Developers should understand the property tax implications before attempting to repurpose buildings in downtown Washington, D.C.

With office vacancy rates in the District of Columbia at 20% and climbing, officials believe that converting office buildings to residential space is an important component of revitalizing Downtown Washington.

These complex projects pose both practical and administerial challenges, however. For developers, one important consideration of such a redevelopment is its real estate tax implications.

High hopes

District leaders announced earlier this year that they hope to add 15,000 residents to the central business district over the next five years – an ambitious goal. The hope is that bringing residents to live downtown will create a more vibrant neighborhood where people live, work, and dine.

The stark reality is that the District of Columbia has one of the lowest return-to-office rates in the country. Actual occupancy in the D.C. metro was only 43% in mid-April and drops below 25% on Fridays, according to Kastle Systems, which tracks office occupancy. Workers simply aren't returning to Downtown D.C.

While residential conversions may be one piece of the puzzle in addressing D.C.'s downtown woes, converting an office building into a residential property is no small feat. Here are a few important factors relating to real estate taxes to keep in mind when considering an office-to-residential conversion.

Real property tax rates

Real property tax rates in the District vary considerably from residential to commercial real estate. Residential properties, including multifamily apartment buildings, are taxed at a 0.85% rate. The commercial tax rate, which is used for office buildings, is more than double that rate at 1.89% for properties assessed over $10 million.

To the extent a property contains both residential and commercial space, D.C. will apply a mixed-use tax rate based on the pro-rata allocation of residential versus commercial space. Consequently, how the District classifies a property can have an immense impact on tax liability and carrying costs.

Timing of reclassification

A costly misstep would be to assume that the tax rate will immediately change from 1.89% to 0.85% after an office property is acquired for residential conversion. In fact, if there is any commercial use continuing at the building, the commercial tax rate will still apply.

Moreover, the District historically has been inconsistent in its application of when a building should "convert" from commercial to residential for purposes of tax classification. Although the D.C. Code provides a property should be reclassified when there is no current use and the property's highest-and-best use is residential, some assessors have taken a more aggressive approach and argued that the property should not be reclassified until the redevelopment is more than 65% complete.

Property acquisition

An additional hurdle lies in the acquisition process itself. When an office building is acquired for a residential conversion, higher transfer and recordation taxes apply. For commercial and mixed-use properties, the transfer and recordation taxes are 5% of the sale, as opposed to 2.9% for a purely residential building.

The mayor's proposed 2024 budget would allow the higher transfer and recordation tax rate to expire later this year, but the D.C. Council had not adopted the measure at the time of this writing and may or may not allow the higher rate to sunset. Under the current code, there is no exception for the acquisition of an office property that is being purchased for purposes of a residential conversion.

Abatements

Finally, in an effort to spur redevelopment, the mayor has announced her intention to offer tax abatements for office-to-residential conversions that meet certain criteria. At this point, it is difficult to determine the financial implications of the tax abatement program for a specific redevelopment because there is no set formula for deriving the amount of an abatement.

What is known, however, is that there are specific requirements to qualify for the abatements. Among other conditions, these include:

• Affordability. 15% of the housing units must be affordable.
• Location. The redevelopment must be within a specific geographic area.
• Designated contractors. 35% of the construction contract must go to specific business enterprises that have been certified by the District.

These requirements further complicate the already challenging task of successfully executing an office-to-residential conversion.

In short, the real estate tax implications of an office-to-residential redevelopment are highly dependent on the unique facts and circumstances of each case, and the varying tax rates can have huge implications for a property's development budget. A developer considering such a conversion should contact experienced counsel early in the process.

Minnesota Supreme Court affirms decision barring use of airport concession fees in income-based property valuation.

A recent Minnesota Supreme Court ruling requires tax assessors to exclude an airport's concession fees from rent-based valuations for property tax purposes. The case offers a flight plan to lower taxes at many of the nation's transportation hubs, and underscores the importance for all taxpayers to exclude business value from taxable property value.

Every major airfield collects fees from food and beverage providers, retailers, banks and other businesses that provide goods or services on airport property. Concessionaires commonly pay these charges in addition to rent owed for the real estate where they operate. Many of these businesses are also responsible for property tax that passes through to tenants in a commercial lease.

The cases leading up to the March 29 state Supreme Court decision involved two car rental companies that challenged their 2019 tax assessments, claiming the assessor's office had overstated their property values by including the concession fee in its income-based valuation.

High-flying fees

Both Enterprise Leasing Co. of Minnesota and Avis Budget Car Rental pay a concession fee equal to 10 percent of gross revenues in addition to real estate rent for their operations at Minneapolis-St. Paul International Airport. The tax assessor for Hennepin County had historically valued the auto rentals for property tax purposes by including the concession fee in its income-based approach to valuation.

