— By Mark S. Hutcheson, Esq. as published by National Real Estate Investor, Jun 1, 2004
Taxing authorities all too quickly use the sale prices paid by real estate investment trusts (REITs) as the basis for taxable value of investment-grade, income-producing property, a practice that unfairly inflates property taxes. This column explains how it happens and what owners affected by such practices should do to resolve the problem.
REITs pay a premium for investment-grade property, typically an amount above the market sales price paid by non-REIT investors. This REIT premium results from the atypical motivation REIT managers have to quickly invest capital into real estate equity. Empirical studies published in The Appraisal Journal demonstrate sales premiums of 21% to 27% in apartment purchases by REITs.
A Victim of Their Own Success
The last decade has seen a substantial increase in the amount of REIT capital invested in the market. The National Association of Real Estate Investment Trusts (NAREIT) reports that the market capitalization of REITs rose from $5.5 billion in 1990 to $151 billion in 2002.
This influx of capital combined with the legal requirement for REITs to hold 75% of capital in real estate equity produces a significant artificial demand for investment-grade property. Thus, REITs are forced to outbid other potential buyers simply to keep the required percentage of capital in equity.
Another major factor driving the REIT premium involves REIT management fees. These fees earned by REITs are based, in part, on the amount of real estate under management, increasing their incentive to quickly move cash into real estate equity. No such incentive exists among non-REIT investors.
Determining Taxable Value
In most states, property taxes are predicated on “market value,” which is generally defined as the price a willing buyer would pay a willing seller under prevailing market conditions. As a practical matter, taxing authorities rely on income information when determining the market value of income-producing property including office buildings, hotels and apartments.
Market value is determined by dividing the property’s net operating income by the capitalization rate (“cap rate”). The universally recognized formula for this approach is V = I/R (where V = value, I = income and R = rate). An inverse relationship prevails between a property’s value and the capitalization rate. In other words, the lower the cap rate the higher the value, and vice versa.
If the taxing authority knows of a sale and can determine the property’s net operating income, it can calculate the cap rate using the V = I/R formula. This calculation works well unless the sale used is a REIT transaction.
The following hypothetical example illustrates how REIT transactions can cause higher taxable values. Assume that Brookfield Apartments and the Newfield Apartments are sister properties, built at the same time and on the same street, and are identical in condition and appearance. Both properties have an annual net operating income of $1 million. Now assume that the Brookfield Apartments sold for $12.5 million to a nationally known apartment REIT. On the same day, the Newfield property sold to a non-REIT investor for $10 million. In this example, the resulting cap rate for the Brookfield transaction would be 8%, while the cap rate for the non-REIT Newfield sale would be 10%.
If the above sales and income data were analyzed by the local taxing authority for its valuations of comparable apartment complexes, the taxing authority would have three options: (1) use the 8% cap rate from the REIT sale and go for the highest value possible; (2) use the 10% cap rate from the non-REIT sale to offset the effect of the REIT premium; or (3) average the two cap rates at 9% and call it a market-derived rate.
Options No. 1 and No. 3 result in an overvaluation of the taxable properties because, in either case, the cap rate is derived from a transaction that does not meet the definition of market value. A market value appraisal of the property would utilize option No. 2, applying the 10% cap rate to arrive at a value unaffected by the REIT premium.
What Every Owner Should Know
Even if you are a REIT purchasing a property at a premium, your taxable value must be determined under the market value standard. Whether or not you are a REIT, you should scrutinize the income and sales data used by the taxing authority in determining market value of your properties.
In many property tax appeals involving REIT properties, the analysis of non-REIT income and sales data has helped achieve reductions of assessed values ranging from 20% to 40%. If the authorities in your area utilize REIT transactions to derive taxable value, you should challenge this practice at every turn.
Mark Hutcheson is a partner with the Austin, Texas law firm of Popp Gray & Hutcheson, the Texas member of American Property Tax Counsel, the national affiliation of property tax attorneys. Hutcheson can be reached at firstname.lastname@example.org.