Opinion ID: 1362962
Heading Depth: 1
Heading Rank: 9

Heading: Rate of Capitalization.

Text: The process of capitalization is described in the record as the calculation of the present worth of an expected future stream of income over the life of the property. Defendant computed capitalization rates of 9.0 percent for 1975 and 9.5 percent for 1976 based on a determination of a moving five-year average of annual capitalization rates published with respect to other public utility companies. Plaintiff contended that this averaging resulted in a capitalization rate lower than the actual rate for the year end and thus in an inflated valuation. The lower the CAP rate, the higher is the indicated value. The court agreed with plaintiff that the CAP rates would not be less than the rates of 13.13 percent for 1974 and 12.29 percent for 1975. These figures were based on a market study by a Mr. Lanz, employed by plaintiff as an Assistant to the Vice President, Finance. Both parties utilized the band of investment method to determine a rate of capitalization. Dr. Ring gave the following description of this method: Well, a capitalization rate is really a composite of the elements of or costs of money that go into the makeup of the rate of capitalization. The methods by which a rate of capitalization is obtained, there are three of them. One would be the band of investment method whereby we visualize the enterprise being made up of capital segments or bands. Let's say 40 percent bonded indebtedness  that bonded indebtedness would be a band of 40 percent. Taking 100 percent as the total capital requirements, one band would be the debt capital which, for our illustration, let's say is 40 percent. The second band would be the cost of preferred capital which, for our illustration, let's say is 10 percent. And the third band would be the equity capital which, in this illustration, would be 50 percent. Defendant weighted the capital segments as 42.1 percent and 42.2 percent for common stock, 7.7 percent and 7.8 percent for preferred stock, and 50.2 percent and 50 percent for debt for the two assessment years, respectively. Plaintiff weighted 33.4 percent and 36.4 percent for common equity, 9 percent and 10 percent for preferred stock, and 57.6 percent and 53 percent for long-term debt. Although the percentages do differ, the parties do not argue over the weightings. Rather, they disagree over the methods used to determine the values of each segment, and particularly the cost of preferred stock and debt, and over defendant's five-year averaging. With regard to this averaging, defendant contends that the interest rates of 1974 and 1975 were not typical, and that the practice of not allowing transient fluctuations in costs of money to swing the values of utility properties up and down from year to year is justified in seeking true cash value. Plaintiff asserts that to use a five-year average CAP rate to capitalize estimated earnings for a single year is improper because in an inflationary economy this results in a CAP rate which is always lower than the CAP rate for the current assessment year. We agree with plaintiff that the appraiser should look to more current costs of money in developing the CAP rate and that defendant's long-range values for utility properties based on the prior five-year period are too low. In the alternative defendant suggests use of the rates of 10.2 percent and 11.3 percent for the two years. Those percentages were the single-year rates for 1974 and 1975 used by defendant in computing its five-year average. Plaintiff criticizes defendant's determination of these CAP rates because defendant used figures compiled in Moody's Public Utility Preferred Stock and Bond Group Average Yields which plaintiff contends are not representative. They are allegedly not representative because the rates do not represent the cost of capital at the end of the year but rather the average of yields for the year, because the figures are not restricted to newly issued preferred stocks and bonds, and because in 1975, for example, out of 76 preferred stocks issued, Moody's reflected only 10. As for the time period to be reviewed in determining a proper rate of capitalization, defendant argues that the rates over the past year should be considered while plaintiff argues that only the cost of capital at the end of the year should be considered. Mr. Lanz considered the cost of bonds and preferred stock issued within 45 days to year-end. Mr. Goodman testified that the period of time he would consider would be a matter of two or three months. Dr. Ring testified that it is proper to consider rates over the past year to determine the CAP rate for the appraisal date: But normally what we do is take an average for the year and look back to the past merely as to whether the amount or the rate that we've arrived at is reasonable   . Though he considered defendant's rates a little low for the two years, Dr. Ring accepted them. As for plaintiff's argument that defendant's study should have been restricted to newly issued preferred stocks and bonds, Mr. Lanz pointed out that Moody's figures include secondarily traded issues. His reasoning was that since the CAP rate should reflect the current cost of money, only newly issued preferred stocks and bonds should be considered. Defendant did not rebut this testimony and in fact did not bother to cross-examine Mr. Lanz. As for Moody's public utility figures not being representative of the industry, although plaintiff criticizes defendant's use of the figures for the January 1, 1975 assessment because they reflect only 10 utilities' issues during 1974, plaintiff for its study used only one issue of bonds and one issue of preferred stock. To the extent a wider sampling is desirable, as plaintiff contends, its own study is less satisfactory than that of defendant. In addition, both issues used by plaintiff occurred in January 1975, and thus were data unknowable to the assessor on the assessment date. Plaintiff's data for January 1, 1976 was based on December 1975 data but again was of only one issue of bonds and one of preferred stock. Though perhaps a good case may be made for using more current data than that of the prior year and for considering only newly issued preferred stocks and bonds, plaintiff's study here is not as satisfactory as that of defendant's. The evidence preponderates in support of defendant's figures of 10.2 percent for 1975 and 11.3 percent for 1976. Applying these rates to the income figures of $88,031,033 for 1975 and $102,684,517 for 1976 results in income values of $863,049,343 and $908,712,540 for the two years, respectively. Using the weightings of 60 percent for income, 30 percent for cost, and 10 percent for stock and debt, plus the allocation factors and other required adjustments, results in assessment values of $347,404,299 for January 1, 1975, and of $348,314,521 for January 1, 1976. Modified and remanded to the tax court for entry of a decree in accordance with this opinion. Costs to neither party.