Weighted Cap Rates

The Next Generation in Weighted Cap Rates
________________________________
A Generalized Analysis
to
Determine Three Unknowns;
Value, Real Estate Taxes
and
Real Estate Tax Recoveries

In this ever more complicated and competitive consulting environment, it is always helpful for the consultant to have yet another skill to offer their clients. This article presents a new technical, but easy to use, cost effective analysis that will reduce property taxes. It can be applied to all leased properties, including most office buildings, retail malls, and many industrial buildings, which the traditional tax assessment analysis can not analyze.

When real estate taxes change, real estate tax recoveries also change. Changes in real estate tax recoveries change the property’s value. Traditional value and tax analyses can solve for value when only two items, taxes and value, are unknown. This article presents a generalized analysis that works on up to three unknowns, value, taxes, and recoveries, and that can be used on all types of property, gross or net leased, single or multi-tenanted. Additionally this article presents practical steps for employing the analysis.

Traditionally analysts have employed a weighted (loaded) capitalization rate formula to analyze property values when the appropriate real estate tax expense was unknown. The first step is to estimate net operating income before real estate taxes (NOIbpt). Then the effective tax rate is added to the capitalization rate to calculate the weighted capitalization rate (weighted cap rate). Next the weighted cap rate is applied to the NOIbpt to determine the market value. Finally the appropriate taxes can be calculated by applying the effective tax rate to the estimated market value.

This article will show that is the traditional analysis is only accurate for prefect gross leased properties. The traditional weighted cap rate analysis can not accurately indicate value or taxes, for any net leased or partially gross (or partially net) leased property. Furthermore, if any tenant or space (or unit) at a gross leased property, regardless of whether the property is single or multi-tenanted, should be or should become at any time over the analysis holding period, a net lease or a partially net lease with respect to real estate taxes, then the traditional weighted cap rate analysis would not be accurate.

Real Estate Taxes

Real estate taxes are also known as ad valorem taxes. Ad valorem is Latin for “according to the value”. Real estate taxes are based on the property’s value, technically the property’s market value.

When given the market value, the assessed value to market value ratio, and actual tax rate, the actual taxes can be calculated as follows:

Calculation of Real Estate Taxes

Market Value

Assessed Value to Market Value Ratio

Assessed Value

Actual Tax Rate

Real Estate Taxes

$6,090,000

50.0%

$3,045,000

6.0%

$182,700

The assessed value to market value ratio is also known as the equalization ratio. The actual effective tax rate is 3.0%, (6.0% x 50.0%). When assessors and property owners dispute real estate taxes, the fundamental issue is determination of the property’s market value.

Market Value

Market value is determined by appraisal. There are three types of appraisal analyses used to determine market value: cost analysis, sales comparison analysis, income analysis. The first two types of analysis present no problem for properties that have real estate tax recoveries in that they intrinsically reflect the impact of taxes and tax recoveries. If the analyses accurately intrinsically reflect the taxes and recoveries, then the analyses will indicate an accurate value. However the last type, the income analysis, presents significant problems, when used to simultaneously estimate the market value of and hence the real estate taxes on a property that has real estate tax recoveries.

Income Producing Properties

Of the three appraisal analyses, the income analysis is most important for income producing properties. There are two types of income analysis; the income capitalization analysis and the discounted cash flow analysis. This article focuses on the first type. However the concepts in this article about real estate taxes and tax recoveries apply to both income analysis types.

Basic Income Capitalization Analysis

Total Gross Income

Total Expenses

Net Operating Income

Capitalization Rate

Indicated Market Value

$1,125,000

$550,000

$575,000

10.0%

$5,750,000

Real Estate Tax Recoveries

Real estate tax recoveries are defined as rental payments made by the tenant that reimburse the landlord for real estate tax expenses. Real estate tax recoveries are also known as passthrough rental incomes or passthroughs. Real estate tax recoveries are based, in some way, on the real estate taxes. Commonly leases prescribe the tenant’s payments as a percentage share of the property’s total taxes. Often when real estate taxes increase or decrease, the tenants’ payments to the landlord also increase or decrease. Some leases call for minimums and maximums (bases and caps) for either the landlord or the tenant. Some tenants pay their share of the taxes directly to the tax collector. However the landlord, as property owner, is ultimately responsible for the taxes.

Sometimes the taxes and the tenant’s recovery payments are not listed in the property’s operating statements.

In properties with all perfect gross leases (e.g., most apartment buildings) the landlord usually pays 100% of the taxes (landlord’s contribution: 100%) and the tenant pays no recoveries. In properties with all net leases (e.g., some warehouse buildings) the landlord’s tax contribution is usually 0.0%; the tenant pays 100% of the taxes. However in net leased properties (or properties that are typically net leased) where the tenant usually pays 100% of the taxes, the landlord must pay the taxes during vacancy and credit loss periods.

