2015 ncuvs conference - economic obsolescence_bwembya chikolwa

31st National Conference of Unit Valuation States San Antonio, Texas October 27 – 29, 2015

Unitary Valuation: Economic Obsolescence Adjustment Conundrum in the Cost Approach

Bwembya Chikolwa Staff Appraiser Property Tax Assistance Division Texas Comptroller of Public Accounts

Disclaimers

The statements made or opinions expressed by the author/presenter in this presentation or related materials do not necessarily represent a policy position of the Texas Comptroller of Public Accounts’ Property Tax Assistance Division. Materials presented on the subject topic are neither definitive nor exhaustive and only present matters the author/presenter believes to salient. As such, the presented material should not be quoted without prior consent of the author/presenter.

© 2015 Bwembya Chikolwa No portion of this presentation may be reproduced, reused, or otherwise distributed in any form without prior written consent.

Topics

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Cost approach model

Economic obsolescence defined

Tests for economic obsolescence

Economic obsolescence models

Regulatory framework for the utility, pipeline, railroad,

telecommunication industries

Investment returns by asset class

Take aways

Case study appraisals

Roundtable discussion

Presenter

Presentation Notes

D


Cost approach model

Property Cost and Obsolescence Components

Source: Reilly , R. 2012. Functional Obsolescence and Economic Obsolescence Considerations in the Property Tax Valuation. Insights magazine, Summer 2012. Chicago: Willamette Management Associates

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Economic obsolescence defined

Economic obsolescence, also referred to as external obsolescence, is the loss in value resulting from influences external to the property itself International, national, industry-based, or local in origin Incurable Subject property’s inability to generate a market-based rate of return on investment (ROI) Source: American Society of Appraisers (2011), Valuing Machinery and Equipment: The Fundaments of Appraising Machinery and Technical Assets, 3rd Ed., Washington, D.C., . pp. 76

Economic obsolescence is loss in value caused by negative externalities, i.e., factors outside a property Temporary or permanent Almost always incurable Marketwide effect and influences a whole class of properties Source: Appraisal Institute (2013), The Appraisal of Real Estate, 14th Ed., Chicago. pp. 632

Economic obsolescence has been interpreted as ‘changes in demand and requirements of public authorities’ in some court cases e.g., PacificCorp v. State of Montana, 253 P.3d at 854 Source: Code of Federal Regulations, 2007

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Test for economic obsolescence Conditions that may indicate existence of economic obsolescence

Income approach value < Cost approach value Market approach value < Cost approach value Decrease in the following factors in recent years for the subject and the industry:

Revenue Profitability Cash flow Product pricing Profit margins Returns on investment

Increase of competition in recent years for the subject and the industry Source: Reilly , R. 2012. Functional Obsolescence and Economic Obsolescence Considerations in the Property Tax Valuation. Insights magazine, Summer 2012. Chicago: Willamette Management Associates

Conditions that may indicate existence of economic obsolescence

Reduced demand for the company’s products Overcapacity in the industry Dislocation of raw material supplies Increasing cost of raw materials, labor, utilities, or transportation, while the selling price of the product

remains fixed or increases at a much lower rate Government regulations that require capital expenditures to be made with little or no return on the new

investment Environmental considerations that require capital expenditures to be made with little or no return on the

new investment Source: Remsha, M.J. 2010. Identifying and Quantifying Economic Obsolescence. American Appraisal

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Economic obsolescence models

Utilization Analysis

Equity-to-Book Ratio Analysis

Best of the Best (Blue-Chip) Technique

Income Shortfall Analysis

Government Regulations Analysis

Market-Derived Approach

Income Approach

Return-on-Capital Analysis

Gross Margin Analysis

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EO can be quantified using many different methods:

Model selection depends on data availability and type of asset being valued Note: The last two methods are not extensively used in unitary valuation. Some of methods discussed in this presentation are derivations of market and income methods


Utilization method

Calculating economic obsolescence using the ‘Utilization method’.

