Power Asset Taxes 7.30.03 Mark Pomykacz, Managing Partner, Federal Appraisal & Consulting LLC UTILITY COMPANIES ARE CURRENTLY SUFFERING A DOUBLE BODY BLOW. They are currently suffering a dramatic industry-wide decline. And in many areas of the country, they are suffering through the negative effects of deregulation; however, while these conditions certainly have a negative impact on power asset values, the effects can be mitigated by acting to reduce property taxes. The tax manager who is knowledgeable of recent industry and assessment events and their implications can find a silver lining in property tax management. Given that property taxes are often the third largest operating expense behind fuel and payroll, the proper managing of property taxes can substantially improve net income and thus preserve company value. Currently, four factors are impacting utility assessments in dramatic ways; the recent dramatic industry-wide decline, deregulation is negatively affecting utility’s income, deregulation mandates the income approach, and structured leases may serve as the basis of assessment. Assessors are forewarned. State-level law makers and regulators, in their enthusiasm to deregulate for the benefit of state-wide consumers, forgot to warn local taxing jurisdictions that their local budgets would be negatively impacted. Deregulation was designed to reduce the cost to utility consumers and thus, income to utility companies. An axiom of appraisal mandates that if income declines, value declines. Since property taxes are based on values, logically and actually, deregulation is lowering property tax assessments, taxes, and local budgets. Note that the deregulation impact is a one-time event, lasting the first several years after deregulation, and resulting in a new permanently lower value for the deregulated assets. Given the size of contribution of power assets to the tax rolls and given the dramatic industry decline, assessors should take special steps to plan for a major loss in municipal income for the next several years, until the industry recovers. Active Tax Managers will carry the day. Jurisdictions are being taken by surprise when utilities successfully argue to dramatically reduce their taxes, due to deregulation and the industry decline. Industry-specific market details, such as In Archive May 2021 July 2020 June 2020 April 2020 March 2020 August 2017 August 2014 April 2014 electricity deregulation, are out side the daily experience of many assessors. Assessors are rarely given the resources to cover such industry-specific events. Additionally, the power industry is currently in a different phase of the economic cycle than the general economy and the real estate industry. Real estate has been doing better than the general economy, while the electricity power industry is truly in a bad state. Real Estate has been doing rather well in many markets. Unless property tax managers act to provide the power industry-specific information, assessors sometimes assume the industry is on par with the general economy or with real estate. Unlike income taxes, where the taxpayer estimates what their taxes should be, and the IRS reacts if the IRS believes the taxes are too low, property tax managers are fundamentally reactive. For property taxes, the jurisdictions decide what the owners should pay, and the owner reacts. This arrangement is to the disadvantage to the passive tax manager, given that the power industry is out of phase and going through a very rough period. The opportunity to lower property taxes will only last for several years, as of course, the industry will recover eventually, and the initial impact of deregulation will pass. The Income Approach for deregulation. Another major surprise for both the inexperienced assessor and tax manager is the switch in appraisal methodology necessitated by deregulation. In the old regulated market days, the cost approach was king. In deregulated markets, the income approach rules. Under regulation, if the utility built it, the consumer will pay (based on the cost and the permitted return on the cost). In a deregulated market, there are no guarantees of recapture of costs. Investors, thus, look to the quantity and quality of the cash flow (an income analysis, with normal market considerations of risk and return). This presents a host of assessment management issues, including appraisal, engineering, legal, and corporate management. Old school power engineering consultants will not be up to the task of estimating assessed value via an income analysis. While most traditional real estate mortgage appraisers will not have the engineering experience needed for electricity power facilities. Given that local assessment laws are often specialized for power facilities, experienced legal advice may be needed to negotiate and litigate the transition to appraisals for deregulation. Recent legal precedents confirm this valuation methodology. Additional precedents may be required to sustain the methodology and obtain the proper tax assessment under deregulation. The fundamental argument in favor of the switch from a cost basis of assessment to an income basis is