Assessments form the foundation of property tax. As a general practice, we think of these purely from the perspective of a number that we either agree with or contest.In fact, there is much more to it, and many factors go into its formation. This brief provides a comprehensive overview of the process.
Within the highly interconnected ecosystem of property tax, assessed value is the foundation upon which tax notices are issued. Different jurisdictions issue assessments on variable schedules, often using different methods, and at times, the frequency of these notices can change due to extenuating circumstances, such as the onset of the pandemic.
The concept of assessed value involves multiple layers of complexity and as such, lends itself to a more detailed discussion. In this brief, we explore some of these dimensions and try putting variability into proper context. Subjectivity and a sense of randomness are often contributing factors when property owners make appeals. itamlink is a tool providing robust and logical structure to this process.
This article will cover the following concepts:
· Main factors driving property taxes
· Asset variability by asset type
· Equalization rates
· Assessment calculation approaches
· Specific assessment calculation methods
· Seeking a balance between equity and efficiency
Understanding the foundational principles underlying assessment practices is key to understanding how to logically respond to property tax obligations. In keeping with a popular industry theme this year—vowing to make property tax professionals more strategic in their approach to PropTax management—we provide an informative guide to add to one’s proverbial and literal PropTax Toolkit.
Main Factors Driving Property Taxes
When a new assessment is issued, property owners regularly question why taxes have increased; several factors can contribute to this. Consider millage rate increases. The millage rate is the amount of tax payable per dollar of the assessed value of a property based on"mills." This represents the amount per $1,000 of the property’s assessed value, which is used to calculate the amount of property tax.
Another consideration might be a non-ad valorem assessment increase. This represents a special assessment in some jurisdictions that is not based on the value of the property, but on unique circumstances that are assessed to provide certain benefits to your property including services such as landscaping, security, lighting, and waste disposal.
Finally, a factor as simple as a property’s change in ownership might have an impact.
In most cases, however, the escalation in tax obligation generally represents an increase in the property’s market value given the underlying strength of various economic factors.
Variability of Tax Rates
Property owners from multiple jurisdictions pay property taxes based on their property’s assessed value. The financial obligation varies based on several considerations, the first of which is the type of asset. At a high level, this refers to residential or non-residential, with the latter category subject to various degrees of subcategorization, including commercial, industrial, retail, and other categories such as land. Often, rates are established at the discretion of local governments with input from the state as well as local school boards.
Another variability factor to consider is property location. There are some urban centers that generate more economic activity than others. In many cases, these have larger populations and a wider variety of real estate assets. Regions with more population often have higher costs of living and require more services, and such considerations are routinely incorporated when deriving assessments.
A notable characteristic of large urban centers is the degree to which divergence between assessed and market values can occur. Market prices can go up based on particular property dynamics, but taxing authorities continually strive to strike a balance between equality and efficiency. Of course, there’s a more mundane explanation as well – unless they are regular in their assessment frequency, they can fall behind.
The sheer volume of properties requiring assessment, in combination with the many variables requiring consideration, contributes to heightened randomness of the process, which in turn factors into the volume of appeals a local government may have to address during a given period.
Specific tax rates are established as a proportion of an asset’s assessed value, expressed as a defined percentage of overall property value, or as the mill rate. The per-dollar tax rate is variable and is a function of whether it is residential or commercial. Generally, non-residential properties—such as commercial and industrial properties—are taxed at higher rates than residential properties.
Assessed values are perhaps the most significant driver of property taxes, but another one alluded to above has todo with need. Simply put, local governments need funding sources and use property tax revenue to finance public services, so tax rates are also calibrated to these revenue requirements.
Before proceeding, it is important to point out that depending on the jurisdiction, assessed value is not necessarily a reflection of current market value. The process begins with an estimate of market value, but the amount used as the basis for assessment can be different.
There are jurisdictions where assessments will be made at 100% of market value, in which case market value becomes the assessment. With this said, variability becomes a recurring assessment theme.There are some municipal districts where assessments come in as a fraction of market values, and the final assessment number is calculated by multiplying the property’s market value by the level of assessment that has been set by that particular taxing district.
For example, if a sample property has a market value of $1M and that level of assessment has been set at 50%, the assessed value is $500,000.
An assessment rate is generally established by and is a function of its market value. In other words, a municipality’s total assessed value divided by the total market value of the municipality is the equalization rate.
If the equalization rate is 100, it means assessed values are calibrated to market rates. It also provides an indication that assessments in a sample district tend to take place on a more regular (for example, annually) basis.
When an equalization rate is lower than the market rate, it first shows that assessed values are lower than market values. More significantly, it is likely an indication that the taxing authority responsible for assessments does so on an infrequent basis.
There are also cases where the equalization rate will be above 100. At first glance, this seems counterintuitive, but occurs when market values have dropped since the last assessment.
Consider a situation that might unfold in a smaller town, when a local manufacturing plant – the town’s major employer – announces its pending closure. Some of that town’s residents who work there are forced to move to other communities which has the cumulative effect of lowering demand for real estate in that local community. The last assessment, conducted five years ago has not captured the drop in market prices, so the equalization rate exceeds 100.
To collect revenues, taxing authorities need to establish a framework used to drive assessments and this can follow several approaches.