The auto rental companies challenged the valuations on their 2019 taxes in the Minnesota Tax Court. Law firm Larkin Hoffman, which represented both taxpayers, argued that the concession fees are not rent and should not be included in the income approach for property tax purposes.

The rental agencies prevailed in tax court. The court found that the concession fee is not real estate rent and that the county substantially overstated market values by including the fee in its calculations. Correcting the assessor's calculation reduced Enterprise's value from $34.873 million to $21.107 million, or 39 percent less than the initial assessment. Avis' property value dropped 39 percent as well, from $20.565 million to $12.497 million.

The county appealed the tax court's decision to the Minnesota Supreme Court, arguing that the concession fee is rent that must be used in the income approach. The Court affirmed the lower court's decision, however, holding that "the concession fee is not rent for purposes of the income approach."

Fee-simple principles

The rental agencies' case stood on fundamental precepts of fee-simple valuation. Minnesota is a fee-simple property tax state, meaning valuations for property tax purposes must value all property rights as though they are unencumbered.

Additionally, the leased-fee interest, or landlord's rights subject to contractual terms, should not be used for property tax valuations. Per the state Supreme Court, rents attributable to specific leases are disregarded except to the extent they represent market rent. It follows that business income should not be included in valuations for property tax purposes.

Taxpayers doing business at airports across the country often pay concession fees or other charges based on their revenues or business performance. Many states, like Minnesota, require those same properties to be valued on a fee-simple basis, which should neutralize any impact of business value.

In representing the rental car agencies at all stages of their appeal, Larkin Hoffman stressed the importance of these valuation concepts and how the very definition of a concession requires its exclusion from calculations of taxable property value. A concession is a "franchise for the right to conduct a business, granted by a governmental body or other authority," according to the Dictionary of Real Estate. Accordingly, if a concession fee is a payment for the right to conduct business and not for the right of occupancy, then it is a business revenue.

The county argued that because the rental agencies' concession agreements included the phrase for "use of the premises," then the concession must only be for the real estate. However, the tax court found that the concession fee was consideration for access to the airport car rental market rather than the real estate.

The tax court reasoned – and the Supreme Court affirmed – that the concession fee was not for the real estate because:

Concession fees were also paid by off-airport rental car companies, indicating that the fee is a business revenue rather than rent;

Inclusion of the concession fee in the income approach would inflate the value to 10 times greater than the cost approach, which would be clearly unreasonable; and

Inclusion of the concession fee in the county's income approach distorted other inputs.

It is well established that a fee-simple property tax valuation should exclude business value. Now, Minnesota courts have also acknowledged that when a concession fee is for the privilege of accessing the airport market rather than for the real estate, that fee represents business value.

To prevent erroneous inclusion of business value, and since airports are special-purpose properties, the court gave primary weight to the cost approach. With this decision, Minnesota's highest court has confirmed that concession fees are not rent for real estate and instead represent business value that should be excluded from the income approach.

For taxpayers in any jurisdiction that taxes property based on its fee-simple value, the recent decision is a reminder to ensure that assessors are excluding business value when calculating taxable property value. For businesses that also pay concession fees in addition to rent, the Minnesota case may provide an impetus to learn how those fees affect their own property values. And if those inquiries spur taxpayers to appeal their assessments, then the Minnesota case law may provide a valuable example and support for their arguments.

The American Property Tax Counsel is proud to announce that Chicago, Illinois will be the site of an in-person meeting for the 2023 Annual APTC Client Seminar.

Save the Dates! October 11-13, 2023 - Fairmont Chicago, Millennium Park - Chicago, Illinois

THEME - Valuation on the Cutting Edge: Utilizing Data in an Evolving Market

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.

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A guide to effectively challenge and reduce bloated tax valuations.

Nobody enjoys paying property taxes, especially when a property is over-valued. Single-tenant, net-leased properties seem especially prone to inconsistent and unfair assessments.

But challenging those valuations can be exhausting in a time when assessors are fearful and obsessed with the dreaded "Dark Store Theory." They vehemently oppose using sales of vacant properties to value their jurisdiction's store, the one with the full parking lot.

How can the taxpayer shut down the hype and bring the assessor back to the table for a reasonable negotiation? Well, that depends. Here are essential points to consider in forming a protest strategy.

Know Your State's Value Standard

Common sense tells us an appraiser must know what they are valuing before they value it. Yet, the failure to identify the property rights being valued often causes disagreement and confusion in tax appeals. These misunderstandings commonly hinge on the difference between fee-simple and leased-fee value.

