By Brian P. Liston
President of Liston & Tsantilis
Legend has it, that in the 16th Century, Anglo-Saxon Lady Godiva’s nude horseback ride through the streets of Coventry, England in 1565 is one of the first known successful property tax appeals!
Although some believe protesting real estate taxes has not progressed much further since Lady Godiva’s epic 1565 naked ride thru the streets of Coventry England, real estate professionals and land owners need to be acutely aware of the changing market dynamic that can negatively affect the values of industrial and commercial properties suffering from functional obsolescence, external obsolescence and physical deterioration. After aggressively combatting real estate taxes throughout the State of Illinois over the past 25 years, it has become evident that property owners share certain issue in common. Recently, many property owners have shared one thing in common: a significant decline in property valuations since the recession in 2008. In an attempt to raise real estate tax revenues, local property tax assessors continue to assign the highest possible market value they can support on commercial and industrial properties even though many of these properties suffer significant functional and external obsolescence and physical deterioration. This continues to occur to industrial and commercial property owners in an increasing aging market where significant technological changes have taken place to the real estate industry and should be attacked in a lower assessed valuation.
High industrial and commercial property assessments result in increased state and local property tax receipts. Given a choice, municipalities generally prefer to increase the assessments for industrial and commercial property owners rather than for residential property owners. I believe there are two major reasons for this conclusion. First, residential property owners are voters who react negatively at local election time to property tax increases. In contrast, Industrial and commercial property owners are typically corporations (and often out-of-state corporations) that are not voters. Second, property assessors often believe that industrial and commercial property owners can well afford to absorb the impact of property tax increases and tax rate hikes because they often believe that industrial/commercial property owners can just pass property tax increases along to their tenants. This belief, however, is often clearly erroneous, particularly during a recessionary economic period.
On the other side of the ledger, taxpayer corporations have an incentive to report the lowest industrial and commercial property values that they can support. Across the board, industrial and commercial property values have generally decreased during the recent economic recession. In fact, such a recession is often the principal explanation for the existence of external obsolescence and functional obsolescence since market conditions and new technologies are related to many industrial and commercial property value decreases. Furthermore, for many taxpayer corporations, property tax expenses have become greater than income tax expenses during this period of low (or no) taxable profits, causing an apparently overstated property tax expense to rise to the forefront of management concerns.
Currently, many taxpayer corporations I represent can barely afford to pay the appropriate amount of property tax expense, let alone an overstated amount of property tax expense. For these taxpayers, consistently appealing overstated property values is not just an appropriate corporate governance policy; it is a matter of business survival of the fittest!
This brief discussion summarizes certain ideas and concepts that can be utilized by real estate owners and real estate professionals in their ongoing pursuit of lower property tax assessments regardless of the applicable investment horizon. It provides a clearer vision of the value of an asset to increase its appeal from a property tax perspective in response to its fall into the abyss of functional or external obsolescence or physical deterioration.
Functional obsolesce is a form of deprecation resulting in loss of value due to the lack of utility or desirability inherent in the design of the property. This lack of utility or desirability may take the form of inadequacies or super-adequacies. Institute for Professionals in Taxation, Property Taxation 3rd edition.
Functional obsolescence is caused by a flaw in the structure, materials or design of the improvement. It is attributable to defects within the property, as opposed to external obsolescence, which is caused by external factors. Functional obsolescence may be curable or incureable. Functional obsolescence can be caused by a deficiency, which means the subject property is below standard in respect to market norms. It also can be caused by a super-adequacy, which means that the subject property exceeds market norms.
The 11th Edition of The Appraisal of Real Estate describes the five types of functional obsolescence: (1) curable functional obsolescence caused by a deficiency requiring an addition (installation) of a new item; (2) curable functional obsolescence caused by a deficiency requiring the substitution (replacement) of an existing item (“curing a defect”); (3) curable functional obsolescence caused by a super-adequacy which is economically feasible to cure (“HVAC, 400 Power Supplies”); (4) incurable functional obsolescence caused by a deficiency; and (5) incurable functional obsolescence caused by a super adequacy (ceiling heights). In the breakdown method, all items of functional obsolescence are estimated and combined. Elements of total deprecation that represent neither physical deterioration nor functional obsolescence must be external obsolescence. The only way that functional obsolescence can be offset is to cure it (when economically feasible) or when market norms change. The foregoing can be illustrated numerically:
Reproduction cost of existing system $500,000
Less depreciation previously charged $200,000
Plus costs to cure (all costs) $800,000
Less cost if installed new 0
Deprecation for functional obsolescence $1,000,000
When valuing an asset, the downward effect of the foregoing analysis should always be considered. American Appraisal Institute Real Estate Valuation Litigation 2011 Edition J.D.Eaton MAI.
External obsolescence is a loss in value caused by factors outside the subject property. Examples may include an oversupplied market, very expensive financing or a locational factor such as proximity to a negative environmental influence. External obsolescence is generally incurable on the date of the value estimate, but this does not mean that it is permanent. External influences can affect both the site and improvements. When this is the case, the loss in value attributable to the externality may have to be allocated between the site and the improvements.
Consider the example of the oversupply of industrial buildings in a competitive market like O’Hare, where there is a known price point value range. Assume external obsolescence has resulted in an approximate 10 percent reduction in rents, which results in a 10 percent loss in building value. Land value is not affected. The replacement cost of a 10-year-old building improvement is $696,000. The market extraction method applied to the comparable in the subject’s market in the last three years when the oversupply did not exist, indicated a total economic life expectancy of 50 years. Using the age life method, deprecation is estimated at 20 percent (10/50).
The deprecation estimated for the subject by the age life method is $139,200 (696,000 x 0.20) and the additional external obsolesce is estimated to be $69,600 ($696,000. x 0.10). Total depreciation is therefore $208,800, allocated as follows: $139,200 to all causes except external obsolescence and $69,600 to external obsolescence. Note that the external obsolescence is caused by the oversupply in the market, and it is unlikely that such a situation will be permanent. As supply and demand again approach equilibrium, the oversupply will probably disappear. USAP Frequently Asked Questions 2010 The Appraisal Foundation Journal.
Physical deterioration is caused by wear and tear from regular use, the impact of the elements and the effect of normal aging process (Chicago winters). Careful maintenance can slow the process of deterioration and neglect can accelerate it. Physical deterioration may be curable or incurable; the three main physical components of a building are items of deferred maintenance, short-lived components, and long-lived components. All physical components in a building fall into one of these three categories and they form the basis for a valuation attack. In the breakdown method, all items of physical deterioration are estimated and the estimates are totaled. Elements of total deprecation that are not physical deterioration must be some form of obsolescence. In addition to physical deterioration, a building may suffer damage or vandalism, which is treated separately.
Each form of depreciation should be carefully analyzed in the valuation process and all obsolescence should be noted so that the results on the immediate and long-term impacts of the property’s valuation can be quantified. In an ever-changing market environment, this analysis provides a necessary edge when valuing an asset suffering from obsolescence and deterioration.
Brian P. Liston, M.B.A., J.D. is president of Liston & Tsantilis in Chicago, where he specializes in the area of eminent domain and property tax litigation. He has successfully tried numerous jury and bench property tax appeal hearings throughout the State of Illinois, bringing successful resolutions to his clients. Liston has been on the team of eight National Association for Industrial and Office Properties awards given for his legal work on incentives and land use projects throughout the Midwest. Recently, his law firm, Liston & Tsantilis, was ranked fifth nationally by the Leading Lawyers Network for its land use work. Additionally, Liston was recently ranked as one of the top 10 tax lawyers in the State of Illinois by his colleagues in the legal field.
