To be competitive in today's market, owners must aggressively challenge property tax valuations on their centers. To do so effectively, they must be able to cogently explain how tenant improvements, leasing commissions and non-reserve capital expenditures impact rental rates and occupancy, and why cap rates won't come close to producing accurate valuations. Without this ability, lower property tax values won't be realized.
The following points should be taken into consideration.
A major incentive to a leasing decision is the amount of tenant improvement (TI) offered to the tenant. The quality of tenants and the character of the lease are affected by the amount of tenant improvements offered.
Depending on the market, tenant improvements may be amortized as part of the rental rate (resulting in above-market rent) or they are simply absorbed by the owner (likely resulting in below-market cash to the owner).
Consider three identical retail properties of 100,000 square feet, where the market rent is $10 a square foot, required TI are $2 a square foot, and there are no other expenses. If the tax authority used the actual rents, and applied a 10 percent capitalization rate the taxable value would be. See table on page 61.):
Property No. 1:$12 million
Property No. 2:$10 million
Property No. 3:$8 million
The tenant improvement was amortized in the rent of Property No. 1, creating a higher-than-market rent. Since the tax authority does not recognize the impact of tenant improvements on the rental rate, Property No. 1 is valued 20 percent higher than market value, as indicated by Property No. 2.
Property No. 3 would be valued at 20 percent below “market” due solely to a business decision of the property owner. Of course, Property No. 3 is likely to suffer from extended vacancy, since most retail tenants demand some owner-provided TI.
Similarly, properties pay tenant representatives leasing commissions. Here, too, tax authorities fail to recognize that these are actual payments of a percentage of the total lease amount. Thus, within every rental payment, there exists an expense deduction, representing the payment to the leasing agent, which was incurred at lease signing.
Leasing commissions are clearly required to maintain limited vacancy at a property. It is imperative that the tax authorities consider the effect of leasing commissions when they do their income analysis. If a property paid zero leasing commissions while a competing property has paid leasing commissions at prevailing market rates, the difference in cash flow can be significant.
Non-Reserve Capital Expenditures
Tax authorities likewise often refuse to make deductions for either reserves or for reserve expenditures above routine maintenance.
Numbers of expenditures fall in the area between routine maintenance and pure capital expenditures such as roofs and HVAC. These expenditures enhance leasing marketability and the desirability of the property. They are akin to qualitative enhancements to the physical characteristics of the property.
How Assessors Approach Valuations
By law, tax authorities in most states value property based on a fee-simple appraisal rather than a leased-fee appraisal. A fee-simple valuation requires a property to be valued using market conditions, including application of market rent and market occupancy. The leased-fee valuation is based on the property's sale price or net operating income (NOI).
While the law in most states dictates fee-simple valuation, in practice tax authorities often use the actual operating statement and/or actual sales, which, of course, are leased-fee rather than fee-simple considerations. The impact of this practice by tax assessors' creates different valuations between otherwise identical properties. This happens because levels of tenant improvements, leasing commissions and non-reserve capital expenditures are management decisions that dramatically affect a property's income but don't show up on the NOI of the owner's P & L. Thus, the taxing authorities use of NOI as a basis for property tax valuation fails to acknowledge the very expenditures that play a critical role in income production.
Adding insult to injury, assessors tend to view the highest sales price in a category of property as indicative of the value of the category as a whole.
Tax authorities defend their lack of consideration of expenditures necessary to maintain income and occupancy, stating that this is offset by their selection of a cap rate for their income capitalization approach. Further, they argue that cap rates reflect investor decisions based on the income of the property, without consideration of the tenant improvements, leasing commission and reserves attributable to the property.
They often view the cap rate as merely a mathematical function. The purchaser agreed to a price that when applied to an income floor results in a cap rate. They believe that the cap rate is an absolute function of the NOI prior to deductions for expenditures necessary to maintain income. Similarly, since it is an ”absolute function” they argue that if an owner insists on deductions for tenant improvements, leasing commissions and reserves, then these deductions will simply be offset by using a lower cap rate. The taxing authorities push a formulaic approach to cap rates, knowing that there are too many variables involved to derive the appropriate cap rate from such simple arithmetic.
Determining a Purchase Price
With an understanding of how the tax authority values property for property tax purposes, it is instructive to step back and examine the perspective from which a purchaser of a property views a purchase.
Purchasers of retail properties have frequently stated that they consider many elements when determining the offer price for a property. The first, and perhaps most significant, is the credit worthiness of the anchor tenants and the overall mix of tenants in the center. This element is clear when we examine the $12 million purchase of a Texas grocery anchored retail center. Six months after the purchase, the anchor went dark (even though it continued to pay rent) and just two years later, the center sold for $3 million.
A second consideration is the ages and maturities of the businesses. A purchaser analyzes whether the center as a whole is in start-up, stabilized or down-swing mode. The purchase price is driven by the purchaser's expectations of cash flow during these stages. A center's age and maturity also affects tenant improvement costs, leasing commission expenses and non-reserve capital expenditures.
The purchaser's final consideration concerns the physical characteristics of the center. While it is these characteristics that the taxing authorities are supposed to value, they wind up being the least important consideration to a purchaser in determining the price to pay for a retail center.
Clearly, assessors and property owners approach valuation in very different ways.
Raymond Gray is a partner in the Austin, Texas, law firm of Popp & Ikard, the Texas member of American Property Tax Counsel, the national organization of property tax attorneys. He can be contacted at [email protected]
THE TAXMAN COMETH
|Property 1||Property 2||Property 3|
|Actual RentTI included||Actual Rent without including TI||Actual Rent without any TI expense|
|Rent Rate $12/sq.ft.||Rent Rate $10/sq.ft.||$8/sq.ft.|
|NOI $120,000||NOI $100,000||NOI $80,000|
|Income allowing for TI $100,000||Income allowing for TI$80,000||Income w/o TI $80,000|
|Source: Pope & Ikard|