The operational costs of a business facility are heavily influenced by property taxes. Failure to comprehend and budget for these costs as a landlord or investor can severely reduce your net operating income (NOI). Additionally, a commercial property’s value declines as NOI declines.
To better comprehend property taxes in commercial real estate, we will utilize this article to guide readers. We’ll address the following subjects in particular:
- Overview of Commercial Real Estate Property Taxes
- Calculating commercial property values and tax obligations
- Reasons for Property Tax Changes
- Future Property Tax Projections
- Methods for Reducing Property Tax Costs
- Final Thoughts
Overview of Commercial Real Estate Property Taxes
Every homeowner has dealt with paying property taxes. Depending on how much your home is worth, you have to pay property taxes to the local tax collector once or twice a year, generally every quarter. Despite minor modifications in how they are carried out, commercial property taxes nevertheless function as intended as a municipal tax depending on the cost of commercial property.
Technically speaking, property taxes are a sort of ad valorem tax, which is a tax determined by an item’s assessed worth. Tax assessors for the local government establish the value of all business properties in their municipality periodically—typically yearly. The yearly amount of your property taxes are then calculated using these tax-assessed values.
Consider the scenario when the assessor assigns your apartment complex a $2,000,000 valuation. The local property tax rate, for example, 1.25 percent, is then multiplied by this valuation to arrive at the $25,000 yearly property tax. Consequently, you would pay two bills totaling $12,500 if your town sent owners invoices every six months.
In the end, two features characterize commercial property taxes. The valuation of your business property is the first factor that affects your tax bill. Second, rather than the state or the federal government, local organizations (such as a town, city, county, or school district) are in charge of assessing property taxes. Therefore, they contribute to local services.
Calculating commercial property values and tax obligations
Investors must first master the business value calculation to comprehend property taxes. Market comparables, often known as “comps,” are used by tax assessors to figure out the worth of residential properties for tax purposes because of how similar they are.
Contrarily, commercial properties don’t have this homogeneity. Commercial assessments are therefore based on an income strategy, which enables assessors to examine a special property. Assessors use the following formula to more precisely evaluate the value of commercial properties:
Commercial property value = NOI / cap rate
All running costs are subtracted from the rental income from the property to calculate NOI (NOTE: depreciation and mortgage interest are not included in operating expenses). The capitalization rate, often known as the cap rate, is a market-driven variable that, essentially, indicates the unleveraged operational return that the property would provide. In general, a property’s stability increases with a lower cap rate (and vice versa).
The commercial value formula is the foundation of every municipality’s approach to valuing commercial real estate, which varies significantly from one municipality to the next. A commercial property owner’s revenue and spending report are often requested by the local tax assessor once each year. Even though some assessors accept any format, the majority of towns have a particular form that property owners must use to provide this information.
Whatever method you use to submit your income and expenditure information, tax assessors will still use the report to determine the value of your property. In accordance with the type of building you have, the assessor will decide the cap rate using the appropriate NOI from the income and cost report (e.g. Class A office space will have a different cap rate than Class C). Your tax liability will be calculated by the local tax assessor when the new assessment has been determined. He will send you an invoice, usually for the next year.
Reasons for Property Tax Changes
The topic of why property taxes vary still exists after describing how governments determine commercial real estate property taxes.
Variations in Value
The tax cost for a building is mostly determined by property valuation, as was previously mentioned. As a result, changes in value are what most significantly affect the corresponding property tax payment. Let’s take the scenario where new owners use a value-add technique to buy a 100-unit apartment complex. The NOI improves from $400,000 to $600,000 as a result of the increases in purchases, renovations, and rental rates. Additionally, as a result of the refurbishment, the municipality decides that the property now justifies a somewhat reduced cap rate, lowering it from 8% to 7%:
- The original valuation was: $400,000 / 8% = $5,000,000
- The new valuation is: $8,571,429 ($600,000 / 7%)
In this simple case, the house increased in value by $3.6 million. Under the assumption of a 1.25 % property tax rate, this would result in an annual increase in property taxes of $45,000. (NOTE: this does not account for any prospective tax abatement, which is covered below).
Rate Variations
Theoretically, a rise in the fundamental property tax rate might also increase the cost of commercial real estate taxes. This is far less common than changes in valuation, yet it is nevertheless possible.