The fee-simple estate of an income-producing property is essentially the value of the net income stream based on market-level rents, expenses and other variables. If the property benefits from a long-term, above-market lease, that revenue is irrelevant to the fee-simple value.

Before I finished that last paragraph, my phone rang. The caller was outraged because an assessor revalued his property at its recent purchase price. The property was clearly not worth what the taxpayer paid for it, he said, because the price was based on a net lease.

Maybe. Maybe not.

Before the caller purchased his property, it was exposed to the open market for willing buyers to make offers to the willing seller. The competitive process culminated in an arm's-length sale reflecting market value. How is that not what the property is worth?

That brings us to the second value standard, the leased-fee estate, which is essentially the value of the income stream from the actual lease in place. The caller's purchase price was exactly what the property's leased fee was worth.

So, before getting angry with assessors for relying on leased-fee sales, taxpayers should learn which property rights their state is valuing for taxation. If the state values the leased-fee rather than fee-simple estate, the taxpayer may not have a basis to complain.

Sales Won't Sell It

The "Dark Store Theory" is the term assessors apply to the use of vacant property sales in valuing occupied properties. From an appraisal theory standpoint, only vacant sales are appropriate for valuing the fee-simple interest in a leased property, because sales of leased properties exclude the right of occupancy, an essential right within the fee-simple estate.

This appraisal standard should be a boon to taxpayers challenging inflated assessments on leased properties. It's great to be right, but there's a problem. Using vacant buildings to value occupied buildings is a very tough sell to a tax panel, appeals court or other arbiter. The decision-maker's gut will turn.

Huge tax reductions have been achieved using vacant sales, so it can be done. It is spectacular in the moment, but legislatures and higher judicial bodies are likely to respond negatively. Legal victories that inflame assessors and politicians are not stable long-term solutions.

What About The Cost Approach?

Cost doesn't equal value, but sometimes estimating a newer property's replacement cost less depreciation is a good test of whether an assessment is reasonable. A cost calculation may support a value reduction, so it is worth considering in a protest strategy.

A common problem with the cost approach in net-lease tax appeals is the conspicuous difference between cost-based value conclusions and those based on income or comparable sales. If the property can't be leased or sold at a rate of return that supports its depreciated cost to build, the numbers will not line up, because there is obsolescence to account for. The decision-makers that hear tax cases dislike big obsolescence deductions, especially if the taxpayer quantifies those deductions using vacant property sales.

Many assessors use cost systems for mass appraisal, so understanding how the local system was developed is helpful. Sometimes assessors use base cost data purchased from third-party services and then tweak that information before entering it in their own systems. Tweaks can involve stretching out the useful life of properties in the source data to unreasonable lengths, or bumping default grades used for certain building types from, say, "average" to "good." Little modifications add up and may be solely to increase tax revenue.

Market Rent Is King

In a fee-simple system, a good way to approach a net-lease tax appeal is with the income approach. All net-lease properties are leased, meaning they produce income. It isn't hard for an assessor to convince a decision-maker in a tax case that the property should be valued by capitalizing its income.

The most crucial element of a fee-simple income approach is the market rent. To win a net-lease tax appeal based on income, the taxpayer must prove this one thing.

"But there is no market rent for my property type," the taxpayer says. "What am I supposed to use for rent?"

That's a real issue, because net leases almost always seem to be the product of a build-to-suit or sale-leaseback transaction, with no regard for the local market. So, how can the taxpayer prove market rent?

Go for Broker

Consider this: Commercial real estate brokers are opinionated about their markets. They know rent because it's how they feed their families. They can speak with credibility about the rent a building would command on the open market. Nobody knows market rent better, and they make powerful rebuttal witnesses who keep any off-base testimony by the assessor in check.

A broker can also be a helpful resource for the taxpayer's appraiser. They can point to meaningful, sometimes hidden information.

The combination of an appraiser's formal analysis with a broker's testimony about realistic market rent is potent and convincing evidence in a tax appeal.

Let's Be Reasonable

As the taxpayer's protest strategy takes shape, subject it to the old "reasonable man" standard.

Would a reasonable decision-maker look at the taxpayer's long list of vacant properties, compare it with the subject property that is open and thriving, and feel good about reducing the value?

Would a reasonable decision-maker look at an income approach based on a reasonable expectation of market rent for the subject building and feel good about reducing the value?

Pushing for the former may be zealous advocacy, but appearing unreasonable to both assessor and decision-maker is unhelpful. And even a victory, if it smells like overreaching, risks a legislative response. Resolving a net-lease tax appeal using a reasonable income approach is a superior long-term strategy.

Legal covenants often cause excessive property taxation for mall owners that are looking to redevelop.

