Jaye Calhoun and Divya Jeswant of Kean Miller LLP on an assessment strategy that may help you trim your property tax bill.

Few states impose property tax on intangible assets such as a trade name, franchise, goodwill and the like. Indeed, some office buildings, industrial properties and big-box stores don't derive significant value from intangibles in the first place.

Intangibles are a significant income generator for many hotels, casinos, restaurants and other properties, however. For these assets, assessors are required to identify and exclude the value attributable to those nontaxable intangibles. The proper method to do so has been the subject of much debate.

Fortunately for taxpayers, recent case law is helping to clarify best practices for isolating and removing value attributable to intangibles from commercial assessments. By following the examples of taxpayers who have successfully applied alternative approaches, property owners across the country may be able to exclude a larger portion of overall property value as intangible and, in turn, lower the property taxes on their business real estate.

Scaling Rushmore

Although some assessors persist in applying the cost approach, most valuation professionals consider the income approach most appropriate for valuing income-producing properties. That is because a property's past, present and future or projected income inevitably impact its valuation.

Many assessors have traditionally applied the "Rushmore Approach" to exclude the value of intangibles from an income-based valuation. This essentially deducts management and franchise fees from a property's net income, treating those amounts as a proxy for the value of intangibles.

Many taxpayers reject the notion that the Rushmore Approach can account for the full value of intangibles. Some of these property owners and their appraisers have countered with the "Business Enterprise Approach," which seeks to remove the often significantly higher revenue generated by intangible assets. This approach is sometimes called the "Income-Parsing Approach" because it requires going-concern income attributable to intangibles to be parsed and stripped from taxable property income.

A spate of decisions over the last few years, particularly concerning hotel valuation, has created a growing momentum favoring the Business Enterprise Approach. Taxpayers should be aware of the potential for significant tax savings with this approach.

Business enterprise successes

The most significant recent cases in which taxpayers successfully argued for using the Business Enterprise Approach are in two states known for high property taxes: Florida and California.

The first is Singh vs. Walt Disney Parks and Resorts U.S. Inc., a 2020 case dealing with the valuation of the Disney Yacht & Beach Club Resort adjacent to Epcot. A Florida appellate court categorically ruled that the Rushmore Approach fails to remove all intangible business value from an assessment. The court was simply unconvinced by the assessor's arguments that deductions for franchise and management fees can remove the entire intangible business value.

Another encouraging decision occurred in 2023, SHR St. Francis LLC vs. City and County of San Francisco. A California appeals court considered various income streams of the Westin St. Francis hotel, including its management agreement, income from cancellations, no-shows and attritions, in-room movies, and guest laundry services.

The court held that it was insufficient to simply deduct the management fees because income from a nontaxable, intangible asset like a management agreement should include both a "return of" and a "return on" that asset. In other words, the owner would expect to generate a profit, or income-based value over and above the cost of the management agreement. The court found that the assessor failed to present evidence that the management agreement's value did not exceed management fees.

In dealing with the remaining items, the court drew a dividing line between "intangible attributes of real property" that merely allow the taxable property to generate income (cancellations/no shows/attritions) and are therefore includible vs. "intangible assets and rights of the business operation" utilizing the real property. These latter assets and rights, including in-room movies and guest laundry services, relate to the intangible business operation and are, therefore ,excludible from income-based, taxable property value.

Another widely reported decision from 2023 is Olympic and Georgia Partners LLC vs. County of Los Angeles. The appellate court in this case pointed out a key flaw in the Rushmore Approach. That it is unlikely the deduction of franchise and management fees could fully account for the value of intangibles because no owner would normally agree to fees "so high as to account completely for all intangible benefits to a hotel owner."

Half Moon Bay legacy

Several recent decisions cite SHC Half Moon Bay LLC vs. County of San Mateo, a 2014 California case involving the Ritz Carlton Half Moon Bay Hotel's workforce, leasehold interest in the employee parking lot, and agreement with a golf course operator. The appellate court explicitly acknowledged that the deduction of management and franchise fees from the hotel's projected revenue stream did not properly identify and exclude intangible assets.

Taxpayers throughout the country have successfully made these same arguments. In 1300 Nicollet LLC vs. County of Hennepin, a Minnesota court in 2023 took stock of case law across the country and observed that although the two methods have been competing for 20 years, there is an emerging preference for the Business Enterprise Approach and increasing skepticism of the Rushmore Approach.

Some states such as New Jersey continue to rigidly administer the Rushmore Approach, while other states consistently uphold the Business Enterprise Approach, at least in recent years. Yet other states view both methods as potentially reasonable for an assessor to apply; some of those cases may have more to do with the standard of proof during appellate review. There are also states such as Louisiana in which the issue is yet to be dealt with judicially, arguably giving taxpayers an opportunity to get ahead of the curve.

Clearly, taxpayers and their commercial appraisers should determine whether the assessor has properly excluded maximal value for intangibles in valuing their income-producing properties for property tax purposes. In particular, appropriately applying the Business Enterprise Approach can generate significant property tax savings on commercial real estate and may be worth pursuing.

Below is a property owner's guide to reducing the taxable value of contaminated real estate.

Valuing contaminated properties presents numerous challenges due to the complexity and uncertainty that contamination entails. The presence of hazardous substances or pollutants can affect both a property's value and potential uses. As an assessment must reflect market value, contamination can significantly impact taxable valuation.

Determining the extent of that impact requires careful consideration of legal, technical, and economic factors as the valuation of contaminated properties is governed by a combination of statutory law, regulatory guidance, and case law. Yet these are the fields a taxpayer with contaminated real estate must tread to evaluate assessments for fairness and, if necessary, to appeal an unfair assessment.

Tax assessment review proceedings are crucial mechanisms for all property owners to ensure fair and accurate assessments. These proceedings provide avenues to challenge property assessments they believe are incorrect or unfair. Understanding the process, timelines, and legal considerations involved is essential for property owners, assessors, and legal professionals alike.

Most real estate taxes in the United States are ad valorum or "according to value." Thus, the owner of a high-value property would expect to pay more real estate taxes than the owner of a lower-value parcel. While the exact procedures to file a tax appeal can vary by state, all give property owners the right to challenge property assessments through various means, including administrative review, grievance procedures, and judicial review.

Four Preparatory Keys

To prepare for a tax appeal, the following important considerations should be addressed:

1. Assess contamination levels: Determining the extent and severity of contamination on a property requires expertise in environmental engineering, so expert assistance is a must. Documentary evidence can significantly strengthen a property owner's case during the appeal process. Procure this with expert testimony from environmental consultants, appraisers, and other qualified professionals to establish the impact of contamination on the property's value. Assessors may need to rely on those reports to understand and truly appreciate the contamination's nature and scope.

2. Estimate remediation costs: The price tag to remove or contain pollutants can vary widely depending on the type, quantity and spread of the materials involved, as well as the chosen remediation method. While there are state statutes concerning remediation and liability, those matters are also codified at federal levels within the Comprehensive Environmental Response, Compensation & Liability Act (CERCLA) of 1980, commonly referred to as the Superfund Law. If a site is designated a "superfund site," it will typically have a remediation plan with anticipated cleanup costs, which assessment professionals can rely upon in determining market value.

3. Gauge market perception: Market perception can play a significant part in valuation since contamination can have a negative impact on the property's appeal to potential users or buyers. Known as "environmental stigma," this can severely depress market values. Prospective buyers are typically hesitant to purchase contaminated properties, often leading to decreased demand and lower market prices.

4. Don't sweat legal liability: Property owners may face legal liabilities for environmental contamination, which can also affect the property's value. This, however, should have no effect on valuation in a tax appeal proceeding, because the statutory mandate to value property in a tax appeal according to its market value cannot be subordinated to environmental property concerns. Most significantly, any liabilities for contamination or remediation must be addressed in a separate proceeding outside the tax appeal.

More to Consider

The three accepted approaches to valuation in the context of a tax appeal are income capitalization, sales comparison, and replacement cost less depreciation. Unfortunately, none of these truly account for the presence of contamination and its negative influence on value. The effects of environmental contamination, and even stigma from nearby contamination, must be part of the valuation equation.

Local case law also plays a significant role in shaping the legal landscape surrounding contamination in tax assessment review proceedings. Many courts have recognized the impact of contamination on property values and have upheld adjustments to tax assessments to account for this factor. Additionally, these same courts have established principles regarding the burden of proof and evidentiary standards in contamination-related tax appeals.

For example, the seminal case in New York is Commerce Holding vs. Board of Assessors of the Town of Babylon. In this 1996 case, a property owner filed a tax appeal contending the assessed values should be reduced to account for contamination by a former on-site tenant. While New York's highest court held that "any fair and non-discriminating method that will achieve [fair market value] is acceptable," they concluded that contaminated property in a tax assessment review proceeding shall be valued as if clean, then reduced by the total remaining costs to cure the contamination.

Clearly, valuing contaminated properties in tax assessment review proceedings requires a nuanced understanding of environmental regulations, property valuation principles, and market dynamics. Assessors and property owners must navigate complex legal and technical challenges to arrive at a fair and accurate valuation that reflects the unique circumstances of each contaminated property. By employing appropriate valuation strategies and seeking expert guidance, stakeholders can ensure that contaminated properties are assessed fairly and in accordance with applicable law. 

Market deterioration and municipal ineptitude are driving taxpayers to the courts for relief.

The New York City real estate market, once the pinnacle of economic health, has undoubtedly declined in recent years. Exploring the factors that brought the market to this point paints a clearer picture of what current conditions mean for property taxpayers and suggests strategies that may offer relief.

Five Causes of Decline 

The COVID-19 pandemic left an indelible mark. The coronavirus took a significant toll on New York City, which became an epicenter of U.S. infections. Many residents fled to suburban areas for more space and less harsh mandates from local authorities. According to a Cornell analysis of U.S. Census Bureau data, "New York City's population plunged by nearly 4 percent – more than 336,000 people – during the pandemic's first year as residents migrated to less dense areas in nearby counties and neighboring states."

The New York City Comptroller's Office estimated that the City lost an additional 130,837 residents from March 2020 through June 2021. This caused unprecedented vacancies in residential and commercial properties, and approximately 100 hotels in the City closed. Those that survived endured high vacancy rates and struggled to pay property taxes.

Economic uncertainty plagues the real estate market. The economic fallout of elevated vacancies and decreasing income has rendered investors and developers hesitant to invest in New York City real estate.

Remote and hybrid work slashed office demand. The decline in office usage that accelerated during the pandemic is ongoing and appears permanent. Most workplaces have loosened to a hybrid work environment, and many employers allow a full-time work-from-home option as well.

This means office buildings that once bustled with employees are now vacant or significantly emptier than they were in 2019. Midtown Manhattan lunch spots and after-work happy hour sbars and restaurants have also taken a hit. The National Bureau of Economic Research estimated in 2022 that New York office buildings had lost as much as $50 billion of value in the wake of reduced demand.

Crime is soaring. New York City police reported making 4,589 arrests for major crimes in June, a 9.3 percent increase from the same period a year earlier. In the first six months of 2023, officers made 25,995 such arrests – the most for any half-year period since 2000.

Property tax revenues are under threat. The previous trends have been slow to erode the municipal view of the tax base. The City's Department of Finance reported a tentative assessment roll of $1.479 trillion for fiscal 2024, a 6.1 percent increase from the previous tax year. For the same period, the department reported a 4.4 percent increase in citywide, taxable, billable assessed value, the portion of market value to which tax rates are applied, to $286.8 billion.

"New York City continues to show mixed signs of growth and economic recovery, with the FY 24 tentative property assessment roll reflecting improvements in subsectors of the residential market while key commercial sectors still lag behind pre-pandemic levels despite modest growth over the past year," Department of Finance Commissioner Preston Niblack said in a press release announcing the tentative tax roll.The decline in office occupancy continues to impact retail stores and hotels in the City contributing to the sector's slow recovery. At the same time, single family homes, which constitute a majority of residential properties, have exhibited a robust recovery and continued growth."

A study by NYU's Stern School of Business and Columbia University's Graduate School of Business calculated that a decrease in lease revenue, renewals and occupancy would cut the value of office buildings in the City by 44 percent over the next six years. Based on those findings, a worst-case analysis by New York City Comptroller Brad Lander found that a 40 percent decline in office property market values over the same six years would result in $1.1 billion less tax revenue for fiscal 2027, the last year of the City's current financial plan. Real estate taxes on office properties currently generate 10 percent of overall City revenue. The City expects office vacancies to peak at a record 22.7 percent this year, posing a potential threat to tax collections.

