adm notice 9602/property tax/ [admin notice]

ADMINISTRATIVE NOTICE 96-02 SUBJECT: Property Tax -- State Tax Commissioner's Policy Statement for the Determination of the Capitalization Rates for Producing Coal, Oil and Gas, Other Mined Minerals, and Managed Timberland for Property Tax Purposes for Tax Year 1996, Pursuant to § 110-1H-8,

110-1I-4.1.9,

§ 110-1J-4.7 and § 110-1K-4.1.8 On July 3, 1995, and December 18, 1995, the Department of Tax and Revenue filed valuation variables to be used in conjunction with legislative regulations for the appraisal of natural resource properties. (See: §§

110 CSR 1H, 1I, 1J, and 1K) This notice will address one of the variables, the capitalization rate, setting forth the generally accepted appraisal procedures used in developing the respective rates and in applying the rates to income streams generated by natural resource properties. To this end, this notice will discuss development of industry capitalization rates for producing coal, oil and gas, other mined minerals, and managed timberland. DISCUSSION The International Association of Assessing Officers text "Property Appraisal and Assessment Administration, 1990, defines a capitalization rate as: "Any rate used to convert an estimate of income to an estimate of market value; the ratio of net operating income to market value." In other words a rate used to convert an estimate of future income into an estimate of present value. Generally, there are three (3) components that must be considered and if appropriate developed and included in an overall capitalization rate. These components are: the discount component, the recapture component, and the property tax component. The development of each of these three (3) components will be discussed in the remainder of this Notice. DISCOUNT COMPONENT Of the three (3) generally accepted methods of estimating a discount component, the bands-of-investment method and the summation method have received primary consideration. Consideration was given to use of the comparison method; however, the Department is of the opinion that the bands-of-investment and summation methods are the more appropriate methods to employ for producing coal, oil and gas, and other mined minerals properties as they lend themselves more readily to the conversion of the equity rate portion of the discount component to a pre-tax rate. In this regard, the first step is to construct a capital structure. The capital structure of an industry depicts typically the sources of capital financing (i.e.: what portion of the total capital financing is raised through debt and through equity financing). The Department developed an average industry capital structure based on mining, oil and gas, and timber industries as grouped in Moody's Industrial Manual and Moody's Handbook on Common Stocks. The capital structure was segregated into percentages of capital financing generated through debt and through equity financing in order to develop a profile for typical leveraging characteristics by type industry. (Equity financing represents capital acquired through sale of stock and earnings retention and debt financing represents capital acquired through issuance of instruments of debt.) Once the capital structure had been established a return on investment is developed for each financing band. The Department analyzed stock growth and dividend yield of companies grouped by industry in Moody's Handbook on Common Stocks in order to develop a return by type industry for common stocks. This "after-tax" return was then adjusted to a "pre-tax" return where applicable and used in developing the equity portion of the discount component. The debt return for the debt finance band was established, for each industry, through analysis of loan rates extracted from questionnaires received from lending institutions. Once a safe rate and a risk rate is developed from the previously mentioned analysis, a management rate (for management of investment portfolios) and a nonliquidity rate (time required to sell the investment) are estimated. A synthesis of these rates (as illustrated in Attachment I) is then used to develop the discount component. RECAPTURE COMPONENT The discount component previously discussed provides an investor with a rate of return-on-investment (interest). The second capitalization rate component, recapture, provides the investor with a return-of-investment (principal i.e.: provides an estimate of return necessary for the investor to recovery the principal invested). Once a capitalization rate has been developed for coal, oil and gas, and other mined minerals properties, the income series is discounted to present worth through selection of a multiplier(s) from a standard mid-year life Inwood table (see Attachment II). The Inwood table has a factor for recapture built into the table coefficients thus removing the need to separately accommodate for recapture in the capitalization rate. PROPERTY TAX COMPONENT The third component, property taxes, was derived by multiplying the assessment rate by the statewide average of tax rates on Class III property. Department research indicates that in addition to royalty rates negotiated in producing coal property leases, property taxes are paid by the coal producer. Thus the capitalization rate for producing coal properties does not contain a property tax component as the income stream does not contain income to be used to pay property taxes. APPLICATION The summation of the previously discussed components (i.e.: discount, recapture, and property tax components) yields a reasonable estimate for the overall capitalization rate. The overall capitalization rate is used to select the factor(s) from a standard mid-year life Inwood table (i.e.: present worth of one

(1) per period) that converts the income stream(s) into an estimate of present worth. The Bands-of-Investment and summation techniques were employed when developing discount rates for producing coal, oil and gas, and other mined mineral properties. Likewise a combination of the bands-of-investment technique and the summation technique was employed in developing a discount rate for managed timberland properties. An adjustment was then made to the managed timberland discount rate to remove the effects of inflation as the income stream developed for managed timberland is a noninflating perpetual (80 year) income series. For more information concerning the development of capitalization rates for producing natural resource and managed timberland properties see 110

