By Michael Donohue
Each year storage owners conduct a budgeting process that includes forecasting the next year's real-estate taxes. This article will examine the factors that influence real-estate taxes, offering the reader a checklist approach to perfecting the forecast.
Why Real-Estate Taxes?
An inaccurate real-estate tax forecast can significantly affect investor returns. For example, take a REIT that recently acquired several storage properties for $20 million on a 10 percent cap rate. The properties were last assessed at $10 million. Utilizing the existing real-estate taxes of $200,000, the REIT expected a first-year equity dividend (which equals cap rate in this example) of 10 percent. However, the property was reassessed upon sale to the sale price, triggering a real-estate tax increase of $200,000 and thereby lowering the equity dividend by one basis point to 9 percent.
About Real-Estate Taxes
Real-estate tax is the most difficult line-item expense to predict due to the complexity of its derivation. It is generally derived by multiplying a real-property assessment by a real-estate tax rate. The real-property assessment is typically the product of the real property value1 multiplied by an assessment ratio2. The real-property value is determined by an assessor who works for an assessing authority. "Value" is a matter of opinion; two qualified individuals working with the exact data can form different value conclusions. Usually, two or more individuals interested in deriving value on the same property do not have the same data available (imperfect market). For these reasons, property owners and their representatives do not always agree with the value derived by assessors. So, to forecast real-estate taxes, one must focus on two broad components: property value and real-estate tax rate. Each component requires separate consideration.
To predict the value the assessor will place on subject property we will consider: 1) all information available to an assessor, 2) the assessor's track record of valuation and analysis and 3) any jurisdictional nuances regarding the use of data. First, we identify the valuation method or methods utilized by the assessor.
Generally, three valuation methods exist: income, sales and cost. Do not assume that all methods are available. For instance, in some jurisdictions, owners are usually bound to employ only the cost approach to value, whereas in other jurisdictions, the income approach to value will be considered the controlling method.
We must ask ourselves: Is the concept of "equalization"3 relevant in the jurisdiction? If so, we must consider the history of assessments of similarly situated properties and how they might influence the assessment of the subject property. Does the jurisdiction survey actual income and expense information from property owners? If so, how is it used to determine value? By answering these questions, we know whether we must incorporate the subject property's actual income and expense into the prediction of the assessed value.
What information is available to the assessor? We review market information such as sales comparables and third-party published information (e.g., expense comparables, investor capitalization rate-requirement surveys, etc.). We interview the assessor to determine what market information might dominate the process.
For the subject property, what have been the historical annual net operating incomes and capitalization rates employed by the assessor in his previous valuation determinations? We must understand what opinions the assessor has previously expressed and documented regarding the subject property. For example, if the assessor has previously employed net operating incomes (NOI) significantly above previously reported actual NOIs, then our forecast of the assessed value (absent consideration of an assessment appeal) should be consistent with this approach.
Taking all of this information into consideration, we essentially undertake the same task as the assessor. Having reviewed the assessor's history of assumptions and data interpretation, we employ the assessor's same methodology (whether or not we consider it to be flawed) to predict the assessed value for the upcoming year (assuming the annual reassessment process). Concurrent to this process, we would forecast the real-estate tax rate.
The real-estate taxes can consist of a variable tax rate and fixed-dollar components such as a trash tax. The fixed-dollar components are generally obtained directly from the taxing authority. The variable-tax rate is determined each tax period by the taxing authority and local electorate. We review the rate history and interview the taxing authority to determine the direction and quantification of any tax-rate change. For instance, upon review of a fire district, we discovered that it was in need of a new fire truck; this information enabled us to accurately predict an increase in the tax rate. Many tax bills represent a cumulative tax from multiple taxing jurisdictions. Thus, all taxing jurisdictions must be investigated to properly forecast the next period's tax rate.
Once the assessed value and real-estate tax-rate forecast figures are determined, one must understand how a jurisdiction applies (or phases-in) changes before making the final forecast. Also, the jurisdiction's fiscal payment period may not be the same as the property owner's fiscal year, so adjustments must be made for the timing of payments within the owner's accounting process. Payments made in advance or arrears must also be addressed to accurately forecast the timing of real-estate tax payments.
This article best serves property owners with geographically dispersed portfolios. If a jurisdiction does not reassess annually, for instance, then the forecasting of real-estate taxes becomes much easier. Our experience in reviewing real-estate portfolios for assessment appeal and real-estate tax-forecasting considerations indicates that each portfolio owner has a subset of properties that are under-assessed. We recommend that each owner perform a tax-spike analysis to better quantify the degree of under-assessment. It is possible that a portfolio could significantly under-perform if many under-assessed properties were suddenly fairly assessed by assessing authorities.
Here is a recommended checklist approach:
- Identify jurisdiction rules
- Identify valuation method of choice
- Determine if survey of income is used
- Determine if actual income and expenses are relevant evidence of value
- Identify assessor's historical NOIs (for previous assessment years)
- Identify assessor's historical cap rates (for previous assessment years)
- Identify source(s) used to derive assessor's historical cap rate
- Identify available market information
- Determine NOI and cap rate, and then convert into predicted assessor value
- Identify real-estate tax-rate history
- Identify real-estate tax-fixed charges
- Identify timing of real-estate payments
- Interview taxing authority
- Determine real-estate tax rate
(1) There exist different kinds of value (e.g., fair market value, investor value, value in use, etc.). Also, jurisdictions tax a defined element as defined by law, such as free simple interests, leased fee interests, etc. The value derived by jurisdictions is a function of a legal mandate.
(2) Assessment ratios can easily confuse the taxpayer. Some jurisdictions simply have a 100 percent tax ratio; thus, the assessed market value multiplied by the assessment ratio of 100 percent is a figure easily understood. These ratios are simply part of a mathematical formula leading to the real-estate tax derivation.
(3) Some jurisdictions utilize an "equalization" concept whereby properties must be equalized. This concept has different meanings to different jurisdictions. For instance, to some jurisdictions, equalization is measured by value per unit, whereas to other jurisdictions, equalization is tested by the consistency of the methodology employed by the assessing authority. Typically, we consult our local attorney for the equalization application in each area.
Michael Donohue is the founder of Storage Tech Specialists, Inc., which has recently merged with Coopers & Lybrand L.L.P. of Virginia. Coopers & Lybrand specializes in property tax appeals for self-storage owners. Mr. Donohue may be reached at 1751 Pinnacle Drive, McLean, VA 22102-3611; phone (800) 388-8270.