Commercial property owners must challenge burdensome and unfair property taxes, and more often than not that task requires challenging the assessor’s assumption of a market cap rate.
The process may begin as informal meetings with assessing authorities, followed by administrative appeals and ultimately, if needed, court proceedings. The parties to these dialogues all recognize that the preferred method to determine the value of commercial properties is the income approach, and will usually agree on the factual elements related to the value calculation.
The most critical element in the income approach is the cap rate, however, and that point is also the most likely source of disagreement.
Cap rates by nature are subject to opinion and manipulation, because cap rates reflect judgments of multiple factors. In defending their value opinion, assessors frequently cite a “market-derived cap rate.” While there is some validity to determining a cap rate from sales of similar properties in the same market, the method as widely used by assessors yields errant results.
Sometimes the assessor’s market-derived cap rate is supported by sales, but the assessor rarely provides an analysis of those sales, showing some performance history of the sold properties. The assessor simply matches market income against the sale price, magically determining a cap rate. The assessor then applies the rate thus determined to case after case, in a one-size-fits-all analysis. It’s all pretty impressive and takes on an air of finality, as if carried down from the mountain on stone tablets.
The fallacy is that a cap rate derived as described bears no relevance to the value of the commercial real estate under appeal.
The assessor, by law, is limited to valuing real property. But the sales used as the basis for the assessor’s market-derived cap rate are the sales of entire enterprises, and consequently indicate value for the entire enterprise. It fails to achieve the goal of finding a value indicator of the real property that houses the enterprise.
The cap rate derived from sales of going concerns is different from one derived from sales of the properties that the enterprises occupy.
Taxpayers must challenge the assessor’s market-derived cap rate to achieve equitable taxation. The flawed methodology is as inappropriate as using the sales comparison approach of going concerns to determine real property value.
The enterprise value cap rate is based on the return on the investment, in the form of property value appreciation and rental income, plus the return of the investment in the form of business revenue. In addition to tangible components, enterprise value entails tax-exempt intangibles such as advertising, a trained work force, market niches or dominance, furniture, fixtures, affiliation such as franchise rights, all of which must be separated from the real property component in a property tax assessment.
Real property value is just one component of enterprise value, so an assessor’s market-derived cap rate that fails to segregate non-real-estate components is useless in valuing the property.
Plan of attack
Prepare to challenge an assessment by analyzing the assessor’s data base used in the valuation. What sold, and at what sale price? Investors buy and sell commercial properties as going concerns, which may generate returns that are more or less than the return from the property alone.
Consider the design and function of the properties used in the assessor’s data base as compared to the subject property. For instance, an assessor in the Midwest recently valued a large corporate headquarters building using a market-derived cap rate. Its data base consisted of regional office building sales, including gross income at the time of sale, sales price, size and location. It used market rents to determine property income.
The assessor’s study used sales of fully occupied, multitenant buildings, then applied that information to a single-tenant structure which had been designed as a national corporate headquarters and was roughly 33 percent occupied. Typical of such studies, the data was inapplicable to the single-tenant, largely vacant subject building.
To say that the going concern cap rate for hotels is X, or that the rate for golf courses is Y, fails to shed light on the cap rate for the real property component of a property.
Market-derived cap rate studies invariably end up being used as indicators—at best—of the value of going concerns, of which one component may be real property. They may look impressive, even somewhat persuasive, but they must be carefully reviewed to determine just what they represent, otherwise the taxpayer may be saddled with a grossly excessive property tax assessment.
Jerome Wallach is a partner at The Wallach Law Firm, the Missouri member of American Property Tax Counsel, the national affiliation of property tax attorneys. He can be reached at [email protected]