Market deterioration and municipal ineptitude are driving taxpayers to the courts for relief.

The New York City real estate market, once the pinnacle of economic health, has undoubtedly declined in recent years. Exploring the factors that brought the market to this point paints a clearer picture of what current conditions mean for property taxpayers and suggests strategies that may offer relief.

Five Causes of Decline 

The COVID-19 pandemic left an indelible mark. The coronavirus took a significant toll on New York City, which became an epicenter of U.S. infections. Many residents fled to suburban areas for more space and less harsh mandates from local authorities. According to a Cornell analysis of U.S. Census Bureau data, "New York City's population plunged by nearly 4 percent – more than 336,000 people – during the pandemic's first year as residents migrated to less dense areas in nearby counties and neighboring states."

The New York City Comptroller's Office estimated that the City lost an additional 130,837 residents from March 2020 through June 2021. This caused unprecedented vacancies in residential and commercial properties, and approximately 100 hotels in the City closed. Those that survived endured high vacancy rates and struggled to pay property taxes.

Economic uncertainty plagues the real estate market. The economic fallout of elevated vacancies and decreasing income has rendered investors and developers hesitant to invest in New York City real estate.

Remote and hybrid work slashed office demand. The decline in office usage that accelerated during the pandemic is ongoing and appears permanent. Most workplaces have loosened to a hybrid work environment, and many employers allow a full-time work-from-home option as well.

This means office buildings that once bustled with employees are now vacant or significantly emptier than they were in 2019. Midtown Manhattan lunch spots and after-work happy hour sbars and restaurants have also taken a hit. The National Bureau of Economic Research estimated in 2022 that New York office buildings had lost as much as $50 billion of value in the wake of reduced demand.

Crime is soaring. New York City police reported making 4,589 arrests for major crimes in June, a 9.3 percent increase from the same period a year earlier. In the first six months of 2023, officers made 25,995 such arrests – the most for any half-year period since 2000.

Property tax revenues are under threat. The previous trends have been slow to erode the municipal view of the tax base. The City's Department of Finance reported a tentative assessment roll of $1.479 trillion for fiscal 2024, a 6.1 percent increase from the previous tax year. For the same period, the department reported a 4.4 percent increase in citywide, taxable, billable assessed value, the portion of market value to which tax rates are applied, to $286.8 billion.

"New York City continues to show mixed signs of growth and economic recovery, with the FY 24 tentative property assessment roll reflecting improvements in subsectors of the residential market while key commercial sectors still lag behind pre-pandemic levels despite modest growth over the past year," Department of Finance Commissioner Preston Niblack said in a press release announcing the tentative tax roll.The decline in office occupancy continues to impact retail stores and hotels in the City contributing to the sector's slow recovery. At the same time, single family homes, which constitute a majority of residential properties, have exhibited a robust recovery and continued growth."

A study by NYU's Stern School of Business and Columbia University's Graduate School of Business calculated that a decrease in lease revenue, renewals and occupancy would cut the value of office buildings in the City by 44 percent over the next six years. Based on those findings, a worst-case analysis by New York City Comptroller Brad Lander found that a 40 percent decline in office property market values over the same six years would result in $1.1 billion less tax revenue for fiscal 2027, the last year of the City's current financial plan. Real estate taxes on office properties currently generate 10 percent of overall City revenue. The City expects office vacancies to peak at a record 22.7 percent this year, posing a potential threat to tax collections.

The result of the forgoing changes is that income is down, expenses are up, demand is evaporating, and market values have plunged by more than 50 percent for most commercial properties except perhaps multifamily (although sales of condominiums have stalled due to high mortgage costs).

How To Get Relief

The hotel industry anticipates a four-year recovery period. Hotel owners preparing arguments for reduced assessments should collect information for their team documenting closure dates, occupancy rates, and any specific pandemic-related expenses incurred during the reopening process.

It is inappropriate for assessors to evaluate hotels for property tax purposes solely based on non-real-estate income. A recent court ruling has affirmed the illegality of utilizing non-real-estate income generated by hotel businesses, leading to an overassessment of real estate taxes that must be refunded to owners. Business-related income, such as that from movie rentals, should not be considered in property tax assessments.

