The seniors housing sector can't seem to catch a break. Owners grappling with staffing shortages and other operational hardships lingering from the pandemic are facing new challenges related to debt and spiraling costs. High interest rates and loan maturations loom over the industry, with $19 billion in loans coming due within the next 24 months, according to Cushman & Wakefield's "H1 2024 Market Trends and Investor Survey" on senior living and care.

Factors driving high costs include wage pressures, inflation and — incredibly — rising property taxes. Despite operational challenges and declining occupancy at many facilities during the COVID-19 pandemic, property tax relief for seniors housing was mixed. Many assessors resisted downward adjustments to taxable values, maintaining that recovery was around the corner. Now, seniors housing operators face property tax assessments that equal or exceed pre-pandemic levels.

As in the hospitality sector, most seniors housing owners understand that their operating properties include more value components than real property alone. In evaluating whether a tax assessment is reasonable and fair, however, owners need to realize that how an assessor addresses their real estate, personal property and intangible assets can drastically affect property tax liability.

Intangibles have value

The Appraisal Institute's "The Appraisal of Senior Housing, Nursing Home, and Hospital Properties" states that the valuation of a going concern in the sector includes real property, tangible personal property and intangible personal property. Real property or real estate equates to fee-simple, leased-fee or leasehold interests; tangible personal property is furniture, fixtures and equipment.

Intangible personal property can include assembled workforces, licenses, certifications, accreditations, approvals such as certificates of need, employment contracts, medical records, goodwill and management.

The Appraisal Institute's text also cites a requirement from the Uniform Standards of Professional Appraisal Practice in stipulating that the market value of real estate must be identified and valued separately, apart from the tangible and intangible personal property. Adopted by Congress in 1989, the Uniform Standards serve as ethical and performance standards for appraisal professionals in the United States.

Assessors and real estate appraisers are familiar with the process of separating real property and tangible personal property for purposes of valuation. Valuing intangible personal property, however, is often less clear.

Top-down vs. ground-up valuation

Appraisers often back into an intangible personal property value by first developing a going-concern value and then subtracting values for real property and tangible personal property. In practice, the whole does not always equal the sum of the parts.

Appraisers frequently opt for this "top-down" approach, so described because the appraiser develops a value opinion for the total going concern and then works "from the top down," assigning values to the various components based on market statistics or other data.

By contrast, some appraisers take a "ground-up" approach by valuing all the components independently and then adding those amounts to value the going concern. If done properly, both methods should yield similar value indications for each component.

For especially difficult property tax cases, taxpayers may find it worthwhile to have two appraisers perform independent appraisals using each method and then present both conclusions to the trier of fact.

Either method can help to demonstrate the considerable investment value imbued in many elements of intangible personal property. The assembled workforce may have taken several months to adequately staff and train, for example, while acquiring and maintaining licenses requires investments of time, capital and effort to overcome regulatory and adherence challenges. The loss of licenses or a portion of the workforce at a seniors housing facility can impair its operation and send effects rippling throughout the business, reaching beyond intangible personal property.

Business appraisers, who are accustomed to valuing intangible assets as part of mergers, acquisitions and similar activities, can provide clarity for taxpayers building a case for a tax assessment reduction on their seniors housing property. A business appraiser can be invaluable in these circumstances, allowing for a ground-up approach to valuing the elements of the intangible personal property and even working alongside real estate appraisers to come up with a clearer picture of the going concern.

Accounting counts

Most seniors housing operators fastidiously follow Generally Accepted Accounting Principles (GAAP) and strive to maintain compliance with accounting rules from the Internal Revenue Service (IRS) and Securities and Exchange Commission (SEC). These taxpayers would be wise to include a fourth consideration for their accounting team, which is to understand how their state and local governments define taxable real estate.

Tax definitions may vary slightly from one jurisdiction to another. Thus, it is possible to have one allocation for IRS, SEC or GAAP guidelines while having a different allocation for property tax purposes that corresponds to tax practices in the area. This type of nuance is one of the reasons seniors housing owners or operators can improve their odds of success in a property tax dispute by working with an adviser who understands both local case law and the area assessor's approach to valuing components of seniors housing properties.

In several states and municipalities across the country, assessors will simply increase a property's assessment to the purchase price entered in county records. This can lead to sticker shock when an operator receives their first tax bill after an acquisition.

By working with tax professionals and valuation experts during the due diligence and acquisition process, and by documenting the consideration paid for each component of an acquired asset's value, operators can limit upside exposure for future increases in property taxes and retain the necessary documentation to support these allocations.

As rising interest rates and other challenges worry commercial property owners with loans nearing maturity, a running theme in the real estate industry is to "survive until '25." For hotel owners, however, the year-to-year struggle to stay afloat has been ongoing.

