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Higher appraisals and taxes may be in store this year

Meteoric growth in the institutional ownership of commercial real estate, dramatic swings in real estate values and shorter and frequent real estate cycles are posing new challenges to property assessments and, therefore, to determining how much property taxes will be owed by owners.

Higher purchase prices paid by real estate investment trusts for properties across the country have further complicated the task of assessors and appraisers. While assessors are asking why the values of properties should not be increased across the board based on prices paid by REITs, smaller owners are arguing that REITs have paid inflated prices for their acquisitions and thus REIT transaction data should not be used to assess fair value of their properties.

There seem to be more questions than answers regarding these issues: How should the real estate be valued for property tax purposes? Should REIT acquisitions be included in the list of comparable sales for non-REIT properties? Should intangible assets be included in property assessments? How should one distinguish between "market value" and "investment value" of properties?

In downtown Boston, for example, many trophy and Class-A buildings have been acquired by REITs in recent years. Industry insiders say that this REIT acquisition phenomenon will have a major impact on assessment of property values in the city, because assessors and appraisers often use comparables of recent sales to support their claims.

"In the city of Boston, assessors are looking at increasing the valuation of Class-A office buildings by around 20%. That is for tax year 1999. That is going to result in average tax increase of anywhere between 12% and 15%," says Miles Friend, vice president and head of eastern regional operations for Marvin F. Poer & Co., a Dallas-based full-service national property tax consulting firm. "What that means is that if you are a downtown office building owner, taxes per sq. ft. will go over $8 per sq. ft. from $7 per sq. ft. in one year. It substantially increases your operating costs."

He says higher assessments are influenced by recent REIT transactions across the country. Washington, D.C., for example, recently completed its first triennial reassessment of properties and values of the properties bumped up dramatically, Friend adds.

"Again because of the transactions that have taken place in the hotel sector, hotel assessments have been increased double digit in Washington, D.C. and likewise taxes have gone up. In some cases, hotel assessments have been increased as high as 50%," Friend says. "The experience we have had in the Virginia and Maryland area is same kind of thing. Market transactions by REITs have contributed to 15%-to-20% increase. REIT transactions seem to be higher than what normal market prices have been."

Friend says REITs can pay more money for their acquisitions than traditional investors and private developers because cost of money for REITs is much lower than to smaller investors. Unlike non-REIT players, REITs have easy access to public markets for both debt and equity and have tax advantages.

REITs emerged as a major player in the marketplace around 1992. "REITs have dominated the market in recent years. There have been a lot of transactions with REITs. Assessors need to be careful. They must ask if these transactions truly reflect market value for assessment purposes," Friend says.

Martin S. Katz, a partner at the Chicago law firm of Fisk Kart and Katz Ltd. and president of American Property Tax Council, a national affiliation of property tax attorneys, says "intangible" assets also are becoming a major issue in property assessments.

He says many non-real estate assets are now being included in the real estate tax process and as a result owners are being forced to bear real estate tax burdens well beyond the value of their real estate.

"It is the only tax that is based on subjective standard, market value," Katz says. "Intangible value has come into the real estate industry. They should be taken out of real estate. You have got to siphon out what is the lawful real estate value for tax purposes."

Property owners can take an active role in getting lower assessments; careful planning and due-diligence can lead to significant tax savings, Katz says.

He says that by utilizing refined valuation methodologies, his firm was able to reduce the assessment of a Chicago hotel substantially. The hotel, which he declines to identify by name because of confidentiality agreement, was acquired for $67 million in mid-1997. The existing taxes were based on a market value of $24.5 million.

"You had potential for a dramatic property tax increase," Katz says. "We brought in an expert, who understands hotel valuation. They recommended the acquisition price was dramatically less than $67 million. You just cannot look at real estate sale price because so many things go with it. You must take out intangibles. Hotels have long been recognized as an operating business."

The assessment of the hotel for tax purposes was finally based on only $29.5 million and not $67 million, Katz says.

