Multifamily investment has its risks, and volatile market circumstances can influence how an asset performs, but an unexpected increase in property taxes during a hold period (that was not contemplated when reviewing financials for a potential acquisition) is every acquisition analyst’s underwriting nightmare. This is especially true since property taxes can have an expense ratio to operating costs in the range of 20% to 35%.
Consider the following scenario:
You’ve reviewed the rent roll and projected rent growth. The trailing 12-month report has been combed over, and opportunities for revenue and expenses upon acquisition takeover have been forecasted. All assumptions for key metrics in the pro forma have been established and the underwriting for a potential new multifamily deal is complete. The acquisition due diligence moves forward, and, eventually, the deal transacts. Year one budgets are formed based on the underwriting, and property performance falls in line accordingly. Year two budgets are formed based on the underwriting and historical operations. A notice is delivered to management, and a property reassessment has occurred via the local municipality. The property taxes have increased significantly and were not accounted for in the initial underwriting. The net operating income (NOI) is severely affected, and the hold period execution will likely underperform. Changes to revenue and expenses can’t make up for the gap in projected NOI, and an early disposition now looks imminent at a reduced price compared with what was forecasted.
“Unexpected” is the key word here, as the above scenario could have been avoidable if a few extra steps were considered in the underwriting process, such as:
1. Tax and Assessment
Property taxes are calculated by applying the respective jurisdictional millage rate to the assessed value of the property. The assessed value and the market value often differ from one another, and it is important to understand that market value is not used for property tax purposes.
The assessment process is conducted by the local taxing authority. Varying factors are considered when determining value, including property location, size, type, land value, building value, comparable sales, and property conditions, which include any improvements made to the property. While the assessment process can vary as to when it will be conducted, it is generally performed periodically to ensure there isn’t a gap between the assessed value and what the market is reflecting. Knowing when a property is reassessed, whether automatically performed upon a sale or historically conducted at a determined time in the future, reduces the surprise element of a property tax increase hitting budget expenses.
2. Historical Analysis
When determining what the assessed value will be upon reassessment, there is no crystal ball to predict the value, nor is there a formula that can be used in Excel. Platforms such as CoStar, Realtors Property Resource, or the local jurisdictional version of the multiple listing service all provide historical tax data and act as useful tools for assessment valuation. By conducting a comparable property search of recent sales in the last three to five years and then reviewing public records of each asset, conclusions can be made as to when a typical property assessment is conducted after a sale and at what percentage of the purchase price.
For instance, one jurisdiction may reassess a multifamily property within the first-year post-sale and use the purchase price as the assessed value. Another jurisdiction may reassess within two or three years upon sale at 80% of the purchase price. And yet another jurisdiction may never reassess upon sale and only increase the millage rate at a steady, inflated rate year over year. Reviewing the historical property tax progression of comparable properties and gaining a sense of timing and value determination can be instrumental when it comes to determining where to position the property tax increase, if any, during a hold period in the underwriting.
3. Broker Discussion
If the potential deal is on the market, the representing broker will likely have some inclination of what the property taxes will be post-acquisition. If the offering memorandum does not provide a brief narrative of the property tax structure and assessment process, it’s prudent to reach out to the representing broker and request guidance.
4. Office of Property Assessment
Each taxing authority will typically have an office of property assessment and usually provides a website with information on property records, millage rates, and notices for impending assessments or jurisdiction-wide reassessments. A quick review of the departmental website will likely provide assurance of if, and when, any type of reassessment may occur.
The Judgment
Collecting historical data and being aware of assessment frequency is key to determining the evolution of property taxes during a hold period, but, as with many elements of forecasting, it is best to err on the side of caution and use conservative assumptions. The school of thought that it is better to underpromise and overdeliver is tried and true and will likely provide a boost to the NOI if initial assumptions for the property taxes are greater than the actual result upon reassessment.
The underwriting process for a potential multifamily deal is often a daunting task, and forecasting various key items, like property taxes, can be slightly overwhelming. However, when the few extra steps are taken into consideration, it will reduce the likelihood of nightmare scenarios such as that described above. Furthermore, it may soften the blow in the event a surprise property reassessment.
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