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Tower 49 gets tax cut.

Both sides claimed victory after a New York State Supreme Court judge decided the owners of Tower 49 had been overassessed in two of eight years during the market downturn, even while benefiting from high occupancy and the fruits of an earlier above market, non-arm's length lease.

The property tax case, In the Matter of Kato Real Estate Corporation, was tried last October and was the first major Class A Midtown office building valuation trial held in about eight years, attorneys said.

The court reviewed and re-calculated values for eight tax years, agreeing with the owners that two years were overassessed by $13.05 million.

These overassessments, from the earliest part of the decade, will result in a tax refund of about $1.3 million plus interest to the Japanese-based owners, who paid the city the full taxes while challenging the assessments.

To get to that number, New York State Supreme Court Justice Stanley Parness granted an assessment cut for fiscal year 1990/91 of about $8.5 million from its initial $91.8 million actual assessed value. (AV), and cut about $4.5 million from the second tax year's $87.75 million AV.

But after re-calculating the value of the over-market lease for nearly half the 640,000 square-foot building, and using its own formula to recapitalize what was deemed "excess rent," the court said the owners did not prove the city had overvalued the property during the six later years.

Actually, city assessors had reduced these values themselves during the market downturn to assessments ranging from a high of $74.25 million in 92/93 to a low of $62.25 million in 97/98.

Challenges to the 98/99 actual assessed value of $65.25 million and 99/2000 AV of $67.5 million are still pending before the city's Tax Commission and Law Department, and were not settled in this case.

Elizabeth Dvorkin, chief of the tax and condemnation division of the city's Law Department, said she was very pleased with the court's decision because it was a fraction of the $15 million refund requested by the owner, and came from assessments during "the bottom" of the read estate market, while those more contemporary were upheld.

"The refund is $1.3 million. It's very small and it's a minimal amount," Dvorkin said. "[Justice Parness] recognizes the strength of the Manhattan real estate market, and that's important for the city." The case was tried for the Corporation Counsel by Judith Greenwald.

During settlement discussions, however, the city lawyers had offered "nothing" for any of the years, said Isaac Sherman, the tax certiorari partner with Sherman & Gordon who tried the case last October. Sherman believes the case warrants further reductions and was discussing an appeal with his client, he said last week.

His expert witness, appraiser James F. Levy, president of Appraisers and Planners. presented evidence that the assessed value should be reduced by more than $88 million for the eight years, Sherman said.

The city's hired appraiser. Mark Vollmer, now of Jones Lang LaSalle, who was presenting evidence at his first major case, calculated the building was actually undervalued by the city throughout the entire time period, coming up with assessments ranging from $99.81 million in FY 90/91 to a low of $82.89 million in 93/94.

Those would have reflected full market values of $221.8 million to $184.2 million, vs. the original city assessor market values of $204 million and $157 million for the very same years.

Sherman explained that during a trial, appraisers for the city are not bound by the assessors' values, and can find the value to be higher. On occasion, he said, "they come in and concede a lower assessment."

For purposes of this trial, the parties stipulated to an equalization rate of 45 percent. so the only question before the court was the full market value of the property during each year.

The case was unique because the fairly new, Class A building glided through the market downturn with an above-market lease, albeit created in a non-arm's length transaction, resulting in an income stream that was the basis for a record high sales price paid by the current owners.

In two previous New York State cases that reviewed assessments on property with over-market leases, including 1009-1019 Second Avenue decided by Justice Parness, the court rejected attempts to disregard the actual rents.

Here, the stable corporate tenancy even allowed the building to show a positive balance sheet of between $17 million and $21 million throughout the years in question, despite a property tax that at times climbed to nearly' $20 per foot.

Whether or not competing buildings had a higher assessment per square foot than Tower 49 was evidence neither presented to him nor a question before him, Justice Parness mentions in passing, perhaps a clue towards what might intrigue him in another case.

Rather, the Tower 49 case hinged on the various treatments by the appraisers and the judge of the: 1) non-arm's length lease; 2) the "excess rent" over what comparable Class A market buildings were obtaining; 3) handling of the tax escalation income; 4) the loss factor/vacancy rate; and 5) the capitalization rate.