The result of the forgoing changes is that income is down, expenses are up, demand is evaporating, and market values have plunged by more than 50 percent for most commercial properties except perhaps multifamily (although sales of condominiums have stalled due to high mortgage costs).

How To Get Relief

The hotel industry anticipates a four-year recovery period. Hotel owners preparing arguments for reduced assessments should collect information for their team documenting closure dates, occupancy rates, and any specific pandemic-related expenses incurred during the reopening process.

It is inappropriate for assessors to evaluate hotels for property tax purposes solely based on non-real-estate income. A recent court ruling has affirmed the illegality of utilizing non-real-estate income generated by hotel businesses, leading to an overassessment of real estate taxes that must be refunded to owners. Business-related income, such as that from movie rentals, should not be considered in property tax assessments.

In addition, it is essential to identify and exclude income from personal property, furnishings, and the value of intangibles, franchises, trained workforce, and going concerns when determining real estate income.

The prevalence of empty stores and closures of local standby establishments in every corner of New York City underscores the severe economic impact on retail properties. Retail and office owners should be prepared to demonstrate declines in gross income and rents reported in their financial filings with the City. They are also required to provide a list of tenants who have vacated or are not paying rent. The Tax Commission now mandates an explanation for declines in rents exceeding 10 percent.

There is considerable potential for assessment reductions, but it is crucial for taxpayers to compile evidence of market value declines, and to collaborate with experienced advisors to secure warranted tax reductions.

There is no longer any absorption of vacant office space since demand is declining. That means that 80 percent occupancy or lower is the norm. Only an adjustment in property taxes to the actual earnings of the property will save the real estate, and over-leveraged properties may be lost.

Tax Process in a Tailspin

Extensive personnel turnover has hampered the review process that relies on action by City agencies, with inexperienced staff and numerous unfilled positions at both the Department of Finance (assessors) and the Tax Commission. Thus, expected remediation of excessive assessments often go unresolved. This leaves no alternative but to go to court.

Resorting to the courts is also difficult because in-person appearances are still relegated to video conferences, with few trials taking place.

The taxpayer's best approach is to push forward with all speed to demand a trial.  Only pressure to demand speedy trials will provide the needed result.

Office property owners should contest excessive assessments now, before a potential crisis drives up taxes.

The Great Recession, from December 2007 to June 2009, was the longest recession since World War II. It was also the deepest, with real gross domestic product (GDP) plummeting 4.3 percent from a peak in 2007 to its trough in 2009.

Entering that recession, unemployment was at an unalarming 5.0 percent, which is on par with historical averages, and interest rates hovered around 6 percent. The roots of the recession lurked at the intersection of risky subprime mortgages and the repeal of the Glass-Steagall Act, which allowed for the mega-mergers of banks and brokerages to escalate.

And here we are in January 2024, looking down a steep market slope. On the bright side, we are in a more advantageous position than at the beginning of the Great Recession. GDP was a respectable $25.46 trillion in 2022, up 19 percent from $21.38 trillion in 2019. Unemployment is at 3.7 percent, and values in the single-family housing market are increasing again, in part due to a lack of supply.

The investors standing on unstable ground this time around are those heavily leveraged in major metropolitan markets, such as New York, Chicago, and San Francisco, or other municipalities that rely on office values. (Think suburban office markets.) The sharp increase in interest rates under the Federal Reserve's tightening monetary policy, and the extreme drop in demand for commercial office space that accelerated during the pandemic, will have significant ramifications on all property types.

Dire developments

What ramifications? Assume a hypothetical "Metro City" that, like most major markets, has a tax base with 75 percent of its independent parcels classified as residential, and 25 percent as commercial real estate. However, the assessment values are strongly weighted on the commercial properties, with 30 percent of the entire assessment value born by office properties.

The municipality has a total tax levy of $16.7 billion and overall assessed property value of $83.1 billion. The office portion of the property makeup is 30 percent, or $24.9 billion in assessed value. The office share of the total tax levy is $5.0 billion.

Now assume that the city's overall office market value collapses by 50 percent. This leaves Metro City with a $2.5 billion deficit – not a small number. To recapture that $2.5 billion, the city must increase its tax rate by 15 percent. That means tax liability increases by 15 percent for every taxpayer, even if their property's assessed value is unchanged.

So, how can developers and owners protect themselves from excessive tax liability, given the current market conditions? One solution is to appeal property tax assessments aggressively. Regardless of the jurisdiction, regardless of property type, property owners must evaluate their opportunity for an assessment appeal.

Office-specific issues

Market transactions show vast valuation differences between Class A office properties, which are typically newer buildings with great amenities, versus "the others," or those office properties 10 or more years old and offering fewer amenities. Properties that fall in the latter category have many opportunities for assessment reductions. Here are key points to consider.

Ensure the appraiser or assessor is using the property's current, effective rental rates. In many instances, an owner will show a tenant's gross rent on the rent roll without disclosing specific lease terms contributing to effective rent. For example, the lease may have been negotiated at $27 per square foot, but the rent roll does not account for free rent, amortization, free parking or other amenities the tenant receives.

Additionally, although office leases historically pass through taxes and other costs to tenants, many negotiated leases now cap expenses for the tenant, potentially shifting a portion of expenses to the landlord. That is a key issue the taxpayer should address in the income analysis of an appeal, because it provides evidence for a reduction in effective rental rates, as well as an imputed increase a buyer would demand in the capitalization rate to reflect the additional risk.

Appraisers need to understand this issue for rental comparables as well as for the subject property. Typically, they will confirm public information posted by various data services, but if they lack the finer details of a transaction, the rates they derive could exceed the true market.

Address vacancy and shadow vacancy. Prior to the pandemic, office vacancy in most markets hovered between 5 percent and 14 percent, depending on the location and building class. As of the third quarter of 2023, vacancy is over 18 percent, according to CBRE.

In October 2023, CBRE reported that suburban Chicago's office vacancy rose 50 basis points to 25.9 percent in the third quarter. Manhattan's overall office vacancy rate including sublease offerings is 22.1 percent, according to Cushman & Wakefield.

Shadow vacancy, or space where the tenant is still paying rent but no one physically occupies the space, is the canary in the coalmine for an office building's future. If a building is 12 percent vacant, the assessor probably won't be sympathetic. But if the owner highlights that leases in the space expire in the next year or two, and/or they are large blocks of space, the assessor (or at least the owner's appraiser) should acknowledge that risk and apply a higher cap rate for the subject property.

Adjust for interest rates. Any investment-grade property is now worth less than it was two years ago, simply because of the rise in interest rates.

Because interest rates have increased significantly, the property owner can argue that the assessor should use the "band of investment" method, which calculates capitalization rates for the components of an investment to produce an overall cap rate by weighted average. This methodology takes into account not only the increase in market interest rates, but also equity demands of lenders. Interest rates have increased over 3 percentage points across the last 2 years, which in many cases equates to a 100 percent increase in interest rates.

Additionally, the equity requirements on commercial mortgages have increased from 30 percent to 50 percent. Increasing the base capitalization rate to reflect these changes in an income analysis will offer significant relief in the assessment.

Jurisdictions that rely heavily on office values to support overall assessment value in the tax base will be experiencing increasing tax rates. This increase in rate is factored into the loaded capitalization rate, which obviously means a lower market value for assessment purposes. Analysts and appraisers should review the increased rates annually.

The near term will be challenging for entities that invested in office properties prior to 2023, but the strategies outlined above can offer some protection in this stormy market.

Incurable obsolescence — the stealth killer of commercial real estate value — is all too often overlooked in property tax appeals.

Any obsolescence can affect a property's value. Normal obsolescence involves curable problems, such as outdated fixtures and finishes that reduce a building's desirability. In valuation, the anticipated cost to cure the obsolescence (in this case, with a refreshed interior) is deducted from the property's taxable value.

As the name suggests, incurable obsolescence cannot be cured within the boundaries of the property. The obsolescence stems from outside circumstances, whether next door or in the larger markets, and no change to the property itself can overcome the deficiency.

Perhaps the government is going to change the traffic pattern, or a hog farm is going in next door. The market value may rise if a good thing is coming to the area. It will surely decline if a bad thing is coming, and the market value declines in relation to the predictability of such an event.

Property owners who learn the common forms and causes of incurable obsolescence will be better equipped to recognize its symptoms in their own real estate. In arguing for a reduced tax assessment value, evidence of obsolescence weighing on a property's operations will often tip the scales in convincing an assessor, review board or court to grant a reduction.

Passing or permanent?

Owners should be aware of functional obsolescence and be prepared to discuss it when appealing assessments. If it is a problem that can't be cured within the boundaries of the property, it is incurable obsolescence and reduces the property's market value.

The condition may have existed from the inception of the property's development and use, but more typically it results over time from factors relating to design, usability, markets, traffic patterns, government takings or regulation. For example, economic need or a government requirement may leave a property without adequate parking to support commercial buildings on the site, rendering those structures incurably obsolete.

Incurable obsolescence can be partial and a handicap to the property's viability without entirely preventing its continued use. For example, an office building designed for single-tenant use will not accommodate multiple users. There is a very limited market for single-tenant, high-rise buildings. The cost of retrofitting such a building into separate leasable offices is infeasible.

The loss in value due to incurable obsolescence may be anticipatory. If the market's users and investors see imminent incurable obsolescence, it may already affect market value. The negative impact of incurable obsolescence occurs when the problem cannot be cured on site at any cost.

In evaluating a property for instances of incurable obsolescence, however, it is important to remember that the source of obsolescence may be offsite.

Owners concerned with the production and marketing of a product or service from their property may not be aware of external elements of incurable obsolescence affecting their property's value. Or they may simply regard the circumstance as a non-priority item — at least until they get their property tax bill.

Instances of the incurable

Incurable obsolescence takes many forms, but taxpayers are most likely to encounter it in one of a few common scenarios. Those include:

Property access changes. Typically imposed by a highway or street authority, moving or removing access points can reduce a commercial property's appeal to users and lower its market value.

Altered traffic patterns. Changes to surrounding roads or highways can reduce commercial value. Limiting the property's visibility and accessibility, for example, may reduce customer traffic and brand exposure for operators on the property.

Size modifications. The property may fail to meet the required property size in relation to improvements. Possible causes include changed government requirements or the physical loss of a portion of the property due to government taking. A simple change in setback lines may have a dramatic negative impact on a property's value.

Takings. Use of eminent domain may reduce the remainder of the property to a legal non-conforming use which may not be altered to accommodate a commercially viable use. Alternatively, commercial uses on a state highway may be untouched by highway takings, but diverting traffic to a new highway kills viable commercial use of properties on the abandoned roadway.

More examples

Other sources of incurable obsolescence span a wide range, from changing industry practices and preferences to evolving government regulations, markets and natural phenomena. Zoning or regulatory changes may restrict usage, for example. The property may no longer meet current tenant needs regarding loading dock height, or access by delivery and customer vehicles. Nearby development or street construction may inundate the property with surface water. Properties have incurred incurable obsolescence for their intended uses from light pollution, and from disruptive air traffic following a change in flight patterns.

Property owners discussing excessive taxable valuation with the assessor should recognize that the assessor has employed the cost approach to value. While cost may be a value indicator, it lacks relevance in situations involving incurable obsolescence. Help the assessor to look beyond cost by showing how obsolescence reduces the property's value in the marketplace.

In preparation for meeting with the assessor, an owner seeking a reduced assessment should look for negative conditions beyond the control or ability of the owner to correct within the boundary of the property. Be prepared to discuss with the assessor how the conditions affect the property value. Bring plat maps, photos, restrictive regulations and ordinances, and any documents that entail restrictions on the use of the property — legal, physical or otherwise — and an explanation of how these matters negatively affect the property's value.

While there is no cure for incurable obsolescence, there are treatments for unfair tax assessments. When incurable obsolescence results in lost improvement value, the owner is entitled to an appropriate downward adjustment of the assessed value. 

Taxpayers should look beyond fair market value in deciding whether — and how — to protest assessments.

Taxpayers usually appeal property tax assessments by proving a market value different from the assessor's finding, but they should not overlook constitutional guarantees of uniform and equal taxation.

As an ad valorem tax, real property taxes are charged on the value of the underlying real estate, usually measured as fair market value. In many states, taxpayers can demonstrate their property's market value with a recent, arm's-length sale price or by independent appraisal evidence.

Two potential concerns emerge for taxpayers in an assessment appeal centered on market value: the declining reliability of data in volatile and rapidly changing markets, and the trailing nature of market data used by assessors. Those data issues can skew the mass appraisal techniques tax assessors often use, including comparisons to sales of similar properties, when assessing real property.

