"A sale involving a first-generation lease is more a financing operation than a transaction in real estate. In the past, many single-tenant real estate users — often retailers not wanting to tie up capital — financed their real estate through sale-leaseback transactions where they recouped the capital costs by inflating both rent and the corresponding sale price."

By Kieran Jennings, Esq., as published by National Real Estate Investor, Summer Special Edition, July 2007

In a build-to-suit transaction, the value of the property to the user who had it built is greater than the value that property holds for the next user.

For instance, a store built as a McDonald's would not have the same value to a Taco Bell. Although both users are fast-food chains, the layout, design and exterior appearance all work to identify, market or assist the first occupant's business.

The decrease in value from the original user to the subsequent user represents built-in obsolescence. Failure to recognize this obsolescence often subjects first generation owners to excessive property tax assessments.

A triple-net-lease property that was a build-to-suit may be sold to a new owner, even if the original user remains the tenant. In this case, the sale price reflects the value of the tenant's lease. The assets involved in the purchase include both the lease and the real estate.

Because the revenue created by the lease primarily drives the price of the deal, an assessment based on sale price can result in an illegal assessment when it is based on the value of the property to the user.

Fighting back

The first step in reducing improper taxes requires that owners prove to the assessor or the courts that the rent and/or sale represent value to the user, not the market value of the property. The next task is to prove actual market value for the real estate.

A sale involving a first-generation lease is more a financing operation than a transaction in real estate. In the past, many single-tenant real estate users — often retailers not wanting to tie up capital — financed their real estate through sale-leaseback transactions where they recouped the capital costs by inflating both rent and the corresponding sale price. This practice is still prevalent today. The user currently has a relationship with a local developer who will acquire the site and build the property on behalf of the user to suit the user's needs. As with a sale-leaseback transaction, the user will enter into a long-term lease based on the costs of building the property to meet the user's specific needs.

The developer then either retains the property or sells it with the lease in place. Thus, the tenant has outsourced to the developer the financing, site selection, construction and other exterior and interior finishes. The third-party purchaser sees the transaction as essentially buying a bond secured by real estate.

Until the first-generation user vacates the property and the real estate is exposed to the open market, the real estate value has not been tested. Furthermore, because the lease drives the sales price of a net-lease property, only a second generation lease reveals true market value and produces a correct assessment.

Case study makes the point

Data from a recent drug store case illustrates the difference in first- and second generation leases for comparable properties built as national retail drug stores. The average drop of $19 per sq. ft. in rent from the first-generation user to the second generation illustrates the difference between value in use and market value.

The difference is due to obsolescence, a fact first-generation tenants must demonstrate to assessors. Data like that shown in the accompanying chart prove the existence and value of the obsolescence.

Not only are the rents affected by the first-generation tenant, the capitalization rate is significantly lower than market rates. The net-lease market into which these properties are sold is among the most active and developed in the real estate market, allowing for substantial liquidity, efficient pricing, and tax deferral through 1031 exchanges.

As a result, the capitalization rates have been reduced to exceedingly narrow margins. Therefore, cap rates derived from sales of first-generation property should not be used in determining assessments.

Proving market value

Assessment laws generally provide that property must be valued using market terms and conditions. Therefore, market rents, those paid by tenants in comparable properties, not contract rents, those paid by the net-lease tenant, determine the income attributable to the real estate.

The difference between market rents and contract rents demonstrate the amount of the obsolescence. Furthermore, the differences in sales prices of property from first-generation users to the next generation can also be used to prove obsolescence.

The road to a fair and honest assessment is not easy, but as illustrated in the accompanying chart, the difference between use value and market value can be substantial.

J. Kieran Jennings, partner at Siegel Siegel Johnson & Jennings, a law firm with offices in Cleveland and Pittsburgh. The firm is the Ohio and Western Pennsylvania member of the American Property Tax Counsel, the national affiliation of property tax attorneys. He can be reached at kjennings@siegeltax.com.

"The first thing any taxpayer needs to know to determine if they want to appeal their taxes is whether a reduction in assessed value yields tax savings. In states that place no limits on the amount of tax increase possible, owners can be certain that reduction in assessed value will generate a tax savings. However, several states' laws require the taxes rise by only a limited percentage in a given year."

By J. Kieran Jennings, Esq., as published by Affordable Housing Finance, Summer Special Edition 2007

Affordable housing owners looking for ways to save money and eliminate non-productive overhead should start by examining their property taxes. That doesn't require taxpayers to become experts in real estate tax law; they need only a working knowledge of the issues to identify when or if should hire an expert .

The basic issues

The first step in this process is to learn how assessors determine property taxes. One of the main indicators of fair market value that assessors use is the income that could be produced from the property using current rents, vacancies, and market expenses. In most states, real estate assessments are based on some percentage of a property's fair market value. Most often, the actual taxes are calculated using a millage rate (for example, $.001) multiplied by the assessment.

