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Property Tax Resources

Jun
06

Benjamin Blair: Creative Deal Structures Can Yield Tax Benefits

Managing expenses is one of the best ways to ensure the long-term profitability of investment properties, and prudent developers know the importance of carefully monitoring and challenging property tax assessments. But student housing, as a subsector populated largely by tax-exempt educational institutions, presents unique opportunities to minimize taxes for some projects.

Excepting abatements and other local incentives, there are two principal ways to minimize property taxes: The property can be entitled to a statutory tax exemption, or the property can be deemed to have a value of zero dollars. In certain instances, creative structuring can take advantage of these options to improve the developer's cash flow and returns.

Beneficial vs. actual ownership

One of the most potent ways to minimize property taxes is a statutory exemption. For university-owned housing, exemptions will almost always eliminate the tax bill before it arrives in the mail. But what if the property is owned by a private developer, not the university?

Although private ownership by a for-profit entity often sentences real estate to a lifetime of property tax liability, some states disregard formal ownership for property tax purposes, focusing instead on who benefits from the asset. In states adopting this "beneficial ownership" doctrine, the law may treat privately owned properties the same as university-owned real estate, entitling them to exemptions otherwise limited to properties used for educational purposes.

Consider the example of a small private college that wants to develop new on-campus housing, but lacks the resources to borrow the necessary funds to construct the building. Instead, the school contracts with a private developer, which builds the student housing and leases it to the college. The school then operates and maintains the property as student housing, just as it would any other dormitory.

Even though a private developer owns the structure, the benefits of the building go to the college, which may be deemed the beneficial owner of the property. Because the college's intent is not to earn a profit, but rather to support its educational mission by providing housing for its students, the property is exempt.

This structure still allows the developer/owner the right to earn a reasonable return on its investment in the property. This result is logical when one considers that the college's intent is to finance the construction of on-campus housing. If the college financed the construction of a dormitory with a bank loan, the school would not be disqualified from claiming an exemption just because the bank earned a return on its loan.

Precluding profit in this manner would effectively prevent any educational institution from borrowing funds at market rates to finance any construction. Just as the bank is entitled to a reasonable return on its loan, the student housing developer is entitled to a reasonable return on the lease.

Of course, beneficial ownership works in both directions, potentially making an otherwise-exempt property taxable. If university-owned property is leased to a private party who uses it to make a profit, then the property would likely not be entitled to an exemption. Even though the true owner is an exempt educational entity, the beneficial owner is not exempt.

Leaseholds without market value

Even when a property lacks a statutory exemption, however, it will not incur property tax liability if it is deemed to have a negligible market value. An assessed value of zero dollars will always result in zero taxes owed.

A recent case from the West Virginia Supreme Court shows how a new student housing development – or, at least, the developer's leasehold interest in the development – could properly be assessed as having no market value.

In that case, a university leased land to a developer for the purpose of developing student housing with a retail component. The developer constructed the improvements on the leased land at its own expense and transferred title of the new building to the university, which executed a sublease to use the student housing. As the subtenant, the university offered the on-campus housing to students, collecting rent and turning it over to the developer, who then returned 50 percent of the net cash back to the university as a payment on its lease.

The university operated the residential facilities, therefore, while the developer was compensated for constructing the improvements and retained the right to sublease the retail space. The developer's interest in the property was a leasehold.

Because university-owned property is exempt, the university's interest in the property was not taxable. But in West Virginia, leaseholds are taxable real property interests, meaning the developer's interest needed to be assessed. The county assessor concluded that the developer's interest in the property had a value independent from the university's exempt interest, and assessed that interest. The developer challenged the assessment, arguing for a zero value.

The case eventually came before the state Supreme Court, which held that the value, if any, of a leasehold interest is based on whether the leasehold is economically advantageous to the lessee and freely assignable, so that the lessee can realize the benefit of the lease in the marketplace. After all, market value is measured by what the interest could garner if sold on the open market.

If the lease could not be freely assigned to another party, it would have no value in the marketplace. Because the lease was drafted in a way that the assessor conceded was not freely assignable, the Court affirmed that the value of the developer's leasehold interest was zero.

Beware potential pitfalls

The applicability of these strategies to a particular project is fact-dependent. For example, some states, especially those with large amounts of public lands, tax possessory interests. In those states, a government-owned property leased to a private entity can be taxed if the private entity has a "possessory interest" in the real estate. Likewise, privately owned improvements on exempt land can be taxable because the tax is being imposed on the improvement, rather than on the whole property. And assessors eager to increase the tax base can still challenge even the best structuring.

Not all development deals will be ripe for these types of exemption-planning opportunities, nor will all student housing developers find these strategies compatible with their business objectives. Competent tax counsel can help developers weigh the myriad factors that may determine what strategy can deliver the best returns.

But property taxes are one of the largest ongoing expenses of property ownership, so opportunities to minimize their impact on a project's financial results deserve full consideration. With some creativity, developers can improve their own profitability while also helping their academic partners achieve their goals. 

Benjamin Blair is a partner in the Indianapolis office of the international law firm of Faegre Baker Daniels LLP, the Indiana and Iowa member of American Property Tax Counsel, the national affiliation of property tax attorneys.
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Apr
18

How Office Owners Can Help Lower Sky-High Property Tax Assessments

​The American Property Tax Counsel argues that if a property tax assessment is premised on a uniform per-square-foot value, rental rate or vacancy rate for all office properties in a metro area, the assessor is likely going to overlook distinguishing factors in submarkets that could benefit building owners.

Managing fixed expenses is the best way to ensure the long-term profitability of investment properties, especially in a flat market. The largest continuing expense for most commercial properties is the property tax bill, and in a market with skyline-defining properties and headline-grabbing sales prices, tax assessors have multi-tenant office properties in the crosshairs.

Any reduction in tax burden can drastically improve an investment's profitability, competitiveness and tenant retention. As another assessment season begins across the Midwest, understanding tax assessors' common errors can equip property managers and owners with the tools necessary to review the accuracy and reasonableness of the assessments on their office properties and, when appropriate, challenge those assessments.

Know the relevant market

To an outsider, the office market can appear monolithic. To such people, rent, occupancy and other income characteristics of office properties are consistent throughout the market. But pulling data from the wrong market can lead assessors to an incorrect result.

For example, assessors may assume that Class A downtown office towers are the best-performing assets in the market, and value them accordingly. Contrary to this perception, though, Class A properties may not outperform all Class B or Class C properties, and downtown may not be the strongest office submarket in a certain metro area.

Nowhere is the distinction between office submarkets clearer than in the downtown-suburban divide. In many Midwestern markets, suburban office properties tend to be newer, have better occupancy, and in some cases, command higher rents than their downtown competition.

