From a small northwestern observatory…

This is a continuation of my piece from last week on Property taxes. I suspect that this will be an issue of no small concern to property investors, appraisers, and financial advisors in 2021 and beyond, not just as a result of COVID, but certainly exacerbated by COVID.

I was recently looking at a 10,000 square foot stand-alone commercial building — an “out-parcel” in a shopping center. For a variety of reasons (COVID being only one of them) this shopping center has fallen on hard times, and the tenant (a big national chain) has declared bankruptcy. This store, and nearly all of the properties near it, are vacant, and there is little forecast that this will change in the near future.

So, the total taxable value of the property back when everything was hunky-dory was about $2.2 million. Today, the total taxable value is… you guessed it, $2.2 million. The question which perplexes property owners, appraisers, and tax assessors is the valuation of these “dark stores”. Do they get valued at their highest-and-best use (even though they are vacant) or as some value-in-use, recognizing the current economic condition. More to the point, even when these properties are up-and-running, should the value be reflective of the current contract rent or some other theory of valuation?

As an aside, about 30 years ago, I published a paper on the impact of the failure of anchor tenants in strip shopping centers. The original tenants are typically very stable, boring grocery stores. The other tenants, who on a per-square-foot basis are usually much more profitable to the landlord, draw business as a result of proximity to the grocery anchor. After one fails or moves out, all too often, the landlords scramble around for a substitute, picking up an anchor tenant that may be very risky and/or fails to provide traffic to the other tenants. The result is often a financial failure of the whole shopping center.

Back in February, 2017, the Texas Comptroller published a piece on the Dark Story Theory and how it impacts property tax assessments. There is a lot more written on the subject, and a full literature review would be beyond the scope of what I hope to accomplish today. This theory first gained purchase with the big-box landlords, but it is now the theory du jour with many tax advisors in the commercial sector. In short, the Dark Story Theory holds that a big-box retailer really only has value due to the unique tenant. As such, these properties should always be valued as if they are vacant (or “dark”), because these locations would be difficult to sell to subsequent buyers without the big-box tenant. The Texas Comptroller article notes that the most vigorous proponent of this theory in that state, at least in 2017, was Lowes Home Improvements Stores, with 141 operating locations in that state. In Texas, Bexar County alone estimates it would cost the schools $850 million per year in property tax revenues if this theory was to succeed. As of 2017, Bexar County had spent $300,000 on Lowe’s tax appeals.

Note that the definition of market value for commercial properties, for tax purposes, may be somewhat different than the definition used for a simple home mortgage. Texas law, for example, taxes property at its current use, including any rents it generates. Note that many dark stores are still generating rent for the landlords due to the complex build-and-lease-back provisions in the original development.

This is not an issue limited to Texas. A study out of the U. North Carolina in 2018 showed that this theory has caught on with commercial property owners throughout the U.S., and that the reductions sought often amount to 50% or more of the otherwise assessed value. With millions of dollars in annual tax expense at stake per building, the landlords can afford to hire the best talent and litigate these appeals. Courts are increasingly finding merit with the landlords’ arguments. In 2008, the Wisconsin Supreme Court held in  Walgreen Co. v. City of Madison, 311 Wis. 2d 158 (2008), that the market value for tax purposes must be based on market rents rather than contract rents, because the latter, “artificially increased sales prices cause by unusual financing arrangements[.]” The Walgreens decision has resulted in over 140 property tax appeals in that state alone. A bill to effectively reverse this decision failed in the Wisconsin legislature in 2018.

In Indiana, the state tax court was persuaded by appraisers and attorneys for Kohl’s to rely on sales data from nine “dark box” retail stores. This was effectively upheld by the State’s Supreme Court. (See Howard Cty. Assessor v. Kohl’s Indiana LP, 57 N.E.3d 913, Ind. T.C. 2016, review denied, 86 N.E.3d 171). In North Carolina, the Lowes Store in Kernersville (Forsythe County) was valued at $16 million. Using the dark story theory, Lowes appealed with a $6 million valuation, which was upheld by the Property Tax commission. (Matter of Lowe’s Home Centers, LLC, COA17-220, 2018 WL 708657, N.C. Ct. App. Feb. 6, 2018)

With the implosion of certain sectors of commercial real estate becoming more of a reality in the COVID recession, we can surmise that these theories will be more vigorously litigated in the coming months. There is very real money at stake on both sides of this issue.

