Could Steep Property Tax Increases Be 2018’s Most Taxing Issue?
In 2018, self-storage owners and operators should be thinking about their taxes–property taxes to be specific. If the governmental levy hasn’t increased, it will soon enough, and the new numbers will be far greater than they expected.
The snag is not Congress, the president, or state and local governments. The problem is you. The market for self-storage has been so euphoric for the past three of four years, everyone has been crowing about the new values; a property that was worth $4 million in 2013 might now sell for $8 million or $10 million, and everyone knows about it—including the local taxing authorities.
Self-storage was off the assessor’s radar for a long time, notes Aaron Swerdlin, vice chairman of Newmark Knight Frank in Houston. “Operators and owners underwrote increases, but the increases were not to the extent we have seen recently as the product type has gained notoriety and visibility. More and more assessors are paying attention to sales and understanding valuations better.”
Property tax assessment on self-storage was once a sleepy task; every few years or even longer, the taxing authority would catch up and re-evaluate. No more.
“Property taxes have always been something that was behind the curve,” says Todd Amsdell, president of the Amsdell Companies, Cleveland. “There were many states where you would get your bill in 2018 and it really was for taxes in 2017 or 2016. What is going on now is that local governments and taxing authorities are playing catch-up in regards to valuations, and they better understand the marketplace.”
Wayne Rose, senior managing director and Americas practice leader for Cushman & Wakefield, Carlsbad, Calif., adds, “Some self-storage properties might not have been assessed for five years; and now, once they are re-assessed, there is a much bigger jump in taxes than if it was just annual uptick. These new numbers are shocking to owners because they didn’t see these larger numbers coming.”
Another problem is the higher cost of construction. It used to cost $3 million to $5 million to build an average self-storage facility; now the costs have increased to $7 million to $12 million, observes Ben Vestal, president of Argus Self-Storage Sales Network in Denver. “We used to put them in the back of industrial parks; now they are competing for sites where the McDonald’s used to go. We are becoming a more institutionalized industry, like where the hotel industry was 25 years ago. Every hotel might be individually owned, but they are Marriott branded. The whole industry is maturing, and real estate taxes are part of the growing pains.”
Finally, taxing jurisdictions are just plain more aggressive. “Some jurisdictions are raising their property tax rate or their millage rate because every government budget seems to be always increasing,” says Rose. “Governments need to fund all these services they provide. And local jurisdictions maybe losing state funding on certain projects, which means they will fund more through property taxes.”
As property taxes can be the largest number on the expense ledger, changes can be very, very meaningful, and buyers must be just as aware as owners.
“There have been situations where we purchased properties that were valued on the books for X million, but the purchase might have doubled that valuation,” says Amsdell. “That’s part of the due diligence when buying a property. You better understand what is going to happen with property taxes or you will find yourself having a very bad day.”
Shawn Hill, a principal with Chicago-based The BSC Group, gives this example: “We did a deal in Fort Wayne, Ind., where a borrower acquired a self-storage property. The new buyer didn’t have a good handle on the potential magnitude of tax change as a result of the acquisition, and within a couple of years of owning the property, the property taxes essentially doubled. As a result, the borrower had to enter a ‘workout’ with their CMBS lender, because the asset lacked sufficient cash flow to service the debt. Convincing the municipality of this burden was not an easy task; and ultimately, the borrower decided the best option was to give the property back to the CMBS special servicer given the non-recourse nature of the debt.”
The industry has experienced record high prices for self-storage facilities and that has meant reassessments.
“We have seen increases from 50 percent to over 300 percent on real estate taxes,” says Vestal. “In San Antonio, we have seen taxes go from $70,000 to over $200,000. It is something that every buyer and seller needs to be aware of—that self-storage no longer flies under the radar. The profitability of our industry is widely known now, and a lot of assessors have taken notice.”
Some of the worst places for reassessments include Illinois’ Cook County (Chicago) and Texas’ Harris County (Houston). Other states and cities that have caused self-storage owners to sit up and take notice include Florida, Denver, and the rest of Texas.