Repurposing malls and anchor stores is a popular topic in community development circles, but legal restrictions make redevelopment extremely difficult. Often locked into their original use by covenants, malls and anchor stores are often grossly over-valued for property tax purposes. In pursuing a redevelopment, taxpayers should ensure the properties are fairly assessed and taxed.

Debilitating obsolescence

It is difficult to overstate the plight of malls and anchors. Gone are the halcyon days when the mall was everyone's shopping destination. There is even a website, deadmalls.com, devoted to failed malls. Credit ratings of most anchor store operators have fallen below investment grade. Commentators usually blame the retail apocalypse on ecommerce and shifting consumer spending habits.

COVID-19 exacerbated these trends and mall foot traffic has been slow to recover. Some chains, including Neiman Marcus and JCPenney, filed bankruptcy. Ecommerce volume surged in 2020 and 2021 before tapering in 2022. Ecommerce and brick-and-mortar sales have not yet reached an equilibrium.

One in five American malls have fully closed and remain "zombies" without a redevelopment plan, estimates Green Street Advisors, a commercial real estate analytics firm. A December 2022 Wall Street Journal article describing the "long death" of the White Plains Mall noted there is no shortage of dying malls. The article observed that converting enclosed shopping centers to other uses remains a "difficult feat." Repurposing, while much discussed, has not really happened.

The question is why. The answer relates, at least in part, to legal challenges inherent in changing the property's use.

Tied hands

Any property valuation begins with a highest and best use analysis. A basic assumption about real estate directs that the price a buyer will pay reflects that buyer's conclusions about the property's most profitable use. Competitive forces within the local market shape a property's highest and best use, but that use must reflect practical and legal restrictions.

Many people incorrectly assume that governmental requirements pose the only legal restrictions on use. Zoning ordinances may impose barriers, owners of neighboring properties may object to redevelopment proposals, or there may be other hinderances to changing the property's use.

Zoning limitations pale in comparison to restrictions in recorded easements and unrecorded operating agreements between mall owners and anchor department stores. While zoning may permit non-retail uses, private agreements generally do not.

Malls would be economically unfeasible without department stores and inline stores that symbiotically drive traffic to each other. Generally, anchors own their pads and inline tenants lease space from the mall owner. A typical mall is subject to two levels of private restrictions designed in an earlier day to promote the efficient functioning of the mall for retail stores.

Recorded operating restrictions or restrictive easement agreements (REAs) impact the entire mall and its anchors and are generally binding for 40 years or longer. Typically, substantive amendments to the REA require the consent of all parties, and their economic interests are not always aligned.

Unrecorded operating agreements govern the relationship between individual anchors and the mall owner. Terms typically address tenancy, hours of operation, required years of operation under a specified tradename and the size of each anchor and the mall. Operating agreements also generally restrict the size and construction of improvements on the anchor pad and regulate usage.

A simple example involves anchors using stores as a delivery point for ecommerce, a concept known as buy online, pick up in store (BOPIS). Many REAs and operating agreements severely limit implementation of this concept.

But what if the mall's highest and best use is no longer retail? Ecommerce and changed consumer practices undermine the REAs' and operating agreements' ability to ensure the property's success, but those private agreements are understandably focused on preserving retail usage.

The common party to these agreements is the mall owner, making the mall owner the logical purchaser when an anchor looks to sell. The potential economic return on any proposed redevelopment must be sufficient to encourage an entrepreneur to take the redevelopment risk for the mall and/or anchors.

Legal risk escalates the economic risk. For example, owners of some anchor properties seek conversions to multifamily or industrial use as salvation from the retail apocalypse. Even if they overcome zoning objections, attempts to change REAs and unrecorded operating agreement restrictions may require unanimous consent among owners with competing economic interests.

The anchor pad may not even be worth its unimproved land value since its use is restricted under the REAs and operating agreements to retail.

Property tax implications

While mall owners and anchors struggle to remain viable in the changed retail environment, ad valorem property taxes pose an immediate challenge. Most states value property as what a willing buyer would pay to a willing seller, but the pre-ecommerce glory of malls and anchors generally encourage high property tax valuations.

Assessors performing an income-based assessment seldom recognize how anchor chains' plunging credit ratings affect value. The sales-comparison approach is equally challenging, as anchor property transaction volume has plummeted since 2006.

Most sales involve a change to non-retail use and thereby require unanimous consent. Consent is easier to obtain when the new use increases foot traffic to the remaining inline tenants and anchors, but it is easy to envision anchors holding the process hostage in an attempt to force the purchase of their failing stores.

REAs and unrecorded operating covenants make calculation of an anchor's value extremely difficult. They also call into question the comparability of previous transactions to repurpose anchors in the same mall, since those anchors may have agreed to one specific new use but may object to another.

