Anemic transaction volume complicates taxpayers' searches for comparable sales data.

Evaluating the feasibility of a property tax appeal becomes increasingly complex when property sales activity slows. While taxpayers can still launch a successful appeal in a market that yields little or no recent sales data, the lack of optimal deal volume does require a thorough understanding of valuation methods beyond the sales-comparison approach.

This article will provide critical information for taxpayers in a low-transaction-volume market to successfully contest property tax assessments directly or to better vet industry experts to assist in those appeals. Many of the concepts are valuation-oriented, underscoring the need for an in-house or outsourced expert to guide appeals that venture outside the parameters of conventional, comparison-based valuations.

Brave new markets

The market for commercial office space changed, perhaps irrevocably, during the COVID-19 pandemic. Occupier demand in the sector has steadily decreased since then. The widespread adoption of remote work, space sharing and similar practices have persisted and, as a corollary, physical and economic occupancy rates for office space have plummeted, along with rents.

Much of the recent transaction volume for office properties has been by distressed sellers forced to sell due to their inability to refinance. Moreover, assessment boards or courts generally reject these sales as poor evidence of fair market value.

Conversely, at the high end of the market there has been a flight to quality; historically, the top-scale properties have always found both buyers and tenants. Valuing buildings that occupy the middle space between these two extremes is perhaps the most challenging, however, and demands a more complex approach suited to the scarcity of comparable market transactions.

Dealing with data

The key to establishing value under these circumstances can be to expand the geographical area of the transaction search and to include less-recent sales for comparison. While those may seem like easy solutions, as in most nuanced situations, the devil is in the details.

These details include the need to vet the accuracy and defensibility of the appraiser's adjustments once a wider net has snared potentially comparable sales. Or more generally, how should the appraiser adjust expanded sales areas and older deals to demonstrate accurate value for the building in the current market?

In a sales-comparison approach, an appraiser can expand the geographic area for current sales beyond the immediate vicinity of the subject property. There is no hard-and-fast rule that comparable sales need to be in the same city, or county, for that matter.

Real estate appraisers often establish a market area that includes not only the county of the subject property but also several surrounding counties, as long as they are "similar." For most commercial properties, similarity for valuation purposes depends on key geographic and demographic qualities.

The appraiser may use analyses of population data, household incomes and traffic patterns to justify adjustments to expanded sales areas for the current market. These are universally accepted valuation elements for retail properties but can also apply to other property types to aid in adjusting market areas.

Sales from previous calendar years, such as those going back five years or so, can still be relied upon to establish current market value if the properties share similar structural and geographic qualities. Using these older sales as a starting point, the appraiser must make critical adjustments for changes in the market conditions which have occurred since the date of the prior sales.

Needed adjustments typically include allowing for current market occupancy rates, both economic or leased rates and physical, onsite occupancy. Elevated levels of unleased space or leased but underutilized offices create a major risk to buyers, driving them to demand higher capitalization rates (and lower asset prices) to reflect increased risk.

In valuation, rising cap rates trigger downward adjustments in overall market value. Also, operational costs have increased markedly in the past few years, especially for insurance. Appraisers must reflect these additional costs in their adjustments to older transaction data.

Complementary approaches

Appraiser training teaches multiple valuation methods, providing alternative methods for establishing value when deal volume is low. These include surveying of market participants, analysis of brokers' for-sale listing volumes, length of market exposure, and analysis of rent or net-income differentials. When taken together, this data will provide reliable information that enables an appraiser to make accurate adjustments and demonstrate current market value for a subject property.

In addition to the sales-comparison approach, commercial property owners can and should consider other valuation methods to establish the current market value of their property. With knowledge of current market rental rates, expense ratios, lending requirements and capitalization rates, an owner can value their commercial property using the income approach, for example.

The more recent the respective leases were negotiated and signed, the more indicative of the current market rental rate. Current expense statements and capitalization rates can be used to ultimately present a credible, current market value of the property.

