There is a tea party underway. But it doesn’t involve a particular political party. It involves a revolt against real estate taxes levied by local taxing authorities against real estate owned by companies with national name recognition like Walgreen’s, General Electric, and Brigestone. These companies contend that they’re being taxed on their hard earned reputation – goodwill. It’s no secret among real estate professionals that the lease rates for buildings occupied by nationally franchised tenants are well above rates of a typical tenant who lacks name recognition. As a result, buildings they occupy sell for a premium price, resulting in higher real estate taxes.
Their argument is that, if the building were occupied by a lesser well-known tenant (and leased at a market rate), it would sell for a much lower price and be taxed at a much lower rate. Therefore, the increased taxes must be based on something other than the value of the physical components that comprise the real estate. So how does their contention square with valuation theory? Are they really being over-taxed? The answer to that question depends on what is being taxed. The term “real estate” refers to the physical components (i.e., the land and everything attached to it) whereas the term “real property” refers to all the rights that are associated with the real estate. Although many people use these terms interchangeably, there is an important distinction between the two concepts. Every first year real estate student is schooled on the difference when taught the bundle of rights theory.
As an appraiser, I am employed to appraise rights related to property. These rights most often consist of the fee simple estate (complete ownership and the value sought in most municipalities for taxation purposes), the leasehold estate (the right to occupy the property), or the leased fee estate (the right to receive lease income generated by the property). In the case of a leased fee estate, the right to receive income from a AAA rated company would be much more valuable than the right to receive income from a company with no brand recognition, say Larry’s Pharmaceuticals. Given these circumstances, the physical components of the property are incidental to the overall transaction price – the price that often gets recorded on the deed (in states that do that sorta thing) and the value on which they are being taxed, despite their obligation to assess taxes based on the fee simple value.
So here’s the rub. The transaction price, the price a buyer is willing to pay for the right to receive income from a AAA rated tenant is recorded on the deed at the court house. This premium price is then taxed a rate that reflects the right to receive income from a AAA rated tenant. I’m just asking. But is this fair?
Another problem lies in the method used by tax assessors to compute value. Most companies with a national franchise own buildings with a highly unique design. The cost to construct such a building typically includes items that would be worthless to any other company. But the method used by tax assessors to calculate taxes is based on the cost to construct. I’m not sure how much those mile-high McDonald’s signs along the interstate cost to build but you can rest assured that it would be worthless to Joe’s Burger Barn.
Sadly, the defense by local taxing authorities and politicians in rejecting the pleas for tax relief by these companies is that it would increase the tax burden of other property owners in the area or reduce funding to one of their darling (and politically sensitive) causes such as education. Seriously? That’s your defense?
When you reach the point that there is no legitimate argument left, forcing you to appeal to the desires of the mob, it’s time to acknowledge your sin and repent in sackcloth and ashes. Just sayin’.
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Good article on an interesting topic.
Thanks, Wyatt!
Mr. Roberts, I am a Certified General Appraiser currently employed as a Tax Appraiser. We have recently had several tax appeals based on the arguments presented in your blog. As a former fee appraiser, and as a county tax appraiser, I have a unique vantage point when viewing this debate. When stating the problem in your article, you stated that “if the building were occupied by a lesser well-known tenant …” That is a hypothetical argument. The improvements are typically encumbered with a long term lease as of the effective date of the reval. The appraisal question then is, is the lease a market lease typical for that type of improvement. In our market, we frequently see big box drugstores and home improvement stores reoccupy a location of a former competitor, often using a sale/leaseback agreement. This shows, that in this market at least, there is negligible functional obsolescence with these improvements. If a county were to appraise a currently leased property using the hypothetical condition (that the building is “Dark”) that would be contrary to actual facts as of the effective date, and would be undervaluing a particular property relative to other commercial properties. An argument could possibly be made that if particular market or area is declining, and that it is unlikely that another “AAA” tenant would ever occupy the space, that the highest and best use of the improvements has changed and that an alternative use is then more likely. By the way, I enjoy your blog and your technical articles very much. Respectfully, Thomas H.
Thank you for your comment, Thomas. This situation reminds me of the the proposed construction of large industrial buildings. I think we would agree that most will suffer from economic obsolescence on the date of completion…yet, they continue to be built. I think that the reason why is because any losses incurred by economic obsolescence will be offset by gains when considering their larger business model.
By the same token, I think that excess rents paid by many AAA rated tenants reflects their willingness to pay above-market rates because, within their larger business model, the excess rents pale in comparison with the impact on their revenues and, ultimately, the bottom line.
I think we’re close in terms of how we think about these situations.
Again, thank you for the comment, Thomas. And nice to meet you, even if it is a virtual meeting!
I agree with you regarding the excess rents paid by many AAA tenants, however, these types of properties are typically bought and sold based on the income stream to the investor / owner. If the lease in place (as of the effective date of the reval) adds or subtracts from the value of the property, wouldn’t you be required to consider this when forming your opinion of value. In North Carolina, where I work, the assessed value (or “True Value”) must reflect the market value of a property, therefore the courts have upheld that the greatest consideration should be given to the income approach when valuing an income producing property, not the cost approach. If the highest and best use of a property is for its continued use as a CVS, or Home Depot, and if there is a likelihood that this will remain (as evidenced by a lease agreement) until the next revaluation, then the obligation of the tax assessor is to consider any material fact regarding that property. The equitability argument comes in when determining if the lease in place is market value, and if the other factors such as expense ratios and cap rates are typical for the property type when applied to similar properties. One thing is certain, this debate is only beginning.
Thomas, yes. Technically, the deviation (up or down) between the market rent and the actual lease rate should be accounted for in the discount rate or cap rate. For example, let’s consider a CVS Pharmacy. Assume that the market rate (based on buildings with a similar highest and best use) was $25/SF NNN but CVS is paying $35/SF NNN. The $10 differential should be discounted at a rate higher than the market rate to account for the additional risk of purchasing an above market lease. The inverse would be true for a below market lease; it should be discounted at a lower rate.
In theory, the credit-worthiness of the tenant is not germane to the value of the real estate. But we know that investors will pay a premium for the income stream from buildings leased to a AAA tenants. From my perspective, the premium the buyer is willing to pay is the result of the perceived risk (or lack thereof) of the tenant, not anything inherent in the real estate.
In reality, property is appraised every day just as you describe.
There are exceptions. For example, I’ve seen some sale transactions in Kentucky (funeral homes and dog kennels in particular) where the business component (intangibles) were sold apart from the real estate component. Few people would argue that the prices paid for these property types didn’t have an intangible element. But what about the case with a national retailer? If my business model entails paying above market rents because I will sell a jillion dollars worth of drugs from my pharmacy then absolutely, I’ll pay an above market rent. But the price an investor is willing to pay for the lease income reflects their perception of the risk.
I’m not saying that appraisers are always consistent in how they appraise property, they aren’t. You guys just happen to be in the unfortunate position of defending a method that is commonly practiced among appraisers, but which in my opinion, isn’t consistent with appraisal theory.
That is a very good point regarding discounting the $10 lease differential between an AAA tenant and a lower rated tenant. What do you feel would be an appropriate way to calculate the discount rate for this portion?
Again, in theory, find another sale exactly like this one, extract a discount rate…you know the drill!!!