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Defending Against Tax Jurisdictions’ Attacks on Market Value

Michigan's Menards case offers valuable lessons to help taxpayers get fair property taxation.

While taxpayers typically pay property taxes based upon their property's market value, assessors frequently misapply evidence or even redefine market value to rake in excessive taxes.

The recently resolved Michigan Tax Tribunal case of Menard Inc. vs. City of Escanaba illustrates several of these efforts to collect excessive taxes and suggests arguments a property owner can use to challenge them.

What is market value?

Market value is the price willing, knowledgeable buyers and sellers in an arms-length transaction would agree the property is worth. Market value differs from insurance value or replacement value because it reflects what a typical buyer would pay for a property as it is. Market value also differs from value to the owner, which reflects how a particular property contributes to the owner's business operation.

Appraisers typically determine market value using one or more of three valuation techniques:

The sales comparison approach adjusts sales of similar property to indicate the likely selling price of the subject property. The income approach values property by considering the present value of the income it would likely earn if rented, whether or not it actually is rented. The cost approach values property by considering its cost of replacement, reducing that cost by all forms of depreciation including physical deterioration, functional obsolescence and economic obsolescence. Such depreciation can and should be quantified by data also utilized in the income and sales approaches.

The Tax Jurisdiction's Evidence

The subject property in the Menard case was a big box retail store, larger than most, with a main floor area over 150,000 square feet and with additional accessory space. The owner used the space as part of its multistate retail business operations and as a delivery point for its internet sales. The building was not subject to a lease.

The tax jurisdiction proposed valuing the store using sales of smaller home improvement stores occupied by Lowe's or Home Depot as tenants pursuant to build-to-suit leases. It also sought to use the rental rates in these build-to-suit leases as evidence of market rent. It claimed that the Menards store suffered no material obsolescence, based on evidence drawn from this build-to-suit data.

As the term suggests, tenants under build-to-suit leases have contracted with a developer to build the store to their specifications. The parties set lease terms before construction even starts, calculating the lease rate to cover all construction costs and provide the developer's expected profit. In essence, such leases recover replacement cost even if market value is less than replacement cost.

Taxpayer's counterpoint

The taxpayer successfully argued such evidence did not reflect the market value of Menards' store. The selected sales reflected the value to the owners of using the stores in their specific retail operations. The lease rates were high enough to recover actual construction costs for each property—not what any other retailer would pay to rent a space not built specifically for its business model. This data, virtually by definition, would not indicate obsolescence in the subject property.

When such stores sold, the taxpayer argued, the sales price reflected the value of a lease to a creditworthy tenant that of course was already using the building in its retail operations. Besides generating cash flow designed to recover construction costs, the specific leases were signed during periods of higher interest rates than on the valuation dates, so that by the time of valuation, the leases provided an above-market return on the original building investment. What the tax jurisdiction called sales of comparable buildings were effectively bond sales from one investor to another secured by a retail building.

A buyer of Menards' property, if it sold, would not receive cash flow from a build-to-suit lease. In fact, it would not receive cash flow from any lease. The tax jurisdiction should have either adjusted the sales to remove the effect of above-market leases, or used sales unencumbered by a lease and for which no lease adjustment would be necessary. Some tax jurisdictions derisively call such transactions "dark store" sales, but they are frequently the best evidence of a building's market value. It is the building that is subject to property tax—not the business operating within the building.

Lessons learned from the Tribunal's decision

The tribunal rejected the tax jurisdiction's build-to-suit lease rates and sales with build-to-suit leases in place.Instead, the Tribunal used the taxpayer's proposed lease rates for conventionally leased buildings in the local area.Such lease rates better reflected the market rent a buyer of the subject property could reasonably expect to collect, and therefore best indicated obsolescence suffered by the subject property.

These lessons apply to valuing any type of building. Build-to-suit rents do not reflect market rent-- except by accident. Alleged comparable sales with build-to-suit leases are typically not comparable to a subject property that is owner occupied.

Even if the subject property is already fully leased with a build-to-suit lease, if local law requires use of market rent, the actual rent from the build-to-suit lease could be given far less or no weight. During the Great Recession, in market lease states, even fully occupied buildings at high contract rent had their values reduced because market rents had fallen. Finally, increased e-commerce volume and changing consumer habits may render many existing retail stores oversized. Office buildings and the tenants' current spaces may be oversized due to higher proportions of people working from home or virtually. Oversized buildings in light of current market conditions suffer from obsolescence that must be reflected in market value.

The Michigan Tax Tribunal resolved the Menard case this year after several years of litigation. Perhaps that resolution can now help other taxpayers to recognize unfair assessment practices, and to build stronger cases as they seek fair assessments for their own properties.

Steven P. Schneider is a partner and Tax Appeals Practice Group member in the law firm Honigman LLP, the Michigan member of American Property Tax Counsel, the national affiliation of property tax attorneys.
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