In addition, it is essential to identify and exclude income from personal property, furnishings, and the value of intangibles, franchises, trained workforce, and going concerns when determining real estate income.

The prevalence of empty stores and closures of local standby establishments in every corner of New York City underscores the severe economic impact on retail properties. Retail and office owners should be prepared to demonstrate declines in gross income and rents reported in their financial filings with the City. They are also required to provide a list of tenants who have vacated or are not paying rent. The Tax Commission now mandates an explanation for declines in rents exceeding 10 percent.

There is considerable potential for assessment reductions, but it is crucial for taxpayers to compile evidence of market value declines, and to collaborate with experienced advisors to secure warranted tax reductions.

There is no longer any absorption of vacant office space since demand is declining. That means that 80 percent occupancy or lower is the norm. Only an adjustment in property taxes to the actual earnings of the property will save the real estate, and over-leveraged properties may be lost.

Tax Process in a Tailspin

Extensive personnel turnover has hampered the review process that relies on action by City agencies, with inexperienced staff and numerous unfilled positions at both the Department of Finance (assessors) and the Tax Commission. Thus, expected remediation of excessive assessments often go unresolved. This leaves no alternative but to go to court.

Resorting to the courts is also difficult because in-person appearances are still relegated to video conferences, with few trials taking place.

The taxpayer's best approach is to push forward with all speed to demand a trial.  Only pressure to demand speedy trials will provide the needed result.

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.

Incurable obsolescence — the stealth killer of commercial real estate value — is all too often overlooked in property tax appeals.

Any obsolescence can affect a property's value. Normal obsolescence involves curable problems, such as outdated fixtures and finishes that reduce a building's desirability. In valuation, the anticipated cost to cure the obsolescence (in this case, with a refreshed interior) is deducted from the property's taxable value.

As the name suggests, incurable obsolescence cannot be cured within the boundaries of the property. The obsolescence stems from outside circumstances, whether next door or in the larger markets, and no change to the property itself can overcome the deficiency.

Perhaps the government is going to change the traffic pattern, or a hog farm is going in next door. The market value may rise if a good thing is coming to the area. It will surely decline if a bad thing is coming, and the market value declines in relation to the predictability of such an event.

Property owners who learn the common forms and causes of incurable obsolescence will be better equipped to recognize its symptoms in their own real estate. In arguing for a reduced tax assessment value, evidence of obsolescence weighing on a property's operations will often tip the scales in convincing an assessor, review board or court to grant a reduction.

Passing or permanent?

Owners should be aware of functional obsolescence and be prepared to discuss it when appealing assessments. If it is a problem that can't be cured within the boundaries of the property, it is incurable obsolescence and reduces the property's market value.

The condition may have existed from the inception of the property's development and use, but more typically it results over time from factors relating to design, usability, markets, traffic patterns, government takings or regulation. For example, economic need or a government requirement may leave a property without adequate parking to support commercial buildings on the site, rendering those structures incurably obsolete.

Incurable obsolescence can be partial and a handicap to the property's viability without entirely preventing its continued use. For example, an office building designed for single-tenant use will not accommodate multiple users. There is a very limited market for single-tenant, high-rise buildings. The cost of retrofitting such a building into separate leasable offices is infeasible.

The loss in value due to incurable obsolescence may be anticipatory. If the market's users and investors see imminent incurable obsolescence, it may already affect market value. The negative impact of incurable obsolescence occurs when the problem cannot be cured on site at any cost.

In evaluating a property for instances of incurable obsolescence, however, it is important to remember that the source of obsolescence may be offsite.

Owners concerned with the production and marketing of a product or service from their property may not be aware of external elements of incurable obsolescence affecting their property's value. Or they may simply regard the circumstance as a non-priority item — at least until they get their property tax bill.

Instances of the incurable

Incurable obsolescence takes many forms, but taxpayers are most likely to encounter it in one of a few common scenarios. Those include:

Property access changes. Typically imposed by a highway or street authority, moving or removing access points can reduce a commercial property's appeal to users and lower its market value.