Volatility and rapid change

Commercial property data can lose relevancy with surprising speed in a volatile market. For example, office properties continue to bear the consequences of increased remote work and occupants' shrinking footprints since the pandemic. Many office properties with mortgages maturing in 2023 have lost half or more of their previously underwritten asset values. Badge swipes tracked by Kastle Systems show an average office attendance of about 50 percent throughout 2023.

In early 2023, Cushman & Wakefield attributed slowing construction to uncertainty in the office market along with challenges related to higher interest rates, supply chain issues, and labor shortages. Office properties may be in danger of becoming "zombie" buildings with utilization of 50 percent or less, while market watchers warn of doom loops or a domino effect of property failures, especially in dense central business districts. Most market participants are waiting for the other shoe to drop and for the market to reveal its bottom.

Assessors are not immune to the valuation problems this market uncertainty creates. Assessors currently valuing properties are likely considering comparable sales that occurred as far back as 2019 or early 2020. Even more recent sales are likely to be based on leases executed years earlier, or on financing obtained prior to the pandemic.

Further undermining data reliability is the decline in sales activity after March 2020, when pandemic-related uncertainty and economic pressures like rising interest rates began to discourage participants from unnecessary transactions. As pre-pandemic leases expire and loans underwritten on those leases mature, transactional data will likely show drastic valuation declines within a short amount of time. The lag in sales data as these properties are brought to market will affect the accuracy of property tax assessments.

What can a taxpayer do when market activity is too chaotic and volatile to accurately price value? Taxpayers should not forget constitutional safeguards of equal protection and uniform taxation.

The U.S. and most state constitutions protect taxpayers against non-uniform and discriminatory tax policies. For example, the Ohio Constitution requires that "land and improvements thereon" are "taxed by uniform rule according to value." Ohio statutes also require that assessors appraise property according to "uniform rule" in both the "mode of assessment" and as a "percentage of value." The constitutions of Pennsylvania and Texas also contain uniformity clauses. The 14th Amendment of the U.S. Constitution prohibits the government from depriving any person of their property without due process or denying any person equal protection of the law.

These constitutional protections are important enough that federal and state courts have held that when the goals of uniform taxation and correctly assessing market value cannot both be met, the constitutional priorities of equity and uniformity prevail.

Uniform, equal taxation

There are a few ways to help ensure consistent and equitable property taxation, starting with regular reassessment cycles. Some Pennsylvania counties have not reassessed countywide since the 1960s. The lack of regular appraisals to determine market value results in fewer properties being taxed on their true market value, especially if recently sold properties are assessed at their sale price while others have not been reappraised in decades.

A related problem is variation in the taxed percentage of market value between similar properties, which leads to non-uniform assessment ratios. There have been a series of successful contests recently in Lackawanna County, Pennsylvania, by taxpayers demonstrating that other property owners with similar properties were not paying taxes based on similar market values. Therefore, properties with the same market values were not being assessed at the same ratio, leading to non-uniform assessments. "The problem in Lackawanna County was not caused by this assessor's office, but gets perpetuated when new construction is placed on the assessment rolls at 100% of construction costs based solely on permit information, while similar properties have not been property reassessed since the base year of 1967," explains James Tressler of Tressler Law LLC, the attorney who brought a number of these successful challenges.

Another way to ensure assessment uniformity is by valuing the unencumbered, fee-simple interest in the real property, regardless of whether a particular property is leased, owner-occupied, or vacant. Ohio amended its controlling legislation to clarify that assessors must value the market value of the fee simple interest for all properties. Valuing the same market-based fee simple interest for all properties safeguards real estate tax assessments from being influenced by the business value of a successful (or unsuccessful) enterprise conducted on the property.

Governments can check discriminatory treatment by allowing taxpayers to contest the unequal ratios of market value across similar properties, or by allowing taxpayers to challenge assessments based on the median assessments of a reasonable number of comparable properties. Texas law contains this type of protection for taxpayers, and similar legislative remedies are being discussed in Ohio.

These additional checks and balances to secure equal and uniform property tax systems assure taxes are not borne discriminatorily by a few. The Pennsylvania Supreme Court wisely reminds us of these protections in a 2017 decision involving Valley Forge Towers Apartments, stating: "As every tax is a burden, it is important that the public has confidence that property taxes are administered in a just and impartial manner, with each taxpayer contributing his or her fair share of the cost of government."

Differentiate personal property from real estate values for fair tax treatment.

North Carolina taxes both real estate and personal property, but differing valuation schedules and processes for the two types can lead to confusion and inflated tax bills for industrial property owners. Understanding how assessors value industrial properties can help those taxpayers detect issues and contest unfair assessments.

Dual processes

North Carolina requires assessors to revalue real property at least every eight years. The value as of Jan. 1 of the valuation year then remains constant until the next valuation, unless specified changes in the property occur to trigger a change in the assessment. Many counties revalue every four years, and a few, even more frequently.

Assessors use a market analysis to determine real property's taxable or fair market value. This involves applying one or more of the three valuation approaches: cost, comparable sales, or income.

The state requires annual valuation of personal property based on installed cost, which is subject to the applicable trending and depreciation schedules. For the most part, taxing authorities rely on the taxpayer's annual business personal property listing to determine what items of personal property are present, the installed cost, and the trending and depreciation schedule applied. The counties follow schedules for auditing the property tax listings, and most disputes that arise stem from these audits.

With industrial real estate, the two tax schemes can create conflicts based on property components that could be considered either real estate or personal property, depending on circumstances. For example, reinforced foundations or specialized wiring for unique machinery could be considered a real estate improvement, thereby adding value to the real estate, or they could be considered personal property subject to depreciation and trending.

Although the tax rate applied is the same for both real estate and personal property, categorization can significantly affect taxable value. Real property improvements enhance market value on a more permanent basis, while personal property value is generally presumed to decline because of annual trending and depreciation.

And of course, no one wants to be taxed twice on the same property: once by having a component or improvement included in the real estate value, and again by having it taxed as personal property.

Defining characteristics

How can a taxpayer determine what is real and what is personal in their industrial property? Generally, personal property items are movable and not permanently affixed to real estate. An issue of intent arises, however, if the item can be removed but not without causing serious damage to the real estate.

A rule of thumb in the North Carolina Department of Revenue's Personal Property Appraisal and Assessment Manual instructs assessors to classify all property and investment necessary for the operation of machinery and equipment as personal. Examples are wiring, venting, flooring, special climate control, conveyors, boilers and furnaces, dock levelers, and equipment foundations. Stated another way, property used as part of a process, or that is in place to support equipment, is generally personal property.

On the other hand, Department of Revenue staff regard items in the plant for lighting, air handling and plumbing for human comfort to be part of the real estate. The department's appraisal and assessment manual includes an extensive chart, and each county's published schedule of values may also provide a helpful listing.

It is often difficult to know whether the county has included what could be classified as personal property in its calculation of real property value. Regardless, if the taxpayer has not listed such items on the annual personal property submissions, it will be difficult to argue after the fact that they should have been excluded from the real estate value.

Taxpayer strategies

Taxpayers can argue for a reduced assessment by identifying personal property items improperly classified as real property in the assessor's calculations and seeking to have them treated as personal property subject to trending and depreciation. Knowing where to look for personal items will help the property owner in this task.

A critical item to be generally classified as personal property is any leasehold improvement. Leasehold improvements often look like real estate but are owned and controlled by the tenant for the lease term. These are items the tenant paid for and received under terms of the lease or other contract, and were installed for the tenant's use. Leasehold items almost always facilitate the tenant's business.

In deciding whether these items are real or personal property, the taxing authority will apply a test akin to a traditional fixture analysis, determining the manner of affixation, whether the item can be removed without serious damage, and whether it is intended to remain permanent. In the end, the assessor will apply a "totality of the circumstances" test, including the lease terms.

The tenant - as the owner of the leasehold improvements - is required to list those items as personal property. The landlord should monitor the tenant's personal property submissions to ensure that all tenant improvements are being listed. This will help to avoid leasehold items being considered as part of the current real estate valuation.

Unlike a traditional fixture analysis, and dependent on the lease terms, the improvements may be taxed to the tenant during the term of the lease. When the improvements are left to the landlord at the end of the lease term, the taxing authority will need to consider assigning any remaining value to the real estate.

The owner of an industrial property needs to be cognizant of how the assessor is valuing both the real estate and personal property, and how those components are taxed. This requires knowing what improvements are included in the valuation of the real property as of the valuation date, and tracking the annual personal property tax listings, especially those submitted by a tenant. Finally, taxpayers must be timely in correcting any erroneous assumptions or listings.

The often-overlooked band-of-investment argument helps taxpayers demand maximum capitalization rates to combat inflated property tax assessments.

When commercial property owners review assessments of their properties' taxable value for fairness, they typically look to the markets for context. This year, however, superficial market observations do little to clarify questions about property valuation. At the risk of understating the obvious, 2023 has been a confusing time in commercial real estate.

Most investors, brokers, appraisers, and even tax courts seem to agree that the office sector is under severe strain and unlikely to recover soon, even if they debate the extent or duration of damage to the property type. With other sectors, however, the wide range of perspectives today can be confusing and even contradictory.

Mainstream news reports of strong occupancy and tenant demand for retail space only tell part of the story. Many retail property owners continue to struggle with historically high tenant improvement costs and contend with tenants seeking concessions far more frequently than they did before the pandemic.

The multifamily and industrial sectors have remained robust relative to other property types, but inflationary construction costs and borrowing costs driven up by interest rate hikes have thinned margins and clouded projections in many deals.

Against that backdrop, economic forecasts garner a mixed reception. Predictions of an impending recession have felt like sage prophecy, foolish overreaction, or an echo chamber of crying wolf, depending on one's perspective or position in the markets.

Ideal time to review assessments

Clearly, the economics of operating investment properties are far less predictable than they were five years ago. Even within stronger property types, performance and pricing have become more volatile.

That kind of uncertainty means increased risk, which any appraiser will tell you should indicate elevated capitalization rates. Combine that risk with climbing interest rates, and the negative impact on overall commercial property value is undeniable. That makes this an ideal time to review property tax exposure and to contest assessors' overstated valuations.

Data trackers and analysts estimate that value losses among commercial property types range from 30 percent to more than 50 percent. Retail and office properties have suffered the greatest declines from their original appraised values, at 57 percent and 48.7 percent, respectively, according to CRED iQa commercial real estate analytics and valuation platform. In a study of $10 billion in assets across property types, CRED iQ noted an average 41.2 percent valuation decline from original appraised values.

And what's more, KC Conway, the principal of The Original Red Shoe Economist and 2018-2023 chief economist for the CCIM Institute, predicts "lots more (commercial real estate) value loss and bank failures to come."

A residential example helps to put these losses into context. The average 30-year fixed residential mortgage interest rate for the week ending Dec. 30, 2021, was 3.11 percent, compared to 6.42 percent for the week ending Dec. 29, 2022, according to Freddie Mac's Primary Mortgage Market Survey. At 3.11 percent, a homebuyer purchasing a $200,000 house with 20 percent down would have had a monthly mortgage payment of $684.

One year later, a homebuyer putting 20 percent down and using a mortgage with 6.42 percent interest would have to purchase a home for $109,138 to achieve the same monthly payment of $684. This is a roughly 45 percent decrease in purchasing power over the span of one year.

The same principle applies to commercial real estate, where climbing interest rates and a related spike in capitalization rates have rapidly hammered down property values.

Cap rate consequences

It is important for taxpayers to understand that assessors often draw the capitalization rates used in property valuation from cap rate surveys, which may not indicate true cap rates because surveys are backward-looking. And cap rates have risen quickly along with buyers targeted internal rate of return (IRR).

With an increase in interest rates, a potential deal that may have met a target IRR in early 2022 would no longer meet that same threshold at the end of 2022. Correspondingly, the buyer looking at a deal in early 2022 vs. the end of 2022 would likely have to lower their purchase price to meet their target IRR. Assuming net operating income remains constant, the cap rate for the deal in late 2022 would be higher than the cap rate reported for the early 2022 deal. This is a chief reason why cap rates tend to follow interest rates.

Taxpayers may be able to achieve a reduced assessment by arguing for a higher capitalization rate that more accurately reflects a buyer's expected rate of return. To support the highest possible cap rate, taxpayers should take a hard look at the mortgage-equity method, often called the "band-of-investment" technique.

Based on the premise that most real estate buyers use a combination of debt and equity, the mortgage-equity method calculates the weighted average of the borrower's cap rate and the lender's cap rate. Equity cap rates tend to be higher than those on debt, and with lenders offering lower loan-to-value mortgages, equity caps play a greater proportional role in today's acquisition pricing.

