When creating a commercial real estate investment proforma or budget, one of the most important operational costs to account for is property taxes – which are fees charged by a state/city/county for the use of shared resources such as roads, water, and trash pickup. In order to project them accurately, it is important for investors to understand how property taxes are calculated. Unfortunately, it isn’t as straightforward as one would hope and it requires knowledge of a concept known as assessed value.
In this article, we are going to discuss assessed value as it applies to real estate investing. We will define what it is, how it is calculated, and how it is used to determine property taxes.
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What is Assessed Value?
A property’s assessed value is the value assigned to it by its governing municipality for the purposes of determining annual property taxes.
To that end, every city/county employs a team of tax assessors whose job it is to go through every residential and commercial property on the tax roll and update the assessed value periodically (usually every ~2-3 years).
Assessed values can go up or down in response to market conditions, so a municipality’s tax revenue can also go up or down based on market conditions.
How Is Assessed Value Calculated?
The exact method used to calculate assessed value varies slightly by municipality, but the general process is described below.
At the beginning of each reassessment period, the municipality collects a significant amount of data for each property to be assessed including things like owners name, address, use, recent sales, building measurements, maps, and building permits.
Based on this information, they may begin to group properties by type (condominiums, residential houses, commercial properties, etc.) and then begin the mass appraisal process because it would be impossible to appraise each property individually. In this mass appraisal process, market valuation models are built for each property type and their geographic neighborhood.
Then, using advanced statistical analysis, the property valuation model will look at sales data, trends, and patterns to create a base rate and adjust for each property. In short, this process is very similar to a traditional appraisal process in the sense it uses the sales approach, cost approach, and income approach and combines all of these techniques into an advanced statistical model and does it all at once.
Once a value is obtained for each property, most municipalities send some sort of notice to each taxpayer to inform them of the proposed valuation for their property and the resulting property tax bill. Property owners have the right to review the notice and file a challenge if they feel the value is incorrect. It should be noted that appeals are almost always filed by taxpayers who believe the value (and the tax bill) is too high and the goal of the appeal is to get both reduced.
Assessed Value Vs. Market Value
At their core, both the assessed value of a property and its market value are determined by appraisals, but they have a very different use. And, if enough time goes by, they can have very different results.
As described above, a property’s assessed value is calculated for the purposes of determining property taxes.
A property’s market value is calculated for the purposes of buying or selling a property and it is often requested by lenders or investment partners to confirm their interest in the deal.
When a property sells, the sales price is one of the key factors that determines the property assessment when the next round of valuations comes up. So, at the time of sale, the assessed value and the market value may be similar. However, it is very common for market values – especially in high growth areas – to rise faster than assessed values. So, after a long period of time, it would be very normal to see a large difference between these two numbers.
What Commercial Real Estate Investors Need To Know About Assessed Value
For the most part, the difference between assessed value and market value is a non-issue, but there are two instances where it may become very important; taxes and appeals.
If the estimated market value of a property is significantly higher than the assessed value, it serves as an indication to commercial real estate investors their property tax bill is likely to go up should they decide to purchase the property.
If the estimated market value of a property is significantly lower than the assessed value, it may be a signal to property owners they should appeal their assessed value with the idea their property tax calculation is based on an unrealistic value.
How Assessed Value Plays Into an Investor’s Due Diligence
All of the previous sections are background to the main point of this article, which is that understanding a property’s assessed value is absolutely critical to being able to project property taxes as part of creating an investment proforma.
With the assessed value known, an investor can do an internet search for the tax assessor’s office for the municipality in which the property is located. On the website, they will find two key pieces of information, the categories of taxes charged and their millage rate. For example, one county may have categories for schools, water, fire, and property and they may each have a different millage rate.
With this information, property taxes can be projected. Let’s review an example.
Determining Property Taxes
Let’s assume that an investor is considering the purchase of an office building with has a fair market value of $1,000,000. To determine the potential property taxes on this purchase, an investor could follow five steps.
Step 1: Determine The Assessed Value
The very first step is to determine what the property’s current assessed value is. In almost all cases, this information can be found through a search of the county tax assessor’s website.
It should be noted some of these websites are easier to use than others, but it is important to keep digging until the assessed value is found.
For the sake of this example, assume the assessed value is $750,000.
Step 2: Determine the Tax Categories and Millage Rate
Once the assessed value is found, the next step is to determine the millage rate and the categories of taxes to be billed. Most county tax assessor websites have the ability to pull the tax bill for the previous year. If so, this information can be found there.
If not, it may take some additional searching to find this information, but it is nearly always available.
