Part 33

E. KUICHLING, M. AM. SOC. C. E. (by letter).—This paper is a very valuable addition to the literature of a comparatively new subject that is rapidly attaining great political importance, and it gives abundant evidence of deep research and thought by the author. The reasons for determining the true value of such properties, as well as the general principles of making the valuation or appraisal, have been set forth so clearly and convincingly that little can be added in this respect; hence, there is room for comment only about details.

One of the perplexing questions is the determination of the proper value of the right of way and real estate of a railroad. The land was originally acquired at a certain cost, essentially for public use, and in the course of time its value, as determined by reproduction cost, usually becomes greatly increased by the development of the adjacent land by its various owners. Without the railroad, such development and appreciation of land values would probably not have occurred, and, therefore, it has been argued by many persons that, for taxation purposes, the railroad lands should be appraised at only their original cost, while, for capitalization purposes, they should be appraised at a value measured by that of the adjacent land at the present time. This claim is based on the theory that the railroad is like any other piece of public work, such as a canal, highway, or pavement, which is built for the use of the public, and on which no tax is levied by State or municipality. On the other hand, it has been held by some of our Courts that a proper valuation must take into account the appreciation or depreciation of land values; but, as the opinion of a Court is not unalterable, the soundness of this doctrine cannot be regarded as permanently established.

The author states[41] that there can be no serious objection to this doctrine in relation to rights of way in the country and small towns, although he admits that it is subject to exceptions in the case of cities and terminal and dock properties. It will be of great interest to learn his reasons for making such exceptions in the case of the most costly lands, and whether the valuation of such lands should be more or less than that of similar adjacent lands used for other purposes. From the context the inference may be drawn that the valuation should be somewhat higher than that of adjacent similar land in the case of a steam or interurban railroad, because its holdings form a continuous strip; but to the writer this reasoning does not appear satisfactory. The statement of the Court, that "the value of land depends largely upon the use to which it is put and the character of the improvements upon it," does not necessarily involve a higher valuation of the property than its cost, and it is quite conceivable that the actual value of the property after being taken by a railroad may be much less than it was before. The only reason in such a case for maintaining the purchase price is to conserve the general valuation of the adjacent similar real estate.

In dealing with the subject of depreciation, the author has been very brief, as he did not consider it essential for the purposes of the paper. This is to be regretted, as depreciation is an important feature in every valuation, and so few trustworthy data concerning it are available. The value of the paper would be greatly enhanced if the author would give the assumed average life of the principal components of a railroad, based on some definite traffic, and normal grades and curves. Much diversity of practice in this respect prevails, and the final judgment of the numerous experts who were engaged in the Michigan valuations cannot fail to be of great interest. The same remarks are also applicable to the unit prices adopted for construction and equipment.

The subjects of expenses for organization, engineering, administration, contingencies, and non-physical values are treated very thoroughly by the author, and particularly interesting is his discussion of the complex question of franchise value. After quoting from numerous judicial opinions, he reaches the conclusion that the franchise simply protects the owners of the property in their enjoyment of the earnings, and that its value merges into the "fair value" of the property and becomes inseparable from the other non-physical elements of value; also, that the aggregate non-physical value of the property depends only on the net income for a period of years. This method of estimation certainly has the merit of being simple, rational, and free from all hypothetical considerations. It is, however, obviously governed by the rates charged for the services rendered, and if these are likely to be altered at any time by governmental action, a corresponding alteration in the "fair value" of the property will take place.

This consideration brings us at once to the intricate question of reasonable rates, which involves the matter of reasonable design and construction of the property. In most cases the working capacity of the plant must be much greater than the average annual demand for the service performed, as so-called "peak loads" of relatively short duration must be provided for. The magnitude of these peak loads, however, varies with the subsequent development of the territory, which is necessarily conjectural; hence it follows that a comparatively large amount of capital is often invested in an enterprise for the purpose of taking care of such anticipated temporary demands, and on this investment a "fair return" should be granted. This condition is particularly noticeable in municipal water-works plants, where provision must be made for supplying water for fire service to an extent which may be several times greater than the normal hourly rate of consumption. In the case of railroads, such demands can usually be met by adding to the rolling stock at moderate expense, while in a water-works the outlay is relatively greater because the entire plant must be adapted in the outset to the anticipated maximum delivery in the course of a comparatively long period of time.

