Three Tests To Determine A Fair Value: An Example From Texas

By: Paul Pennington

This article originated because of differences of opinion among Texas appraisal districts, taxpayers, and their representatives relating to the reliability of the commonly used mass appraisal income approach model. It examines the elements of the model, presents associated problems, and provides a suggested resolution.

THE TEXAS CONSTITUTION sets out five rules for the property tax. Taxation must be equal and uniform. All property must be valued and taxed equally and uniformly. This applies to similar types of property-for example, all residential homes, commercial properties and personal properties. No single property or type of property should pay more than its fair share of taxes.1 Sometimes, the methods used in the past must be reexamined and tested to achieve equal and uniform taxation. This article originated because of differences of opinion among Texas appraisal districts (districts), taxpayers, and their representatives relating to the reliability of the commonly used mass appraisal income approach model (the model). Although this approach provides districts with a standardized analysis and is direct and systematic, it is, in the opinion of some, inconsistent. An examination of the district's model illustrates the fundamental differences of opinion in the definitions and application of three major components needed to secure market value assessments. The areas of disagreement revolve around the use of market value sales data, the application of the fee simple estate ownership, and the fairness and equality of valuations.

The Model

In the normal course of a valuation review, the district examines the property's December 31, 12-month profit and loss statement and the January rent roll. They generally use a model whose result is determined by these steps:

1. The January rent roll and the most recently signed leases or lease. By using these leases, an aggregate rate is arrived at as of January 1-one rental rate being applied to the entire property. Another method is to use the district's defined lease rate by applying mass appraisal standards

2. The district's market vacancy is deducted

3. The district's standards for operating expenses, generally with no allowances for reserves, tenant finish out, or leasing commissions, for example, is deducted

4. A net operating income (NOI) on the subject property is calculated

5. A standardized capitalization rate that districts have determined is reflective of the market, property class, and age is applied, which in their opinion, results in a fee simple market value

In all fairness to districts and their staff, they do not, as a policy, limit themselves to the income approach to value. Generally, they give consideration to additional information, such as recent appraisals, purchase prices, asking prices, the sales comparison approach, and the cost approach to value.

THE PROBLEM

To determine a fair value, commonly accepted valuation techniques, such as the sales comparison, income, and cost approaches should be considered, and then the most appropriate method used. However, because this article revolves around property tax valuations, the valuation should use a test consisting of three tax components to avoid an incorrect result. The components, as previously stated (i.e., market value, fee simple estate, and fair and equal taxation) make up the analysis of property to determine a fair valuation. The following paragraphs review some commonly used terms.

The first term to understand for property tax purposes is market value. The Texas Property Tax Code (Texas Code) requires all property to be appraised at market value as of January 1 of each year. The Texas Code defines market value as follows:

Market value means the price at which a property would transfer for cash or its equivalent under prevailing market conditions if:

1. Exposed for sale in the open market with a reasonable time for the seller to find a purchaser;

2. Both the seller and the purchaser know of all the uses and purposes to which the property is adapted and for which it is capable of being used and of the enforceable restrictions on its use; and

3. Both the seller and purchaser seek to maximize their gains and neither is in a position to take advantage of the exigencies of the other.

A fee simple estate is defined as: "Absolute ownership unencumbered by any other interest or estate subject only to the four powers of government." The fee simple estate is divided into several components:

1. Leased Fee. The lessor's interest, the right to receive the rent as stipulated by the lease, and the reversion of the property at the expiration of the lease

2. Leasehold. The lessee's interest and the right to use and occupy the real estate during the term of the lease, subject to any contractual restrictions. The leasehold may include rights to develop, alter, or sublease, for example

As previously mentioned, the Texas Constitution states that taxation must be equal and uniform and that all property must be valued and taxed equally and uniformly. In addition, no single property or type of property should pay more than its fair share of taxes.

Consider, on the surface, some of the problems a knowledgeable investor might have with the district's income model described above. Furthermore, recognize that the model is simply, in reality, a pro forma, a projection of the property's future net operating income (NOI). Forecasting a property's performance is difficult and is not conducive to mass appraisal techniques. It is difficult to predict all the ups and downs of a property, the real estate industry, and the numerous external factors that can affect property. Therefore, it is difficult to predict the performance of a property. Due diligence must be used in the model's forecast.

To begin with, the methods to determine market rental rates should be considered. The approach might be standardized; however, it is generally not based on intimate knowledge of each property's individual lease property, nor is it usually confirmed by comparable market leases. It can be argued that using the model's technique to determine a single rental rate for an entire building creates, in theory, a single tenant property. Having a single tenant building can be looked at in the same manner as an investor owning one stock. Extending this analogy, an investor with a multi-tenant building might be the same as an investor with a diversified investment portfolio. Thus, a single tenant property could have more risk than a similar multi-tenant building. This possible increased risk is reflected in the capitalization rate that is discussed later. Moreover, the model does not consider income appreciation, depreciation, or the effects of inflation. The same arguments can be used in predicting the occupancy rate of a property.

Using the district's standards for operating expenses and not making allowances for reserves, tenant finish out, or leasing commissions, is not typical for a knowledgeable investor. An investor also considers the operating expenses of like properties in the subject's neighborhood or submarket. Considering the arguments noted above, it is questionable if the NOI derived from the district's pro forma is accurate.

At this point in the review of the model, additional areas of concern appear. Now, the concepts of fee simple and leased fee estates come into play. Contrary to the district's position, its approach assumes that a knowledgeable investor uses a leased fee capitalization rate when buying a property on a fee simple basis. The market place reveals that a knowledgeable buyer is counting on income appreciation when purchasing a leased fee estate. The model noted above relies on the assumption that an aggregate lease rate (which averages three to five years lease term depending on property type), as well as the district's stabilized occupancy rates, apply to the property. In other words, it is assumed that the property will maintain these lease rates and occupancy levels throughout the year for purposes of taxation. This, in the opinion of some, creates a dilemma. These problems are explained by Jeff Tarpley, MAI, with the Dallas appraisal firm of Butler-Burgher, Inc., in the following excerpt from a recent fee simple appraisal:

...This method involves capitalizing the stabilized net operating income (NOI) by an appropriate capitalization rate (Ro) in order to estimate the stabilized value of the project. Ideally, the Overall Capitalization Rate (Ro) utilized in Direct Capitalization is typically derived from comparable sales. Income producing properties subject to existing lease(s) are normally purchased on the basis of actual rents at the date of sale (leased fee estate). However, the subject is being appraised on a fee simple basis (subject to market rent at the date of valuation). The overall rates derived from existing rents at the date of sale (leased fee) are much lower than those derived utilizing market rent (fee simple). Mathematically, this is attributable to market rent being higher than existing rents; consequently, the resulting overall rate should be higher. With regard to appraisal methodology, this is a reflection of the risk inherent in attempting to achieve market rents when there are higher than actual rents at the date of sale. For example, tenants may resist paying the higher rates and vacate the property. In addition, the landlord may have to offer tenant finish out and other concessions above those offered in the past in order to lease the building at higher market rental rates.

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