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Nov
01

Tax Trauma - How Higher Assessments Can Cause Lower Net Rents

Resurgent demand for commercial real estate is driving sale prices to record highs, pressuring assessors to increase taxable property values substantially. In the Minneapolis-St. Paul area, tax bills on some suburban and downtown Minneapolis buildings have shot up 30 percent or more within two years following a sale.

These assessment spikes yield staggeringly larger tax bills, with some buildings now taxed at $8 to $10 per square foot, up from $5 to $6.50, for taxes payable in 2014.

For landlords with well-occupied properties, the tax burden itself is less important than the increased occupancy cost it creates, because most tenants compare lease proposals by total occupancy cost rather than by net rent alone. It does not matter to a tenant where the rent dollar goes; for every dollar that taxes increase, tenants will likely try to reduce net rent payments by that same amount in order to keep occupancy costs flat.

Assessors under Pressure

The Minnesota Department of Revenue prepares an annual sales-ratio study that compares assessments to sales prices. This puts pressure on assessors to react strongly to rising sale prices when properties are revalued each year.

If a sale price is 50 percent higher than the assessed value, then a 20 percent assessment increase in the first year after the sale, and 20 percent again the next year, will only raise the value to something approaching the sale price.

For example, a downtown Minneapolis property assessed at $107 million sold for $200 million. The assessments increased only 10 percent the first year and another 10 percent the second year, but jumped another 34 percent in year three. These repeated increases drive building costs well beyond owner and taxpayer expectations.

Assessors increased another property’s value by 30 percent in the year after the sale. Yet another pair of buildings were assessed 10 percent higher the year before they sold, then increased 30 percent and 50 percent in the year following the sale, putting them at approximately 90 percent of the purchase price.

Tenant Repercussions

Tenants notice operating cost increases, especially those recurring over consecutive years. Operating cost increases can discourage a tenant from renewing its lease at a higher rent.

As an example, a local tenant in a build-to-suit property had projected taxes at $4 per square foot, but with taxes of $10 per square foot this year, the tenant faces occupancy costs far in excess of projections. Whether the difference is looked at in an absolute sense as $6 per square foot or as 250 percent higher than expectations, the tenant is in a very different financial position than anticipated. How can the next lease be at the same net rate?

Many national tenants demand lease provisions that cap annual increases in real estate tax charges as protection against these increases, turning a triple-net lease into a quasi-gross lease, at least for taxes. Common in retail properties and found in flex space or office buildings as well, this practice puts a dent into the owner’s return. As in many other states, Minnesota assessors try to equalize assessments, so a few high-priced sales may trigger increased assessments for neighboring buildings. If an assessor is trying to avoid being accused of “chasing sales,” then one or two sales in a market area can lift all assessments. Comparable properties may see an increase in taxes with no changes to their own net rents or occupancy. Such increases can be a burden if the assessor has done a poor job of equalizing.

One of the biggest surprises for new buyers can occur when trying to renew leases. Many landlords discover that higher assessments lead to lower net rents or increased vacancy numbers that are far different from the assumptions made at the time of purchase. Relatively few buyers project double-digit tax increases, so tax hikes approaching 30 percent can inflict a troublesome dampening effect on net rents and occupancy.

Even tax increases limited to 10 percent annually for two or three years will exceed the 3 percent increases that a typical buyer builds into a discounted cash flow analysis when evaluating a purchase. That unexpected cost can decrease cash flow in future years to the point that the purchase price appears too optimistic. When this increase in taxes is combined with lower net rents as tenants fight to keep occupancy costs under control, the entire analysis at the time of sale becomes a meaningless historical curiosity.

Clearly, potential buyers must perform due diligence on assessor practices when a contemplated sale price is significantly higher than current assessments, or risk nasty surprises in the next few years.

 

jgendler

John Gendler is a partner in the Minneapolis law firm of Smith, Gendler, Shiell, Sheff, Ford & Maher, P.A., the Minnesota 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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Sep
25

How Eden Prairie Mall Challenged the Minnesota Tax Court

"It is now clear that the Minnesota Tax Court doesn't need to merely pick one of the taxable property values presented at trial and can find a taxable value outside the range of values introduced at trial..."

