Property taxes make up a significant portion of a commercial building’s operating expenses. As a landlord or investor, failing to understand – and plan for – these expenses can crush your net operating income (NOI). And, when NOI takes a hit, a commercial property’s valuation suffers.
As such, we’ll use this article to help readers understand property taxes in commercial real estate. Specifically, we’ll cover the following topics:
- An Overview of Property Taxes in Commercial Real Estate
- Determining Commercial Property Valuations and Tax Bills
- Why Property Taxes Change
- Projecting Future Property Taxes
- Strategies for Limiting Property Tax Expense
- Final Thoughts
An Overview of Property Taxes in Commercial Real Estate
If you own a home, you’ve dealt with property taxes. Typically on a quarterly or semi-annual basis, you need to pay the local tax collector a property tax bill based on your home’s value. While commercial property taxes differ slightly in execution, the concept is the same: a local tax based on a commercial property’s value.
In technical terms, property taxes represent a type of ad valorem tax, that is, one based upon an item’s assessed value. At some interval – normally annually – local government tax assessors determine the value of all commercial properties in their municipality. These tax-assessed values then become the basis for determining your annual property tax bill.
For example, assume the assessor determines your apartment building has a $2,000,000 valuation. Next, you multiply this valuation by the local property tax rate – say, 1.25% – to determine the annual property tax of $25,000. If your municipality bills owners semiannually, you would then pay two bills of $12,500.
Bottom line, two characteristics define commercial property taxes. First, your tax bill depends on the value of your commercial property. Second, property taxes are assessed by local entities (e.g. town, city, county, school district, etc.), not the state or federal government. As a result, they fund local services.
Determining Commercial Property Valuations and Tax Bills
To understand property taxes, investors need to first grasp the commercial value formula. Due to their similarity, tax assessors use market comparables (“comps”) to determine the tax-assessed value of residential properties.
Commercial properties, on the other hand, lack this uniformity. As a result, commercial valuations depend on an income approach, something that allows assessors to analyze a unique property. More precisely, assessors determine a commercial property’s value with the following formula:
- Commercial property value = NOI / cap rate
NOI equals the properties rental revenues minus all operating expenses (NOTE: depreciation and mortgage interest are not included in operating expenses). Capitalization, or cap, rate is a market-driven factor that, conceptually, represents the unleveraged operating return a property would generate. Generally speaking, the lower the cap rate, the more stable a property (and vice versa).
Every municipality has a slightly different approach to commercial property assessments, but all revolve around this commercial value formula. Normally on an annual basis, the local tax assessor will request an income and expense report from commercial property owners. While some assessors accept any format, most municipalities have a specific form that property owners must use to submit this information.
Regardless of how you submit your income and expense information, tax assessors will use this report to determine your property’s value. The income and expense report provides the relevant NOI, and the assessor will assign a cap rate based on your building type (e.g. Class A office space will have a different cap rate than Class C). After determining the new value, the local assessor will calculate your tax liability and mail you a bill, usually for the next year.
Why Property Taxes Change
After explaining how municipalities calculate commercial real estate property taxes, the question remains: why do property taxes change?
Changes in Valuation
As outlined, property valuation plays the largest role in a building’s tax bill. Accordingly, changes in value drive the largest changes in the associated property tax bill. For example, assume that new owners purchase a 100-unit apartment building with a value-add strategy. After the purchase, renovation, and rental increases, the NOI jumps from $400,000 to $600,000. Furthermore, due to the renovation, the municipality determines that the property now warrants a slightly lower cap rate, decreasing it from 8% to 7%:
- Original valuation: $400,000 / 8% = $5,000,000
- New valuation: $600,000 / 7% = $8,571,429
In this basic example, the property’s value increased by ~$3.6 million. Assuming a 1.25% property tax rate, that would correspond with a $45,000 increase in annual property taxes (NOTE: this ignores any potential tax abatement, which we’ll discuss below).
Changes in Rate
In theory, commercial property taxes can also increase due to an increase in the underlying property tax rate. This happens far more infrequently than valuation changes, but it certainly can change.
