Using the State of the Real Estate Industry For Tax Advantages

The downturn started with residential real estate and still continues. In fact, by many measures 2008 was one of the worst years in decades for the housing and homebuilding industry. Worse yet, 2009 appears to be more challenging. More so because the downturn is now affecting commercial and industrial real estate, as well, and the general economy has not found bottom yet.

Real estate owners can use the current state of affairs to their advantage. Property taxes are based on market value and most markets have been affected. This whitepaper will provide an overview of the economics of the real estate market, followed by some proactive measures that owners and taxpayers can take.

Real Estate Market Overview 

During the first three quarters of 2008 housing stood out as one of the weakest sectors of what was thought to be a fairly stable economy. Then, in the fall, credit markets in the United States froze, and in 2009 this condition has eased only slightly. Already weak consumer confidence has plummeted, job losses mounted, and the economy is clearly now in a steep recession.

What can we expect in the commercial and industrial markets? First, in general, no sector is immune to what is happening. This whitepaper will address occupancy and vacancy dynamics affecting office, retail, and industrial real estate sectors:

Offices

At the end of the third quarter of 2008 the US vacancy factor was 10.6 percent, which was up from 2007 at 9.7 percent. The Grubb and Ellis Company predicts that vacancy will be closer to 17 percent by the end of 2009. The firm points out that it should be marginally better than the 17.9 percent that occurred following the recession in 2001. Smaller cities in the secondary and tertiary markets will feel it the worst when a big employer downsizes. Some of those most affected thus far include Baltimore, Orlando, Denver, Atlanta and Silicon Valley. All have increased vacancy by over two percent.

Tenants will demand and get more concessions. Foreshadowing that, Korpacz Realty Advisors expect market rents to increase, on average, by only two percent. A year ago rents jumped over four percent. Grubb and Ellis reports that Class A office rents fell by .2 percent by the end of 2008 and Class B declined by .7 percent. Many expect those declines to worsen in view of the 55 million square feet of new construction that will hit the market in 2009, coupled with an increase in sublease space estimated at 45 million square feet, for a total of 100 million square feet. That much space is likely to have a downward pressure on rental rates.

Lastly, IRR reports that office capitalization rates rose to nearly 8 percent from under 7.5 percent over the last year. Discount rates also increased, according to IRR, to 9.34 percent from 8.86 percent last year.

Retail

Retail performance is tied to the severity of the residential downturn. Weakened consumer confidence and increased job losses exacerbate the already poor start to the New Year for retailers. After Christmas 2008 the effect became more apparent as bankruptcies increased amongst retailers. Circuit City and Linens-n-Things are amongst the largest. The International Council of Shopping Centers expects 3,100 chain stores to close in the first half of 2009.

IRR estimates that the backlog of retail space will take nearly 3 years to absorb. This even with the fact that retail development is down by one third from last year. Vacancy in neighborhood and community centers is nearly 10 percent. Market rents are expected to rise less than 2 percent as reported in Korpacz.

Lastly, capitalization rates rose to 7.4 percent while discount rates are nearly 9 percent. Community center discount rates are over 9 percent.

Industrials

The drivers of demand for industrial space were uniformly negative by the end of 2008. Retail sales fell. Business capital spending fell nearly 3 percent every month in the second half of 2008 as report by Grubb and Ellis. Additionally, exports and imports slipped in the second half of 2008 as the demand for goods softened across the globe. Finally, transportation companies slashed expansion plans and mothballed extra capacity to ride out the rest of the downturn.

All of the foregoing adds up to decreased absorption in 2008 of almost 70 percent from 2007. Average vacancy is 10 percent, up from 8.5 percent the year before. Korpacz expects vacancy in the warehouse sector to be 16 percent by the end of 2009.

Capitalization rates for industrials range from just under eight percent to just over 8.5 percent. This range includes, and is dependent on, whether it is a warehouse, flex or R&D. Discount rates hover around 9 percent.

Property Tax Trends

Based on the most recent Survey of Property Tax Assessors published by Grant Thornton in 2008, nearly one-third of all large jurisdictions surveyed get over 1,000 appeals per year! This is significant because almost 75 percent of these same jurisdictions reappraise every one to three years. Each of these offices may be staffed by as few as two appraisers!

Assessors are bracing for a challenging 2009 and 2010. At a recent conference, one state official was hedging her bets. She indicated that her state assessed property one year in arrears and thus the market was much better as of January 1, 2008. Furthermore, she added that taxpayers should not expect to win on an argument using diminished market conditions!

Given the many appeals that any jurisdiction may have and its attitude towards value, it is safe to say that a taxpayer must have a good command of the facts to win an appeal. Here are some suggestions from successful appeals:


Local Market Real Estate Statistics: Knowledge of these statistics is essential to any appeal. The assessor will likely know these statistics and transactions quite well.

Specific Industry Statistics: Economic obsolescence or the loss in value due to external influences can sometimes be measured by the state of the particular industry. For instance, if the subject property is an oil refinery and demand for oil has dropped. Capacity utilization has also dropped which is an indication that economic obsolescence is present.

Negative Effects on Value of Location Characteristics: Visibility, accessibility, topography, drainage, etc all affect value. How does each affect the subject?

Negative Effects on Value of Physical Attributes: Age, Gross Building Area, Rooms, Units, Land Area, Ceiling Height, and Quality of Construction all affect value.

Vacancy: Some jurisdictions will adjust an assessment of a Hotel, Mall, office building or an apartment building that has a high vacancy rate.

Excess Maintenance Costs: Some properties experience high maintenance costs as a result of inferior construction components. This is an indication that there is a loss in value due to a functional inadequacy.

Below Market Rents: Some income-producing properties are encumbered by long term leases with below market rents. Assessors should take that into account.

Sale-Leaseback Effects: These transactions are largely used for financing and the consideration includes more than just the real property. Any price derived from this kind of transaction does not meet the definition of an arms-length transaction; a necessary element of market value.

Walgreen’s Effect: In Walgreen Co. v. City of Madison, 2008 WI 80 (Wis. 2008), the Supreme Court of Wisconsin recognized the fact that developers will enter into a contract with Walgreen’s whereby they agree to bear all of the financial costs and burden of building a store for the retailer. Not unlike the Sale-Leaseback above, through this transaction Walgreen’s finances the entire development through the builder and then pays a rent to include more than just the real property. They pay for carrying costs, debt service, interest and other intangibles. The court concluded that any sale price or rent from this transaction did not reflect market value.

The foregoing list is certainly not exhaustive. It is simply, a list that prompts the taxpayer/owner to consider all of the factors that may affect value for the subject property.