Valuing Leased Property for Property Tax Review

Although the tax rates and the fractional ratio of assessed value to full value set by the assessing jurisdiction may be challenged, the most common challenge by an individual taxpayer is a challenge to the full value ascribed to the property by the assessing jurisdiction. All other variables remaining the same, a reduction in the property's value will result in a corresponding reduction in its assessed value, and therefore in the tax levied against it. (Keep in mind, however, that if a substantial portion of the properties within a taxing jurisdiction receive reductions, that taxing jurisdiction's tax base has been lowered. Assuming their fiscal needs stay the same, the tax rate would then need to be increased in order to collect the same monies. In that case, even though their assessments have been lowered, those properties with reduced assessments may not see a corresponding decrease in taxes.)

How Market Value is Determined

Determining the fair market value of a property depends on many factors ' location, actual and potential legally permitted uses, layout, age, condition, amenities, and desirability in the rental and/or sales market ' to name just a few. The importance of these various factors will vary depending on the type of property and the supply and demands of the market as of any specific date in time. The same property can also have different values to different purchasers. For example, a prospective user/purchaser may be willing to pay a different price from that of a purchaser who is buying the same property for resale or investment. The market value of a property in its existing use and condition could very well be different from a property's 'highest and best use' ('potential' use) because a buyer of the property for its existing use may not be willing to pay as much as a purchaser who intends to develop the property in what he/she expects to be a more profitable way.

Property is generally valued in its existing use for property tax purposes as of a particular date each year known as the taxable status date. The three primary valuation methods used for property tax valuation are the sales, cost, and income approaches to value.

When dealing with most commercial properties for which there is a rental market (regardless of whether that particular property is actually leased or not), the income approach to value is the preferred approach. Although the sales approach will theoretically provide the best evidence if there are current sales available, there are generally so many variables affecting a sale, it can become less reliable than the income approach. The income approach is predicated on valuing the property from an investor/purchaser's point of view, ie, what type of return can be expected from this property. This is done by ascertaining the amount of income the property can generate after considering the achievable rents, less the property's operating costs and then deriving the rate of return that an investor would expect to receive on his/her investment, and capitalizing the property's net income into a present day value. For example, if a property generated $100,000 in net income, and an investor would expect a 10% return on his investment, he would be willing to pay $1,000,000 ($100,000 ' 10%) for that property for investment purposes. The selection of an appropriate capitalization rate is affected by market conditions, the type of property involved and the relative risk of that investment.

In order to employ the income approach, therefore, one must be aware of the actual income and expenses being generated at the property as well as the general rental market for similar properties, and be able to derive the appropriate capitalization rate to be used in arriving at a present value. Rental income established by leases entered into as of the taxable status date is certainly good evidence of the rental value of the property. However, if there are older leases, or renewal leases in place, or if the leases were executed between related entities, they may not be indicative of the current rental market for that property. Therefore, actual leases of a property must be tested against the market to see if they are truly economic as of the taxable status date at issue.

As a result, the income ascribed to a property for property tax purposes is not necessarily the actual income being achieved at the property. For this reason, the value of property for property tax review may not always be the same as its value in the market. For example, if a property is encumbered by a long-term lease favorable to the tenant, the owner may complain that his actual income is lower than should be expected, and, therefore, he should be entitled to a reduction in his property's value for tax purposes. An investor looking to purchase this property would want to pay less due to its being encumbered by a long-term lease at a low rent. In this instance, however, the property's value for property tax purposes may be higher than its value in the market, because the below-market lease may be rejected and an economic rent substituted for valuation purposes. Conversely, a lease that has become above-market due to escalations or renewal terms set at a time when market expectations were higher than what they ultimately came to be, would also be rejected in favor of the current market rents, thereby giving that property a value for taxation purposes below that indicated by its actual reported income.

