Get Real About Tax Assessments

"A property's chain affiliation may affect its assessed value for property-tax purposes..."

By Stephen H. Paul, Esq., as published by Scotsman Guide, June 2010

Imagine this scenario: Two hotels in the same city are of similar age, size and construction quality. Both are located in popular areas with convenient access to sites attractive to overnight travelers. They're nearly indistinguishable — hotel guests would enjoy comparably satisfying overnight stays. But one hotel's assessed value for property-tax purposes is materially greater than the other. Why the difference?

There is a good chance that the hotel with the higher assessment operates under the flag of a recognized hotel chain and the other does not.

Should the flagged property's owner face the penalty of a higher tax bill because of the flag? Uniform appraisal standards and various state-tax authorities say that it should not. After all, tangible real property is assessed, not intangible personal property.

Moreover, in the past 10 to 12 years, several courts have handed down opinions that intangible value, such as that springing from a flagged hotel's identity, must be excluded from the real property's value. But including intangible value in the real-property assessment of properties such as flagged hotels remains an important and ongoing local property-tax issue across the country.

Other property types — such as restaurants, shopping malls, theaters, racetracks and casinos — also are affected by this issue. Property-owners and others concerned about their taxable values — e.g., potential buyers, their mortgage brokers, real estate agents and lenders — must be aware of this. Owners and buyers should be prepared to challenge assessments, and brokers should understand how to assure that these properties' tax valuations are performed correctly.

Property assessors and appraisers refer to the intangible value in varying fashions. They may talk about "business enterprise value," "going concern value" or "capitalized economic profit." But the basic concept is the same: It refers to including the intangible assets and rights that make the taxable property usable in the value. It is the value associated with the business operation, rather than the property itself.

There are three generally accepted approaches to valuing real property: the cost approach, the sales-comparison approach and the income-capitalization approach.

Regardless of the method used, assessors should be identifying and excluding all value outside of the real estate itself from the real property's value. How an assessment limits the property's valuation to the real estate's taxable value varies by approach.

The cost approach

Because this approach focuses on costs of land and improvements, it might appear unlikely that added value associated with the property's economic activity could embellish the assessment. Assessors must pay close attention to functional and economic obsolescence that may reduce the property's cost value, however. Functional obsolescence is the loss in a property's utility resulting from distinctive floor plans, site designs, or difficulty of upgrading or modifying property for a particular use, among other things.

Flagged or chain properties often are constructed according to designs specific to the chain. They also often have logos and other items that can hurt the real property's value because of the costs of modifying the property for other uses.

Economic obsolescence occurs because of external factors. For chain hotels, restaurants and other businesses, property-value reductions often come from market-demand changes because of a recession, changes in the public's tastes and market saturation with similar chain businesses.

Owners of chain-business properties more frequently cannot sell or lease property for as much as the tax-assessed value based on cost. Functional and economic obsolescence can factor into this.

An appraiser should identify and quantify the obsolescence and exclude it from the property's value. Failing to reduce the assessment for obsolescence may result in assessing the property too high because of characteristics attributable to the chain venture.

Sales-comparison approach

With this approach, appraisers analyze recent sales of comparable properties to determine the subject property's value. They adjust the comparable sales to quantify differences between the sold properties and the subject property. An appraisal used for real estate tax purposes should identify the intangible values reflected in the comparable properties' sales prices and eliminate them from the sales.

If sales of vacant properties, properties of non-chain-business enterprises, or sales of chain or flagged properties to non-chain operators who drop the chain affiliation are available, the sales approach should be used to avoid overstatement of value that otherwise might result.

Essentially, appraisers should use sales of comparable properties, sans the flagged or chain business, to arrive at a value.

The income approach

This approach aims to determine the property value by capitalizing the annual net operating income. For real estate assessment purposes, the income considered must come from the real estate only and not from the business interest occupying the property.

Thus, the income attributable to the property's intangible component — as well as to the tangible personal property — must be identified and extracted to arrive at a value. This can be difficult, but it is necessary if an appraisal relies on the income approach.

An appraiser might identify and analyze the comparable properties' incomes to develop a market value. As with the sales approach, in developing a model to determine market value based on income, the appraiser should select non-chain properties to avoid contaminating the data with associated intangible value and should reconcile income and expense items to account for property differences.