Until recently, the method had become disfavored by some tax courts and county boards of equalization. Common criticisms are that the methodology is too susceptible to manipulation, or that the equity component is too subjective and/or too difficult to support. Arguably, many critics just don't understand it. But in the current climate, the band-of-investment is increasingly accepted and perhaps more relevant than ever.

Band-of-investment strategies

Taxpayers can use the methodology in a few ways. For properties purchased or refinanced recently but before the Fed's interest rate hikes really accelerated, taxpayers may argue for straightforward adjustments to recent appraisals to reflect market changes. More complex situations may require a specialist's appraisal to support the value change.

Importantly, even properties which have maintained strong performance are subject to value loss from market changes, which may justify making the additional effort to prepare a mortgage-equity argument.

Before attempting such strategies, taxpayers should evaluate the jurisdictional laws and definitions that control property taxes, including the effective date of the challenged assessment. With 2024 looming and bringing with it a new lien date for measuring assessments in many jurisdictions, now is an ideal time to review portfolios for excessive property tax assessments.

2023 Municipal Revaluations

It is always important to carefully review your tax bill and/or notices of assessments, but even more so in the year in which your city or town conducts a revaluation.

Each assessment should be carefully reviewed, even if your assessment has not increased substantially, as an appeal immediately after a revaluation maximizes a property owner's potential tax savings.

Connecticut law requires that each municipality conduct a general revaluation of the real estate within its borders at least once every five years.The purpose of a revaluation is for a municipality to determine the market value of real estate to be used to calculate property taxes.

Once a property's value is set in a general revaluation, it remains constant over the entire five-year cycle, absent appeal, demolition, improvements or expansion. Of course, the annual taxes usually increase, as a municipality's mill rate increases incrementally from year to year. Municipalities across the state are on differing revaluation cycles. The following is a list of Connecticut municipalities conducting revaluations this year:

If your municipality is conducting a general revaluation for the October 1, 2023 Grand List you will receive a notice of tax assessment change soon, if you have not already.

Once the notices are issued there may be a chance to meet informally with the assessor to discuss the new assessment, which should represent 70 percent of the fair market value of your real estate. However, if a property owner wishes to challenge the assessment formally, a written appeal must be filed with the local Board of Assessment Appeals by the February 20, 2024 statutory deadline.

It is in your best interest to be proactive in monitoring the revaluation process and your new assessment so that you can take all necessary steps to ensure that the assessment is equitable.

News on the Newly Enacted Tax-Payer Appraisal Deadline

While we have deadlines and key dates fresh on the mind, 2023 was the inaugural year for a new deadline that was implemented into Connecticut's overvaluation statute, C.G.S. 12-117a, by the Connecticut General Assembly. Per the newly amended statute, if a taxpayer brings an overvaluation appeal on real property that has an assessed value over $1 million, the taxpayer is now required to file an appraisal of the property with the superior court by no later than 120 days after commencing the appeal.

It remains to be seen what relief, if any, a taxing authority may seek from the court if a taxpayer fails to meet this deadline, but expect some case law to develop on this subject if the statute is not amended in future legislative sessions. One recent superior court decision involving a tax appeal captioned as Shortline Properties, Inc. v. City of Stamford, FST-CV23-6060950-S discussed the implications of this deadline to a certain extent, but it did not squarely address the question of what judicial relief is available to municipal defendants.

The court did make clear, however, that appraisals filed for purposes of this statutory requirement must be from the grand list date from which the taxpayer commenced the appeal. In this case, the taxpayer's appraisal appeared to be from two years prior to the grand list date in question, and the court concluded that this did not meet the appraisal requirement. That said, the case remains pending and although the court rejected the appraisal, it allowed the plaintiff to proceed with prosecuting the appeal.

Tax considerations often drive site selection and form an importance piece of the reshoring puzzle.

COVID-19 laid bare many problems inherent in offshore supply chains and spurred widespread interest in reshoring manufacturing to the United States. As companies and communities explore site selection and expansion opportunities, they should remember that manufacturing profitability often hinges on tax strategy.

Staging a comeback

For the first time in decades, industry and the public sector are working to make American manufacturing competitive in a rapidly changing global marketplace. The recent enactments of the Inflation Reduction Act, the Bipartisan Infrastructure Law and the CHIPS and Science Act have directed billions of dollars into enhancing domestic manufacturing capacity.

The semiconductor industry presents a high-profile case study. The United States holds 12 percent of the world's semiconductor manufacturing capacity, eroded from 37 percent in 1990. The CHIPS Act's $52 billion in federal funding is intended to strengthen domestic semiconductor manufacturing, design and research and reinforce the nation's chip supply chains, fortifying the economy and national security along the way.

Simultaneously, the United States is becoming a leading producer of electric vehicles and vehicle battery plants. Since 2021, announced U.S. investments in semiconductors and electronics exceed $166 billion, and announced U.S. investments in electric vehicles and battery manufacturing exceed $150 billion.

Deciding where manufacturing occurs depends partly on proximity to suppliers, available labor, distribution hubs and customers, and operating costs. Property tax is typically a significant component of operating costs. That's why tax abatements on real property and equipment are a commonly offered incentive.

Most states offer incentives to attract industry, and one of the hotbeds for increased American manufacturing has been the southeastern United States, specifically South Carolina, Georgia and North Carolina. All are leaders in foreign direct investment.

Abatements generally provide a manufacturer with predictable property taxes, helping to overcome the uncertainty of future tax liability that can put companies at a disadvantage. An example is South Carolina's "fee in lieu of tax" agreement (FILOT) which offers manufacturers predictable and consistent taxation. Generally, FILOT agreements fix tax rates and the value of real estate and improvements for the length of the agreement, while allowing manufacturers to depreciate the value of machinery and equipment.

FILOT agreements can have up to a 50-year term. However, by fixing a manufacturer's real property value at actual cost without depreciation, the owner's taxes over time may be higher than they would be without the agreement. That's because they do not account for depreciation, valuation changes or required improvements to accommodate changes in the marketplace for the manufacturer's product.By locking in the real property value, the manufacturer receives the benefits of predictability and protection from higher taxes on appreciating real property.In exchange, however, the manufacturer loses the benefit of any depreciation and takes the risk of a locked-in property value if the property's market value diminishes.

Other states offer different incentives including more traditional property-tax abatements, where a manufacturer receives a grant as a partial rebate or discount on the new property taxes the project creates. Since tax rates and taxable value assessments change over time, these systems can provide less certainty for manufacturers than FILOT-type agreements, but potentially offer more long-term flexibility to respond to changing tax rates, depending on how the agreements are negotiated.

As a manufacturer's industry evolves and demand for its products changes, flexibility to appeal tax assessments can be a key to maintaining profitability and competitiveness.

Committed but flexible

Certainly, a manufacturer is better off in an appreciating real estate market by fixing the value of the real estate and improvements. Organizations negotiating for incentives should protect their ability to protest unfair assessments of taxable value, however, because valuing a manufacturing plant in the traditional ad valorem system is challenging and subject to controversy.

For example, most state ad valorem property tax systems define "value" as a variant of "market value," assuming an exchange between a willing buyer and a willing seller. However, will the buyer of a manufacturing facility benefit from the features of a specialized building constructed for a different manufacturer's specific needs? The answer is usually "no."

Manufacturing facilities are special-purpose properties, which The Dictionary of Real Estate Appraisal defines as a "property with a unique physical design, special construction materials, or a layout that particularly adapts its utility to the use for which it was built." And changes in the manufacturing process can render many buildings economically obsolete.

If the facility's use is no longer viable, it should be appraised as an alternative use. This necessarily occurred as American industry declined. Often there were no manufacturers who could effectively use single-purpose buildings vacated by other manufacturers, necessitating drastic value reductions.

An assessor's three traditional valuation methods all have limitations. A sales comparison approach is difficult when the production facility has essentially been designed to produce specific products. Put differently, finding sales of comparable facilities can be extremely challenging.

An income approach requires a market rent calculation, but manufacturers historically own their facilities, making an income approach difficult. A cost approach using actual cost ignores that the same building might not be appropriate to respond to changes in the marketplace for the product being produced. The cost approach without depreciation also limits the manufacturer's flexibility in responding to changes in the marketplace for its product.

Remember, too, that a manufacturer must be nimble, as changes in the market or technology can render an entire plant (or industry) obsolete virtually overnight. Adapting processes may require equipment upgrades or replacement, structural modifications or other changes that affect property value.

The speed at which manufacturers need to be able to adapt to a changing marketplace, the strong desire for certainty in costs and the difficulties in valuing manufacturing facilities for tax purposes all argue in favor of valuing real property and improvements on the basis of cost less depreciation.

Successful reshoring will require focused efforts by the public and private sector, together with sensitivity to industry's need to be nimble and the implications of historical incentives to ensure that reshored industry remains competitive. Flexibility offers the key to long term success, and property taxes form an important piece of the puzzle.

Here are some property tax strategies owners can use in the rebounding apartment sector.

Multifamily construction and renovations are enjoying a resurgence after taking a pause during the pandemic. And with residential, apartment-style rental units back in vogue with renters and investors, developers are even converting underutilized office buildings and shopping malls into multifamily housing.

As developers step up construction spending to tempt renters with an assortment of amenities, tax assessors are having a field day, tabulating costs on renovations and new projects that they are using to justify ever-larger assessments of taxable value across the sector. Multifamily owners must look out for themselves to guard against unfair, blanket assessment increases founded on these gross generalizations about the industry.

New offerings, New Renters

The target demographics for today's projects include young professionals not yet equipped to buy their own homes; middle-aged, single-family homeowners looking for a more carefree housing option; and aging individuals looking to downsize and become part of a seniors community.

Apartment models have evolved to better suit today's renters. Gone are the cookie-cutter, brick-and-mortar, garden style structures with minimal common areas. New apartment communities are more often high-end projects boasting pools, gyms, lush landscaping, retail shops and other non-traditional apartment features.

The added expense to deliver amenity-rich apartments is only one of many rising costs for multifamily developers and owners. Supply chain breakdowns, material shortages, rising interest rates on commercial mortgages, governmental bureaucracy, and increased inflation have forced owners of apartments and other commercial buildings to search for avenues to reduce their costs. While costs associated with owning and maintaining apartment buildings are trending higher, real property taxes remain one of the largest expenses, warranting an annual review and challenge.

Fortunately, in ad valorem jurisdictions where a property's tax assessment is tied to its market value, the law allows taxpayers to appeal assessments and seek relief from onerous real estate taxes. The process involves the filing of an annual administrative grievance followed by a judicial action against the tax-assessing entity.

The Protest Process

In tax appeal proceedings, the aggrieved party or petitioner bears the initial burden of proof. Assessments are presumptively valid, so it is up to the taxpayer to provide substantial evidence that calls into question the assessment's correctness. Taxpayers often meet this minimum standard by submitting a qualified appraisal.

In a court setting, once the presumption of validity is rebutted, the judge must determine by a preponderance of the evidence whether the property was overvalued. However, most tax assessment cases reach a resolution through negotiation and settlement without the need for a formal expert report or judicial oversight. A tax advisor skilled in real property tax assessment challenges is more often than not all the taxpayer requires.

The three traditional approaches to real property valuation in a tax appeal are the income capitalization, comparable sales, and cost approaches. Absent a recent arm's-length sale of the subject property, appraisal professionals, practitioners, and the courts generally regard income capitalization as the preferred method to value income-producing properties.

In utilizing the income approach, a taxpayer's team is seeking to value the property based on its net-income-generating potential. In other words, what would a buyer pay on the valuation date for the future income stream?

Point-by-Point Analysis

There are several steps to properly arrive at a value conclusion through the income approach. Understanding and following the steps will not only inform the property owner's valuation, but also provides a checklist to review and question calculations in the assessor's conclusion.

To calculate potential gross income, it is important to analyze the subject property's actual rental data and test it against market rents to reflect the property's economics. Similarly, the assessor or appraiser must gather, review and analyze occupancy and collection data. The appraiser will need to deduct for vacancy and collection loss because many buildings are seldom at 100 percent occupancy, and some tenants may be behind in their rent payments.

The same process is applied to real estate-related expenses such as insurance, utilities, and replacement reserves. These should be deducted to arrive at a net operating income before the deduction of real estate taxes.

In analyzing data for a tax assessment challenge involving income-producing property, real estate taxes are not accounted for at this stage because this is the expense in question. In addition, since the property tax expense is a percentage of market value, it is accounted for in the capitalization rate along with an appropriate rate of return reflecting the risk of investment.

