Page 14 — Office Properties Quarterly — September 2019 Property Tax H ow many people remember the bubble that burst in 2008? Or, how many people are willing to admit they remember the previous market downturn, in 2001? For the millennials in the room, and those of you who have tried to block those parts of your career out of your memory, market downturns can be tough to navigate in the commercial real estate world. Some prognosticators have begun sug- gesting that the next one may be coming. How quickly? Most aren’t willing to stand out on that limb. In the meantime, lease rates continue to rise. Sales prices con- tinue to increase. And, as a result, property taxes are rising to unprec- edented levels. So, as you begin to prepare for that downturn, along with ensuring that your financing package is where you want it, don’t forget to review all of your operat- ing expense categories. And even though your property taxes may be labeled as a “fixed” expense, that is the one you should probably review first. Property taxes always have been the single biggest expense on your cash flow statement. But, as assess- ments continue to escalate, tax bills have seemingly gotten out of hand. “Seemingly” may not be the right word. Even in this appreciat- ing market, there are still properties being foreclosed on. If you lose a major tenant, paying the mortgage and the tax bill can be impossible. There was a time when developers took an even big- ger risk than they do today. They covered all of the streets and other infrastructure and built that cost into their pro formas. Today, most of the infrastructure gets rolled into a spe- cial district bond, which increases the mill levy and the property tax bills going forward. So, not only is the tax bill rising because the mar- ket is appreciating. It is also rising because there are many more spe- cial districts than there ever were before. Those mill levies are not some- thing you and I can do much about, nor is the assessment rate. Thus, the most important check regard- ing your tax bill involves reviewing the assessment each year and filing an appeal, if warranted (and, if you missed the June 1 appeal deadline, there is still an opportunity to file an appeal for this year; contact a property tax professional to deter- mine your options). The assessor is responsible for estimating what every parcel in the county is worth every two years. Each odd year is a new assess- ment. The following even year, the valuation should remain the same, unless there is an “unusual” con- dition (most often resulting from construction or demolition of a building). The assessors’ staffs are not large enough to do an actual appraisal on each property. So, instead, your new assessment is based on mass appraisal techniques that the asses- sor employs. Based on sales the assessors review (along with lease rates, cost-to-construct information and other information associated with real estate valuations), they are able to derive many generalities within the market. Those generali- ties then get applied against your property: Is your property a Class A, B, C, etc.? A single-tenant building or multitenant? When was it built? Has it been remodeled since then? And many other considerations that are kept on file for your property from year to year. Based on what the assessor has on record for your property, and how that compares to those gener- alities, the computer will spit out a number, estimating what your prop- erty is likely worth. Do not take that valuation personally. But you do not have to take it lying down, either. Whether you have a tax agent or an attorney review the assessment for you or you do it yourself, it should never be ignored. Real estate appraisal involves subjectivity. Therefore, opinions will always differ between appraisers who value the same property, using the same data and information. The formulas used in mass appraisal, and those results, are no different. For as inexact as the process can be, the assessors get it right way more often than they get it wrong. Or, sometimes they get it wrong, but it’s to your benefit, as the valuation should/could be even higher than what the assessor says. Yet, every year, there are definitely a signifi- cant number of properties that are overvalued and should be protested. If your property is one of those, it is not because the assessor has a per- sonal vendetta against you. You may have a vacancy issue that the assessor was not able to consider. You may have deferred maintenance issues or one of a multitude of other factors that could be negatively affecting your property. Occasionally, it even makes sense to file a protest when you purchased the property for more than what the assessor has assigned (granted, that is not the case very often). The market will turn. I don’t know when. I don’t know how hard. But it will turn. Be sure your net oper- ating income doesn’t take an even bigger hit than necessary by ensur- ing that your property tax bill isn’t any higher than necessary. Simi- larly, even if the turn doesn’t come for several more years, be sure to optimize your bottom line. Review your assessment closely each year with a professional who knows the statutes and rules that the assessor must comply with. ▲ Reviewing assessment can optimize bottom line I n May the Colorado assess- ments of value were sent to property owners. As in 2017, many commercial property owners were stunned by the increase in values, most likely signal- ing a hefty increase to their property