Regardless of the approach, a flagged property's value must be scrutinized to eliminate intangible value. The cost approach must account for functional and economic obsolescence. The sales approach must avoid inclusion of going-concern value in comparable sales. And the income approach should not entail simply a capitalization of the net operating income of the business occupying the property without isolating and eliminating business-enterprise value.

Owners of flagged or chain properties must be aware of how intangible value can disrupt property values and must be prepared to challenge assessments. Potential buyers should scrutinize appraisals for overvaluation arising out of the inclusion of intangible value. Brokers and lenders should approach appraisals with equal scrutiny in evaluating the security for mortgages. If intangible value is included in a flagged hotel's assessment and the hotel later loses its chain affiliation, the loan's security would be compromised. Lenders can mitigate this risk by being aware of the issue and assuring that any intangible value is identified and eliminated in the property's initial valuation.

Appraisers of flagged properties have the difficult task of identifying and quantifying intangible value attributable to a business enterprise and distinguishing it from the real property value. With diligent prodding from parties interested in the property's appraisal, an incorrectly large assessment is avoidable.

Stephen H. Paul is a partner in the Indianapolis law firm of Baker & Daniels LLP, the Indiana member of the American Property Tax Counsel. He can be reached at stephen.paul@bakerd.com.
Mr. Paul thanks his colleague Fenton D. Strickland for his contributions to this article.

"Companies out of compliance on tax abatement agreements can still make a compelling case for relief."

By Stephen Paul, Esq. & Fenton Strickland, Esq. - as published by National Real Estate Investor, January/February 2010

The race among states and cities to lure new companies and retain existing businesses has been furious, featuring aggressive offerings of significant tax allowances in exchange for promises of jobs and capital investment.

But taxpayers must be cautious. When the government lends a bigger hand that hand can claw back realized tax savings.

Deals involving property tax abatement usually include a promise by a business to invest certain sums of money in its properties and create and/or retain a certain number of jobs.

In return, the local taxing authority exempts all or a portion of the property taxes a business otherwise would have to pay on the new development over some specific period of time.

Governments often insist that abatement contracts permit them to recoup tax savings if a company falls short of its investment and/or hiring aims. Generally referred to as "clawbacks," these provisions in tax abatement agreements are becoming more commonplace and governments are keen on enforcing them.

Many current beneficiaries of tax abatements operate under agreements that originated prior to the recession that began in December 2007, when business expansion appeared more attainable.

However, new economic challenges have frustrated expansion objectives. And with governments mired in search of additional revenue, the potential for clawback appears greater.

Recognizing that clawback is a risk commensurate with the tax benefit, tax abatement recipients facing the prospect of clawback still have the possibility of avoiding the risk.

Escaping clawbacks

When a company enters into an abatement agreement with a municipality, it should be fully aware of the ramifications if the investment and/or hiring fall short of promised levels.

Agreements often allow taxing authorities to cancel abatements when companies fall out of compliance and may also require reimbursement of past tax savings in proportion to investment or employment shortfalls.

In other cases, noncompliance could mean recoupment by the tax collector of all tax abatement savings to date. Total recoupment of tax savings is illustrated in the chart above, where the recipient of a long-term abatement complied with job requirements for seven years but fell out of compliance in year eight, violating the abatement agreement.

When a clawback provision exists, the owner should examine the language to see if it applies to the circumstances of his property. Some clawback language might excuse shortcomings because of factors beyond the property owner's control.

This amorphous test often is tied to an unforeseeable reduction in demand for the company's product or services, or something similar. Because of the recent economic downturn, much litigation can be expected regarding these issues.

In some situations, a taxpayer should consider renegotiating the abatement agreement. A business can be in a surprisingly strong negotiating position, especially in instances where it can boast contributions to the local economy.

Confronted with the possibility of losing such a business to another municipality, local officials might be willing to work out a deal.

Where negotiation fails, a business can consider fighting the government's clawback.

Special attention should be paid to the applicable statutes. The local government's clawback effort might run afoul of statutory abatement cancellation and reimbursement schemes to such a degree that the provision should be nullified.

When a business has complied with abatement terms before the shortfall, a court might hesitate to award the government a windfall recoupment of all tax abatement savings.