Altered traffic patterns. Changes to surrounding roads or highways can reduce commercial value. Limiting the property's visibility and accessibility, for example, may reduce customer traffic and brand exposure for operators on the property.

Size modifications. The property may fail to meet the required property size in relation to improvements. Possible causes include changed government requirements or the physical loss of a portion of the property due to government taking. A simple change in setback lines may have a dramatic negative impact on a property's value.

Takings. Use of eminent domain may reduce the remainder of the property to a legal non-conforming use which may not be altered to accommodate a commercially viable use. Alternatively, commercial uses on a state highway may be untouched by highway takings, but diverting traffic to a new highway kills viable commercial use of properties on the abandoned roadway.

More examples

Other sources of incurable obsolescence span a wide range, from changing industry practices and preferences to evolving government regulations, markets and natural phenomena. Zoning or regulatory changes may restrict usage, for example. The property may no longer meet current tenant needs regarding loading dock height, or access by delivery and customer vehicles. Nearby development or street construction may inundate the property with surface water. Properties have incurred incurable obsolescence for their intended uses from light pollution, and from disruptive air traffic following a change in flight patterns.

Property owners discussing excessive taxable valuation with the assessor should recognize that the assessor has employed the cost approach to value. While cost may be a value indicator, it lacks relevance in situations involving incurable obsolescence. Help the assessor to look beyond cost by showing how obsolescence reduces the property's value in the marketplace.

In preparation for meeting with the assessor, an owner seeking a reduced assessment should look for negative conditions beyond the control or ability of the owner to correct within the boundary of the property. Be prepared to discuss with the assessor how the conditions affect the property value. Bring plat maps, photos, restrictive regulations and ordinances, and any documents that entail restrictions on the use of the property — legal, physical or otherwise — and an explanation of how these matters negatively affect the property's value.

While there is no cure for incurable obsolescence, there are treatments for unfair tax assessments. When incurable obsolescence results in lost improvement value, the owner is entitled to an appropriate downward adjustment of the assessed value. 

The American Property Tax Counsel is proud to announce that Chicago, Illinois will be the site of an in-person meeting for the 2024 Annual APTC Client Seminar.

Save the Dates! October 23-25, 2024 - Fairmont Chicago, Millennium Park - Chicago, Illinois

THEME - How to Hang On While the Market Hangs Fire

APTC seminars provide an exclusive forum where invited guests can collaborate with nationally known presenters and experienced property tax attorneys to develop strategies to successfully reduce and manage property taxes.

FEATURED SPEAKERS 

MEMBER SPEAKERS 

Taxpayers should look beyond fair market value in deciding whether — and how — to protest assessments.

Taxpayers usually appeal property tax assessments by proving a market value different from the assessor's finding, but they should not overlook constitutional guarantees of uniform and equal taxation.

As an ad valorem tax, real property taxes are charged on the value of the underlying real estate, usually measured as fair market value. In many states, taxpayers can demonstrate their property's market value with a recent, arm's-length sale price or by independent appraisal evidence.

Two potential concerns emerge for taxpayers in an assessment appeal centered on market value: the declining reliability of data in volatile and rapidly changing markets, and the trailing nature of market data used by assessors. Those data issues can skew the mass appraisal techniques tax assessors often use, including comparisons to sales of similar properties, when assessing real property.

Volatility and rapid change

Commercial property data can lose relevancy with surprising speed in a volatile market. For example, office properties continue to bear the consequences of increased remote work and occupants' shrinking footprints since the pandemic. Many office properties with mortgages maturing in 2023 have lost half or more of their previously underwritten asset values. Badge swipes tracked by Kastle Systems show an average office attendance of about 50 percent throughout 2023.

In early 2023, Cushman & Wakefield attributed slowing construction to uncertainty in the office market along with challenges related to higher interest rates, supply chain issues, and labor shortages. Office properties may be in danger of becoming "zombie" buildings with utilization of 50 percent or less, while market watchers warn of doom loops or a domino effect of property failures, especially in dense central business districts. Most market participants are waiting for the other shoe to drop and for the market to reveal its bottom.

