By Sule Aygoren Carranza

As published by Real Estate Forum

Sule Aygoren Carranza, Associate Editor, Real Estate Forum, NY

Andrew H. Raines, Partner, Stokes Bartholomes, Evans & Petree, Memphis
Fred DiIorio, Tax Administrator, General Motors Corp., Detroit
James P. Regan, Managing Partner, Fisk Kart Katz and Regan, Ltd., Chicago
Michael Hilborn, Consultant/Former General Counsel, Urban Retail Properties Co., Chicago
David J. Crapo, Managing Member, Wood Crapo LLC, Salt Lake City
John E. Garippa, Senior Partner, Garippa, Lotz & Giannuario, Montclair, NJ


“The discrepancy between today’s high sales prices and in-place fundamentals has property tax professionals going head-to-head with the assessment community.”

AS THE HEATED INVESTMENT ENVIRONMENT OF THE PAST few years pushed cap rates to record-low levels, it also widened the divide between asset sale prices and their true value based on performance. Driven by a desire to put money to work and the lack of alternate investments, many investors have rationalized paying high price tags, claiming they were buying assets based on projected value rather than in-place fundamentals.
This dichotomy is especially taxing for property tax attorneys when dealing with assessors, who must value the property at a specific point in time. In many cases, local law dictates the sales prices are the best evidence of market value, often considered the standard for real estate tax assessment. However, these days, that sales price doesn’t necessarily determine value, and the fine line between market value and investment value is increasingly blurred.
So what’s a property tax lawyer to do? That quandary was one of the issues addressed by a panel of experts at the America Property Tax Counsel’s annual seminar, held in Scottsdale, AZ last fall. The executives discussed the three classical approaches that assessors must reconcile in order to determine value – the income approach, the sales comparison approach and the cost approach – and deliberated the various issues that can allay the influence of today’s high asset prices on tax assessments. An edited version of that discussion follows.
SULE A. CARRANZA: We recognize the disconnect between the prices investors are paying for real estate and the value dictated by their current earnings, but is there a definition of market value that is all encompassing?
JAMES P. REGAN: There’s a wide variance in the understanding of market value. We recently had a discussion with a client who was concerned about value and how it was a factor in the liquidation of properties. For instance, how do you disassemble a manufacturing plant, and what is the value of the plant after it’s been disassembled? The other thing we have to look at very carefully is that there seems to be a misapprehension that price paid is market value. We must recognize that there is a difference between cost, price and value.
FRED DiIORIO: The difference of those three factors – price, cost and actual value – all relate indirectly to what motivates a buyer to purchase a specific property All those things come into play when you are trying to define the market value.
DAVID J. CRAPO: You have to look at what the investor is actually getting for the “price.” What are all the different components that make up this price? How much is attributable to real estate? How much is attributable to intangibles such as a brand name and other non-real estate components of the business enterprise? You hear the phrase “price is not fair market value” all the time. You often don’t use price as fair market value because you’re trying to decide what adjustments need to go into this particular transaction.
CARRANZA: Does the need to grow drive investors to pursue properties at lower cap rates? How much does the competition among REIT’s, institutional investors and foreign investors for class A assets contribute to the inflated pricing?
ANDREW H. RAINES: It’s had a significant impact. We’ve had discussions with REITs and institutional investors and they have indicated that if there is a property they really want, they’ll pay whatever it takes to own it. So there are going to be situations where the market value, as we would see it, takes a back seat to the competition between institutional investors for that property.
JOHN E. GARIPPA: We’ve found that institutional investors will pay a very high premium for properties that are fully leased at very high rental rates. At the same time, if you have a building that has high vacancy, you’re going to see a significant disparity in the price that building would sell for because in many instances, those same institutional investors aren’t interested in it. They want real estate plus a bond. That’s what those payments are based on.
The problem we all face is something I like to call “rule one of the appraisal bible,” which is that every high sale is market value and every low sale is a distressed dale. All of us have faced that issue. Assessors will never come and discuss with you myriad lower sales that are out there, but the one high sale that comes through – that class A office building that sold at $300 a sf – that’s the sale that dictates the market. That’s the problem both we and our clients face.
DiIORIO: What it comes down to is to simply quantify the buyer’s motivation in the purchase price, so you can pull out a high cost. What motivated that particular investor to spend $300 per SF for a class A building when he could have gone around the corner and paid $150 a foot for another asset? Does that really reflect the market value? The value of that particular asset to the buyer is not the value of the entire marketplace, and the marketplace is the ultimate arbitrator of value.
CARRANZA: The Appraisal Institute is recognizing a distinction between investment value and market value. However, how do you delineate the boundaries between the two in today’s market?
REGAN: Fred [DiIorio] mentioned the notion that motivation is a large factor in any purchase. In today’s market, there are a lot of motivations. We have an incredible problem with supply and demand. There is a tremendous amount of cheap capital available, but there is a limited supply of class A commercial buildings. The stock and bond markets have been unreliable, and investors need to put their money to work. They are looking for ways to establish a steady stream of income and protect that money, even if the return isn’t as great as they would like it to be. The line between fair market value and investment value is very hazy today, and investment value begins to expend itself because the needs and the motives of the investor are so great.
CRAPO: The question is, do you ever have anything but investment value when you are dealing with a complex income-producing property? What you are really looking at is the income that will be produced from that property, and it goes back to motivations. You’ve got to look at every single sale and what is actually being bought before you can say you are paying a market value for the underlying real estate.