“We were selling a property near Atlanta, and I had a spirited discussion with the seller,” recalls Steve Mellon, lead of JJL’s Self-Storage Team in Houston. “We were marketing the property for $5 million, and it was on the books as being valued at $2 million. I told the seller, when we bring it to market, people won’t underwrite it all the way to $5 million, mostly likely they’ll underwrite to $3.5 million or $4 million. The seller disagreed, saying, ‘since I bought this property taxes haven’t moved; it won’t be an issue for the next buyer’.”
However, while the facility was under contract, an assessment was released from the taxing authority. It was higher than the purchase contract was for underwriting the property. It threw a wrench in the deal until the issue was resolved.
Mellon brings up a good point. How should properties be underwritten? If you buy it for $10 million and it’s on the books for $4 million, do you underwrite to $10 million? That’s not the right answer, but leaving it at $4 million is not the right answer either. “Some people are more conservative; some more aggressive. It’s just risk versus reward,” says Mellon. “Tax consultants get paid to be experts, and they sometimes miss the mark.”
Therefore, it’s important for a buyer to understand the nature of that appraisal district or assessment authority.
“A potential buyer needs to understand the relevant laws to gauge what the most accurate tax forecast should be for the proforma,” says Kate Spencer, managing director and practice group leader, self-storage for Cushman & Wakefield in Dallas. “I’ve seen examples where the tax expense was forecast too low and was re-assessed at a higher level after the sale. The buyer ended up paying too much for the property. Or the opposite, where the tax expense was forecast too high than what actually happened, and the buyer’s offer was too conservative, thus did not win the bid. Most buyers run a couple of scenarios in terms of how taxes could play out based on the jurisdiction of where the property is.”
Hill suggests digging into that jurisdiction to decipher the process. “Generally, you can start by protesting through an appeals process,” he says. “If you don’t win the appeal, then you may need to go to the next step, which ultimately may involve going to court in some states. But, every jurisdiction is different, and buyers should make sure they have a clear understanding of the process, the timing, and their rights.”
Understand your exposure and how it can affect your cash flow, because it will ultimately impact the profitability of the investment and value of the real estate.
Owners of a self-storage property should by now be aware of the tax situation in their local community. However, tax issues also come up during transactions and need to be addressed accurately.
Taxes are a metaphor for how aggressive the overall market is, says Swerdlin. “When you are trying to win a deal, you are constantly looking at the bottom line, because if you save $10,000 in expenses, that’s $200,000 on the purchase price,” he says. “Paying a little less on telephones or spending less on office supplies, that is not going to move the purchase price. Real estate taxes will, so it is the place where people get aggressive. If they are wrong, it will have a big impact on their return.”
Swerdlin adds, “Without exception, in 100 percent of the deals we have done over the last three years, there are two things that have been the key to getting to the price for sellers to sell and buyers to buy: first is stabilized rental rates and second is real estate taxes.”
The trouble is, it’s kind a war of wits out there, with buyers and brokers on one side and tax authorities on the other. And the assessors have become very savvy, which means brokers must be just as quick. Mellon, for example, markets self-storage properties “unpriced”. The reason: Tax assessors would find the offering price and marketing materials and use it against owners as the reason why they set higher assessments.
“I had a client cuss me out,” Mellon says. “The client called and said, ‘You know the property we are trying to sell, well, the assessor got hold of your marketing materials, and I have to argue why this property that we are trying to sell for $25 million isn’t worth $25 million.’ We stopped putting pricing in marketing materials.”
In non-disclosure states such as Texas, one doesn’t have to signify what was paid for a property. However, the assessor will guess, and do so purely from the high side. So, you must then show the assessor that you paid less. It’s a ploy by the taxing authority to force buyers to show what they paid for a property. Harris County is known for purposely over-assessing to get buyers to show what was paid.
One strategy mentioned by Mellon is to apply a percentage of goodwill toward the purchase price. So, even though funds for $10 million is transferring, the buyer is only paying $7 million for real estate and $3 million for goodwill (the business). The tax assessor can’t tax goodwill.
Loopholes And Shifty Taxes
However, a similar tactic is getting closed out. In particular, an attempt by taxing authorities to close a nifty loophole that operators have been using to avoid properties being revalued at closing.
