, are special-purpose properties, whose value can be deeply impacted by business cycles and other factors. When new, such a facility is likely to be literally state-of-the-art for its unique process; its value at that point in time—i.e., the value upon which its future taxation rate will be based—will be roughly equal to its construction or development cost.

As the facility ages, its value diminishes with increasing speed, and—without a major upgrade—it ceases to be state-of-the-art. The local taxing authorities, however, will most likely have the facility on a straight-line depreciation schedule. Straight-line depreciation does not reflect such business realities as the shrinking demand for particular products, industry restructuring and consolidation, or functional obsolescence of the plant and equipment itself. The end result is a growing discrepancy between the presumed value of the company’s assets and their actual market value to the owner or a potential buyer.

In theory, the value estimate for your property on the local assessor’s books is supposed to be a good reflection of the price that property would get in the current market. In practice, most assessors, pressed for time and lacking insight into the special issues of the industry, rely on a “wholesale” straight-line approach, starting from the cost of construction or acquisition and taking the bottom-line value from the appropriate depreciation tables. This gap—between the assumed and the real value of the company’s assets—is where one may find the potential tax savings. Today, as the industry faces large declines in demand due to the crisis in Asian markets, it makes particularly good sense to reexamine the value basis for any aging production facility.

If a company’s tax manager believes his or her facility has a potential to realize a tax saving, the first step is to contact a valuation specialist to discuss the situation. A brief meeting and site visit will usually allow the valuation consultant to establish a general picture of the facility: its net book value, planned capital improvements, environmental projects slated for the near future, and basic financial information. The consultant will also check with your local taxing authority to confirm the current assessed value and learn when the property had last been given an onsite inspection.

Comparing this information with data gleaned from recent sales of similar properties, an experienced consultant can do a “desktop audit” of the plant—i.e., a quick overview that answers the general question of whether a detailed analysis is likely to prove worthwhile.

The next step is to return for a more thorough investigation of the property. This will determine its exact square footage and acreage, zoning issues, the age and condition of all facilities, floodplain characteristics, and any other specific information that may have an effect on value. A detailed examination may reveal that taxes are still being paid on facilities that have been demolished or abandoned years before, or more surprising still, that the actual acreage owned varies significantly from the number officially recorded.

One area of special interest is what appraisers call functional obsolescence, in effect, all those “utility-related” factors that impair the facility’s capacity to function profitably. One way to identify these factors is simply to ask the plant engineer a hypothetical question: “If something happened and you had to rebuild this plant from the ground up, what would you do differently?”

Having reviewed all records and completed a detailed investigation of the property, as well as a weighted analysis of sales of comparable properties in the area (if any), the consultant’s final step is to produce a self-contained report for the company’s use. It should be logically organized, clearly written, and fully documented, to convincingly demonstrate that the stated value for the property has been arrived at objectively.

If the jurisdiction is one that taxes machinery, equipment (M&E) and inventory as personal property, the investigation should be extremely detailed. Typically, the tax savings on machinery and equipment are somewhat less than for real estate, since M&E depreciation schedules are shorter and assessors, aware of their own lack of expertise, tend to be conservative in the values they assign to these assets. But there is useful information to be found, particularly in newer facilities where the equipment may be devaluing rapidly.

As an example, consider a typical mill, with new M&E installed three years ago and valued initially at $5 million. If an assessor devaluates these assets according to a standard 25-year life formula based on original cost, the depreciation is $200,000/year, resulting in a current value of $4.4 million. If it can be shown that the M&E should have been depreciated due to industry external and functional obsolescence factors, the current value could be closer to $3,000,000, yielding a saving of almost $50,000 at a typical industrial property tax rate of 3.3%

Allocation principles in action. The approach suggested here is based on well-established and long-accepted valuation and depreciation principles. The innovation is simply in how the principles are applied.

Other trends in the industry may result in tax savings as well. For example, if a company invested in state-of-the-art equipment early in the decade specifically for paper for business forms, this equipment may see some dramatic hits if present trends continue. Currently, it has been reported that since 1991, paper production for business forms is down by 25%, as computers make inroads into this specialty area. This would be a classic example of value being diminished by a specialty-specific external obsolescence factor.

To see how this works in practice, consider the recent experience of a large paper operation located on about 80 acres in a rural area of the Midwest. This mill, typical of many in the region, has buildings dating from the mid-1990s back to the 1890s. There are three paper machines for the manufacture of high-quality paper for books, catalogs, and magazines; a fourth paper machine was converted to an off-machine coater.

In this case, the appraisal was not commissioned for property tax purposes but had been carried out routinely as part of a larger purchase price allocation following the plant’s acquisition by a large national manufacturer. In the report, a total of $6,000,000 was allocated to the buildings and land, while the value on the assessor’s books was slightly under $10 million—a fairly dramatic discrepancy. Among other surprises, detailed inspection revealed that more than 5% of the facility’s square footage had been boarded up since the early 1980s, but was still being carried on the tax rolls.