Assessors are not immune to the valuation problems this market uncertainty creates. Assessors currently valuing properties are likely considering comparable sales that occurred as far back as 2019 or early 2020. Even more recent sales are likely to be based on leases executed years earlier, or on financing obtained prior to the pandemic.

Further undermining data reliability is the decline in sales activity after March 2020, when pandemic-related uncertainty and economic pressures like rising interest rates began to discourage participants from unnecessary transactions. As pre-pandemic leases expire and loans underwritten on those leases mature, transactional data will likely show drastic valuation declines within a short amount of time. The lag in sales data as these properties are brought to market will affect the accuracy of property tax assessments.

What can a taxpayer do when market activity is too chaotic and volatile to accurately price value? Taxpayers should not forget constitutional safeguards of equal protection and uniform taxation.

The U.S. and most state constitutions protect taxpayers against non-uniform and discriminatory tax policies. For example, the Ohio Constitution requires that "land and improvements thereon" are "taxed by uniform rule according to value." Ohio statutes also require that assessors appraise property according to "uniform rule" in both the "mode of assessment" and as a "percentage of value." The constitutions of Pennsylvania and Texas also contain uniformity clauses. The 14th Amendment of the U.S. Constitution prohibits the government from depriving any person of their property without due process or denying any person equal protection of the law.

These constitutional protections are important enough that federal and state courts have held that when the goals of uniform taxation and correctly assessing market value cannot both be met, the constitutional priorities of equity and uniformity prevail.

Uniform, equal taxation

There are a few ways to help ensure consistent and equitable property taxation, starting with regular reassessment cycles. Some Pennsylvania counties have not reassessed countywide since the 1960s. The lack of regular appraisals to determine market value results in fewer properties being taxed on their true market value, especially if recently sold properties are assessed at their sale price while others have not been reappraised in decades.

A related problem is variation in the taxed percentage of market value between similar properties, which leads to non-uniform assessment ratios. There have been a series of successful contests recently in Lackawanna County, Pennsylvania, by taxpayers demonstrating that other property owners with similar properties were not paying taxes based on similar market values. Therefore, properties with the same market values were not being assessed at the same ratio, leading to non-uniform assessments. "The problem in Lackawanna County was not caused by this assessor's office, but gets perpetuated when new construction is placed on the assessment rolls at 100% of construction costs based solely on permit information, while similar properties have not been property reassessed since the base year of 1967," explains James Tressler of Tressler Law LLC, the attorney who brought a number of these successful challenges.

Another way to ensure assessment uniformity is by valuing the unencumbered, fee-simple interest in the real property, regardless of whether a particular property is leased, owner-occupied, or vacant. Ohio amended its controlling legislation to clarify that assessors must value the market value of the fee simple interest for all properties. Valuing the same market-based fee simple interest for all properties safeguards real estate tax assessments from being influenced by the business value of a successful (or unsuccessful) enterprise conducted on the property.

Governments can check discriminatory treatment by allowing taxpayers to contest the unequal ratios of market value across similar properties, or by allowing taxpayers to challenge assessments based on the median assessments of a reasonable number of comparable properties. Texas law contains this type of protection for taxpayers, and similar legislative remedies are being discussed in Ohio.

These additional checks and balances to secure equal and uniform property tax systems assure taxes are not borne discriminatorily by a few. The Pennsylvania Supreme Court wisely reminds us of these protections in a 2017 decision involving Valley Forge Towers Apartments, stating: "As every tax is a burden, it is important that the public has confidence that property taxes are administered in a just and impartial manner, with each taxpayer contributing his or her fair share of the cost of government."

Differentiate personal property from real estate values for fair tax treatment.

North Carolina taxes both real estate and personal property, but differing valuation schedules and processes for the two types can lead to confusion and inflated tax bills for industrial property owners. Understanding how assessors value industrial properties can help those taxpayers detect issues and contest unfair assessments.

Dual processes

North Carolina requires assessors to revalue real property at least every eight years. The value as of Jan. 1 of the valuation year then remains constant until the next valuation, unless specified changes in the property occur to trigger a change in the assessment. Many counties revalue every four years, and a few, even more frequently.

