Property Taxes in the Shadow of COVID-19
Important property assessment considerations for
leased real estate and the role of fee simple interest
By Mike Clark, CMI, Director of West Coast Real Estate, Invoke Tax Partners
The unprecedented nature of COVID-19 has understandably left many property owners and leaseholders unsure of how the many variables of the pandemic can and will impact their property appraisal and subsequent tax burden. There are three important questions to consider first:
Answering these three questions in conjunction with state property tax laws and basic appraisal principles dealing with ownership rights, along with analysis of COVID-19 closures of non-essential businesses, will lay the foundation to valid, and possibly significant property tax savings in 2021 for leased real estate.
This white paper deals particularly with the situation in the State of California, but it also pertains to any other state where the assessors are mandated by law to evaluate the fee simple interest of real estate, and experienced government orders to close non-essential real estate to stem the spread of COVID-19. Appraisal principles are universal.
Understanding Fair Cash Value of the Fee Simple Interest
The next question to address: What is the market/economic rent of leased space that a tenant cannot use as the result of the government exercising their police powers to forbid that use?
This issue can be best illustrated with a short property tax war story. Some years ago, when the commercial real estate market was hot with steadily increasing property values, a client engaged our analysis of a prospective acquisition of an industrial property in Southern California. After conducting an analysis of the specific industrial market, sale comps, and the in-place leases of the subject, we informed the client that it was likely that the new Prop 13 re-assessment would come in a bit higher than the acquisition price. The client wanted to know why, particularly when California property tax law (specifically Rule 2) states that the purchase price is presumed to be the best indication of fair cash value unless a preponderance of evidence shows otherwise. But Rule 2 also states:
“…and “fair market value” mean the price at which the unencumbered or unrestricted fee simple interest in the real property (subject to any legally enforceable governmental restrictions) would transfer for cash or its equivalent under the conditions set forth in the preceding sentence.”
Further, the California Assessors Handbook, AH 502, Page 6, states:
“For example, a property encumbered with a lease containing rental terms that are below or above the current economic, or market, rent should be valued as if not so encumbered. As state in Rule 4(b)(2), the appraiser must convert the sale price of a property encumbered with a lease to which the property remained subject to its unencumbered-fee price equivalent by deducting from the sale price of the seller’s equity the amount by which it is estimated that the lease enhanced that price or adding to the price of the seller’s equity the amount by which it is estimated that the lease depressed that price.”
To show a preponderance of evidence that the sale price of the subject property was below the fair cash value of the fee simple interest, the assessor just had to present evidence that the market/economic rent for the subject was higher than the contract rent in place at the time of the sale. The client acquired the leased fee interest and our due diligence revealed that the contract rent of the subject was materially, if not significantly, well below market/economic rent. This indicated that their tenants had a positive leasehold interest and the price paid for the subject reflected a lease fee interest below the fee simple interest. The assessor is required to assess the fee simple interest.
But the converse is true too. If the contract rents were significantly higher than current economic/market rents, the leased fee value would exceed the fair cash value of the fee simple and the assessor would be obligated (we hope) to assess the Prop 13 base year assessment at a number less than the purchase price of the leased fee. This is truer than ever in the time of the COVID-19 pandemic.
Basic Rules of Thumb for Leased Properties
Fee Simple Interest = Leased Fee Interest + Leasehold Interest
Also, from The Dictionary of Real Estate Appraisal, 6th Edition:
- Fee Simple Estate – Absolute ownership unencumbered by any other interest or estate, subject only to the limitations imposed by the governmental powers of taxation, eminent domain, police power, escheat.
- Leased Fee Interest – The ownership interest held by the lessor, which includes the right to receive the contract rent specified in the lease plus the reversionary right when the lease expires.
- Leasehold Interest – The right held by the lessee to use and occupy real estate for a stated term and under the conditions specified in the lease.
- Negative Leasehold – A lease situation in which the market rent is less than the contract rent.
- Positive Leasehold – A lease situation in which market rent is greater than contract rent.
COVID-19 Market Conditions
On March 4, 2020, California Governor Gavin Newsom declared a State of Emergency due to the increasing health threat posed by the rapidly spreading COVID-19 virus. On March 19, 2020, “California Governor Gavin Newsom issued a stay-at-home order to protect the health and well-being of all Californians and to establish consistency across the state in order to slow the spread of COVID-19.” Only essential businesses were permitted to remain open; non-essential businesses were ordered closed. As most tenants in office and retail properties were considered “non-essential,” they were ordered to shut down. Some commercial properties that were considered essential could remain open. These included grocery stores, home improvement stores, pharmacies – any goods or service providers that dealt in products and services needed for daily life.
