Retail Centers Get Equal Treatment Through Fee-Simple Valuation Method

By Mark Hutcheson, As published by Real Estate Forum, March 2003

There are several distinctions between a retail center's business value as a "going-concern" and a center's market value for property tax purposes.  Most states require that property tax assessments of retail centers be based on the market value of the fee-simple interest and exclude any value attributable to intangibles.  While these requirements exist in the tax law, they are commonly ignored by appraisal districts and assessors when determining value for property taxes.

Fee-simple valuations of retail centers are based on market driven variables that may or may not reflect a retail center's actual performance.  A fee-simple valuation utilizes market rents, market occupancy rates and market expenses.  Leased-fee valuations, on the other hand, value property based on its actual performance.  A leased-fee valuation would utilize actual rental rates, actual occupancy and actual expenses to determine a center's value.

When retail centers are valued for property-tax purposes, assessors are usually required to use a fee-simple valuation.  The reason states require this stems from the equal taxation principle.  If properties are identical in all physical respects or made hypothetically identical by appraisal adjustments, the equality principle demands that the properties be valued and taxed equally.

Property owners who obtain higher rents than their competitors, whether by virtue of business acumen or simply blind luck, should not have to pay higher property taxes than comparable competing retail centers that are unable to achieve the same rental rates.  While income taxes increase with the profits of a business, property taxes must be based solely on the physical characteristics of the underlying real estate.

Thus, in determining market value for property tax purposes, an assessor must appraise the property based on its fee-simple market value, rather than using the actual rates and lease terms in place.  The only specific property information required would be the leasable area and the necessary capital improvements.

There are also distinctions involved in measuring intangibles, which are generally defined as anything that has value but cannot be perceived by the senses.  For example, the goodwill of a business is usually valuable but not tangible.  Similarly, a contract may establish valuable rights, but they cannot be physically perceived.  One example of an intangible contract is a business agreement that outlines the rights and duties of the contracting parties and is separate from an underlying real property lease.

For retail centers, the primary source of intangibles comes from the tenants' businesses.  The synergy created by a well designed tenant mix will increase sales as well as percentage and base rents.  Whether the property is a regional mall or power center, the success of its tenants will result in rents that are attributable to the intangible value of tenants' businesses.

The following hypothetical example will demonstrate intangibles' impact: consider a shopping center that includes 200,000 sf of net leasable area.  Its anchor, XYZ Grocery, is a well-known regional chain that draws a reasonable amount of traffic from the community.  The center's rental rates are competitive at $5 per sf for the anchor space and $14 per sf for line space.

All was going well until a television news program carried a story claiming that XYZ purchased its produce from South America labor camps.  Three months after this program, XYZ's customer base fell by two-thirds and the center no longer received percentage rents.  Also, sales for the line space shops steadily fell and several tenants requested a renegotiated rent at a reduced rate.

In this example, the center's taxable real property before and after the news program remained the same.  The business value of the center, however, was affected dramatically, as the property could no longer demand the same rental rate as it previously obtained.  This example demonstrates the direct relationship between a center's rental rates and the failure of its tenants' businesses.  The same relationship exists when a center lands a hot anchor tenant that brings in additional traffic, causing rents to increase above those in the competing market.

Owners should always review their rents and compare the relationship between the business successes of their anchor tenants and the corresponding rental rates and occupancies for non-anchor space.  If rents have trended up as a result of an anchor's success, owners should survey the rental and occupancy rates of competing centers and utilize these market-driven variables instead of their center's actual performance.  Maintaining a clear distinction between a retail center's business value and its taxable value will ensure that the center is treated fairly when compared to competing centers.

Mark S. Hutcheson is a partner in the Austin, TX-based law firm of Popp and Ikard, which is a member of American Property Tax Counsel.  He may be contacted at mark@property-tax.com