Disparities in Rental Rates May Alter Property Values

As published by Real Estate Forum, July 2002, by John Garippa

In the past 12 months, a significant amount of commercial office space has been placed on the market.  What is the significance of this market event and how does it affect tax assessments?

In the past, it has been relatively easy for owners and tenants of commercial space to value the assets in their portfolios for tax assessment purposes.  One had only to look at the rent as detailed in a recent lease.  That rent, when capitalized at a market rate, would give a reasonable parameter of value that could be used to gauge the appropriateness of a tax assessment.  Generally, the rent on a recently negotiated lease typically represented a market indicator.  That dynamic, however, has undergone dramatic change over the past 12 months for obvious reasons.

In the aftermath of a slowing economy that was further unhinged by the events of Sept. 11, the commercial office marketplace has been overwhelmed by substantial amounts of sublease space.  Corporate tenants, attempting to improve their bottom line, have determined that they no longer require some of the space they currently lease.  As a result, throughout the country, large inventories of office space have been returned to the market.

It is not at all unusual in this situation to see space that had been recently leased at high rents offered in the sublease market at a considerable discount.  In many cases, the question now becomes what amount the tax should be levied upon; the original, higher dollar lease in place, or the current discounted sublease market rate?

The tax law in most jurisdictions stipulates property taxes must be levied on the current fair market value of a property.  There have been numerous cases cited as precedent detailing that taxpayers, as a group, should not be burdened by an owner of real estate that made a poor investment decision and leased property at below-market rates.  In those instances, the courts have utilized the current market value of an asset and ignored older, below-market leases in order to properly assess property at its current market value.  This is usually accomplished because of the prevailing need for uniformity of assessment practices.

In the current marketplace, an interesting switch has taken place.  The older leases, executed in stronger economic times, are at rents that cannot be supported in the weaker market that now exists.  The identical properties, leased and subleased within a 12-month period, demonstrate diminished demand as measured by significant rental reductions.  Under the same theory and legal precedent, these properties must be assessed at markedly lower rates than those agreed to in the original leases under which the subleases operate.

Therefore, the proper assessment, in a state that uses market value as its operating standard, should be based on the current rental rate in the sublease market and not the rate negotiated in the underlying lease.  When the size of the available commercial space inventory is considered, the scope of this determination looms large.  Not only is the dollar rental level eroding, the amount of time necessary in order to rent out this space is continuing to climb.  This means the vacancy allowance that must be considered in valuing commercial real estate for tax assessment purposes must also climb.  Sophisticated property owners and tax managers must now look not just at the details of the executed lease, but also at the ever-present realities of the marketplace.  Leases at rents that may not be sustainable in the current market are important for tax purposes.

Interestingly, the motivated party in this situation that files the tax assessment is typically the tenant, who remains obligated to pay the taxes.  The owner of a fully leased commercial office property may not have the same motivation to file a tax appeal as the tenant seeking to sublease the space.  In this environment, owners, property managers and tenants should ignore the current leased rates of property and review what would happen if that property were placed on the market for rental.  That is the real valuation exercise required for valuing the property for tax purposes in most jurisdictions.

The sad reality is that in the current economic climate, rents for many types of commercial property would probably be below leases executed as recently as two years ago.  While this development is certainly not welcome, in the short run it can be used to lower tax assessments that can make the property more attractive to tenants.

John Garippa is the senior partner of Garippa, Lotz & Giannuario, a law firm based in Montclair, NJ, and president of the American Property Tax Counsel, an affiliation of property tax attorneys.  He may be contacted at john@taxappeal.com.