Hoteliers that survived the industry's downturn from the COVID-19 pandemic may have thought their troubles were ending, only to be slammed with record-setting inflation and skyrocketing interest rates. During the pandemic and the uncertainty it unleashed on hospitality operations, many jurisdictions across the country provided hotel owners with some form of property tax relief. For example, one jurisdiction removed all improvement value from hotel assessments and only applied land value in determining property tax liability.

Relief measures are winding down, however. Many jurisdictions have begun to value hotel properties as they did prior to COVID, claiming that the hospitality industry has rebounded.

While in many instances, industry statistics such as occupancy and revenue per available room or RevPar show some markets recovering, it is important to know that each hotel property is unique. That's why it is critical for property owners to review individual property tax assessments annually and determine whether the asset may be a good candidate for a reduction.

Competing approaches

Many jurisdictions have recognized that hospitality properties are operating businesses, with real estate serving as only one component of the overall valuation. Property owners typically must prove the proper allocation of that real estate component when challenging their tax assessments.

Over the last two decades, appraisers, tax assessors and property owners have employed two competing methodologies to allocate value to the real estate component of hotel properties in calculating taxable value. Those are the Rushmore Method and the Business Enterprise Value Method.

Taxing jurisdictions often value hospitality properties using the Rushmore Method, which removes management and franchise fees from the income stream as part of an income-based assessment. Proponents of this method argue that removing management and franchise fees offsets the business value, and that all remaining income should be applied to the real estate value.

By contrast, the Business Enterprise Value Method applies a more in-depth analysis to identify income streams attributable to each component of a hotel's going-concern value. The appraiser or assessor can then capitalize the remaining income stream, which is attributable to the real estate alone, to determine taxable property value.

A hotel owner should be sure to differentiate and clearly communicate the business' various income streams on a profit-and-loss statement. This will ensure that their property tax counsel and appraiser adequately understand and allocate income to appropriate components of the business.

While these methodologies may seem foreign to some hotel owners or taxing jurisdictions, they are familiar to business valuation professionals. These experts apply similar methods to valuing business components during mergers or the outright acquisition of a business.

In a conventional, income-based real estate valuation, an appraiser applies a market capitalization rate to a property's income stream to determine value. In the valuation of a business, experts can develop an appropriate capitalization rate for components of the business' income by taking the weighted average cost of capital, less an appropriate long-term growth rate, such as an inflation forecast. A similar approach can derive a going-concern or valuation of non-realty components from individual income streams within a larger hotel operation.

On top of analyzing the income streams for a hospitality property, it is important for the taxpayer's appraiser to analyze property improvement plan requirements. Hotel owners report anecdotally that as the effects of COVID have waned, hotel brands have grown stricter in enforcing post-COVID property improvement plan requirements.

Taxing jurisdictions often review building permits pulled during these renovation periods to gauge improvements made to the property. This often translates into higher property tax assessments. Depending on a jurisdiction's laws, however, these improvement plans carried out for brand compliance do not necessarily increase real estate value.

Business Enterprise Value advances

Rushmore was taxing authorities' go-to method for valuing hospitality properties for a long time because of it simplistic and straightforward nature. Over the past decade, however, significant legal decisions have found the Business Enterprise Value Method preferable over the Rushmore Method.

The first major decision in this area was SHC Half Moon Bay LLC vs. County of San Mateo. In this 2014 California case, the court found that the county's real property valuation methodology failed to properly exclude business values for the hotel's workforce, the hotel's leasehold interest in the employee parking lot, and the hotel's agreement with a golf course operator.

The second major decision occurred in 2020 in Florida. In Singh vs. Walt Disney Parks and Resorts U.S. Inc., the court found that in using the Rushmore Method, the county's appraiser failed to remove all intangible business value from the real property assessment.

Although taxpayers have notched key victories in employing the Business Enterprise Value Method to allocate value to the real estate component of hotels, there are still jurisdictions that steadfastly apply the Rushmore Method to hotel property tax assessments.

Hospitality owners seeking to improve their odds of success in a property tax dispute should consider working with tax counsel that intimately knows both the case law in their jurisdiction and the differences between competing valuation methodologies. This knowledge is critical to communicating strong arguments to tax tribunals and assessors.

The often-overlooked band-of-investment argument helps taxpayers demand maximum capitalization rates to combat inflated property tax assessments.

When commercial property owners review assessments of their properties' taxable value for fairness, they typically look to the markets for context. This year, however, superficial market observations do little to clarify questions about property valuation. At the risk of understating the obvious, 2023 has been a confusing time in commercial real estate.

Most investors, brokers, appraisers, and even tax courts seem to agree that the office sector is under severe strain and unlikely to recover soon, even if they debate the extent or duration of damage to the property type. With other sectors, however, the wide range of perspectives today can be confusing and even contradictory.