Right now owners of affordable housing face unprecedented increases in fuel and utility costs. And, because net income is a key indicator of market value, an increase in operating expenses likely causes a decrease in value. That means an owner's property might not be worth what the taxman says it is, and an appeal may be necessary.

Where does the taxpayer begin?

The first thing any taxpayer needs to know to determine if they want to appeal their taxes is whether a reduction in assessed value yields tax savings. In states that place no limits on the amount of tax increase possible, owners can be certain that reduction in assessed value will generate a tax savings. However, several states' laws require the taxes rise by only a limited percentage in a given year. In such states, a complex analysis is required to determine whether a reduction in assessed value actually results in a tax savings. This type of analysis calls for the skills of a property tax professional.

Some states' assessments may be based on ratios sometimes known as sale ratios or common-level ratios. In states such as New Jersey and Pennsylvania, an assessment may have originally been based on 100 percent of the appraised market value of the property, but over time that 100 percent assessment no longer reflects market value. So, at regular intervals, each county in these states conducts a study comparing the sale prices of all properties sold in a given period with the last assessed value of these same properties. For example, if the assessed values of properties sold for an average of 50 percent of the sales prices of those same properties, then the sales ratio for that period of time will be 50 percent for all properties in the municipality. This ratio then is used to convert the assessed value back to market value. Owners will want to track down the current-year ratio percentage and then review their assessment to ensure that the correct ratio has been applied in developing their assessment.

Finally, many states establish predetermined ratios. Ohio, for instance, places its predetermined ratio of assessment at 35 percent of the appraised market value every year in all counties. Assessed market value is determined by dividing the assessed value by the ratio percentage. As an example, a $35,000 assessment divided by 35 percent yields an assessed market value of $ 100,000, which then can be compared to the actual fair market value of the property. If the assessed market value appears to be higher then the actual fair market value (what a willing buyer would pay a willing seller in an arm's length transaction), then the taxpayer should consider contesting the assessment.

What can taxpayers do when over-assessed?

If you determine that your property has been over—assessed, file an appeal to reduce your real estate taxes. In some states, that will mean filing a formal complaint by a particular date. In other jurisdictions, the filing deadline depends on the mailing date of the assessment notices. Some jurisdictions mandate that parties must appeal their assessment within 15 days of receiving notice. If the deadline passes, in most jurisdictions, the taxpayer is prohibited from contesting their taxes until the following year. It is, therefore, imperative to know the local rules.

How does the taxpayer prove the case in an appeal?

As with every aspect of assessment law, proving the case varies from jurisdiction to jurisdiction. Most typically, an appeal that has merit can be proven with a qualified appraisal. However, the rules regarding how that appraisal is prepared can vary from state to state. For instance, some states mandate that actual income and expenses be used to determine the market value of the property. In other states, an appraiser or property owner must prove the value based on unencumbered market conditions. An unencumbered market condition exists when a property built under Sec. 42, with a majority of its rents restricted, is appraised as if the property were conventional apartment. However, a property that enjoyed greater occupancy or rents because of Sec. 8 rent subsidy may be able to use a lower income figure based on prevailing market conditions. The income approach to value represents the common thread across exists the country for establishing market value.

Must an attorney file a property tax appeal?

Rules governing appeals vary greatly from state to state. In most states, an attorney is not required to file an appeal at the local level, but an appeal in court almost always requires an attorney. However, in a number of states, the courts have determined that the filing of property tax appeal is the practice of law, requiring an attorney

What risks and benefits come with contesting taxes?

Risks come into play when the appeals process is poorly handled, as that can impair a taxpayer's ability to reduce a property's value to its proper level in the future. Evidence poorly presented often remains in the record and is not retractable. Furthermore, in several states and with increasing frequency, school districts participate in the appeals process. In those states, the hearings may put the taxpayer at risk for an increase in assessment, if such is warranted.

The benefits of controlling real estate taxes far outweigh any risks involved, and by spending a little time learning the process, taxpayers can all but eliminate those risks. A newly established assessment often forms the basis for future assessment. Thus, a reduced tax this year positions an owner for future years because tax increases compound over the years. Even if assessments steadily climb in future years, having started at lower base can save money indefinitely.

Keeping real estate taxes and all non-productive expenses down becomes crucial to the economic health of an affordable housing property.

J. Kieran Jennings, partner at Siegel Siegel Johnson & Jennings Co., LPA, with offices in Cleveland and Pittsburgh. The firm is the Ohio and Western Pennsylvania member of the American property Tax Counsel, the national affiliation of property tax attorneys. He can be reached at kjennings@siegeltax.com.