The factors influencing the relative performance of downtown and suburban office properties vary, but they include employees' desire to work closer to their homes, and comparatively low land prices, which allow office building construction with the larger floorplates many tenants prefer. Suburban office markets also typically are able to offer free parking, while paid parking — which is common in the central business district — increases occupancy costs for tenants and their employees. Downtown towers though may appeal to large law firms, accounting firms and banks seeking a prestigious address.

If an assessment is premised on a uniform per-square-foot value, rental rate or vacancy rate for all office properties in a metro area, the assessor is likely failing to consider distinguishing factors in submarkets. Finding those distinctions can benefit owners on either side of the downtown-suburban divide.

Don't blindly trust sales

Assessors are often too reliant on sales data. Although some properties may be valued by considering sales prices for comparable properties, office properties do not neatly lend themselves to such an analysis. Applying the recent sales price of a downtown office tower to all other office towers in the downtown area may seem reasonable on its face, but fails to recognize how buyers and sellers interact in the office market.

For many real estate types, an assessor can identify comparable sales and adjust those transactions to reflect differences between the comparable and subject properties. Unlike owner-occupied buildings, investment properties that are otherwise similar are not easily adjusted for real estate-related factors. This is because market participants do not settle on sales prices based on attributes of the real property, but on attributes of the income stream.

Buyers of multi-tenant office buildings are motivated by the durability of the income stream, reflecting either potential for growth or existing leases with creditworthy, in-place tenants. Knowing a target's income characteristics, buyers apply their own capitalization rate thresholds and back into the sales price. But that price necessarily reflects the particular income stream being purchased, which may have limited applicability to another property. This approach is opposite to the way many assessors believe sales prices are set.

This is not to say that sales of comparable properties are entirely irrelevant in valuing an office property for tax purposes. For example, because capitalization rates reflect the behavior of investors in the market, sales of properties that are comparable as investments can inform the selection of a capitalization rate in a particular analysis. But if an assessor has used a recent sale as the sole basis to set the assessments of the competitive set, whether their assessments truly reflect the market is questionable.

When income isn't income

As income-generating assets, office properties are most commonly valued using the income approach. But even though office rents are not as attributable to personal or intangible property as is, for example, a hotel's income, the rents paid by office tenants are not entirely attributable to the real estate. Simply capitalizing a building's existing income stream mistakenly assumes it is.

The market for office properties in many areas is extremely competitive, and nearly all leases in some markets reflect tenant incentives like improvement allowances. Even long-standing tenants expect such incentives when their leases are up for renewal, and tenants are accustomed to using those allowances to refresh their space. Landlords, in turn, collect marginally higher rent that amortizes those costs over the lease period. But the impact of above-market allowances must be removed from the lease rate in determining the market level of rent. An assessor cannot say that a lease is $15 per square foot if the landlord paid the tenant $5 per square foot upfront.

Assessors also often misunderstand reimbursement income. Triple-net leases are uncommon in the office market; instead, landlords build an assumed level of expenses into their base rent and if the expense exceeds that base-level in future years, the tenant reimburses the landlord for the excess. Some assessors mistakenly view reimbursement income as additional profit. But, as the word "reimbursement" suggests, landlords only collect reimbursement income when, and to the extent, expenses exceed the base amount. Assessors should be reminded that reimbursement income is not a profit center.

As the office market continues its slow expansion, assessors are eager to capitalize on the most visible parts of the city skyline. But by grounding the assessor in the economic realities of the office market, diligent owners and property managers can reduce fixed expenses, lower tenant occupancy costs and ultimately improve profitability.

Benjamin Blair is a partner in the Indianapolis office of international law firm Faegre Baker Daniels LLP, the Indiana and Iowa member of American Property Tax Counsel, the national affiliation of property tax attorneys​.
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May
29

Cash in on Tax Savings for Green-Buildings

Energy-efficient buildings may not yet command premium rents and prices in smaller markets, but green features could mean property tax savings.

A growing number of commercial properties incorporate energy-efficient attributes that exceed basic code requirements. While conserving resources, these sustainable building strategies can also enhance the owner's bottom line by reducing operating costs. As investors consider developing or buying green properties in certain markets, though, they should consider a less-obvious source of savings – their property tax bills.

No single set of attributes defines a green building; rather, sustainable structures lie on a spectrum. At one end are otherwise-conventional buildings with modest upgrades, ranging to a high end of properties employing comprehensive design and operational strategies that approach zero net consumption of energy or water.

The features most commonly associated with green building tend to be efficient heating and cooling equipment, better insulation, rainwater catchment and on-site power generation methods such as solar, wind, or geothermal. While roof-top solar panels garner attention, other design attributes including passive solar collection, drought-tolerant landscaping, and building-control systems can be equally effective at achieving sustainability objectives. Ultimately, each attribute adds costs to the construction or operation of a property, while not necessarily generating the same incremental gain in value.

How green is the market?

Green design and operations have become standard for Class A properties in many primary markets. With above-average adoption rates, the investment premium for energy-efficient attributes may disappear and properties lacking those attributes may decline in value. Similarly, buildings without green features may be at a competitive disadvantage in attracting potential tenants and buyers.

In many secondary and tertiary markets including across the Midwest, Southeast, Great Plains and elsewhere, however, buyers and tenants have not shifted their preferences toward green construction. This greatly reduces the direct economic benefits of green features. When the pool of tenants willing to pay premium rent for energy-efficient features approaches zero, the pool of buyers demanding those features likewise declines.

Accordingly, whether green attributes have an overall positive or negative impact on a property's market value is highly dependent on the local market, even when the nation overall shifts demand toward such features. Energy-efficient construction may be a market prerequisite in one location, while constituting over-engineering and over-building in another. The question for owners of sustainable buildings evaluating their tax assessments, then, is how buyers and sellers in that market react to specific green features.

Necessary, adequate or superadequate?

Assessors often value properties, at least initially, based on the costs of construction, using either replacement cost tables or information from construction permits. But most green buildings have higher upfront costs, with a goal of achieving long-term efficiency objectives. A green building assessed purely on a cost basis, without considering whether its features are above-market, may be over-assessed and, as a result, overtaxed.

Any cost-based property valuation must account for all depreciation, from ordinary wear-and-tear to obsolescence brought about by market factors. One type of functional obsolescence is superadequacy, which applies to an attribute that exceeds current market requirements. Essentially, a superadequacy is a cost without a corresponding value increase.

Importantly, obsolescence is measured against the market, so even a newly constructed property with no physical deterioration could suffer from substantial obsolescence. A particular green feature might represent a positive value element, a market requirement, or functional or external obsolescence, depending on the property type and location.