REAs and operating agreements often hamstring mall and anchor redevelopment. Most were signed before ecommerce and did not envision retail losing its vitality. The parties to these covenants often have divergent economic interests and perspectives, and the natural party to lead redevelopment – the mall owner – must overcome these hurdles. In the short term, however, owners should address highest and best use with assessors to reduce property tax burdens until the zombie can be brought back to life.

Tennessee's appeal process allows Nashville taxpayers to challenge the complicated assessment of new construction.

Over the past decade, Nashville has enjoyed a baffling explosion of growth that sent cranes shooting up all over the city, festooned with developer names like Bell, Clark and Giarratana. Highrise towers of glass and steel rose out of the old rail yards like the emerging monolith in the opening scene of "2001: A Space Odyssey" multiplied in a funhouse mirror.

The Metropolitan Government is eager to add new projects to its tax rolls, and its Assessor of Property decides when and how that happens. The assumptions made by the Assessor's office about a project's cost and timing dictate how quickly and how much a new building is taxed. So, as always, taxpayers need to keep an eye on what the assessor is doing.

The assessor's difficult job has become even more complicated in the post-COVID quagmire of supply chain failures. Twelve-month projects have stretched into 24-month projects, and the assessor's assumptions about completion times have been thrown out of whack. To make matters worse, Tennessee's property tax statutes were not designed to give relief for construction delays or lengthy projects, and the clock is ticking.

New Construction Assessed at Material Cost

The last Davidson County reappraisal was in 2021, and the next will be in 2025. Normally, the assessor's values remain unchanged over the four-year cycle, but new construction is an exception to that rule.

Under the statute for assessing projects under construction, if a new improvement is partially complete on Jan. 1, the assessor is to value the property for that year at land value plus the cost of materials used in the improvement as of that date. This materials-only value favors taxpayers because it excludes labor costs.

The construction documents that are generally accepted as evidence of project costs do not typically segregate labor versus material costs, however. Those costs are most often listed as combined totals, making the exact material costs difficult to determine.

One example from a recently reviewed document described work that included a $279,000 line item for "caulking." Unless labor and materials are both included in that number, that's a heck of a lot of white goop! Rather than demand proof of exact material costs, assessors will sometimes allocate material costs based on a pre-established rule of thumb.

Substantially Complete?

Now for the tricky part. The new construction statute allows assessors to pick up new improvements after Jan. 1, so long as the structure is "substantially complete" prior to Sept. 1 that same year. So, for example, if a building is 50 percent complete at Jan. 1 and 100 percent complete at Sept. 1, the assessor will prorate at the 50 percent value for eight months of the year, and at the 100 percent value for four months of the year. If the improvements are not "substantially complete" by Sept. 1, the assessor must wait to pick up the as-complete value in the following year.

Tennessee has no statutory definition of "substantially complete" for purposes of adding the full value to the tax rolls, but cases make it clear that tenant finish-out and certificates of occupancy are not required. In the absence of simple, objective standards for completion, assessors make subjective judgments about completion that may not favor the taxpayer. Taxpayers can challenge those judgments through an administrative appeal.

Adding Insult to Injury

Under Tennessee law, new improvements may not be valued as incomplete for more than one year after construction began. Now, your immediate reaction might be, "That's ridiculous! How can you value an incomplete property as complete just because it took longer than 12 months to construct!?"

The assessor in Davidson County has taken the position that the statute prevents them from using the taxpayer-favorable, materials-only value in the second year a property is incomplete. They will likely still use the cost approach to determine the appraised value but add back the cost of labor that was taken out in the first year, greatly increasing the tax burden before the property is generating income. The legislature has not acted to provide relief from this further insult to developers already injured by increasingly protracted construction timelines.

The Good News

Tennessee assessors are only authorized to reassess a property at specific times, but taxpayers can appeal the assessor's Jan. 1 value of Nashville property to the Metropolitan Board of Equalization every year. If the assessor issues a prorated assessment for a new construction project later in the year, the taxpayer can appeal that value directly to the State Board of Equalization.

In light of the complexity of Tennessee's law on the assessment of new construction, owners of new projects in Nashville should seek counsel as to whether their assessments are fair and legal and avail themselves of the right to appeal if appropriate.

The 'work from home' revolution has devastated office building values.

Of all the property types, office buildings may wrestle with the pandemic's damaging consequences the longest.

The fallout from COVID-19 will clearly have a lasting economic impact. During the government-mandated shutdowns, businesses — including brick-and-mortar retail stores, restaurants, movie theaters and gyms — suffered tremendous losses.

With everyone except first responders and essential workers stuck at home, office occupancy rates plummeted as business districts, commercial developments, roads and public gathering places emptied. Many companies could not survive the shutdowns and were forced to lay off employees or permanently close their doors.

