The logical and proper valuation of big box stores for assessment purposes is not based on the income stream. We believe the cost approach with adjustments for obsolescence is the most satisfactory methodology. This conclusion was arrived at after lengthy discussions and negotiations amongst appraisers that took place outside the usual litigation environment, subject to the supervision of legal counsel and overriding purview of the Assessment Review Board in Ontario.
We examined the current value assessments of 162 big box freestanding stores in the Province of Ontario owned by a single operator. There were outstanding assessment appeals by the taxpayer for the 2008 base year (2009-2012 taxation), and the 2012 base year (2013-2016 tax years). Most significantly, we settled those appeals on the basis of the cost approach, including going forward to the 2016 base year (2017-2020 tax years). The settlement process began in 2013 and resolution was achieved in 2016.
Big box stores are large discount stores, including WalMart, Home Depot and our own Canadian Tire. These stores generally exceed at least 40,000 square feet in area. Unlike most property types, the buildings are built to suit or custom built for a specific retailer’s business. The boxes are not built on a speculative basis to be sold or leased in the marketplace after development.
Upon sale of the fee simple interest in the big box store, the original use may be modified for the new user, or the building may be demolished. Such stores are rarely purchased to be leased by a single tenant after the purchase (for retail purposes or otherwise).
There has been much litigation in the United States relating to the big box store valuation conundrum. Kennard and Fisher asked:
“. . . if it cost $70.00 per square foot to build an anchor department store, then why is it they sell for about half of their replacement cost new?”
This question led, in part, to the so-called “dark store” theory of valuation which resulted in numerous decisions of courts and tribunals concluding that the sales comparison approach, based on market sales of the big box store resulted in an objective determination of market value. Invariably these sale prices were substantially less than the cost to construct. Application of the “dark store” theory has devastated assessments of big box stores in many American jurisdictions.
In Ontario, the assessment standard is “current value”. Current value in essence means the same as what you might know as fair market value, or appraised value, or actual value. Current value is defined in the Assessment Act as follows:
“Current Value means in relation to land, the amount of money the fee simple, if unencumbered, would realize if sold at arm’s length by a willing seller to a willing buyer.”
There has been much litigation in the Province of Ontario as to the meaning of current value. It is clear that this valuation standard is an objective, market based concept.
The value to the owner, or the subjective value of the real estate, is irrelevant for assessment purposes. The statutory standard of value is based on objective analysis of data from the marketplace. The identity of the occupant is not relevant.
Historical Reliance on Income Approach
“An appraisal is the logical application of available data to reach a value conclusion.” (borrowed from William Kennard)
The data showed that these big box properties are never built speculatively and then put on the market for rent or sale. Once the property is rented by the developer to a retailer, the real property may be sold from investor to investor. Generally the developer and the retailer are either related or the same person. The attractiveness of the purchase to investors is a function of the lease amount – rent amount, terms and quality of tenant – rather than the fee simple interest in the real estate.
Frequently the developers/retailers sell the real estate for financing purposes, and lease it back.
Sales-leasebacks are financing arrangements rather than pure fee simple real estate transactions. Sales of real estate occupied by a long-term tenant reflect the value of the leased fee of the real estate and, implicitly, the quality of the tenant. However, for assessment purposes we are searching for the fee simple value – not the leased fee interest.
Municipal assessments in Ontario are undertaken by a single corporation collectively owned by all the municipalities – MPAC. The three statutory parties to the appeals are the property owner (ie. the taxpayer), MPAC and the municipality in which the property is located.
Notwithstanding the above concerns regarding the income approach, Ontario big box stores had been valued by assessors using an income approach with rents derived from available financing transactions. The basis for determining market rent was a mystery. The capitalization rates relied upon by the assessor seem to have been drawn from sales of shopping centre regional malls. Frequently, the rents applied by MPAC were nothing more than the previous base year’s economic rent indexed to the next base year. The number of open- market lease transactions available was extremely limited and, therefore, data extracted to support the appraised value came from a very shallow pool. The assessed values were based more on hokum-pokum than objective data reflective of a true market.
To a great extent, historically the resolution of assessment appeal litigation with MPAC regarding big box stores in Ontario was based upon comparability and equity as between similar properties. Eg. Is a WalMart store worth $1 per square foot less than Home Depot? Is the Toronto market for big box stores worth $2 per square foot more than in Ottawa?