Of course, as market demands evolve, some features that were superadequate when originally constructed may become standard. Tax assessments must reflect property and market conditions on a certain date, however, and until the market changes, must account for superadequacies.

And while superadequacy is an element of the cost approach to value, it should be a consideration in income- or sales-based analyses as well. The value of green features, like everything else in an appraisal, must be supported with market research and data. If no demand is found for the property's features, that must be reflected in the value conclusion.

Getting the value right

Assessors may ask: "If a green building has an out-of-pocket cost of $1 million, how can it appraise for only $750,000? Why would an investor spend the extra money?"

Certain items may motivate a particular owner, but property tax assessments are usually based on the real estate's market value alone, regardless of business value or intangible value. If the market does not recognize a feature as valuable, then the value a particular user assigns to that feature is irrelevant for property tax purposes.

In questioning how a green feature affects a property's market value (as opposed to its value to the user), consider whether the feature creates a direct monetary benefit to the property owner or user, either in the form of higher income or lower expenses. Sustainability features may boost the owner's business, perhaps resulting in goodwill or broader market recognition, but that increase will not necessarily accrue to the real property itself. And indirect benefits – those nonmonetary benefits to the community or environment – are unlikely to change real estate value.

Valuing a green building involves most of the techniques used for conventional properties, but the nuances and complexities require greater knowledge and training. Local tax assessors, particularly in smaller jurisdictions where sustainable features have not reached market acceptance, often lack that requisite knowledge. It is no wonder that assessments often fail to consider all of the relevant market factors, creating opportunities for taxpayers to appeal excessive assessments.

As demand for sustainable buildings expands, assessors want to capture that growth in the local tax base. But by focusing on whether the local market demands or ignores energy-efficient features, diligent owners can reduce their property's tax assessments and achieve significant savings.


Benjamin Blair is an attorney in the Indianapolis office of the international law firm of Faegre Baker Daniels LLP, the Indiana and Iowa member of American Property Tax Counsel, the national affiliation of property tax attorneys. He can be reached at This email address is being protected from spambots. You need JavaScript enabled to view it..
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Aug
22

Delaware Court Unlocks Opportunities to Reduce Property Tax Burden

Reducing property tax assessments can be challenging under the best of circumstances, and distinctions between state tax systems make minimizing that burden across an office or industrial portfolio especially daunting. But a recent Delaware Supreme Court decision provides taxpayers with a new, yet surprisingly familiar, opportunity to ease the tax burden on properties in The First State.

Delaware's Tax Assessment System Shows its Age

Under Delaware law, property must be valued at its "true value in money," a term interpreted to mean the property's "present actual market value." However, in order to implement the Delaware Constitution's mandate of tax uniformity, the state applies a base­year method of assessing property. That means that all property in a jurisdiction is assessed in terms of its value as of a certain date, and that value remains on the books indefinitely until the jurisdiction performs a general reassessment. For Delaware's northernmost county, New Castle County, the last reassessment occurred in 1983, so all property therein is valued as of July 1, 1983.

A major challenge to contesting assessments in Delaware is that a taxpayer must determine the property's 1983 market value. Determining what a property is worth today is not always easy, but proving a property's value as of three decades ago has proven increasingly difficult. Furthermore, in the absence of regular adjustments to a property's assessed value, the county asserts that a property should be valued either as it existed in 1983 or, if it was built after 1983, as if it is new and undepreciated.

Delaware's courts have explained that taxpayers have two options in assessment appeals. The first option is to use data from the base year. The property owner could, for example, find sales of comparable properties in or around 1983, or using prevailing market rents and capitalization rates from 1983. The alternative route is to calculate the current market value of the property and "trend back" that amount to 1983. The County Board of Assessment Review has expressed a near-absolute preference for 1983 data, and rarely finds a taxpayer's trending formula acceptable.

The inequities of this practice are blatant. Under the county's interpretation of the base year system, a building constructed in 1983 and located next door to a similar new building should be assessed and taxed at the same level, even though buyers, sellers and tenants are likely to value the buildings quite differently. If the owner of the 34-year-old building wanted to contest its assessment, the owner would have to identify data for new buildings in 1983. Of course, as time marches on and years turn to decades, relevant data from the base year becomes increasingly difficult to find.

Taxpayers Highlight the System's Obsolescence

Taxpayers have raised many challenges to Delaware's assessment system, but most successful challenges have been fact-specific, and no recent court has gone so far as to order Delaware's counties to complete a reassessment. But after several attempts, the taxpayers in Commerce Associates LP v. New Castle County Office of Assessment successfully underscored the largest flaw in the system.

One Commerce Center is an office condominium building in Wilmington, Delaware. The county originally assessed each office condominium upon construction in 1983. After keeping the same tax assessment for decades, the owners of several of the condominiums challenged their assessments in 2015.

Before the County Board of Assessment Review, the owners presented five different analyses. Two analyses relied on comparable sales transactions, one using 1983 sales of buildings that were about 32 years old, and one using modern asking prices trended back to 1983 using the Consumer Price Index (CPI). Two analyses relied on income, one using 1983 data and one using 2015 data trended back to 1983 using the GPI. The fifth analysis employed a cost approach using the original construction expense and reflecting depreciation. These approaches showed that the properties were over-assessed by more than 40 percent.

The county presented evidence of the condominiums' sale prices in 1985, when each unit was relatively new. The county also presented an income approach using 1983 data and a cost approach reflecting no depreciation. The county's approaches all supported the original assessed values, and the board ultimately denied the taxpayers' appeals.

State Supreme Court Approves a Decrease

After having their appeals denied by the Superior Court, the taxpayers brought their challenge to the Delaware Supreme Court. In a tersely worded decision, the Supreme Court reiterated that assessors must consider all relevant factors bearing on the value of a property in its current condition. While the County argued that no depreciation was needed because the properties were brand new in 1983, the court noted that the properties were, in reality, more than 34 years old. Failing to account for their age and any resulting depreciation or appreciation resulted in a flawed value.

Although the county has yet to implement the court's decision, the effects of the decision will likely be widespread. Most properties in New Castle County built after 1983 are assessed without any depreciation. Because each tax year brings with it a new opportunity to challenge an assessment, property owners can bring a new appeal reflecting the property's current depreciation to the Board of Assessment Review every year. Ultimately, this could result in the downfall of the decades-old base-year assessment, as the county finds it necessary to update assessments for a larger number of properties.

A number of questions remain unanswered by the court's ruling. How should assessors value properties in areas that were rural in 1983 but are now highly developed? How can taxpayers quantify and reconcile appreciation and depreciation?

Future cases will need to resolve these questions, but for now, owners of Delaware property should evaluate their portfolios and determine whether opportunities exist to improve profitability by reducing property taxes.

