Market Value for Property Tax Purposes in a Recessionary Market

Market value is the most probable cash or cash equivalent price that specific property rights would sell for between a willing seller and a willing buyer as of the valuation date, provided the property was exposed to a competitive market for a typical period of time. Market value assumes that all conditions for a fair transaction are present and that the parties are unrelated and knowledgeable.

A market value analysis for property tax purposes differs significantly from a market value analysis for other business purposes, such as financing or acquisitions. When deciding whether to file a property tax appeal and pursue the negotiation of a settlement and/or trial of your appeal, it is essential to understand this crucial difference in valuation methodology. This crucial difference arises from the requirement that property tax values be based on the fee simple interest, not the leased fee.

Fee Simple Interest

A fee simple interest is absolute ownership, subject only to four governmental powers (escheat, eminent domain, police power and taxation). A fee simple interest includes the entire bundle of rights: 1) the right to sell an interest; 2) the right to lease an interest; 3) the right of occupancy; 4) the right to mortgage the property; and 5) the right to give all or a portion of the property away. The property is valued at its full market value as if it were not subject to any encumbrance, such as a mortgage, life estate or lease. Any additional value effect (positive for above market leases or negative for below market leases) that is attributable to the leases of the property should not impact the value of the fee simple estate, because leases are contract rights, not real estate. Appraisals of property for property tax purposes, therefore, are required to be based on the fee simple estate.

Leased Fee

A leased fee estate is a fee simple interest that is subject to one or more leases. Simply stated, it is the ownership interest of the landlord, which includes the right to collect rent, the right of repossession upon termination or expiration of the lease, and any other landlord rights specified by the lease. During the term of the lease, the landlord has neither the right to occupy the property, nor the right to lease the property to another tenant. These are rights of the tenant. Depending upon the lease terms, the tenant may sublet space or assign the lease. Appraisals of property for financings and acquisitions are typically based on the leased fee estate, and the lending or purchase documents will include instruments that encumber and/or transfer the leases, whether above or below market.

Accordingly, the market value for acquisition or lending purposes is how much a purchaser would pay for the property subject to the existing leases. The market value for property tax purposes is how much a purchaser would pay for the property as if it were occupied to market levels at a market level of rent. If the lease of the subject property provides either inadequate or excessive rentals, that disparity should not affect market value for property tax purposes. If the lease was made years ago when the market commanded higher rents, that should not affect today's market value. Long-term leases that are below today's market rent should not negatively impact fee simple market value.

Actual Leases

This is not to suggest that we can totally ignore the actual leases of the subject property when valuing property for ad valorem tax purposes. The leases must be examined to determine whether the contract rents are at, below or above market rent. Other lease terms must be analyzed to determine whether they are typical of the market. Consideration must be given to the credit-worthiness or strength of the tenant, the type of lease arrangement, whether operating expenses are at market levels, and whether the occupancy rate is consistent with the market.

Market value is determined by using appraisal methodology's three approaches to value: the cost approach, the income approach and the sales comparison approach. The cost approach is especially useful when valuing new or newer improvements. Under the sales comparison approach, sales of properties similar to the subject property are analyzed and adjusted to develop an indication of market value. Under the income approach, the property's value is determined by capitalizing the anticipated income stream from the property as of a certain date. Because it is the fee simple estate that is the bundle of rights to be valued for property tax purposes, each of these approaches should value the property as if it were occupied and leased at market rates as of the assessment date.

REO Properties

As real property values have significantly declined during the current recession, the number of transactions involving retail properties in many local retail markets has been at reduced levels and remains stagnant. A lack of arm's-length transactions is typical during a market downturn. Sellers who are under no compulsion to sell choose not to sell at what buyers are willing to pay. For example, many banks have been holding and managing a significant number of their Real Estate Owned (REO) properties due to advantageous changes in banking regulations and in anticipation of improvements in the market. Qualified buyers continue to wait at the sidelines for clear indications that the price at which sellers will sell has hit the bottom. Any qualified buyers willing to make a move in today's market expect significant discounts from the prices at which similar properties sold before the downturn.

If comparable sales are available, one must determine whether these were sales of the fee simple estate (as if occupied at market levels at a market level of rent) or leased fee estate (subject to one or more leases). Fee simple market comparable sales for shopping center properties are extremely rare, but may exist for owner-occupied retail stores sold as second-generation space. Alternatively, leased fee sales may be adjusted to the extent adequate evidence can be found in the marketplace to support the adjustments. Otherwise, the comparable sales approach may not be helpful at all.

