The 'work from home' revolution has devastated office building values.
Of all the property types, office buildings may wrestle with the pandemic's damaging consequences the longest.
The fallout from COVID-19 will clearly have a lasting economic impact. During the government-mandated shutdowns, businesses — including brick-and-mortar retail stores, restaurants, movie theaters and gyms — suffered tremendous losses.
With everyone except first responders and essential workers stuck at home, office occupancy rates plummeted as business districts, commercial developments, roads and public gathering places emptied. Many companies could not survive the shutdowns and were forced to lay off employees or permanently close their doors.
During the throes of the pandemic, companies that remained in business were compelled to adapt and learn how to effectively put their employees to work from home. Virtual meetings eventually became commonplace and routine. Then as the pandemic waned, companies began to demand that employees return to the office. While some workers ventured back to the workplace, many expressed a desire to continue to work from home.
This widespread sentiment has persisted. In fact, nearly 40 percent of workers would rather quit their jobs than return to the office full-time, and more than half would take a pay cut of 5 percent or more to retain their workplace flexibility, according to a recent survey by Owl Labs.
Given the tightening job market and the need to retain workers, many companies complied with employees' demands and either permitted them to work remotely or allowed hybrid arrangements. Little did these employers know that allowing employees to work from home would have a profound effect on the appraisal of office buildings for property tax appeal purposes.
Office valuations suffer
Property taxes are the largest single expense for most office landlords, and most property taxes in the United States are ad valorum, or market-value based. In other words, higher-valued properties have greater property tax levies. Therefore, property owners frequently file tax appeals to reduce this expense.
In the context of a real property tax appeal, the valuation of office buildings can be complex. Typically, an arms-length or comparable sale is the best evidence of value in a tax appeal proceeding. Since there aren't many arms-length purchases of single office buildings today, they are commonly valued by capitalizing the property's rental income stream minus property-based expenses. As a result, the actual rents collected are critical to the building valuation.
And rents have suffered. The mass exodus from office buildings to remote locations significantly lessened the demand for dedicated office space. With employees working remotely, many companies have realized they can function as well as before while occupying much less space. Thus, as leases expire, the tenants that choose to renew their leases are requesting a much smaller footprint with lower overall rents.
Compounding the decreased demand for office space, building expenses have skyrocketed. Rapid inflation has helped to propel insurance and general property maintenance costs, which have surged upward by more than 15 percent since 2020. Furthermore, lingering COVID-19 health concerns have led to enhanced cleaning protocols and upgraded air filtration systems, which have likewise raised building expenses.
Simultaneously, the Federal Reserve has raised interest rates to combat inflation. These higher interest rates, meanwhile, have further reduced property values by increasing the cost of financing. Mortgage interest rates and the risks on the equity side have also increased. This has a negative effect on the market valuation of office buildings as higher capitalization rates generate much lower appraised market values.
Challenge unfair assessments
Altogether, reduced office space demand, weakened cash flows, higher building expenses and rising interest rates do not bode well for the U.S. office sector. Landlords are being forced to offer concessions such as free rent or are paying for extensive interior buildouts to attract tenants.
This large shift in lease renewal rates, occupancies, expenses and capitalization rates have produced the equivalent of the four horsemen of the apocalypse for office building valuations, driving property tax appeals and raising a distinct possibility that many office buildings will become stranded assets. Experience indicates these changes can result in a 10 percent to 30 percent drop in market value from pre-pandemic levels.
A good rule of thumb would be that if a building's net operating income has dropped, the real estate tax levy should go down correspondingly. Most municipalities, however, have not reduced assessments to reflect the economic downturn.
Consequently, now more than ever, property owners must be vigilant to avoid paying excessive property tax bills. Conferring with experienced counsel, questioning assessors' property valuations and challenging tax assessments will help to ensure an office building's current real property taxes are based on this new valuation reality.