As many industry veterans know, new construction can lead to overbuilding in some multifamily markets when, all too often, optimistic developers assume their projects will be successful despite signs of pending excess inventory. And when overbuilding does occur, new properties generally compete more successfully for tenants than old properties, thereby squeezing existing supply even further.
This mind-set has consistently led to overdevelopment in the past and may be ushering in an oversupply of multifamily properties in some markets now, as well, creating challenges for tax-paying property owners.
Minneapolis Metro an Example of Soaring Apartment Assessments
The Minneapolis–St. Paul area presents a good example of the potential ramifications of oversupply. In the metro area, developers completed approximately 2,900 units in 2013, and twice that number, or more than 6,100 units, are under construction this year. In 2012, tax assessments for new apartments in the area came to just over $80 million. The next year, the assessed value for new construction of apartments built in the city jumped to $194.7 million, and in 2014, new-apartment assessments in Minneapolis skyrocketed to more than $600 million, an astonishing increase of 7.5 times in just three years.
Almost all of the construction in Minneapolis is occurring in or near the central business district. Nearly all of the new product is luxury housing by Minneapolis standards, including conversions of old office buildings to apartments, and development of sites frequently thought to be potential office locations but that have now been built out as apartments.
Normally, basic economics dictates that rents will decline in the face of oversupply, but landlords employ a number of strategies to entice tenants before resorting to slashed rents. New-apartment landlords in Minneapolis are already offering one to two months of free rent to renters on an initial lease. Alternatively, some properties are touting free health-club memberships or a standing discount at the property’s ground-floor restaurant. Creative managers will continue to develop additional concessions before reducing rents.
Existing properties without the latest finishes or amenity packages will increasingly need to lower rents or upgrade units and common areas to compete with their newer competitors. In harsh-weather places like Minnesota, owners may even start including garage stalls or indoor parking in the rent.
The Fallacy of Asking Rents
It’s important that owner–operators explain to tax assessors that the rents shown on a rent roll may be more face rate than effective rate. Many owners take free rent off the first month, so the rent for all the other months can be stated as a higher number. Similarly, the cost for tenant health-club memberships will never appear on a rent roll, although it may appear as an expense on the financials. Waived application fees, reduced damage deposits, and similar inducements all need to be considered when calculating gross rent potential.
Tax assessors can make assumptions about gross rent potential using unachieved asking rents, some type of market vacancy, and a low operating expense, especially for a new building. Assessors might also ignore unusual or start-up costs, such as the health-club memberships, as atypical operating expenses.
Financing appraisals may ignore other apartments under construction in the market and may have overly optimistic expectations for occupancy and rent growth. Assessors who gain access to these appraisals may rely on these potentially misleading assumptions.
In the case of an apartment glut, the taxpayer—the apartment owner—must indicate the actual costs and point out that historical market figures fail to accurately reflect changed market conditions. Assessors must consider any rent concessions and other inducements to prospective tenants, such as gift certificates.
Owners should point out to the assessor that historical vacancy figures typically exclude newly constructed inventory and ignore its impact on the market. The property owner must also consider the capital expenses that will eventually be required for upgrades in order to keep the property competitive. The assessor could use a discounted cash-flow analysis, which accounts for current vacancies and any capital expenses but requires predictions about the future. Assessors will try to project rapid rent increases and reduced vacancies, leading to a much higher current value. Those assumptions of when, and by how much, rents will increase can significantly change the opinion of value.
Get to the Real Numbers
The apartment taxpayer–owner’s challenge, then, is to steer the discussion with the assessor away from assumptions to real numbers. What has happened to rents and vacancies? Has free rent become standard, and how is that being accounted for? How long are units sitting empty? How often is carpeting being replaced rather than cleaned? Are there additional services being included in the rent?
If the assessor hasn’t considered all of these factors, the assessment may be too high.
John Gendler is a partner in the Minneapolis law firm of Smith Gendler Shiell Sheff Ford & Maher. The firm is the Minnesota member of American Property Tax Counsel, the national organization of property tax attorneys. Mr. Gendler can be reached at email@example.com.