Assessors use a market analysis to determine real property's taxable or fair market value. This involves applying one or more of the three valuation approaches: cost, comparable sales, or income.

The state requires annual valuation of personal property based on installed cost, which is subject to the applicable trending and depreciation schedules. For the most part, taxing authorities rely on the taxpayer's annual business personal property listing to determine what items of personal property are present, the installed cost, and the trending and depreciation schedule applied. The counties follow schedules for auditing the property tax listings, and most disputes that arise stem from these audits.

With industrial real estate, the two tax schemes can create conflicts based on property components that could be considered either real estate or personal property, depending on circumstances. For example, reinforced foundations or specialized wiring for unique machinery could be considered a real estate improvement, thereby adding value to the real estate, or they could be considered personal property subject to depreciation and trending.

Although the tax rate applied is the same for both real estate and personal property, categorization can significantly affect taxable value. Real property improvements enhance market value on a more permanent basis, while personal property value is generally presumed to decline because of annual trending and depreciation.

And of course, no one wants to be taxed twice on the same property: once by having a component or improvement included in the real estate value, and again by having it taxed as personal property.

Defining characteristics

How can a taxpayer determine what is real and what is personal in their industrial property? Generally, personal property items are movable and not permanently affixed to real estate. An issue of intent arises, however, if the item can be removed but not without causing serious damage to the real estate.

A rule of thumb in the North Carolina Department of Revenue's Personal Property Appraisal and Assessment Manual instructs assessors to classify all property and investment necessary for the operation of machinery and equipment as personal. Examples are wiring, venting, flooring, special climate control, conveyors, boilers and furnaces, dock levelers, and equipment foundations. Stated another way, property used as part of a process, or that is in place to support equipment, is generally personal property.

On the other hand, Department of Revenue staff regard items in the plant for lighting, air handling and plumbing for human comfort to be part of the real estate. The department's appraisal and assessment manual includes an extensive chart, and each county's published schedule of values may also provide a helpful listing.

It is often difficult to know whether the county has included what could be classified as personal property in its calculation of real property value. Regardless, if the taxpayer has not listed such items on the annual personal property submissions, it will be difficult to argue after the fact that they should have been excluded from the real estate value.

Taxpayer strategies

Taxpayers can argue for a reduced assessment by identifying personal property items improperly classified as real property in the assessor's calculations and seeking to have them treated as personal property subject to trending and depreciation. Knowing where to look for personal items will help the property owner in this task.

A critical item to be generally classified as personal property is any leasehold improvement. Leasehold improvements often look like real estate but are owned and controlled by the tenant for the lease term. These are items the tenant paid for and received under terms of the lease or other contract, and were installed for the tenant's use. Leasehold items almost always facilitate the tenant's business.

In deciding whether these items are real or personal property, the taxing authority will apply a test akin to a traditional fixture analysis, determining the manner of affixation, whether the item can be removed without serious damage, and whether it is intended to remain permanent. In the end, the assessor will apply a "totality of the circumstances" test, including the lease terms.

The tenant - as the owner of the leasehold improvements - is required to list those items as personal property. The landlord should monitor the tenant's personal property submissions to ensure that all tenant improvements are being listed. This will help to avoid leasehold items being considered as part of the current real estate valuation.

Unlike a traditional fixture analysis, and dependent on the lease terms, the improvements may be taxed to the tenant during the term of the lease. When the improvements are left to the landlord at the end of the lease term, the taxing authority will need to consider assigning any remaining value to the real estate.

The owner of an industrial property needs to be cognizant of how the assessor is valuing both the real estate and personal property, and how those components are taxed. This requires knowing what improvements are included in the valuation of the real property as of the valuation date, and tracking the annual personal property tax listings, especially those submitted by a tenant. Finally, taxpayers must be timely in correcting any erroneous assumptions or listings.

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.

2023 Municipal Revaluations

It is always important to carefully review your tax bill and/or notices of assessments, but even more so in the year in which your city or town conducts a revaluation.