CSR

1-H, 1-I, 1-J, and 1-K, or contact the Department of Tax and Revenue at (304)

558-3940. Issued: January 26, 1996 James H. Paige III Secretary Department of Tax and Revenue Department of Tax and Revenue Operator on Duty 8:30 am - 4:00 pm Property Tax Division Monday through Friday P. O. Box 2389 Phone: (304)

558-3940 Charleston, WV 25328-2389 FAX: (304)

558-1843 A. COAL PROPERTIES SURVEY June 1, 1995 James H. Paige III Secretary/Tax Commissioner Department of Tax and Revenue 1. Capitalization Rate Survey and Results. In developing a capitalization rate for use in valuing income producing properties, consideration should be given to the three approaches generally considered in estimating a discount rate. However, due to the limited amount of sales involving producing properties, the Bands-of-Investment and the summation techniques will be utilized. Summation Technique (a) Safe Rate - 90-day Treasury Bills January - December 1994 = 4.270% January - December 1993 = 3.019% January - December 1992 = 3.460% (b) Risk Rate 1. Debt - interest differential between Loan Rates and 90-day Treasury Bills. Loan Rates * Risk Rate 1994 - 8.845% 4.575% 1993 - 8.422% 5.403% 1992 - 9.605% 6.145% * From Questionnaire 2. Equity - differential between Equity Rates and 90day Treasury Bills. Equity Rates * Risk Rate 1994 - [12.5% ¸ (1-.29)] - 4.270 = 13.336% 1993 - [12.5% ¸ (1-.27)] - 3.019 = 14.104% 1992 - [13.5% ¸ (1-.27)] - 3.460 = 15.033% * Moody's Handbook on Common Stocks and Value Line Investments Survey Analysis 3. Risk Rate - Composite of Loan and Equity Rates weighted by industry estimated capital structure.* Equity Rates Debt Rate Composite Risk Rate 1994 - 8.002% 1.830% 9.832% 1993 - 8.462% 2.161% 10.623% 1992 - 9.020% 2.458% 11.478% * Debt Equity Ratio = 40% Debt - 60% Equity (c) Non-Liquidity Rate - interest differential between 90-day Treasury Bill rates and one year Treasury Bill rates which reflect time necessary to sell active properties. 1 Yr. 3 Mth. Non-Liq. T-Bill - T-Bill = Rate January-December 1994 = 4.978% - 4.270% = .708% January-December 1993 = 3.434% - 3.019% = .415% January-December 1992 = 3.757% - 3.460% = .297% (d) Management Rate - charges for management of investment portfolios (from questionnaire). Rates: (1) 5% of gross income (2) $5/$1000 of principal or .500% Capitalization Rate (Coal) 1994 1993 1992 Safe Rate 4.270 3.019 3.460 Risk Rate 9.832 10.623 11.478 Non-Liq. Rate .708 .415 .297 Mgmt. Rate .500 .500 .500 15.310 14.557 15.735 * Weight X .40 X .30 X .30 6.124 4.367 4.721 Weighted Total = 15.212% Round to 15.25% * The valuation of an active coal property is dependent on the weighted average of the past three years of production. Therefore, the capitalization rate will be estimated in the same manner. B. OIL AND GAS PROPERTIES SURVEY June 1, 1995 James H. Paige III Secretary/Tax Commissioner Department of Tax and Revenue 1. Capitalization Rate Survey and Results. In developing a capitalization rate for use in valuing income producing properties, consideration should be given to the three approaches generally considered in estimating a discount rate. However, due to the limited amount of sales involving producing properties, the Bands-of-Investment and the summation techniques will be utilized. Summation Technique (a) Safe Rate - 90-day Treasury Bills January - December 1994 = 4.270% ¸ (.95) = 4.495 (b) Risk Rate 1. Debt - interest differential between Loan Rates and 90-day Treasury Bills. Loan Rates * Risk Rate 1994 - 10.126% 5.856% ¸ (.95) = 6.164 * From Questionnaire 2. Equity - differential between Equity Rates and 90day Treasury Bills. Equity Rates * Risk Rate 1994 - [12.50% ¸ (1-.37)] - 4.270 = 15.571% * Moody's Handbook on Common Stocks and Value Line Investments Survey Analysis 3. Risk Rate - Composite of Loan and Equity Rates weighted by industry estimated capital structure.* Equity Rates Debt Rate Composite Risk Rate 1994 - 8.564% 2.774% 11.338% * Debt Equity Ratio = 45% Debt - 55% Equity (c) Non-Liquidity Rate - interest differential between 90-day Treasury Bill rates and one year Treasury Bill rates which reflect time necessary to sell active properties. 1 Yr. 3 Mth. Non-Liq. T-Bill - T-Bill = Rate January-December 1994 = 4.978% - 4.270% = .708% (d) Management Rate - charges for management of investment portfolios (from questionnaire). Rate: .500% (e) Property Tax Rate - sixty percent (60%) of the Statewide average of tax rates on Class