The problem of rate-making has been excluded by the author from his present paper on valuation; but, inasmuch as he is so well qualified for the task, and also because the non-physical value of the property depends mainly on the rates obtained for the service rendered, it is hoped that he will deal with this feature in a subsequent paper, thereby bringing out a discussion on the obscure subject of "fair return." It is noticeable that these phrases occur frequently in judicial opinions, but the fundamental principles on which a definite conclusion should be reached are seldom set forth clearly.

RICHARD T. DANA, M. AM. SOC. C. E. (by letter).—The solution of this problem includes practically all the factors in the general subject of economics, in which engineering occupies a large but by no means preponderant part. Mr. Riggs has done some very valuable and pioneer work in contributing this paper at this time; and the writer, in calling attention to what appears to be a radical error in it, does not wish to be taken as attempting to detract in any way from its great value as a whole. It is most important, in the inception of such an investigation, on the part of the members of this Society, to remove from the subject the stumbling blocks as they appear.

The author makes the following statement:

"It is true that the 'value' of a property is an unstable figure, subject to fluctuations due to natural or artificial causes, and that a material change in value may occur suddenly, but the 'value' of any given property on any given date is, or should be, from an engineering standpoint, a definite sum which may not be varied or changed to suit the whim or will of the people for whom the work is done."

The fundamental conception of a value is so important in an investigation of this kind that it is worthy of careful and thorough discussion.

The appraisals which the writer has had occasion to make have generally been for one or other of the following purposes, namely:

(I) Taxation, in the interest of the community or corporation taxed;

(II) Bonding, in the interest of the banker or representative of persons who contemplated lending money on the property;

(III) Rate-making, in order to determine what was a fair amount of money that the property should be allowed to earn for the owners.

Now, in general, a proper value for any property for any one of these purposes is different from its proper value for any of the others. This proposition is of immense significance, for the reason that, if the value for the property arrived at, on one basis, be accepted and applied for one of the other purposes, it will inevitably result in gross injury and financial loss to some one.

In attacking this problem, one must be careful to take the correct standpoint, which is not necessarily that of engineering. Engineering science is indispensable for a large part of the work, but there are other indispensables, which would not ordinarily be recognized as engineering. The writer takes the view that engineering is a part of economics, rather than economics being a part of engineering.

To illustrate this point, consider two objects, one of which is concrete and simple and the other more complex.

(1) A steam shovel belonging to a railroad, costing $10,000, new;

(2) The entire railroad as an operating entity.

Assume for (1) that the shovel has been purchased recently, is in perfect condition, and that the railroad has some work for it to commence on as soon as it can be properly installed. What is its:

(I) Taxable value,

(II) Bonding value, and

(III) Rate-making value?

(I) The tax assessor cannot properly appraise it at $10,000, because it certainly would not sell for that sum, and if the community should have to sell it for taxes the actual return minus the charges would be so much less than the $10,000 that the community's books would show a heavy loss; and this practice, if largely indulged in, would bring the community into financial straits. The community must be exceedingly conservative in its estimate, for this very reason; and, therefore, it has been customary, almost universally, to tax such articles practically on their sale value at what might be called panic prices. The company which sold the shovel to the railroad would not buy it back two days after the sale for more than the original price minus what that company considers its selling charges, say 20%; so that, in this case, even if a customer were at the door, the shovel would not be worth more than $8,000, and a fair tax appraisal could not consistently be more than $8,000 minus charges of, say, $250, or $7,750.