For the sake of this example, assume the county just charges one flat tax category and the millage rate is 0.33.
Step 3: Determine What the Post-Sale or New Assessed Value Would Likely Be
When a property is sold, the local tax authority often reassesses its value within the first year or two post sale.
The new assessed value is often similar to the market value but not always precisely the same as the assessment methodology varies by state and municipality. It can also be based on a percentage of the market value. Savvy investors can usually inquire with their local tax assessor’s office to understand the methods used by the tax assessor.
For the sake of the example, assume that the post-sale assessed value is the same as the sales price of $1,000,000.
Step 4: Estimate Property Taxes
With the current assessed value, an estimate of the post-sale assessment, and the millage rate, investors can make an estimate of what real estate taxes will be. They should do it with the current assessed value to ensure their calculation matches the tax bill (to verify their methodology is sound. Once the methodology has been confirmed, investors can perform the same calculation on the post-sale assessed value.
The key point here is the “mil” in millage rate means per thousand. With this in mind, the real estate property taxes can be estimated as follows:
Current Assessed Value = ($750,000 / 100) * .33 = $2,475
Post-Sale Assessed Value = ($1,000,000 / 100) * .33 = $3,300
So, based on these calculations, an investor could assume property taxes would rise from $2,475 to $3,300 in the first year or two of ownership – depending on when the property is reassessed.
Step 5: Project Estimated Post-Sale Annual Property Taxes For the Entire Holding Period
Finally, the entire point of this exercise is to model property taxes for the entire planned holding period of the investment. This requires using the post-sale assessed value as a starting point and then making an assumption about how much those taxes will grow over time. For most operating expenses, of which property taxes are a line item, the general assumption is a growth rate of 2% – 3% annually. So, if the planned holding period for the example investment is five years and the assumed growth rate is 3% annually, the property tax line item may look something like this:
Year 1: $3,300
Year 2: $3,399
Year 3: $3,501
Year 4: $3,605
Year 5: $3,714
Once the property tax line item is populated for each year of the holding period, the exercise is complete.
Appealing Property Tax Bills as Part of a Value-Add Strategy
Appealing a property tax bill, especially in times of economic distress, can be an effective way of adding value to a property. To understand how this works, it is important to understand how a commercial property is valued.
Commercial properties are valued based on the amount of Net Operating Income they produce. Net Operating Income is calculated as a property’s gross income less its operating expenses – of which property taxes is one.
So, assume an investor feels their property has too high of an assessed value, which is very common during a market downturn. They may be able to determine this based on recent sales of similar properties, especially if they are lower than the property assessment. If the appeal to the local government is successful, property taxes may be reduced. And, because property taxes are an operating expense line item, lower taxes means higher net operating income.
To put this point in context, assume a certain property type trades at a 7% capitalization rate (cap rate). For every $1 increase in Net Operating Income (or decrease in property taxes), the value of the property would rise by $14 ($1/7%). So, if an investor could reduce their taxes by $1,000, they could increase the property’s value by $14,285.
Signs that a Property Is Over-Assessed
Here are some signs a property might be over-assessed:
- If the annual tax bill increases significantly year-over-year
- If comparable properties in the area have a lower assessed value
- If a property’s revenue went up a small percentage compared to the percentage increase in the assessed value or market value
- If the rate of increase in the property’s assessed value was markedly higher than the inflation rate over the same period
Property owners can appeal the property tax assessment with the municipality where the property is located. The owner needs to be able to show the municipality how their property is over-assessed. This often includes showing the tax assessor that assessments for comparable properties are lower. The decision to issue a reassessment ultimately lies with the municipality, so the rate of success on appeals varies widely by jurisdiction.
Summary of Commercial Real Estate Assessed Values
A property’s assessed value is the value assigned to it by the municipality in which it is located. This goes for both commercial properties and residential properties.
Municipalities regularly reassess the properties within their jurisdiction for property tax purposes. Although the specific methodology can vary, the general approach is to perform mass appraisals on properties by grouping them into buckets by property type and neighborhood and then looking at comparable sales to make a final determination.
Depending on market conditions, a property’s assessed value can be very different, especially if a property has had one owner for a very long period of time.
For investors, having a solid understanding of a property’s assessed value and how it feeds into the property tax calculation is very important for creating a financial model.
Interested In Learning More?
First National Realty Partners is one of the country’s leading private equity commercial real estate investment firms. We utilize our liquidity and decades of experience to find multi-tenanted, world-class investment opportunities for our partners.
If you are an Accredited Investor and want to learn more about our investment opportunities, contact us at (800) 605-4966 or firstname.lastname@example.org for more information.