III properties. 1994 = 60% of 2.2320 = 1.339 % Capitalization Rate (Oil/Gas) 1994 Safe Rate = 4.495 Risk Rate = 11.338 Non-Liq. Rate = .708 Mgmt. Rate = .500 Property Tax Rate = 1.339 18.380 = Capitalization Rate 18.25% (Rounded) C. OTHER ACTIVE NATURAL RESOURCE PROPERTIES SURVEY June 1, 1995 James H. Paige III Secretary/Tax Commissioner Department of Tax and Revenue 1. Capitalization Rate Survey and Results. In developing a capitalization rate for use in valuing income producing properties, consideration should be given to the three approaches generally considered in estimating a discount rate. However, due to the limited amount of sales involving producing properties, the Bands-of-Investment and the summation techniques will be utilized. Summation Technique (a) Safe Rate - 90-day Treasury Bills January - December 1994 = 4.270% January - December 1993 = 3.019% January - December 1992 = 3.460% (b) Risk Rate 1. Debt - interest differential between Loan Rates and 90-day Treasury Bills. Loan Rates * Risk Rate 1994 - 9.569% 5.299% 1993 - 8.450% 5.431% 1992 - 9.467% 6.007% * From Questionnaire 2. Equity - differential between Equity Rates and 90day Treasury Bills. Equity Rates * Risk Rate 1994 - [12.50% ¸ (1-.29)] - 4.270 = 13.336% 1993 - [12.50% ¸ (1-.27)] - 3.019 = 14.104% 1992 - [13.50% ¸ (1-.27)] - 3.460 = 15.033% * Moody's Handbook on Common Stocks and Value Line Investments Survey Analysis 3. Risk Rate - Composite of Loan and Equity Rates weighted by industry estimated capital structure.* Equity Rates * Debt Rate Composite Risk Rate 1994 - 8.001% 2.120% = 10.121% 1993 - 8.462% 2.172% = 10.634% 1992 - 9.020% 2.403% = 11.423% * Debt Equity Ratio = 40% Debt - 60% Equity (c) Non-Liquidity Rate - interest differential between 90-day Treasury Bill rates and one year Treasury Bill rates which reflect time necessary to sell active properties. 1 Yr. 3 Mth. Non-Liq. T-Bill - T-Bill = Rate January-December 1994 = 4.978 - 4.270% = .708% January-December 1993 = 3.434% - 3.019% = .415% January-December 1992 = 3.757% - 3.460% = .297% (d) Management Rate - charges for management of investment portfolios (from questionnaire). Rates: (1) 5% of gross income (2) $5/$1000 of principal or .500% (e) Property Tax Rate - sixty percent

(60%) of the statewide average of tax rates on Class

III properties. 1994 = 60% of 2.2320 = 1.339 % 1993 = 60% of 2.3455 = 1.407 % 1992 = 60% of 2.3887 = 1.433 % Capitalization Rate (Other Natural Resources) 1994 1993 1992 Safe Rate 4.270 3.019 3.460 Risk Rate 10.121 10.634 11.423 Non-Liq. Rate .708 .415 .297 Mgmt. Rate .500 .500 .500 Property Tax Rate 1.339 1.407 1.433 16.938 15.975 17.113 * Weight X .40 X .30 X .30 6.775 4.793 5.134 Weighted Total = 16.702% Round to 16.75% * The valuation of an active natural resource property is dependent on the weighted average of the past three years of production. Therefore, the capitalization rate will be estimated in the same manner. D. TIMBERLAND PROPERTIES SURVEY June 1, 1995 James H. Paige III Secretary/Tax Commissioner Department of Tax and Revenue 1. Capitalization Rate Survey and Results A single Statewide capitalization rate for timberland has been determined using the following format(s): - The rate will be based on the assumption of a level, terminal (80 year) income series. - The rate, because of the use of a level, non-inflationary income series, will be void of any expected inflation rate. - The rate will be determined by the summation technique. A. Safe Rate: (Long Term U. S. Securities) (30