Benjamin Blair is an attorney in the Indianapolis office of the international law firm of Faegre Baker Daniels, LLP, the Indiana and Iowa member of American Property Tax Counsel. He can be reached at This email address is being protected from spambots. You need JavaScript enabled to view it..
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Apr
26

Add Value Through Correct Valuation

Even in a booming market, managing expenses is the best way to ensure the long-term profitability of investment properties. For most student housing, the largest expense after debt service is property tax.

Assessors in college towns are happy to shift the tax burden onto out-of-town students and investors in student housing communities. And due to the perplexing assessment systems in most jurisdictions, owners and developers of student housing communities often treat tax assessments as a given, making appeals the exception rather than the rule. Yet any reduction in the tax burden can substantially increase profitability, so prudent owners monitor tax assessments closely.

Most ad valorem tax disputes hinge on property value. Developers are adept at valuing assets for investment, but there are substantial differences between taxable value and how much a property is worth as an investment. Knowing these differences can protect owners from overzealous assessors.

Identify the right income

Because student housing communities are income-producing properties, developed and purchased for the high-quality income streams they generate, most assessors argue that capitalized income is the best indication of their real estate value. Accordingly, assessors often ask for the property’s historic income and expense information. Taxpayers should be hesitant to provide the property’s operating statements without considering appropriate caveats, however.

In most states, property tax assessments reflect the property’s market value. Consequently, the assessor should value the asset using market levels of rent, vacancy, and expenses – not the property’s actual financial results. Just because the subject student housing operator maximizes revenues, for example, doesn’t mean that all of its competitors do.

Consider vacancy: Because of the school calendar, many student housing communities generate the majority of their annual income in a nine-month window and sit nearly vacant over the summer months. That equates to a market-wide effective vacancy of 25 percent. The fact that one complex appeals to summer students does not mean that competing properties should be valued as fully occupied year-round.

Further, unlike most standard apartments, the rent a student housing community can generate is attributable to substantial non-realty components. Most units are furnished, and rent often includes utilities, premium cable television, high-speed internet and other amenities. As a result, the income stream is not exclusively attributable to the real estate, but to personal property, intangibles, and business value as well. Likewise, some developments have favorable contracts with the university whose students will be housed by the community. Such non-realty components are not taxable, and must be removed. Failing to cleanse the income stream solely to its realty component can result in an overstated, overtaxed property value.

Scrutinize comparable sales

In certain markets, evaluating the selling prices for other student housing communities may be a valid method of determining a property’s taxable market value, but assessors often misinterpret that sales data. Just as a property’s income stream reflects more than the value of the real estate, a sales price – usually based on the same income stream – may reflect more than the value of the realty alone.

The most relevant sales for comparison are those where the real estate transacts without any personal property, intangibles, or business value. Since such sales are rare, an assessor using the sales of nearby student housing communities must take care to remove the value of everything but the realty. This task, often overlooked by assessors, requires identifying and measuring hard-to-value assets with certainty.

Moreover, comparable sales have to be adjusted to account for differences between the sold property and the property being assessed. Three communities might all have the same number of beds, but one might have mostly one- and two-bedroom layouts, while another has more community amenities that appeal to a different mix of students. They may serve different schools with different demographics. If the differences between the properties affect their respective rents, then the sales prices should be adjusted accordingly so they best match the configuration of the subject property.

In the absence of sales of purpose-built student housing, some assessors might be tempted to use sales of other types of multifamily housing. Despite superficial similarities, the properties compete in different markets, which appear as structural differences between the properties. An assessor failing to account for such differences may be making a fundamental error.

Cashing in on unusual cases

As the student housing market grows and matures, a particular community may face other circumstances that require a closer look during tax season. For example, public-private partnerships (P3s) are becoming more common in the student housing marketplace. Whether a taxpayer enters a P3 for monetization, development, or operational purposes, the agreement’s characterization can have substantial property tax consequences. Parties to P3s should keep taxability in mind as they draft contracts.

Similarly, in some states dormitories are exempt from property tax because they are deemed educational property. This exemption has historically extended to dormitories owned and operated by colleges and universities. But some properties owned or managed by third parties may still qualify for exemptions because, for example, the school can be deemed the beneficial owner of the property. Of course, the inverse can also be true, so operators should be cautious when drafting contracts so as not to convert an exempt property into a taxable one.

As the student housing market continues to surge, assessors are eager to expand the local tax base by capturing a piece of that growth. But by focusing on the key distinctions of the student housing market, diligent owners can improve the profitability of existing properties and free capital for new investment.

 

 Ben Blair jpgBenjamin Blair is an attorney in the Indianapolis office of the international law firm of Faegre Baker Daniels, LLP, the Indiana and Iowa member of American Property Tax Counsel. He can be reached at This email address is being protected from spambots. You need JavaScript enabled to view it..  

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Mar
28

Partially Built Properties Raise Property Tax Issues

As the commercial real estate industry continues its slow but steady recovery, investment in large, speculative real estate developments and new construction is returning, and surpassing pre-recession levels in many markets.  By their nature, large developments often take longer to construct than smaller projects, and this lengthy construction time can generate higher carrying costs for a developer at a time when the property is not generating income.

One of the largest expenses for commercial real estate is property tax.  The property tax burden can be even more onerous when the development does not yet have tenants, who ordinarily would reimburse the developer for taxes, or whose rent would otherwise provide the funds to pay taxes on the property.

As the number of large-scale construction projects ramps up, many properties will be under construction on a given assessment date, on the date on which an assessor values the property for that year’s property taxes.  This raises questions as to how and whether the property should be assessed, and the answers to those questions may provide opportunities for taxpaying developers to reduce their carrying costs.

Most states value property using a fair market value standard, and assess a property based on its value to the market.  Other states apply a market-value-in-use standard, which seeks to value the property’s current use.  In both systems, a property that is partially build on the assessment date would arguably have limited or no value because it is unable to generate income for its owner.  Further, as seen in many markets during the recent recession, few buyers are willing to purchase a partially constructed building.

In either circumstance, the property’s in-progress status would significantly hinder its value.  Even the value of the land would be impaired, because a buyer wanting that land would have to demolish the existing construction to begin anew.

Nevertheless, many states authorize local tax assessors to value developments for tax purposes while still under construction.  The means employed by assessors vary, and some states lack explicit guidance on how assessors should perform such a valuation.

Despite the many issues involved in valuing a property that is only partially built, some assessors create another layer of difficulty by assessing only some partially constructed projects on any given assessment date.  A recent review of the assessments in one midsized US market revealed that only one of the many projects in the construction pipeline was assessed as “construction in progress.”  Every other partially built property maintained its prior value until the project was completed and placed in service.