that deregulation is at its heart, the establishment of competitive markets. In competitive markets, the cost to build periodically diverges from the income-based value as the market cycles through periods of growth and decline. In periods of decline, the income approach indicates a lower value than the cost approach (calculated before external obsolescence). Yet, since in deregulated markets, investors will not pay more for an asset than the value based on its cash flow, the cost approach value exceeds the market value in a declining market. The Wild Card, Structured Leases. The assessment law in some jurisdictions permits the appraisal of real property based on the leases in place. There are a number of usability criterion, but the most important are that the lease be at market levels and between unrelated parties. Over the last decade, many power assets have become subject to leases created through structured finance arrangements. By their nature, no structured lease is intrinsically disqualified from being the basis of assessment, in jurisdiction permit appraisals based on leases in place. Many structured leases can pass all the usability criterion. Some structured leases would yield higher assessments, others, lower assessments. Copyright 2003 CyberTech, Inc. Readers Comments DateCommentGeorge Kamburoff 8.5.03This is well-written and timely, and the author makes a good exposition of the issues. He misses an important point, however. Taxes are the price we pay for civilization. That load must be borne by the wealthy as well as the workers. Do we really want to keep finding ways for millionaires and businesses to dodge their fair share of the taxes that pay for our (and their) police, fire, and social services? If we continue this madness, Leona Helmsly will be proven right when she explained conservative tax policy as: “Only little people pay taxes”.Jack Sprat 8.13.03Mark has a point in theory, but in actual practice many power companies may find themselves paying higher rather than lower real estate taxes. For many years, utilities paid taxes on outdated power plant property values. They often argued with local jurisdictions about the low values of their generating plants and often used their depreciated plant values to convince tax assessors that the actual market values of their plants were miserably low. Recently those utilities sold their plants to independent power producers for the fair market values based on the plants’ projected earnings which was often many times greater than the plants’ depreciated or book values. It’s hard to argue with a local tax assessor that a plant you just paid $10 million for is really only worth $3 million which was the previous tax assessment value. Fair market value is fair market value, and the Utilities made a bundle selling plants, which the ratepayers had paid much of the depreciation on, for market value. That was one of the lies of deregulation– that the rates would go down. How can rates go down when the ratepayers start paying the carrying charges on the fair market value of the generating plants instead of the depreciated value which is all the utilities were allowed to charge in their approved regulated rate bases? With new full market prices for power plants come full market taxes. If the taxing jurisdictions really understood how to compute the fair market value of power plants, based on their income potential, the taxes on power plants would go up almost across the board nationally. The new independent power producers had better hope the tax assessors don’t find out just how far out of whack their taxes are and hire the expertise to do fair market value computations for the generating plants in their jurisdictions.

Tax Saving Ideas The following is a list of often overlooked expenses and tax deductions that pertain to the real estate industry and could improve after tax cash flow. Appraisal fees for charitable donations or casualty losses Appreciation on property donated to a charity Casualty losses Commissions and closing costs on sale of property Dues to labor unions for property staff Property improvement costs Investment advisory fees Lead paint removal Mortgage prepayment penalties and late fees Points on a home mortgage and certain refinancings Real estate taxes associated with the purchase or sale of property Seller-paid points on the purchase of a home Special equipment for the disabled for ADA compliance State personal property taxes Theft or embezzlement losses Trade or business tools with life of 1 year or less Self-managed real estate 401K for the self-employed