Readers are asked to define real estate tax recoveries in the broadest sense, since the issues discussed within apply to many properties that do not at first glance appear to be relevant.

Property Value/Real Estate Tax Assessment Dilemma

Market value determines the real estate taxes. An appraisal determines the market value. On an income producing property, the income analysis is the most important part of the appraisal. The income analysis is based on net operating income. But real estate taxes effect net operating income. In fact, real estate taxes effect both the gross income (through real estate tax recoveries) and the operating expenses (obviously through real estate tax expenses). Hence taxes effect the market value. The dilemma is that there is a circular analysis process for income producing properties. Market value determines the tax, but tax effects the market value. If either the market value or the taxes are given incorrectly, then the basic income analysis will yield incorrect taxes or market value, respectively.

On the next page is an example of a basic income capitalization analysis that assumes an incorrect real estate tax expense.

An Example of An Incorrect Tax Assumption

Total Gross Income

Actual Real Estate Taxes

All Other Expenses

Total Expenses

Net Operating Income

Capitalization Rate

Indicated Market Value

Actual Effective Tax Rate

Indicated Real Estate Taxes

$1,125,000

250,000

300,000

$550,000

$575,000

10.0%

$5,750,000

3.0%

$172,500

Q: Compare?

A: Inconsistent!

Note that the actual taxes do not match the indicated taxes. Obviously a tax appeal is needed. But what should the taxes be? On what market value should the taxes be based?

Basic Value & Tax Assessment Analysis

Analysts have long ago figured out a basic algebraic formula that, for certain types of properties, solves for both the market value and taxes, when neither the market value nor the taxes are known. The formula solves for two variables; market value and taxes. The formula avoids the difficulties of the iteration mathematics, and has become a standard within the real estate analysis community.

Presented on the next page is an example of a basic value and tax analysis.

Basic Value & Tax Assessment Analysis

Total Gross Income

Actual Real Estate Taxes

All Other Expenses

Total Expenses

Net Operating Income

Actual Effective Tax Rate

Capitalization Rate

Tax Adjusted Capitalization Rate

Indicated Market Value, Rounded

Actual Effective Tax Rate

First Indicated Real Estate Taxes

$1,125,000

NA

300,000

$300,000

$825,000

3.0%

10.0%

13.0%

$6,350,000

3.0%

$190,500

If we cross-check the above basic income capitalization analysis, but use the indicated taxes instead of the actual taxes, we find seemingly consist results. Presented on the next page is a proof that the indicated results a basic value and tax analysis appear to be accurate.

Cross-Check Proof

Total Gross Income

Indicated Real Estate Taxes

All Other Expenses

Total Expenses

Net Operating Income

Capitalization Rate

Indicated Market Value, Rounded

Actual Effective Tax Rate

Second Indicated Real Estate Taxes

$1,125,000

190,500

300,000

$490,500

$634,500

10.0%

$6,350,000

3.0%

$190,500

Q: Compare?

A: Seemingly

Consistent.

Seemingly Consistent?

The indicated value and taxes in this analysis would be correct, if all the other income and expense data are correct. However, as shown on the next pages in the Inconsistency Proof, this is, in fact, not correct for many important types of properties. The problem arises when gross income is effected by real estate taxes. When a property has real estate tax recoveries, the level of tax expense directly effects the gross income.

For the sake of the presentation, assume that the actual lease (and market lease terms) calls for the tenant to pay 50% of the real estate taxes.

Actual Taxes and Tax Recoveries

Actual Real Estate Tax Recoveries

All Other Rents, Income and Recoveries

Total Gross Income

Actual Real Estate Taxes

All Other Expenses

Total Expenses

Net Operating Income

$125,000

1,000,000

$1,125,000

$250,000

300,000

$550,000

$575,000

In this case, real estate taxes are recovered at a rate of 50% ($125,000 / $250,000). The tenant’s tax contribution is the total real estate tax expense paid by the tenant. This means the landlord’s tax contribution is 50% (100%-50% tenant contribution). The landlord’s tax contribution is the difference between the total real estate tax expense and total real estate tax recoveries divided by the total real estate tax expense.

The calculations below show the inconsistencies with the basic tax assessment analysis. Given the indicated taxes of $190,500 and the landlord’s tax contribution of 50%, we calculate the total indicated real estate tax recoveries to be $95,250. Because the indicated real estate tax recoveries are different from the actual amount, the indicated market value and its resultant indicated taxes are inconsistent.

