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SHC Half Moon Bay, LLC v. County of San Mateo
Citations: 226 Cal. App. 4th 471; 171 Cal. Rptr. 3d 893; 2014 WL 2126637; 2014 Cal. App. LEXIS 446Docket: A137218
Court: California Court of Appeal; May 22, 2014; California; State Appellate Court
Original Court Document: View Document
The California Constitution mandates that property be assessed at fair market value, with assessors required to tax all property unless exempt under federal or state law. Intangible assets and rights, which cannot enhance the value of taxable property, are specifically exempt from taxation. The Revenue and Taxation Code stipulates that intangible rights related to a business's going concern value must not be included in taxable property valuation. In the case Elk Hills Power, LLC v. Board of Equalization, the California Supreme Court clarified that intangible assets with quantifiable fair market value, such as business goodwill and customer base, should be deducted from income stream analysis prior to taxation. This appeal involves a property tax assessment dispute for the Ritz Carlton Half Moon Bay Hotel, where the appellant, SHC Half Moon Bay, LLC, argues that the San Mateo County Assessor inflated the hotel's value by including $16,850,000 in intangible assets. SHC contends that the income approach used for assessment violated California law by not excluding the value of these intangible assets. The County of San Mateo defends the assessment. The court identifies three methods for determining fair market value: market data, income, and cost methods. The income approach involves estimating the future income a buyer could expect and discounting it to present value. Upon review, the court found that the assessor's income approach failed to account for the contribution of intangible assets to the income stream, violating section 110, subdivision (d). Specifically, the court noted that the assessment neglected to deduct the value of the hotel’s workforce, leasehold interest in the employee parking lot, and agreement with the golf course operator before the assessment. The luxury hotel, situated on approximately 14 acres at 1 Miramontes Point Road, Half Moon Bay, comprises five structures including a six-story main building with 209 guest rooms, a restaurant, spa, fitness center, and additional amenities. It was purchased by SHC in 2004 for $124,350,000, which included real and personal property as well as intangible assets. The hotel was assessed by the Assessor at $116,980,000, reflecting a deduction for personal property, and SHC paid the property taxes timely. SHC contested this assessment, arguing that it erroneously included $16,850,000 in nontaxable intangible assets, such as the hotel’s workforce, leasehold interest, agreement with the golf course operator, and goodwill. SHC asserted that the income approach used for assessment did not adequately exclude intangible assets and that the method for excluding these assets should align with Section 502 of the Assessors’ Handbook, which emphasizes the need to identify and value specific categories of intangible property rather than merely deducting management and franchise fees. To support its appeal, SHC presented a valuation report by James A. Gavin from Duff & Phelps, who allocated the property’s purchase price between tangible and intangible assets according to financial accounting standards. Gavin determined the value of tangible assets to be $99,500,000 and allocated $16,850,000 to intangible assets, detailing specific values for various components including $1,000,000 for the workforce and $14,150,000 for goodwill. At the Board hearing, Gavin described his methodology for calculating goodwill as a residual value after accounting for all tangible and intangible assets. A premium is being ascribed to a property based on factors such as brand and location, contributing to a valuation of $14,150,000, which is derived as a residual after deducting other combined numbers from the purchase price. Gavin acknowledged that the income method reflects market practices for hotel trading but recommended aligning the valuation with the Assessors’ Handbook, which advocates for the separate identification and valuation of intangible assets and rights, deducting them from the business enterprise's total to ascertain the taxable property value. The County contended that SHC’s appraisal, which utilized a controversial methodology, improperly excluded the value of nontaxable intangible assets by deducting management and franchise fees from the income approach. The County criticized SHC's method of assigning a per square foot value to the land and improvements and argued that SHC's assumptions did not align with actual hotel market conditions. The Assessor employed the widely accepted Rushmore Method, using the sales, cost, and income approaches, with the income capitalization approach deemed most effective for valuing the hotel. The Assessor calculated a stabilized income stream, estimating a 71% occupancy rate with net revenue of $330 per room, and derived a net operating income of 18% after accounting for fixed expenses and deducting management fees. Utilizing a capitalization rate of 6.5%, the Assessor concluded a fair market value of $129,700,000 for the hotel, deducting $7,340,000 