Real Estate Taxes...Watch for that Reassessment!
Updated: Jun 10, 2019
Last week, we finished the top half of the Profit & Loss statement and our review of the revenue portion of the underwriting. This week we start on the bottom half; the expenses. We’re starting with what is typically one of largest, and seemingly most straightforward expense line items – Real Estate Taxes.
The real estate tax amount is the easiest number to verify on the statement. You can find this amount, for the current year and all previous years, right online on any County’s site. These sites are a wealth of information. Not only can you verify the taxes for the current year. You can see if they’re paid, the tax assessment, the just market value, the millage rate used to calculate and any trends of value or tax amount. Even if you trust the number shown in the Offering Memorandum, ALWAYS go to the County Property Appraiser and Tax Collector sites for quick, free information on the investment property you’re reviewing.
You may be asking yourself, if this number is public and easily verified, how can I be manipulated by the OM? Why would this be a topic in the Cover Your Ass series with so many other line items to consider? The reason is because you’re not buying this property for its past cashflow. You’re buying it for its future cashflow. You can verify the 2016, 2017, 2018 numbers all you want. You can even more or less verify the current year’s number.
Where you’ll run into (potentially major) issues is when you look at these payments and trends and agree to project them out without understanding where they came from and where they’re going.
At least in the State of Florida, the tax assessed value of any non-homesteaded property is capped at a maximum 10% increase per year. This was recently reaffirmed with Amendment 2 in November 2018. The underlying value can increase as much as the market will bear, but the millage rate will be charged to this lower, capped amount. (Side note: some tax items, such as school taxes, are assessed at the non-capped just market value. For simplicity, we’ll assume the millage is charged entirely on capped amounts as they make up the vast majority of taxes and each County will have its own calculations.) This cap is for the benefit of the owner of commercial, and non-homesteaded, assets. It ensures that a drastic tax increase won’t overburden the owner year-to-year. What it doesn’t ensure, however, is that a new owner doesn’t become overburdened. The onus is on the investor to properly understand the future increase when acquiring a property.
Let’s look at an example:
A current owner purchases an apartment complex in 2013 for $2,000,000. In 2014, the County comes in and adjusts the Just Market Value to this purchase price. In Florida, a standard rule of thumb is that the Tax Assessed Value will fall around 80-90% of the Just Value. This is essentially to account for sales and transaction costs for any disposition and other plugs to give some concession to the owner. We’ll use 80% so, in 2014, the assessed value is $1,600,000. At a cumulative millage rate of 15.9461, the real estate taxes would be approximately $25,500 ($1,600,000/1000 x 15.9461) – excluding any non-ad valorem taxes.
Move forward to 2019 and the owner elects to sell the property for $5,000,000 due to massive rent increases and a compressed cap rate market. The market value of that property has increased by $3,000,000. However, due to the cap, the tax assessed value has only increased 10% per year to approximately $2,350,000 in 2018, the last year taxes were paid. This is a much more nominal $750,000 increase over the same period. That lower assessment is what the CURRENT owner is paying taxes on or, with the same millage rate, only $37,355 in taxes.
You had asked earlier, why should this be included in CYA? How can this be manipulated?
You may be looking at an Offering Memorandum and you’ll see the real estate tax line item at $37,355. Hell, you may even see it at $33,950 (their 2017 number because “the owner works on a cash basis and 2018 hasn’t been paid yet”). This number may just be assumed to be the “proforma” real estate taxes. Maybe it’ll be increased by their standard 2-3% expense growth factor if they’re being generous. If you use this number, you will be in bad shape going forward.
Real estate taxes are assessed as of January 1st of the current year. So, if you buy a property anytime in 2019, that assessment has already been made and you’ll essentially get the benefit of the cap…for one year. The 2019 taxes, if the OM elected to estimate them for you, would be around $41,000. This is already 10% higher than the 2018 number they may be showing. You left a few bucks on the table, but nothing major.
As we stated, this cap is for the benefit of the current owner, not for YOU.
Come January 1, 2020, the County is sure as hell going to come to your new property, recent purchase price in hand, and determine a Just Market Value for that apartment at suspiciously close to your $5,000,000 purchase price. When they use that 80% assessment value, your Tax Assessed Value will be jacking up to $4,000,000. At the same millage rate, you can expect your real estate taxes in that first full year of ownership to skyrocket to $63,700, a 71% increase over the 2018 numbers shown in the P&L!
This is an increase of $26,500 of unexpected expenses. This expense drops right to the bottom line, and not in a good way. Some expenses are exchanged for higher revenue, like costs for new amenities and services, maybe better property management. Real estate taxes, however, are not. You get zero benefit from this expense, just a dollar-for-dollar decrease in your projected Net Operating Income. At a market 7.0% capitalization rate, this decrease in NOI is a $377,500 hit to your value immediately. From December 31, 2019 to January 1, 2020, you just effectively lost almost $400,000 in value. Assuming your $5,000,000 purchase price, this implies an over-payment of 7.55% at the time of acquisition by not properly accounting for this reassessment. It could take you years of improvements and rent increases just to get back to square one.
Real Estate Taxes should be a manageable expense line item to underwrite into your proforma. Just remember, most expenses follow a straight-line trend with inflationary increases annually. These taxes, however, do not. Make sure, as you’re reviewing historical taxes and seeing “proforma” taxes that follow this trend, you adjust accordingly. Those trends were based on the former owner’s capped values, not yours. This is one of the primary line items that can massively increase post-acquisition and significantly affect your future underwritten cash flows. So be sure to understand this reassessment risk, adjust your proforma accordingly and cover your ass.
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Next Week: Why do I need flood insurance when it wasn’t on the proforma?