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Value Erosion

Lease Terms Can Impact Property Valuation' "But Tax Assessors May Not Realize It

"The loss of tenant reimbursements ... can have a significant impact on the property's net operating income."

By Douglas S. John, Esq., as published by Commercial Property Executive, April 2012

In the past 24 months, published lease rates have continued to decline or remained flat in most markets and for almost all property types.

But published lease rates tell only part of the story. In an effort to keep and attract tenants, landlords have been forced to offer lease terms that can erode a property's value.

In states where tax assessors rely on leased fee valuations (valuing property based on its actual performance), the rates listed in rent rolls may omit these changes to leases. Similarly, where state law requires tax assessors to use fee-simple assumptions of market rent, published lease data typically reflects either asking rates or reported rates that also ignore the effect of these changing terms. Unfortunately for taxpayers, assessors rely on these sources, which are often unreliable indicators of true market lease rates and can result in inflated tax bills.

Taxpayers and their attorneys must dig deep into the terms of lease transactions and explain to assessors how changing terms impact their property's valuation. Following are some key changes in the leasing market and how they are affecting property values.

Transition from Triple Net to Modified Gross Leases: Tenants with sufficient leverage are no longer inclined to fully reimburse landlords for real estate taxes, insurance or common-area maintenance charges. As a result, when leases are renegotiated, the structure may transition from a triple-net lease to some form of a modified gross or even a full-service lease. A cursory review of the rent roll by the tax assessor may suggest that the rate is unchanged upon renewal. But the loss of tenant reimbursements for expenses can have a significant impact on the property's net operating income, resulting in a significant loss of value.

Free Rent: Free rent is a common inducement landlords use to keep or attract tenants. This can take many forms, with landlords offering from a few months to a year or more. In some distressed retail centers, landlords have been known to give anchor tenants free rent for extended periods as a means of retaining other tenants.

To obtain longer lease terms' "and in some instances in lieu of providing tenant improvement allowances they cannot afford' "landlords are also offering free rent on the back end of a lease rather than the front end, with tenants taking it at month 24, 36 or 48. A rent roll reflecting a 72-month lease may only provide 60 months of rent payments, with the final year rent free. In addition, landlords are offering furniture, equipment, free parking and moving allowances.

These rent concessions typically are omitted from rent rolls or published lease data, masking the extent of a property's economic vacancy, reducing its net operating income and contributing to a loss of value.

Tenant Improvements: Some space users want allowances for tenant improvements. But how a landlord accounts for their cost can significantly affect a property's value. For instance, say a tenant renews its lease at the same base rate as before but the landlord also provides $20 per square foot to rehab the property. If the landlord amortizes the improvements into the renewal lease rate, the rate reflected in the rent roll will overstate the effective lease rate. It is critical to explain to assessing authorities that using lease rates that amortize tenant improvements will result in overvaluation of the property.

Co-Tenancy Clauses: Tenants are also using their leverage to include co-tenancy clauses in leases or renewals that allow them to either reduce their lease rate or terminate the lease if the property's occupancy rate falls below a specific level or if a key anchor tenant moves out of the property. When an anchor tenant goes dark, the impact on the property's value is compounded by the potential loss in rent and expense reimbursements from smaller tenants that may decide to exercise their rights under the co-tenancy clause. The existence of a cotenancy clause may have a ruinous impact on the value of a property and should always be brought to the assessor's attention.

These and many other changes to leases that may be seen in the coming years—such as marginal or nonexistent escalator clauses and FASB rule changes—will continue to weigh down property values. It is critical that taxpayers and their attorneys develop presentations that clearly demonstrate to tax assessors, administrative tribunals and courts how a wide variety of lease changes can affect a property's valuation.

dough johnsmallDouglas S. John is an attorney in the Tucson, Arizona, law firm of Bancroft & John P.C., the Arizona and Nevada member of American Property Tax Counsel (APTC), the national affi liation of property tax attorneys. He can be reached at This email address is being protected from spambots. You need JavaScript enabled to view it..

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