tax burden in 2020. We have properties in our manage- ment portfolio whose assessed values increased 80-190%! In many cases property taxes (from the last increase) are now accounting for nearly 50% of total building operating expenses. These tax hikes may be coming at a very inopportune point in the real estate and economic cycles. Now is the time to consider the effects that these operating cost increases may have on your property, and your ten- ants, and formulate a plan to deal with the increase. If your existing leases are triple net, the property taxes get passed directly through to the tenant. The same goes with most modified gross leases whereby the tenant pays only the increase in expenses over the base year; in these cases, when the base year was established can dramatically affect how much of the tax increase the tenant will bear.While these types of leases do offer the landlord protection against escalating costs, many small businesses operate on slim margins. Property tax increases, coupled with the dramatic increase in property insurance costs, will directly cut into a small business’s profit mar- gin. These increases are happening dur- ing what most economists believe are the very late stages of the longest economic recovery in U.S. history. In other words, a downturn seems imminent and, historically speak- ing, extremely likely. This could be a perfect storm of decreasing profits and increasing costs for small- business owners, resulting in an increase in tenant defaults. And thus, even with triple-net and modified gross leases, the property taxes can become the owner’s bur- den. What can an owner do to mitigate the effects of these property tax increases that could ultimately result in a loss of income due to increased vacancy? Q Financial Analysis. The first step is to perform a sensitivity analysis. Revisit the long-term financial model of your property and also the upcom- ing budget. The analysis should focus on finding one critical number, your breakeven point. This number will help you determine what level of vacancy your property could handle, as well as what level of rent conces- sions you may be able to offer if your tenants get into financial trouble. For small businesses, rent is often one of the largest single expense items, especially for office users. If belt-tightening time comes, you don’t want your space to be the first item they slash. A reduction in rent may be a far better outcome than vacant space, especially in a down market when it will be difficult to re-lease. Q Leasing strategies. Make sure any new leases or renewals you sign pro- tect you against tax increases. Taxes usually make up the largest single above-the-line expense. Your triple- net or modified gross leases should always be written in a way that pass- es along the increased taxes to the tenant. Do not allow caps on noncon- trollable expenses, especially taxes and insurance. Also, when negotiating renewals and extensions, do not reset the base year to the current year. Of course, with gross leases the landlord bears the entire burden of the tax increases. This additional cost is a direct hit to net operating income. Landlords also are exposed if they have negotiated triple-net leases with caps on operating expenses that include noncontrollable expenses, of which taxes and insurance are nor- mally included. Remember, no matter how your leases are structured, you are vulnerable to varying degrees. Q Stay informed. Another measure is to periodically review the county assessor’s website as most of its pages now provide a wealth of infor- mation. The Denver County website has a tab that lists “Comparable Prop- erties,” as well as a tab for “Neigh- borhood Sales.” Using the websites you can easily track transactions in your area and determine how much nearby properties increased in actual sales price, providing a means for you to extrapolate your future assessed value. Your calculations won’t be perfect, but it is a good method to estimate ballpark future tax increases and provide clearer optics into your local submarket. Q Communicate with tenants. Your management company should be proactive in communicating tax increases to the tenants. During this last increase, in 2018, we sent out a preemptive letter in January to ten- ants in buildings in which we knew significant increases were loom- ing.We also included a tax increase explanation in the cover letter with the estimated common area main- tence charges in March. The goal is to open up the lines of communication between ownership and tenants. It is also a goodwill ges- ture that signals that you care about their interests and are not so insensi- tive as to suddenly slap them with large increase, especially if you knew months in advance. This goodwill could come in handy during lease negotiations. If a tenant is getting into financial trouble, it is best to be fore- warned so that you can be proactive rather than reactive. In conclusion, if we do head into an economic retraction, armed with your updated financial model, you can make informed decisions regarding lease negotiations, offering conces- sions, or possibly even not passing along tax increases to your tenants. ▲ Coping with Colorado property tax increases Mike Walter President, 1st Net Real Estate Services Inc. Brian Lantzy Vice president, Wheelhouse Commercial Now is the time to consider the effects that these operating cost increases may have on your property, and your tenants, and formulate a plan to deal with the increase.