During the throes of the pandemic, companies that remained in business were compelled to adapt and learn how to effectively put their employees to work from home. Virtual meetings eventually became commonplace and routine. Then as the pandemic waned, companies began to demand that employees return to the office. While some workers ventured back to the workplace, many expressed a desire to continue to work from home.

This widespread sentiment has persisted. In fact, nearly 40 percent of workers would rather quit their jobs than return to the office full-time, and more than half would take a pay cut of 5 percent or more to retain their workplace flexibility, according to a recent survey by Owl Labs.

Given the tightening job market and the need to retain workers, many companies complied with employees' demands and either permitted them to work remotely or allowed hybrid arrangements. Little did these employers know that allowing employees to work from home would have a profound effect on the appraisal of office buildings for property tax appeal purposes.

Office valuations suffer

Property taxes are the largest single expense for most office landlords, and most property taxes in the United States are ad valorum, or market-value based. In other words, higher-valued properties have greater property tax levies. Therefore, property owners frequently file tax appeals to reduce this expense.

In the context of a real property tax appeal, the valuation of office buildings can be complex. Typically, an arms-length or comparable sale is the best evidence of value in a tax appeal proceeding. Since there aren't many arms-length purchases of single office buildings today, they are commonly valued by capitalizing the property's rental income stream minus property-based expenses. As a result, the actual rents collected are critical to the building valuation.

And rents have suffered. The mass exodus from office buildings to remote locations significantly lessened the demand for dedicated office space. With employees working remotely, many companies have realized they can function as well as before while occupying much less space. Thus, as leases expire, the tenants that choose to renew their leases are requesting a much smaller footprint with lower overall rents.

Compounding the decreased demand for office space, building expenses have skyrocketed. Rapid inflation has helped to propel insurance and general property maintenance costs, which have surged upward by more than 15 percent since 2020. Furthermore, lingering COVID-19 health concerns have led to enhanced cleaning protocols and upgraded air filtration systems, which have likewise raised building expenses.

Simultaneously, the Federal Reserve has raised interest rates to combat inflation. These higher interest rates, meanwhile, have further reduced property values by increasing the cost of financing. Mortgage interest rates and the risks on the equity side have also increased. This has a negative effect on the market valuation of office buildings as higher capitalization rates generate much lower appraised market values.

Challenge unfair assessments

Altogether, reduced office space demand, weakened cash flows, higher building expenses and rising interest rates do not bode well for the U.S. office sector. Landlords are being forced to offer concessions such as free rent or are paying for extensive interior buildouts to attract tenants.

This large shift in lease renewal rates, occupancies, expenses and capitalization rates have produced the equivalent of the four horsemen of the apocalypse for office building valuations, driving property tax appeals and raising a distinct possibility that many office buildings will become stranded assets. Experience indicates these changes can result in a 10 percent to 30 percent drop in market value from pre-pandemic levels.

A good rule of thumb would be that if a building's net operating income has dropped, the real estate tax levy should go down correspondingly. Most municipalities, however, have not reduced assessments to reflect the economic downturn.

Consequently, now more than ever, property owners must be vigilant to avoid paying excessive property tax bills. Conferring with experienced counsel, questioning assessors' property valuations and challenging tax assessments will help to ensure an office building's current real property taxes are based on this new valuation reality.

Legal covenants often cause excessive property taxation for mall owners that are looking to redevelop.

The repurposing of malls and anchor stores is a popular topic in community development circles, but legal restrictions make redevelopment extremely difficult. Often locked into their original use by covenants, malls and anchor stores are often grossly overvalued for property tax purposes.

In pursuing a redevelopment, taxpayers should ensure the properties are fairly assessed and taxed.

Debilitating obsolescence

It is difficult to overstate the plight of malls and department store anchors. Gone are the halcyon days when the mall was everyone's shopping destination. There is even a website, www.deadmalls.com, devoted to failed malls. Credit ratings of most anchor store operators have fallen below investment grade. Commentators usually blame the retail apocalypse on e-commerce and shifting consumer spending habits.

COVID-19 exacerbated these trends and mall foot traffic has been slow to recover. Some chains, including Neiman Marcus and JCPenney, have filed bankruptcy. E-commerce volume surged in 2020 and 2021 before tapering in 2022. To date, e-commerce and brick-and-mortar sales have not yet reached an equilibrium.

One in five American malls have fully closed and remain "zombies" without a redevelopment plan, estimates Green Street Advisors, a commercial real estate analytics firm. A December 2022 article from The Wall Street Journal that detailed the "long death" of the White Plains Mall noted there is no shortage of dying malls. The article observed that converting enclosed shopping centers to other uses remains a "difficult feat." Repurposing, while much-discussed, has not really happened.

