Valuation Management Group serves its lender clients by reviewing residential and commercial appraisals prepared by independent appraisers. This post presents a few thoughts on how both investors and appraisers should view and handle real estate taxes. In appraising income properties, it is important for the appraiser to “mirror the market.” This concept of mirroring the market is a key principle of proper income approach methodology. From the investor’s view point, what would a prudent investor do to analyze the investment and future cash flows?
Our reviewers periodically see reports where a potential spike in real estate taxes is not adequately addressed. We share the following thoughts for the benefit of our clients and appraisers in hopes that any potential errors can be avoided.
To set the stage, consider a retail center that is assessed for $1,000,000 and pays a corresponding tax bill. Assume that a variety of new leases have been negotiated and that the market has improved through higher rents, lower vacancy rates, and lower cap rates. These changes favorably impact the net operating income and hence the value of the property. We’ll say it’s now worth $6,000,000 and under contract to sell for this amount. [Note: while this example seems outlandish, it is not.
Another key principle is that an appraisal assumes a sale of the subject at the appraised value. Thus, one question the appraiser needs to consider is, “What would a prudent investor do in his/her analysis regarding the impact of the current sale on the future real estate taxes post closing or settlement?” A clear risk is present that the assessor could change the assessment in consequence of the sale. The risk could be huge, as in this example.
- In the tax section of the appraisal, a best practice would be to tell the reader what the local assessor does with a sale.
- Some jurisdictions change the assessment promptly. Others wait for the next yearly cycle. Yet others wait for the multi-year re-assessment period.
- Some raise the assessment all the way to the purchase price, others raise it to just a few percentage points below, and others not near purchase price at all.
- In the income approach, where a forecast of future income and expenses is made, a best practice would be in the subsection dealing with taxes to tell the reader how this risk of a huge tax increase is being handled (based on market support from what investors actually do—perhaps learned through interviewing brokers or investors themselves).
- To ignore the risk and say nothing would certainly not be appropriate.
As an example by using the previous scenario, the appraiser could state that his/her research indicates that the tax assessor in the subject area typically changes the Fair Market Value (FMV) assessment to about 90% of sale price upon recording of the transaction. So a sale of $6,000,000 would indicate a tax assessment FMV of roughly $5,400,000, versus the former assessment of just $1,000,000. Assume that the governing body assesses at 40% of FMV with a 38.0 millage rate/$1,000 of assessed value. Now the potential impact to the income stream has grown from $38,000 to $205,200, a difference of more than $160,000. Of course, depending upon how the leases are set-up, taxes may be the burden of the landlord, tenant, or some form of both. But, anyway you cut it, the appraiser should analyze the scenario and potential tax increase in order to mirror the market and give an accurate picture of Net Operating Income.
Valuation Management Group is a national, residential and commercial appraisal management services company that manages the appraisal process, including the appraisal review, for financial institutions, banks, mortgage bankers, and credit unions. VMG offers a full array of commercial and residential appraisal products and services. The company’s goal is to take the appraisal process from ordinary to extraordinary for its clients and appraisers.