"Due diligence and up-front component allocation are very important in such cases," Katz says. "Property taxes are so unique. It's the only tax type that is locally based and differs significantly from state to state. If you're dealing with property taxes you must be somebody with local knowledge. You have to know what is going on in property taxes, especially today when prices are dramatically higher."

He says dramatic recovery in the market over the last two years, volatility in capital markets, REITs, securitization of real estate and uncertainty in the marketplace have posed new challenges for assessors and appraisers and investors alike.

"A lot of this has to do with REIT acquisitions. In some cities, assessors have picked up the record acquisition prices by REITs and dramatically increased the prices. There is so much pressure on assessors," Katz says.

"REITs also show how volatile the market can be," he adds. "Three months ago, REITs would have got any property they wanted to acquire. It's no longer the case today. In the 1990s, there has been some steady rise in real estate values. Cycles are more frequent. There are shorter cycles and more dramatic swings."

Even within a particular real estate sector, swings can be dramatic, Katz says. Within the hotel sector, for example, the limited-service sector has performed miserably. Full-service hotels have done better.

Bill Kinn, managing director of New York-based Landauer Real Estate Counselors, says any short-term swings would not have direct impact on assessments and taxes because taxing authorities lag in catching up ticks and downturns.

"Most taxing authorities don't assess properties annually," Kinn says. "The pricing is very much based on the specific of the location. Changes in recent market conditions had most direct impact on hotel type properties, including multifamily and Central Business District and suburban office buildings."

He says large investment-grade properties are typically valued by using some type of discount cash-flow analysis, and it becomes very difficult for assessors to accurately reflect their market value. Assessors, however, are trying to be more efficient.

"Property tax delinquencies are being less and less common in New York because property values have gone up and assessors are doing more accurate and most efficient jobs in assessing properties," Kinn says.

J.E. Robert Cos., a McLean, Va.-based real estate investment advisory firm and manager of real estate assets and delinquent tax liens, recently collected more than $200 million in delinquent property tax liens it was assigned by New York City to collect as lead servicer of the country's largest tax lien collection program outsourced to the private sector by a municipality.

"The amount of tax delinquencies will be going down," Kinn says. "When you cannot afford to pay taxes, you are in low water. That is not likely to happen in this market. We have strong stable market."

Keith Kramer, president of Keith M. Kramer Associates, Inc., a St. Louis-based real estate appraisal firm specializing in market analysis and appraisal of multifamily properties nationwide, says values of apartments have gone up substantially over the last couple of years and so have real estate taxes.

He says REITs obviously have pushed values of properties up, but they have also made good investment decisions.

"They have got good properties. We cannot say what they are doing is wrong because they have made very lucrative investment for themselves," Kramer says.

"The question is, 'How do you deal with these issues? What's the realistic assessment of the property?' We cannot knock REITs."

Michael Horwitz, a Boston-based principal and national director of business development with national accounting firm Ernst & Young LLP's Property Tax Group, says assessors have a difficult job in the rapidly changing marketplace.

"In this dynamic real estate market, which has tended to reflect shortage of supply of new real estate and increased demand by institutional and REIT investors, transactions are occurring at very high prices," Horwitz says.

"There appears to be a component of the purchase prices that reflect items other than pure real estate. These items include good will, opportunities to adjust lease rates in future years, management efficiencies as well as the low borrowing cost afforded to REITs. With all these various factors in play, the appropriate assignment of an assessed value is difficult."

He says assessors are now trying to understand these new non-traditional factors in real estate acquisitions. The Massachusetts Association of Appraisers, for example, has stated that purchases by REITs do not necessarily reflect "fair market value" for assessment purposes, he adds.

Horwitz offers this advice to property owners: "Develop a cooperative relationship with local assessing officials so that you can jointly develop a fair assessment which would not necessitate an appeal," Horwitz says. "When all property values are increasing, it's more important to mitigate potential increases in assessment than to expect to receive major reduction in assessment."