Valuation and Litigation The Deloitte & Touche Real Estate Newsletter for Attorneys Published Spring, 2000 Considerations for Valuation and Litigation By Mark Pomykacz Perhaps today, litigating our differences has become a normal business venue. Certainly, experience indicates that even the best intentions and the most prudent management practices can offer no guarantee of avoiding litigation. Given that real estate is one of the most expensive business and personal activities, it is not surprising that subtle differences between parties lead to disputes over large dollar amounts. Disputed real estate valuations often range in the millions of dollars and sometimes in the $10’s of millions. Even leasing disputes can amount very large, disputed valuations. Over a seven-to-ten-year lease period, many aggregated lease payments will exceed the value (sale price) of the property. Furthermore, the complexity of real estate valuation unfortunately leaves room for dramatically different opinions of value, rent, and damages. The scale of real estate valuations and the complexity of such valuations require the use of real estate valuation experts. Some sample valuation for litigation issues include: Bankruptcy and Reorganization Issues Property Tax, Estate Tax, Transfer Tax, Other Tax Issues Contract Disputes, Contract of Sale Issues, Landlord-Tenant Issues Partnership Disputes, GP Mis-management, Partial Interest Issues Environmental Damages, past and future lost income, stigma and cost to correct Condemnation and Takings Insurance Claims Once a dispute over real estate valuation is recognized as possibly destined for court, our advice is to prepare earlier, prepare intensely, use the right professionals, and interact deeply with your litigation team. Presented below are basic considerations when working on litigation involving valuation issues. While some disputes are centered on a valuation, most are cases where valuation issues arise in the context of proving a contractual default and/or where once a default has been established, the dollar damages must be estimated. The term “valuation” herein is intended to also include income and yield analysis and estimation. Many of the biggest cases never require a value (sale price) estimate. Partnership disputes, insurance claims, poor management and the resultant poor yield, and lost income often involve disputes over expected income and yields, all of which real estate appraisers are suited to handle. Also discussed below are some of the more common mistakes made by clients, appraisers, and litigators. The considerations below are not arranged in order of either chronology or priority, except for the paramount consideration, which immediately follows. It is paramount to maintain the appraiser’s independence and objectivity. Even the perception of tainted objectivity could destroy their effectiveness as an expert witness. Identify and Clarify the Valuation Issue Unless a client and/or their attorney are experienced with the particular valuation issues at hand, the valuation experts should be consulted as early as possible. Also, unless the appraiser is experienced with the particular valuation concerns surrounding legal issues at hand, the attorney should be consulted as early as possible. Neither the appraiser nor the client and their attorney should make assumptions about the appraisal methodology, the scope of the problem, or the legal strategy without first consulting the other. ♦ The “Full Narrative, FIRREA” type report is often not appropriate for litigation purposes. Appraisals prepared for one purpose and use (or for one litigation case) are often not appropriate for (another) litigation. Appraisal methods and reporting formats vary dramatically and this is appropriate as appraisal issues vary dramatically from case to case. ♦ A preliminary analysis is often helpful for measuring the scope of the problem and testing valuation and legal strategy, but great care must be exercised to avoid the reality and perception of an expert with tainted objectivity. ♦ Different practical appraisal problems require different appraisal methodologies, procedures, and reporting formats. Often the supply of data to be analyzed in the appraisal, or lack thereof, drives the appraisal methodology. Thus, the expert appraiser and the attorney experienced in one type of case may not be able to predict the valuation needs of another case, at the outset. ♦ There must be a continual dialogue beginning in the earliest stages of the case, between the appraiser, the client, and their attorney to resolve and sharpen the legal strategy and appraisal methodology. Protect Client-Attorney Privilege Clients should not hire the appraiser directly and should limit their discussions until the attorneys have hired the appraiser. All working documents prepared by the appraiser for a case should be labeled “draft”, “confidential”, or “prepared for counsel in connection with litigation”. Select Valuation Experts that Meet the Needs of the Case and Round out the Team ♦ Is a designated (MAI) appraiser required? ♦ Is a state licensed appraiser required? Will the expert’s report need to be USPAP and/or FIRREA compliant? ♦ Will other types of experts be needed to support the valuation opinions, e.g.: accounting, environmental, engineering, architectural, zoning, financial or brokerage. Ensure that the Legal Strategy Matches the Most Defensible Valuation Methodology Some valuation methodologies preferred by investors and owners, like the discounted cash flow (DCF), are commonly disbelieved by judges and juries. Conversely, sometimes legal precedents vary sufficiently from the circumstances in the case at hand to warrant another methodology. ♦ Valuation theory