Jeffrey Greenberger with Greenberger & Brewer LLP, Cincinnati, explains: “If I sell you my self-storage facility, the transaction is going to register immediately as a transfer at the auditor’s office. The office will look at it and use the most recent sale price as grounds to raise valuation automatically. What a lot of smart real estate operators have been doing, and self-storage is a prime example, is to buy a corporate entity.”
Here’s the way it works: A buyer enters into a real estate contract where everyone agrees that the day before closing the ownership is to be transferred into a brand spanking new entity such as a limited liability corporation. Now, what happens is, rather than selling the real estate through a deed transfer, the interest in the LLC is sold. It keeps the assessor from noticing a transfer of the property. Effectively, the stock in this entity is sold, and this gives the buyer three more years before the assessor gets wind of the transfer and the sale. It gives the buyer time to make the deal worth what was paid for it.
Valuing on sale price is horrible for a self-storage operator, because buyers are acquiring on speculation that they can do things better or more efficiently, otherwise you couldn’t make money on the deal, says Greenberger. “Legislatures are horrified by this loophole and are working state by state to close it and prohibit real estate transactions from happening this way. It seems like people are gaming the system, but I don’t believe they are, because what they are really doing is buying enough time to make the property worth what they paid.”
Greenberger takes issues with another trend-line that has caused self-storage valuations to increase.
The valuation of self-storage assets used to be predictable as assessors would use a comparables approach; but about 10 years ago, tax auditors stopped accepting that as the proper method and started treating self-storage as an ongoing retail business, using the income approach to valuation. If a business generates $7.5 million annually, then assessors are valuing it that way, just like a retail business that sells items.
“Are we selling the lease of the space? I contend we are not. Other than incidentals, we don’t have things for sale. We are a rental business and we should be valued on the comparable way of looking at things,” Greenberger says. “What is this land compared to other pieces of land that has an asset built upon it? Do not value that parcel based upon the business that sits on it rather than the value of the land and building, which in my argument is the right way to assess property.”
Look at it this way: If an owner has an empty building in Oakland, Calif., he is still taxed because the building and the land have value. If someone comes in tomorrow and opens a marijuana dispensary, they are paying an exorbitant amount of money for the space. Is the building miraculously worth five times more than when it was empty?
Finally, Greenberger highlights the most vexing, insidious, and ultimately economically wounding practice that is now beginning to surface among taxing authorities: the retroactive real estate tax grab.
In the compliant golden days, just about three or more years ago, an owner used to be able to sell a property and walk away knowing what the tax liability was going to be based on the sale price. Not anymore.
This is what’s happening. You have a property worth $3 million and the effective tax rate on $3 million is, for example, $75,000 in property taxes, which you have paid from 2015 through 2017. You sell your property in 2018 for $5 million. The auditors will catch that and adjust the value going forward to what they believe is the best way to determine value, a recent transaction. Fine and fair, but now they are going way back and rebilling 2016 and 2017 taxes at the $5 million rate. You have paid that bill and it is done, but now they are sending you an adjusted bill saying the value was $5 million, ergo, here’s another $50,000 tax bill, surprise, surprise!
Of course, the big companies have caught on to this.
Real estate contracts used to state there will be a proration of the taxes at closing. Everyone agrees it will be final. Now, national REITs have placed into real estate purchase agreements something the sellers weren’t noticing: a paragraph that said any adjustments made after closing will be borne by the seller. No one really thought through what this meant, but ex-owners are now getting these bill-backs from the national REITs: Here’s you share of the $120,000 tax liability for previous years that the auditor and assessor have imposed based upon the sale. We paid it; now you pay us.
The retro-tax grab has upset all real estate markets; and buyers and sellers have contested the provision through the courts, says Greenberger. “In some states, including my home state of Ohio, there have been some very unfavorable court rulings, allowing the taxing authority to re-visit a sale and not just adjust the tax-rate based on the sale value but also to retroactively adjust the tax for a year or two prior based on the current value.”
The Ohio Supreme Court has recognized the way that the law is written; a retro-tax grab can legally be done, says Greenberger. “This has nothing to do with self-storage specifically; it has to do with real estate. With markets up, this has been a nasty little trick.”
Steve Bergsman is an author, journalist, and columnist. His stories have appeared in over 100 newspapers, magazines, newsletters, and wire services around the globe; and his most recent book is “The Death of Johnny Ace.”