Aside from the apparent inequity of this situation, it raises potential legal ramifications as well.  Nearly every state’s constitution requires that property taxes be assessed and administered uniformly and equally.  Under these provisions, which are at the heart of the modern data-based property tax system, if two properties are identical, then the process by which they are assessed should be identical and the resulting values should be identical.  The techniques used to value one property in a jurisdiction should apply to all similar properties.

As the recovery continues for commercial real estate, assessors are eager to restore the tax rolls to pre-recession values or higher.  But that restoration of tax rolls should not come at the expense of developers who have major projects under way.

Whether in-progress buildings should even be assessed is questionable, but if they are, then every property should be subject to the same standard.  Increasing the value of only select projects violates state constitutions.  Fortunately, those same constitutions give developers an avenue to challenge their unfair tax liabilities.

Reprinted with permission from the “ISSUE DATE” edition of the “PUBLICATION”© 2016 ALM Media Properties, LLC. All rights reserved.

Further duplication without permission is prohibited. ALMReprints.com – 877-257-3382 - This email address is being protected from spambots. You need JavaScript enabled to view it..

paul Ben Blair jpg

Stephen Paul is a partner and Benjamin Blair is an associate in the Indianapolis office of the law firm of Faegre Baker Daniels, LLP, the Indiana and Iowa member of American Property Tax Counsel. They can be reached at This email address is being protected from spambots. You need JavaScript enabled to view it. or This email address is being protected from spambots. You need JavaScript enabled to view it..  The views expressed here are the authors' own.

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Jun
30

Retail Property Tax Valuation Debate Heats Up in Hoosier State

Indiana has become the latest battleground in the debate over how assessors should value retail real estate and other commercial properties for property tax purposes. The debate’s conclusion will likely affect owners of retail, office and even industrial properties in Indiana, and may affect taxpayers grappling with similar issues in other states.

At the heart of the debate is the question of what assessors should value under Indiana’s market value-in-use standard. Though that term can seem somewhat puzzling, the Indiana Supreme Court has stated that any valuation standard must be based on objective data while also protecting Indiana taxpayers who choose to use their properties at something less than full market potential.

How is market value in-use different from market value? In many if not most situations, they are identical. Where a property is being used for its highest and best use, the property’s market value-in-use will be the same as its market value.

Because a property can be used for something less than its highest and best use, however, its market value-in-use may be lower than its market value. This is the case in the example of agricultural land surrounded by commercial development.

A property cannot be used for something greater than its highest and best use, however; by definition, nothing is higher or better than the highest and best use. Accordingly, a property’s market value-in-use cannot exceed its market value.

Importantly, market value-in-use does not mean the value to the individual user. This distinction may seem like mere semantics, but how the state defines market value-in-use affects many commercial taxpayers. A series of Indiana cases show why.

Since at least 2010, when the Indiana Tax Court issued a pair of decisions addressing the meaning of market value-in-use, Indiana has recognized that market value-in-use as determined by objectively verifiable market data, is the value of a property for its use, not the value of its use to the particular user.

Indiana courts also recognize that in markets where both buyers and sellers frequently exchange and use properties for the same general purpose, a sale often indicates value. The Indiana Board of Tax Review has affirmed and applied these rulings in subsequent cases, including a pair of decisions issued in December 2014 involving big-box retail stores.

These decisions followed longstanding precedent from the Indiana’s Tax Court and kept Indiana in line with the overwhelming majority of other states that have considered the question. Had the board instead agreed with the assessors’ interpretation of market value-in-use as being the value of the use, it would potentially have created a number of anomalous outcomes, including similar properties being assessed differently based on the property owners’ characteristics and not on the properties’ characteristics.

Following the board’s decisions, local governments petitioned the Indiana legislature to change the valuation standard for commercial properties. After a heated debate, legislators left the market value-in-use standard unchanged but amended the property tax statute to modify the evidence available to prove a property’s value, based on the facts of the case.

It is too early to know the full ramifications of the new statute. Assessors’ repeated attacks on the market value-in-use standard, however, will produce one certain result, Taxpayers that own property in Indiana or are considering doing business there will face increasing uncertainty. For that reason, taxpayers must monitor their assessments to ensure fairness as the debate continues.

paul Ben Blair jpgStephen Paul is a partner and Benjamin Blair is an associate in the Indianapolis office of the law firm of Faegre Baker Daniels, LLP, the Indiana and Iowa member of American Property Tax Counsel. They can be reached at This email address is being protected from spambots. You need JavaScript enabled to view it. or This email address is being protected from spambots. You need JavaScript enabled to view it..  The views expressed here are the authors' own.

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Jun
30

Weigh Anchor Inducements To Sink Property Tax Bills

Anchors weigh heavily in tax decisions

As the post-recession recovery for retail properties continues, local assessors are eager to increase shopping center tax assessments to their pre-recession highs or beyond. But regional and super-regional shopping centers are among the most complex types of real estate that assessors regularly value, and that complexity yields errors.

By failing to remove the value of an often-overlooked intangible asset, assessors are improperly attributing excess income to the real property, resulting in excessive tax assessments. This error stems from assessors incorrectly answering one of the most fundamental questions in property assessment: What property is being valued?

Too many assessors look at the income generated by a shopping center and conclude that the income is entirely attributable to the real estate. But the value of a shopping center's going concern is not equal to the market value of its real property. Unless the assessor makes an effort to extract the non-real-estate components, the value indications under the income and sales comparison approaches to value will capture not just the value of the real property, but also non-taxable personal and intangible property.

AGREEMENTS ARE INTANGIBLE

One major non-realty component of a shopping center's value is its operating agreements with anchor tenants.

Shopping centers depend on their anchor tenants for more than rent, Anchors typically make major advertising expenditures to draw customers to the property. As a result, customers ordinarily visit the mall with the initial purpose of shopping at the anchor retailer, and only then venturing out into the rest of the mall, which is typically the domain of more specialized retailers.

Shopping centers with better-quality anchors are able to draw more customers and charge higher rents to inline tenants. The presence of high-quality anchors also conveys stability, which attracts potential inline tenants. Conversely, when a mall loses one or more of its anchor tenants, inline tenants almost always follow the anchor, and the landlord must offer larger concessions to attract replacement tenants.

Beyond helping to attract and retain inline tenants, high-quality anchor tenants contribute indirectly to higher income generation for the shopping center. Because shopping centers often collect percentage rent, or rental income based in part on an inline tenant's retail sales, the long-term presence of an anchor that draws customers is vital to a mall's long-term financial success.