(II) Assuming that the railroad is a very small one, that it wants to borrow money, and desires to put up the shovel as collateral for the loan. What would be its loan value to the lender? In considering this point, it is necessary to assume that no aid is rendered by the credit of the railroad itself, but that the protection for the loan is to be furnished by the shovel only. Now, the banker will reason that, in the event of the note remaining unpaid, he will have to sell the shovel to reimburse the bank for its loan, and he will be required to consider the matter on a conservative basis. He cannot lend on the shovel up to its full value, for in the first place it is not a "negotiable security." If it were a security, with a free market on some stock exchange, he would probably lend to the amount of 80% of its value, but a steam shovel in a sand bank on a railroad is by no means as convenient of exchange, nor as easy to foreclose on as a stock certificate in a banker's box; therefore he will lend, or he ought to lend, less than 80% of its sale value, minus the selling charges. If he lends more than this, he is lending on the credit of the owner of the shovel rather than on the shovel itself. Granted that the maker of the shovel is willing to buy it back at its full selling price less the selling cost, the maximum loan value of the shovel would be a little less than 64% of its purchase price, or $6,400. To lend more than this on the shovel would not be conservative banking.

There is another bonding or loan value to this shovel, when it is considered as part of the assets of the railroad, the bonds of which are to be held by the banker, under which circumstances a higher value than $6,400 would be admissible.

(III) If the value is to be determined with a view of ascertaining what is a reasonable figure that the owner of the shovel ought to be allowed to earn as a public utility organization, the problem is entirely distinct from the foregoing two cases. Assume that the railroad is entitled to earn at least 6% on its investment in the shovel. Now, its investment is $10,000, because that is the money that it cost; and nothing had been credited to its account, since the shovel had just been purchased and had not yet done any work. The shovel cannot be considered as being worth more than its cost, and it can easily be shown it is not worth less for rate-making purposes.

These three illustrations, which are very briefly outlined, should demonstrate the fact that there is almost no relationship between any two of the different kinds of value which are being considered.

Now, from the standpoint of the railroad as a whole:

(I) Should railroad property be taxed on the basis of what the entire railroad would bring on a foreclosure procedure? Obviously not, because the railroad is taxed in sections. The Town of Squedunk will tax the portion of the railroad that lies within that town, and will have considerable difficulty in putting down as security for its own bonds the locomotives and cars which go through once a week or twice a day at 40 miles per hour. To cover partly the flitting assets, it taxes the railroad on a franchise value. It may tax a railroad's land on the same basis that it taxes land owned by private individuals, notwithstanding the fact that when the railroad buys the right of way it generally has to pay more money per acre than the householder or the farmer. This unit cost to the railroad may be two or three times that to the farmer, yet the writer has never heard of a community attempting to tax railroad property two or three times as heavily as adjoining property used for private or commercial purposes.

(II) On the other hand, this same property is an absolutely sound asset for the railroad, and the railroad probably bought the property from the proceeds of the sale of bonds. If the public service commissions were to rule that the railroad may be allowed to issue bonds only to the amount of the taxable value of the property which is to be held as security for the bonds, the result would be an absolute paralysis of railroad construction. A bond is an obligation to pay so much interest for so many years, and to pay back the principal at the end of its term. The bondholder is interested in the absolute regularity of his interest, and in the security that lies behind the principal, and it is to-day the custom of banking houses to consider a bond well secured when, in a territory of reasonably rapid growth, the principal is earning say twice the interest on its bonds, and when the cost of reproduction is in excess of the amount of the bonds, provided that the property is in good physical condition. If it should be necessary to foreclose on the bonds, it is then reasonable to suppose that some one else will buy it in for at least the amount of its bonded indebtedness. What can this possibly have to do with the taxable value of the track in the Town of Squedunk? One may be 1.5 times the other, or three times the other, depending on a multitude of circumstances.

