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Challenging the Assessments of Chain Restaurants in Texas

By Paul Pennington

author discusses a special type of valuation discrimination
in Texas relating to the assessments of chain restaurants
as a class of property, based on the principal appraisal method
being used-the cost approach.

THE DALLAS/FORT WORTH AREA, fast food chain locations sell
for a fraction of their original construction cost because
they no longer operate as chain restaurants or because they
are sold to second generation non-restaurant-chain operators.
Texas appraisal districts, however, tend to take the opposite
approach, which is a dollar spent equates to a dollar of taxable
market value. So how do you prove that the districts are wrong?
Can one prove that the cost approach is not the best approach
to use when valuing chain locations? Doesn’t the cost approach
really determine the fee simple taxable market value of a
chain restaurant? Is it true that the income and the sales
comparison approaches may not be appropriate in valuing a
new chain property? How do appraisal districts measure the
going concern value of a chain restaurant? These are some
of the questions that are discussed in this article.


it safe to assume that the cost approach is the best approach
to use when valuing a chain restaurant? The answer in this
author’s estimation is no. The cost approach should be challenged
as the exclusive method of determining the taxable realty
value of chain locations. Further, the other two approaches
to value, income and sales comparisons, should be modified
to truly appraise the taxable restaurant market. In the third
quarter, 1990 issue of the Enterprise Valuation Reporter,
John D. Emory, value points out that:

Business valuation has to do with the value of the rights
inherent in ownership of a commercial, industrial or service
organization pursuing an economic activity. Real estate appraisal
involves the valuation of land, improvements and associated
rights. Real estate appraisal does not deal adequately with
the whole area of intangible business assets such as patents,
trademarks, copyrights, goodwill, customer lists, employment
contracts, covenants not to compete, exploration rights, intangible
drilling costs, franchises and licenses. The more a company
depends on its intangible assets to generate earnings, the
more important such assets are in any business enterprise

Reilly notes in the January 1993 issue of Valuation, published
by the American Society of Appraisers, that:

Traditionally, real estate appraisals of location-dependent
commercial encompass a portion of (if not all of) the intangible
business enterprise value of the property. . . . The naive
application of real estate appraisal procedures to location-dependent
businesses will ignore the fact that the real property’s highest
and best use (and total concluded value) are dependent upon
the existence and assemblage of such location-specific intangible
assets as business licenses, certificates, permits, and franchises
and such non-location-specific intangible assets as a trained
and assembled workforce, goodwill, and going concern value.
Therefore, by including an economic contribution from these
intangible assets, the real estate appraisal may overstate
the true market value associated exclusively with the subject
"bricks and sticks" for these location-dependent

has been this author’s experience that Texas appraisal districts
believe the primary approach to valuing chains is the cost approach;
that is, the acquisition cost of the land plus the cost of personal
property, plus the hard and soft costs of the improvements,
less accrued depreciation, represent the taxable market value
of a chain restaurant. The theory apparently relies heavily
on the principle of "substitution," which The Appraisal
of Real Estate, published by the American Institute of Real
Estate Appraisers, defines as:

The principal of substitution is basic to the cost
approach. This principal affirms that no prudent investor
would pay more for a property than the cost to acquire the
site and construction improvements of equal desirability and
utility without undue delay. . . . Because cost and market
value are closely related when properties are new, the cost
approach is important in estimating the market value of new
or relatively new construction. The approach is especially
persuasive when land value is well supported and the improvements
are new or suffer only minor accrued depreciation and, therefore,
represent a use that approximates the highest and best use
of the land as though vacant.


     However, a problem arises, for
example, when the crane operator erects the golden arches, accompanied
by the McDonald’s logo and all of the associated paraphernalia,
because at that point, an intangible personal property value
is created. At the very least, a functional obsolescence becomes
apparent, which is not dealt with by the appraisal district’s
cost approach. By not addressing this issue, appraisal districts
may be assessing an intangible value that is exempted by law.
The Texas Property Tax Code (Code), is very clear on this point.
The Code divides taxable property into two categories real and
tangible personal property. The test to qualify taxable property
is noted in Section 11.01 of the Code:

(a) All real and tangible personal property that this state
has jurisdiction to tax is taxable unless exempt
by law.
(b) This state has jurisdiction to tax real property if located
in this state.
(c) This state has jurisdiction to tax tangible personal property
if the property is:

(1) located in this state for longer than a temporary period;

(2) temporarily located outside this state and the owner
resides in this state; or
(3) used continually, whether regularly or irregularly,
in this state.