A limited number of market comparables necessitates greater reliance upon the income approach when valuing retail properties. Since our focus is the fee simple estate, the contract rents specified in your leases may not significantly influence the property tax valuation analysis. While your leases greatly influence market value when financing or selling your retail property, it is the market rent that is central to the income approach for property tax purposes. Market rent is the rent that properties similar to your property can command in the retail market as of the assessment date. If your rent roll approximates market rents as of the assessment date, then your rent roll or contract rents will be given greater weight in valuing your property for property tax purposes.

It is possible for the leasehold value to approximate the fee simple value if a property's leases and occupancy level are consistent with the market as of the assessment date. In today's declining retail market, however, this is less likely to occur. It is more likely that your occupancy level and contract rents are above market rents, especially if all or a majority of your leases were negotiated prior to the advent of the recession. If so, your leasehold value may exceed your fee simple market value, and your property taxes may be significantly higher than they should be.

Assume that there is a strip center with several tenants whose leases were entered into at the height of the market, and that the lease terms are above market levels as of the assessment date. Assuming that the other factors (such as vacancy rates, operating expenses and capitalization rates) involved in the valuation analysis are equal, the market value of the strip center on a leased fee basis would be higher than the market value of the strip center on a fee simple basis. Conversely, the leased fee value probably would be less than the fee simple value if the leases were negotiated at a time when the market was down and the economy had been expanding between the lease execution dates and the assessment date at issue.

Market Rents

Market rents can be derived from market rent lease comparables. Unlike the sluggish market for retail property acquisitions, the retail leasing market has been somewhat more active. When retailers such as Linen 'N Things and Circuit City went bankrupt, and other national and regional retailers closed underperforming or duplicative stores as a result of mergers and consolidations, some retailers and non-traditional retail space tenants leased certain of these formerly dark storefronts and big boxes. Provided that these new leases are arm's-length transactions and comparable to your retail property in physical characteristics and location, or reliably adjusted to account for inevitable differences, they may provide reliable indications of market rents that can be used in the income approach to value.

In today's market, another potential source of market rents is the renegotiated leases of existing tenants of the subject property and comparable properties. Reports abound of struggling retailers requesting, and to some extent successfully negotiating, amended lease terms. During a recession, these renegotiated lease terms may provide an alternative indication of market rent, provided that this is a market phenomenon for comparable retail properties in your market area and the circumstances surrounding the renegotiated terms is closely examined.

The motivations of the parties to a renegotiated lease may be dissimilar to the motivations of the parties to a new lease. The tenant may agree to a higher rent, because the tenant avoids the costs of relocating its business. The landlord may accept a lower rent to avoid the costs of obtaining a new tenant and increasing the property's vacancy rate. To the extent that these differing motivations exist, it may be possible to adjust these rents, assuming adequate market data exists to support these adjustments.

Like market rent, the other factors involved in the income approach must be at market levels. Two of these factors, vacancy and the capitalization rate, have a significant impact on the market value. Whether your retail property is 100% leased or completely vacant, it is the market vacancy level that should be used in the income approach. Similarly, capitalization rates must be at market rates for fee simple estates. Capitalization rates for leased fee estates generally are lower than capitalization rates for fee simple estates due to the greater risks involved in acquiring a property at below market levels of occupancy or below market rents.

Market Comparables

Since the preferred approach to derive capitalization rates is from comparable market sales, a lack of comparable market sales also impacts the income approach. If market comparables are not available, the overall capitalization rate can be estimated using published surveys such as Price Waterhouse Coopers LLP's Korpacz Real Estate Investor Survey and the Real Estate Research Corporation's RERC Real Estate Report. Other possible methods of estimating yield requirements include the band of investment, the debt coverage formula or yield capitalization techniques.

Conclusion

When deciding whether to file a property tax petition for your retail property this year, remember that it is the market rent, market vacancy and other market factors as of the assessment date that are central to the valuation of your fee simple estate. Your actual leases must be analyzed, but are not necessarily the decisive factor in the property tax valuation analysis. Retail competition is tough, and for many retailers the level of retail sales is stagnant if not down significantly. Can you afford not to consider carefully, with professional help if necessary, whether your taxes are too high?

JoAnn H. Maloney is an attorney with the Minneapolis firm of Fred-rikson & Byron, P.A. A member of the Property Tax Appeals Group, she represents owners and lessees of commercial properties, with particular emphasis on shopping centers and department stores, as well as warehouses and office buildings. She can be reached at 612-492-7380; [email protected].

Retail property values have fallen dramatically across the country, with some authorities placing the peak of the retail market in early 2007. The December 2009 Moody's/REAL Commercial Property Price Indices indicate that, as of October 2009, U.S. retail property prices were 19.4% lower than last year and 36% lower than two years ago. These declines vary greatly by region. For example, Moody's reported an 8% annual price decline for the Southern Region and a 31.9% annual price decline for the Eastern Region.