In a recent case, we had six or seven comparable sales brought in by the assessing authority. They said, “We’ve taken the sales prices of those deals and came up with a market ratio and capitalization rate. We can take that same cap rate and apply it to your property.” They didn’t make one single adjustment for any other component in the purchase price. So we checked every transaction and each had at least five or six different components that were motivating the sale. When you factored those out, you came up with a much different valuation for the hard real estate. That’s why I question whether, with a complex property, you have anything but investment value.
CARRANZA: Often, an investor considers how the asset will contribute to its portfolio, while the assessor employs a direct capitalization methodology to determine the value of a property at a specific moment in time. Growth is an important ingredient to an investor’s discounted cash flow analysis, but it’s only one factor. Can the assessor rely on 6% to 8% cap rates without carefully analyzing the sale?
RAINES: In all sales, especially where cap rates are 6% to 7%, a careful analysis has to be made. But what we see a lot of times is with a sales price, regardless of the cap rate and especially when it’s that low, the assessor wants to take that value as if it’s written in stone. They do not make an analysis of the five or 10 other factors that should be considered in determining whether it’s a real reflection of market value.
GARIPPA: If you think about the definition of market value, we all have to prove a value in court as of specific date in time – a valuation date. What almost never gets factored in when these sales are analyzed are the leases that have been recently executed. So is that capitalization rate reflective of the date of sale, or is it a cap rate that’s reflective of lease negotiations that took place over several years? That’s an important distinction.
The cap rate of an asset based on a recent lease negotiation would be very different than what you would find if you looked at the same asset predicated on a lease negotiation of two or three years prior. That’s the kind of thing the assessment community never does. They take a high sales price and they run with it. You just can’t ask, “What was the capitalization rate that was derived from a transaction?” That’s a meaningless term.
MICHAEL HILBORN: I agree that the cap rate is meaningless, particularly when you have a seller saying that they sold at cap rate X and a buyer on the same transaction saying that they bought at cap rate Y. In most cases, that’s attributable to the fact that the buyer is taking a forward look at how he can enhance the property two years down the road. That would justify paying this very high price and, thus, the very low cap rate, which is really an artificial rate.
CARRANZA: So then can we ever be sure that any sales approach can capture the value of a real estate asset?
REGAN: I don’t think we can. Most appraisals I have seen seldom analyze the sales, so you don’t know whether it’s a fair market, a market sale or an investment-value sale – it’s all lumped together. I’d be willing to say that on a commercial property today, you cannot get a value using the sales comparison approach. It’s so inexact and so fraught with assumptions that it’s not an accurate picture of a property’s value.
RAINES: I found buyers to be optimistic when they determine their sale price. Every sale I have ever seen has speculation in it.
GARIPPA: If there is a Fortune 400 tenant that signed a 10-year deal, do you think that building is going to go out at a higher price than if I signed a five-year deal with that Fortune 400 company was buying my lease? We both may have signed a lease rate of $30 per sf, but which lease is going to be evaluated in the market as a far more valuable commodity? All of that goes to inflating the sale price and our friends in the assessor community, sadly, never discuss any of it.
I like the language one New Jersey tax court judge used to describe the discounted cash flow analysis. he described it as “an amalgam of attenuated hypotheses.” If you think about it, all those attenuated hypotheses that are out there went into inflating these purchase prices, and that’s why a tax court will generally not accept a discounted cash flow.
CARRANZA: The Financial Accounting Standards Board recently issued its reporting standards for commercial mergers and acquisitions. Do those standards expose the weakness of the sales approach when estimating the market value of a property’s real estate assets?
REGAN: We have to be very careful. There are various constructs for various disciplines. FASB 141 and 142 are for reporting purposes, whereas we have another construct for valuation. We have to make certain that we keep them straight. At the same time, when we look at the FASB’s concerns as evidenced in 141 and 142, what they are seeing is that a purchase of a large commercial entity or of commercial real estate is extremely complex. and we have to begin to look at its various parts. And they specify that we have to look at leases. It’s very interesting.
In Illinois, for instance, we are supposed to be valuing the fee simple value. Now, fee simple rally defines the rights of an owner. it doesn’t relate to the question of value. But in our everyday world, they say you have to look at the fee simple value, and that mans the value of a commercial entity that has market rents.
The Financial Accounting Standards Board now says, We want to look at the value of the land and the building vacant, because we recognize there are all kinds of value wrapped into leases, separate form the property.” Their concerns should help us understand how to value real estate. We are looking at one construct to help us clarify another. So much of what we are faced with from assessors is imprecision. These accounting standards are telling us we have to be very precise in what we value because it will help us to make certain that we are valuing real estate and not adjuncts to real estate.
CRAPO: I think it helps taxpayers rebut the sales price because now you can start to see a breakout of the nontaxable components of a sale. But there’s been a bit of a backlash. We’re starting to see assessing jurisdictions say, “That just makes our cost approach a lot stronger because now we have the components broken up into separate parts. Under FASB 141 and 142, you have to do an impairment analysis for these assets to determine whether they are sufficiently carried on your books to cover the carrying costs of that particular asset.”
If you are making an argument in a cost approach that you’re experiencing obsolescence or extreme depreciation on a property, assessors often will want to look at your books. did you write down an impairment against those particular assets? If not, they’ll say there is no obsolescence. Your cost approach is not fair market value by definition because you are going in each year and analyzing where there is an impairment to that cost.
That can be difficult. You need to be careful because the carrying costs analysis is different than fair market value analysis for property tax purposes. But it opens up new concerns for litigators in this area for taxpayers to start to balance the cost approach, the income approach and the sales approach and how do we really get to that fair market value of just the tangible, taxable property?

James P. Regan is the managing partner of the Chicago law firm of Fisk Kart Katz and Regan, Ltd., the Illinois member of American Property Tax Counsel (APTC), the national affiliation of property tax attorneys.