“Whenever the operating level of an asset is significantly less than its rated or design capability… the asset is less valuable than it would otherwise be”

Source: American Society of Appraisers (2011), Valuing Machinery and Equipment: The Fundaments of Appraising Machinery and Technical Assets, 3rd Ed., Washington, D.C.

Inutility Formula:

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X = scale factor → “6/10ths Formula” used Capacity A: Design/Supply; Capacity B: Current/Demand Used in: - Telecommunications industry - Pipeline industry: BP Pipelines (Alaska) Inc. v. State of Alaska, Department of Revenue, ---P.3d---, 2014 WL

685986 (Alaska Feb. 19, 2014) Audited financial data v. Internal unaudited data


Equity-to-book ratio method

Calculating economic obsolescence using the ‘Equity-to-book ratio method’. Derived from sales approach: market-to-book ratio in excess of one implies a sale price in

excess of book value; vice versa is also true Source: American Society of Appraisers (2011), Valuing Machinery and Equipment: The Fundaments of Appraising Machinery and Technical Assets, 3rd Ed., Washington, D.C.

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Used to check if economic obsolescence exists: - PacifiCorp v. State of Montana, Dept. of Revenue, 253 P.3d 847 (Mont. 2011) Stock & Debt method arguments: - Discounts and premiums - Investor intent

BK Value MK Value MK to BK Book Market MK to BKPer Share Per Share Ratio Value Value Ratio

Company Name Ticker A B C = B/A D E F = E/D

Sunoco Logistics Partners L.P. SXL 58.51 48.93 0.8362 1,589,000,000 1,732,000,000 1.0900 Enbridge Energy Partners LP EEP 14.69 29.02 1.9754 5,701,700,000 6,604,500,000 1.1583 Magellan Midstream Partners LP MMP 6.70 50.59 7.5495 2,323,408,000 2,721,985,000 1.1715 Nustar Energy LP NS 33.03 45.59 1.3804 2,411,004,000 2,377,120,000 0.9859 Buckeye Partners, L.P. BPL 24.12 47.77 1.9803 2,941,444,000 3,074,862,000 1.0454 Enterprise Products EPD 14.60 51.75 3.5449 14,655,200,000 14,655,200,000 1.0000 Kinder Morgan Egy Ptnrs L.P. KMP 30.34 81.26 2.6779 17,330,000,000 18,911,000,000 1.0912 Plains All American PL LP PAA 19.80 52.62 2.6581 6,320,000,000 7,300,000,000 1.1551

Average Book to Market: 2.8253 Average Book to Market: 1.0872

Equity 74.00% x 2.83 = 2.09Debt 26.00% x 1.09 = 0.28

100.00% 2.37M/B Ratio = 2.38

Notes:A: Book value per share = (total equity - preferred equity - noncontrolling interest) / Outstanding sharesB: Market value per share = share price from Yahoo Finance/NYSE, etc.D&E: Company financials show outstanding long term debt and its fair value.

Industry Market Capital Structure

PIPELINE INDUSTRYBook to Market - Common Equity Per Share Book to Market - Long-Term Debt


Blue-chip technique

Calculating economic obsolescence using the ‘Best of the best method’. EO involves selecting several economic performance indicators for comparable

companies, such as rate of return, gross or net margins, and utilization, among others, for comparison against the subject

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Used in electric coop industry Was used in railroad industry RCLD v. HCLD Relevance v. Hodgepodge

STANDARD #1 STANDARD #2 STANDARD #3 STANDARD #4 STANDARD #5MWH / MWH / NET MWH / O & M EXP. MWH / DIST. CUSTOMERS /

COMPANY CUSTOMER DIST. PLANT Less POWER EXP. O & M EXP. NET DIST.Center Point H (T&D) 35.6882 0.0235 0.0663 0.3504 0.0007Oncor Electric D (T&D) 34.7092 0.0194 0.0791 0.5729 0.0006TNMP (T&D) 34.4549 0.0157 0.0639 0.3877 0.0005Entergy Texas, Inc. (FI) 53.2518 0.0201 0.1301 0.6728 0.0004Southwestern Electric Co. (FI) 54.3288 0.0236 0.1078 0.3908 0.0004Southwestern Public Serv. (FI) 73.4368 0.0392 0.0938 0.7817 0.0005

