Valuation realities & property tax issues.

With the economy of Los Angeles and, indeed, all of Southern California, continuing in recession, the decline in real estate values is a hard reality, especially for income-producing properties. These include commercial, office, multifamily, hospitality and similar investment-oriented properties, as well as investor- and user-occupied facilities of all types. The reduction in spending for aerospace and defense, even though directly impacting industrial properties, also has a negative effect on support facilities such as office buildings, apartments and commercial/retail complexes.

The good news? Property taxes, although a significant ongoing expense, are controllable.

The precipitous decline in real estate values has prompted taxpayers throughout California to question the validity of their property tax assessments. Many counties are experiencing a record number of assessment appeals requesting property tax relief. To what extent are valuation issues and property taxation linked? We will attempt to answer these questions in this article and suggest ways in which a taxpayer may wish to proceed to settle disputes with the county assessor. Some background as to the causes and effects of the current real estate crisis is helpful to gain perspective.

The passage of Proposition 13 in 1978 was heralded as a victory for taxpayers in limiting the seeming uncontrolled growth in property taxes and government spending. "Prop 13" shifted the property tax system from a foundation based upon fair market value to one based on acquisition and new construction. For the first time, property owners could have significantly different property taxes depending solely on the date of acquisition of the property and/or completion of new construction.

During the 1980s, Southern California experienced phenomenal growth in real estate. The era was characterized not only by substantial increases in perceived values, but also by a general view that property taxes, although significant, were not an important concern. The average commercial owner typically felt that the 2% maximum inflation of real property values mandated by Prop 13 would never create assessed values exceeding fair market value. According to the 1992,-93 Assessment Roll recently released by the Los Angeles County Assessor, between the period of 1986 to 1992 the total Los Angeles County Net Assessed Valuation (exclusive of public utility valuation and exemptions) increased dramatically, from $266.5 billion to more than $480.5 billion. This increase paralleled the boom in new construction and sales of property; the two events which trigger re-assessment under Prop 13.

The increase in property tax assessments through 1992 created substantial revenue for local governments. The potential loss of these revenues as the real estate market declines is significant. Recent statistics for Los Angeles show that the mean price per square foot for Class A office space has declined by as much as 30%. Unfortunately property taxes tend to be relatively inflexible on the downside for several reasons. The first problem is that Prop 13 allows a 2% maximum assessment increase which is tied to the increase in the California Consumer Price Index (CPI). Unless property owners are filing assessment appeals (and obtaining reductions) there is relatively little motivation on the part of county assessors to lower the assessed value of property.

The increase in the California CPI has continued despite substantial decreases in real estate values. A practical result has been the continued inflation in real estate values at the allowable 2% per year in the face of a deflationary market. The properties most affected by these changes are those properties which have been reassessed since 1986.

A second, more pervasive problem exists in the minds of commercial property owners who, on the one hand, are faced with bolstering perceptions of value to creditors but, conversely, must face significantly higher property taxes to support these perceptions. In essence, it is difficult for owners to accept and recognize losses in value as this creates a "stigma" associated with the property.

Therefore, the recognition of diminution in value is inflexible downwards both on the assessor's side and the owner's side. The owner can improve the relative financial position of the property through reductions in property taxes. This is, however, tantamount to an admission of value decline -- a paradox that is not easily resolved.

With the real estate boom turning quickly to bust, the interest in property tax relief has grown as fast as the roll values did in the late 1980's. Between 1987 and 1990, the Report on Budgets, Workloads and Assessment Appeal activities (published by the California State Board of Equalization) indicated that the growth in assessment appeals increased from $46 billion in property to $94 billion. Recent discussions with county assessors have indicated a doubling again of assessment appeal applications in 1992.

An assessment appeal in California is filed for the regular tax roll between July 2nd and September 15th for the assessments enrolled on March 1st of the calendar year. The fiscal tax year runs from July 1 to June 30th. The assessment appeal applications vary from county to county within the state and several counties have "local rules" for filing and hearing assessment appeal applications. The taxpayer should always consult with the Assessment Appeals Board of the county if any questions arise on how to file the appeal.

A property owner who is faced with a decline in value should first attempt to determine from the county assessor how his property has been assessed and whether the county is even aware of potential declines in value for the subject property. Several Southern California counties have reviewed assessments and have lowered them of their own volition. Often the county will offer to review the taxpayer's evidence of value declines and meet with the taxpayer to discuss their particular property issues. Large commercial property owners must be prepared to provide thorough appraisal analysis to support their case for assessment reduction. Simple "negotiations" with assessor personnel will not be sufficient to obtain reductions. The assessor's office is very busy, and well-documented evidence is appreciated, going a long way towards expediting settlement of the assessment appeal process.

Commercial real estate values fluctuate significantly based on numerous complex factors in the market. A decline in value perceived by a property owner does not necessarily translate into overassessment for property taxes. California law prescribes that the fair market value of real estate as of the lien date (March 1st of each year) must be compared to the 2% inflated value factor from the date which a property was acquired or newly constructed. Assessed value for property taxes is the lesser of fair market value or the original "base" value increased by the 2% inflation factor.

"Value" can be determined several ways. However, the key to property tax relief is following the defined valuation concepts as promulgated by the California Revenue and Taxation Code. Following statutory methodology improves the credibility of one's opinion of value and the chances of prevailing at the assessment appeals board.

The taxpayer/applicant must be prepared to prove the fair market value of the subject property. California statutes favor the assessor, and, with very few exceptions, the burden of proof lies with the taxpayer. It is not enough to prove the assessor is wrong; the taxpayer must be prepared to prove they are right. Although estimating fair market value traditionally encompasses three approaches, the most easily explained and understood method of valuing real estate for property taxes is the Sales Comparison Approach. This methodology relies heavily on active real estate markets for which there are verifiable sales transactions.

Unfortunately, the current real estate market has few comparable sales, particularly for commercial entities. When few truly comparable sales exist, the preferred method of valuation is the Income Approach. Under this method, the taxpayer is essentially estimating the value of the property as the present value of the income stream that can be reasonably anticipated from the property.

The third approach is the Cost Approach. It is based primarily on the principle of substitution, which states that an investor would pay no more for a property than the cost of replacing that property with one of equivalent condition and utility. The Cost Approach to valuation can be very difficult to apply in the current economy, even for newly constructed properties, because of functional and economic obsolescence. In fact, many buildings today sell for well below replacement cost. In light of the current market conditions, Deloitte & Touche relies primarily on the income and sales comparison approaches to support the taxpayer's assessment appeals case.

Significant opportunities exist in the current real estate market to reduce operating costs on commercial properties through reductions in property taxes. Taxpayers must realize, however, that "problem" properties may not necessarily be overassessed. Many foreclosures we have reviewed have been proven to be fairly assessed for property taxes; the property has simply been burdened by excessive debt.

Commercial property owners in most cases must rely on professional expertise in valuing property and negotiating assessment reductions with the County Assessor. In addition, assessment appeals boards, while quasi-judicial in nature, should be treated seriously as a court of last resort by the taxpayer. We strongly recommend that competent professional advice be obtained in challenging assessments at the appeals board level, particularly in the case of commercial properties.