(III) The value of the property for rate-making is a complex one to determine, and, of course, there is no opportunity for a full discussion of it here. One point, however, will serve to establish thoroughly the difference between this and taxable or bonding value. If the community is prosperous and the business is a good one and honestly managed, the railroad ought to be allowed to earn a reasonable percentage, say, at least 6%, on what has been put into it. If the community should decree otherwise, then people will not build railroads for investment purposes, and all will lose money. Now, it is a well-known fact that a new railroad's earnings have to grow for several years before they are on a normal basis, and part of what the owners of the property have put into it is, for example, the interest on its cost before its earnings are on a normal basis. This may amount to a considerable percentage of the original construction cost of the property, if the business is several years in developing. Granted that the community ought to allow the property to earn a reasonable interest on what has been put into it, then the rate-making value will be very much larger than the sum of the taxable valuation of all its different parts. It will also be much greater than its bonding value, because, as a bond proposition, it can borrow money up to a limited percentage of what it is actually worth.

GEORGE T. HAMMOND, M. AM. SOC. C. E. (by letter).—The engineer called on to fix the valuation of public service corporation property has so little engineering literature on this special subject to guide him that he must feel grateful to the author of this excellent paper for adding so much of a kind that is very desirable.

Estimating the cost of an engineering structure in advance of its construction is one of the most ordinary professional duties, but how difficult it actually is, and how much engineers differ with one another in their estimates on the same structure! Perhaps there is no professional duty which calls for so much study and so much experience, or which tests so closely the ability and capacity of the engineer. How seldom professional estimators agree with each other; or designing engineers with contracting engineers; as witness the bids received at the public lettings of contracts when compared with the engineers' estimates of cost; and, if this is true, which no one will attempt to deny, how much more so is it probable that estimators will disagree when they attempt to place a value on works already completed, and in service, perhaps, for many years, in which various changes in value have occurred, and in which questions of fact are mixed with legal questions involving legal rights, as well as financial questions.

The tendency in all such valuations appears to be a mixing up of things in general—like the witches' stew. Everything goes into the pot and is boiled together until all becomes soup, at least until the official commission, like the witches, considers it done and ready to be served up in the form of a report. It is then observed that the substance served out is of a complex nature; that the valuation of engineering structures has become mixed with other and uncertain values; that the whole value, as stated, is, after all, little better than the commission's opinion of the value; and that another commission would reach a different conclusion.

The author states that the valuation of corporation property:

"Should be the honest judgment of the men composing the commission, as to the actual cost of reproduction, present physical value, or 'fair value,' and should be ascertained by a systematic and scientific method which takes into account all the facts concerning the property, its physical value, its strategic location, its operating revenues and expenses, and its franchises, rights, competition, opposition, and all other tangible or intangible elements, which would affect values. The method of valuation should be such as to minimize or entirely eliminate all differences due to errors of personal judgment."

This, it seems, complicates actual present values with conditions which might, or might not, continue. Outside of the physical valuation of the plant, which offers the easiest problem presented, how can one fairly put a value on operating expenses and revenues, which might be affected favorably or advisedly by good or bad management, and by numerous other complex and almost incomprehensible circumstances.

The tendency of all such commissions seems to be to confuse together and mix up some things which are logically separate. Thus, the value of the plant and franchise, good will, and present investment or income value, etc., are too often taken together. The value of the plant is dependent on the cost of reproduction, and also the depreciation of the structures, as engineering structures, and should be based on present prices for which the work could be replaced, minus the depreciation, which is a question of engineering judgment and experience. The other items of value are largely dependent on the situation of the plant and its prospects as an income-producing property, and this again is a matter of opinion, in which the opinions of financiers and investors are sometimes of more moment than those of engineers. The opinion of lawyers as to the value of the franchises and the cost of the legal complications possible or probable must also enter into any seriously worthy opinion as to value.

The few salient lights in the picture of valuation, presented by the author, serve especially to reveal the darkness which involves the whole subject of valuation, estimating, and the use of cost data for such purposes, and to suggest that, with all the wonderful progress on the theoretical side of the profession, engineers have as yet advanced but little in this division of the practical side—cost data, valuation, and estimating. Engineers cannot compare the results of different estimators and appraisers without sorrow and even shame for their ignorance, or their incapacity to agree in the application of scientific principles and the results of practical experience to this branch of their work.

At present we would seem to be a long way from a method of valuation, "such as to minimize or entirely eliminate all differences due to errors of personal judgment."