Part 19

It is contended by the writer:

That the Physical Value, or present value of the physical property, should fairly represent the actual capital invested in the property at the date of appraisal; that it should be made up of the sum of the various elements which constitute the cost of reproducing the property together with any appreciation which may have been added to any of them, less all depreciation.

That the Non-Physical Value is the difference between the "fair value" as defined by the Courts, or the reasonable value of the property as a business or producing property, and the physical value, or actual present worth; and that the only proper method for determining such values involves a study of income accounts.

This Non-Physical Value may be: positive, or a value in excess of the physical property, or negative, or less than the physical value. In the case of a property having a negative intangible value, a deduction should be made from the physical value.

It is further contended that, in making the physical appraisal, the purpose of the appraisal should not be permitted to modify the figures. The resultant figure should be the same, whether it is to be used as a basis for assessment, rate-making, or limitation of capitalization. It should be an engineering estimate of the amount of _bona fide_ capital still remaining in the property, or of the complete cost of reproduction under existing conditions, less depreciation. This figure is definite, within reasonable limits, and it cannot be conceded that it is permissible to vary it, submitting one result as a physical value for taxation, and another and different result as a present physical valuation for rate-making.

There may be some question as to the propriety of using non-physical values for certain ultimate ends; in fact, the Supreme Court, in the Omaha and Knoxville water cases, clearly indicates that they must not be used for certain purposes; but, in any case, to furnish information, this element of value should be determined, and, as in the case of physical values, it should be an unchangeable figure[18] and should represent the difference between the worth of the actual physical property and the final business value of the property considered as an earning proposition.

It is not necessary to go minutely into detail as to the various steps to be taken in making the appraisal of physical property. Each appraisal will offer some problems peculiar to itself, and no general set of rules can be laid down which will be applicable to all cases. It is deemed sufficient to call attention to general matters of major importance and to refer to some points which have not been mentioned in the preceding narrative, omitting argument in the case of such as have there been fully discussed.

The distinction should be kept in mind that any element of value which belongs to the property by reason of its physical existence is classed as an element of physical value. The property is considered as an operating property in the sense that it is reproduced complete, ready to operate; and any expense, or any element of value needed to complete it, is an element of the physical value, but any value arising as a result of surplus earning power, any good-will value, going-concern value, or value due to established business, strategic location, favorable traffic arrangements, etc., should be considered as intangible values.

The valuation of physical property is naturally divided into four parts:

I. —The preliminary study,

II. —The field inspection,

III. —The computation,

IV. —The preparation of the final figure.

I.—The Preliminary Study.

The preliminary steps should include a general examination of the property, a study of its corporate history, an examination of its records, maps and profiles, and the preparation of an inventory of its property.

The work in Wisconsin and Minnesota was done in co-operation with the railroad companies, who prepared (generally, but not in every case) their own inventories on forms adopted by the appraiser. In Michigan, all this information was secured by the appraiser. There can certainly be no valid objection to the use of information compiled by the companies, whose familiarity with their own records and property would enable them to supply lists which under all ordinary conditions would be more complete and up-to-date than if made up by men having no special knowledge of the property.

The chief difficulty encountered in making an inventory from recorded data lies in the fact that very few sets of records are corrected to date, and many additions and erasures will of necessity have to be made in the field.

In making a field inspection, it is of great assistance to be able to refer to maps of large yards, to profiles, to standard plans, and to drawings of the principal structures, so that the investigation of office records should include a careful examination of the maps of principal terminals, with a view to securing such as will simplify the field inspection. The investigation should be extended to cover a study, not only of the engineering office data, but also statistical data to be derived from the records of the auditor, superintendent, and superintendent of motive power, and should cover earnings, operating expenses, car and locomotive mileage, and such other data as will facilitate the distribution of such elements of value as are not localized, together with such other statistics as will furnish a thorough knowledge of the property and its operations.

It has been claimed by the appraiser in Washington—and the view is also held by the Commissioner of Railroads in Nebraska—that original cost is essential, in view of the Supreme Court's decision, particularly in Smyth _vs._ Ames. The writer cannot accept the correctness of this position. It would appear that the language of the Court should be construed to mean that original cost, where ascertainable, is a proper matter to take into account, along with many other things; but it can hardly be considered mandatory.