Sherman said the case was difficult because they had to convince the court that the high value of the owner's lease, made with itself, should not be used to capitalize the income and derive a value, particularly when there were intervening deals at much lower rents.

"We had to explain a rich bottom line was not so rich, and that the first owner had created the lease itself, and then sold the building at a record price with that piece of paper in existence," explained Sherman. "Neither . . . bore any relationship to the actual market."

The 640,000 square-foot Class A office building, located at 12 East 49th Street. was developed by David Solomon and First Boston Corp.

First Boston kicked off the building's occupancy in 1984 by leasing 305.000 square feet in the top half at $53 a square foot. With that over-market lease in place, and based on the income stream, the building was sold in 1986 to the Japanese-based company, Kato Real Estate Corp, for nearly $500 a foot - $299.5 million - which was one of the record high prices paid at that time.

Vollmer, who was appearing on his first major case, used the actual building income and projected from there, incorporating the full recapitalization of tax escalation payments, something the court disagreed with.

Levy, who has been testifying on certiorari and estate matters in New York and New England court rooms since the 1960's, worked with rents in the comparable Midtown marketplace and demonstrated that by using his rental value, the building was entitled to the reduction, Sherman said.

Justice Parness, who typically takes pieces of each appraiser's methodology and evidence and melds them to reflect textbook rules, has not deviated from that system here.

"He threw out the sale, which was based upon the lease, but then followed the lease," noted Levy.

The judge took Levy's projections that divided up the rent into two pieces, creating an "excess rent" over the comparable market rents of about $38 to $33, but then applied a discounted cash-flow to the excess. The judge said the excess rents should not be ignored, as Levy did, but instead valued to account for the purchaser's risk that they may not continue past the lease term.

Levy said Tower 49, a mid-block building, was compared by the city to Swiss Tower, an institutional quality building. "When leases were made at Swiss Tower, Tower 49 had leases being made averaging $20 less a foot," he noted.

There were lessons for both sides throughout Justice Parness' 34-page decision. In perhaps a dig at the city's threats to the real estate community of re-assessing based on sales price, the judge reiterated the use of the income capitalization approach to market value as "the surest ground to a sound appraisal" for income-producing property, which was, in fact, later echoed by the city's attorney in her reaction to the decision.

"The proper way [to assess] is to use income capitalization to set values," concurred the Law Department's Dvorkin. "[The judge] makes a point of that."

In discussing the calculation of hypothetical lease payments, the judge also refers to "the well documented cyclical nature of the real estate market," and a June 1999 Julien J. Studley analyses of the present market, as a way to disparage the ability of anyone on 1/5/90 (the city's tax status date) to predict the future market economy in 1999.

Ironically, in the Beaver & Broad case Justice Parness decided in 1995, he derided the city for trying to place a value on the empty office space at 67 Broad Street, when the building was merely being used as a retail taxpayer.

Reviewing the tax years of 91/92 and 92/93 in the Beaver & Broad matter, Justice Parness said the city's appraiser "absolutely ignores the fact that both major tenants had left the building by 12/31/91, prior to the tax status date of 1/5/92."

Yet in the latest case. even as he used Levy's market rents as a basis to calculate the final assessments, Justice Parness was apparently annoyed that by the time he got to the case, both parties had the benefit of the real market facts to work with.

Levy, who testified in 1998, could not use the real experience of the market to raise the projected value of the First Boston lease any higher than the $38 a foot calculated for 1990, for the upcoming end of the lease in September, 1999.

"You have to put yourselves mentally and in the shoes of the particular time." Levy explained. "And in 1990, 1991, 1992 and 1993. it was the bottom of the market, and also why I felt that using a straight 9 percent cap rate was wrong. It's a judgement factor," he stressed.

Justice Parness states, "Further, the ability to review the market each year in certiorari mitigates against opting lot the most pessimistic view of future conditions," perhaps seeing the consequences of not correctly adjusting values as close as possible to the initial time period, thereby in fact, allowing parties to set values by looking back from the future, knowing by then which way the market has blown.

But early on in the decision, he conveys the dilemma confronting anyone trying to hypothetically assign a rental value. "That two respected appraisers can disagree on market rental value for the First Boston office space, a difference of 40 percent +/-, only highlights the difficulty in employing comparables to establish where the market is at any one time, particularly in an adversarial context," Justice Parness wrote.