Inconsistency Proof

Indicated Real Estate Tax Recoveries

All Other Rents, Income and Recoveries

Total Gross Income

Indicated Real Estate Taxes

All Other Expenses

Total Expenses

Net Operating Income

Capitalization Rate

Indicated Market Value, Rounded

Actual Effective Tax Rate

Indicated Real Estate Taxes

$95,250

$1,000,000

$1,095,250

190,500

300,000

$490,500

$604,750

10.0%

$6,050,000

3.0%

$181,500

Q: Compare?

A: Inconsistent!

 

Generalized Value and Tax Assessment Analysis

The problem with the basic value and tax assessment analysis is that it can not solve for three co-dependent variables; market value, taxes and tax recoveries. If taxes are not appropriately assessed, then any real estate tax recoveries based on these taxes will not be appropriate either. Such real estate tax recoveries should not be used in the calculation of gross or net income. However the property still has the value created by the potential for real estate tax recoveries. To capture this value, the capitalization rate must be adjusted for the potential real estate tax recoveries.

The capitalization rate can be adjusted for the potential real estate tax recoveries by adjusting the effective tax rate for the landlord’s tax contribution. The effective tax rate is adjusted by multiplying the effective tax rate by the landlord’s tax contribution and is thereby converted into the landlord’s effective tax rate. By adding the landlord’s effective tax rate, instead of the full tax rate, the adjusted capitalization rate truly reflects the landlord’s equity interest (the fee estate or leased fee estate) in the property.

Generalized Value and Tax Assessment Analysis

Actual Real Estate Tax Recoveries

All Other Rents, Income and Recoveries

Total Gross Income

Actual Real Estate Taxes

All Other Expenses

Total Expenses

Net Operating Income

Actual Effective Tax Rate

Real Estate Taxes Not Recovered

Landlord’s Tax Contribution

Capitalization Rate

Tax Adjusted Capitalization Rate

Indicated Market Value, Rounded

Actual Effective Tax Rate

Indicated Real Estate Taxes

Real Estate Tax Recovery Rate

Indicated Real Estate Tax Recoveries

NA

$1,000,000

$1,000,000

NA

300,000

$300,000

$700,000

3.0%

50.0%

1.5%

10.0%

11.5%

$6,090,000

3.0%

$182,700

50.0%

$91,350

 Consistency Proof

Indicated Real Estate Tax Recoveries

All Other Rents, Income and Recoveries

Total Gross Income

Indicated Real Estate Taxes

All Other Expenses

Total Expenses

Net Operating Income

Capitalization Rate

Indicated Market Value, Rounded

Actual Effective Tax Rate

Indicated Real Estate Taxes

Real Estate Tax Recovery Rate

Indicated Real Estate Tax Recoveries

$91,350

$1,000,000

$1,091,350

$182,700

300,000

$482,700

$608,650

10.0%

$6,090,000

3.0%

$182,700

50.0%

$91,350

Q: Compare?

A: Consistent!

The proof indicates consistency for all three variables; market value, taxes and tax recoveries. The generalized formula works!

Estimating Landlord’s Tax Contribution

The analyst has two methods of estimating the landlord’s tax contribution, and its inverse, the percentage of real estate taxes recovered by the landlord: a trend-based projection method and a lease by lease analysis method.

Trend-Based Projection

A trend-based projection is an analysis of the property’s historical experience and/or an analysis of market-wide experiences. When estimating real estate tax recoveries, the analyst must be aware of the usual pitfalls encountered when estimating and forecasting income and expenses, such as above or below market experiences at the subject property, unusually variable income or expense item experiences at the subject property, the incomparability of market data.

Example of a Trend-Based Projection Analysis

1 Years Ago

2 Years Ago

Last Year

 

Projection

Subject Property

60%

55%

50%

 

50%

Market Comparables

60%

60%

50%

Lease by Lease Analysis

A lease by lease analysis is an analysis of every lease for its real estate tax recoveries potential. The percentage of taxes to be paid by the each tenant should be tallied to ascertain the landlord’s contribution for taxes for the entire property. Any percentage estimated using the actual leases must be adjusted for expectations of stabilized vacancy and credit loss, and for rollover to market lease terms, and local assessment procedures.

Example of Lease by Lease Analysis

Landlord’s TaxContribution

Square

Feet

Sq. Ft Weighted

Contribution

Remaining

Lease Term

Market LeaseTerms?

