Part two of two

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.

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

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.

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.

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.

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%).

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.

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.

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.

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.