Real estate investment trusts (REITs) and insurance companies are big buyers of commercial real estate these days, and their advantage in the capital markets is driving up prices. In turn, assessors are using the price data generated from these sales to institutional buyers to produce inflated taxable values for commercial properties owned by less-capitalized investors.
Assessors typically value commercial real estate using a direct capitalization income approach by dividing the property's annual net operating income (NOI) by an overall capitalization rate. The NOI can be based on the trailing 12 months or projected over the next 12 months.
Determining a proper capitalization rate, however, is often more challenging. That's especially true in this economic environment. An overall cap rate reflects the relationship between a single year's net operating income expectancy and the total property price or value.
Crux of the problem
To determine cap rates, assessors usually look to sales of comparable commercial properties. Relatively weak transaction volume since the start of the recession, however, has forced assessors to extrapolate cap rates from the small number of transactions that have occurred.
These sales increasingly involve high-priced properties sold to well-capitalized institutions. Deal volume for assets priced at $25 million or more rose 126% for the first 11 months of 2010 compared with the same period in 2009, says Real Capital Analytics. From this data, assessors will likely derive cap rates that reflect the buying power of well-capitalized buyers and apply those rates to all investment-grade property.
REITs and insurers have access to particularly low-cost capital resources. Their strategy primarily has been to focus on acquisitions of large, core assets in major cities. Low-cost capital enables these investors to achieve greater returns on lower cap rates than average investors.
Insurers also have far lower default and delinquency rates on loans than other lender groups. The 60-day delinquency rate for commercial mortgages originated by life insurance companies was just 0.29% at mid-year 2010, reports the American Council of Life Insurers.
Compare that with loan delinquencies in commercial mortgage-backed securities at greater than 7%, according to credit rating agency Realpoint. Meanwhile, Real Capital Analytics pegs the commercial real estate loan delinquency rate for banks at 4.28%. Low delinquencies mean insurance fund managers are able to focus more on deploying capital and less on working out distressed assets.
Doing the math
Increasing acquisition volume by well-capitalized buyers gives assessors market data to support lower cap rates, as the following hypothetical example illustrates. LRG, a large insurance company, purchases an office building with a $650,000 NOI for $10 million, reflecting a 6.5% cap rate. SML, a small real estate investment firm, seeks to buy a comparable building across the street that also generates NOI of $650,000.
Due to SML's lack of capital and lower credit rating, the firm's debt structure on the deal is approximately 300 basis points higher than that of LRG. SML would need to purchase the property at an 8% cap rate to achieve the same return at 50% loan-to-value.
SML offers to purchase the building for a little more than $8 million. However, because this price is significantly lower than the LRG purchase price across the street, the seller backs out and the transaction never occurs.
Should the assessor use the 6.5% cap rate reflected by the LRG purchase, or adjust the rate to reflect what a more typical investor like SML might offer in the open market? This is the issue confronting assessors and those who represent property owners in ad valorem tax disputes.
Under most states' property tax laws, your assessment should reflect the purchasing power of a typical buyer, not that of an extraordinarily well-capitalized investor. A careful review of how the assessor arrived at both the value and the underlying cap rate is critical to ensure your property is fairly assessed.
Mark Hutcheson is a partner with the Austin, Texas, law firm of Popp, Gray & Hutcheson LLP, the Texas member of American Property Tax Counsel. He can be contacted at [email protected].