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REITs signal appraisers to refine valuation approach

The numerous acquisitions of major commercial and industrial properties by real estate investment trusts is likely to have a dramatic impact on property taxes.

The purchase prices being paid by REITs are typically significantly higher than the current fair market value basis for ad valorem taxation. In many cases, these properties have not been reassessed since the market recovery. As a result, assessing authorities across the nation have not yet considered the base of data they could utilize to significantly increase assessments and taxes. Even where properties have been reassessed, most assessors have been slow to react to the upturn of the market.

However, in view of the increased pressure to produce greater revenues for local taxing bodies, the current situation is a "ticking time bomb." Our law firm, which is the Illinois member of American Property Tax Counsel, The National Affiliation of Property Tax Attorneys (APTC), recently appealed the assessment of an office complex purchased by a REIT for $58 million, or approximately $170 per sq. ft. The property taxes were previously based on a fair market value of $29 million, or $84 per sq. ft. As a result of the recorded acquisition price, the assessor proposed an increase to $51 million, $148 per sq. ft. and greater than a 75% increase.

Our client projected annual tax increases over the next several years in the 5% to 10% range. The proposed assessment would have had a cataclysmic effect on the property's anticipated cashflow and earnings.

This leads us to an analysis of the "real estate" component of a REIT acquisition. REITs have entirely different considerations from a typical private investor. REITs are driven by a compulsion to constantly grow.

In my opening remarks as APTC president at our seminar last November on The Valuation of Hotel Properties, I commented on what I call the LSD Factor -- the excess, non-real estate value paid by a REIT for Liquidity, Securitization and Diversification. The greater the market perception of security in a REIT stock and the lower the dividend expectation, the lower the cap rate that can be employed to purchase new properties. This may allow a larger, recognized REIT to acquire at a 5% or 6% cap rate. Smaller, less prominent REITs can only acquire properties at higher cap rates because of greater anticipated dividends by investors.

Appraisers should recognize and react to the changes in the industry caused by the proliferation of REITs by refining traditional approaches to real estate valuation. An appraiser we interviewed as a potential expert witness for our REIT office building appeal indicated that REIT acquisitions should not be viewed as "arm's length sales" because REITs are under continuing pressure to grow and, therefore, cannot be considered "voluntary" purchasers under the classic definition. The appraisal submitted in evidence valued the real estate $20 million below the REIT acquisition price. We were ultimately successful in negotiating a settlement only slightly above the appraiser's value.

A recent REIT Prospectus which we reviewed contained the following language:

"The company did not obtain appraisals of the fair market value of any of the original properties or related assets that the company will own... The public offering price of the shares and the related underlying valuation of the company have been determined primarily by capitalizing estimated cashflow of the company available for distribution, the enterprise value of the company as a going concern (emphasis added) and other factors, rather than through a property by property valuation based upon historical cost or current market value. ..."

These issues were reviewed at this year's APTC Seminar, Controlling Office Building Property Taxes (Art, Science or Magic?). The seminar included participation by Landauer Associates as well as a number of REITs, and the members of APTC who are the leading attorneys in property tax law. The presentations and panel discussions set the course for innovative appeal methodologies and acquisition strategies that will minimize future property tax increases and lead to significant tax reductions.

Martin S. Katz is president of Fisk Kart and Katz Ltd., the Illinois member law firm of The American Property Tax Counsel.

* Many properties have not been reassessed since the recovery, and even where there has been reassessment, most assessors are slow to react to the upturn

* The Liquidation, Securitization and Diversification Factor, which allows larger REITs to acquire at a 5% to 6% cap, while smaller REITs can only acquire at higher cap rates because of greater anticipated dividends by investors

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