Appraisers offer advice for minimizing commercial property tax bills.
If there is one message that appraisers try to convey to property owners it is that owners should be scrutinizing the assessed value of every property, every year.
Property taxes represent a substantial expense for owners and tenants. The U.S. real estate industry generates $293 billion in federal, state and local taxes each year, according to BOMA International. "The third largest cost item for business is property tax," says David Canary, an attorney specializing in state and local tax litigation at the law firm of Garvey Schubert & Barer in Portland, Ore. So when the bottom line gets squeezed, oftentimes companies look for ways to reduce that tax bill, Canary says.
Some states have very favorable property tax structures. "But by and large, property taxes have become so significant that they impact every aspect of the business," says Ray Head, director of property tax services at Deloitte & Touche in Austin, Texas.
Property taxes can impact development by escalating holding costs of acquired land. Leasing, marketing and even tenant relations can be significantly impacted by property taxes. "It affects net operating incomes of properties, and ultimately the value of commercial and investment real estate," Head says.
As a result, properties should be examined each year to determine if a property has been over-assessed, and if that over-assessment can be effectively challenged. Most owners are proactive in examining their property assessments on an annual basis, but not all are willing to take it a step further and file an appeal. A REIT, for example, may compare the property tax assessment to its internal value on a piece of property. If the assessed value is less, the REIT doesn't appeal. "It is more prudent to look at the assessed value of a property every year to see if any over-assessment factors may be in place," Head says.
Assessing authorities are known to make mistakes - for better or worse. Houston County in Texas, for example, has about 1.4 million separately identified real estate parcels that the county is charged to appraise. "Just the nature of mass appraisal would tell you that there is no way that assessors can look at 1.4 million pieces of property each year," Head says. Assessors' methodologies may involve applying norms and generalities to individual properties. "So it is our job when we appeal a piece of property to bring in the specifics," he says.
Lack of standardization One indisputable fact of property taxation is that the U.S. system is not consistent. No two state property tax systems, procedures or valuation methods are the same. Differences emerge within states from county to county and even city to city. The lack of standardization makes it more difficult for property owners to develop a uniform strategy for ensuring that property tax liability is minimized each year.
"Property tax is the only tax we pay that is so subjective in nature," says Wayne Tenenbaum, a property tax attorney with Neill, Terrill & Embree LLC in Overland Park, Kan. "It's a constant battle to balance the interests of the property owner and the taxing authorities," he says.
A variety of state and national industry associations are working for more equitable commercial tax scenarios. "Our tax issues tend to center around depreciation," says Thomas Bisacquino, president of the National Association of Industrial and Office Properties (NAIOP) in Washington, D.C. NAIOP is lobbying for changes to tax law relative to depreciation for tenant improvements.
Current tax law treats tenant improvements based on a 39-year depreciation schedule. However, most leases are five to seven years, or even shorter. "So what happens is that the improvement gets torn out and redone for a new tenant, but the owner still has to depreciate the original improvement over that 39-year schedule," Bisacquino says. NAIOP is working to reduce tenant improvement depreciation to a 10-year schedule.
Another issue targeted by NAIOP is Internet sales tax. Specifically, the organization argues that the so-called zero Internet sales tax has a negative impact on property taxes. "Lost sales tax revenue has to be made up by the states," Bisacquino says. "We feel strongly that states will look at property taxes to do that." The moratorium on taxing Internet sales extends through 2002. Meanwhile, NAIOP plans to continue to debate the Internet sales tax issue. "It's an issue that the industry is clearly coalescing behind," Bisacquino says.
Do your own analysis The best course for minimizing property tax liability is evaluating each property on a case-by-case basis. Owners can check several factors to determine if a property has been over-assessed.
One method is to determine whether a property has an equitable valuation compared with competing properties. "Not all states allow an equity argument, but many do," Head says. For example, if a flex industrial building is valued at $80 per sq. ft., and a similar building across the street is valued at $70 per sq. ft., there is a good argument that the property has not been assessed equitably compared with the competition.
"The major step we advise clients to take is to prepare an analysis of the tax burdens of comparable properties in the subject's market," agrees Donald Blake Jr., an executive vice president at Joseph J. Blake and Associates, New York. "The selection of the right comparables can often provide sufficient market evidence supporting a tax reduction."
Another option is to examine property value using a fee-simple basis. Plug in values for normal vacancies, expenses and income or lease rate to come up with a value. For example, 95% occupancy might be considered a more typical occupancy rate rather than the current 100%. "You probably want to do both a leased-fee income approach and a fee-simple income approach and compare the values derived from those approaches to the assessed value," Head says.
A third check is to examine sales of like-kind properties. "If sales per square foot are being reported at values less than your indicated value, then you may have an appeal opportunity based on the sales comparison approach," Head says.