In the case of a property only recently built, in which the records are complete and the engineering and construction files are available, it may not be specially difficult to determine cost, but in the case of any of the large railway systems of the United States, which are made up of the consolidation of many different roads, some of them built many years ago, some of them having gone through many changes of management, reorganization, and earlier consolidation, it is practically impossible to secure either the old financial books or the old construction records, and without these complete records it would appear to be an utter impossibility to secure the primary cost. Primary cost is but the first step. The work of building up, by securing the amount of additions and betterments that have been made from year to year, is one of appalling magnitude and of utter uncertainty and conjecture. Keeping in mind that, prior to July 1st, 1907, the railroad companies of the country did not have a system of uniform accounting, and that additions to property were charged to operating expenses to the extent of hundreds of millions of dollars; that policies were different on different roads, and under different managements of the same road, and that the accounting methods were determined by the policy of the road or management; and the further fact that the distribution of ordinary railroad accounts may be extremely reliable on one road and abounding with errors on another; it will be seen that any attempt to depend on the auditor's office for anything approximating a complete statement of cost would lead into a maze of figures which would be confusing, unreliable, and incapable of proof.

Therefore, it is the writer's conclusion that, beyond such figures on recent construction, or records of cost of such special structures as are matters of particular record, it is not advisable to attempt to secure complete data as to the cost to date of a railroad. In the Michigan appraisal, original cost was secured in the case of many structures, notably the Port Huron Tunnel, and it is by no means argued that original cost should not be considered, or investigated, but it is held that such an undertaking as to secure, from the financial books of the company, an accurate or reliable statement of construction cost, plus additions and betterments, less property destroyed, of the Michigan Central Railroad, for example, would be absolutely an impossibility, particularly if the work was to be undertaken, as in the Washington appraisal, by men who were utter strangers to the property. The admission of the appraiser of Washington, that, except for a few gaps, the information was complete, is fatal, as the gaps must needs be filled by estimates, and it would appear to be better to depend on estimated figures throughout than to use what purported to be actual costs on part and estimates on the remainder.

If original cost is essential, it is hard to get away from accepting the book values of the companies, as these, objectionable as they may be, from the viewpoint of the public, are just as apt to be as near the actual truth as any statement made up by strangers from an examination of old records covering many years of operation.

II.—The Field Inspection.

The field inspection, to be of the greatest value, should be made by civil or mechanical engineers of long experience, preferably by men who have had charge of their respective departments on railroads of considerable extent, or of properties similar to that under investigation. The writer is of the opinion that in this particular phase of the work, the practice adopted in the Michigan appraisal was considerably in advance of more recent valuations. Each particular structure or piece of equipment should be examined and its condition noted; special features should be fully described and careful record made of everything that would tend to affect the value. The argument has been often made that the fixing of a percentage of depreciation by a man in the field is purely arbitrary and amounts to nothing but a guess. In the computing office it is often necessary to check the field figure of depreciation by the use of tables of fixed annual depreciation, but it must be borne in mind that mortality tables of any form are based on a system of averages. The actual depreciation on rail, for instance, varies greatly; the conditions of traffic, curvature, gradient, rolling stock, and various local conditions tend to shorten or lengthen the life, so that the personal opinion of an experienced man on the ground is likely to be much more nearly correct than the arbitrary application of a rule of averages.

The writer has inspected station buildings more than 50 years old, and their condition and adaptability for the service required of them would give them a very high percentage; he is also familiar with buildings less than 10 years old, which, by reason of changed traffic conditions and consequent shifting of business, have become obsolete and have been permitted to depreciate so rapidly that any table average would give too high a result.

In the case of a water-works inspection, so much of the value is included in the system of distribution mains, a form of property which is inaccessible, that much more dependence must be placed on a figure based on age; but there, also, as full investigation as possible should be made, in order to determine to what extent tuberculation or electrolysis has affected the pipes.

A general inspection (made in Minnesota by the appraiser with two assistants) would appear to be an excellent thing as a review of the whole work, but whether such an inspection would be sufficiently thorough to base thereon a set of final values, would appear to be doubtful.