Appeal prospects

How can the taxpayer gauge a tax appeal's likelihood of success? Among other things, consider the size of the rental units, location, competition, and parking to form a reliable value opinion. Give special attention to the tax system in the state and local jurisdiction where the property is located to ensure the taxpayer meets all statutory filing requirements and deadlines. If a challenge is not timely and properly commenced, the aggrieved party will lose its right to real property tax relief for that tax year.

Given the complexity of commercial property valuations and the nuances involved in disputing the correctness of valuation calculations, savvy apartment building owners may benefit by discussing their property's economics with a specialist in real property tax assessment review challenges. 

Appraisals designed for lenders often inflate assessments of seniors living real estate for property taxation.

Appraisal methodologies for financing seniors housing properties factor in more than real estate to produce amounts that exceed property-only value. That means seniors housing owners may be paying real estate taxes on non-real-estate assets.

Everyone can agree that a seniors living operation—whether independent living, assisted living, memory care, skilled nursing or some combination—consists of a variety of assets. There are real estate assets (the land and building), personal property assets like furniture and kitchen equipment, and intangible business assets such as the work force, tenants, and operating licenses. These multiple assets and asset types present a challenge when developing an appropriate ad valorem tax valuation.

To appropriately value this asset type for property taxation, an owner must show the assessor the real estate's stand-alone value. Most states acknowledge that business assets are not subject to property tax, so the intangible business assets and their respective values must be identified and excluded.

The International Association of Assessing Officers, in its guide, "Understanding Intangible Assets and Real Estate: A Guide for Real Property Valuation Professionals," has developed a four-part test to help determine whether something intangible rises to the level of an asset. The IAAO test is as follows:

1. An intangible asset should be identifiable.

2. An intangible asset should have evidence of legal ownership, that is, documents that substantiate rights.

3. An intangible asset should be capable of being separate and divisible from the real estate.

4. An intangible asset should be legally transferrable.

The Appraisal Institute's current, 15th edition of "The Appraisal of Real Estate" recognizes the valuation methodology of separating the components of assets in a business or real estate transaction. Potential intangible business assets identified in the text include contracts for healthcare service, contracts for meals, and contracts for laundry assistance, all of which represent income streams or businesses. An assembled workforce is an intangible business asset with a quantifiable value. How long would it take an operator to staff-up a property prior to opening? What are the carrying costs during that time?

Many seniors housing owners and investors feel that the entire value associated with seniors living real estate is attributable to the business. While this may be a firm belief, the real estate must have some value. For fair taxation, the taxpayer must differentiate and value both the tangible and intangible components of the asset.

Multifamily comparisons

For 30 years, Ohio law has permitted appraisers to reference data obtained from traditional multifamily properties to value just the real estate in seniors housing. The theory has been that traditional apartments are primarily real estate and lack much of the associated business value that comes with seniors living assets. Therefore, an appraiser who takes the gross building area of a seniors living property can select, analyze, adjust, and apply multifamily data to determine fair market value.

This approach presents at least two issues. One, seniors living designs differ from traditional apartments. For instance, seniors living units are typically smaller, lack full kitchens, and require wider hallways to accommodate wheelchairs. Two, the multifamily market has generally prospered in recent years while seniors living properties have struggled to recover from pandemic-related losses.

This means Ohio appraisers are comparing seniors living properties to multifamily assets selling at higher and higher dollars per unit. Multifamily properties generally experience lower vacancy, credit loss, expenses and capitalization rates than do seniors housing assets. In short, these two product types often move in opposite market directions.

Difficulties with financing data

More and more, county assessors and school board attorneys throughout Ohio rely on appraisers who value seniors living properties as if done for lending purposes. While these going-concern valuations may satisfy lenders' needs, these same techniques are not reliable or accurate enough to support a state's constitutionally protected valuation and assessment process.

Going concern appraisal reports back into a real estate value. After first developing a total value for all assets present, the appraiser attempts to extract the business value.

There are several techniques routinely used in appraisals for financing that are inappropriate for determining taxable value. These include the lease fee coverage ratio approach, a management fee capitalization approach, and the cost residual approach. These appraisal techniques have been approved by banks, but they are largely untested in courts.

These approaches are tainted from the start because they look first to the total going concern value. That inherently requires an evaluation of business income, which should not be considered when determining a fee simple value of the real property.

Of the going concern methodologies, the cost residual method appears best suited to assess taxable property value. However, challenges and subjectivity abound when identifying and determining all aspects of depreciation that may impact market acceptance of the real estate asset, especially for an older property.

Starting with the business is problematic given the dollars involved in seniors housing resident services. Median asking rent for a conventional apartment was $1,000 per month in the Federal Reserve's 2022 Survey of Household Economics and Decision Making. By comparison, the median monthly rate for assisted living is $4,000, according to the American Health Care Association/National Center for Assisted Living. Importantly, that $4,000 excludes fees for additional services like medication management and bathing assistance.

Service fees constitute significant revenue in most seniors housing operations. A 2019 CBRE Senior Housing Market Insight report found that 65% of the revenue in assisted living properties comes from services provided above and beyond pure rent. The 2023 JLL Valuation Index Survey found that the average "Majority Assisted Living" asset class saw an expense ratio of 71%.

Owners and appraisers must closely examine operating statements to develop and support their opinions of value. Appraisers should consider looking at properties as having multiple income streams to verify whether their opinion of value for the real estate is reasonable and supportable. Operators and investors should be open and honest about return expectations.

Because the income generated by intangible business assets at seniors living properties are taxed in other ways, assessors must continue to carefully review seniors living real estate to ensure fair taxation. 

Spencer Fane's Michael Miller on the critical steps for finding tax relief.

This is a challenging time in the property tax world. Pandemic-era federal assistance programs have dried up, increasing communities' appetite for tax dollars to deal with crime, homelessness, transportation and other issues. Recognizing that inflation has put taxpayers under pressure, governments may offer tax relief to homeowners, their voters, but not to the commercial property owner.

In Colorado, a November ballot issue would reduce the valuation of a residential property by $40,000 and of a commercial property by $50,000. This will be little help to an owner of a $2 million commercial property.

Relief for the commercial property owner must instead come from a deep dive into the assessor's valuation, best performed by the property owner and an experienced property tax professional working as a team. What follows are key stages for preparing an appeal.

1. Understand and observe all filing deadlines.

Every state has a deadline for starting the appeal process. If a taxpayer misses that deadline, they lose the right to appeal. In some states, after paying their tax, a taxpayer might be allowed to file for an abatement sometime later.

It is important to provide the property tax professional with relevant information in sufficient time to analyze it before filing the appeal. This is a challenge in many cases, such as when the taxpayer receiving tax notices is out of state and their advisor is local. Contacting the advisor before tax notices go out can provide a head start, often enabling the advisor to find the property's taxable value before the notice arrives.

2. Critically analyze the assessment basis.

By itself, a substantial value increase does not qualify as a reason to appeal. Often, the assessor will justify the increase based on the general market strength shown in substantially rising prices. The taxpayer must ask, is this for the entire county, or for this specific type of property in this specific location?

A recent example illustrates how assessors' generalizations can overstate an individual property's value change. As our firm appealed a client's assessment in an expensive resort area, the local newspaper quoted the assessor stating that prices had increased 50% or even more. Available sales of comparable properties all occurred at least a year prior to the valuation period, while one was near the valuation period.

The assessor trended the earlier sales to the valuation period by making a 50% adjustment to each sales price. However, our team compared the most recent year-ago sale with the current sale of a comparable property in the same location, showing that the price per square foot only went up 14%. It was clear the 50% increase was a mass appraisal number covering the entire county, while prices in the subject property's submarket increased at a much slower pace. This deep dive yielded results in the appeal.

3. Analyze the assessor's comparable sales.

Most jurisdictions require assessors to value the fee simple estate, the real estate alone. Assessors have attempted to debate what this means, but what it clearly does not mean is a sale price based upon the income generated by a lease. Nor can the taxable value be based on the success of the business operated from the property.

Simply stated, fee simple value must be limited to the real estate, not the business. When applying this to an owner-occupied property, this means a fee-simple buyer would be purchasing a vacant property. Value is based on the price at which a willing buyer would buy, and a willing seller would sell, the property. And in the sale of an owner-occupied property, there is no lease.

Often in this situation, the assessor will nevertheless use the sale of a leased property as a comparable. It is not comparable, because the buyer is buying the income stream from the lease, not just the bricks and mortar. Moreover, the rent seldom reflects current market rent. Possibly the lease was signed when rents were higher than today, the lease escalated rents automatically, or the landlord agreed to build the property according to the tenant's specifications and increased the rent by the amortized cost. Every lease is unique. The sale of a leased property is simply not the same as the sale of a property without a lease.

While examining income properties within the assessor's comparable sales, be sure to analyze the income's source. Taxable values of income-producing properties are based on income derived from the real estate and not income derived from other sources.

A hotel buyer, for example, is buying not only the bricks and mortar, but also the flag or brand, and the hotel's reputation. These are intangibles included in the acquisition price. However, intangible value is not subject to a property tax.

Another example of this concept is seniors housing. Seniors housing has numerous profit centers beyond rent for the room. It may have a beauty shop, a physical therapy center, a recreation facility such as a bowling alley, special medical services and many other offerings. The resident pays rent, but also pays extra for the many services. For property tax purposes, the income used to determine value must be separated between business cashflow and income generated from the real estate.

Property tax in the current environment can indeed present a challenge, but it need not be overwhelming. The taxpayer must analyze the assessor's value in depth to find factors that would result in a successful appeal. It may start with sticker shock over the assessor's notice, but an experienced tax professional's analysis can level the playing field between the assessor aggressively pursuing increased funding and the property tax owner looking for tax relief.

Not long ago, assessors' student housing properties valuations generally struggled keeping pace with the rising market.College enrollment was high, rent growth outpaced expenses and student expectations lined up with most newer facility amenities. However, the COVID-19 pandemic and its fallout changed the game.

Property taxes are often the single highest expense on a property's profit and loss statement. When market changes make student housing less profitable, the tax burden should not be allowed to remain high. When this occurs, the assessor's property valuation needs to be challenged and reduced.

Projecting Income:Look Forward, Not Back

Many jurisdictions assess student housing properties' value using a cost approach.A computer system estimates the cost to build the property new, then deducts physical depreciation based on the property's age. Due to skyrocketing construction costs, those depreciation deductions are outpaced by base cost increases. It is common to see cost-based values increase despite struggles facing the real estate market. Owners can combat increases by appealing the assessor's value.

When a student housing property owner files an assessment appeal, the appeal review board often evaluates the three prior years' operating income. This allows the appeal board to develop an income model intended to represent stabilized operations. Then the net income is capitalized, producing an estimated market value. When the market rises and rent increases, looking at the past three year's performance is probably a favorable method for taxpayers. However, in a flat or falling market, determining value based on past success proves unfair. Property values' steady upward trajectory, by and large, has stalled out given the gut-punch of 2022 interest rate hikes. Capitalization rates have risen along with the interest rates, though it becomes difficult to see clearly because sales transaction volume slowed to a trickle. Sellers would rather sit on their property than swallow the loss the current market forced on them.

For student housing specifically, it is not uncommon for brokers to cite 15% to 20% market value declines from early 2022 to early 2023. In addition to general market woes, some developers expect college enrollment to drop in the near future due, in part, to fewer students graduating from high school.This will make leasing more difficult and put downward pressure on rents and occupancy. Falling rental income should be taken into consideration by the board or tribunal hearing a property tax appeal.

Projecting Expenses: The Compounding Costs of COVID

Waves of new development during the late 1990's and mid-2010's saw student housing units grow exponentially.At the time, they were state-of-the-art facilities with all the amenities a student could desire. For some, common areas evolved from utilitarian waiting rooms to shared workspaces or workout gyms.For others, bathrooms were no longer shared with a full suite, but only a single roommate.

When the property's design fails to meet changing tenant expectations, that produces functional obsolescence. Many boom-time properties now suffer functional obsolescence.Worrisome trends that predated COVID-19 have been fast-tracked by the pandemic, becoming major problems.

Most people, including future college students, were quarantined for months and developed new tastes and behaviors. Student tenants are not as tolerant of sharing a bathroom with a roommate. One-to-one bathrooms are no longer a luxury in most markets, but trying to retro-fit a property to achieve the best bed-to-bath ratio often fails the cost-benefit analysis. When a design deficiency can't feasibly be corrected, it is known as incurable functional obsolescence.