Each assessment should be carefully reviewed, even if your assessment has not increased substantially, as an appeal immediately after a revaluation maximizes a property owner's potential tax savings.

Connecticut law requires that each municipality conduct a general revaluation of the real estate within its borders at least once every five years.The purpose of a revaluation is for a municipality to determine the market value of real estate to be used to calculate property taxes.

Once a property's value is set in a general revaluation, it remains constant over the entire five-year cycle, absent appeal, demolition, improvements or expansion. Of course, the annual taxes usually increase, as a municipality's mill rate increases incrementally from year to year. Municipalities across the state are on differing revaluation cycles. The following is a list of Connecticut municipalities conducting revaluations this year:

If your municipality is conducting a general revaluation for the October 1, 2023 Grand List you will receive a notice of tax assessment change soon, if you have not already.

Once the notices are issued there may be a chance to meet informally with the assessor to discuss the new assessment, which should represent 70 percent of the fair market value of your real estate. However, if a property owner wishes to challenge the assessment formally, a written appeal must be filed with the local Board of Assessment Appeals by the February 20, 2024 statutory deadline.

It is in your best interest to be proactive in monitoring the revaluation process and your new assessment so that you can take all necessary steps to ensure that the assessment is equitable.

News on the Newly Enacted Tax-Payer Appraisal Deadline

While we have deadlines and key dates fresh on the mind, 2023 was the inaugural year for a new deadline that was implemented into Connecticut's overvaluation statute, C.G.S. 12-117a, by the Connecticut General Assembly. Per the newly amended statute, if a taxpayer brings an overvaluation appeal on real property that has an assessed value over $1 million, the taxpayer is now required to file an appraisal of the property with the superior court by no later than 120 days after commencing the appeal.

It remains to be seen what relief, if any, a taxing authority may seek from the court if a taxpayer fails to meet this deadline, but expect some case law to develop on this subject if the statute is not amended in future legislative sessions. One recent superior court decision involving a tax appeal captioned as Shortline Properties, Inc. v. City of Stamford, FST-CV23-6060950-S discussed the implications of this deadline to a certain extent, but it did not squarely address the question of what judicial relief is available to municipal defendants.

The court did make clear, however, that appraisals filed for purposes of this statutory requirement must be from the grand list date from which the taxpayer commenced the appeal. In this case, the taxpayer's appraisal appeared to be from two years prior to the grand list date in question, and the court concluded that this did not meet the appraisal requirement. That said, the case remains pending and although the court rejected the appraisal, it allowed the plaintiff to proceed with prosecuting the appeal.

Tax considerations often drive site selection and form an importance piece of the reshoring puzzle.

COVID-19 laid bare many problems inherent in offshore supply chains and spurred widespread interest in reshoring manufacturing to the United States. As companies and communities explore site selection and expansion opportunities, they should remember that manufacturing profitability often hinges on tax strategy.

Staging a comeback

For the first time in decades, industry and the public sector are working to make American manufacturing competitive in a rapidly changing global marketplace. The recent enactments of the Inflation Reduction Act, the Bipartisan Infrastructure Law and the CHIPS and Science Act have directed billions of dollars into enhancing domestic manufacturing capacity.

The semiconductor industry presents a high-profile case study. The United States holds 12 percent of the world's semiconductor manufacturing capacity, eroded from 37 percent in 1990. The CHIPS Act's $52 billion in federal funding is intended to strengthen domestic semiconductor manufacturing, design and research and reinforce the nation's chip supply chains, fortifying the economy and national security along the way.

Simultaneously, the United States is becoming a leading producer of electric vehicles and vehicle battery plants. Since 2021, announced U.S. investments in semiconductors and electronics exceed $166 billion, and announced U.S. investments in electric vehicles and battery manufacturing exceed $150 billion.

Deciding where manufacturing occurs depends partly on proximity to suppliers, available labor, distribution hubs and customers, and operating costs. Property tax is typically a significant component of operating costs. That's why tax abatements on real property and equipment are a commonly offered incentive.