for personal property to arrive at a final valuation of $122.3 million, which is within 5% of the roll value of $116,980,000. This proximity to the appraised value supports the validity of the purchase price assumption. Thomas E. Callahan critiqued Gavin’s report, asserting that the income capitalization approach is the appropriate method for valuing income-producing properties like hotels for property tax assessments. Callahan analyzed the valuation of hotel properties, emphasizing that the intangible business value is typically excluded from the real property value through the deduction of a market rate management fee and, where applicable, a franchise fee. This deduction leads to an income stream perceived by investors as a return on the hotel's tangible assets. In the case at hand, the significant portion of the hotel's business value was removed due to the management fee owed to the Ritz Carlton Hotel Company, LLC. Additionally, pre-opening expenses, such as workforce training and marketing costs, are also deducted as intangible value. Callahan criticized Gavin’s report for significantly underestimating the replacement cost per guest room, arguing that a more realistic figure increases the value of the hotel's tangible assets from approximately $107.5 million to $128.3 million. As an expert in hotel valuations, Callahan noted that investors predominantly rely on the income capitalization approach for valuation, highlighting that management agreements necessitate the deduction of market rate fees to reflect a pure asset income return. He acknowledged that while additional deductions, such as the capitalized value of labor in place, are minor, they are still relevant, with the total for related assets amounting to $2.7 million. Callahan expressed that the majority of the business value is removed through management and franchise fees, asserting that the Assessor used an appropriate valuation methodology. He dismissed the cost method as unsuitable for luxury properties and disagreed with the Assessors’ Handbook. Deputy Assessor Angela Hunter testified on the assessment process, stating that the $1.6 million deduction for management and franchise fees encompassed all intangible assets, including goodwill. The County provided articles on the Rushmore Approach for hotel valuation and referenced the California Assessors’ Association’s position paper advocating for an alternative to the Assessors’ Handbook. The County clarified that the California Assessors Association's views are not binding on assessors and do not dictate hotel valuation. The Board upheld the property assessment, emphasizing that assessors' valuations are presumed correct, placing the burden on applicants to prove otherwise. The Board deemed the Assessor’s income methodology an appropriate valuation method, stating that even if the cost approach were applied, evidence indicated higher construction costs than suggested by the FASB 141 report. The Board dismissed SHC's criticism of the Rushmore Approach for allegedly including intangible assets, noting that the evidence presented did not warrant rejecting its use. Although SHC suggested capitalizing typical rental income as a better approach, it failed to provide supporting evidence. The FASB 141 allocation proposed by SHC was deemed acceptable for financial reporting but not for property tax appraisal, with the Board finding insufficient evidence to support SHC's valuation claims. The Board concluded that goodwill should be valued at $0, as management fees would benefit the Ritz-Carlton rather than SHC. The Assessor's Handbook was acknowledged as guidance rather than a binding document. The Board affirmed the assessment of $116,980,000. In a subsequent legal action, SHC's verified complaint for a property tax refund alleged the Board's failure to exclude intangible assets, improper burden placement, constitutional compliance issues, and lack of response to material points raised. The trial court upheld the Board’s decision, citing EHP Glendale, confirming the income approach as valid for property valuation. The court upheld the Assessor's use of the Rushmore method to accurately assess the income stream associated with taxable real property, specifically for hotel appraisals. It affirmed that substantial evidence indicated the assessment excluded non-taxable intangible value and was compliant with the Revenue and Taxation Code. The Assessor demonstrated adherence to statutory requirements through a detailed analysis employing three authorized methods to ascertain fair market value, presenting evidence including comparable sales, cost estimates, and expert opinions. The court found no legal violations in the assessment process and rejected SHC's claims regarding non-compliance with the Assessors’ Handbook, clarifying that the handbook serves as non-mandatory guidelines. Additionally, the court dismissed SHC's assertions that the Board improperly assigned the burden of proof and failed to address all material concerns raised during the hearing. The court ultimately ruled in favor of the County. The excerpt also reiterates taxation principles, emphasizing that property must be assessed at fair market value, while intangible property is generally exempt from taxation, although assessors may consider intangible assets necessary for the