The authorities responsible for levying property tax typically assesses the real property value by estimating what the property would sell for in an arms-length transaction (that is, a transaction between unrelated parties). But that estimate requires the selection of a particular methodology.
Several quantitative methods are used to calculate a property’s assessed value. Some local areas base this on the most recent sale price or acquisition value of a subject property, the income it might generate(e.g., consider a multi-tenant office building where tenants pay rent),or a cost replacement model which considers the cost of land.
Assessment timing can also be subject to variation, as some taxing jurisdictions will be more regular with their assessments (e.g., annually), while others can go several years between assessments.
In previous papers, we have provided details about variations in specific assessment methods, but given the nature of this discussion, it would be useful to summarize these approaches:
When assessing commercial properties, these three methods are commonly deployed:
a) Cost Approach: the first step in using this method is estimating the land value of the site the asset is situated on, and this is often calculated using sales data from similar properties. Once determined, it is then added to the replacement cost of the building(s), less depreciation.
When deriving a building’s replacement cost, the authority in charge of making the assessment needs to carefully consider several factors, including age, size, condition, quality of construction, and other features that might impact value.
The cost approach is typically applied when a particular property rarely, if ever, will be listed for sale in the open market. In addition, such assets generally do not generate rental income for owners. Examples of such buildings might include large industrial plants, communication towers, and institutional buildings such as legislative buildings, schools, and hospitals.
b) Income Approach: For many commercial assets, the income approach usually provides the best indicator of value. Specifically, this means the income generated by a particular property is used as part of a formula to derive value. This method is used across several asset classes including office, multi-family, and hospitality. In each of these instances, income is generated by the owners.
The income approach considers the amount of revenue an asset generates, less expenses to yield net operating income (NOI), and a capitalization rate (or “cap rate”) is applied to NOI to provide an estimate of value.
c) Market Approach: This method is best used when comparing assets sharing many similar qualities, as it will use information from property sales as the basis to estimate the value of properties. The information can come from multiple sources including the Registry of Deeds, local government, real estate lawyers, or commercial brokers specializing in investment sales or capital markets.
Land rates and building assessments can both be estimated using the sales comparison approach. Perhaps the most important consideration when using this method is ensuring the subject property is situated in the same general location as comparables, as this is the key market value factor.
Regardless of the method ultimately used, property tax professionals need to understand that when they received an assessment notice, the value is representative of a mass appeal, which is an estimation of the most probably market value of a property in a given year. In turn, this highlights the importance of conducting thorough individual appraisals to ensure accuracy and precision in the amount of property tax that is ultimately paid.
Seeking the Optimal Balance
One of the unspoken aspects of this discussion concerns the need to strike a balance. Local governments are often challenged with the need to address a tradeoff between equitable taxation and the need to support economic activity.
A striking example of this conundrum is found today in California, where lawmakers are trying to detangle the effects of apiece of legislation from 1978 called Proposition 13 which sought to create a harmonious balance between residential and non-residential property tax.
We will discuss this in a future brief, but for now, it is important to realize this is an issue with no ready solution. One of the emerging themes of the past several months is how local governments are trying to make up for shortfalls in their budgets.
There are many reasons why this is happening, but one of the main contributors is the dramatic shift to hybrid or remote work combined with other considerations, which has led to lower occupancy rates for office buildings and has ultimately lowered the demand for office space.
This has rippling effects. The decline in occupancy lowers the volume of pedestrian traffic in prominent areas, which leads to shuttered restaurants and bars in prominent commercial areas. This contributes to lower revenues, which in turn reduces property values, particularly if the income approach is used for valuation.
Of course, the decline in revenues for restaurants and bars is closely connected to recent events’ impact on the retail sector. Retail has generally experienced an overall decline over the past few years. This is not tied to one contributing factor, but a few.
Perhaps the biggest of these is the ongoing societal shift to online purchasing, the impact of which has now been steadily felt over years. However, this decline has really accelerated since the beginning of the pandemic, which has also impacted hospitality assets and other commercial properties.
The way we use real estate is changing, and local government officials are faced with making hard decisions. Equity in assessments is critical, and thus local jurisdictions must adopt greater regularity and frequency in providing timely assessments.
Being timely avoids situations where after long periods where no assessments have taken place, a new assessment can come in significantly higher than what had almost come to be expected and for which a budget was already established. By not being regular, those paying develop a sense of complacency, and feel a tangible sense of what might be described as“sticker shock” when new assessments are released.
In such situations, a quick fix sometimes used by taxing authorities to manage the shock felt by residential customers, is to indiscriminately shift that tax burden along to owners of commercial property. Local governments can avoid this by increasing the frequency of assessments.
One of the main challenges faced by property owners who manage large portfolios is trying to derive a standardized methodology for managing the inflow of documentation from many jurisdictions across multiple property types. Once completed, the information needs to be organized into a standardized format, and often this defaults to an exercise in wishful thinking.
This paper has touched on just one aspect of the property tax lifecycle – assessments – and, given the complexities associated with just this preliminary step, one can see how difficult it can be to create order in this process. Having tools like itamlink can go a long way in streamlining this process and elevating the way in which assessments are audited and property taxes are managed.
If you haven’t seen itamlink in action, getin touch with us for a demo. It really is a game-changer.
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