Assessing Market Value
Understanding real estate taxes can help minimize risk in future assessments, even if the calculus can seem arcane.
Capital markets continue to attract investors seeking the stability of the U.S. dollar. As capital becomes globalized and returns in gateway and primary markets are compressed, commercial real estate investors are increasingly looking to secondary and tertiary
markets for yield. These investors can find higher rates of return in non-core markets, but increased return comes with additional uncertainty. A common question from out-of-market investors searching for yield is, “How are real estate taxes calculated for multifamily developments?”
In a basic sense, market value is based on the transfer of a property under specific conditions set forth in the definition. Because a transaction or a hypothetical transaction must occur before an asset has realized value, market value considers the potential tax implication for an acquisition and a
refinance as if the property were selling. The method of financing does not impact the analysis of real estate tax at the property level. The valuation process analyzes the potential impact to property taxes for a recapitalization in a similar manner to an acquisition because both are based on exchange value.
Market value presumes a hypothetical sale, and the valuation for tax purposes must be analyzed relative to the market or underwritten value of the property. This analysis holds especially true in disclosure states where the sale price is public information and disclosed to the local taxing authority. As of June,
there are 12 non-disclosure states in the U.S. The other 38 generally require a sales disclosure to be submitted to the county or city.
In the case of a refinance where a property is not actually selling, the property owner gets the temporary benefit of enhanced cash flow but does not benefit from the increased value due to below market taxes. A prudent buyer would underwrite year one taxes to reflect the purchase price of the property.
Because the benefit is temporary and does not transfer to the next owner, capitalizing the existing or below market taxes can overvalue an asset as taxes generally increase following a sale.
Property value is based on the present value benefits the buyer anticipates receiving, which must reflect any potential tax increase or other special circumstance what would erode future benefits. This concept explains why taxes often increase in a refinance, to mirror the hypothetical buyer’s anticipated
Additionally, buyers look at comparable or substitute sales as an indication of value for a property and to extract a market-oriented cap rate. The sales price paid by the buyer and corresponding cap rate are reflective of any potential tax increase
triggered by the sale. The same methodology must be applied for valuation purposes, even if the property is not actually selling. This approach aligns risk, buyer motivation, and asset value.
Several states require real estate taxes to be fair and equitable among comparable properties, which is supported by analyzing tax comparables with a similar geographic location and economic characteristics. Assessed values and mill levies (tax rates) are often county and submarket specific, so it is important
to select comparable properties from the same taxing jurisdiction for consistency. For example, in the Kansas City MSA, real estate taxes are influenced by state statute in either Kansas or Missouri. Kansas is a disclosure state, and tax values are near their true market value. Missouri is
largely a nondisclosure state, and values are generally below the actual market value. The table above shows various real estate tax metrics for a Class A apartment project located in each state of the Kansas City MSA.
Depending on the geographic location of the property, the tax burden can vary significantly, which impacts the asset’s acquisition price and investment returns. Analyzing sale to reassessment ratios within the taxing jurisdiction of the property can mitigate future tax increases.
The data indicates that properties in the same taxing jurisdiction are generally taxed between 90 percent and 100 percent of the actual market value. The tax ratio can be confirmed by a ratio study prepared by the state’s department of revenue that analyzes mass appraisal accuracy and level of uniformity. Applying
the same methodology to an acquired or refinanced property will result in an alignment of value and risk profile consistent with the market-extracted cap rates obtained from similar sales.
Prior to the sale, a property may be undertaxed in relation to its actual market value, which is a benefit that would not transfer to the next owner. The buyer’s exposure to increased taxes can be mitigated by increasing the pro forma tax projection to mirror similar projects (fair and equitable taxation)
and the purchase price (ad valorem taxation).
Real estate taxes are one of the largest non-controllable operating expenses. Having a deep understanding of local taxing policy is critical in a successful investment strategy. Taxes vary by state, county, and submarket, so accurate data at the local level can help
mitigate future reassessment risk. Market value and real estate taxes are not mutually exclusive — rather, they are interrelated in their impact on market-extracted cap rates, asset pricing, and investment returns.
For more on this topic, check out CCIM Institute's “Real Estate Tax Update" course.