How can a hotel owner cut expenses after years of cost consciousness have seemingly exhausted their options? Protesting an unfair tax valuation may be the answer. Property taxes can range from four percent to 10 percent of a hotel's total expenses, and because taxes are unrelated to the cost of sales, they’re not only troubling but can drag down the bottom line.

The prospects for lowering a valuation are strong. Hotel values are currently at seven-year lows. The average worth of a hotel room in the United States is expected to bottom out this year at roughly half of the more than $100,000 per-room average the industry reached at its peak in 2006, according to the U.S. Hotel Valuation Index.

Unfortunately, tax authorities often deny that hotel values are at a low point. Consider the example of a 300-room, full-service hotel built in 2002 with a major flag in a large metropolitan area. The assessor valued the hotel at $53.5 million while the taxpayer stated a value of $30 million. How is this possible, and how can a taxpayer overcome this degree of disparity?

To start, there is a difference between the going concern value of a hotel and its property tax value. The going concern consists of real estate, personal property and the business enterprise value. Only the value attributable to the real estate and personal property is taxable. Assessors have typically accepted some variation of this valuation concept and instead argued the components of the methodology.

Recently, however, some tax assessors have argued the decline in hotel values isn't attributable to the real estate but instead is due to the business enterprise value, which has no effect on property tax values.

In addition, tax assessors increasingly rely on the cost-based valuation approach because of their lack of acceptance of current income figures, and because they believe the costs of construction have remained fairly level.

The cost approach estimates the cost to construct a new building before adding land value to arrive at an opinion of value, with adjustments for physical deterioration, functional obsolescence and economic obsolescence.

Deterioration is a deduction for physical wear to equate the new building to the existing building. Assessors typically assume a 60-year life for a full-service hotel, so a 10-year-old hotel would receive a 16-percent reduction for wear and tear. Functional obsolescence measures deductions necessary for changes in market design preferences from the time the building was constructed to the present.

External obsolescence reflects factors outside the property, which generally affects a class of properties throughout the marketplace, not just a single hotel. Examples include a market downturn resulting in less use of the property or in market-wide overbuilding. These factors are often overlooked by assessors. In the earlier example, the gap in values is explained by the tax assessor's failure to make a deduction for external obsolescence.

The assessor, using information from valuation services, determined that the cost to build a new, full-service hotel was $205,000 per room, resulting in a base value of $61.5 million. The assessor deducted physical deterioration of 13 percent for the eight-year-old structure to arrive at a final value of $53.5 million.

The property owner showed that the income to the going concern without a deduction for taxes was $7.1 million for the year. After a deduction for business enterprise value, the resulting $4 million income was capitalized at a loaded capitalization rate of 13.3 percent, resulting in a market value of $30 million.

Cost figures often ignore current economic conditions. In simple terms, the rent or income to the property must support its cost, otherwise an investor would not build the project.

In this example, the rent necessary to support the construction would be $7.1 million, or $53.5 million divided by a 13.3-percent capitalization rate. The net operating income to the real estate was $4 million, which doesn't support the construction cost. Thus, there must be some external obsolescence at hand. A deduction for this external obsolescence results in a significant reduction of value from the assessor's cost approach and produces a number similar to the taxpayer's value. In this particular case, the end result of educating the assessor on the existence of economic obsolescence meant a tax savings of 44 percent.

Mark Hutcheson is a partner with the Austin, TX law firm of Popp, Gray & Hutcheson LLP. The firm devotes its practice to the representation of taxpayers in property tax disputes and is the Texas member of American Property Tax Counsel. Contact Hutcheson at mark.hutcheson@property-tax.com.