Investment Value, Market Value Differ for Property Tax Purposes

— By Jim Popp, as published in National Real Estate Investor, January 2001

When does the $25 million purchase price for a retail center equal market value for property tax purposes? As a leading investor in retail centers recently testified in trial, “rarely, if ever.” A significant problem for taxpayers in negotiations with tax assessors is that physically similar retail centers most likely do not have similar investment values.

This investor testified, much to the assessor’s disbelief, that the real estate component of a center is not his primary investment criteria. Instead, the investor reviewed first and foremost the tenant mix of the center, and then, since most centers involve percentage rent, the maturity of the business within the center.

Only after considering these investment criteria did the investor finally review the traditional physical elements of the center.

However, the gap between an investor’s criteria in purchasing a retail center and an assessor’s perception and acceptance of the purchase as evidence of market value is often difficult to bridge. As a result, it is important to be aware of and adequately communicate the distinguishing characteristics between a retail center and other types of real estate valued by assessors, such as office buildings or apartment complexes.

Market value for property tax purposes is generally determined by market rent, market occupancy and market expenses rather than actual property specific parameters. Although it may appear overly simplistic, it is the communication of the actual investment in and operation of a retail center, and how the center compares to its competitors, that leads to significant property tax reductions.

Distinguishing Qualities
Many factors affect the investment value of a retail center, but the rent structure is a particularly important starting point to communicate to any assessor. Rent consists of base rent, pass-throughs and percentage rent. Rent that exceeds a reasonable return on the cost of the basic components of the real estate is usually derived from influences that are not directly related to the real estate itself. These other influences must be explained to the assessor in order to distinguish investment value and arrive at an appropriate taxable market value for the center.

The tenant mix of the center is a primary investment criteria because of its impact on rental income. The combination of anchor to side shops, as well as the characteristics of the anchor itself, affects this criteria. For example, in a typical grocery-anchored center the base rent structure, from lowest to highest, would be:

  • large anchors, such as national-credit grocery store tenants;
  • small anchors of medium-size national-credit stores, such as drug stores and large shoe/clothing stores;
  • regional-credit stores and small national-credit tenants;
  • local side shops; and
  • restaurant and pad-site tenants.

The variations on tenant mix between physically identical retail centers clearly affects income, and thus investment value but should not affect the market value of the centers for property tax purposes.

Other Considerations
In addition to tenant mix, there are other factors that explain how physically similar retail center can generate different rental rates. The larger the tenant, the more value it brings to the property, and thus the lower the rent. Tenants with more secure credit can demand lower rent. Tenant improvement requirements and the repayment term also can affect rent. Moreover, the location in the center and the configuration of the space affects rental rates. A national-tenant strategy will affect the rent the national tenant is willing to pay. A taxpayer should review and explain these influences and others with the assessor.

An investor also will evaluate the business maturity of the center in its market environment. Further, since most centers involve percentage rent, a review of the sales of each tenant is important. Are the businesses in the center in a start-up, mature or downward phase of their business lives? The percentage rent expectation has an effect on property tax value. The effect of percentage rent should be explained to the assessor.

Finally, there are many other influences on investment value of a retail center that should be considered when discussing market value. These include the marketplace of the center, the class of property of the center, the determination of the appropriate market occupancy for the center, the absorption rate and depth of the market relating to the center, the cost of sustaining and maintaining tenants, and the appropriate capitalization rate.

The strategy of distinguishing between investment-value components of a retail center and purely real estate components has led to significant property tax savings for retail center owners.

Jim Popp is a partner with the law firm of Popp Gray & Hutcheson. Popp Gray & Hutcheson devotes its practice to the representation of taxpayers in property tax matters and is the Texas member of the American Property Tax Counsel.