yr. T-Bills) 1994 = 7.370 X 5/15 = 2.457 1993 = 6.598 X 4/15 = 1.759 1992 = 7.667 X 3/15 = 1.533 1991 = 8.136 X 2/15 = 1.085 1990 = 8.608 X 1/15 = 0.574 7.408% B. Risk Rate: Debt (Long Term Loan Rates - Safe Rate) 1994 10.258 - 7.370 = 2.888 X 5/15 = .963 1993 9.433 - 6.598 = 2.835 X 4/15 = .756 1992 9.711 - 7.667 = 2.044 X 3/15 = .409 1991 10.506 - 8.136 = 2.370 X 2/15 = .316 1990 13.108 - 8.608 = 4.500 X 1/15 = .300 2.744 Equity: (Equity Rate - Safe Rate) 1994 12.50 - 7.370 = 5.130 X 5/15 = 1.710 1993 12.00 - 6.598 = 5.402 X 4/15 = 1.441 1992 13.00 - 7.667 = 5.333 X 3/15 = 1.067 1991 13.50 - 8.136 = 5.364 X 2/15 = .715 1990 13.50 - 8.608 = 4.892 X 1/15 = .326 5.259 Risk Rate (Debt and Equity Rates weighted by industry Estimated Capital Structure*) Debt 2.744 X .45 = 1.235 Equity 5.259 X .55 = 2.892 Composite Risk Rate 4.127% * Capital Structure: 45% Debt; 55% Equity C. Non-Liquidity Rate: (12 Mth. T-Bills vs. 3 Mth. T-Bills) 1994 4.978 - 4.270 = .708 X 5/15 = .236 1993 3.434 - 3.019 = .415 X 4/15 = .111 1992 3.757 - 3.460 = .297 X 3/15 = .059 1991 5.513 - 5.412 = .101 X 2/15 = .013 1990 7.363 - 7.498 = .000 X 1/15 = .000 .419% D. Management Rate: 0.500% E. Property Tax Rate: 60% of Class III Rate 1994 1.339 X 5/15 = .446 1993 1.407 X 4/15 = .375 1992 1.433 X 3/15 = .287 1991 1.476 X 2/15 = .197 1990 1.487 X 1/15 = .099 1.404% F. Inflation Rate: Bureau of Labor Statistics 1994 2.7 X 5/15 = .900 1993 2.7 X 4/15 = .720 1992 2.9 X 3/15 = .580 1991 3.1 X 2/15 = .413 1990 6.1 X 1/15 = .407 (3.020) Capitalization Rate: Managed Timberland = 10.838% Rounded to 11.0 % Midyear Factors for Present Worth of 1 and Present Worth of 1 Per Annum (Coal) Percent 15.25 Present Worth Present Worth Period of 1 of 1 Per Annum 1 0.931 0.931 2 0.808 1.740 3 0.701 2.441 4 0.608 3.050 5 0.528 3.577 6 0.458 4.036 7 0.397 4.433 8 0.345 4.778 9 0.299 5.077 10 0.260 5.337 11 0.225 5.562 12 0.195 5.758 13 0.170 5.927 14 0.147 6.075 15 0.128 6.202 Midyear Factors for Present Worth of 1 and Present Worth of 1 Per Annum (Oil/Gas) Percent 18.25 Present Worth Present Worth Period of 1 of 1 Per Annum 1 0.919601 0.919601 2 0.777675 1.697276 3 0.657653 2.354930 4 0.556155 2.911085 5 0.470321 3.381406 6 0.397735 3.779141 7 0.336351 4.115492 8 0.284440 4.399933 9 0.240542 4.640474 10 0.203418 4.843892 11 0.173034 5.015916 12 0.145474 5.161390 13 0.123023 5.284413 14 0.104036 5.388449 15 0.087980 5.476429 16 0.074402 5.550831 17 0.062919 5.613749 18 0.053208 5.666958 19 0.044997 5.711954 20 0.038052 5.750006 21 0.032179 5.782186 22 0.027213 5.809399 23 0.023013 5.832412 24 0.019461 5.851873 25 0.016458 5.868331 26 0.013918 5.882249 27 0.011770 5.894018 28 0.009953 5.903972 29 0.008417 5.912389 30 0.007118 5.919507 31 0.006020 5.925527 32 0.005091 5.930617 33 0.004305 5.934922 34 0.003641 5.938562 35 0.003079 5.941641 36 0.002604 5.944245 37 0.002202 5.946446 38 0.001862 5.948308 39 0.001575 5.949883 40 0.001332 5.951214 Midyear Factors for Present Worth of 1 and Present Worth of 1 Per Annum (Other Mined Minerals) Percent 16.75 Present Worth Present Worth Period of 1 of 1 Per Annum 1 0.925 0.925 2 0.793 1.718 3 0.679 2.397 4 0.582 2.979 5 0.498 3.477 6 0.427 3.904 7 0.365 4.269 8 0.313 4.582 9 0.268 4.850 10 0.230 5.080 11 0.197 5.276 12 0.168 5.445 13 0.144 5.589 14 0.124 5.713 15 0.106 5.819