To finance a neighborhood project, for instance, a city could desire to raise money. Instead of releasing bonds or raising residential property taxes, local leaders may choose to raise commercial property tax rates. If adopted, this strategy might result in a considerable rise in the annual tax burden on commercial properties.
Future Property Tax Projections
In any cash-flow calculations for investment, investors must include future property taxes as a significant operational expenditure. That instance, if you are financing a contract for ten years, you need to have a precise estimate of the property taxes for the full ten years. Investors need to take the following actions to achieve this:
Understand the local tax assessment model.
Investors must, above all, comprehend how the neighborhood tax assessor establishes property prices. Exactly how do the revenue and spending reports appear? How often do the municipal tax assessments for businesses get updated? When were the most recent increases in property tax rates?
These may be a few examples of potential concerns. The main takeaway from this is that in order to accurately identify possible real estate taxes, one must have a good understanding of how the tax rates evaluation system functions. With the use of this knowledge, you can devise the best strategy for projecting (and lowering) your future real estate tax obligations.
Projections of NOI
The operational pro formas are the next thing you should review. This pro formas will be used by you (or the deal’s sponsor) to create NOI predictions throughout the underwriting process. You may predict future property tax costs using this knowledge together with an understanding of the neighborhood assessment system.
Assume, for instance, that the regional tax assessor calculates the assessments of commercial real estate every two years. With this arrangement, you may be certain that your tax liability will be fixed for the first 2 years. The next question is: What NOI do you anticipate for Year 2 of operations? These Year 2 findings will probably serve as the foundation for the appraisal for Years 3 and 4. Using this reasoning as a guide, you may predict how much property taxes will cost throughout the deal’s ten-year life.
Historical Data
Investors want to review past property tax outcomes as part of their due diligence process for a sale. Yes, you should perform the aforementioned NOI predictions. However, reviewing the tax bills and appraisals for a home from earlier years can also help you better grasp the neighborhood tax assessment system.
Take a look at a property’s values from the last ten years, for instance. If values typically rise by 3% a year and you don’t intend to materially alter the property’s activities, you should anticipate a similar rate of growth.
But what if it increased in value by 30% in a single year? Numerous things may have caused this, including a sharp growth in NOI, a modification to the tax assessment mechanism, an incorrect value that was never contested, etc. You should carefully study any significant jumps like this one to see if there is any reason to believe that there will be more of them in the future.
Methods for Reducing Property Tax Costs
Finally, we must consider ways to reduce the cost of commercial property taxes. There are two main tactics:
Tax reductions
Tax reductions are offered by local governments as a means of promoting investment. A tax abatement, in technical terms, is a reduction in taxes intended to stimulate local economic growth. Although each municipality has its procedures and guidelines, they all use a similar framework for giving tax abatements.
Consider a building that was purchased for $500,000 in tax assessed value. Tax breaks fix this value for a while to entice real estate investors. Assume, for illustration, that a group of investors purchases this property, invests $1,000,000 in refurbishing it, and leases it to new tenants, increasing its worth to $2,000,000 as a consequence.
The local authority would impose taxes on the structure based on its previous worth rather than its increased value following renovation. This reduction will eventually fade down, or “burn off,” depending on the local regulations. In other words, the eventual basis for property taxes will be the current value rather than the initial one. On the other hand, the owners would gain from lower property taxes throughout the abatement term.
Assessment Obstacles
The assessment of a building can also be contested by investors to reduce their property tax obligations. If, for instance, a local tax assessor values an office property at $5,000,000 but your NOI and market cap rates point to a $3,500,000 valuation, which is what you should do. After then, you have the option to formally contest the tax assessor’s assessment.
This type of problem is handled differently by each municipality, but the key lesson is that you may always contest an evaluation. And these difficulties frequently make financial sense when considering price fluctuations that might total millions of dollars. In connection with this, the majority of cities have law offices that focus on issues relating to commercial property assessment. Although you may contest an assessment on your own, hiring a lawyer who is familiar with the local tax assessment system may be a preferable option, particularly for big commercial properties.
Final Reflections
The majority of any business property’s running expenditures are made up of property taxes. Investors must thus comprehend the following to decrease property taxes: 1) how tax assessors arrive at those bills; 2) when and how tax bills might grow, and 3) minimization techniques.
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