can be elaborate. Valuation models are sometimes highly complex and sensitive. Seemingly minor changes in methodology and modeling can dramatically change the conclusions. ♦ Ensure legal instructions are appropriate. Hypothetical assumptions are appropriate and acceptable in some situations, but not all. Maintain an attorney-expert relationship that’s conducive to the free exchange of ideas, questions, and concerns, since it is common that neither the attorney or the appraiser will fully understand initially the impact of their instructions to the other. ♦ Ensure that appraisal terms match the definitions in law and to the layman. If not, care must be exercised to keep communications clear to all, especially to the judge and jury. Give the Valuation Experts Enough Time and Resources For example, it takes 4 to 6 weeks to complete a “full analysis” appraisal on a single asset. Some require less, others a lot more. ♦ Remember that beyond the essential correct methodology, a valuation is dependent on market data, which takes time to collect when it must be gathered from third party sources. ♦ Also appraisers, if given the opportunity, can sometimes substantially increase their accuracy over that of nonlitigation appraisals by employing techniques that, due to their obscurity, complexity and/or cost, they are rarely asked to provide. These techniques should be considered early in the case for best results. Involve the Valuation Experts in Deposing and Crossing of the Opposition’s Experts and in Analyzing the Testimony of the Opposition’s Experts and in Analyzing the Opposition’s Valuation Strategy ♦ Recognize that most cases settle. Then employ the valuation experts in establishing the case’s probability of winning a valuation judgment or verdict and in setting appropriate settlement terms. ♦ Involve the appraiser in the search for, review of, and interpretation of valuation related documents. Research the Judge’s history on Valuation Issues Does the judge have experience with valuation issues? Does the judge dislike certain valuation techniques, such as the discounted cash flow or others?

Managing Commercial Real Estate Before and During Economic Recessions The United States economy and real estate markets have been healthy for an unprecedented period of time. Unfortunately, national economies and real estate markets are subject to economic cycles. Now, due to the unforeseen COVID-19 pandemic in combination with underlying market conditions, the chances of a significant economic recession are increasing. Best practices for effectively managing commercial real estate holdings in the next several years will be different than those for the last ten years. While it remains everyone’s goal to maximize profits and yields, sometimes the short-term goal is to minimize losses. Both before and during a recessionary downturn, best management practices require specialized knowledge and experience in order to minimize losses. In their decades of professional practice, senior management at Federal Appraisal LLC has lived through several significant recessionary periods. This market experience allows them to advise businesses and investors on how best to preserve profits and minimize losses during challenging economic times. Federal Appraisal provides the following appraisal and consulting services to assist their clients with preserving value during recessionary periods and economic downturns: Property tax appraisal and consulting services during economic downturnsreducing property taxesproperty tax assessment appeals litigation/expert testimony Identification of potential surplus property for pre-transactional or re-positioning due diligence Analysis of opportunities for investment in distressed properties Appraisal and consulting services for gift and estate tax planning and reporting purposes Feasibility studies for development, renovation, and/or changes in real estate highest and best use Marketability studies for the impact of recession on demand (for multifamily, office, retail, industrial properties, and more) Case Study One – Concrete Pipe Manufacturer Federal Appraisal advised a regional manufacturer on the value of its various real estate holdings, identifying surplus property to be sold and for how much, and what property was to be preserved and maintained to maximize value to the company. The process identified millions of dollars in untapped, idle value which could be redirected to core business activities. Case Study Two – Property Tax Appeals on Commercial Real Estate Investment Portfolio The senior management at Federal Appraisal reviewed the investor’s portfolio, identified the properties deserving property tax reductions, completed property tax appeals, negotiated tax reductions for some properties, and provided expert testimony in trials for tax reductions for others. The process saved the client more than $10,000,000 in property taxes. Case Study Three – Opportunity Investor Federal Appraisal provided pre-acquisition appraisals and due diligence support to an investor buying a portfolio of troubled power plants, earning the investor yields greater than 25%. Read more at Impairment Studies.