Property taxes are charges levied by state and local governments on real estate within their jurisdiction. Taxes are calculated based on the value of the property and they are collected on a regular basis, usually quarterly or annually.
For commercial property owners and investors, real estate taxes are one of the largest operating expenses that they will pay on an annual basis. As a result, it is critical that they be estimated accurately as part of the pre-purchase due diligence process. But, this can be tricky because they are calculated a little bit differently depending on where the property is located.
Before reviewing how to calculate the property tax bill, it is first necessary to understand why getting them right is so important.
Commercial Property Valuation
The market value of a commercial property is based on the amount of Net Operating Income (NOI) it produces. NOI is calculated as a property’s Gross Income minus it’s operating expenses, of which property taxes are one line item. Income and expenses are detailed in a proforma financial projection like the one in the table below (NOTE: The proforma is for illustrative purposes only – it does not represent an actual property):
The key takeaway from this proforma is that the property tax line item is one of the largest operating expenses and it is a significant component of total operating expenses. As such, it has a material impact on Net Operating Income. To illustrate this point, consider the following example.
In year one of the proforma, assume that Net Operating Income (NOI) is $290,000. If a 7% cap rate is applied, the estimated value of the property is $4.1M ($290,000 / 7%).
Now, assume that year 1 property taxes are estimated incorrectly. Instead of $125,000, they actually turn out to be $150,000, which means that NOI is reduced to $265,000. Using the same 7% cap rate, the estimated value falls to $3.7M, a $400,000 difference.
The point is this, it is critically important that the property tax estimate be as accurate as possible. A big miss could impact the value of the property and the price an investor is willing to pay for it.
Five Steps to Estimating Property Taxes
When creating a proforma for a potential purchase, property taxes can be estimated using a four step process. To demonstrate how this works, one of our portfolio holdings will be used as a case study. The property is a Tesla dealership located at 50 W. Ogden Avenue, Westmont, IL 60559.
Step 1: Determine the Property’s Current Assessed Value
A property’s assessed value is the basis for the property tax calculation. It is determined by the local tax assessor’s office and evaluated on an annual basis. Property taxes are almost always assessed at the county level and nearly every county tax assessor has a website on which they can be searched.
Start by determining which county the property is located in. In the example, the property is located in DuPage County, IL.
Next, perform an internet search for the county tax assessor’s website. Navigate to the website and look for a link or an option to search property tax records. Every website is slightly different, but they usually have some sort of search function.
Finally, search for the property. Most websites have the option to search by owner name, address, or parcel ID. Use whatever information is available. In the example case, the address is known so it can be searched.
Select the appropriate option from the search results and click on the link to bring up more detail. Again, every tax assessor is a bit different, but they all include some listing of the assessed value. Search for it. For the example property, it can be seen in the screenshot below:
From the screenshot, it can be seen that the 2019 assessed value was $1,163,200. This is the basis for the property tax calculation.
Step 2: Determine the Millage Rate
A property’s millage rate – also called the property tax rate or “mill rate” – is the amount of tax charged by the local municipality. It can vary by county, but it is usually charged per $100 or per $1,000 in assessed property value. This amount is detailed on the property tax record.
The millage rate can be seen in the screenshot below:
From the screenshot, it can be seen that the millage rate is 6.5542. In this case, it is just one amount. In other cases, the millage rate may be broken down by the different taxing entities. For example, there could be one rate for the school district and another for fire departments or water districts.
To determine if the millage rate is per $100 or per $1,000, use the current property tax bill as a reference. In this case, it can be seen that the assessed value of $1,163,200 divided by $100 and multiplied by 6.5542 feet to the current tax bill of $76,238. See the table below for the calculation:
Step 3: Determine the Newly Assessed Value
This is the tricky part. When a property is sold, it is re-assessed by the taxing authority and a new tax amount is calculated. The tricky part is trying to determine what the re-assessed value of the property is.
In many cases, the new value is the same or similar to the purchase price. In other cases, it is based upon a fraction of the purchase price. On the tax assessor’s website, look for a sale history of the property or search for any links that will provide information about the tax calculation methodology. If it is unavailable, it is a safe bet to use the purchase price as the newly assessed value. For the purposes of this example, assume that the purchase price is $2M.
Step 4: Calculate Property Taxes After Sale
At this point, the inputs needed to calculate the new property taxes are:
- Newly Assessed Value: $2,000,000
- Millage Rate: 6.5542
- Millage Per: Per $100
Using these three inputs, the new property taxes are calculated as $2,000,000/$100 = 20,000. Multiply this figure by 6.5542 for post-sale taxes of $131,084.
As a sanity check, an investor could look at this calculation and say, the newly assessed value is a little bit less than double the current assessed value and the calculated taxes are a little less than double the current tax bill so it makes sense.
Step 5: Estimate Steady State Growth
Most commercial real estate investments are held for multiple years and property taxes are due every year. Once the initial adjustment is made to account for the new assessment, an additional assumption has to be made about how much those taxes will grow each year.
This can also be a little bit tricky because it varies by state and/or county. Assessed values are reviewed each year and adjusted for changes in local market prices. Some states have a cap on how much the assessed value can grow each year, others don’t. For the sake of this example, assume that the investment holding period is 5 years and that the cap on growth is 3% annually. In such a case, property taxes would be modeled as:
- Year 1: $131,084 (as calculated above)
- Year 2: $135,016
- Year 3: $139,067
- Year 4: $143,239
- Year 5: $147,536
With this last step, the property tax calculation is complete. These values can be plugged into the proforma and the analyst can have a higher degree of confidence that the property tax estimate is as accurate as possible.
Interested In Learning More?
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To learn more about our investment opportunities, contact us at (800) 605-4966 or firstname.lastname@example.org for more information.