By John Gendler, Esq., as published by NREIonline, September 2011

In several cases over the past few years, the Minnesota Tax Court has found a taxable property value higher than the amounts presented in witness testimony from either side of a tax argument.

Because the Tax Court has the power to increase values as well as decrease them, this trend has raised concerns when considering whether a case should be taken to trial. However, a Minnesota Supreme Court opinion issued this year suggests that the Tax Court's decisions in the future are more likely to reflect facts presented in testimony.

Legal showdown

The pivotal decision stems from Eden Prairie Mall, LLC vs. County of Hennepin in which the Minnesota Supreme Court rejected the Tax Court's value increase for a recently renovated mall from $90 million to id="mce_marker"22 million.

The Supreme Court has said the Minnesota Tax Court cannot simply copy a county attorney's memorandum — including arithmetic mistakes — when deciding to find a value for a property that is higher than that testified to by either appraiser.

Both the taxpayer and government presented appraisals prepared by independent appraisers who had earned the MAI designation from the Appraisal Institute. (The professional accreditation refers to "Member, Appraisal Institute.")

The diverse appraisal testimony included value opinions for Jan. 2, 2005, and for Jan. 2, 2006, as a separate value must be found for each year in Minnesota.

The taxpayer's appraiser relied exclusively on an income approach, citing the lack of comparable sales, and testified to a value of $68.75 million in 2005 and a value of $60.55 million in 2006.

The original assessments being appealed put the mall's market value at $90 million in 2005, increasing to id="mce_marker"00 million in 2006. The government's appraiser gave most weight to the income approach, testifying to a value of id="mce_marker"10 million in 2005 and id="mce_marker"15 million in 2006. Neither appraiser prepared a discounted cash flow analysis.

The judge based her decision on a direct-capitalization income approach, finding that the government's cost and sales approaches were not meaningful given the recent major renovation of the mall. The Tax Court found the value of the mall to be id="mce_marker"22.9 million the first year and a slightly lower id="mce_marker"20.1 million for the later assessment.

In the decision, the Tax Court adopted an argument made by the government's attorney, which resulted in the indicated value being higher than that found by the government's appraiser. Like the government's attorney, the court stated that the government's appraiser had made a mistake in his calculations.

JGendler_eden_chart

Independent judgment

The Supreme Court said that the Tax Court did have the authority to make a value determination that is higher or lower than the testimony of the experts because the judges bring their "own expertise and judgment in valuation matters."

The Supreme Court noted, however, that "market value determinations involve the exercise of complex and sophisticated judgments of market conditions, anticipated future income, and investor expectations ...." In other words, the Tax Court can set taxable values based on its own analysis supported by the factual record. But did that analysis occur?

The Supreme Court pointed out that the Tax Court rejected both appraisers' opinions of market value and adopted, verbatim, a calculation presented by the government's attorney in a post-trial brief, "including several arithmetic errors."

The Supreme Court said "adopting verbatim the recalculated assumptions and nearly verbatim the value determinations ... presented in a post-trial brief raises doubts over whether the Tax Court exercised its own skill and independent judgment."

Although the Supreme Court affirmed other portions of the case, including the increase in value of a separate anchor store, this part of the case was returned to the Tax Court for additional explanation, including its use of income higher than that used by either appraiser.

Furthermore, the Supreme Court explicitly stated the Tax Court could reopen the record and admit additional evidence. It is not clear whether the Tax Court must admit additional evidence, but presumably the taxpayer will seek to do so when the Tax Court reconsiders its decision. At this writing, the Tax Court has not issued a new decision.

It is now clear that the Minnesota Tax Court doesn't need to merely pick one of the taxable property values presented at trial and can find a taxable value outside the range of values introduced at trial.

Importantly, however, it is also clear that the Minnesota Supreme Court will scrutinize those findings, demanding that the Tax Court explain in detail why it is rejecting the testimony and substituting its own opinions and data.

This precedent-setting case could encourage the Tax Court to stay within the range of testimony from the various appraisers, absent a compelling explanation for doing otherwise.

jgendler

John Gendler is a partner in the Minneapolis law firm of Smith, Gendler, Shiell, Sheff, Ford & Maher, P.A., the Minnesota 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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