Lease #1

60%

20,000

12,000

3 yrs

Yes

Lease #2

60%

25,000

15,000

4 yrs

Yes

Lease #x

55%

30,000

16,500

3 yrs

Yes

Vacant Unit #1

55%

20,000

11,000

5 yrs

Yes

Vacant Unit #x

55%

30,000

16,500

5 yrs

Yes

Total

125,000

71,000

If property was 100% occupied, the tenants would pay 57% (71,000/125,000)of the taxes. The landlord’s building wide tax contribution, at 100% occupancy, is estimated at 43% (100%-57%). However market expectations call for a vacancy and credit loss rate of 7%. Therefore the landlord’s building wide tax contribution, at stabilized vacancy and credit loss, is estimated at 50% (43% + 7%).

Net Leased Properties and Average Vacancy & Credit Loss

Unless properties are net leased for very long terms, say more than 20 years to high credit rated tenants, the basic value and tax assessment analysis will not work and the generalized value and tax assessment analysis must be used. Over a typical holding period, most properties are expected to experience some vacancy and credit loss. If a property has some vacancy and credit loss over a holding period, then its average or stabilized vacancy and credit loss represent the percentage of real estate taxes not recovered by the landlord.

A generalized analysis can be constructed as follows. No tax recovery income and no taxes should be included in the net income estimate. The stabilized vacancy and credit loss should continue to be deducted from all other potential rents, income and recoveries. No vacancy and credit loss are taken against the potential tax recovery income. The taxes, the tax recovery income and its vacancy and credit loss should only be reflected in the adjustment to the capitalization rate.

Benefits to Property Owner & Consultant

The generalized tax assessment analysis for a net leased property shown on the next page yields additional savings over the basic tax assessment analysis of $4,200. It may take the consultant one hour to complete the analysis and one hour to explain the procedure. On a 25% contingency fee basis, the consultant would earn a healthy $1,050 fee.

Generalized Value and Tax Assessment Analysis for a Net Leased Property

Basic

Value

And Tax

Analysis

Generalized Value

and Tax

Analysis

Holding Period

10 Years

10 Years

Average/Stabilized Vacancy & Credit Loss:

On All Other Rents, Income and Recoveries

7%

7%

On Real Estate Tax Recoveries

NA

7%

Potential Real Estate Tax Recoveries

NA

NA

Vacancy & Credit Loss Real Estate Tax Recoveries

NA

NA

Effective Gross Real Estate Tax Recoveries

NA

NA

Potential All Other Rents, Income and Recoveries

$1,075,269

$1,075,269

Vacancy & Credit Loss All Other Income and Recoveries

7%

7%

Effective Gross All Other Income and Recoveries

$1,000,000

$1,000,000

Real Estate Tax Recoveries

All Other Rents, Income and Recoveries

Total Gross Income

Real Estate Taxes

All Other Expenses

Total Expenses

Net Operating Income

Actual Effective Tax Rate

Real Estate Taxes Not Recovered

Landlord’s Tax Contribution

Capitalization Rate

Tax Adjusted Capitalization Rate

Indicated Market Value, Rounded

Actual Effective Tax Rate

Indicated Real Estate Taxes

Real Estate Tax Recovery Rate

Indicated Real Estate Tax Recoveries

NA

$1,000,000

$1,000,000

NA

300,000

$300,000

$700,000

3.0%

0.0%

0.0%

10.0%

10.0%

$7,000,000

3.0%

$210,000

100.0%

$210,000

NA

$1,000,000

$1,000,000

NA

300,000

$300,000

$700,000

3.0%

7.0%

0.2%

10.0%

10.2%

$6,860,000

3.0%

$205,800

93.0%

$191,394

Discounted Cash Flow Analyses

The principle of not using tax recovery income that is based on inappropriately assessed taxes is equally applicable to discounted cash flows (DCF’s). However the generalized capitalization rate adjustment procedure described above can not be applied to the discount rate in a DCF. Analysts must use an iteration process. (The generalized cap rate adjustment procedure can e applied to the reversionary capitalization rate in a DCF.) Depending on the DCF software used, various iteration techniques can be used instead of the algebraic formula discussed above. In certain software packages, the analyst sets up the tax recoveries as dependent upon the data entered in the taxes cash flow. When the time comes for the analyst to calculate the property value, the analyst enters a guess estimate of the taxes and calculates the first value. This first value is analyzed to find the indicated taxes. If the indicated taxes do not match the guess estimate, then the analyst must make a second guess estimate, recalculate the property value, and reanalyze the second property value for its second indicated taxes. If the second indicated taxes do not match the second guess estimate, then the analyst must repeat the above steps until they match.

 Conclusion

In conclusion, the basic tax assessment analysis is not valid for many important types of properties, including most office buildings, retail malls, and many industrial buildings. For such properties, the generalized analysis must be employed. The basic analysis remains valid for properties with only gross leases, such as residential apartment buildings, but the generalized analysis can be used for all properties. This easy to use analysis will save property owners tax dollars and earn fees for tax consultants.