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The Forgotten Factor: How property tax liabilities can kill a real estate deal
- October 1, 2017: Vol. 4, Number 10

The Forgotten Factor: How property tax liabilities can kill a real estate deal

by Ross Litkenhous

Today, only 25 percent of commercial real estate firms are managing their property tax liabilities using enhanced technology and analysis, and yet almost three-quarters of them believe they could make better investment decisions with better tax planning.

Why would an industry that invested more than $500 billion in 2016 in the United States and Canada alone be leaving such a large expense item to chance? A survey by Altus Group of 200 executives from the top commercial real estate firms across North America revealed that, while they know the data exists, more than half acknowledge they lack the tools to assist with data capture and analysis, while 44 percent lack the expertise or resources to even identify the property tax data sources, and 39 percent are inhibited from using their data due to the lack of normalization in formatting.

The impacts for the 75 percent not using enhanced technology and analysis in their tax planning can be tremendous, from a weakened negotiating position during acquisitions, to compressions in ROI for investors. How financially significant can this impact be? Let’s consider the following scenario.

An asset adviser invests in a completely vacant class A office building in Washington, D.C. What did the enhanced tax analysis during underwriting uncover?

The D.C. Office of Tax and Revenue (OTR) has been assessing office buildings with little to no regard for existing or impending vacancy. Several office buildings have traded over the past year at values below current assessments because of existing or impending vacancy, but OTR’s current model does not account for vacancies the way the market does.

For example: 500 D Street SW, a newly constructed and 100 percent vacant class A office building, sold March 1, 2017, for $93 million. It had recently been assessed for tax year 2018 at $141.7 million as of the Jan. 1, 2017, valuation date. In this case, the owner’s tax bill for 2018 will be based on the higher assessment of $141.7 million, as opposed to the purchase price.

Owners have the option to appeal within 45 days of a transaction, but if they are not aware of this rule, they could be stuck with a punitively high tax bill for future years. However, regardless of whether or not the new owner pursues an appeal for tax year 2018, the reality is that the appeal may not be resolved by the time they have to pay the higher tax bill in 2018, which can put significant pressure on cash flows if they did not underwrite accordingly.

Additionally, the Jan. 1, 2016, value was $101.1 million, more than $8 million higher than the purchase price. The taxes for this value are paid in March and September of 2017, and because the deadline to appeal this value was back in 2016, the new owners would have no recourse to appeal unless the prior owner still had pending litigation.

What’s more, there is no guarantee that OTR would agree that the purchase price is considered market value. The OTR model would produce a much higher value because the model lacks a sufficient mechanism to discount a property’s value based on chronic or imminent vacancy.

The reality is that 500 D Street SW was acquired for $93 million because it was 100 percent vacant, but OTR does not see it that way. In this case, in the first year of operation the owner would have to not only pay the September 2017 payment based on the Jan. 1, 2016, value (this is second-half tax bill for tax year 2017 assessment), which in this case was $101.1 million, but they would also have to pay the following year’s 2018 taxes that are based on the Jan. 1, 2017, value of $141.7 million (unless they filed an appeal within 45 days of the purchase date).

To make matters worse, if the seller had an active appeal under way at the time of sale and subsequently withdrew the appeal, OTR in some situations may not allow a new appeal to be filed for the same tax year by the new owner.

In other words, owners not underwriting real estate taxes above their anticipated purchase price in years one and two, and not attentive to the timing of tax payments based on certain dates of valuation, could very well miss anticipated returns and forecasted cash flows. In the case of 500 D Street SW, here is how the taxes will play out based on current assessments:

TY2017: Current assessment of $101 million results in a $1.86 million tax bill with the first half of that total due March 31, 2017, and the second half due Sept. 15, 2017.

TY2018: Current assessment of $141.7 million results in a $2.6 million tax bill, first half of that payment due March 31, 2018; second half of the payment due Sept. 15, 2018.

Real estate taxes in some cases can account for 40 percent to 50 percent of an operating budget, and with an unexpected tax bill more than 50 percent higher than what was originally budgeted, a deal could be severely diminished right out of the gate. In the case above, an owner may not be budgeting to pay $2.6 million in 2018, instead expecting to pay $1.7 million on the new purchase price.

Even if the owner is successful in the appeal, it often does not happen until court-ordered mediation, which might take place three years after the valuation date. Assessors can be reluctant to make changes at the first level that would lower a real estate tax liability by nearly $1 million, and the second level of appeal has become more difficult to produce reductions. While court-ordered mediations often result in reasonable settlements, in order to file, taxes must be paid. While a successful appeal might result in a reduction of the taxes due from $2.6 million to $1.7 million, the $2.6 million might have to be prepaid and sit for two years until the difference is refunded.

If the owner failed to do his or her research and analyze applicable data, the expected tax bill would be $1.7 million (based on the $93 million purchase price), which would mean a deficit of $900,000 in budgeted operating expenses in calendar year 2018. A hit of nearly $1 million to NOI, based on a 5 percent capitalization rate, equates to $18 million in lost value. If owners then escalated this $1.7 million tax expense year over year at an arbitrary 3 percent or 5 percent, the loss would just be compounded.

500 D Street SW is not a singular situation in D.C. — similar issues exist for 300 12th Street SW, 100 M Street NE and 2450 M Street NW.

The bottom line: If you do not do your research on trends and practices and how these trends are affecting comparable properties, you are going to get crushed on a deal.

 

Ross Litkenhous (ross.litkenhous@altusgroup.com) is a vice president of strategic development at Altus Group.

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