A fourth check is to examine the accuracy of the appraisal criteria. It is not uncommon for assessors to make errors in the physical descriptions of properties. For example, Head worked on a property tax appeal for a 200,000 sq. ft. industrial building. The assessor had incorrectly recorded the building size as 240,000 sq. ft. The taxing authority had valued the property at $90 per sq. ft. So just by removing the extra 40,000 sq. ft., the property value was reduced by $3.6 million.
Another common mistake occurs when a property has been classified incorrectly. For example, a Class-B flex building may be elevated to Class-A status by an appraiser. Depending on the assessor's cost schedules, a change in classification can translate into significant savings. A Class-A flex property might be valued at $90 per sq. ft. compared with a Class-B rating of $78 per sq. ft.
Emerging arguments Appraisers are finding a variety of new issues and arguments to add strength to appeals cases. One trend that has emerged on the East Coast focuses on decreasing appraised values on properties with environmental contamination. Property owners have been successful in securing reduced property values as a result of the recognition that contaminated property has economic implications related to the cost of cleanup. "Since property tax is based on market value, we are finding that contaminated properties have suffered substantial decreases in values," Canary says.
The liability for cleaning up contamination also lowers the value of a property. Initially, the courts ruled that they didn't want to reward property owners by giving them tax breaks. But ultimately the courts have recognized the correlation between market value and appraised value for property tax purposes, Canary says. Whether or not that market value rewards a polluter is not a factor, he adds.
Oregon is one state that has an administrative rule dictating that the present or future costs of clean up must be taken into account when assessing property values for property tax purposes, Canary says. Oregon, which has had the rule on its books since the early 1990s, is one of the few states to have a formal statute in place addressing contamination issues. "Now states such as New Jersey and Michigan have adopted similar rulings," he adds.
Residential vs. commercial rates One of the biggest issues surrounding multifamily properties in many states is their classification, which dictates whether they are assessed a commercial vs. a residential tax rate. "That is a top concern with regard to apartments," says Keith Kramer, president of Keith M. Kramer Associates Inc. in St. Louis. "Some parts of the country view apartments as commercial property, and they are assessed at a higher rate," Kramer says.
Missouri apartment owners successfully lobbied the state Legislature in 1995 to lower the assessed rate. Apartment properties made the transition from being assessed as commercial properties at a rate of 33% to being assessed as residential properties at a rate of 19% of market value. The goal was to provide apartment residents with the same tax consideration as single-family homeowners. "Ultimately, it is the renter that is paying a hefty portion of the tax burden," Kramer says.
Despite property tax reforms, appealing property tax assessments continues to be an issue for owners. "In all fairness, here in Missouri, I think our apartment properties are assessed fairly," Kramer says. However, disputes still arise when assessors apply mass appraisal techniques without taking into consideration a property's unique characteristics or circumstances, he adds.
Kramer represented the owners of a 154-unit apartment building in St. Louis County in the appeal of a 1997 property tax valuation. One unique component of the project that was not identified by the tax assessor is that rent for 36 of the units included all utilities. The remainder of the units did not include utilities in the rent. The assessor's office developed an appraised value based on the premise that none of the units included utilities.
"That was a significant expense that the assessors neglected to take into consideration," Kramer says. The difference in appraisal between the St. Louis County assessment and Kramer's assessment was about $350,000 - due largely to the discrepancy in utility charges. In most cases, once assessors are apprised of an inequity or oversight, they are willing to adjust the appraised value accordingly, he adds.
Functional obsolescence Industrial property owners are fighting property tax appraisals with issues pertaining to functional obsolescence. Functional obsolescence relates to internal factors that have made a property functionally less desirable to own. Rapidly changing technology, for example, can curb the efficiency of processes, equipment, layout and design of a facility. "The problem is that assessors don't keep up with how quickly manufacturing processes become obsolete," Canary says.
Due to the magnitude of properties that need to be assessed each year, property tax assessors often use mass appraisal to determine valuation. In such a mass appraisal, an assessor might take the original cost of a building and apply it to the current building. For example, a property that cost $20 million to build in 1980 would be inflated to 2000 prices. What that assessment doesn't take into account is the actual life of a facility where value may actually decline much more rapidly, Canary notes.
Garvey, Schubert & Barer represented an Oregon tile manufacturing plant in appealing its assessed values for the 1996, 1997 and 1998 tax years. The argument was based largely on decline in value due to functional obsolescence of the facility.
Constructed in the 1920s, the building wasn't large enough to accommodate new manufacturing processes. So instead of a straight assembly line, the assembly line was a serpentine shape with more opportunities for breakdowns in the line, Canary says. "You certainly have some functional obsolescence that can be measured by excess operating costs," Canary says.