Shopping center developers typically ·offer significant inducements to attract and retain anchor tenants, and to convince those tenants to sign favorable long-term operating agreements. These inducements may take the form of cash, a preferred site, site improvements, or reduced expense recoveries, and may occur both upon the initial development of the shopping center and during redevelopment ·

Whatever the form and timing, shopping centers have to subsidize the anchor's costs. The shopping center gets a return on this investment over the lifetime of the tenancy in the form of higher in-line rents.

Because the higher rental income from in-line tenants is, in part, a byproduct of the anchor operating agreements rather than a reflection of the real estate value alone, it is inappropriate to attribute the entire income stream to the real property. But when assessors use the total income of the shopping center's business in their calculations, they implicitly value the total assets of the business, rather than the real property alone.

PROPER ASSESSMENT TECHNIQUE

To properly value just the shopping center’s real property, the income attributable to the favorable anchor operating agreements must be subtracted from the ' shopping center's total income prior to capitalization.

The calculation of the income attributable to anchor inducements is a two-step process. First, the appraiser must determine the value of the anchor inducements, accounting for both a return of the initial investment and a return on that investment that would be expected by developers in the market. There is no one-size-fits-all method of determining the amount needed to induce a particular anchor tenant. Every shopping center owner has its own method of determining how much it should pay in inducements to potential anchors given the location, size, age, design, and tenant distribution of the shopping center.

Whatever method is used to determine the value of the favorable contracts, it is important that appraisers select values that reflect inducements actually provided by market participants. For that reason, it is important that taxpayers contesting assessments select appraisers who have experience with shopping centers and who understand the dynamics of that industry.

ANCHOR INDUCEMENTS

Once the assessor calculates the total return of and on the inducements, the second step in this process is to determine the income attributable to those inducements. To do this, the appraiser must amortize the total return over the term of a typical anchor agreement – generally 10 to 15 years – at a yield rate high enough to account for the fact that intangibles are the highest-risk components of a business enterprise.

The appraiser will then subtract the resulting figure from the going concern's net operating income, along with return of and on personal property and other non-real-estate expenses, such as start-up costs. The result will be the net income from the real property alone, which is the correct base for the income approach for property tax purposes.

For most retail properties, the largest expense after debt service is the property tax bill. Any reduction in the tax burden can drastically impact a property's profitability, and a reduction in property taxes passed through to tenants can itself be a method of attracting and retaining better-quality tenants. So as the retail market continues its slow recovery, proper treatment of anchor agreements may be a way to keep from drowning in excessive property taxes.

paul Ben Blair jpg

Stephen Paul is a partner and Benjamin Blair is an associate in the Indianapolis office of the law firm of Faegre Baker Daniels, LLP, the Indiana and Iowa member of America Property Tax Counsel.  They can be reached at This email address is being protected from spambots. You need JavaScript enabled to view it. or This email address is being protected from spambots. You need JavaScript enabled to view it.. The views expressed here are the authors' own.

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Jun
23

Disparate Treatment under City's Assessment Forgiveness Plan is Ruled Constitutional: Armour v. City of Indianapolis

By Stephen H. Paul, Esq. and Benjamin A. Blair, Esq. as published by IPT - Tax Report, July 2012

On June 4, 2012, the Supreme Court of the United States issued a significant decision in Armour v. City of Indianapolis, No. 11-161, finding that a city's forgiveness of sewer assessments for some property owners without offering refunds to others did not violate the Equal Protection Clause. Applying a rational basis standard of review, the Court held that administrative concerns can be sufficient to justify tax-related distinctions without running afoul of the Constitution.

Introduction
On June 4, 2012, the Supreme Court of the United States decided Armour v. City of Indianapolis, No. 11-161, which affirmed the Indiana Supreme Court's ruling that when a city switches from one method of infrastructure financing to another, the city's decision to forgive certain financial obligations arising under the prior financing method may be justified by administrative concerns even when the forgiveness creates disparate consequences. Although ostensibly a sewer-financing case, the Supreme Court's decision directly affects the scope of state and municipal taxing authority and the impact of the Equal Protection Clause on tax-related distinctions.

Facts
For more than a century, cities in Indiana have been permitted to apportion the costs of infrastructure projects among all affected property owners by a statute called Barrett Law. When a city built a Barrett Law project, the city would divide the total cost of the project equally amongst the affected lots. The city would issue a lot-by-lot assessment and would collect payment of the assessment in the same manner as other taxes. Barrett Law allowed lot owners to pay the assessment either in a single lump sum or as installment payments over a period of 10, 20, or 30 years with accruing interest. Until fully paid, an assessment constituted a lien against the property, and the city could foreclose on the property in the event of a default.

For several decades, the City of Indianapolis (the "City") used the Barrett Law system to fund sewer projects. One of the Barrett Law projects was the Brisbane/Manning Project, which began in 2001. It connected about 180 homes to the City's sewer infrastructure, and in July 2004, the homeowners were sent formal notice of their payment obligations. Each property was assessed $9,278 for the project, with options for 10-, 20-, and 30-year payment plans at 3.5% interest. Thirty-eight homeowners paid the assessment in full.

In 2005, the City adopted a new system of sewer-financing, the Septic Tank Elimination Program ("STEP"), in which each homeowner was charged a flat fee and the remainder of the cost was financed by bonds paid by all taxpayers. STEP had the advantage of lowering sewer-connection costs for individual lot owners. However, more than 40 Barrett Law sewer projects had been constructed before STEP was adopted, and more than half of those projects still had installment paying lot owners, including the Brisbane/Manning Project, which had been in place for only a year. In enacting STEP, the City decided to forgive all outstanding assessments under the Barrett Law system because the system presented financial hardships on lower income homeowners who most needed sanitary sewer service. However, no refunds would be issued for assessments already paid. Thus, while 38 of the homeowners in the Brisbane/Manning project had paid $9,278, others paid as little as $309.27 for the same sewer connection.

The homeowners who had paid in a lump sum brought a lawsuit seeking a refund from the City, claiming that the City's refusal to provide refunds at the same time that the City forgave outstanding assessments of other homeowners violated the Federal Constitution's Equal Protection Clause, which provides that "no state shall ... deny to any person within its jurisdiction the equal protection of the laws." The trial court granted summary judgment in favor of the homeowners, and the Indiana Court of Appeals affirmed that judgment. The Indiana Supreme Court reversed the lower court, finding that the City's distinction was "rationally related to its legitimate interest in reducing its administrative costs, providing relief for property owners experiencing financial hardship, establishing a clear transition from Barrett Law to STEP, and preserving its limited resources." Slip op. at 5. The homeowners appealed to the U.S. Supreme Court to consider the equal protection question.

Holding
In a 6-3 decision, the Supreme Court held that the City's tax-related distinction was supported by a rational basis and thus did not violate the Equal Protection Clause.