2008 Base Year
In order to prepare for the 2008 CVA reassessment, the Municipal Property Assessment Corporation (“MPAC”) determined a scale of fair market rents applicable to big box retailers based on the name of the occupant and “bench marking” of rents according to market area (ie. land values) and notional base rents for WalMart stores. An extract from that analysis produced by MPAC is set out below:
Market Area (b) 500,000 – 750,000 per acre – Regions 3, 13, 16, 19, 21, 22
Base benchmark rent
Base + 0.50 – higher building cost2
Base + 1.00 – higher building cost2
Base + 1.00 – higher building cost2
Base + 1.00 – higher building cost2
Base + 1.25 – higher building cost3
1 Adjusted rate may be further adjusted if effective age greater than 20 years.
2 Higher buildings = higher building costs
3 Plus 0.24 for coolers and freezers
We commenced the appeals litigation with the assertion that the income approach utilized by MPAC was invalid because there was insufficient data regarding fair market rents available to support it. The taxpayer relied upon the cost approach as the most appropriate measure, conditional upon a full measure of obsolescences being accounted for in the valuation process.
Although we left open the option of referring to the “dark store theory”, that path was not pursued. The expectation was that a settlement could be negotiated using the cost approach with appropriate adjustments for obsolescence. It was also our view that the scorched earth results of the dark store theory were based on a faulty assumption regarding non-compete clauses registered on title for the big box stores.
The Settlement Process
In 2013, negotiations began between MPAC and the big box property owners.
The big box operators had retained the services of appraisers familiar with assessment practices. MPAC similarly directed experienced appraisers within its organization to grapple with the appeals. Counsel for both the taxpayers and MPAC agreed to suspend ordinary litigation proceedings and litigation tactics to permit an open and frank exchange of views between the parties, in particular amongst appraisers without counsel present. Counsel for both the property owner and MPAC agreed from the outset that full disclosure of information and candid, without prejudice exchanges of opinions amongst the appraisers would be the hallmarks of the negotiations. Furthermore, counsel agreed that the consensual results of the appraisal discussions would guide the terms of settlement of outstanding appeals and future assessments.
As part of our negotiations, and after an initial state of discussions, MPAC and the property owner invited municipal representatives to form a Municipal Working Group (“MWG”) and participate in the negotiations. The MWG included seven (7) representatives from some of the affected municipalities. Each representative signed an undertaking of confidentiality and non- disclosure.
As a prelude to those negotiations, MPAC and the property owner issued a Joint Communique to the MWG, which became the starting point for negotiations. The Joint Communique provided a current status report of the initial negotiations, which included the following statements:
- MPAC and the taxpayer have agreed that the cost approach is the most reliable determinant of current value for these properties.
- MPAC and the taxpayer have agreed that the appropriate approach to determine economic life of the buildings is the market extraction method.
- MPAC and the taxpayer have agreed that the MPAC automated cost approach to determine RCN of the buildings overstates actual construction costs.
- MPAC and the taxpayer are reviewing 300 land sales and the assessments of approximately 600 comparable land parcels to respond to municipal concerns that land values may have been understated in the comparative sales analysis.
The property owner and MPAC invited the MWG to review and challenge the various data files and analyses undertaken jointly by the property owner and MPAC. In 2016, the property owner and MPAC entered into a Memorandum of Understanding as to principles for resolution of outstanding appeals for 2008 and 2012 base years, and the principles for assessment going forward with the 2016 CVA reassessment. The Memorandum of Understanding was endorsed by the MWG.
The Memorandum of Understanding was widely distributed to the municipalities, and published in the Canadian Property Tax Association’s monthly newsletter as an article authored by an MPAC officer. A copy of that article is attached.
The result of this process has been to resolve two cycles of assessment appeals (2008 and 2012), and to set in place assessment principles for the 2016 cycle. The process was based on three elements not commonly found in assessment appeals:
- Candid and transparent disclosure of information, on a multi-party basis.
- Involvement of municipalities relatively early in the appeal process to provide a forum for their concerns and understanding.
- Most importantly, establishing a protective zone where appraisers could meet, share data, exchange views and analysis, all without tactical advocacy of their respective client’s interests.
In summary, the participants in the process found success when:
- Legal counsel provided interest based general counsel to their respective clients and facilitated the process, rather than simply litigating conventionally.
- Appraisers appraised with open minds, rather than advocating for or against the status quo.
- Trust and patience was maintained, even when unexpected developments created log-jams, hurdles or delays.
In other words, the appraisers were not advocates, and legal counsel were not experts. The result was a happy resolution to a thorny assessment problem.