Tangible personal property that is operated or located exclusively
outside this state during the year preceding the tax year
and on January 1 of the tax year is not taxable in this state.

The Code states in Section 11.02 that:

Intangible personal property, except as provided by Subsection
(1)) of this Section, is not taxable.

The Code identifies intangible personal property in Section
1.04, (6) as:

A claim, interest (other than an interest in tangible property),
right, or other thing that has value but cannot be seen, felt,
weighed, measured, or otherwise perceived by the senses, although
its existence may be evidenced by a document. It includes
a stock, bond, note or account receivable, franchise, license
or permit demand or time deposit, certificate of deposit,
share account, share certificate account, share deposit account,
insurance policy, annuity, pension, cause of action, contract,
and goodwill.

     To prove the existence of intangible
personal property, just think about the last time you were driving
down the road with a car full of kids after a ball game and
you asked them where they would like to stop and eat. More than
likely you heard an adamant response in favor of Burger King,
McDonald’s, or another national fast-food restaurant. It seems
likely that the kids wanted to go to a fast food chain because
of franchise name recognition. Corporate-owned and franchise
stores guarantee the customer the same quality of goods and
services, be it a McDonald’s in Dallas or one in Denver.

     Appraisal districts adhere to
several other misconceptions. For example, chains always work
and if they don’t, it’s due to a location problem. Therefore,
a successful chain location must be worth at least the cost
to assemble the land, the building, and the personal property.
Such speculation, however, is questionable, since it is sometimes
difficult to define what constitutes a successful chain operation.
For example, consider Addison, a suburb of Dallas. Addison,
admittedly, is a very unusual community, in that less than
10,000 citizens live there but it has well over 120 restaurants.
Addison is a community with an extremely high density of office,
retail, and industrial space. Since 1978, one particular tract
of land in Addison has had four chains built on it-three of
which failed. Some might argue that the location of the tract
of land caused the three to fail. However, it might simply
be that these restaurants worked for a period of time, some
longer than others. Further, the public’s taste changes and
over the past 16 years, this site supported a steak house,
a Mexican, a Cajun, and now a seafood restaurant. This site
averages approximately one new restaurant every four years.
What is the typical life span of a chain location in a very
competitive market?

     The cost approach typically
assumes that the economic life and physical life would be
longer than four years. However, in highly competitive markets,
appraisal districts typically do not recognize "real
world" conditions when they use 20-, 30-, and sometimes
40-year lives on chains. Ask yourself, when was the last time
you saw a 20-, 30-, or 40-year-old chain location? If you
saw a 30-year-old McDonald’s for example, you’d more than
likely be looking at some sort of historical landmark.

     Generally speaking, as restaurants
get older they must be remodeled to keep up with the public’s
taste, or they are sold or leased to second-generation owners
or tenants. Therefore, four restaurants on one site in 16
years might not be realistic for mass appraisal purposes;
however using 20-, 30-, and 40-year lives is not realistic
either in today’s highly competitive market place. That is
not to say that the structure itself may not have a 40-year
life, but the highest and best use may change during its life.
For example, at the time of this writing, several McDonald’s
sites were about to sell or go under contract to a back and
neck injury company by the name of K Clinic. Thus, the highest
and best use of these locations had changed over the last
two decades. Moreover, the purchase prices were a fraction
of the values carried on the 1994 Dallas Central Appraisal
District tax roll.


