Last time, I talked about how property assessments are calculated and the considerations property owners must take into account if they believe their assessments are inflated. But I know that many property owners will say, “Why does it matter if my property has been over-assessed?”
It’s a fair question. In a commercial property landlord-tenant scenario, it is common practice for a lease to be calculated on a net basis – all of the operating costs are passed to the tenant. In situations where property assessments result in higher property taxes, many owners will simply opt to pass the additional costs to their tenants rather than incur the headaches of appealing the assessment on their property.
This may seem to be the easier course. Challenging the assessment can be a costly and time-consuming process that incurs the expense of outside help, such as the counsel of a real estate lawyer and valuation experts. And as I noted in my last post, the potential gain likely will not justify the cost if your annual tax bill is less than $20,000.
However, there are obvious benefits to setting the record straight in a landlord-tenant scenario and even more so when the owner is the chief occupant.
The landlord’s competitive advantage
As a landlord, ensuring that your property is being assessed, and taxed, on a basis that is fair and equitable in terms of market value doesn’t so much create a competitive advantage as remove a competitive disadvantage.
Astute tenants will keep their ears and eyes open, particularly if their leases are up for renewal. If your net rent is, for example, $2 per square foot higher than your competitors’ due to higher operating costs, your tenants will eventually take notice and demand a reduction in their rent. This means in the long term you stand to lose $2 per square foot in net rent.
This is a significant pinch to your bottom line and it will have a business impact such as making it more difficult to service debt.
Take, for example, a building that would rent for $10 a square foot with a hypothetical cap rate of 10 per cent. (The cap rate is basically the percentage of net income the property earns in a year versus its purchase price.) In my example, a property that would rent for $10 a square foot, with a cap rate of 10 per cent, would be worth $100 a square foot.
If your excessive operating costs reduced your net rent to $8, your value, at that same cap rate, becomes only $80 per square foot. This is why it is important to manage your expenses. Buyers will see less value in the property.
If you are seeking financing, it will reduce your borrowing ceiling, since banks will only give you a percentage of estimated value. If you are an owner occupier this is money straight off your bottom line.
Now, say for example that your assessment had resulted in an unfair increase in your property taxes that translates into an increase in operating costs of 50 cents per square foot. This is by no means an extreme example.
If your property is 100,000 square feet, that adds up to $50,000 in additional operating costs. If you could have that amount back in your pocket, it would increase profit margins, which in turn frees up capital.
You have more income available to service debt, reinvest back in the property and, if you so chose, take out more equity for other investments. At current capitalization rates of six to seven per cent, that could add up to more than $750,000 that goes straight to your balance sheet.
The owner-occupier’s windfall
In a landlord-tenant arrangement, the benefits that arise from reducing your operating expenses accrue to your bottom line over time. However, if you are the owner-occupier of the property, the gain is wholesale and immediate.
But when it comes to working with an assessor, it is important to consider that the process of reassessment can be quite subjective. While your assessment can be off base due to factual errors in the lot size, building size and zoning classification, the path to a successful appeal is typically less obvious.
I worked on one file where I believed a large commercial property had been over-assessed by $2 a square foot as the result of projected net income that I thought was high. The assessor, based on his research, believed it to be bang on. In this instance, the building was owner occupied. The assessor had formed an opinion on its value by using an income approach, which estimates what the rental rate would be if the building was leased out to tenants.
But after I reviewed his research, and he reviewed mine, we agreed some adjustment was warranted. We reached a consensus with a projected rent reduction of $1 per square foot. In this case, considering the size of the property involved, it was enough to reduce the assessed value by $8 million.
What’s the moral of this story? It can pay off, and pay off handsomely, to ensure your assessment is fair and equitable with the market average, and is not needlessly inflating your operating costs.
The larger the property in question, the more dramatic the savings can be. Not only can this provide more wiggle room in negotiations to attract and retain good tenants, it also frees up capital for other purposes.
To discuss this or any other valuation topic in the context of your property, please contact me at [email protected]. I am also interested in your feedback and suggestions for future articles.
About John Clark: With over 30 years of experience in the national real estate appraisal and valuation industry, John Clark (BA, AACI, P.App., FRICS, Chartered Valuation Surveyor) is a leading expert on real estate matters that impact the value of commercial, institutional, residential and other special use properties. He joined The Regional Group of Companies Inc. in 1988 and has served as Vice-President of Valuation and Consulting since 1990. He is a Fellow of the Appraisal Institute of Canada and served as its National President, 2001-2002.