Most states offer incentives to attract industry, and one of the hotbeds for increased American manufacturing has been the southeastern United States, specifically South Carolina, Georgia and North Carolina. All are leaders in foreign direct investment.

Abatements generally provide a manufacturer with predictable property taxes, helping to overcome the uncertainty of future tax liability that can put companies at a disadvantage. An example is South Carolina's "fee in lieu of tax" agreement (FILOT) which offers manufacturers predictable and consistent taxation. Generally, FILOT agreements fix tax rates and the value of real estate and improvements for the length of the agreement, while allowing manufacturers to depreciate the value of machinery and equipment.

FILOT agreements can have up to a 50-year term. However, by fixing a manufacturer's real property value at actual cost without depreciation, the owner's taxes over time may be higher than they would be without the agreement. That's because they do not account for depreciation, valuation changes or required improvements to accommodate changes in the marketplace for the manufacturer's product.By locking in the real property value, the manufacturer receives the benefits of predictability and protection from higher taxes on appreciating real property.In exchange, however, the manufacturer loses the benefit of any depreciation and takes the risk of a locked-in property value if the property's market value diminishes.

Other states offer different incentives including more traditional property-tax abatements, where a manufacturer receives a grant as a partial rebate or discount on the new property taxes the project creates. Since tax rates and taxable value assessments change over time, these systems can provide less certainty for manufacturers than FILOT-type agreements, but potentially offer more long-term flexibility to respond to changing tax rates, depending on how the agreements are negotiated.

As a manufacturer's industry evolves and demand for its products changes, flexibility to appeal tax assessments can be a key to maintaining profitability and competitiveness.

Committed but flexible

Certainly, a manufacturer is better off in an appreciating real estate market by fixing the value of the real estate and improvements. Organizations negotiating for incentives should protect their ability to protest unfair assessments of taxable value, however, because valuing a manufacturing plant in the traditional ad valorem system is challenging and subject to controversy.

For example, most state ad valorem property tax systems define "value" as a variant of "market value," assuming an exchange between a willing buyer and a willing seller. However, will the buyer of a manufacturing facility benefit from the features of a specialized building constructed for a different manufacturer's specific needs? The answer is usually "no."

Manufacturing facilities are special-purpose properties, which The Dictionary of Real Estate Appraisal defines as a "property with a unique physical design, special construction materials, or a layout that particularly adapts its utility to the use for which it was built." And changes in the manufacturing process can render many buildings economically obsolete.

If the facility's use is no longer viable, it should be appraised as an alternative use. This necessarily occurred as American industry declined. Often there were no manufacturers who could effectively use single-purpose buildings vacated by other manufacturers, necessitating drastic value reductions.

An assessor's three traditional valuation methods all have limitations. A sales comparison approach is difficult when the production facility has essentially been designed to produce specific products. Put differently, finding sales of comparable facilities can be extremely challenging.

An income approach requires a market rent calculation, but manufacturers historically own their facilities, making an income approach difficult. A cost approach using actual cost ignores that the same building might not be appropriate to respond to changes in the marketplace for the product being produced. The cost approach without depreciation also limits the manufacturer's flexibility in responding to changes in the marketplace for its product.

Remember, too, that a manufacturer must be nimble, as changes in the market or technology can render an entire plant (or industry) obsolete virtually overnight. Adapting processes may require equipment upgrades or replacement, structural modifications or other changes that affect property value.

The speed at which manufacturers need to be able to adapt to a changing marketplace, the strong desire for certainty in costs and the difficulties in valuing manufacturing facilities for tax purposes all argue in favor of valuing real property and improvements on the basis of cost less depreciation.

Successful reshoring will require focused efforts by the public and private sector, together with sensitivity to industry's need to be nimble and the implications of historical incentives to ensure that reshored industry remains competitive. Flexibility offers the key to long term success, and property taxes form an important piece of the puzzle.

Here are some property tax strategies owners can use in the rebounding apartment sector.

Multifamily construction and renovations are enjoying a resurgence after taking a pause during the pandemic. And with residential, apartment-style rental units back in vogue with renters and investors, developers are even converting underutilized office buildings and shopping malls into multifamily housing.