productive use of taxable property. Section 110(d)(1) and (2) establishes that intangible rights and assets cannot be directly taxed when assessors employ unit valuation methods. Specifically, section 110(d)(1) prohibits tax assessors from including intangible asset values related to a business's going concern value in the property’s unit value prior to assessment. Section 110(d)(2) mandates that taxing authorities must actively exclude the value of intangible assets from the taxable base value of a unit. Section 110(e) allows assessors to assume the presence of intangible assets necessary for the beneficial use of taxable property without directly integrating their value. This dual framework ensures that while assessors can enhance the valuation of taxable property based on the assumption of intangible assets, the actual value of those intangibles must not be reflected in the property valuation. The California Supreme Court has clarified that assessors must fulfill their duty to assess property at fair market value without improperly incorporating intangible asset values. The taxability of intangibles has historically been contentious, leading to the State Board of Equalization’s 1998 adoption of the Assessors’ Handbook, which serves as a guideline for county assessors on this issue. The Handbook emphasizes that simply deducting related expenses does not eliminate the value of intangible assets from income streams. Although assessors’ handbooks are not legally binding regulations, they are considered authoritative references in valuation matters, as supported by case law including Elk Hills, where the California Supreme Court acknowledged the Handbook’s relevance. The Assessor utilized the income method to value a hotel, as outlined in Rule 8, which details two methods for estimating future income. The relevant method focuses on operating income while excluding sufficient amounts for working capital and management compensation. Under this method, the Assessor capitalizes future income from the property, accounting for risks of income loss. The valuation is based on the premise that a willing buyer would pay an amount reflecting the present value of anticipated future income. The second part addresses the standard of review for this valuation. The parties disagree on whether a de novo or substantial evidence standard should apply. The California Supreme Court clarified that when an approved valuation method is used, the Assessor's findings are presumed correct if supported by substantial evidence. However, if a taxpayer disputes the validity of the valuation method itself, this becomes a legal question subject to de novo review. SHC contends that the Assessor's failure to exclude intangible assets from the valuation challenges the income method's validity, which supports applying a de novo standard. Several cases back this conclusion, indicating that challenges to the valuation methodology itself are treated as legal issues subject to independent review. In the Sky River case, the assessor employed the income approach to value wind farm electricity generation facilities, leading to an upheld property valuation by the assessment appeals board. Taxpayers contested this assessment in superior court, claiming overvaluation due to flawed methodology. The trial court ruled in favor of the taxpayers, stating the assessor's method resulted in an inflated value and overstated tax. The County appealed, asserting the trial court should have deferred to the board's findings, while the taxpayers argued for a de novo standard of review based on methodological issues rather than factual disputes. The Sky River court agreed, determining that the choice of income tax rate for conversion from after-tax to before-tax calculations constituted a legal question regarding the methodology. In Elk Hills, the California Supreme Court similarly applied a de novo review regarding the State Board of Equalization's method of assessing intangible assets, including emission reduction credits, in valuing an electric power plant. The court identified the issue as a question of law based on methodology rather than factual matters. In the current case, SHC challenges the Assessor’s methodology, which incorporates intangible assets into property valuation, framing it as a question of law consistent with the precedents set in Sky River and Elk Hills. The County contends that a substantial evidence standard of review should apply, arguing SHC's challenge pertains to the application of an accepted methodology. However, the court acknowledges the income method's validity but finds the County's argument unpersuasive, implying the questions raised are more about legal methodology than factual application. SHC challenges the validity of the valuation methods used by the Assessor, claiming the inclusion of nontaxable, intangible property constitutes a legal issue. The County's counsel acknowledged that the assessment methodology, particularly regarding the deduction of intangible assets, is central to the dispute. The case of EHP Glendale is referenced, where the trial court ruled in favor of the hotel owner, Eagle, for the assessor's failure to exclude intangible values, but this was reversed on appeal due to an incomplete record. The appellate court deemed the question of whether the assessor’s