Governor Newsom’s executive order is his legal exercise of ‘police power’ and it is the first consideration in real estate appraisal as it defines the legally permissible use of the property and includes such limitations as property taxation, condemnation, escheat, rent control, zoning, and laws involving public health and safety. Police power, as defined in The Dictionary of Real Estate, 6th Edition is the inherent power of government to regulate property in order to protect public health, safety, and general welfare.
With that exercise of police power, all closed properties suffered from external obsolescence.
As defined by the Dictionary of Real Estate, 6th Edition, an external obsolescence is a type of depreciation; a diminution in value caused by negative external influences and generally incurable on the part of the owner, landlord, or tenant. The external influence may be either temporary or permanent.
The State of California government imposed severe external obsolescence on all closed non-essential properties during the COVID-19 crisis by denying the use of the properties for their intended use, rendering them valueless until permitted to reopen. The government considered the closed properties as contaminated by the COVID-19 virus if allowed to operate during the pandemic. The closure order had the same effect and force of law as red-tagging by local authorities.
The State of California adopted the Federal guidelines for reopening of non-essential property, utilizing the four re-opening phases. Phase 1 basically closed all non-essential businesses and Phase 4 primarily re-opened all businesses. Phase 2 and Phase 3 set guidelines for partial re-opening of non-essential businesses with strict criteria. As specific counties were able to stem the growth of COVID-19 infections, certain properties were allowed to re-open under strict and limited conditions in Phase 2 or 3. Office and retail properties were not allowed to reopen until late Phase 2 or early Phase 3, and then on a very limited basis. When it seemed that COVID-19 infections were lessening, general re-opening of non-essential properties was allowed. However, by late June 2020, infections rose at an alarming rate and 13 counties containing 80% of California’s population were ordered re-closed on July 1, 2020, with the balance of counties ordered reclosed on July 13, 2020. A third wave of COVID-19 infection caused another shut-down beginning on December 10 lasting until early January 2021. In all, non-essential businesses in California were closed for between 40% to over 50% of the year 2020.
As of the January 1, 2021 assessment date, we know these important COVID-19-related market conditions as they relate to an owner or investor of an office or retail property:
How to Approach the Property Appraisal with COVID-19 Shut-Downs
The goal for an appraiser is to estimate the Fair Cash Value of the Fee Simple Interest of the subject property as of the date of assessment, or January 1, 2021. At that point in time, the preceding 12 months were devastating for tenants. The landlords? Not so much, as their leases obligated their tenants to pay the required contract rents by virtue of the leases in place. Some landlords granted rent abatements or deferrals to some tenants (mostly to the squeaky wheels or tenants that were likely to close permanently if rent relief was not given). Overall, the landlord’s revenue did not decrease commensurately with the shut-down of tenant space.
This bears repeating: What is the market/economic rent of leased space that a tenant cannot use as the result of the government exercising their police powers to forbid that use?
In a disrupted real estate market, an appraiser will likely rely on the income approach utilizing economic/market rents capitalized by a market-derived overall capitalization rate in either direct capitalization, but most likely using a Discounted Cash Flow (“DCF”) model.
- For Year 1 in the DCF, depending on the duration of closure times and what percentage of the property was occupied by “non-essential” businesses, a potential large proportion of market rent was zero. Then also consider in triple net (or ‘NNN’) leases, the tenants also paid their prorated share of common area maintenance, insurance and property taxes. These won’t be reimbursed to the landlord for those periods of shutdown, further eroding the potential gross income to the landlord.
- For Year 2 in the DCF, the beginning 3 months were shut down for non-essential businesses in California, and the following 9 months were rife with possible negative events.
- For Years 3 through 5 in the DCF, hopefully recovery trends upward, moderately and positively.
For example: Take a 100,000 square foot office building in Alameda County where office buildings were shut down over 50% of 2020:
But it gets worse: 50% of the reimbursable expenses are not payable either. This is your Year 1 income position in the valuation of the Fee Simple Interest.
Next Steps for Property Tax Relief
Overall, most commercial real estate suffered during 2021. The owners of leased real estate suffered, but not nearly as much as their tenants who were shut down by government orders and still obligated by their lease to pay their contract rent and reimbursable expenses. A Prop 8 appeal to the County Board of Assessment Appeals could grant relief ultimately to the most damaged parties: NNN tenants.
If you believe that you were negatively impacted by the COVID-19 shutdowns and want to explore an appraisal method that ensures these important economic conditions are taken into consideration, it is best to work with an experienced property tax professional.