Drawing a New Battle Line

By:  Art Gering
As published in Real Estate Forum, January 2002.

Executive Forum Participants:

John Garippa President, American Property Tax Counsel Senior Partner, Garippa, Lotz & Giannuario Montclair, NJ	Martin P. Lutsky Director of Property Tax Rouse Co. Columbia, MD
Laurence May Director of Property Tax Marriott International Washington, D.C.	James Popp Partner Popp & Ikard Austin, TX
James P. Regan Partner Fisk Kart Katz and Regan, Ltd. Chicago, IL	Moderator: Art Gering Managing Editor Real Estate Forum

Whether your focus is on hotels, assisted-living facilities or super regional malls, real estate operators are able to maximize an asset's income stream through skilled labor and savvy management. While this is a definite plus for one's bottom line, it could have a negative impact on property tax assessments.

Property tax professionals contend that taxing authorities have mixed the income attributable to strong operations and management performance with the value of the underlying real estate. This has resulted in assessments that do not properly reflect an asset's true market value and consequently, higher tax bills for owners.

At its recent annual convention in Scottsdale, AZ, a group of American Property Tax Counsel members assessed the progress being made in the executive suite and with taxing jurisdictions to remove non-real estate items (also called intangibles) such as labor and management from the valuation of commercial real estate. Moderated by Real Estate Forum managing editor Art Gering, the panel offered some solutions to the valuation quandary and discussed other issues impacting the property tax field today. An edited version of the discussion follows.

Art Gering: Identify those non-real estate items that are relevant to your company for property tax purposes.

Martin P. Lutsky: One item is the work force. Depending on the property, that could be very large; some of our properties have between 50 and 70 people working on site. Other non-real estate items can include receivables, interest income, late fees or license agreements.

Obviously, we get value from the image portrayed by our anchor department stores. We can give them land concession dollars and sometimes that has to be accounted for in the income stream. Also, branding has been employed to a great extent within the retail industry. Some of us brand by the types of merchants at our properties such as the Limited, Victoria's Secret and the Gap, and some companies brand their properties toward a specific type of customer.

Laurence May: Marriott International operates hotels and retirement communities. We are operating a business within the confines of real estate and the real estate is only a small component of the total business assets. There have been attempts made to extract from the income stream the money attributable to the non-real estate components. That has been a process over the past 20 years and it has been difficult. All of the operating expenses in hotel or retirement communities are focused on the operating business, not on the real estate as it would be in apartments or office buildings.

Gering: When did your industry begin changing its view on real estate?

May: The industry hasn't tried to make much of a distinction in how they record the value of the property. It's only been in recent years that the IRS has allowed booking intangibles. Previously, everything had to be attributed either to the real estate or the personal property. For property tax purposes, it's been an important issue because in dealing with the assessors, we've had to try to segregate those components and take them out.

Lutsky: We've changed within the past two or three years in that we've begun to recognize that maybe there is such a thing as federal income tax treatment, GAAP treatment and a property tax treatment and they don't necessarily have to match up or equal each other. Appraisers started looking at the issue of non-real estate components recently and tax assessors started looking at it when we brought it up 10 years ago.

Gering: What have been your experiences to date on the acceptance of non-real estate components by taxing jurisdictions and courts?

John Garippa: The acceptance of these theories is in its infancy. They have been propounded over the past five to 10 years and now what we are finding is that those who are writing the textbooks have begun to adopt and advance these theories. As a result, you're going to see greater acceptance by the courts and taxing jurisdictions in the years to come. For example, the American Institute of Real Estate Appraisers has begun to discuss these theories at length and it now offers a course that relates to the valuation of intangibles and its removal from real property. You would not have seen this five years ago.

James P. Regan: You'll find differences from one jurisdiction to another. I work mostly in metropolitan Chicago and in terms of hotel valuations, Cook County recognized the presence of intangible assets in hotels early on in this process, maybe over the past 12 years. They have not included them in their valuation of the real estate. For example, in December 1999, a full-service hotel in Downtown Chicago sold for $120 million. That was just the hotel business. The appraiser valued the real estate at $41 million and the county accepted that as the value.

The arena where we are going to have to fight this battle is regional shopping centers. The shopping centers in many jurisdictions are the largest taxpayers and it's a great intransigence for taxing authorities to accept some of these theories because officials see a large source of revenue that's going to disappear. That's a problem that is not theoretical or methodological, but practical.

James Popp: We started with hotels in the '80s and developed some business value theories that the assessors started to accept. We began to argue over the amount rather than the existence of intangibles. In the '90s, there was some movement made in the health-care industry. The appraisal districts and tax authorities began to recognize that there were business centers in that industry such as skilled nursing and food services, but there was little development on how to qualify that.

Most recently in shopping malls and retail centers, appraisal districts are starting to recognize the existence of intangibles, but little progress has been made in accepting it.

The good news/bad news is now that we've convinced many of the appraisal districts and taxing authorities that business value exists in hotels, they've come full circle and have begun to deny even the existence of business value.

Gering: What do you believe will be the impact of changes on property tax assessments if taxing officials accept your view of intangibles?

May: If they accept the premise, and a lot of them are starting to, the question is how much and how do you quantify it. One of the problems that I run into is that the assessor will acknowledge the existence of intangible value but won't buy off on a methodology to get it out. So it's an education process. Now that we have the weight of the Appraisal Institute behind us, it's possible to go forward and sell the argument. If we're successful, and I think eventually we will be, that is going to reduce taxable values. That's not a pleasant prospect for assessors.

