Written by: Patrick Price, CRE, CCIM — Vice President of Operations, Property Tax
Supply and Demand
The office asset class is in trouble. The pandemic accelerated a trend of remote and hybrid work schedules. Office space demand has now been reduced below the stabilized supply of existing inventory, creating excess space that will not be absorbed in the foreseeable future—most academic studies and forecasts targeting between 15% and 25% of office square footage as superfluous. However, the latest benchmark from Kastle Building Systems states that in 10 of the largest cities, we still only see about 50% of the in-building utility as existed pre-pandemic. The trend of companies vacating, or at least downsizing, continues as more and more leases reach their expirations in this post-pandemic era. In an August report from Costar, it was estimated that 55% of all active leases in January 2020 have yet to expire, meaning more pain is likely to come just from this specific corporate down-sizing.
While increased vacancy obviously affects net operating income and free cash flow to the owners/investors of office buildings, this has not occurred in isolation. Simultaneously, these buildings have felt the same effects of inflation. Maintenance and repairs, utilities, insurance, and cleaning services have all increased in cost while the top-line revenues were being crushed from lower occupancy.
In a recent report on apartment real estate, Trepp reported this is consistent across all asset classes, which demonstrates the significant inflationary trends of operating expenses in just the last two years. While inflation has cooled, these increases are likely not going to reverse, and the means by which inflation was managed created further problems in the financial/debt markets.
Interest Rates and Financial Markets
There is already a significant impact visible throughout the market: lower occupancy, less demand, more concessions necessary to attract or retain tenants, and more competition that puts pressure on rental rates—all while expenses continue to increase. Net Operating Income (NOI) had already been decimated before investors/owners made their loan payments. Many of these owners were already in situations where their NOI could not service the existing debt.
To make matters worse, the federal methodology to control runaway inflation was to raise interest rates. Thus, debt that had initially been secured to acquire these properties (or refinance them) at rates of perhaps 3%-4% must now be refinanced at 7%, 8% or more, depending on risk and credit. For the uninitiated, CRE debt is not like homeowner mortgages—the artificially low rates of the past weren’t locked in for 20 or 30 years. Many CRE deals have floating rates; those that are fixed may be amortized over 20+ years to set the monthly payments, or they may even have interest-only payments. But they mature (or balloon) every 3-7 years, and new financing must be arranged.
Thus, they are subject to the risk of interest rates virtually doubling at a time when they are in crisis. A recent article by CRE Analyst illustrated that as many as 69% of current office building loans are unable to refinance at their maturity (reflecting billions of dollars).
In order to meet debt-service-coverage-ratios (DSCR) that banks require, an investor/owner must have ample NOI to cover the loan payments, and then some. This means that the owners will not be able to service as much debt as in the past (they can borrow less) and will need to put more equity money into the property to refinance. When the property is suffering financially, this will force owners to throw good money after bad investments.
In isolation, any of the above would have impaired values of office buildings—excess supply, higher vacancy, lower rents, increased expenses, and higher interest rates. In concert, these factors have evaporated an incredible amount of value. The most heavily affected are Class B and C, as there is a flight to quality in newer trophy buildings (a very competitive landscape). This leaves massive vacancy in many of the older, less-amenitized buildings—a lot of which now have vacancy rates of 40%, 50% or more.
Most observers would typically evaluate the decline by comparative sales. But in a distressed market environment, transaction volume comes to a halt. There is a discrepancy between what sellers wish to receive and what buyers are willing to pay. There is also not much appetite from purchasers in this asset class, nor are lenders as willing to provide financing.
An August 2023 report from Green Street reported that large property sales in the CRE markets were down -61% from the prior year. So absent of deal volume, one has to look elsewhere for potential indicators. Additionally, Green Street data recently showed that the Commercial Mortgage Back Securities (CMBS) markets have applied the brakes. Without ready and willing financing, deal volume will continue to be depressed as onlookers attempt to discern the price discovery that is taking place.
Likewise, the more liquid and real-time markets for share prices in publicly-traded REITs are demonstrating material corrections. Green Street reports on the largest public REITs in the office sector and illustrated that they are now trading at an average discount of -45% to Net Asset Value. These markets reprice assets more quickly than the illiquid sale transactions themselves, which takes time to play out. In November 2023, it further reported that the average $/SF for office sales was down -31% year-over-year on top of the decline of -12% from the prior year. Green Street stated that the average $/SF was at its lowest since 2013, erasing a decade of gains with an even more uncertain future outlook.
One Way to Help: Minimize Property Taxes
Property taxes are one of the largest expenses for any commercial property asset, including office buildings. Fortunately, in most cases, they are supposed to be tied to the Fair Market Value of the property being taxed. Unlike many other expenses, this means that they can potentially be mitigated in light of market value deterioration. So, while you may not be able to control utilities or maintenance, owners can—and should be—doing something about their property tax expenses.
Given that it is such a large percentage of total operating cost, reducing this expense can go a very long way towards offsetting the impacts of inflation and the higher cost of debt service in this new interest rate environment.
Managing and reducing the property tax liability can:
- Increase net operating income
- Preserve property value
- Help owners financially survive
Whether holding the asset, or attempting to liquidate and dispose of the asset, this one step can potentially sustain operating feasibility and add millions of dollars in value to the office property.
DMA’s Approach to Helping Office Investors/Owners
The property tax dispute process can be overwhelming and intimidating. Not only must you be aware of valuation, you must be equally adept at navigating the procedures, processes, and local nuances of ad valorem tax methodologies and dispute resolution. This is where DMA can help.
Our team of property tax experts across North America assists large taxpayers in managing their property tax liabilities. Our regional professionals leverage in-depth knowledge of local assessment practices, and proven credibility within each market to drive results.
But how, exactly, does our team go about getting successful results?
Most states require all property to be assessed by each corresponding jurisdiction (often called a Tax Assessor) at its Fair Market Value. Thus, the critical component is the ability to analyze and research the markets of your specific property’s situation and nuances, educate the assessor, prepare compelling and persuasive evidence that documents an appropriate assessment, and then aggressively negotiate on your behalf.
In most scenarios, we have an opportunity to do all of this prior to the issuance of assessment notices, then negotiate informally with the assessing officials. If we are not successful in affecting that initial notice, we can then appeal before an administrative body—often referred to as a Board of Review or Board of Equalization. Between these administrative remedies, DMA is typically able to obtain a reduction in the value of your property with a very high rate of success. We are successful in what we do because we are experts at what we do.
There are many nuances to the property tax process, including:
- States having unique statutory requirements or definitions pertaining to value
- States having cyclical, multi-year revaluations (when your assessment is tied to a historical date)
- Knowing which approaches to value may (and may not) be considered
- The importance of equity and uniformity in the assessment process
Fortunately, DMA understands these nuances and can inform you of those most applicable to your situation.
Our team works behind the scenes to reduce this important expense, while your team focuses on their daily tasks and other important initiatives. DMA’s proven approach is client experience-focused with a results-driven process, which ultimately ensures a long lasting partnership. It defines how we work together, and how we are compensated—we only get paid if we are successful in reducing your property taxes.
If you are an owner, investor, or manager in a distressed asset class, DMA can help.