Mean - All 47.6450 0.0236 0.0902 0.5261 0.0005Mean - FI Only 60.3391 0.0276 0.1106 0.6151 0.0004

Subject Property % Good Calculation IOU Standards% GOOD 1 (MWH/CUST/ 60.33914 ) = 0.334104% GOOD 2 (MWH/NDTP/ 0.02764 ) = 0.198514% GOOD 3 (MWH/OPEX/ 0.11056 ) = 0.444839% GOOD 4 (MWH/DTEX/ 0.61511 ) = 0.177044% GOOD 5 (CUST/NDTP/ 0.00045 ) = 0.606548

AVG % GOOD 0.352210

Net Book Value = 1,171,800,535

LESS: Economic Obsolescence (1 - 0.35221) 759,081,101

412,719,434Indicated Value


Income shortfall method (1) Calculating economic obsolescence using the ‘Income shortfall method’.

Percentage return differential between the projected allowed (regulated) rate of return and a hypothetical market (unregulated) rate of return, which is then discounted to present value.

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Based on Projected Return-to-Net Book

Based on Previous Year's Return-to-Net Book

YE 2014 YE 2013Net Book Value 908,505,802 848,159,633Cap Rate (x) 8.90% 8.90%Expected Income 80,857,016 75,486,207

Projected Income (a) / Prior Year's Income (b) (-) 47,234,634 (a) 40,192,652 (b)Income Shortfall 33,622,382 35,293,555 Cap Rate (÷) 8.90% 8.90%

377,779,574 396,556,802

Net Book 908,505,802 908,505,802

Less Economic Obsolescence (c & d):

1 - ( 377,779,574 ÷ 908,505,802) (-) 377,779,574 ('c) 424,771,636 (d)1 - ( 396,556,802 ÷ 848,159,633)Market Value 530,726,228 483,734,166

Adopted Market Value 507,230,197

Value always

equals that from

Income Approach


Income shortfall method (2) Legal precedents against/for the ‘Income shortfall method’.

Recent court rulings on method though inclined ‘against’, show that issue is not settled with certainty.

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AGAINST1971 Northern Natural Gas v. Deweyer, 208 Kansas 337, 492 P.2d 147 1976 In re: Onondaga County Water District v. Board of Assessors of Minetto, 39 N.Y.2d 601, 350 N.E.2d

3901979 Consumer's Power Co. v. Port Seldon Township, 91 Mich. App. 180, 183 N.W.2d 6801979 Utah Power & Light Co. v. Utah State Tax Comm’n., 590 P.2d 332 (Ut. 1979)1988 AT&T Communications v. Department of Revenue, Wash, BTA Bo. 336191988 Transcon. Gas Pipe Line Corp. v. Bernards Twp., 545 A2.d 746, 754 (N.J. 1988)

1989 United Telephone Co. v. Dep't of Revenue, 770 P2d. 431989 Pacific Power & Light Co. v. Dept. of Revenue, State of Oregon, 775 P.2d 303 (Or. 1989)1990 Michigan Bell Telephone Co. v. Dep't of Treasury, Michigan Tax Tribunal, Docket No. 905531994 aff'd Michigan Bell Tel. Co. v. Department of Treasury, 445 Mich. 470, 518 N.W.2d 8081997 Alta Pac. Assoc., Ltd. v. Utah State Tax Comm'n., 931 P.2d 103, 112 (Ut. 1997)1999 Delta Air Lines, Inc. v. Dept. of Revenue, State of Oregon, 984 P.2d 836, 849 (Or. 1999).2008 Eurofresh, Inc. v. Graham County, 187 P.3d 530, 537 (Ariz. App. 2008)2009 Quest v. State of Montana, Department of Revenue, SPT 2008-2 (Nov 30, 2009, on appeal).2011 PacifiCorp v. State of Montana, Dept. of Revenue, 253 P.3d 847 (Mont. 2011).2011 Jones v. Southern Natural Gas Co., 63 So.3d 1080 (La. Ct. App. 2011)2012 Southwest Airlines Co. v. Arizona Dept. of Revenue, 2012 WL 3041179 (Ariz. App. 2012)