Garvey, Schubert & Barer was successful in getting the assessed value lowered for the ceiling tile manufacturer. The assessed value in 1996 of $38.8 million was lowered to $29.5 million. The 1997 assessed value of $37.2 million was lowered to $28.5 million, and the 1998 value of $37.2 million was lowered to $30.8 million. The total tax refunds awarded to the manufacturer for the three years totaled $370,000.
Renovation pressures Investors have long recognized that hotel properties that have gone several years without a major renovation are less competitive and possess a lower value. Now appraisers are beginning to accept the fact that lack of renovation can affect values. "In some cases, we have been successful in proving that a value is lower than what an assessment shows due to the need for renovation," says John Ellis, president of the SouthernChapter of the Appraisal Institute, and managing director of the Los Angeles office of Integra Realty Resources Inc.
Ellis recently worked on a tax appeal for a 1,500-room convention center hotel in Southern California for taxes paid in 1996 through 1999. One of the major arguments for reducing the assessed value in 1996 and 1997 was the need for renovations. Integra was successful in getting the $180 million appraised value reduced by $40 million in 1996 and $30 million in 1997. About half of that reduction can be attributed directly to the need for renovations, Ellis notes. The property had not received any major renovation work since it was built in 1984. However, a renovation project did begin in 1997.
A second argument that was used to reduce the hotel's value upon appeal was based on the taxing authority's selection of a capitalization rate to calculate value. "Assessors tend to look at cap rates that are in line with other commercial properties," Ellis says. However, the hotel market is unique due to risks tied directly to business cycles rather than real estate cycles. For example, when the economy dips, there is a decline in day-to-day occupancies. Other properties such as office and industrial properties are insulated from similar dips through long-term leases.
So risks that are present in the hotel industry are not in play for other commercial properties, Ellis says. The tax assessor had used a cap rate of 9.0% to calculate the value of the convention center hotel, while Integra placed the cap rate at 10.5%. The tax assessor used a cap rate that was in line with other investment-grade properties rather than other major hotels. Integra researched cap rates on similar sales in Southern California and around the country to come up with the 10.5% rate.
Accessing research Ellis had tapped into the Integra Realty Resources network to come up with an appropriate cap rate for the convention center hotel. Integra has more than 40 offices around the country, and the group has a practice of sharing www.costargroup.com to locate data on comparable properties.to help other members. Such research is a key element in developing accurate appraisals. Groups such as Integra track sales through their own databases, while appraisers also can tap third-party resources such as the Costar COMPS[R] database at
The Appraisal Institute also is in the process of launching its own commercial database. The Appraisal Institute has selected PropertyFirst.com to develop and host an online database of appraiser-verified commercial real estate sales, lease and expense information. The database will be available to all commercial real estate investment, finance and leasing professionals via the Internet. The database is set to launch in the first quarter of 2001.
"This commercial database is unique in that it will have appraiser-verified data," says Donald E. Kelly, vice president for public affairs at the Appraisal Institute in Washington, D.C. Essentially, an independent third party will have done the research and verified the information regarding the transaction. In addition to providing quality information, the database is expected to cover a broad scope of different properties due to input from the Appraisal Institute's 18,000 members around the country. Appraisers, as well as other real estate professionals such as institutional investors and lenders, will benefit from the readily available source of data, Kelly adds.
Changing landscape One challenge for appraisers is dealing with emerging issues ranging from new technologies and new appraisal theories to new property types. Industrial facilities, for example, are being converted to telecommunications hotels - a property classification that did not exist three years ago.
Firms such as New York-based Cushman & Wakefield Inc. are meeting these challenges with increased specialization, and by allocating experts to work on specific property types. "Specialization is something that is clearly continuing," says Frank P. Liantonio, an executive managing director and co-manager of the valuation practice at Cushman & Wakefield. The company assembled a core group of professionals who can follow trends in the telecommunication hotels sector in all aspects, ranging from appraisal to financing. "We're positioning ourselves as experts in that property type," Liantonio says.
Another question that has been raised concerns the impact building technology has on establishing property value. "We have been approached by a client in the fiber business who wants to think through the issue of how you could quantify the value of having fiber distributed through a building," Liantonio says.
These days it is important to have access to bandwidth and fiber. "Those buildings that have access will be competitive, and those that don't won't be competitive," he says. In most cases, technology access is being quantified by the higher rents a wired building warrants, he adds.
Ultimately, appraisers are kept on their toes evaluating the emerging issues affecting property tax valuations. Appraisers constantly weigh factors that relate to property-specific and market criteria ranging from comps to employment growth. "I think the appraisal process is always recognizing internal and external factors that are influencing value," Liantonio says.