The question is why. The answer relates, at least in part, to legal challenges inherent in changing the property's use.

Tied hands

Any property valuation begins with a "highest and best use" analysis. A basic assumption about real estate directs that the price a buyer will pay reflects that buyer's conclusions about the property's most profitable use. Competitive forces within the local market shape a property's highest and best use, but that use must reflect practical and legal restrictions.

Many people incorrectly assume that governmental requirements pose the only legal restrictions on use. Zoning ordinances may impose barriers, owners of neighboring properties may object to redevelopment proposals, or there may be other hinderances to changing the property's use.

Zoning limitations pale in comparison to restrictions in recorded easements and unrecorded operating agreements between mall owners and anchor department stores. While zoning may permit non-retail uses, private agreements generally do not.

Malls would be economically unfeasible without department stores and inline stores that symbiotically drive traffic to each other. Generally, anchors own their pads and inline tenants lease space from the mall owner. A typical mall is subject to two levels of private restrictions designed in an earlier time period to promote the efficient functioning of the mall for retail stores.

Recorded operating restrictions or restrictive easement agreements (REAs) impact the entire mall and its anchors and are generally binding for 40 years or longer. Typically, substantive amendments to the REA require the consent of all parties, and their economic interests are not always aligned.

Unrecorded operating agreements govern the relationship between individual anchors and the mall owner. Terms typically address tenancy, hours of operation, required years of operation under a specified tradename and the size of each anchor and the mall. Operating agreements also generally restrict the size and construction of improvements on the anchor pad and regulate usage.

A simple example involves anchors using stores as a delivery point for e-commerce, a concept known as buy online, pick up in store (BOPIS). Many REAs and operating agreements severely limit implementation of this concept.

But what if the mall's highest and best use is no longer retail? E-commerce and changed consumer practices undermine the REAs' and operating agreements' ability to ensure the property's success, but those private agreements are understandably focused on preserving retail usage.

The common party to these agreements is the mall owner, making it the logical purchaser when an anchor looks to sell. The potential economic return on any proposed redevelopment must be sufficient to encourage an entrepreneur to take the redevelopment risk for the mall and/or anchors.

Legal risk escalates the economic risk. For example, owners of some anchor properties seek conversions to multifamily or industrial use as salvation from the "retail apocalypse." Even if they overcome zoning objections, attempts to change REAs and unrecorded operating agreement restrictions may require unanimous consent among owners with competing economic interests.

The anchor pad may not even be worth its unimproved land value since its use is restricted to retail under the REAs and operating agreements.

Property tax implications

While mall owners and anchors struggle to remain viable in the changed retail environment, ad valorem property taxes pose an immediate challenge. Most states value property as what a willing buyer would pay to a willing seller, but the glory of malls and anchors before e-commerce generally encourage high property tax valuations.

Assessors performing an income-based assessment seldom recognize how anchor chains' plunging credit ratings affect value. The sales-comparison approach is equally challenging, as anchor property transaction volume has plummeted since 2006.

Most sales involve a change to non-retail use and thereby require unanimous consent. Consent is easier to obtain when the new use increases foot traffic to the remaining inline tenants and anchors, but it is easy to envision anchors holding the process hostage in an attempt to force the purchase of their failing stores.

REAs and unrecorded operating covenants make calculation of an anchor's value extremely difficult. They also call into question the comparability of previous transactions to repurpose anchors in the same mall, since those anchors may have agreed to one specific new use but may object to another.

REAs and operating agreements often hamstring mall and anchor redevelopment. Most were signed before e-commerce and did not envision retail losing its vitality. The parties to these covenants often have divergent economic interests and perspectives, and the natural party to lead redevelopment — the mall owner — must overcome these hurdles.

In the short term, however, owners should address highest and best use with assessors to reduce property tax burdens until their zombies can be brought back to life.

J. Kieran Jennings was quoted in the December 14 digital issue of the Wall Street Journal's Property Report, Page B6, titled, "Falling Building Values Spur Tax Appeals." 

Mr. Jennings is a partner in the law firm Siegel Jennings Co., L.P.A, the Ohio, Illinois and Western Pennsylvania member of American Property Tax Counsel (APTC), the national affiliation of property tax attorneys. 

Fighting for laws that produce equal, uniform taxation best serves taxpayers and state governments.

It has been said that the people who complain about taxes can be divided into two classes: men and women. While we all complain, taxes ensure various levels of government have funds to perform essential functions—to keep society civil and in, more or less, working order.

A tax must be fair to be supported, however. In countless instances, a taxpayer's first complaint about an assessor's valuation is that the amount exceeds their neighbors' valuations. In essence, the property owner claims that the property valuation and resulting tax liability is unfair or non-uniform.