FOR1980 Burlington Northern, Inc. v. Dept of Revenue, 291 Ore. 7291998 Canal Square Limited Partnership v. State Board of Tax Commissioners, 694 N.E.2d 801(Indiana

1998)1994 GTE North Incorporated v. Indiana Board of Tax Commissioners, 634 N.E.2d 8822011 United Airlines, Inc. v. Prop. Tax Adm'r (Colo. Bd. of Assessment, App., N. 53259, Oct. 19, 2011)2012 PacifiCorp v. Idaho State Tax Commission, 291 P.3d 442 (Supreme Court of Idaho 2012)2012 Boston Gas Co. v. Board of Assessors of Boston, 82 Mass.App.Ct. 517, 976 N.E.2d 176

(Mass.App.Ct., 2012), 10/3/12.2012 Beaver County v. Property Tax Division of the Utah State Tax Comm'n, No. 080905451 (3rd Dist. Ct.

Utah, Feb. 15, 2012)2014 BP Pipelines (Alaska) Inc. v. State of Alaska, Department of Revenue, ---P.3d---, 2014 WL 685986

(Alaska Feb. 19, 2014)2015 State of Alaska, Department of Revenue v. BP Pipelines (Alaska) Inc, ---P.3d---, 2015 WL 5061652

(Alaska August 28, 2015)-Tariff regulation is not a form of economic obsolescence-Excess capacity is a form of economic obsolescence


Govt. regulations method (1) Calculating economic obsolescence using the ‘Govt. regulations method’.

Loss in earnings resulting from the ‘regulatory lag’, i.e., the allowed rate of return was not permitted to be increased fast enough, and the utility was not being given the opportunity to earn on its rate base at current market rates

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Govt. regulations method (2)

Formula:

EO = 𝑪𝑪𝑪𝑪𝑪𝑪𝑪𝑪𝑪𝑪𝑪𝑪𝑪𝑪 𝑴𝑴𝑴𝑴𝑪𝑪𝑴𝑴𝑪𝑪𝑪𝑪 𝑹𝑹𝑪𝑪𝑪𝑪𝑪𝑪𝑪𝑪𝑪𝑪 − 𝑨𝑨𝑨𝑨𝑨𝑨𝑨𝑨𝑨𝑨𝑪𝑪𝑨𝑨 𝑹𝑹𝑪𝑪𝑪𝑪𝑪𝑪𝑪𝑪𝑪𝑪𝑪𝑪𝑪𝑪𝑪𝑪𝑪𝑪𝑪𝑪𝑪𝑪𝑪𝑪 𝑴𝑴𝑴𝑴𝑪𝑪𝑴𝑴𝑪𝑪𝑪𝑪 𝑹𝑹𝑪𝑪𝑪𝑪𝑪𝑪𝑪𝑪𝑪𝑪

Salient facts on govt. regulation:

Social/regulatory compact v. Regulatory capture

‘Just and reasonable’ principle → ‘Zone of reasonableness’ Earned ROEs ≥ Allowed ROEs

Govt. regulators do not determine market value, market participants do Govt. regulations influence property values Ability to recover and earn returns and a conducive regulatory framework heavily impact

credit ratings, e.g. Moody’s Investor Service weights 50% for the two in utility industry ratings