Online shopping became a near-necessity during quarantine, reshaping our consumer habits long-term. When a building full of button-clicking students receives more Amazon boxes than envelopes, there better be package lockers or another delivery management system to handle the volume. Maybe some unutilized common area space presents an easy opportunity to convert, making this type of obsolescence curable. Even so, the cure does not come without landlord expense.

Not all new expenses involve obsolete building design. New cleaning protocols originated during the pandemic but have not receded with the COVID case count. The "janitorial" line item has swollen, further narrowing landlord margins.

Even if the building is clean, it may not be tidy. Kids who were forced to stay home for meals tend not to go out as frequently. They order-in, and they party-in, too. That creates a lot of trash. Kids do not appreciate having to haul trash down a flight of stairs or ride with it down an elevator. Trash chutes appease them, but not if the building doesn't have one.

Rising operating costs are not all associated with COVID. For example, HVAC systems that use a coolant being phased out by new regulations will have to be upgraded to comply. Also, insurance, payroll, and other outside service costs have increased with general inflation.

Increasing operating expenses drive down a property's net income and should be accounted for by tax appeal decision-makers.

Question the Assessor's Valuation

When property owners appeal their assessment based on a drop in income, "bad management" becomes the common refrain heard from assessors. This implies the property is worth more than the income indicates, because it has been poorly operated. Sometimes this is true, but if a property suffers lackluster performance caused by unavoidable market changes, the assessment should account for that. Taxpayers would be wise to seek seasoned property tax counsel for advice as to what relief may be available.

Here are the steps to start an informal discussion with the assessor that may lead to a tax reduction.

Owners of large commercial real estate portfolios typically have internal staff to deal with assessed property values and the resultant taxes on a regular basis. But what about owners of small or medium-value properties?

How can a taxpayer, without knowledgeable staff or outside assistance, determine whether their assessment is fair or if they should seek an adjustment? And if seeking a reduction seems appropriate, going it alone through discussion with the Assessor may be productive.

Any such informal review or discussion should be the result of careful consideration and preparation. The following points are essential in that review and will help the taxpayer build and present a strong case for a reduced valuation.

Getting started

A government representative, usually the county collector, issues a property tax bill based on the value the county assessor has placed on the taxpayer's real estate. The property owner may launch an appeal to contest that assessed value. However, in many states, the tax bill arrives after the due date for appealing the assessor's valuation.

Owners should review their property's assessed value each year. Begin the process as soon as the assessor posts new values to its website, usually in January. If there has been no increase, the assessor won't provide a statement of the assessed value until it is included in the tax bill sent later in the year, at which time the appeal period will have ended in most jurisdictions.

If the assessor's value opinion is less than the taxpayer believes it should be, they can simply pay the taxes due and plan to revisit the assessor's website the next year. If the assessor's opinion is approximately the same or greater than the property owner's value estimate, however, the taxpayer should investigate further and consider whether to seek a meeting with the assessor followed by an appeal.Some jurisdictions (states) have cycles of more than one year so the valuation for tax purposes may extend beyond the first year's valuation date into the following year or years.

Know dates and procedures

Missing the filing deadline is fatal to any potential relief from property tax. Most jurisdictions will notify taxpayers of an assessment increase and provide the timeline for review on appeal. Even when an assessed value is unchanged from previous years, the owner may still deem the assessment to be excessive and worth appealing.

While the owner is entitled to appeal an unchanged valuation, in most states there is no obligation for the assessor to notify the owner of altered assessed value—at least not until the time for appeal has run out.

Learn the lingo

Appraisers, assessors, attorneys, real estate brokers and other professionals dealing regularly with property tax matters frequently use words and phrases unique to the valuation of real estate. These terms and their interpretations fill volumes of legal writing and serve as linchpins in court decisions and business transactions.

Taxpayers who familiarize themselves with valuation lingo will be better prepared to discuss value with assessing officials. (For a list of key terms and definitions, see Property Tax Terms.)

Call the assessor

Most assessors or members of their staff will meet for informal discussions prior to, and sometimes during, a formal appeal. Call to request a meeting and provide the assessor with a heads-up about which property or properties will be discussed. This will save time by ensuring the assessor's team has an opportunity to review their work and supporting data for an informed discussion.

The meeting will be informal. The assessor or representative will be prepared to defend the assessed value. It is important for the taxpayer to realize that value was probably, in whole or in part, generated by a computer.

Bring relevant materials and documents in duplicate so that a set can be left with the assessor's office. They may not want to accept them but give it a try.

The informal meeting is often the property owner's first opportunity to show the property was overvalued in the assessment. The owner will need to support their proposed value using at least one of three standard approaches to valuation, which are cost, income, and sales comparison.

Of these, a non-appraiser is most likely to apply a sales comparison. While adjustments may be necessary in the application of a comparative sales calculation, it is less complex and dependent on expert analysis than either the cost or income approach. For the non-professional, the fewer adjustments required, the better.

For example, developing an informed opinion of a single-family home value based on the sale of two nearly identical homes on the same street does not present a great challenge. The further away the sales occur and the more they differ from the subject property, however, the greater the challenge and the less reliable the sales become as comparatives.(comparables is the term appraisers use)

The cost approach, unless it reflects the actual and recent construction cost plus the land value of the property in question, requires the application of factors best left to professionals in the valuation field. The income approach is even more complex, drawing a value conclusion not from actual rent at the subject property but by applying market rents to the initial rates of return that provide the basis for prices paid for acquisition of similar properties.

Like the cost approach, income-based valuation is best left to the experts. However, an owner who owns and invests in income-producing properties may very well be able to show a lower valuation using their own formulas learned through experience and practice. If such be the case, present that opinion and back-up information to the assessor.

Escalate as needed

Assuming informal discussions fail to achieve a value reduction, the taxpayer must file a timely appeal or accept the assessor's opinion. Filing requires the owner to know and conform to the prescribed filing date. The taxpayer must also decide when or if they will engage an attorney to pursue the appeal.Jurisdictions vary on the point at which an attorney is required to pursue a formal appeal.Filing dates and the required point to seek expert assistance are critical and vary by state. It is up to the taxpayer to learn these dates for their area, and to act while there is sufficient time remaining to file and win an appeal.

Property Tax Terms

A general understanding of real estate valuation terminology is intrinsic to discussions with the assessor.

Assessed Value: The taxable percentage (usually set by statute) of the assessor's opinion of fair market value.

Fair Market Value: What a willing and informed buyer would pay to a willing and informed seller. Fair market value is not value in use, sentimental value, or personal value unique to the owner.

Deferred Maintenance: The property needs a paint job, roof replacement or similar repairs, in which case the cost of correcting the deficiency is deducted from the property's value.

Obsolescence: A curable problem of which the anticipated cost to cure is deducted from the value of the property without the problem.

Incurable Obsolescence: A problem on the property that can't be cured at any cost, such as loss of parking or loss of access due to a road project.

Owners can use the hurting office market to their benefit.

It's no secret that the real estate market suffered in the COVID-19 pandemic, and no property type was hurt more than office buildings. While hospitality and entertainment properties nearly suffocated, their post-quarantine rebound has been impressive. Real estate professionals who projected multiyear recoveries for hotels and movie theaters back in 2020 and 2021 have been proven wrong. Offices, however, have not been so lucky.

The pandemic hastened a work-remote trend that was already leading office tenants to downsize their spaces, and the shift soon stifled any countervailing influx of tenants that landlords could have relied upon to stabilize their properties. Tenants have also realized that if they are using remote workers anyway, they can employ overseas workers for significantly less pay and with zero office requirements. As a result, many landlords have seen their occupancy and rents drop. Some have been able to maintain rent levels by giving away major concessions or tenant improvements. Some have not.

Falling rents and occupancy deflate property values. A trending loss in property value means it's time to review the tax assessor's value of an organization's property, and to challenge the assessment if appropriate.

Why care about the office market?

Perhaps your company owns or leases a building that it fully occupies. The difficulties of the post-COVID office market are unfortunate, but they don't impact you. Your building is full.

Wrong.

Most jurisdictions value the fee-simple property rights of an income-producing property. Basically, that means valuation is based on capitalization of the income stream that the property would produce if leased at market levels.

This is true for owner-occupied offices, too. If the property is leased after a build-to-suit or sale-leaseback transaction, those typically above-market rents or extended terms are irrelevant to a fee-simple analysis.

If the assessor values a property for property tax purposes based on fee-simple property rights determined using a market-derived income stream, and if current market rent levels and occupancy rates are dropping, then the property's tax assessment should be dropping, too – even if the building is full.

Inflation and interest rates

The problems specific to office buildings are not the only ones for the taxpayer to consider. Inflation has made it more expensive to do just about everything, and that includes operating an office building. Payroll, utilities, insurance: All of these costs are steadily rising, even for owner-occupied buildings.

Local governments are feeling the squeeze, too. Their budgets often depend largely on property tax revenue. When inflation reduces a budget's effectiveness, there will be pressure on the assessor to find ways to dig deep and expand the tax base.

The Federal Reserve's solution for inflation was an aggressive program of interest rate hikes over the course of 2022. The rising cost of money has a significant impact on capitalization rates, which investors and appraisers use to value a property's income stream. The higher interest rates go, the higher cap rates go. The higher cap rates go, the lower property values go.

Where are the sales?

The problem with attempting to demonstrate the impact of rising interest rates on cap rates is the sheer lack of sale transactions. Banks aren't bullish on office lending right now, and sellers would rather hang on to a struggling property than sell it for less than it would be worth if stabilized. How can a taxpayer know what kind of price an office building's income stream will bring if office buildings aren't selling?

This is where the assessors will use sales of office properties to support high values. In many markets, an office property that sold in 2021 is worth significantly less today. But today, there often aren't enough comparable office sales occurring to prove declining value. Assessors can point to the most recent office sales, albeit a few years old, and justify their value on a comparative basis.

What those older sales do not reflect is the more recent plague of dropping rents and rising vacancy. The taxpayer needs a way to discount those old sales and prove what the value is today, not three years ago.

Is it time to appeal?

Consider your office property. Could it sell today for the price it sold for two or three years ago? Probably not. Maybe the organization recently bought it, or even built it, for more than it could sell for today. This is not an uncommon problem anymore.

In many jurisdictions, the best way to challenge an office property's assessed value is by using the income approach. If the building were leased at market rent, what would that look like? If the building were occupied at current market occupancy levels, how much vacancy would there be? The taxpayer may need to talk to a broker or two to answer these questions.

The taxpayer may need help to turn market data into a viable appeal strategy. A property tax professional can prepare a fee-simple income approach and help estimate the current market value of the property. In the present situation, there is a good chance property tax relief is available, even if the office building is fully occupied.

Developers should understand the property tax implications before attempting to repurpose buildings in downtown Washington, D.C.

With office vacancy rates in the District of Columbia at 20% and climbing, officials believe that converting office buildings to residential space is an important component of revitalizing Downtown Washington.

These complex projects pose both practical and administerial challenges, however. For developers, one important consideration of such a redevelopment is its real estate tax implications.

High hopes

District leaders announced earlier this year that they hope to add 15,000 residents to the central business district over the next five years – an ambitious goal. The hope is that bringing residents to live downtown will create a more vibrant neighborhood where people live, work, and dine.

The stark reality is that the District of Columbia has one of the lowest return-to-office rates in the country. Actual occupancy in the D.C. metro was only 43% in mid-April and drops below 25% on Fridays, according to Kastle Systems, which tracks office occupancy. Workers simply aren't returning to Downtown D.C.

While residential conversions may be one piece of the puzzle in addressing D.C.'s downtown woes, converting an office building into a residential property is no small feat. Here are a few important factors relating to real estate taxes to keep in mind when considering an office-to-residential conversion.

Real property tax rates

Real property tax rates in the District vary considerably from residential to commercial real estate. Residential properties, including multifamily apartment buildings, are taxed at a 0.85% rate. The commercial tax rate, which is used for office buildings, is more than double that rate at 1.89% for properties assessed over $10 million.

To the extent a property contains both residential and commercial space, D.C. will apply a mixed-use tax rate based on the pro-rata allocation of residential versus commercial space. Consequently, how the District classifies a property can have an immense impact on tax liability and carrying costs.

Timing of reclassification

A costly misstep would be to assume that the tax rate will immediately change from 1.89% to 0.85% after an office property is acquired for residential conversion. In fact, if there is any commercial use continuing at the building, the commercial tax rate will still apply.

Moreover, the District historically has been inconsistent in its application of when a building should "convert" from commercial to residential for purposes of tax classification. Although the D.C. Code provides a property should be reclassified when there is no current use and the property's highest-and-best use is residential, some assessors have taken a more aggressive approach and argued that the property should not be reclassified until the redevelopment is more than 65% complete.