Analysis
The Court began by finding that the proper question was whether the City's distinction between homeowners had a rational basis. Although the Equal Protection Clause strongly protects individual rights in certain circumstances, a classification that does not involve fundamental rights and which does not proceed along suspect lines "cannot run afoul of the Equal Protection Clause if there is a rational relationship between the disparity of treatment and some legitimate purpose." Slip op. at 6. Rational basis review requires deference to reasonable underlying legislative judgments, and legislatures have "especially broad latitude" in creating classifications and distinctions in tax statutes. Id.

The City's classification involved neither a fundamental right nor a suspect classification. "Its subject matter is local, economic, social, and commercial." Id. The City did not discriminate against out-of-state commerce or new residents, actions which would have increased the degree of scrutiny the Court would give to the City's action. The distinction between fully-paid homeowners and those who had their debt forgiven was simply "a tax classification." Id. Hence, the Court found that the case fell directly within the scope of its precedents holding such a law constitutionally valid

if there is a plausible policy reason for the classification, the legislative facts on which the classification is apparently based rationally may have been considered true by the governmental decision maker, and the relationship of the classification to its goal is not so attenuated as to render the distinction arbitrary or irrational.

Slip op. at 7 (quoting Nordlinger v. Hahn, 505 U.S. 1, 11 (1992)).

The Court found that the City's decision to stop collecting outstanding Barrett Law debts was based on rational administrative concerns. Administrative considerations can justify a tax-related distinction. The City's administrative burdens would have included the need to maintain parallel and expensive administrative systems to monitor both the new and the old financing systems, with the possible need to track down defaulting debtors and bring legal action. The fixed administrative costs would have continued to increase on a per-debtor basis as debts were paid off. Further, the City would have to calculate and administer refunds, which would require appropriating funds from other city programs. In other words, the entire purpose of transitioning from Barrett Law to STEP would have been defeated. While the homeowners put forth systems they deemed superior to the one implemented by the City, the Court noted that "the Constitution does not require the City to draw the perfect line nor even to draw a line superior to some other line it might have drawn... only that the line actually drawn be a rational line." Slip op. at 11.

Although the Indiana court held that relieving financial hardship was also a rational governmental concern, the Court noted that it did not need to consider that argument, explicitly holding that "the administrative considerations we have mentioned are sufficient to show a rational basis for the City's distinction." Slip op. at 10. The homeowners correctly stated that administrative considerations could not justify a system where a city arbitrarily allocated taxes among a few citizens while forgiving others simply because it is easier to collect taxes from a few people than from many. "But that is not because administrative considerations can never justify tax differences." Slip op. at 11. "The question is whether reducing those expenses, in the particular circumstances, provides a rational basis justifying the tax difference in question." Slip op. at 12. The Court held that the homeowners had not met their burden of showing that there was no rational basis justifying the distinction.

In a spirited dissent, Chief Justice Roberts noted that the Court had never before held that administrative burdens alone justify grossly disparate tax treatment of those who should be treated alike. "The reason we have rejected this argument is obvious: The Equal Protection Clause does not provide that no State shall 'deny to any person within its jurisdiction the equal protection of the laws, unless it's too much of a bother.'" Dissent at 4. Similarly, the City's argument that the unequal burden was justified because it would have been "fiscally challenging" to issue refunds "gives euphemism a bad name." Dissent at 5. The dissent disagreed that the City could evade returning money to its rightful owner by the "simple expedient of spending it." Dissent at 6.

The City had been presented with three choices: 1) continue to collect installment payments from all homeowners; 2) forgive the debts of installment-plan homeowners and give equivalent refunds to lump-sum homeowners; or 3) forgive future payments and offer no refunds of past payments. "The first two choices had the benefit of complying with state law, treating all of Indianapolis' citizens equally, and comporting with the Constitution." Dissent at 2. The City chose the third option, and the dissent saw the equal protection violation as plain.

The Ongoing Vitality of Allegheny
The Court's decision in Armour will have a significant impact beyond the limits of Indianapolis' sewer system, particularly in the realm of equal protection challenges to state tax regimes.

The most substantial disagreement between the majority and the dissent, and the area where some commentators have expressed concern, is the continuing vitality of Allegheny Pittsburgh Coal Co. v. Commission of Webster County, 488 U.S. 336 (1989). That case involved a county assessor who valued real property on the basis of its recent purchase price, except where the property had not been recently transferred, in which case the assessment for each property remained essentially flat. The system resulted in gross disparities in the assessed value of generally comparable properties. The Constitution allows a State to divide property into different classes, but the division must not be arbitrary and the distinctions in practice must follow state law. The Supreme Court held that the assessments violated the Equal Protection Clause because the Clause requires that similarly situated property owners achieve rough equality in tax treatment.

The majority in Armour distinguished the earlier decision by emphasizing that Allegheny was "the rare case where the facts precluded any alternative reading of state law and thus any alternative rational basis." Slip op. at 13. There, the assessor "clearly and dramatically violated" a clear state law requirement of equal valuation. In contrast, the City in Armour followed state law by apportioning the cost of its Barrett Law projects equally. State law said nothing about how to design a forgiveness program or how to draw rational distinctions in doing so. Thus, to adopt the view of the homeowners "would risk transforming ordinary violations of ordinary state tax law into violations of the Federal Constitution." Slip op. at 13-14.

The dissent found the equal protection violations to be identical between Armour and Allegheny. Whereas the majority spent little time on the Allegheny decision, the dissent saw the cases as direct analogs, even down to the levels of disparity. Whereas the majority found that the City complied with state law, the dissent viewed the state law as requiring the assessment to be equally apportioned amongst the homeowners. The result of the City's decision was that some homeowners were charged 30 times what the City charged their neighbors for the same service.

The fundamentally different treatments given by the majority and the dissent treatments to Allegheny show that Allegheny is still an important case in equal protection claims relating to taxation. The sides disagreed about how central Allegheny is to the argument for rational basis and the manner in which compliance with state law demonstrates a rational basis.

The majority seems to have taken steps to avoid dealing with Allegheny, despite the obvious parallels between the cases. The Court only discussed Allegheny after finding that the City had a rational basis for the distinction. Whereas Allegheny stands for the notion that failure to comply with state law demonstrates a lack of rational basis, the majority found a rational basis and then read the state law in a way that supported its finding.

The dissent viewed compliance with state law as central to the argument for rational basis. If a City's tax regime fails to comply with state law, it fails rational basis review. Thus while the majority took a broad view of compliance, saying that the assessment itself complied with state law, the dissent took a narrow view of compliance, saying that the end result of the tax regime must comply with state law.