Fair and Equitable is the monthly journal of the International Association of Assessing Officers, the primary professional group for tax assessors around the U.S. In the current edition, there is a striking article about rising property taxes due to COVID. In summary, it’s not very good news.

In most towns, cities, and counties, one of the primary sources of operating budgets is property taxes. However, many, and perhaps most cities also rely on sales taxes, tourism taxes, and sometimes even local option income taxes. All of these latter sources of revenues have gone in the tank since the onset of the COVID recession. A study out of the U. of Wisconsin indicates that the shortfall for 2020 is $165 Billion across all cities. Many cities which are highly dependent on tourism — Nashville, New Orleans, and Las Vegas immediately come to mind — are particularly hard-hit.

Many states have hard caps in property tax increases, although some do provide exceptions for emergencies. Houston, for example, has an annual tax increase limit of 3.5%, but may exceed this in the case of declared emergencies.

For the uninitiated, the property tax bill you receive every year is the product of two things — the property ‘assessment’ (determined by the local property assessor or appraiser) and the ‘tax rate’ (sometimes somewhat archaically called ‘millage’), set by the taxing authority, such as the city, county, or school district. This gets particularly cumbersome during recessions because, arguably, the assessed values of some properties, particularly in this case commercial properties (such as restaurants, bars, or such) may decrease even as the local taxing authority needs to raise more money. Hence, to get a 5% increase in tax revenues when some properties are declining in value, the local county council may need to actually raise the tax rates by 10% or 20%. Nashville, for example, just raised tax rates by 34%. Notably, Tennessee has been historically less dependent on property taxes as a source of revenue, with the average tax bill in that state about 40% below the national average. As a result, Tennessee tax payers may feel some very real sticker shock in 2021.

What’s more, if some properties go down in value more than others (as is happening now), the burden of higher taxes falls disproportionally on property owners who are still solvent.

Property owners are advised to take a very serious look at tax assessments in light of the potential declines in property values. Some assessors are trying to get ahead of the game. For example, New Orlean’s assessor Erroll Williams has made pro-active, across the board cuts in the values of hotels and restaurants by as much as 57%. Cook County, Illinois, Assessor Fritz Kaegi is in the midst of a re-evaluation of every commercial property in his jurisdiction.

All in all, a phone call to your friendly, neighborhood real estate appraiser is probably warranted. If and as we can be of any assistance, please let me know.

John A. Kilpatrick, Ph.D., MAI — john@greenfieldadvisors.com

Let’s all start by admitting that the S&P 500 has been on a tear this year. If you had put a dollar in an S&P Index Fund on March 31, it would have been worth $$1.38 when you sang Aude Lang Sine last week. Personally, I hope it keeps going! ACCRE is designed in no small part to hold value during market swings, to outperform REITs in general, and to attenuate a well-diversified portfolio. It did all of those this year, and particularly in December. Let’s get down to the basics.

I use January 31 as a benchmark date — that was nominally the beginning of the COVID bear market. As you can see (below) ACCRE did very well compared both to the broad market and to the S&P Property Index. Indeed, but for some market reversals in the fall, we’d be well ahead today. December was a great month for us, and we’re back in the lead against both benchmarks. A dollar invested in ACCRE at the inception would be worth $1.65 today, compared to $1.59 for that same dollar in the S&P 500 and $1.19 in the Property Index.

We feel like we’re well positioned for the coming year, and in fact we were up on the first day of trading, today, while the main market indices all tanked.

One important measure is our Sharpes Index, which looks at excess returns (returns in excess of what we would have earned in treasury bills) adjusted for risk (volatility — measured by the standard deviation of those returns). An additional measure is the correlation with the S&P 500. We generally measure this over the life of the fund, and it hovers around +50%, which is where we want it to be. However, in December, this hit about +15%, suggesting that the market may be looking at real estate very differently from other securities.

Well-curated real estate continues to be viewed as a safe haven, with very real value opportunities when and as this recession is over. As always, this in no way constitutes investment advice, and your own financial investments should be made in consultation with appropriate advisors.

If we can answer any other questions, or be of any assistance, please let us know.

John A. Kilpatrick, Ph.D. — john@greenfieldadvisors.com