Property acquisition

An additional hurdle lies in the acquisition process itself. When an office building is acquired for a residential conversion, higher transfer and recordation taxes apply. For commercial and mixed-use properties, the transfer and recordation taxes are 5% of the sale, as opposed to 2.9% for a purely residential building.

The mayor's proposed 2024 budget would allow the higher transfer and recordation tax rate to expire later this year, but the D.C. Council had not adopted the measure at the time of this writing and may or may not allow the higher rate to sunset. Under the current code, there is no exception for the acquisition of an office property that is being purchased for purposes of a residential conversion.

Abatements

Finally, in an effort to spur redevelopment, the mayor has announced her intention to offer tax abatements for office-to-residential conversions that meet certain criteria. At this point, it is difficult to determine the financial implications of the tax abatement program for a specific redevelopment because there is no set formula for deriving the amount of an abatement.

What is known, however, is that there are specific requirements to qualify for the abatements. Among other conditions, these include:

• Affordability. 15% of the housing units must be affordable.
• Location. The redevelopment must be within a specific geographic area.
• Designated contractors. 35% of the construction contract must go to specific business enterprises that have been certified by the District.

These requirements further complicate the already challenging task of successfully executing an office-to-residential conversion.

In short, the real estate tax implications of an office-to-residential redevelopment are highly dependent on the unique facts and circumstances of each case, and the varying tax rates can have huge implications for a property's development budget. A developer considering such a conversion should contact experienced counsel early in the process.

Minnesota Supreme Court affirms decision barring use of airport concession fees in income-based property valuation.

A recent Minnesota Supreme Court ruling requires tax assessors to exclude an airport's concession fees from rent-based valuations for property tax purposes. The case offers a flight plan to lower taxes at many of the nation's transportation hubs, and underscores the importance for all taxpayers to exclude business value from taxable property value.

Every major airfield collects fees from food and beverage providers, retailers, banks and other businesses that provide goods or services on airport property. Concessionaires commonly pay these charges in addition to rent owed for the real estate where they operate. Many of these businesses are also responsible for property tax that passes through to tenants in a commercial lease.

The cases leading up to the March 29 state Supreme Court decision involved two car rental companies that challenged their 2019 tax assessments, claiming the assessor's office had overstated their property values by including the concession fee in its income-based valuation.

High-flying fees

Both Enterprise Leasing Co. of Minnesota and Avis Budget Car Rental pay a concession fee equal to 10 percent of gross revenues in addition to real estate rent for their operations at Minneapolis-St. Paul International Airport. The tax assessor for Hennepin County had historically valued the auto rentals for property tax purposes by including the concession fee in its income-based approach to valuation.

The auto rental companies challenged the valuations on their 2019 taxes in the Minnesota Tax Court. Law firm Larkin Hoffman, which represented both taxpayers, argued that the concession fees are not rent and should not be included in the income approach for property tax purposes.

The rental agencies prevailed in tax court. The court found that the concession fee is not real estate rent and that the county substantially overstated market values by including the fee in its calculations. Correcting the assessor's calculation reduced Enterprise's value from $34.873 million to $21.107 million, or 39 percent less than the initial assessment. Avis' property value dropped 39 percent as well, from $20.565 million to $12.497 million.

The county appealed the tax court's decision to the Minnesota Supreme Court, arguing that the concession fee is rent that must be used in the income approach. The Court affirmed the lower court's decision, however, holding that "the concession fee is not rent for purposes of the income approach."

Fee-simple principles

The rental agencies' case stood on fundamental precepts of fee-simple valuation. Minnesota is a fee-simple property tax state, meaning valuations for property tax purposes must value all property rights as though they are unencumbered.

Additionally, the leased-fee interest, or landlord's rights subject to contractual terms, should not be used for property tax valuations. Per the state Supreme Court, rents attributable to specific leases are disregarded except to the extent they represent market rent. It follows that business income should not be included in valuations for property tax purposes.

Taxpayers doing business at airports across the country often pay concession fees or other charges based on their revenues or business performance. Many states, like Minnesota, require those same properties to be valued on a fee-simple basis, which should neutralize any impact of business value.

In representing the rental car agencies at all stages of their appeal, Larkin Hoffman stressed the importance of these valuation concepts and how the very definition of a concession requires its exclusion from calculations of taxable property value. A concession is a "franchise for the right to conduct a business, granted by a governmental body or other authority," according to the Dictionary of Real Estate. Accordingly, if a concession fee is a payment for the right to conduct business and not for the right of occupancy, then it is a business revenue.

The county argued that because the rental agencies' concession agreements included the phrase for "use of the premises," then the concession must only be for the real estate. However, the tax court found that the concession fee was consideration for access to the airport car rental market rather than the real estate.

The tax court reasoned – and the Supreme Court affirmed – that the concession fee was not for the real estate because:

Concession fees were also paid by off-airport rental car companies, indicating that the fee is a business revenue rather than rent;

Inclusion of the concession fee in the income approach would inflate the value to 10 times greater than the cost approach, which would be clearly unreasonable; and

Inclusion of the concession fee in the county's income approach distorted other inputs.

It is well established that a fee-simple property tax valuation should exclude business value. Now, Minnesota courts have also acknowledged that when a concession fee is for the privilege of accessing the airport market rather than for the real estate, that fee represents business value.

To prevent erroneous inclusion of business value, and since airports are special-purpose properties, the court gave primary weight to the cost approach. With this decision, Minnesota's highest court has confirmed that concession fees are not rent for real estate and instead represent business value that should be excluded from the income approach.

For taxpayers in any jurisdiction that taxes property based on its fee-simple value, the recent decision is a reminder to ensure that assessors are excluding business value when calculating taxable property value. For businesses that also pay concession fees in addition to rent, the Minnesota case may provide an impetus to learn how those fees affect their own property values. And if those inquiries spur taxpayers to appeal their assessments, then the Minnesota case law may provide a valuable example and support for their arguments.

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.

Legal covenants often cause excessive property taxation for mall owners that are looking to redevelop.

Repurposing malls and anchor stores is a popular topic in community development circles, but legal restrictions make redevelopment extremely difficult. Often locked into their original use by covenants, malls and anchor stores are often grossly over-valued for property tax purposes. In pursuing a redevelopment, taxpayers should ensure the properties are fairly assessed and taxed.

Debilitating obsolescence

It is difficult to overstate the plight of malls and anchors. Gone are the halcyon days when the mall was everyone's shopping destination. There is even a website, deadmalls.com, devoted to failed malls. Credit ratings of most anchor store operators have fallen below investment grade. Commentators usually blame the retail apocalypse on ecommerce and shifting consumer spending habits.

COVID-19 exacerbated these trends and mall foot traffic has been slow to recover. Some chains, including Neiman Marcus and JCPenney, filed bankruptcy. Ecommerce volume surged in 2020 and 2021 before tapering in 2022. Ecommerce and brick-and-mortar sales have not yet reached an equilibrium.

One in five American malls have fully closed and remain "zombies" without a redevelopment plan, estimates Green Street Advisors, a commercial real estate analytics firm. A December 2022 Wall Street Journal article describing the "long death" of the White Plains Mall noted there is no shortage of dying malls. The article observed that converting enclosed shopping centers to other uses remains a "difficult feat." Repurposing, while much discussed, has not really happened.

The question is why. The answer relates, at least in part, to legal challenges inherent in changing the property's use.

Tied hands

Any property valuation begins with a highest and best use analysis. A basic assumption about real estate directs that the price a buyer will pay reflects that buyer's conclusions about the property's most profitable use. Competitive forces within the local market shape a property's highest and best use, but that use must reflect practical and legal restrictions.

Many people incorrectly assume that governmental requirements pose the only legal restrictions on use. Zoning ordinances may impose barriers, owners of neighboring properties may object to redevelopment proposals, or there may be other hinderances to changing the property's use.

Zoning limitations pale in comparison to restrictions in recorded easements and unrecorded operating agreements between mall owners and anchor department stores. While zoning may permit non-retail uses, private agreements generally do not.

Malls would be economically unfeasible without department stores and inline stores that symbiotically drive traffic to each other. Generally, anchors own their pads and inline tenants lease space from the mall owner. A typical mall is subject to two levels of private restrictions designed in an earlier day to promote the efficient functioning of the mall for retail stores.

Recorded operating restrictions or restrictive easement agreements (REAs) impact the entire mall and its anchors and are generally binding for 40 years or longer. Typically, substantive amendments to the REA require the consent of all parties, and their economic interests are not always aligned.

Unrecorded operating agreements govern the relationship between individual anchors and the mall owner. Terms typically address tenancy, hours of operation, required years of operation under a specified tradename and the size of each anchor and the mall. Operating agreements also generally restrict the size and construction of improvements on the anchor pad and regulate usage.

A simple example involves anchors using stores as a delivery point for ecommerce, a concept known as buy online, pick up in store (BOPIS). Many REAs and operating agreements severely limit implementation of this concept.

But what if the mall's highest and best use is no longer retail? Ecommerce and changed consumer practices undermine the REAs' and operating agreements' ability to ensure the property's success, but those private agreements are understandably focused on preserving retail usage.

The common party to these agreements is the mall owner, making the mall owner the logical purchaser when an anchor looks to sell. The potential economic return on any proposed redevelopment must be sufficient to encourage an entrepreneur to take the redevelopment risk for the mall and/or anchors.

Legal risk escalates the economic risk. For example, owners of some anchor properties seek conversions to multifamily or industrial use as salvation from the retail apocalypse. Even if they overcome zoning objections, attempts to change REAs and unrecorded operating agreement restrictions may require unanimous consent among owners with competing economic interests.

The anchor pad may not even be worth its unimproved land value since its use is restricted under the REAs and operating agreements to retail.

Property tax implications

While mall owners and anchors struggle to remain viable in the changed retail environment, ad valorem property taxes pose an immediate challenge. Most states value property as what a willing buyer would pay to a willing seller, but the pre-ecommerce glory of malls and anchors generally encourage high property tax valuations.

Assessors performing an income-based assessment seldom recognize how anchor chains' plunging credit ratings affect value. The sales-comparison approach is equally challenging, as anchor property transaction volume has plummeted since 2006.

Most sales involve a change to non-retail use and thereby require unanimous consent. Consent is easier to obtain when the new use increases foot traffic to the remaining inline tenants and anchors, but it is easy to envision anchors holding the process hostage in an attempt to force the purchase of their failing stores.

REAs and unrecorded operating covenants make calculation of an anchor's value extremely difficult. They also call into question the comparability of previous transactions to repurpose anchors in the same mall, since those anchors may have agreed to one specific new use but may object to another.

REAs and operating agreements often hamstring mall and anchor redevelopment. Most were signed before ecommerce and did not envision retail losing its vitality. The parties to these covenants often have divergent economic interests and perspectives, and the natural party to lead redevelopment – the mall owner – must overcome these hurdles. In the short term, however, owners should address highest and best use with assessors to reduce property tax burdens until the zombie can be brought back to life.

Tennessee's appeal process allows Nashville taxpayers to challenge the complicated assessment of new construction.

Over the past decade, Nashville has enjoyed a baffling explosion of growth that sent cranes shooting up all over the city, festooned with developer names like Bell, Clark and Giarratana. Highrise towers of glass and steel rose out of the old rail yards like the emerging monolith in the opening scene of "2001: A Space Odyssey" multiplied in a funhouse mirror.

The Metropolitan Government is eager to add new projects to its tax rolls, and its Assessor of Property decides when and how that happens. The assumptions made by the Assessor's office about a project's cost and timing dictate how quickly and how much a new building is taxed. So, as always, taxpayers need to keep an eye on what the assessor is doing.

The assessor's difficult job has become even more complicated in the post-COVID quagmire of supply chain failures. Twelve-month projects have stretched into 24-month projects, and the assessor's assumptions about completion times have been thrown out of whack. To make matters worse, Tennessee's property tax statutes were not designed to give relief for construction delays or lengthy projects, and the clock is ticking.

New Construction Assessed at Material Cost

The last Davidson County reappraisal was in 2021, and the next will be in 2025. Normally, the assessor's values remain unchanged over the four-year cycle, but new construction is an exception to that rule.

Under the statute for assessing projects under construction, if a new improvement is partially complete on Jan. 1, the assessor is to value the property for that year at land value plus the cost of materials used in the improvement as of that date. This materials-only value favors taxpayers because it excludes labor costs.

The construction documents that are generally accepted as evidence of project costs do not typically segregate labor versus material costs, however. Those costs are most often listed as combined totals, making the exact material costs difficult to determine.