methodology was flawed as one of fact, distinguishing it from SHC's situation, which raises a legal question about the nature of the appraisal method itself. The court emphasizes that if a method systematically misapplies or misjudges property value, it presents a legal issue. Thus, the focus shifts to whether the income approach used by the Assessor appropriately identified and excluded intangible assets as mandated by California law, indicating that a de novo standard of review applies to the case. The deduction of the management and franchise fee from the hotel’s projected revenue under the income approach failed to comply with California law by not identifying and excluding certain intangible assets, including the hotel's assembled workforce, leasehold interest in the employee parking lot, and the agreement with the golf course operator. Although the deduction did exclude the intangible asset of goodwill, the Assessor's expert, Callahan, acknowledged that not all intangible assets and rights were removed. He stated that the deduction accounted for the majority of the property's business value and identified the need to also deduct the capitalized value of pre-opening expenses and labor in place, estimating this to be around $6,000 per guest room for such a property. The key issue raised is whether the majority of the business value was removed by the management and franchise fee, with Callahan suggesting that an additional deduction for labor in place could be warranted, albeit it would be relatively minor compared to the overall valuation. Callahan's report indicated that the Assessor's method was legally incorrect because it did not properly attribute and deduct income attributable to intangible assets before taxation, aligning with established legal precedents requiring such deductions. The document cites various cases illustrating similar errors by assessors in failing to exclude intangible assets that enhance a property's income stream. The County did not provide a defense against these precedents. The appraiser employed multiple valuation methods, including the income approach, to assess the value of stock owned by GTE Corporation in its subsidiary, Sprint. In a reassessment petition, Sprint contended that the Board improperly included the value of various nontaxable intangible assets—such as the Sprint trade name, customer base, workforce, favorable leases, advertising relationships, and goodwill—claiming that these should not have been accounted for in the appraisal as required by California law. Sprint argued that the Board's appraisal was fundamentally flawed for attributing the fair market value solely to tangible property without considering the identifiable intangible assets. The court agreed with Sprint, stating that the Board had erred by ignoring evidence of separate intangible assets, which appraisers are legally obligated to identify and exclude from property assessments. The court criticized the Board's assumption that unit valuation based on income only taxes intangible values that enhance tangible property, highlighting the Board's failure to fulfill its duty to exclude intangible assets from assessments. Similarly, in the current case, the Assessor and the Board neglected credible evidence presented by SHC regarding intangible assets essential for the property's productive use. The Assessor's method of deducting management and franchise fees was deemed insufficient to account for the full intangible value, as it did not explain how this deduction encompassed the majority of intangible assets, nor did it identify and value all relevant intangible components. The Assessor's actions were characterized as merely superficial compliance with the requirement to exempt intangible assets from taxation, a practice criticized in the GTE Sprint case. However, the court was not convinced by SHC's argument that the income method was invalid due to its failure to exclude goodwill. Goodwill is deemed an intangible asset that must be deducted from an income stream analysis prior to taxation, as established by California Supreme Court precedents. Assessor's property assessments carry a presumption of correctness, imposing the burden on the taxpayer, here SHC, to prove the assessment is incorrect. During the evidentiary hearing, SHC claimed goodwill was valued at $14,150,000, while the Assessor valued it at $0, arguing that management and franchise fees accounted for goodwill. The Board faced a factual dispute about the goodwill's value and ultimately sided with the Assessor, determining it to be $0 based on the argument that the fees benefited the Ritz-Carlton rather than SHC. The court reviewed the Board's decision for substantial evidence and found it supported the Board's conclusion. However, the Assessor's valuation did not comply with legal standards as it failed to exclude certain intangible assets from the taxable property valuation, specifically the hotel’s workforce, leasehold interest in the employee parking lot, and the agreement with the golf course operator. Consequently, the trial court's judgment is reversed, instructing a new judgment in favor of SHC and mandating the Board to recalculate property value excluding the identified intangible assets without necessitating a new hearing. Each party is to bear its own appeal costs.