     Does the cost approach really
determine the fee simple market value of a restaurant? It
does not appear so. For example, a national chain restaurant
opened in Dallas in 1993 and was closed by early 1994. According
to the current broker, the owners had removed some of their
personal property. However, they did not expect to recoup
their original investment; in fact, they will probably realize
a sizable loss. The Dallas Central Appraisal District, however,
is still carrying the property on its tax rolls based on the
cost approach. How can the asking price not be a better indicator
of market value than cost? Cases such as this indicate that,
unlike appraisal districts, the market place does not recognize,
nor will it pay for, unique designs, paraphernalia, etc. Therefore,
some components of a closed chain restaurant may create a
certain amount of functional obsolescence, which the seller
can not recoup.

     According to one national chain
operator, if one of their locations closed or was sold to
a second generation operator, they would hope to recoup $30,000
to $40,000 for their personal property packages, which run
between $200,000 and $300,000 new. In the case of the real
estate, they would be happy to recoup their original land
cost, plus $100,000 for the improvements.

     Texas courts have long established
that property should be valued "fee simple" for
property tax purposes. That is, "… absolute ownership
unencumbered by any other interest or estate, … subject
only to the limitations imposed by government powers of taxation,
eminent domain, police power, and escheat." (See The
Appraisal of Real Estate, published by the American Institute
of Real Estate Appraisers.) Appraisal districts would argue
that the cost approach recognizes the fee simple value of
a newly built Wendy’s or McDonald’s. However, it could be
argued that the franchise/going concern value of a newly constructed
Wendy’s or McDonald’s would be encumbered, much like a leased
fee estate encumbers income-producing properties. For example,
a franchise is defined as, "A privilege or right that
is conferred by grant on an individual or a group of individuals;
usually an exclusive right to furnish public services or to
sell a particular product in a certain community." (See
The Dictionary of Real Estate Appraisal, published by the
American Institute of Real Estate Appraisers.)

     A franchise agreement contains
terms and conditions that dictate the manner in which the
property is maintained and presented to the public. If the
owner or lessee of a newly constructed fast food restaurant
did not adhere to the terms and conditions, the franchise
agreement could be revoked. Thus, the agreement encumbers
the ownership of a property. Typically, the loss of a franchise
agreement would have an adverse effect on the property’s value.
However, with the loss of the agreement the property would
be unencumbered by the restraints of a franchise, and so could
be appraised as fee simple.


     Why not use the sale comparison
and/or the income approach on a new property? In Texas, most
appraisal districts that use restaurant sales, sale/leasebacks,
and the income approach view going concern chain or discount
second-generation sales as not being comparable. This approach
results in the assessment of not only the taxable value of
a restaurant but includes exempt intangible personal property.
It is difficult, but not impossible, to use the sales comparison
and income approaches to value, if you define what you are
looking for.

     For example, in the Dallas metro
area, a chain location selling as a going concern, 99 percent
of the time sells for a great deal more than those that were
vacant at the date of sale or those that have become second-generation
restaurants. The going concern value of the restaurant seems
to make a significant difference in the overall value of a
restaurant. Therefore, when trying to establish the fee simple
value of only the tangible real property, one must find comparable
market sales (not necessarily chain restaurant sales) and,
using paired data analysis, identify specific differences.

     It is preferable if sales comparables
are vacant or are locations selling to second-generation non-chain-restaurant
operators. This would simplify the value attributable to intangible
personal property. After the sales comparables are collected,
a sequence of market-driven adjustments should be made to
quantify the comparison between the comparable properties
and the subject. The elements of comparison include:

1. Real property rights conveyed;
2. Financing terms;
3. Condition of sale;

4. Date of sale;
5. Location;
6. Physical characteristics; and
7. Segregated market value of the real, personal, and intangible

     After the sales comparables have
been adjusted on a market data grid, a reconciliation of the
data should give an estimate of value, which will give the taxable
value of a chain restaurant excluding any personal and intangible
personal property.