Too many jurisdictions lack an efficient mechanism to address non-uniform taxation. Fortunately, several states specifically require tax uniformity, and two offer legal remedies to help taxpayers combat unfair assessments.

A constitutional concept

Most taxing jurisdictions seek to assess real property at market value, which is the amount the property might sell for as of a certain date. Many states even address the legal requirements of taxation in their governing documents.

Ohio's constitution, for example, requires that "Land and improvements thereon shall be taxed by uniform rule according to value." Virginia's constitution states: "All taxes shall be levied and collected under general laws and shall be uniform upon the same class of subjects within the territorial limits of the authority levying the tax."

• Washington's constitution necessitates that all taxes shall be uniform upon the same class of property within the limits of the assessor's authority, while Missouri's constitution requires that assessments must be based upon market value and be uniform.

• That all four of these sampled constitutions mention the importance of taxation uniformity underscores the importance of the concept. Taxpayers seeking an effective model for opposing an assessment on the basis of unequal treatment can look to two other states: Texas and Georgia.

Ready remedies

Texas and Georgia have taken great strides in establishing the methods to ensure property assessments meet their constitutional goals of equal and uniform taxation. Both states empower taxpayers by setting out specific steps to show an overvaluation. Taxpayers in these jurisdictions are assured the right to have their property assessed for taxation in a uniform and equal manner when compared to nearby comparable properties.

In Georgia, a property owner can challenge an assessor's valuation of their real property based on uniformity.The state's standard appeal forms have a box to check as to whether the appeal is being filed based on value, taxability or uniformity.

Under a 1991 Georgia case, Gwinnett County Board of Tax Assessors vs. Ackerman/Indian Trail Association Ltd., a property owner who can show that numerous similar properties in the same area and county have lower assessed values can use that information as grounds to advocate for a lower assessed value.

Texas property owners can challenge an assessor's valuation by arguing there has been an unequal appraisal.Texas property owners in this position can file a protest if they believe the property is taxed at a higher value than comparable properties.

To prevail in seeking a lower valuation, the property owner can submit sale or appraisal evidence. Alternatively, the taxpayer can prevail by showing their assessed valuation exceeds the median appraised value of a reasonable number of appropriately adjusted comparable properties.

In a 2001 case, Harris County Appraisal District vs. United Investors Realty Trust, a Texas appeals court found that when there is a conflict between taxation at market value and equal and uniform taxation, equality and uniformity prevail. This means it is more important that taxes be equally and uniformly imposed and collected than it is to arrive at the property's market value when the "corrected" value makes the property a taxation outlier in its competitive set.

A pervasive need

For sure, a tax assessor's job of valuing all land and improvements is daunting, and they must use many data points and much subjectivity to assess values. Given the scope of their job, mistakes in valuation will occur—especially if the valuation incorporates inaccurate data regarding gross building area, square footage, age, condition or other variables.

Because mistakes are inevitable, property tax systems must provide taxpayers with efficient and effective methods of challenging overvaluations. All jurisdictions provide taxpayers the right and some mechanism to contest the assessor's valuation through an administrative and/or judicial process. This procedural right gives taxpayers a means to correct apparent overvaluations and to seek fairness—or at least it provides the opportunity to argue for fairness.

Taxpayers' pursuit of that procedural right most often revolves around valuation and ignores the constitutional requirement of uniformity. Or worse, the available procedure conflates uniformity with valuation by stating that if the assessed value reflects market value, that equates to uniformity. This thinking is only accurate in theory, as achieving market value assessments for all is aspirational but elusive.

If taxpayers in every jurisdiction could argue a solution along the lines of Texas' defense, it would ensure uniform and equal taxation for all.

Many times, an appeal board hearing a valuation complaint will require either evidence of a recent sale of the subject property or an appraisal report before it will adjust an assessor's valuation. However, sales are often unavailable and appraisal reports can be expensive. Given the cost of appraisals, owners of lower value real estate must often weigh cost versus potential tax savings before deciding whether to hire an appraiser and contest an unfair assessment.

Fairness across the assessor's jurisdiction must be the paramount goal. The defenses or means of redress provided by Georgia and Texas are vital to ensure that taxpayers have access to a constitutionally mandated equal and uniform valuation. These statutory provisions provide a cost-effective method for taxpayers to challenge an overvaluation.

Constitutions that provide an equal and uniform defense give taxpayers fair and equitable access to assessors' valuation systems and promote equal and uniform taxation. Expanded taxpayer access and improved assessor responsiveness promotes trust in government.

Every jurisdiction should follow these examples to provide taxpayers an equal and uniform defense.