One example from a recently reviewed document described work that included a $279,000 line item for "caulking." Unless labor and materials are both included in that number, that's a heck of a lot of white goop! Rather than demand proof of exact material costs, assessors will sometimes allocate material costs based on a pre-established rule of thumb.

Substantially Complete?

Now for the tricky part. The new construction statute allows assessors to pick up new improvements after Jan. 1, so long as the structure is "substantially complete" prior to Sept. 1 that same year. So, for example, if a building is 50 percent complete at Jan. 1 and 100 percent complete at Sept. 1, the assessor will prorate at the 50 percent value for eight months of the year, and at the 100 percent value for four months of the year. If the improvements are not "substantially complete" by Sept. 1, the assessor must wait to pick up the as-complete value in the following year.

Tennessee has no statutory definition of "substantially complete" for purposes of adding the full value to the tax rolls, but cases make it clear that tenant finish-out and certificates of occupancy are not required. In the absence of simple, objective standards for completion, assessors make subjective judgments about completion that may not favor the taxpayer. Taxpayers can challenge those judgments through an administrative appeal.

Adding Insult to Injury

Under Tennessee law, new improvements may not be valued as incomplete for more than one year after construction began. Now, your immediate reaction might be, "That's ridiculous! How can you value an incomplete property as complete just because it took longer than 12 months to construct!?"

The assessor in Davidson County has taken the position that the statute prevents them from using the taxpayer-favorable, materials-only value in the second year a property is incomplete. They will likely still use the cost approach to determine the appraised value but add back the cost of labor that was taken out in the first year, greatly increasing the tax burden before the property is generating income. The legislature has not acted to provide relief from this further insult to developers already injured by increasingly protracted construction timelines.

The Good News

Tennessee assessors are only authorized to reassess a property at specific times, but taxpayers can appeal the assessor's Jan. 1 value of Nashville property to the Metropolitan Board of Equalization every year. If the assessor issues a prorated assessment for a new construction project later in the year, the taxpayer can appeal that value directly to the State Board of Equalization.

In light of the complexity of Tennessee's law on the assessment of new construction, owners of new projects in Nashville should seek counsel as to whether their assessments are fair and legal and avail themselves of the right to appeal if appropriate.

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.

Legal covenants often cause excessive property taxation for mall owners that are looking to redevelop.

The repurposing of malls and anchor stores is a popular topic in community development circles, but legal restrictions make redevelopment extremely difficult. Often locked into their original use by covenants, malls and anchor stores are often grossly overvalued for property tax purposes.

In pursuing a redevelopment, taxpayers should ensure the properties are fairly assessed and taxed.

Debilitating obsolescence

It is difficult to overstate the plight of malls and department store anchors. Gone are the halcyon days when the mall was everyone's shopping destination. There is even a website, www.deadmalls.com, devoted to failed malls. Credit ratings of most anchor store operators have fallen below investment grade. Commentators usually blame the retail apocalypse on e-commerce and shifting consumer spending habits.

COVID-19 exacerbated these trends and mall foot traffic has been slow to recover. Some chains, including Neiman Marcus and JCPenney, have filed bankruptcy. E-commerce volume surged in 2020 and 2021 before tapering in 2022. To date, e-commerce and brick-and-mortar sales have not yet reached an equilibrium.

One in five American malls have fully closed and remain "zombies" without a redevelopment plan, estimates Green Street Advisors, a commercial real estate analytics firm. A December 2022 article from The Wall Street Journal that detailed the "long death" of the White Plains Mall noted there is no shortage of dying malls. The article observed that converting enclosed shopping centers to other uses remains a "difficult feat." Repurposing, while much-discussed, has not really happened.

The question is why. The answer relates, at least in part, to legal challenges inherent in changing the property's use.

Tied hands

Any property valuation begins with a "highest and best use" analysis. A basic assumption about real estate directs that the price a buyer will pay reflects that buyer's conclusions about the property's most profitable use. Competitive forces within the local market shape a property's highest and best use, but that use must reflect practical and legal restrictions.

Many people incorrectly assume that governmental requirements pose the only legal restrictions on use. Zoning ordinances may impose barriers, owners of neighboring properties may object to redevelopment proposals, or there may be other hinderances to changing the property's use.

Zoning limitations pale in comparison to restrictions in recorded easements and unrecorded operating agreements between mall owners and anchor department stores. While zoning may permit non-retail uses, private agreements generally do not.

Malls would be economically unfeasible without department stores and inline stores that symbiotically drive traffic to each other. Generally, anchors own their pads and inline tenants lease space from the mall owner. A typical mall is subject to two levels of private restrictions designed in an earlier time period to promote the efficient functioning of the mall for retail stores.

Recorded operating restrictions or restrictive easement agreements (REAs) impact the entire mall and its anchors and are generally binding for 40 years or longer. Typically, substantive amendments to the REA require the consent of all parties, and their economic interests are not always aligned.

Unrecorded operating agreements govern the relationship between individual anchors and the mall owner. Terms typically address tenancy, hours of operation, required years of operation under a specified tradename and the size of each anchor and the mall. Operating agreements also generally restrict the size and construction of improvements on the anchor pad and regulate usage.

A simple example involves anchors using stores as a delivery point for e-commerce, a concept known as buy online, pick up in store (BOPIS). Many REAs and operating agreements severely limit implementation of this concept.

But what if the mall's highest and best use is no longer retail? E-commerce and changed consumer practices undermine the REAs' and operating agreements' ability to ensure the property's success, but those private agreements are understandably focused on preserving retail usage.

The common party to these agreements is the mall owner, making it the logical purchaser when an anchor looks to sell. The potential economic return on any proposed redevelopment must be sufficient to encourage an entrepreneur to take the redevelopment risk for the mall and/or anchors.

Legal risk escalates the economic risk. For example, owners of some anchor properties seek conversions to multifamily or industrial use as salvation from the "retail apocalypse." Even if they overcome zoning objections, attempts to change REAs and unrecorded operating agreement restrictions may require unanimous consent among owners with competing economic interests.

The anchor pad may not even be worth its unimproved land value since its use is restricted to retail under the REAs and operating agreements.

Property tax implications

While mall owners and anchors struggle to remain viable in the changed retail environment, ad valorem property taxes pose an immediate challenge. Most states value property as what a willing buyer would pay to a willing seller, but the glory of malls and anchors before e-commerce generally encourage high property tax valuations.

Assessors performing an income-based assessment seldom recognize how anchor chains' plunging credit ratings affect value. The sales-comparison approach is equally challenging, as anchor property transaction volume has plummeted since 2006.

Most sales involve a change to non-retail use and thereby require unanimous consent. Consent is easier to obtain when the new use increases foot traffic to the remaining inline tenants and anchors, but it is easy to envision anchors holding the process hostage in an attempt to force the purchase of their failing stores.

REAs and unrecorded operating covenants make calculation of an anchor's value extremely difficult. They also call into question the comparability of previous transactions to repurpose anchors in the same mall, since those anchors may have agreed to one specific new use but may object to another.

REAs and operating agreements often hamstring mall and anchor redevelopment. Most were signed before e-commerce and did not envision retail losing its vitality. The parties to these covenants often have divergent economic interests and perspectives, and the natural party to lead redevelopment — the mall owner — must overcome these hurdles.

In the short term, however, owners should address highest and best use with assessors to reduce property tax burdens until their zombies can be brought back to life.

J. Kieran Jennings was quoted in the December 14 digital issue of the Wall Street Journal's Property Report, Page B6, titled, "Falling Building Values Spur Tax Appeals." 

Mr. Jennings is a partner in the law firm Siegel Jennings Co., L.P.A, the Ohio, Illinois and Western Pennsylvania member of American Property Tax Counsel (APTC), the national affiliation of property tax attorneys. 

Fighting for laws that produce equal, uniform taxation best serves taxpayers and state governments.

It has been said that the people who complain about taxes can be divided into two classes: men and women. While we all complain, taxes ensure various levels of government have funds to perform essential functions—to keep society civil and in, more or less, working order.

A tax must be fair to be supported, however. In countless instances, a taxpayer's first complaint about an assessor's valuation is that the amount exceeds their neighbors' valuations. In essence, the property owner claims that the property valuation and resulting tax liability is unfair or non-uniform.

Too many jurisdictions lack an efficient mechanism to address non-uniform taxation. Fortunately, several states specifically require tax uniformity, and two offer legal remedies to help taxpayers combat unfair assessments.

A constitutional concept

Most taxing jurisdictions seek to assess real property at market value, which is the amount the property might sell for as of a certain date. Many states even address the legal requirements of taxation in their governing documents.

Ohio's constitution, for example, requires that "Land and improvements thereon shall be taxed by uniform rule according to value." Virginia's constitution states: "All taxes shall be levied and collected under general laws and shall be uniform upon the same class of subjects within the territorial limits of the authority levying the tax."

• Washington's constitution necessitates that all taxes shall be uniform upon the same class of property within the limits of the assessor's authority, while Missouri's constitution requires that assessments must be based upon market value and be uniform.

• That all four of these sampled constitutions mention the importance of taxation uniformity underscores the importance of the concept. Taxpayers seeking an effective model for opposing an assessment on the basis of unequal treatment can look to two other states: Texas and Georgia.

Ready remedies

Texas and Georgia have taken great strides in establishing the methods to ensure property assessments meet their constitutional goals of equal and uniform taxation. Both states empower taxpayers by setting out specific steps to show an overvaluation. Taxpayers in these jurisdictions are assured the right to have their property assessed for taxation in a uniform and equal manner when compared to nearby comparable properties.

In Georgia, a property owner can challenge an assessor's valuation of their real property based on uniformity.The state's standard appeal forms have a box to check as to whether the appeal is being filed based on value, taxability or uniformity.

Under a 1991 Georgia case, Gwinnett County Board of Tax Assessors vs. Ackerman/Indian Trail Association Ltd., a property owner who can show that numerous similar properties in the same area and county have lower assessed values can use that information as grounds to advocate for a lower assessed value.

Texas property owners can challenge an assessor's valuation by arguing there has been an unequal appraisal.Texas property owners in this position can file a protest if they believe the property is taxed at a higher value than comparable properties.

To prevail in seeking a lower valuation, the property owner can submit sale or appraisal evidence. Alternatively, the taxpayer can prevail by showing their assessed valuation exceeds the median appraised value of a reasonable number of appropriately adjusted comparable properties.

In a 2001 case, Harris County Appraisal District vs. United Investors Realty Trust, a Texas appeals court found that when there is a conflict between taxation at market value and equal and uniform taxation, equality and uniformity prevail. This means it is more important that taxes be equally and uniformly imposed and collected than it is to arrive at the property's market value when the "corrected" value makes the property a taxation outlier in its competitive set.

A pervasive need

For sure, a tax assessor's job of valuing all land and improvements is daunting, and they must use many data points and much subjectivity to assess values. Given the scope of their job, mistakes in valuation will occur—especially if the valuation incorporates inaccurate data regarding gross building area, square footage, age, condition or other variables.

Because mistakes are inevitable, property tax systems must provide taxpayers with efficient and effective methods of challenging overvaluations. All jurisdictions provide taxpayers the right and some mechanism to contest the assessor's valuation through an administrative and/or judicial process. This procedural right gives taxpayers a means to correct apparent overvaluations and to seek fairness—or at least it provides the opportunity to argue for fairness.

Taxpayers' pursuit of that procedural right most often revolves around valuation and ignores the constitutional requirement of uniformity. Or worse, the available procedure conflates uniformity with valuation by stating that if the assessed value reflects market value, that equates to uniformity. This thinking is only accurate in theory, as achieving market value assessments for all is aspirational but elusive.

If taxpayers in every jurisdiction could argue a solution along the lines of Texas' defense, it would ensure uniform and equal taxation for all.

Many times, an appeal board hearing a valuation complaint will require either evidence of a recent sale of the subject property or an appraisal report before it will adjust an assessor's valuation. However, sales are often unavailable and appraisal reports can be expensive. Given the cost of appraisals, owners of lower value real estate must often weigh cost versus potential tax savings before deciding whether to hire an appraiser and contest an unfair assessment.

Fairness across the assessor's jurisdiction must be the paramount goal. The defenses or means of redress provided by Georgia and Texas are vital to ensure that taxpayers have access to a constitutionally mandated equal and uniform valuation. These statutory provisions provide a cost-effective method for taxpayers to challenge an overvaluation.

Constitutions that provide an equal and uniform defense give taxpayers fair and equitable access to assessors' valuation systems and promote equal and uniform taxation. Expanded taxpayer access and improved assessor responsiveness promotes trust in government.

Every jurisdiction should follow these examples to provide taxpayers an equal and uniform defense.