     In arriving at a value based
on the income approach, it is difficult, but not impossible,
to arrive at a taxable market value. One must identify comparable
chain restaurants or comparable non-chain-restaurants, and
analyze their income, expenses, and capitalization rates.
A reconciliation of income and operating expenses of comparable
properties should be performed to develop a market income
pro forma, resulting in an estimate of value. A major problem
with this approach is that overage rent (the percent paid
over and above the guaranteed minimum rent) leads to yet another

     An appraiser must be able to
quantify that the base rent with its overage does not exceed
market rent for the real property being appraised. Further,
overage rents tend to enter the gray area of going concern.
If one is confronted with a Wendy’s, which is located in a
submarket of 15 other chain locations, all of which rent between
$22.00 and $28.00 per square foot including overages, this
does not constitute the market rental range. Rather, it quantifies
rental rates for going concern chain locations within a particular
market. If the purpose of the appraisal is to use all three
approaches to value in determining the fee simple market value
of a property, the market area being examined should be broadened.
If the Wendy’s is paying $25.00 per square foot, but comparable
non-chain locations lease for $15.00 per square foot, some
of the difference could be attributable to the Wendy’s intangible
personal property. Therefore, for property tax purposes, one
wants to identify that income which is attributable to the
real estate and not to the restaurant’s business cash flow.

     How do appraisal districts measure
the going concern value of a chain restaurant? The answer
is very simple: they don’t. So how should a taxpayer account
for going concern? In The Appraisal of Real Estate, 10th edition
(published by the American Institute of Real Estate Appraisers)
going concern is defined as follows:

Going concern value is the value of a proven property operation.
It includes the incremental value associated with the business
concern, which is distinct from the value of the real estate
only. Going concern value includes an intangible enhancement
of the value of an operating business enterprise that is produced
by the assemblage of the land, building, labor, equipment,
and marketing operation. This process creates an economically
viable business that is expected to continue. Going concern
value refers to the total value of the property, including
both real and intangible personal property attributed to business
value. Going concern appraisals are commonly conducted for
hotels and motels, restaurants, bowling alleys, industrial
enterprises, retail stores, shopping centers, and similar
properties. For these types of property, the physical real
estate assets are integral parts of an ongoing business. It
may be difficult to separate the market value of the land
and building from the total value of the business, but such
a division of realty and nonrealty components of value is
not impossible and is, in fact, often required by federal

Robert Martin, a Dallas metro area appraiser and consultant
of real estate and closely held businesses and professional
practices; states that:

It is possible to segregate these real and intangible values
by using a residual approach. Here are the steps that an appraiser
would follow in segregating the goodwill value of a business
from the value of the real property:

Step 1. Determine the value of the business as a going concern.
Step 2. Determine the value of the real property using generally
accepted appraisal methods.
Step 3. Subtract the value of the real property from the value
of the business.

The residual value represents the amount of goodwill in the
"going concern" enterprise. Mathematically, the
procedure would look like this:

Estate             Goodwill

Business   –    Personal Property
  =    Going concern
Value                  Value

applying this procedure to a question of ad valorem taxation,
only the value of the real and personal property would be
taxable. Any value assigned to goodwill would not be taxable.

using the above procedure for property tax purposes, one should
limit the appraisal to the taxable value of the real estate
and personal property only. One should only be concerned with
the fee simple taxable market values of the components, discounting
any identifiable functional obsolescence, intangible personal
property, and going concern value. All three approaches to value
may be used, but certain adjustments must be taken into consideration.
For example, in using the cost approach one must be able to
quantify the real world life of a chain restaurant based on
industry norms. Further, one must be able to establish the amount
of functional obsolescence that is created by chains that use
unique design and construction layouts. This can be determined
in the market by researching the similar sales in the same general
vicinity of chain locations and second-generation operators.
The market will identify the value that a chain’s uniqueness
has when the property sells, and the new owner determines which
items in the original assemblage are useful to the operation
of the location and which are not. Also, the new owner will
determine the amount of remodeling and refitting of equipment
that will be required by the new operator.
     In using the sales comparison
approach, one should focus on comparable nonchain locations
and chain locations selling to second generation operators.
The same principle applies to the income approach. Use market
income and expenses of nonchain and chain locations being operated
by second-generation owners. Once the chain’s name is removed
from an improvement, the market will ultimately dictate the
value of the land, fixed assets, and improvements.

PAUL PENNINGTON is the President of P. E. Pennington & Co.,
Inc,. a regional property tax consulting firm, established in
1988 with offices in Austin and Dallas, TX.

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