As market values decline, prudent retailers are, of necessity, closely managing their operating expenses. For most, this includes or should include their property taxes. The amount of your property taxes is based upon the assessor's estimated market value of your property. To determine whether you are paying more than your fair share of property taxes, a fair and reasonable estimate of your property's market value must be determined.

Market Value

Market value is the most probable cash or cash equivalent price that specific property rights would sell for between a willing seller and a willing buyer as of the valuation date, provided the property was exposed to a competitive market for a typical period of time. Market value assumes that all conditions for a fair transaction are present and that the parties are unrelated and knowledgeable.

A market value analysis for property tax purposes differs significantly from a market value analysis for other business purposes, such as financing or acquisitions. When deciding whether to file a property tax appeal and pursue the negotiation of a settlement and/or trial of your appeal, it is essential to understand this crucial difference in valuation methodology. This crucial difference arises from the requirement that property tax values be based on the fee simple interest, not the leased fee.

Fee Simple Interest

A fee simple interest is absolute ownership, subject only to four governmental powers (escheat, eminent domain, police power and taxation). A fee simple interest includes the entire bundle of rights: 1) the right to sell an interest; 2) the right to lease an interest; 3) the right of occupancy; 4) the right to mortgage the property; and 5) the right to give all or a portion of the property away. The property is valued at its full market value as if it were not subject to any encumbrance, such as a mortgage, life estate or lease. Any additional value effect (positive for above market leases or negative for below market leases) that is attributable to the leases of the property should not impact the value of the fee simple estate, because leases are contract rights, not real estate. Appraisals of property for property tax purposes, therefore, are required to be based on the fee simple estate.

Leased Fee

A leased fee estate is a fee simple interest that is subject to one or more leases. Simply stated, it is the ownership interest of the landlord, which includes the right to collect rent, the right of repossession upon termination or expiration of the lease, and any other landlord rights specified by the lease. During the term of the lease, the landlord has neither the right to occupy the property, nor the right to lease the property to another tenant. These are rights of the tenant. Depending upon the lease terms, the tenant may sublet space or assign the lease. Appraisals of property for financings and acquisitions are typically based on the leased fee estate, and the lending or purchase documents will include instruments that encumber and/or transfer the leases, whether above or below market.

Accordingly, the market value for acquisition or lending purposes is how much a purchaser would pay for the property subject to the existing leases. The market value for property tax purposes is how much a purchaser would pay for the property as if it were occupied to market levels at a market level of rent. If the lease of the subject property provides either inadequate or excessive rentals, that disparity should not affect market value for property tax purposes. If the lease was made years ago when the market commanded higher rents, that should not affect today's market value. Long-term leases that are below today's market rent should not negatively impact fee simple market value.

Actual Leases

This is not to suggest that we can totally ignore the actual leases of the subject property when valuing property for ad valorem tax purposes. The leases must be examined to determine whether the contract rents are at, below or above market rent. Other lease terms must be analyzed to determine whether they are typical of the market. Consideration must be given to the credit-worthiness or strength of the tenant, the type of lease arrangement, whether operating expenses are at market levels, and whether the occupancy rate is consistent with the market.

Market value is determined by using appraisal methodology's three approaches to value: the cost approach, the income approach and the sales comparison approach. The cost approach is especially useful when valuing new or newer improvements. Under the sales comparison approach, sales of properties similar to the subject property are analyzed and adjusted to develop an indication of market value. Under the income approach, the property's value is determined by capitalizing the anticipated income stream from the property as of a certain date. Because it is the fee simple estate that is the bundle of rights to be valued for property tax purposes, each of these approaches should value the property as if it were occupied and leased at market rates as of the assessment date.

REO Properties

As real property values have significantly declined during the current recession, the number of transactions involving retail properties in many local retail markets has been at reduced levels and remains stagnant. A lack of arm's-length transactions is typical during a market downturn. Sellers who are under no compulsion to sell choose not to sell at what buyers are willing to pay. For example, many banks have been holding and managing a significant number of their Real Estate Owned (REO) properties due to advantageous changes in banking regulations and in anticipation of improvements in the market. Qualified buyers continue to wait at the sidelines for clear indications that the price at which sellers will sell has hit the bottom. Any qualified buyers willing to make a move in today's market expect significant discounts from the prices at which similar properties sold before the downturn.

If comparable sales are available, one must determine whether these were sales of the fee simple estate (as if occupied at market levels at a market level of rent) or leased fee estate (subject to one or more leases). Fee simple market comparable sales for shopping center properties are extremely rare, but may exist for owner-occupied retail stores sold as second-generation space. Alternatively, leased fee sales may be adjusted to the extent adequate evidence can be found in the marketplace to support the adjustments. Otherwise, the comparable sales approach may not be helpful at all.