Every case is unique, but the value of the abatement makes fighting the clawback worthwhile.

Stephen Paul is a partner in the Indianapolis law firm of Baker & Daniels, the Indiana member of American Property Tax Counsel. He can be reached at stephen.paul@bakerd.com.

Fenton Strickland can be reached at fenton.strickland@bakerd.com.

Stock price offers a reliable indicator for assessed value.

"Prediction of a property's ability to generate income is precisely what the income approach to value in property assessment attempts to accomplish."

By Stephen Paul, Esq., as published in National Real Estate Investor July/August 2009

Assessing the value of REIT assets for property tax purposes has historically been an ordeal for assessors, as well as for owners challenging their work. Published data indicates that property values have dropped over the past two years, but the lack of sales leaves relatively little to prove the declines.

Without an active market of REITs buying and selling property, the sales comparison approach to value loses its usefulness. Even if taxpayers and assessors agree that properties in most REIT sectors are best valued under the income approach, decisions about estimates of future income streams, capitalization rates, and other factors required under the income approach often breed intense discord.

These difficulties are amplified in today's market due to lower predictability of occupancies, lease terms, and percentage rents. Thus, REIT owners need new ways to substantiate for the tax authorities the decline in their property values.

Stock prices are telling

In many REIT sectors, declining stock values actually have the potential to provide suitable proof of decreasing property values. Since the trend in a REIT's stock price represents the market's prediction of the direction in which the capitalized funds from operations of the REIT likely will move, readily available stock market data could be used to show an assessor that assessed values should be reduced.

This methodology is particularly appropriate for REIT properties. The stock price for any ordinary non-REIT company, in effect, states how the market values the company's assets, but any indication of the value oPrediction of a property's ability to generate income is precisely what the income approach to value in property assessment attempts to accomplish.f the real property itself is unclear.

REITs are different. By definition, REIT assets comprise investments in real property. To qualify as a REIT, at least 75% of income must come from real estate sources, and at least 95% of income must be derived from interest, dividends, and the property itself. The trend in the value of a REIT stock thus reveals how the market values the income-producing capability of the REIT's real property.

Prediction of a property's ability to generate income is precisely what the income approach to value in property assessment attempts to accomplish. The income approach estimates future benefits from ownership of the property. But this estimate requires extensive market research to evaluate risk factors in order to accurately predict income streams and expenses.

Examples of these risk factors include whether tenants and locations are favorable, whether acquisitions were prudent, the likelihood that locations will go dark, and the extent to which rent collections might be in jeopardy. Evaluating such risks is problematic during a deep recession like that experienced currently.

In setting the stock price, however, the market already has evaluated the risk factors associated with the properties of a particular REIT. The market has performed the research that is so troublesome in a difficult economic climate.

Because the trend in a REIT's stock price represents a statement by the market in direct relation to the real property itself, the trend in value of the stock price can provide valuable support for reduced assessments and input for analysis under the income approach.

Understanding that REITs generally own many properties, often in multiple states or even worldwide, it should be acknowledged that stock price cannot determine with precision assessed values of individual properties. But the correlation between a REIT's stock price and its property value can be employed to demonstrate the necessity for some assessment reduction on individual properties.

Here's how

A simple linear regression analysis provides an ideal tool to prove the correlation between a REIT's stock price and the value of its properties. To illustrate the point, let's use data from an actual REIT property in the Midwest.

Assume the REIT appeals the 2008 assessment of one of its properties. That property is assessed for 2008 at $5.6 million when the REIT's stock is trading at $11.50 per share. Assume further that the assessed values and stock quotes have been as follows over the last six years

Plotting the stock quotes on the x-axis and assessed values on the y-axis of a graph produces a scatter diagram as shown in the accompanying chart. Using a simple linear regression formula, a trend line can be drawn through the data.

Because the trend line so closely matches the assessments across the six year period, it clearly illustrates that the stock price correlates very closely to the assessed values. Thus, stock price is a reliable predictor of assessed value.

This demonstrated correlation is not exhibited, however, by the 2008 assessment on which the REIT has filed an appeal. During the period illustrated in the chart, the increase in stock price from $9.95 in 2002 to $22.16 in 2007 had been matched by increases in assessed value from about $3.7 to $5.4 million.