Taxpayers deciding whether to appeal a property tax assessment may be frustrated or confused by the market's low deal volume. Property tax professionals are equipped to provide advice and assessment appeal strategies in any market type, however. That means tax relief may be available despite the difficulty the current market has placed on the sales comparison approach to valuation.

Owners can use the hurting office market to their benefit.

It's no secret that the real estate market suffered in the COVID-19 pandemic, and no property type was hurt more than office buildings. While hospitality and entertainment properties nearly suffocated, their post-quarantine rebound has been impressive. Real estate professionals who projected multiyear recoveries for hotels and movie theaters back in 2020 and 2021 have been proven wrong. Offices, however, have not been so lucky.

The pandemic hastened a work-remote trend that was already leading office tenants to downsize their spaces, and the shift soon stifled any countervailing influx of tenants that landlords could have relied upon to stabilize their properties. Tenants have also realized that if they are using remote workers anyway, they can employ overseas workers for significantly less pay and with zero office requirements. As a result, many landlords have seen their occupancy and rents drop. Some have been able to maintain rent levels by giving away major concessions or tenant improvements. Some have not.

Falling rents and occupancy deflate property values. A trending loss in property value means it's time to review the tax assessor's value of an organization's property, and to challenge the assessment if appropriate.

Why care about the office market?

Perhaps your company owns or leases a building that it fully occupies. The difficulties of the post-COVID office market are unfortunate, but they don't impact you. Your building is full.

Wrong.

Most jurisdictions value the fee-simple property rights of an income-producing property. Basically, that means valuation is based on capitalization of the income stream that the property would produce if leased at market levels.

This is true for owner-occupied offices, too. If the property is leased after a build-to-suit or sale-leaseback transaction, those typically above-market rents or extended terms are irrelevant to a fee-simple analysis.

If the assessor values a property for property tax purposes based on fee-simple property rights determined using a market-derived income stream, and if current market rent levels and occupancy rates are dropping, then the property's tax assessment should be dropping, too – even if the building is full.

Inflation and interest rates

The problems specific to office buildings are not the only ones for the taxpayer to consider. Inflation has made it more expensive to do just about everything, and that includes operating an office building. Payroll, utilities, insurance: All of these costs are steadily rising, even for owner-occupied buildings.

Local governments are feeling the squeeze, too. Their budgets often depend largely on property tax revenue. When inflation reduces a budget's effectiveness, there will be pressure on the assessor to find ways to dig deep and expand the tax base.

The Federal Reserve's solution for inflation was an aggressive program of interest rate hikes over the course of 2022. The rising cost of money has a significant impact on capitalization rates, which investors and appraisers use to value a property's income stream. The higher interest rates go, the higher cap rates go. The higher cap rates go, the lower property values go.

Where are the sales?

The problem with attempting to demonstrate the impact of rising interest rates on cap rates is the sheer lack of sale transactions. Banks aren't bullish on office lending right now, and sellers would rather hang on to a struggling property than sell it for less than it would be worth if stabilized. How can a taxpayer know what kind of price an office building's income stream will bring if office buildings aren't selling?

This is where the assessors will use sales of office properties to support high values. In many markets, an office property that sold in 2021 is worth significantly less today. But today, there often aren't enough comparable office sales occurring to prove declining value. Assessors can point to the most recent office sales, albeit a few years old, and justify their value on a comparative basis.

What those older sales do not reflect is the more recent plague of dropping rents and rising vacancy. The taxpayer needs a way to discount those old sales and prove what the value is today, not three years ago.

Is it time to appeal?

Consider your office property. Could it sell today for the price it sold for two or three years ago? Probably not. Maybe the organization recently bought it, or even built it, for more than it could sell for today. This is not an uncommon problem anymore.

In many jurisdictions, the best way to challenge an office property's assessed value is by using the income approach. If the building were leased at market rent, what would that look like? If the building were occupied at current market occupancy levels, how much vacancy would there be? The taxpayer may need to talk to a broker or two to answer these questions.

The taxpayer may need help to turn market data into a viable appeal strategy. A property tax professional can prepare a fee-simple income approach and help estimate the current market value of the property. In the present situation, there is a good chance property tax relief is available, even if the office building is fully occupied.