Are property tax appeals the silver lining in today’s market?

There has been no shortage of bad news in the world of commercial real estate in recent months. By shining a light on deficiencies and shortfalls, property owners and asset managers can find the silver lining in the market downturn – using property tax appeals to reduce operating costs and stimulate future revenues.

First, the bad news – challenges for all sectors

As pandemic restrictions eased, it seemed that real estate would rebound as well – but then came the rise of inflation and efforts to combat it through interest rate increases. After a quick rebound in late 2021/early 2022, news reports over the past three quarters have shown sharp declines in transaction volumes and pricing, impacting all market sectors.

The challenges of the office market have been well documented, impacting both the US and Canadian markets, and many others around the globe. Work-from-home, hybrid work, and layoffs in the tech sector have driven office vacancies to an average of 18.6% nationally in the US, and 17.3% in Canada. In particular, class B and C office buildings are struggling to compete, and many may be in need of significant capital investment to renovate or repurpose.

The retail sector is seeing continued strength in needs-based retail (grocery and pharmacy), however mall owners are under continuous pressure to maintain occupancy. Even sectors that have been strong performers, like industrial and multi-family, are facing downward pressure on values as inflation and higher interest rates continue to increase costs.

The combination of softening fundamentals, interest rate volatility and limited price discovery has led to tightening of capital. Banks and other traditional lenders are limiting their exposure to commercial real estate. As deals come up for refinancing, borrowers may find that their net operating income (NOI) no longer cover basic debt service options required to secure financing.

More bad news – property tax appraisals increasing

For the 2023 taxation year, even with all indications that values should be declining, many property tax assessments and appraisals remain unchanged or are actually higher than in previous years. A number of factors may have contributed to this, including:

• Time constraints and legislated valuation dates can mean the assessor is not always able to consider the latest data before final assessed values must be submitted

• Assessors are often wary of overstating losses in value and tend to assume properties will recover in the short term

• Lack of recent transactions may have led to reliance on data that pre-dates the market downturn

• Cost-based valuations have risen with inflation, but may not account for all sources of depreciation including external or economic obsolescence

Appraisals for real property taxes have a legislated valuation date (also called a base date or lien date). In most regions in the US and Canada, the valuation date is January 1 of the taxation year, but it may be July 1 of the prior year, or even several years earlier. The date the tax appraiser is required to finalize the assessed values may be months before the reference date. Because of the timing of the assessment cycle, the assessor may not have considered transactions that occurred in the latter half of the previous year. As a result, many properties across the US and Canada are likely to be paying too much in property tax in 2023.

Tax appraisers often feel pressure to maintain the assessment base – as reducing the total assessment base usually necessitates increasing the tax rate to raise the same amount of revenue. This can lead to a tendency toward excessive optimism. Many assessment regions have treated pandemic revenue losses as short term and assumed that NOIs would stabilize to 2019 levels within a year or two. Value adjustments previously granted to account for pandemic impacts may have been removed.

Tax appraisals and assessments for multi-tenanted properties such as office, retail and multi-family are typically determined using the income approach: capitalization of net operating income. The assessor calculates net income based on market analysis of rental rates, occupancy and operating expense ratios. Capitalization rates are derived from sales of similar properties at or near the valuation date.

The assessor’s calculated NOI may not account for some losses in revenue. As office owners compete to retain or attract tenants, they are increasingly offering inducements such as full turnkey space, or funding of tenant improvements. Similarly, to maintain occupancy levels, retail property owners are increasingly compelled to lease space on gross rents, or percent rent-in-lieu. Assessors may not account for these costs or identify the drop in net effective rents.

With the rise in interest rates and market instability, in Q1 2023 commercial real estate transaction volumes were down by 50-70%. There continues to be a substantial gap between list prices and what buyers are willing to pay, and limited transactions available for analysis. Consequently, most of the sales being used by property tax assessors to determine capitalization rates likely reflect the market before the downturn. If the price paid for a property does not reflect the expected transaction value, assessors may question whether there was undue pressure on the seller.

For healthcare facilities, data centers and other special purpose properties, property tax assessments and appraisals are typically determined using the cost approach. Assessors employ a cost manual, which provides indexed construction costs and depreciation tables. As appraisal texts are careful to assert, however, the cost of a property does not equal its value. It is incumbent upon the appraiser to study the market to prove the correlation between development costs and prices paid to acquire similar property.

In markets where values and costs are steadily increasing, as was the case between 2012 and 2020 in the US and Canada, historically low interest rates resulted in significant equity accumulation as values increased. Rapid cost inflation since 2021, coupled with increased interest rates has turned this model upside down, where market values are trending inversely to costs.

Figure 1 – Cost vs. value when values accelerates

Figure 2 – Cost vs. value when costs accelerate and values are throttled (2023 to current)

As costs begin to exceed value, developments may be halted, or even abandoned. The tax appraiser should examine recent transactions, listings and bids, to identify and quantify all forms of obsolescence.

Now the good news – your bad news could lead to property tax refunds and unlock future revenue potential

With property tax appeals, you can translate your losses into savings. In almost all jurisdictions across Canada and the US, property tax assessments can be challenged each year – through an informal review request, an appeal, contestation or protest, or formal litigation. Through the appeal process, a property tax expert can shine a light on all the deficiencies and shortfalls that may not have been initially evident to the assessor. With application of appraisal techniques to analysis of market and property data, as well as investor surveys, it is possible to determine not only the most probable selling price, but also a value that is equitable with competing properties.

Use of appraisal tools – such as a Band of Investment analysis – can demonstrate the impact of the rise in interest rates on capitalization rates. While this analysis should be supported by market evidence, applying the formula clearly demonstrates a correlation between higher interest rates and higher capitalization rates, equating to lower market values.

Figure 3 – Band of Investment calculation

In a gross lease environment, where the landlord pays the property tax, a property tax reduction will result in a direct increase in NOI, as illustrated below. If leases are net/net, the reduction in costs can stimulate increases in base rents.

Table 4 – Potential impact of property tax reduction on NOI

What are your options?

Use the checklist below to find the silver lining for your investment property.

Assessment notice checklist:

• If your municipality offers online resources, set up an account and download any of your property records

• Determine your appeal deadline – in many cases, the deadline is not a set date, but a certain number of days from the date of the notice

• Check that the description of your property is accurate

• Does the notice indicate whether the value of your property has changed? Can you compare to previous notices?

• Save a copy of your notice in your tax management database

• Forward to a property tax expert for review

Many jurisdictions do not provide a notice if the property has not been reassessed. In most cases, you still have the ability to appeal. Review your previous notice, contact your local assessment authority, or call a property tax expert to discuss your options.