After observing how capitalizing a $3 to $10 per foot change in rents for the 305,000 square-foot First Boston space could produce additional value in the $5 million to $10 million range, Justice Parness noted, "Similarly, differences in the capitalization rate selected can profoundly change resulting values, as well as can predictions as to future taxes, escalation income, operating expenses, etc."

Nevertheless, he finds fault with each appraiser's choices. "Vollmer completely ignored actual market conditions or future income risks, particularly as to tax escalation income projections, and relied entirely on the mathematics of capitalization of the reported income in each year as if in a vacuum," the Judge writes on page 33 of the 34-page decision. "On the other hand. Levy's values are a product of subjective selection of lower rents and higher capitalization, vacancy and expense S/F rates."

To obtain one set of values for the building, the judge ends up using Levy's effective market rents; deducts the excess from gross income: splits Levy's 10 percent vacancy rate; adjusts for advertising and leasing expenses by applying a $1 million-a-year rate when the actual cost was less than $3 million for the eight years; applies capitalization and effective tax rates to the NOI's (Net Operating Incomes); adds in a present value analysis for the unsteady tax escalation income; and adds in the present value of receiving the "excess" First Boston income.

The judge adopts a 9 percent cap rate for each year, and after adding it to the applicable effective tax rate. determines effective cap rates in the mid-13 percents for all the years under review.

Levy explained, "In a tax appeal, you are challenging the actual assessment, so you don't use the assessment as an expense because that's the unknown." That's also why the judge disregarded Vollmer's use of the recapitalized, challenged taxes as the escalation income.

Later, Justice Parness quotes from the Seagram and Pepsi-Cola cases, as he writes: "Obviously, the very subjective aspect of the selection and valuation process precludes the ability to determine market value to a mathematical certainty. However, the court is obligated to fix the precise value of the property 'only if the petitioner shows it is less than the value fixed by the appraiser.'" In the end, Justice Parness decided the reconstituted evidence supported a lower value only for the first two years.

"The judge has found a clear view of the strength of the city's real estate, and he's confirmed the assessment policy of the city, at least as applied to this building," said Dvorkin. "This will have to be taken into account by the petitioner's bar in bringing cases and formulating settlement demands."

It was the Dinkins administration's insistence on maintaining high assessments long after the real estate market bottomed out that contributed towards the loss of many office buildings in the early 1990's because the resulting tenant rents could not support the city's real estate taxes per foot.

These policies, and the city's chaotic decline, also prompted the real estate industry to encourage Mayor Rudolph Giuliani's candidacy and contributed towards his election in 1993.

Those owners that were lucky enough to have corporate credit tenants often had to renegotiate leases at lower numbers to ensure their continued tenancy. And there were bankruptcies, like that of Drexel Lambert, that left office buildings like 55 Broad Street totally empty.

City officials have recently chided tax certiorari attorneys that their clients are doing well now, so what does it matter if they didn't do well years ago? That argument has not sat well with those owners that struggled to pay the city millions of dollars towards what they still believe were overpayments, yet have kept challenging year-after-year, laying out money for court filing fees, but to no avail.

That's one reason why Sherman was pleased that his client's earliest and highest two assessments covering 90/91 and 91/92 were reduced.

"We're happy that the judge bought into the position that we advanced on the case, but we're disappointed in his addition of the 'excess rent' from the non-arm's length lease," Sherman said.

Currently, Dvorkin said, there are 9,000 city properties that have at least some of the same years open and under review. Attorneys expect some may now be settled depending on the open years and the circumstances of the building.

The court itself has taken up merely a handful of cases over the last two decades, including the seminal One New York Plaza case involving a Downtown office tower full of asbestos that needed to be removed before new tenants could occupy the vacant space. That case resulted in a $30 million plus refund.

In other cases heard over this decade, the court has agreed with owners that the future development value of an assemblage is not reflective of its current value: and that higher cap rates should be employed when valuing riskier, nearly vacant Downtown buildings.

Justice Parness has also decided equalization rate disputes when there have been evidentiary and wide discrepancies between application and reality.
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Title Annotation:office building valuation case ruling
Author:Weiss, Lois
Publication:Real Estate Weekly
Date:Sep 1, 1999
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