"Businesses today have greater difficulty than ever before in predicting future space needs as business requirements and market conditions change rapidly. Federal, state and local laws and regulations, too, have become unpredictable..."
Technological advances are rapidly altering the way corporations use commercial real estate, and recognizing these fundamental shifts can have a profound effect in efforts to reduce property taxes.
Our world changed at an incredible pace in the last 100 years, and those changes have accelerated in the 21st Century. As one technology enthusiast observed in 1999, "From 1946 until now, if the automobile had been improved as much as the computer has been improved, you'd have a car that would go a million miles an hour and cost a penny!"
There was little telecommuting 10 years ago, when the average cubical size ranged from 50 to 75 square feet and the BlackBerry was the latest fad in a mobile technology industry still in its infancy. Corporate campuses with sprawling Frank Lloyd Wright-style buildings were the norm. Today those edifices of expansive glass, with their inefficient angles and giant atriums, are considered too expensive to maintain and are becoming the exception rather than the rule.
Technology and the commercial real estate boom that ended in 2007 have combined to fuel a dramatic shift in the use of commercial space from the aesthetic to the practical. Companies realize that every dollar saved by a more efficient use of real estate not only makes them more environmentally responsible, but also goes directly to the bottom line.
The New Workplace
At Indianapolis-based health benefits provider WellPoint, more than 6,000 associates work from home, and as with many other businesses, that number is increasing daily. Most of these associates almost never need to come into the office. At least 1.4 million square feet of commercial office space would be required to house these 6,000 associates. Most of the space once occupied by these telecommuters has been or will soon be returned to the landlord.
Today, preferred venues for companies like WellPoint are square or rectangular in shape, utilize a central core and are easy to maintain. More efficient space design and better technology are changing the physical layout and proportions of the workspace itself, as well. Innovations such as flat screen monitors replacing the cumbersome CRT monitors of old have decreased cubicle sizes to as little as 35 square feet, but have driven up parking requirements to five or six spaces per 1,000 square feet of leased space.
In addition to work-at-home programs, other alternative workplace strategies including hoteling, desk sharing, and more have all come of age. Space once used to provide each individual with a large cubicle or enclosed office is rapidly becoming obsolete.
Businesses today have greater difficulty than ever before in predicting future space needs as business requirements and market conditions change rapidly. Federal, state and local laws and regulations, too, have become unpredictable. As a result, lease flexibility is now a fundamental requirement for many tenants. Lease terms are shorter and often come with enhanced termination and contraction options.
The need for less space, evolution of lease terms, and collapse of the capital markets have led to a substantial loss in value for commercial real estate. But for parties responsible for paying property taxes, this dark cloud has a silver lining in the form of a significant opportunity to reduce the assessed value of real estate in most markets.
Economic factors affecting value
A property's value is driven not merely by the inherent qualities of the asset itself, but also by market factors. The Appraisal Institute, the recognized leader worldwide in real estate appraisal education, has identified four predominant and interdependent influences on property values, rooted in fundamental economic principles of supply and demand. Those are utility, scarcity, desire, and effective purchasing power.
Utility and scarcity weigh in on the supply side of the equation as the ability of a property to satisfy users' needs and desires, in context with the anticipated supply of properties relative to demand. Desire and effective purchasing power are on the demand side, and take into account individual wants beyond essential needs, and the market's ability to pay for property. By looking at these four influential factors, it's easy to see how property values have suffered from evolving appetites for office space and from the recent trends in lease terms and the capital markets.
For example, properties with atriums and other large open spaces are expensive to heat, cool, and maintain. Such features provide little utility, and a surplus of these properties exists on the market. Pair that surplus with a decreasing desire in the market for large expanses of unusable space, and the value of these properties declines.
Or, take into account the increasingly strong position tenants command to negotiate favorable contraction and termination provisions in leases. Clearly, this trend is a reflection of both the surplus of space in the market and a general inability or unwillingness to pay a higher price for unusable property or be compelled to accept less favorable terms.
Translating market influences into assessment reductions
In order to understand how these market dynamics translate into reduced property tax assessments, economic factors influencing value should be viewed within the context of the accepted approaches to property value. The predominant methodologies are the cost approach, sales comparison, and income capitalization.
The first of these approaches to value generally focuses on the replacement cost of the improvements, assigning value upon examining the cost of developing similar structures. This value is adjusted to account for the property's age, condition, and usefulness. The latter point is where inefficient designs come into play as elements of functional or economic obsolescence.
Functional obsolescence refers to the loss in utility resulting from factors that would make it difficult to modify the property for a particular use. Building characteristics tending to contribute more to the aesthetic than to the practical enter into this calculation of functional obsolescence. Enormous atriums, indoor gardens, arboreta, and water features, as well as odd angles and unique architecture, often trace to the preferences of a one-time, build-to-suit tenant and detract from the building's usefulness to subsequent tenants.
Most cost approach values are based on replacement cost, or the cost to substitute an asset of similar size and use but with contemporary materials and design. Because an assessment on the basis of replacement cost doesn't contemplate reproduction of an exact replica, unusable space is excluded from the calculation and results in a lower value.
The public's appetite for sprawling improvements that are distinctively designed and aesthetically pleasing has yielded in the last decade to desires for efficiency and simplicity. To the extent that the property owner can show that tastes have changed in the market, these inefficient design characteristics can demonstrate economic obsolescence, which occurs because of factors outside of the property itself and also reduces the property's value.
The sales comparison approach entails an analysis of sales and listings of similar properties to arrive at an assessed value for a property. The comparable sales used in this analysis should be adjusted to account for variances between the comparables and the property being assessed, including (in some states) the terms of leases on the property. If the comparable sales selected involve inefficient designs that have become abundant on the market and for which the market's desire is dwindling, the comparable sale prices should indicate a reduced willingness to pay a high price for such property.
Sales comparison analysis should employ the most recent sales of similar properties. This way, the sales also reflect latest real estate market trends.
For income-producing property, the income capitalization approach will likely reflect the decreased utility of, and demand for, an inefficiently designed building. Under this approach, property value is assessed by capitalizing annual net operating income. Recent lease activity should reveal terms favoring tenants, as well as increased market vacancy, softening rental rates, and tenant preferences for smaller and simpler designs.
In the case of property encumbered by long-term leases, comparable properties with more recent leases may be reliable indicators of the property's current income-producing capability.
Each approach should reveal that technological and market shifts reducing the utility of oversized, inefficient space, as well as the market's desire to pay for such space, have reduced the taxable value of many commercial properties. Technology is changing ever more rapidly in the 21st Century, and taxing jurisdictions should be open to consider such evidence for its impact on reducing values.