Leases entered into between related entities or owner-occupied spaces may likewise be subject to a market rental analysis, regardless of the actual rent being generated, as these rental levels are often not indicative of true market rent. In addition, a property with vacancy rates in excess of an average vacancy rate for that type of property would be rejected, and an economic rent, less a current vacancy factor would be used to arrive at its value for taxation purposes. (Obviously, a vacant building, even if it shows no income whatsoever, is not worth '0,' either in the market or for tax purposes, although an owner would love to see its taxes tied to its income that directly so that if there were no income there would be no taxes!)

The expenses taken to offset the gross income and arrive at the net income to be capitalized must be analyzed in a similar manner. The actual expenses, if reasonable and comparable to the operation of similar properties, will be adopted. If there is an aberration ' either indicating too high or too low an expense ' it will be rejected in favor of expenses derived from comparable data as well.

This analysis is part of an appraisal process and is most accurately and effectively performed by a qualified real estate appraiser. In fact, the proof of a property's value in the trial of a tax review proceeding is dependent on a professional appraiser's report and testimony and becomes primarily a 'battle of the experts' between the municipality and property owner's respective appraisers. Because appraising property is not an exact science, there is often much room for disagreement as to the appropriate rent, expenses, and capitalization rate to be applied to a particular property. However, when initially determining the likelihood of success in a tax review, the more accurate information available as to the various components of this analysis, the better able the taxpayer will be to predict its outcome.

Dale Allinson is a partner in the real estate tax certiorari and condemnation practice group at Certilman Balin Adler & Hyman, LLP in East Meadow, New York.

When a taxpayer commences a real property tax review proceeding, his/her focus is on the bottom line ' the amount of the real estate taxes paid on that property and getting them reduced. These bottom-line taxes are, however, the end product of a multistep process that ultimately results in the tax bill issued for that property.

Working backward, the taxes billed are the result of the property's assessed value multiplied by the appropriate tax rates set by the various taxing jurisdictions within which a property is located. The tax rates are derived from that taxing jurisdiction's total budgetary requirements divided into the total taxable assessments available for taxation within that jurisdiction. For example, if a school district funded totally by property taxes requires a budget of $1 million and the assessments of the properties within its jurisdiction total $2 million then for each $1 of assessment, the school district would need to collect 50 cents in taxes. Consequently, if the budget stays the same but the overall taxable assessments within the jurisdiction are increased or decreased, the tax rate is affected inversely, although the total tax dollars collected remain the same.

Under an ad valorem tax system, the formula used to determine a property's share of the tax burden must reflect the value of that property in order to be constitutionally valid. In some jurisdictions, assessments are set at 'full value' so that the assessment is equal to the property's value as of a particular date. In that case, a property worth $250,000 would carry an assessment of $250,000. Full value for assessment purposes has been determined to mean market value, ie, what a willing buyer would pay a willing seller. Assessments may also be based on a uniform fraction of the property's full value. For example, if properties in an assessing jurisdiction are to be assessed at 10% of full value, that $250,000 property's assessment should be $25,000.

Although the tax rates and the fractional ratio of assessed value to full value set by the assessing jurisdiction may be challenged, the most common challenge by an individual taxpayer is a challenge to the full value ascribed to the property by the assessing jurisdiction. All other variables remaining the same, a reduction in the property's value will result in a corresponding reduction in its assessed value, and therefore in the tax levied against it. (Keep in mind, however, that if a substantial portion of the properties within a taxing jurisdiction receive reductions, that taxing jurisdiction's tax base has been lowered. Assuming their fiscal needs stay the same, the tax rate would then need to be increased in order to collect the same monies. In that case, even though their assessments have been lowered, those properties with reduced assessments may not see a corresponding decrease in taxes.)

How Market Value is Determined

Determining the fair market value of a property depends on many factors ' location, actual and potential legally permitted uses, layout, age, condition, amenities, and desirability in the rental and/or sales market ' to name just a few. The importance of these various factors will vary depending on the type of property and the supply and demands of the market as of any specific date in time. The same property can also have different values to different purchasers. For example, a prospective user/purchaser may be willing to pay a different price from that of a purchaser who is buying the same property for resale or investment. The market value of a property in its existing use and condition could very well be different from a property's 'highest and best use' ('potential' use) because a buyer of the property for its existing use may not be willing to pay as much as a purchaser who intends to develop the property in what he/she expects to be a more profitable way.