John Lynch, a partner at the Boston law firm of Lynch, DeSimone & Nylen, LLP, which specializes in real estate practice, says assessors have a difficult time keeping up with rapidly changing markets and setting values once a year or once every three to five years.

"Conditions today may be widely different than six months ago. In 1998, we just came through a mini-recession. When the stock market sneezed, everybody got a cold. That is true in real estate," Lynch says. "It's very important that cities and towns get the assessments right. Their assessments are either too low or too high. Its consequences could be greater for property tax payers. For the owners of real estate, property taxes could be the single biggest component of their expenses other than the mortgage."

Municipalities, on the other hand, are also heavily dependent on property taxes to support their school systems, fire and police departments and other local projects, Lynch says. Any substantial decline in their revenue base could seriously disrupt their ability to run local governments.

"Real estate taxes are based on values of the properties. What it is, it's all an opinion. It's subject to review, variance and question," Lynch says.

"Businesses are done out of real estate, and real estate values are largely influenced by business value. Assessors frequently attend to added business values in real estate or they confuse them with real estate value."

Frank Liantonio, executive managing director of Cushman & Wakefield's Valuation Advisory Services Group, says 1998 was a very busy year for the appraisal and valuation industry.

"Business through September was at record level for our valuation advisory group in 20 years," Liantonio says. "The valuation business is continuing to concentrate among a few larger national providers."

He says more firms now are offering specialized services and are dealing with a particular property type such as hospitality, health care, or retail. "We have established a new group to provide underwriting and due diligence services."

Valuation service providers also are using old and brand new valuations techniques, says Richard Parli, President of Fairfax, Va.-based Parli Appraisal Inc. He says some of the techniques frequently used by appraisers include the application of fundamental market analysis and dealing with market fundamentals such as growth in household formation forecast, disposable household income for new retail space, and growth in particular types of jobs in office and industrial space.

"This is the methodology used by major retailers and hotel developers," Parli says. "The key for appraisers is to be knowledgeable and to substantiate particular cash-flows on particular types of projects."

Appraising the Appraisal Profession Real estate appraisers, whose numbers declined significantly around the nation during early to mid-1990s, have started to come back slowly. "We have seen a rebound in number of our members since 1997," says John Ross, executive vice president of the Appraisal Institute, a Chicago-based national organization for professional real estate appraisers that confers professional designations such MAI for commercial and SRA for residential appraisers. "The number of our members slipped below 20,000 in later part of 1997." In 1993, membership of the Appraisal Institute was at whopping 32,652. It dropped below 20,000 in 1997, and is now back to 20,633.

"The appraisal profession saw some real upheavals in the '90s, but now we're in an upswing. We're gaining members," Ross says. "We're seeing more and more involvement of appraisers in real estate transactions. They are the only independent party that has no stake in the transaction."

He says members of the Appraisal Institute, created in 1991 after the Society for Real Estate Appraisers and the American Institute of Real Estate Appraisers merged, reflect their unbiased and objective approach to property appraisal and analysis.

So, why has the real estate appraisal profession been in doldrums in recent years?

Industry insiders attribute the decline to several factors, including regulatory changes and the overwhelming availability of electronic data and information. Anyone who can log on to databases and pull relevant information about a particular market and economic trends can provide a rough valuation of properties.

All he or she needs is a state appraisal license. The professional designation has lost its charm since 1993, when licensing of appraisers was first introduced.

Ross says that, although all appraisers are licensed by states now, the professional designations conferred by the Appraisal Institute adds a new dimension to an appraiser's career and skills. They receive educational training and peer review that exceeds state and federal requirements. An individual earning an SRA or an MAI designation conferred by the Appraisal Institute must meet these requirements:

* Complete a series of examinations and attend specified courses.

* Pass a comprehensive examination.

* Receive credit for 2,000 hours of residential appraisal for SRA designation, or 3,000 hours of specialized experience for MAI, beyond their state certification experience.

* Achieve a passing grade on a demonstration appraisal report.

* Hold an undergraduate college degree.

* Abide by the industry's professional practice and ethics.

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