The inspection in the field, in addition to the placing of a percentage for depreciation, should involve a complete check of the inventory, a correction of all errors, due to the construction of new property or the destruction or removal of old, and a compilation of all information required for a complete, correct, and intelligent appraisal of the physical property by the computing office. Every appraisal is different, and every property offers new problems and diverse conditions. These must be met, and therefore the field inspector must call particular attention to all matters specially affecting the values of the property he is inspecting.

It is impossible to anticipate all these conditions in advance, although the use of carefully prepared blanks and the standardizing of the form in which the data are gathered greatly simplify the work, not only in the office, but in the field.

III. The Computation.

On the completion of the field work, with all the preliminary data in the office, the computation must proceed, and with this part of the work there are many questions which must be taken up, considered, and definitely answered.

The classification and arrangement of the information as to the property to be valued, the costs and prices of the various materials entering into construction, the making and checking of such tables as may be required for estimating, the computing, checking, filing, indexing, and the various other routine details of work need not be referred to specially, as they must be worked out for each appraisal. The matters of principle that will be met are more important, and, while it would be impossible to mention all that may come up, it may not be amiss to refer to a few.

(_a_) In making an appraisal of several properties, to what extent shall these properties be grouped or classified?

(_b_) What unit prices shall be assigned in the estimates of cost of reproduction, and how shall they be determined?

(_c_) How shall right-of-way and real estate values be ascertained? Shall such elements as appreciation, or any increments due to the purpose for which the land is used, be treated as physical or non-physical values?

(_d_) What method shall be finally adopted in determining depreciation? What elements shall depreciation be made to cover?

(_e_) What elements of cost or appreciation shall be treated as parts of the physical property although not capable of inventory, and what shall be treated as non-physical?

(_f_) Is an allowance for contingencies a proper item to include in an appraisal?

(_g_) What weight shall be given the matters of adaptability, proper or improper design, and the economics of location?

(_h_) How shall the values of such property as locomotives, cars, etc., be geographically assigned?

(_i_) What is the effect upon values of large terminals?

(_j_) Should an allowance be made by reason of rapid development of the art?

These are not by any means all the perplexing questions that arise; each valuation offers some that are special, but these cover the more important points.

(_a_) _Classification of Properties._—In making an appraisal involving the properties of a large number of companies, such for instance as any of the State railroad appraisals, it becomes evident that there are certain properties which are small, badly run down, and either built to serve a very limited trade or located in a territory which has not developed, and that such properties cannot be compared equitably with the large trunk-line roads, or even with smaller roads in a good territory and doing a good business. Several such properties exist in Michigan in a district which was originally a lumber-producing country, and at the time they were built local conditions were such that prices of timber and labor were far below any cost that it would be reasonable to assume to-day. Whether taxation or rate-making be the ultimate end of the work, it is certain that these carriers are entitled to some classification which will separate them from the more prosperous roads. Many of these roads would not be built to-day under any circumstances, yet their maintenance and continued operation is absolutely essential to the people of the district served by them.

Whether this classification should be undertaken at the time of making the appraisal of physical property, and an attempt be made to classify unit prices, or whether this should be taken up in connection with the intangible values, and solved, as far as the valuation is concerned, by the adoption of such a method as will affect these physical values by a subtractive or negative non-physical value, or whether the entire matter should be left for the subsequent work of rate-making or assessment, is one which must be determined at the outset of the physical valuation. It may not be left without determination, as the question will be raised in all probability in the form of an attack on the valuation, if it is not considered and a conclusion reached.

It is the writer's opinion that the application of an intangible subtractive value is the proper solution, except in the case of roads which would not to-day be rebuilt. In fixing a uniform price for identically the same labor or material, whether on a small poverty-stricken road or a main trunk line, no serious injustice is done, provided the price fixed is one which, from a strictly engineering standpoint, is a reasonable figure for cost of reproduction. The differences in class are due, not to special differences in cost of physical property, but rather to differences in earning ability on account of good or poor territory served, efficient or inefficient management, or other reasons not connected with the physical structure; hence such differences are reflected in the earnings, and are clearly elements to be adjusted in the non-physical valuation.

(_b_) _Unit Values._—The general reliability of the appraisal rests very largely on the reasonableness and fairness of the various prices which are applied to the different parts of the property in making the estimate of cost of reproduction. These unit prices should be determined before any actual figures are made. They should be made up from the most complete data available, and, before being tabulated, should be carefully reviewed by all the experienced men engaged on the appraisal, in order that no figure which is either too high or too low may be used.