Mainstream news reports of strong occupancy and tenant demand for retail space only tell part of the story. Many retail property owners continue to struggle with historically high tenant improvement costs and contend with tenants seeking concessions far more frequently than they did before the pandemic.

The multifamily and industrial sectors have remained robust relative to other property types, but inflationary construction costs and borrowing costs driven up by interest rate hikes have thinned margins and clouded projections in many deals.

Against that backdrop, economic forecasts garner a mixed reception. Predictions of an impending recession have felt like sage prophecy, foolish overreaction, or an echo chamber of crying wolf, depending on one's perspective or position in the markets.

Ideal time to review assessments

Clearly, the economics of operating investment properties are far less predictable than they were five years ago. Even within stronger property types, performance and pricing have become more volatile.

That kind of uncertainty means increased risk, which any appraiser will tell you should indicate elevated capitalization rates. Combine that risk with climbing interest rates, and the negative impact on overall commercial property value is undeniable. That makes this an ideal time to review property tax exposure and to contest assessors' overstated valuations.

Data trackers and analysts estimate that value losses among commercial property types range from 30 percent to more than 50 percent. Retail and office properties have suffered the greatest declines from their original appraised values, at 57 percent and 48.7 percent, respectively, according to CRED iQa commercial real estate analytics and valuation platform. In a study of $10 billion in assets across property types, CRED iQ noted an average 41.2 percent valuation decline from original appraised values.

And what's more, KC Conway, the principal of The Original Red Shoe Economist and 2018-2023 chief economist for the CCIM Institute, predicts "lots more (commercial real estate) value loss and bank failures to come."

A residential example helps to put these losses into context. The average 30-year fixed residential mortgage interest rate for the week ending Dec. 30, 2021, was 3.11 percent, compared to 6.42 percent for the week ending Dec. 29, 2022, according to Freddie Mac's Primary Mortgage Market Survey. At 3.11 percent, a homebuyer purchasing a $200,000 house with 20 percent down would have had a monthly mortgage payment of $684.

One year later, a homebuyer putting 20 percent down and using a mortgage with 6.42 percent interest would have to purchase a home for $109,138 to achieve the same monthly payment of $684. This is a roughly 45 percent decrease in purchasing power over the span of one year.

The same principle applies to commercial real estate, where climbing interest rates and a related spike in capitalization rates have rapidly hammered down property values.

Cap rate consequences

It is important for taxpayers to understand that assessors often draw the capitalization rates used in property valuation from cap rate surveys, which may not indicate true cap rates because surveys are backward-looking. And cap rates have risen quickly along with buyers targeted internal rate of return (IRR).

With an increase in interest rates, a potential deal that may have met a target IRR in early 2022 would no longer meet that same threshold at the end of 2022. Correspondingly, the buyer looking at a deal in early 2022 vs. the end of 2022 would likely have to lower their purchase price to meet their target IRR. Assuming net operating income remains constant, the cap rate for the deal in late 2022 would be higher than the cap rate reported for the early 2022 deal. This is a chief reason why cap rates tend to follow interest rates.

Taxpayers may be able to achieve a reduced assessment by arguing for a higher capitalization rate that more accurately reflects a buyer's expected rate of return. To support the highest possible cap rate, taxpayers should take a hard look at the mortgage-equity method, often called the "band-of-investment" technique.

Based on the premise that most real estate buyers use a combination of debt and equity, the mortgage-equity method calculates the weighted average of the borrower's cap rate and the lender's cap rate. Equity cap rates tend to be higher than those on debt, and with lenders offering lower loan-to-value mortgages, equity caps play a greater proportional role in today's acquisition pricing.

Until recently, the method had become disfavored by some tax courts and county boards of equalization. Common criticisms are that the methodology is too susceptible to manipulation, or that the equity component is too subjective and/or too difficult to support. Arguably, many critics just don't understand it. But in the current climate, the band-of-investment is increasingly accepted and perhaps more relevant than ever.

Band-of-investment strategies

Taxpayers can use the methodology in a few ways. For properties purchased or refinanced recently but before the Fed's interest rate hikes really accelerated, taxpayers may argue for straightforward adjustments to recent appraisals to reflect market changes. More complex situations may require a specialist's appraisal to support the value change.

Importantly, even properties which have maintained strong performance are subject to value loss from market changes, which may justify making the additional effort to prepare a mortgage-equity argument.

Before attempting such strategies, taxpayers should evaluate the jurisdictional laws and definitions that control property taxes, including the effective date of the challenged assessment. With 2024 looming and bringing with it a new lien date for measuring assessments in many jurisdictions, now is an ideal time to review portfolios for excessive property tax assessments.