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AEP Texas North Company

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Year-End 2010 2011 2012 2013 2014Allowed Rate of Return† 7.72% 8.01% 7.89% 7.21% 7.23% PUCT Allowed Return (WACC)Current Desired Rate of Return 9.75% 9.24% 8.23% 8.97% 8.90% Capitalization RateIndicated Fraction Non-Obsolete 79.16% 86.63% 95.87% 80.36% 81.24%

Regulatory Analysis Economic Obsolescence

20.84% 13.37% 4.13% 19.64% 18.76% = 1 - ((Market Return - Allowed Return)/Market Return)

Notes:1. Capitalization rate is a proxy for market return or desired rate of return.2. †PUCT Earnings Report, Sch. V. Allowed ROE 9.96% on 12/13/2007, Docket No. 33309.



Some utilities are able to tie their ROE with regulatory lag

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Govt. Regulation: For v. Against

For: “To be truly successful, free markets

require common-sense regulation to prevent manipulation and deceit”

Robert Shiller, 2013 Nobel Laurette in Economics. “Faith in an Unregulated Free Market? Don’t Fall for It,” NY Times, Upshot, Oct. 9., 2015 “Markets Can Be Very, Very Wrong” Paul Krugman, 2008 Nobel Laurette in Economics. The Conscience of a Liberal, NY Times, Sept. 30, 2011

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Against: “Actual market prices are, on the

basis of all available information, best estimates of intrinsic values”

Eugene F. Fama, 2013 Nobel Laurette in Economics, father of the efficient markets hypothesis

“Governments never learn. Only people learn”

Milton Friedman, 1976 Nobel Laurette in Economics, grandmaster of free-market economic theory


Govt. Regulation: Electric/Gas Distribution Industries

Regulatory agencies: Federal Energy Regulatory Commission - Federal Railroad Commission of Texas – State → Gas Distribution Public Utility Commission (PUC) – State Environmental Protection Agency (EPA) - Federal North American Electric Reliability Corporation (NERC)

Mandates: Cost-of-service/cost-based rates Safety Reliability Environmental protection M&A approval

Recent events: FERC Order 1000 → To increase competition in electric transmission industry EPA’s Clean Power Plan → Reduction of carbon pollution from the power section Cyber & Grid Security → Issues, impacts, and costs associated with the risks of cyber-physical attacks on

power infrastructure Coal to gas switching Renewables → ~17% of operating generating capacity, 65% of new capacity Smart grid/Smart meter technology/Grid neutrality/Microgrids Economics of storage → Tesla and SolarCity story, et. al Rate recovery mechanisms:

Riders Trackers Factors Clauses Forward test years

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Test questions on economic obsolescence: What, where & how Negative impact


Govt. Regulation: Pipeline Industry

Regulatory agencies: Federal Energy Regulatory Commission (FERC) - Federal Railroad Commission of Texas (RRC) – State, Texas only U.S. Dept. of Transport, PHMSA – Federal U.S. Dept. of Transport, STB – Federal, Ammonia EPA – Federal: Clean Water Act, Oil Pollution Act, Clean Air Act, et. al

Mandates: Cost-of-service/cost-based rates Safety M&A approval Environmental protection

Recent events: Shale play pipeline build out Pipeline ruptures

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Govt. Regulation: Railroad Industry

Regulatory agencies: Surface Transportation Board (STB) - Federal Federal Railroad Administration (FRA) – Federal U.S. Dept. of Transport, PHMSA – Federal

Mandates: Authorized rates/Revenue adequacy M&A approval Rail abandonment Safety

Recent events: Positive train control → Dec. 31, 2015 deadline Crude-by-rail (CBR) → ~5-6% of revenue

→ New rules: Robust tank cars; lower speed limits; electronically controlled brakes

Coal volumes → ~15-20% of revenue Alabama DoR v. CSX → 4R-Act: Comparison with competitors to determine if tax is

discriminatory Rate protection for certain “captive shippers”

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Govt. Regulation: Telecommunications Industry

Regulatory agencies: Federal Communications Commission (FCC) - Federal Public Utility Commission (PUC) – State

Mandates: Authorized rates Universal service fund M&A approval

Recent events: AT&T’s ‘Project Velocity IP’ → FCC application to shut-down or divest its copper network Title II of Communications Act → Reclassification of broadband as a utility → Net Neutrality FCC’s ‘Connect America Funding Phase II’ → 2015 support for broadband deployment Wireless spectrum auctions & wars Convergence in the Telecom Industry

Test questions on economic obsolescence:

What, where & how Negative impact

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Investment Returns: Electrics

Where are utilities relative to the S&P 500?

