Copyright © 2001, Mark Pomykacz

Part one of two

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 (NOI_bpt). 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 NOI_bpt 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 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:

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 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.

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.

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.

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.

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?

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.

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.

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.

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.

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