Lutsky: The valuation of the class A or A-plus malls will be affected. We're never going to argue that there are a lot of intangibles in the class C property. I don't think there's a magic bullet; we're not going to get a 50% reduction because that's high in a regional shopping center. You might be able to get into the 25% range.

Garippa: Any corporate tax director that's not seriously looking at the impact of intangibles on their portfolio is short-selling their company. For hotels, the impact of intangibles can be probably on the order of 50%. On seniors-housing facilities, it's not quite as high as 50%, but it's probably in the area of 30%. For shopping centers, it's probably 15% to 20%.

May: John's right; it's huge in terms of tax liability. The potential danger we face is if assessors see that we're winning the battle. I would anticipate that in some places you could see legislative efforts on the part of the assessors' associations to change the law to tax intangibles.

Popp: I've looked at the successful corporate tax departments in terms of large value reductions and there are some common characteristics. They've sought venues for their causes where there's some finality. They've sought teams of advocates, both appraisers and lawyers, who are highly skilled in their areas. They've been willing to look at the big picture rather than individual cases. Instead of measuring success by one victory on one property, they measure it by its impact on their entire portfolio. The most successful tax departments have been willing to take calculated risks and have had strong support from management.

Lutsky: We've been realistic about where we've tried to sell intangibles and where we should pull back. I think we understand what can be won and what can't be won.

Gering: John, What needs to be done so that tax authorities and courts accept these issues?

Garippa: Recently, in one of our major hotel cases, we actually brought into court and put into evidence all of the latest materials outlining intangible theories. We brought in an expert witness, the founder and the teacher of a course on intangibles, who explained the course materials and the evolution of the theory.

In order for us to make advances, we are going to have to take small steps and begin the education process where it matters most. That means talking it to taxing jurisdictions, administrative hearings and ultimately to court. And what you're probably going to see is incremental advances. This may take five to 10 years to fully develop.

Perhaps the most damage to our cause has been done by poorly researched, improperly litigated attempts to reduce assessments by simply using the catchword intangible. As a result, the tax jurisdictions raise a defense mechanism and they regard it as a scam to reduce tax assessments.

Regan: Very often the tax director has be an advocate in his own company because the company is not willing to recognize or address the intangibles in their real estate portfolio. They've got to be able to describe more clearly what revenues are derived from what assets and whether they're from intangibles.

Real estate today is very complex and dynamic. But we deal with terms and concepts that have different layers of meaning. Different groups, for whatever reasons, can choose the meaning that is most helpful to them. What we're trying to do is get back to the basics and look at some of these key ideas and real estate terms and then begin to apply them in a modern setting.

Popp: As John mentioned, it's a process of education, litigation and legislation and it's a slow process. One has to develop the theories, but then after you develop them, you have to convince others. Looking at the intangible theories we've developed, you have to determine whether the theories have been subjected to peer review and acceptance. We're in the process of ding that.

Moreover, we have to be concerned with legislation. My experience has been that whenever we're successful in the valuation field, the appraisers and assessors try to change the rules. So you go to the legislature and try to develop the rules for valuation of property.

Gering: What has changed in terms of property tax assessments since Sept. 11?

May: In terms of hotels we're anticipating huge opportunities for tax reduction in this next year. In the two weeks after the attack, Marriott revenues dropped 50% and many hotels in some locations are operating at below 25% occupancy, when they would normally be at 80%. So it's a significant impact on the company and there are going to be huge opportunities for property tax reductions.

Regan: A hotel consulting company, Pannel Kerr & Foster, projects that 36% of hotels will not be able to cover their debt from operations this year as a result of the fall-off in occupancy. I've told people in my office that we will have to go back to all of the hotels we represent in 2002 and look at them all over again because of what has occurred.

Office vacancies have just begun to increase at tremendous rates as well. For instance, companies in the Chicago area like Lucent Technologies, Motorola and Tellabs are responsible for up to 30% vacancies in the suburban office markets.

Garippa: We knew that the economy was contracting before Sept. 11, but a lot of us didn't realize the significance of the contraction. You know the old story: A recession is when your neighbor is out of work and a depression is when you're out of work. For the hotel industry, they're in a depression.

When it's reported that 36% of hotels for the next year will not be able to make debt service and you're in an industry where profit margins are 5% to 10% at most, this development has enormous importance. We're not talking about just reducing assessments; we're talking about the viability of a project and many of them will no longer be viable.

You're also going to see a tremendous amount of downsizing in the corporate world and that downsizing will eventually hit real estate. Space keeps getting pushed into the market. For instance, AT&T is abandoning their corporate headquarters in New Jersey. When you have one of the bedrock companies in the US doing things like this, anyone who says that life is the same is really ignoring reality.

Lutsky: Hotels are obviously affected quicker. For retailers like us, it's going to take a while to feel the impact. We'll see the first effects when the holiday shopping season results are in. My personal guess is we're not going to get a lot of percentage rent in 2001.

The economy has been slowing down for the past year. In our industry we look at occupancy cost ratios and we are starting to see the tenant sales slow down and the cost of being in our centers increasing. So, we have been tracking that number as it keeps creeping up. It's costing tenants more because their sales are coming down.

Popp: The nature of taxing authorities is that when the economy is going up, property values go up faster. When things are going down, values go down much slower than the reality. Taxing units are, if anything, digging in and becoming more difficult to deal with in terms of values because they saw the slowdown in the economy and now the effects of Sept. 11. They're much more entrenched than they otherwise would be and values are going down slower than the reality should dictate.