‘Just and reasonable’ principle

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Investors with a low risk appetite in search of income favor the utility sector, as utility stocks have low beta and offer attractive yields


Investment Returns: MLPs

10-year performance value of $1,000 invested

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Source: AMZ/Alerian MLP Index fact sheet as of June 30, 2015


Take Aways (1) At trial, ‘Go Big or Go Home’

…..The district court noted that it “was especially impressed byMr. Tegarden and found his testimony and opinions to bemore credible, more reliable, more persuasive, and entitled togreater weight than the testimony and opinions of thewitnesses for the Tax Commission”Source: PacifiCorp v. Idaho State Tax Commission, 291 P.3d 442 (Supreme

Court of Idaho 2012)

Bearer of the burden of proof: Taxpayer v. Assessor Additional reductions of adjustments might be made if a

taxpayer could show that additional depreciable value existedSource: PacifiCorp v. State of Montana, Dept. of Revenue, 253 P.3d 847

(Mont. 2011)

Submission of competent evidence Establishment of factors comprising the claimed obsolescence Identification of affected assets Quantification of the amount of obsolescence for each asset

Tariff income is not a primary driver of economic value. Excesscapacity is a form of economic obsolescence

Source: BP Pipelines (Alaska) Inc. v. State of Alaska, Department of Revenue, ---P.3d---, 2014 WL 685986 (Alaska Feb. 19, 2014)

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Take Aways (2)

Economic obsolescence, by definition, does not occur to a strong and growing company, but rather in one that is a victim of external forces which hamper its income earning capacity Source: PacifiCorp v. State of Montana, Dept. of Revenue, 253 P.3d 847 (Mont. 2011)

FERC definition of depreciation

Depreciation studies occur every 4 – 5 years May not incorporate all forms of obsolescence Decision to deduct for external obsolescence is a product of appraisal judgement Source: PacifiCorp v. Idaho State Tax Commission, 291 P.3d 442 (Supreme Court of Idaho 2012)

The ‘Income shortfall method’, if not tied to the income approach result, is a valid

methodology provided it is correctly applied Source: ©2015 Bwembya Chikolwa

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For more information please contact

Bwembya Chikolwa Staff Appraiser

Property Tax Assistance Division Texas Comptroller of Public Accounts

(512) 475 5677 [email protected]

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Additional Disclaimers

Apologies for putting too many details on slides

No political persuasion is being advanced

This discussion/presentation is irrelevant as everything has been/will be decided by the courts of law. However:

It’s prudent to question our redundancy

To explore ways of changing our minnow status

Presentation is based on assumption after assumption:

Holmesian Mysteries

Acting as a polemicist in this presentation

© 2015 Bwembya Chikolwa Not to be reproduced, reused, or otherwise distributed in any form without prior written consent

RAILROADS

PIPELINES ELECTRICS/GAS DISTRIBUTION

TELECOM/ TECHNOLOGY

POSITIVE TRAIN

CONTROL

GIS MAPPING/

SAFETY REMOTE

SENSING & IMAGING

SMART TECH/ CYBER

SECURITY

CBR ~5-6% of railroad revenue

~15-20% of railroad revenue

~50-60% carbon dioxide cut for each MWH Cheaper fuel generation cost

4.5 times safer EPA mercury and air toxics standards

COMPLEX PROPERTY APPRAISAL

EPA/state methane emission rules

2015 ncuvs conference - economic obsolescence_bwembya chikolwa

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