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

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

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

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

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

Dire developments

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

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

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

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

Office-specific issues

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

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

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

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

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

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

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

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

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

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

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

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

The wrong method could leave owners with bigger bills than they should have.

Because industrial properties vary in design and function, not all valuation methods approaches apply to every property. When assessors choose an unsuitable method that inflates taxable value, the taxpayer's best appeal strategy may be to show flaws in the appraiser's approach by explaining the appropriate appraisal methodology.

Industrial properties are typically designed for a specific owner's use in manufacturing, distribution, research and development, or heavy industrial activities. These include standalone flex buildings, multiuse industrial complexes, high-tech facilities, steel mills, timber mills and other subtypes.

The basic valuation premise for property taxation is to determine what the property would sell for in an open-market transaction between a willing seller and willing buyer. Most buyers and sellers in the industrial market would have a thorough understanding of a property's best use before transacting a sale, but an assessor with a limited perspective may treat all industrial real estate as having uniform valuation characteristics.

Taxing authorities often overlook appraisal principles, that if properly applied would reduce the market value of industrial properties. Taxpayers should review their assessments to determine the assessor's valuation approach and evaluate if the appropriate input data was used and the calculations reflect the appropriate adjustments to value.

The appraiser must consider the highest and best use of the property when selecting the appropriate valuation method, considering what is legally and physically permissible and financially feasible for the property as of the valuation date. They will use one of three primary appraisal methods, which are the cost approach, sales-comparison approach, and income-capitalization approach.

Cost Approach

The cost approach is based on theory of substitution, would a prospective purchaser buy this property at a depreciated value or simply build a new facility? Using this approach, an appraiser determines the cost to build a new facility less all forms of depreciation.

A willing buyer would consider not only physical depreciation, but the property's functional operation and any external forces limiting its use. External or economic obsolescence are forces outside the property owner's control, such as government restrictions, consumer demand, or the availability of a raw product or steady labor force.

Functional obsolescence is value loss due to physical or functional deficiencies, such as an outdated building design, inefficient production layout, inadequate infrastructure or outdated equipment.

Most assessor cost models stop at physical depreciation and ignore external and functional obsolescence. They simply add up the component costs of the building, land, and equipment.

This typical cost model fails the "willing seller and willing buyer" test because a potential buyer is not going to evaluate a manufacturing facility by tallying the value of the property's components. A buyer will focus on output capacity, available raw product, available labor, and the market for the product. How many widgets can the facility produce as of the assessment date, and at what cost?

Thus, the often-missed analysis in the cost approach is to really look at theory of substitution. Would a new facility with new equipment and a better layout have higher production capacity? An appraiser should not simply reproduce the same equipment for the cost model if modern equipment offers benefits such as reduced labor, higher speed, or increased output. The appraiser must know the industry and the equipment capabilities of both the older, existing equipment and the new, technically advanced equipment.

Comparing apples to apples in the cost model seldom provides a reliable value. An example would be a plywood and veneer mill built in the 1960s that an assessor values by counting costs invested in the various add-ons and rebuilding of equipment. Simply trending the values would not capture rebuilt equipment or used-equipment purchases, overvaluing the equipment.

The appraiser should determine the cost for the widget capacity of the present facility as of the date of value and compare that to how many widgets a new facility could produce and at what cost. Next, the appraiser should consider all three forms of depreciation to arrive at the proper taxable valuation. Omitting these steps in the cost approach will overvalue the property and overtax the owner.

Sales-Comparison Approach

The sales-comparison approach compares the subject property with property that is similar to the subject. Appraisers often use this approach for single-use real estate with a high degree of market transferability such as warehouses and distribution centers. The appraiser must consider not just the comparable property's floor plate, type of construction and square footage, but also its location, market access and number of loading docks.

The sales comparison model is difficult to use for properties that lack a ready market or that suffer from external or functional obsolescence. Consider the research and development campuses built in the 1980s to house all a company's processes, from research to manufacturing and distribution. Most manufacturing and distribution moved overseas in the 2000s, leaving these campuses half empty.

Adapting these buildings for reuse depends on land-use restrictions, the market for alternative uses, available labor, and the functionality and cost feasibility of conversion. When searching for comparable sales, the appraiser should evaluate what is legally permissible and financially feasible and weigh external forces that impact demand and functional use. After selecting like-kind properties, the appraiser must adjust the sales to reflect the reality of the subject property, or it will be over-valued.

Income- Capitalization Approach

The income-capitalization approach estimates a property's value based on the income it generates, using a capitalization rate from comparable sales or market data. This approach is used for properties with long-term tenants or stable cash flows. The appraiser is to look not at what the value is to the owner, but at what a willing buyer would pay for the property. This requires carefully selected market data and proper adjustment to reflect market value.

Clearly, appraising industrial properties requires a thorough understanding of their unique characteristics and uses, as well as an awareness of economic and functional obsolescence. A knowledgeable appraiser can help the taxpayer ensure their property assessment is consistent with the marketplace to avoid overpaying property taxes. 

Cynthia Fraser is Co-Chair of Foster Garvey's Litigation Practice and the Oregon Representative of American Property Tax Counsel (APTC). The firm is the Oregon member of APTC, the national affiliation of property tax attorneys. Lisa Laubacher is a CMI and Director at Popp Hutcheson PLLC, the Texas member of APTC.