At this point, many or most companies would simply accept the appraisal report, record the asset values in their books, and go about their business as usual. This company’s tax manager, however, was more vigilant and proactive than most, and he recognized the potential opportunity embodied in the allocation appraisal. He informed the taxing authority, in this case the state industrial revenue board, that he had reason to believe the assessed value of the company’s real estate assets was substantially overstated, and requested a meeting.

What happened next was instructive, and it reminds us that logic alone does not rule the world. The tax authority did not dispute the company’s position, and indeed was prepared to reduce the value of the assets for tax purposes. But here the city administration intervened. With more than 600 employees, the company was by far the largest employer in the area as well as the single most important contributor to the city’s budget. Adjusting its tax basis downward would mean an instant dramatic impairment on the city’s ability to function. Ultimately, the matter went into Alternative Dispute Resolution and was settled in mediation. The tax value was reduced, but only to $7,000,000, and only on the understanding that the city would be able to regain some of its lost revenues in succeeding years. In addition, the company agreed to commit to future investments in the area and to provide a certain amount of interim financial support to the local government.

“There was no doubt we could have won a much larger tax reduction if we had been willing to fight for it on technical grounds,” a senior company official later explained. “However, we realized that through this acquisition we had become not only a major employer but also a prominent corporate citizen in this area. For the good of the community, we decided not to press our advantage to its limit.”

The report provided a full account and analysis of all relevant appraisal issues, with photographs, data on sales of comparable properties, and an analysis of current industry conditions—in short, everything needed to enable a reader to follow the steps that the appraiser took to logically arrive at the stated value. At the equalization hearing, the company’s tax manager used this and other information provided by us to support his case, and was able to win a substantial adjustment of approximately 30% on property taxes, amounting to nearly $100,000 in the first year alone.

Determining property tax savings. To determine if a plant may benefit from an allocation appraisal, a good place to start is the five-point checklist below.

The first four questions can probably be answered fairly easily without any special research. Item number five—the appraisal methodology used by the local assessor—is harder to answer but potentially very important. According to accepted valuation guidelines, a proper appraisal is required to consider three different approaches to value—the cost, income capitalization, and sales-comparison approaches. Only after all three approaches have been considered is it possible to derive an objective, supportable value for an asset. In the case of a pulp and paper mill today, there may be a sound argument for not utilizing the income capitalization approach, but a good appraisal should at least include the remaining two, i.e., the cost and the sales-comparison approaches.

Since pulp and paper mills are usually large, unique properties, few exist in the local assessor’s jurisdiction. Typically, then, a local assessor does not have ready access to current sales-comparison information, let alone regional or national information on sales of similar properties. Moreover, few assessors have the luxury of time and information to calculate the impact of depreciation—physical, functional, and external—and they will therefore overlook factors that can potentially be of importance to the mill owner. A complete and expert depreciation analysis by an outside consultant can more accurately uncover and calculate depreciation in the functional and external areas lowering the value of the property, and resulting in more appropriate tax treatment.

If the answer is “yes” for one or more of the five factors on the checklist, you should consider calling a valuation consultant to discuss your situation. Choose one who has specific experience in preparing and managing assessment appeals as well as expertise in financial management (to assure that business value is not included in the assessed value of your assets for tax purposes), and who uses up-to-date data processing and analytica technology.

If the initial study indicates there is a realistic likelihood that your company will realize a substantial net saving from a detailed tax abatement investigation, your consultant can then provide a comprehensive review of all real and personal property, develop assessment, tax billing, and comparable property histories for facilities comparable to yours, prepare reassessment petitions and supporting documentation, and file the necessary forms.

In general, it is a useful (though not infallible) rule of thumb that any older facility, or one whose value is diminished by a documentable degree of obsolescence, probably deserves a closer look. The benefits can be substantial, and the risk is essentially the cost of a phone call.

Mr. RONALD Bruzek is Senior Appraiser with Marshall & Stevens, Inc.

• Functional obsolescence. Is the facility state-of-the-art?Or has the technology and equipment been superceded in significant respects by competitors in the industry?

• Middle or old age. Is the average age of the buildings and/or improvements on the site 25 years old or more?

• Assessed vs. book value. Is there evidence that the assessed value of your buildings and/or improvements is higher than their net book value?

• Environmental/safety exposure. Are there any significant environmental problems (such as with landfills, chlorine issues, etc.) that may potentially impair the value of your property and/or require a significant outlay of resources to correct them?

• “Rote” valuation. Does your local tax assessor base his or her valuations strictly on the cost approach to value, without reference to income and sales-comparison data?