Allegheny, though a "rare case", has long provided taxpayers with some guidance on how to proceed in an equal protection challenge to an unequal tax regime. The decision in Armour shows how rare Allegheny truly is, and how difficult the path for future taxpayers will be. The most significant lesson for taxpayers seeking to overturn a tax regime on equal protection grounds is that the bar is set extremely high. Taxpayers who attack legislative line-drawing have the burden of showing that it was not rational for the City to draw the line to avoid an administrative burden. Slip op. at 12. Taxpayers must show that the administrative burden on the municipality is "too insubstantial to justify the classification." Id. The homeowners in Armour were unable to do so. The discriminatory effect in future cases will need to be egregious in order for taxpayers to successfully show an equal protection violation in light of Armour.

The Impact of Armour on Amnesty Programs
The Court's decision in Armour is also significant because it may be broadly interpreted to give state and municipal governments a wide berth in crafting amnesty programs and other tax policies.

The Court drew a parallel between Indianapolis' assessment forgiveness and other common amnesty programs involving mortgage payments, taxes, and parking tickets. Slip op. at 9-10. The City's distinction between past payments and future obligations is a line consistently drawn by courts between actions previously taken and those yet to come. The Court implied that to overturn the City's sewer-financing distinction would require overturning tax amnesty programs that are regularly used by governments.

The dissent, however, emphasized that the Court's analogy to typical amnesty programs was misplaced. "Amnesty programs are designed to entice those who are unlikely ever to pay their debts to come forward and pay at least a portion of what they owe." Dissent at 5. Because administrative convenience alone does not justify those programs, their constitutionality would not be in question.

The Court's decision continues the line of cases allowing under the Equal Protection Clause distinctions between taxpayers in forgiveness situations. As more states offer tax amnesty programs to increase tax revenues and encourage future compliance, they can feel secure that their programs should receive broad support from the courts, so long as they serve a rational purpose.

Conclusion
The question in Armour was summarized by Justice Breyer, the eventual author of the decision, near the close of oral argument as whether the City's choices were rational. To the majority of the Court – including, notably, Justice Thomas who broke with the conservative wing of the Court – found that administrative considerations alone can justify a tax-related distinction between taxpayers and a city's decision to stop collecting on certain assessments. Despite an invitation by the dissent, the Court refused to say "enough is enough" to continuing pressures on the Equal Protection Clause. The Supreme Court rarely grants certiorari to state tax cases, and the decision in Armour shows that taxpayers will continue to have an high burden when they do reach the courthouse steps.

Blair Ben small

Benjamin A. Blair, Esq. is a partner in the Indianapolis office of Faegre Baker Daniels, the Indiana member of American Property Tax Counsel, the national affiliation of property tax attorneys. He can be reached at This email address is being protected from spambots. You need JavaScript enabled to view it.

 Paul Steve

Stephen H. Paul is a partner in the Indianapolis office of Faegre Baker Daniels, the Indiana member of American Property Tax Counsel, the national affiliation of property tax attorneys. He can be reached at This email address is being protected from spambots. You need JavaScript enabled to view it..

 

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Jan
30

Obsolescence Creates Tax-Saving Opportunities For Shopping Center Owners

"External obsolescence may be market-wide or industry-specific, international, national, or local in origin. It can be temporary or permanent, but in most cases, the property owner is unable to fix the problem..."

By Benjamin A. Blair, Esq., as published by rebusinessonline.com, December 2012

Shopping center owners often find that factors beyond their control detract from the marketability and profitability of their investments, particularly in the current depressed market. Economic change and evolving technology, for example, have altered the way retailers and property owners transact business. While lenders keep a tight grip on potential financing, brick-and-mortar retailers must compete against an increasingly global, virtual marketplace.

Despite — and indeed because of — this bleak picture, property owners have reason for optimism. Several states and localities, including Chicago and Indiana, are in the midst of systematic property reassessments. Because this cycle of reassessments falls during a time when retailers are still struggling under the effects of the recession, property owners have an opportunity to reap tax savings from this market turbulence and increase the property's bottom line.

The goal of a property tax assessment is to apply the tax rate to an accurate property value. This value is generally set at either market value or at the property's value-in-use. A property's value, however it is set, can be affected by any number of factors, the most important of which for retail properties is the property's ability to earn rental income.

Real-life scenario

Imagine a neighborhood shopping center with leaking roofs and peeling paint. Perhaps the tenant spaces are awkwardly shaped or poorly constructed. An investor would value this property less than an otherwise comparable property in better condition. This depreciation, called physical and functional obsolescence, is due to the physical condition or flaws in the construction of the property.

But just as a property can suffer from physical and functional obsolescence, a property can suffer depreciation from sources external to the property itself. This depreciation, termed economic or external obsolescence, is a usually incurable loss in value caused by negative influences outside the property. External obsolescence may be market-wide or industry-specific, international, national, or local in origin. It can be temporary or permanent, but in most cases, the property owner is unable to fix the problem.

In order to use external obsolescence to reduce a property's tax assessment, the owner must first identify whether external obsolescence is present. Then the owner must quantify the effect of the obsolescence on the property. Unsupported claims of obsolescence are unlikely to impress an assessor and encourage a reduction in the property's assessment.

To quantify the obsolescence, the owner must know its source. Shopping centers in today's market are subject to external obsolescence from a variety of sources. General economic conditions have reduced the demand for leases and have resulted in fewer tenants. Existing tenants, feeling pressure from lower-overhead competitors, are seeking lower rents to reduce strain on their business. Many retail lease rents are based on a percentage of sales, and as sales fall, so does rental income.

As a result of the real estate boom in the middle of the last decade, many markets are oversupplied with competitive properties, and some uncertainty exists as to the future of brick-and-mortar retail. Further, buyers and sellers are still cautious while engaging in sales, and lenders continue to restrict available capital. Changes in interest rates, inflation, capitalization rates, and elected officials can all have an effect on property value.

Proving cause and effect

After identifying the source of the property's obsolescence, the owner must be able to show the impact of the obsolescence on the property. For example, if the owner has lowered rents in order to keep or attract tenants, the valuation of the property should reflect that lowered income earning potential. Decreased demand from investors, whether because of financing restrictions or lower income potential, should reduce the assessment to reflect the smaller market for investment properties.

And when determining value by comparing the sale of similar properties, owners should emphasize the differences in market conditions, which reduce the value of the property.

For most properties, the largest expense after debt service is the property tax bill, so any reduction in that tax burden can drastically improve the property's profitability. Thus, while the economic climate may be turbulent for some time, prepared and informed property owners can use the nuances of external obsolescence to help weather the storm.

Blair Ben small Benjamin A. Blair is a tax associate in the national law firm of Faegre Baker Daniels, the Indiana member of American Property Tax Counsel, the national affiliation of property tax attorneys. He can be reached at This email address is being protected from spambots. You need JavaScript enabled to view it.

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