For instance, a city may want to raise money to fund a local project. Rather than issuing bonds or increasing residential property taxes, city officials could decide to increase commercial property tax rates. This approach, if enacted, could significantly increase a commercial property’s annual tax bill.
Projecting Future Property Taxes
As a major operating expense, investors need to project future property taxes in any cash-flow projections for an investment. That is, if underwriting a 10-year deal, you’ll want to have an accurate estimate of property taxes for that entire 10-year period. To do this, investors should take several steps:
Learn Your Local Tax Assessment Model
Most importantly, investors need to understand how the local tax assessor determines property values. What does the income and expense report look like? How frequently does the municipality update its commercial tax assessments? When was the last time property tax rates increased?
These are just a sample of questions to ask. But, the important takeaway is that, to accurately project future property taxes, you first need an intimate understanding of how the local tax assessment system functions. With this knowledge, you can then craft the most appropriate strategy for projecting (and minimizing) your future property tax bills.
Next, you need to look at your operating pro formas. During a deal’s underwriting process, you (or the deal’s sponsor) will generate NOI projections via these pro formas. Armed with this information and a familiarity with the local assessment system, you can project future property tax bills.
For example, assume that the local tax assessor determines commercial real estate valuations on a biannual basis. With this system, you know you’ll have your tax bill locked in for the first two years. The question then becomes, what NOI do you project for Year 2 of operations? These Year 2 results will likely be used as the basis for as the valuation for Years 3 and 4. Extending this logic, you can then forecast property tax bills over the deal’s 10-year horizon.
During a deal’s due diligence period, investors should also look at historic property tax results. Yes, you’ll absolutely want to conduct the above NOI projections. But, looking back at a property’s tax bills – and valuations – for prior years can also inform your understanding of the local tax assessment system.
For example, say you look at a property’s valuations for the prior decade. If, on average, values increased by 3% per year, and you don’t plan on significantly changing the property’s operations, you should expect similar growth.
But, what if the valuation jumped 30% one year? This could’ve been the result of a variety of factors: dramatic NOI increase, change in tax assessment model, valuation mistake that was never challenged, etc. If you see a major jump like this, you’ll want to closely investigate to determine whether you should expect a similar one in the future.
Strategies for Limiting Property Tax Expense
Lastly, we need to ask how to minimize commercial property tax expenses. Two primary strategies exist:
Local governments grant tax abatements as a way to encourage investment. Technically speaking, a tax abatement reduces taxes in order to promote local economic development. Municipalities have their own formulas and policies for offering tax abatements, but they all follow a similar model.
Say that a building has a tax-assessed value of $500,000 at acquisition. To encourage real estate investors, tax abatements lock-in this valuation for a period of time. For example, assume that a group of investors buys this building, puts $1,000,000 into renovating and leasing it to new tenants, and increases the value to $2,000,000 as a result.
With a tax abatement, the local government would tax the building based on the original value – not the new, after-rehab value. Depending on the local policy, this abatement will phase out – or “burn off” – at some point in time. That is, the property taxes will eventually be based on the current – not original – valuation. But, during the abatement period, the owners would benefit from reduced property taxes.
Additionally, investors can limit their property tax bills by challenging a building’s assessment. For example, say that a local tax assessor assigns a $5,000,000 valuation to an office building, but your NOI and market cap rates suggest a $3,500,000 valuation. You can then formally challenge the tax assessor’s valuation.
Every municipality has a different process for this sort of challenge, but the important takeaway is that you always can challenge an assessment. And, when looking at potentially millions of dollars in valuation swings, these challenges often make financial sense. Related, most cities have law firms that specialize in commercial property assessment challenges. While you can challenge an assessment on your own, retaining an attorney who knows the ins and outs of the local tax assessment system could be the better choice – especially with large commercial properties.
Property taxes comprise a large portion of any commercial property’s operating expenses. As a result, investors need to understand: 1) how tax assessors determine those bills; 2) when and how tax bills can increase; and 3) strategies to minimize property taxes.
If you’d like to discuss different real estate investing options for your unique situation, we’d love to chat! Drop us a note, and we’ll set up a meeting to talk about available commercial real estate investment opportunities – and the associated property tax implications.