Property is generally valued in its existing use for property tax purposes as of a particular date each year known as the taxable status date. The three primary valuation methods used for property tax valuation are the sales, cost, and income approaches to value.

When dealing with most commercial properties for which there is a rental market (regardless of whether that particular property is actually leased or not), the income approach to value is the preferred approach. Although the sales approach will theoretically provide the best evidence if there are current sales available, there are generally so many variables affecting a sale, it can become less reliable than the income approach. The income approach is predicated on valuing the property from an investor/purchaser's point of view, ie, what type of return can be expected from this property. This is done by ascertaining the amount of income the property can generate after considering the achievable rents, less the property's operating costs and then deriving the rate of return that an investor would expect to receive on his/her investment, and capitalizing the property's net income into a present day value. For example, if a property generated $100,000 in net income, and an investor would expect a 10% return on his investment, he would be willing to pay $1,000,000 ($100,000 ' 10%) for that property for investment purposes. The selection of an appropriate capitalization rate is affected by market conditions, the type of property involved and the relative risk of that investment.

In order to employ the income approach, therefore, one must be aware of the actual income and expenses being generated at the property as well as the general rental market for similar properties, and be able to derive the appropriate capitalization rate to be used in arriving at a present value. Rental income established by leases entered into as of the taxable status date is certainly good evidence of the rental value of the property. However, if there are older leases, or renewal leases in place, or if the leases were executed between related entities, they may not be indicative of the current rental market for that property. Therefore, actual leases of a property must be tested against the market to see if they are truly economic as of the taxable status date at issue.

As a result, the income ascribed to a property for property tax purposes is not necessarily the actual income being achieved at the property. For this reason, the value of property for property tax review may not always be the same as its value in the market. For example, if a property is encumbered by a long-term lease favorable to the tenant, the owner may complain that his actual income is lower than should be expected, and, therefore, he should be entitled to a reduction in his property's value for tax purposes. An investor looking to purchase this property would want to pay less due to its being encumbered by a long-term lease at a low rent. In this instance, however, the property's value for property tax purposes may be higher than its value in the market, because the below-market lease may be rejected and an economic rent substituted for valuation purposes. Conversely, a lease that has become above-market due to escalations or renewal terms set at a time when market expectations were higher than what they ultimately came to be, would also be rejected in favor of the current market rents, thereby giving that property a value for taxation purposes below that indicated by its actual reported income.

Leases entered into between related entities or owner-occupied spaces may likewise be subject to a market rental analysis, regardless of the actual rent being generated, as these rental levels are often not indicative of true market rent. In addition, a property with vacancy rates in excess of an average vacancy rate for that type of property would be rejected, and an economic rent, less a current vacancy factor would be used to arrive at its value for taxation purposes. (Obviously, a vacant building, even if it shows no income whatsoever, is not worth '0,' either in the market or for tax purposes, although an owner would love to see its taxes tied to its income that directly so that if there were no income there would be no taxes!)

The expenses taken to offset the gross income and arrive at the net income to be capitalized must be analyzed in a similar manner. The actual expenses, if reasonable and comparable to the operation of similar properties, will be adopted. If there is an aberration ' either indicating too high or too low an expense ' it will be rejected in favor of expenses derived from comparable data as well.

This analysis is part of an appraisal process and is most accurately and effectively performed by a qualified real estate appraiser. In fact, the proof of a property's value in the trial of a tax review proceeding is dependent on a professional appraiser's report and testimony and becomes primarily a 'battle of the experts' between the municipality and property owner's respective appraisers. Because appraising property is not an exact science, there is often much room for disagreement as to the appropriate rent, expenses, and capitalization rate to be applied to a particular property. However, when initially determining the likelihood of success in a tax review, the more accurate information available as to the various components of this analysis, the better able the taxpayer will be to predict its outcome.

Dale Allinson is a partner in the real estate tax certiorari and condemnation practice group at Certilman Balin Adler & Hyman, LLP in East Meadow, New York.