As a basis, the average of either 5 or 10 years should be used in preference to current prices on all such material and equipment as is fairly stable. Rail, and all forms of rail structures, machinery, locomotives, cars, etc., can be reduced to such a unit that averages can be secured which will eliminate the error due to a period of extreme high or low prices.

In the case of such materials as lumber and ties, the price of which has been steadily rising, due to the growing scarcity of the material, a price based upon a long average is unfair to the corporation, and it would appear to be proper to use current prices. There can be no hard-and-fast rule which will be applicable to all appraisals. The unit prices must be such reasonable figures as can be sustained in Court. Their adoption should not be final until every possible test of their accuracy and reasonableness has been made. When they have been adopted, and such modification made as may be fair for certain territory, on account of local conditions, transportation facilities, or other consideration which may affect them, the adopted figures should be applied to all property alike. The use of different unit figures for different roads in the same territory is highly undesirable, and should be avoided.

(_c_) _Right of Way and Real Estate._—The valuation work which has been accomplished during the past decade, and the study of values for taxation and rate-making, have brought into prominence the perplexing features of land values as applied to corporation property. It is comparatively simple to fix within very close limits the reproduction cost of tracks, bridges, locomotives, or any of the other elements of physical structure. Not so with the land. A few years' development may change farm land right of way into city right of way, surrounded by factories, or it may change desirable residential property adjacent to a road into slums.

In view of the clear language of the Court in 82 Fed., 839, and 157 Fed., 849, it is evident that any valuation which does not take into account the appreciation or depreciation of land values cannot be sustained. There can be no serious objection to the doctrine that the property of a corporation generally increases or decreases in value in the same proportion as adjacent property, and it must therefore be admitted that a value based on the sale value of adjacent lands is a reasonable one and must stand. This reasoning, of course, will be subject to exceptions, in the case of terminal properties, docks and water-front properties, and right of way in large cities, but it is believed to be sound when applied to right of way in the country and in small towns and cities.

The next question to be determined is whether the increment of value due to the use of the land is a proper one. It would appear that in the use of land for water-works, gas-works, street-car barns, or other isolated tracts of land used for corporation purposes, this increment would be much less than in the case of a steam or interurban railroad, the holdings of which form a continuous and unbroken strip; and, in the case of street railroads, water-works, and like properties, it would be indeed difficult to compute and afterward sustain any considerable increment.

In the case of railway properties, however, it is quite evident that the following facts can be sustained: The actual cost of property purchased for railway purposes will range from two and one-half to five times the selling price of similar and adjacent property used for other purposes. While the actual percentage will vary somewhat, as between land in cities and in the country, and as between fully settled districts well served by roads and sparsely populated regions, yet the difference is very marked, and is capable of determination by an examination of the public records.

This difference can be determined either by a comparison of railway purchases and other transfers, as was done in the later studies in Michigan and in Wisconsin, or by extending the investigation to include assessed valuations, and using the averages, as was done in the work of Mr. Morgan in Minnesota.

In establishing figures for use in a valuation, it would appear to be better to base them on an analysis of actual transfers than to undertake to fix values by any methods of examination and personal appraisal. Enough instances of the wide divergence of expert opinion have been cited to show conclusively that such a method, applied to the thousands of acres of a large corporation, may lead to serious error.

A single attorney or real estate man who has had experience in abstracting and conveyancing, and who has bought some right of way, can examine the records of an average county the largest city in which has a population of 20,000 or less, abstract all railway transfers for 5 years, locate them on the maps, secure data as to actual selling prices of near-by lands, and, in a comparatively short time, be in position to furnish figures which will establish the relation between sales for railway and other purposes in that county. The work that half a dozen such men could do in 90 days would go very far toward establishing with a fair degree of definiteness the value of the railway purpose increment for the majority of counties in any average State. Of course, such an investigation in the large cities is a matter of much greater labor, and would require sufficient time to make complete examinations, probably necessitating a special force for such city work.

On every appraisal, the question has been asked, should this railway purpose increment be added to the value of the property? Clearly, yes.