Property Tax Resources

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Tax Strategies for Net Lease Properties

A guide to effectively challenge and reduce bloated tax valuations.

Nobody enjoys paying property taxes, especially when a property is over-valued. Single-tenant, net-leased properties seem especially prone to inconsistent and unfair assessments.

But challenging those valuations can be exhausting in a time when assessors are fearful and obsessed with the dreaded "Dark Store Theory." They vehemently oppose using sales of vacant properties to value their jurisdiction's store, the one with the full parking lot.

How can the taxpayer shut down the hype and bring the assessor back to the table for a reasonable negotiation? Well, that depends. Here are essential points to consider in forming a protest strategy.

Know Your State's Value Standard

Common sense tells us an appraiser must know what they are valuing before they value it. Yet, the failure to identify the property rights being valued often causes disagreement and confusion in tax appeals. These misunderstandings commonly hinge on the difference between fee-simple and leased-fee value.

The fee-simple estate of an income-producing property is essentially the value of the net income stream based on market-level rents, expenses and other variables. If the property benefits from a long-term, above-market lease, that revenue is irrelevant to the fee-simple value.

Before I finished that last paragraph, my phone rang. The caller was outraged because an assessor revalued his property at its recent purchase price. The property was clearly not worth what the taxpayer paid for it, he said, because the price was based on a net lease.

Maybe. Maybe not.

Before the caller purchased his property, it was exposed to the open market for willing buyers to make offers to the willing seller. The competitive process culminated in an arm's-length sale reflecting market value. How is that not what the property is worth?

That brings us to the second value standard, the leased-fee estate, which is essentially the value of the income stream from the actual lease in place. The caller's purchase price was exactly what the property's leased fee was worth.

So, before getting angry with assessors for relying on leased-fee sales, taxpayers should learn which property rights their state is valuing for taxation. If the state values the leased-fee rather than fee-simple estate, the taxpayer may not have a basis to complain.

Sales Won't Sell It

The "Dark Store Theory" is the term assessors apply to the use of vacant property sales in valuing occupied properties. From an appraisal theory standpoint, only vacant sales are appropriate for valuing the fee-simple interest in a leased property, because sales of leased properties exclude the right of occupancy, an essential right within the fee-simple estate.

This appraisal standard should be a boon to taxpayers challenging inflated assessments on leased properties. It's great to be right, but there's a problem. Using vacant buildings to value occupied buildings is a very tough sell to a tax panel, appeals court or other arbiter. The decision-maker's gut will turn.

Huge tax reductions have been achieved using vacant sales, so it can be done. It is spectacular in the moment, but legislatures and higher judicial bodies are likely to respond negatively. Legal victories that inflame assessors and politicians are not stable long-term solutions.

What About The Cost Approach?

Cost doesn't equal value, but sometimes estimating a newer property's replacement cost less depreciation is a good test of whether an assessment is reasonable. A cost calculation may support a value reduction, so it is worth considering in a protest strategy.

A common problem with the cost approach in net-lease tax appeals is the conspicuous difference between cost-based value conclusions and those based on income or comparable sales. If the property can't be leased or sold at a rate of return that supports its depreciated cost to build, the numbers will not line up, because there is obsolescence to account for. The decision-makers that hear tax cases dislike big obsolescence deductions, especially if the taxpayer quantifies those deductions using vacant property sales.

Many assessors use cost systems for mass appraisal, so understanding how the local system was developed is helpful. Sometimes assessors use base cost data purchased from third-party services and then tweak that information before entering it in their own systems. Tweaks can involve stretching out the useful life of properties in the source data to unreasonable lengths, or bumping default grades used for certain building types from, say, "average" to "good." Little modifications add up and may be solely to increase tax revenue.

Market Rent Is King

In a fee-simple system, a good way to approach a net-lease tax appeal is with the income approach. All net-lease properties are leased, meaning they produce income. It isn't hard for an assessor to convince a decision-maker in a tax case that the property should be valued by capitalizing its income.

The most crucial element of a fee-simple income approach is the market rent. To win a net-lease tax appeal based on income, the taxpayer must prove this one thing.

"But there is no market rent for my property type," the taxpayer says. "What am I supposed to use for rent?"

That's a real issue, because net leases almost always seem to be the product of a build-to-suit or sale-leaseback transaction, with no regard for the local market. So, how can the taxpayer prove market rent?

Go for Broker

Consider this: Commercial real estate brokers are opinionated about their markets. They know rent because it's how they feed their families. They can speak with credibility about the rent a building would command on the open market. Nobody knows market rent better, and they make powerful rebuttal witnesses who keep any off-base testimony by the assessor in check.

A broker can also be a helpful resource for the taxpayer's appraiser. They can point to meaningful, sometimes hidden information.

The combination of an appraiser's formal analysis with a broker's testimony about realistic market rent is potent and convincing evidence in a tax appeal.

Let's Be Reasonable

As the taxpayer's protest strategy takes shape, subject it to the old "reasonable man" standard.

Would a reasonable decision-maker look at the taxpayer's long list of vacant properties, compare it with the subject property that is open and thriving, and feel good about reducing the value?

Would a reasonable decision-maker look at an income approach based on a reasonable expectation of market rent for the subject building and feel good about reducing the value?

Pushing for the former may be zealous advocacy, but appearing unreasonable to both assessor and decision-maker is unhelpful. And even a victory, if it smells like overreaching, risks a legislative response. Resolving a net-lease tax appeal using a reasonable income approach is a superior long-term strategy.

Drew Raines is a shareholder in the Memphis law firm of Evans Petree PC, the Arkansas and Tennessee member of American Property Tax Counsel, the national affiliation of property tax attorneys.
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