As developers step up construction spending to tempt renters with an assortment of amenities, tax assessors are having a field day, tabulating costs on renovations and new projects that they are using to justify ever-larger assessments of taxable value across the sector. Multifamily owners must look out for themselves to guard against unfair, blanket assessment increases founded on these gross generalizations about the industry.

New offerings, New Renters

The target demographics for today's projects include young professionals not yet equipped to buy their own homes; middle-aged, single-family homeowners looking for a more carefree housing option; and aging individuals looking to downsize and become part of a seniors community.

Apartment models have evolved to better suit today's renters. Gone are the cookie-cutter, brick-and-mortar, garden style structures with minimal common areas. New apartment communities are more often high-end projects boasting pools, gyms, lush landscaping, retail shops and other non-traditional apartment features.

The added expense to deliver amenity-rich apartments is only one of many rising costs for multifamily developers and owners. Supply chain breakdowns, material shortages, rising interest rates on commercial mortgages, governmental bureaucracy, and increased inflation have forced owners of apartments and other commercial buildings to search for avenues to reduce their costs. While costs associated with owning and maintaining apartment buildings are trending higher, real property taxes remain one of the largest expenses, warranting an annual review and challenge.

Fortunately, in ad valorem jurisdictions where a property's tax assessment is tied to its market value, the law allows taxpayers to appeal assessments and seek relief from onerous real estate taxes. The process involves the filing of an annual administrative grievance followed by a judicial action against the tax-assessing entity.

The Protest Process

In tax appeal proceedings, the aggrieved party or petitioner bears the initial burden of proof. Assessments are presumptively valid, so it is up to the taxpayer to provide substantial evidence that calls into question the assessment's correctness. Taxpayers often meet this minimum standard by submitting a qualified appraisal.

In a court setting, once the presumption of validity is rebutted, the judge must determine by a preponderance of the evidence whether the property was overvalued. However, most tax assessment cases reach a resolution through negotiation and settlement without the need for a formal expert report or judicial oversight. A tax advisor skilled in real property tax assessment challenges is more often than not all the taxpayer requires.

The three traditional approaches to real property valuation in a tax appeal are the income capitalization, comparable sales, and cost approaches. Absent a recent arm's-length sale of the subject property, appraisal professionals, practitioners, and the courts generally regard income capitalization as the preferred method to value income-producing properties.

In utilizing the income approach, a taxpayer's team is seeking to value the property based on its net-income-generating potential. In other words, what would a buyer pay on the valuation date for the future income stream?

Point-by-Point Analysis

There are several steps to properly arrive at a value conclusion through the income approach. Understanding and following the steps will not only inform the property owner's valuation, but also provides a checklist to review and question calculations in the assessor's conclusion.

To calculate potential gross income, it is important to analyze the subject property's actual rental data and test it against market rents to reflect the property's economics. Similarly, the assessor or appraiser must gather, review and analyze occupancy and collection data. The appraiser will need to deduct for vacancy and collection loss because many buildings are seldom at 100 percent occupancy, and some tenants may be behind in their rent payments.

The same process is applied to real estate-related expenses such as insurance, utilities, and replacement reserves. These should be deducted to arrive at a net operating income before the deduction of real estate taxes.

In analyzing data for a tax assessment challenge involving income-producing property, real estate taxes are not accounted for at this stage because this is the expense in question. In addition, since the property tax expense is a percentage of market value, it is accounted for in the capitalization rate along with an appropriate rate of return reflecting the risk of investment.

Appeal prospects

How can the taxpayer gauge a tax appeal's likelihood of success? Among other things, consider the size of the rental units, location, competition, and parking to form a reliable value opinion. Give special attention to the tax system in the state and local jurisdiction where the property is located to ensure the taxpayer meets all statutory filing requirements and deadlines. If a challenge is not timely and properly commenced, the aggrieved party will lose its right to real property tax relief for that tax year.

Given the complexity of commercial property valuations and the nuances involved in disputing the correctness of valuation calculations, savvy apartment building owners may benefit by discussing their property's economics with a specialist in real property tax assessment review challenges.