A limited number of market comparables necessitates greater reliance upon the income approach when valuing retail properties. Since our focus is the fee simple estate, the contract rents specified in your leases may not significantly influence the property tax valuation analysis. While your leases greatly influence market value when financing or selling your retail property, it is the market rent that is central to the income approach for property tax purposes. Market rent is the rent that properties similar to your property can command in the retail market as of the assessment date. If your rent roll approximates market rents as of the assessment date, then your rent roll or contract rents will be given greater weight in valuing your property for property tax purposes.

It is possible for the leasehold value to approximate the fee simple value if a property's leases and occupancy level are consistent with the market as of the assessment date. In today's declining retail market, however, this is less likely to occur. It is more likely that your occupancy level and contract rents are above market rents, especially if all or a majority of your leases were negotiated prior to the advent of the recession. If so, your leasehold value may exceed your fee simple market value, and your property taxes may be significantly higher than they should be.

Assume that there is a strip center with several tenants whose leases were entered into at the height of the market, and that the lease terms are above market levels as of the assessment date. Assuming that the other factors (such as vacancy rates, operating expenses and capitalization rates) involved in the valuation analysis are equal, the market value of the strip center on a leased fee basis would be higher than the market value of the strip center on a fee simple basis. Conversely, the leased fee value probably would be less than the fee simple value if the leases were negotiated at a time when the market was down and the economy had been expanding between the lease execution dates and the assessment date at issue.

Market Rents

Market rents can be derived from market rent lease comparables. Unlike the sluggish market for retail property acquisitions, the retail leasing market has been somewhat more active. When retailers such as Linen 'N Things and Circuit City went bankrupt, and other national and regional retailers closed underperforming or duplicative stores as a result of mergers and consolidations, some retailers and non-traditional retail space tenants leased certain of these formerly dark storefronts and big boxes. Provided that these new leases are arm's-length transactions and comparable to your retail property in physical characteristics and location, or reliably adjusted to account for inevitable differences, they may provide reliable indications of market rents that can be used in the income approach to value.

In today's market, another potential source of market rents is the renegotiated leases of existing tenants of the subject property and comparable properties. Reports abound of struggling retailers requesting, and to some extent successfully negotiating, amended lease terms. During a recession, these renegotiated lease terms may provide an alternative indication of market rent, provided that this is a market phenomenon for comparable retail properties in your market area and the circumstances surrounding the renegotiated terms is closely examined.

The motivations of the parties to a renegotiated lease may be dissimilar to the motivations of the parties to a new lease. The tenant may agree to a higher rent, because the tenant avoids the costs of relocating its business. The landlord may accept a lower rent to avoid the costs of obtaining a new tenant and increasing the property's vacancy rate. To the extent that these differing motivations exist, it may be possible to adjust these rents, assuming adequate market data exists to support these adjustments.

Like market rent, the other factors involved in the income approach must be at market levels. Two of these factors, vacancy and the capitalization rate, have a significant impact on the market value. Whether your retail property is 100% leased or completely vacant, it is the market vacancy level that should be used in the income approach. Similarly, capitalization rates must be at market rates for fee simple estates. Capitalization rates for leased fee estates generally are lower than capitalization rates for fee simple estates due to the greater risks involved in acquiring a property at below market levels of occupancy or below market rents.

Market Comparables

Since the preferred approach to derive capitalization rates is from comparable market sales, a lack of comparable market sales also impacts the income approach. If market comparables are not available, the overall capitalization rate can be estimated using published surveys such as Price Waterhouse Coopers LLP's Korpacz Real Estate Investor Survey and the Real Estate Research Corporation's RERC Real Estate Report. Other possible methods of estimating yield requirements include the band of investment, the debt coverage formula or yield capitalization techniques.

Conclusion

When deciding whether to file a property tax petition for your retail property this year, remember that it is the market rent, market vacancy and other market factors as of the assessment date that are central to the valuation of your fee simple estate. Your actual leases must be analyzed, but are not necessarily the decisive factor in the property tax valuation analysis. Retail competition is tough, and for many retailers the level of retail sales is stagnant if not down significantly. Can you afford not to consider carefully, with professional help if necessary, whether your taxes are too high?

JoAnn H. Maloney is an attorney with the Minneapolis firm of Fred-rikson & Byron, P.A. A member of the Property Tax Appeals Group, she represents owners and lessees of commercial properties, with particular emphasis on shopping centers and department stores, as well as warehouses and office buildings. She can be reached at 612-492-7380; [email protected].