But a further increase in assessed value to $5.6 million for 2008 is inconsistent with the stock losing nearly 50% of its value and falling to $11.50 per share.

Therefore, the REIT owner should urge the assessor to reduce the property's 2008 assessment.

In the current market, demonstrating that assessed values should be reduced demands resourcefulness. Absent comparable sales and easily identified factors under the income approach, analysis of the correlation between stock performance and assessed value can help demonstrate a necessary reduction in assessed value.

Stephen Paul is a partner in the Indianapolis law firm of Baker & Daniels, the Indiana member of the American Property Tax Counsel. He can be reached at stephen.paul@bakerd.com.

Don't value medical office buildings higher than general office space.

"These facilities require certain specialized construction components and finishes to accommodate industry needs."

By Stephen Paul, Esq., as published by National Real Estate Investor, December 2008

Construction of medical office buildings is burgeoning throughout the country due to the aging population and its healthcare needs. Because these facilities generally operate as for-profit medical services, they usually become subject to property tax. Medical office owners often find their buildings assessed for real property tax purposes at excessive values when compared to general office properties.

Assessors normally use the cost approach to determine the value of newly constructed property. For the most part, medical office buildings house multiple tenants, including medical practitioners and associated healthcare facilities such as pharmacies, diagnostic imaging, labs or medical administrative services.

These facilities require certain specialized construction components and finishes to accommodate industry needs. Generally, the construction finishes are higher quality than available in the average office. So, logically, if construction costs more, the return on investment needs to be higher to offset these increased costs.

Two obvious construction cost differences stand out between general office and medical office space. First, medical offices require more partitioning due to the need for numerous small exam rooms, medical staff offices and nursing stations and for extensive file storage.

Secondly, medical office space calls for more plumbing fixtures because every exam room must have facilities to maintain sanitary conditions as doctors move from patient to patient.

Major costs also are incurred when an office building must accommodate X-ray machines, magnetic resonance imagining equipment, or CAT-scan equipment/ rooms that require special shielding, such as cinder blocks and double or triple thicknesses of drywall or lead. Moreover, some medical office buildings include outpatient surgical centers, which demand nonporous finishes, high intensity lighting and greater electrical service. Thus, the cost per square foot of medical office space rises well above that of conventional office space.

Data from Marshall & Swift Valuation Service, the industry bible, supports these facts. The data shows that the base cost to construct medical office space is 26% higher than the cost of building general office space.

Highly persuasive argument

Let's examine a property tax appeal involving a medical office property in Indianapolis in 2007. The assessor valued a newly constructed building at $16.9 million. At the same time, the valuation on an Indianapolis general office building with the same square footage amounted to $11.3 million.

The cost to build the medical building was $15 million; the general office property cost $12.4 million to construct. The assessor valued the medical office building $5.6 million higher than the general office property, or nearly 50% more.

In preparation for the tax appeal, the taxpayer documented each construction component and compared it to general office buildings of similar size. This comparison showed that the real estate should be valued based on the basic components of a general office building.

Because each building has the exact same basic components, no justification exists for a larger tax assessment on the medical office building. In the appeal, the taxpayer also argued that an alternate or second user of the medical office building would likely purchase the property simply for office space.

As a result of this painstaking development and presentation of the relevant facts, the Appeal Board ruled in favor of the taxpayer and reduced the property's valuation by $1.3 million to $15.6 million. While this reduction was warranted, the medical office building remains valued higher than the general office building, proving that medical office buildings pay higher property taxes.

Lesson for assessors

Although the cost may be greater to construct medical office space, the added cost doesn't automatically justify higher property tax assessments. Because it is expensive to retrofit medical office space to fit general office needs, those costs should be deducted from construction costs to arrive at what would be market value for a general office building. Clearly, using the cost approach to value properties produces higher property valuations for medical office space than for general office space.

In a property tax appeal, the taxpayer must demonstrate that medical office property requires specialized construction and finishes, and lay out these facts to obtain an appropriate reduction in the property's assessment.

Stephen Paul is a partner in the Indianapolis law firm of Baker & Daniels, the Indiana member of American Property Tax Counsel (APTC), the national affiliation of property tax attorneys. He can be reached at stephen.paul@bakerd.com.