Valbridge Valuation Advisory Re: Attn: Multi-Family Property Taxes Lenders and Purchasers Cash is king, and property taxes can kill the cash flow of a multi-family property. What does that mean to you? When you underwrite a loan request for a multi-family property, you make certain assumptions in order to project debt service coverage. One of the biggest expenses, and therefore assumptions, impacting a property s projected cash flow is property taxes. If the loan is approved, an appraisal is ordered to ensure adequate collateral value. Once again, the appraiser must make certain assumptions about operating expenses, including the amount of property taxes assessed. APARTMENTS CASH FLOW BANK LOAN REQUEST FOR SALE APPROVED Unfortunately, we see an increasing number of cases where after the property is sold and the loan is closed, tax assessors are revisiting the assessed value of the properties. More often than not, the result is a substantial increase in the assessed value of the property, which means a corresponding increase in the property taxes. APARTMENTS TAX ASSESSOR TAX BILL CASH FLOW SOLD When a property is underwritten based on property taxes of $x, and post-sale those property taxes are increased by some multiple of $x, an undesirable scenario comes into play. SHAREHOLDERS BOARD OF DIRECTORS REGULATORS BANK APARTMENTS UNEMPLOYMENT OFFICE FORECLOSURE SALE
No, increased property taxes do not always mean the property will be foreclosed on and the new owner will be out of work, but there are unpleasant scenarios between that and what the loan looked like at origination. Further complicating the issue is the fact that there is no uniformity in the way property taxes are assessed from one locality to the next. The following illustrates how not recognizing this potential change in expense can impact the net operating income, critical to the investor, and the debt coverage ratio, critical to the lender and the regulators to whom they answer. EXAMPLE OF INCREASED TAXES POST-SALE Calais Midtown, located at 3210 Louisiana Street, is mid-rise construction built in 2003, and had a 92% occupancy rate (considered a stabilized occupancy for this property and submarket) at the time of sale. It is in the midtown submarket of Houston, which has undergone substantial redevelopment over the last 5 to 10 years. This creates a situation in which many properties are well below market value, thus increasing the risk of a reassessment. The following looks at the net operating income for the property prior to the sale and in Year 1 of the new ownership after the appraisal district has reassessed the property. It assumes all expenses are the same except for the real property taxes. The result is an increase of $1,129,714, or 187%, in the real property tax expense from one year to the next. If this has not been properly anticipated by the investor or the lender, the purchase price would have been too high and the net income debt coverage ratio would be well below expectations. The table below illustrates the dramatic difference a purchaser would realize related to pre-tax cash flow and equity dividend rate, as well the change in the debt coverage ratio, of interest to the lender. Financing Assumptions Equity $13,600,000 Loan Amount $54,400,000 (80% of purchase price) Interest Rate 4.0% Loan Term 30 years
In this instance, not only does the debt coverage ratio decline nearly 25%, it falls below the minimum coverage most lenders require of 1.20. This is an extreme example of how not understanding the tax assessment and tax burden on properties can lead to economic disaster. It is likely this variable would be recognized by most purchasers and lenders. However, in most transactions where the variance is not so dramatic, the change in net operating income can be the difference between a successful investment compared to a marginal one. A competent transaction team that includes an experienced, knowledgeable, and independent appraiser may help overcome this risk factor. To be sure you understand how property taxes are assessed in your area, and to prevent the above scenario from playing out in your multi-family loan portfolio, contact the experts with the Valbridge Property Advisors Multi-Family Group today [hyperlink to landing page]. ESTIMATING THE POTENTIAL FOR REASSESSMENT POST-SALE HARRIS COUNTY, TX It is important to consider a property s assessment in relation to its overall value estimate. Up until roughly 2007-2008, the sale of a multifamily project in Harris County did not automatically trigger a re-assessment by the Harris County Appraisal District. However, based on extensive research of pre- and post-sale assessments of multifamily projects sold between 2009 and 2014, we conclude the sale of a multifamily project in Harris County triggers a re-assessment of the property by the Harris County Appraisal District (HCAD). Starting in 2009-2010 buyers, sellers, and brokers of apartment projects recognized that a sale of an apartment community triggered a re-assessment of that project by the Harris County Appraisal District (HCAD). Currently, knowledgeable market participants in the Harris County multifamily sector are consistent in their underwriting criteria as it relates to the pro forma ad valorem tax expense and the method used to forecast this expense. The revision in the method of estimating a post-sale stabilized tax liability in turn impacts the overall capitalization rate. We have reviewed many offering packages and have obtained buyer s pro forma operating statements for numerous consummated multifamily sales. Within each of the Class A, B, and C
market sectors, participants are consistently utilizing a pro forma ad valorem tax expense that reflects an assessed value equal to 80% to 100% of the purchase price. We have researched both the pre- and post-sale re-assessments for many multifamily projects that have sold in Harris County during 2015. The following chart includes a list of sold apartment communities studied. We have focused our analysis of the post-sale assessed values that transacted in 2015 and were reassessed in 2016. Note that communities sold in 2016 will not be re-assessed until January 1, 2017; thus, no 2016 sales are included in the table. Below is a comparison in dollar terms of the pre- and post-sale assessment to the sale price of each.
The percentage increase between the pre-sale and post-sale ad valorem assessment is displayed in below. Below is a look at the average and median percentages pre- and post-sale: Median % Pre Sale 76% Average % Pre Sale 73% Median % Post Sale 99% Average % Post Sale 92% Median % Change 17% Average % Change 37% It is typical for the buyer of Class A multifamily product to utilize a re-assessment ratio of 90% to 100% of the expected sales price in the seller s and buyer s pro forma operating statements. If the actual tax assessment at the time of sale is below the 90% threshold (which is often the case), the buyer assumes an assessment that approximates a range of 90% to 100% of the property s sale price. In this manner, the buyer is able to derive a tax liability that is consistent with the sale price of the project, and by doing so, averts the unforeseen risk of a post-sale ad valorem tax increase. The theory is once a property is sold (the consummation of a sale is implicit in the appraisal premise of market value), the local assessor will more than likely discover the sales price and will adjust the pre-sale assessment to be reflective of the sales price or market value. This is especially easy to accomplish in full-disclosure states. We recognize Texas is a non-disclosure state; however, there are various resources available to the appraisal district to allow the assessing authority to confirm the sales price, such as a REIT sale reported in their annual SEC filing. Even if the authority is not successful in obtaining the actual sales price, a deed record is always available to the assessing authority. If the appraisal district is unsuccessful in obtaining the sale price of a project, the assessor may increase the assessment to such a
high level that forces the owner to bring in the actual purchase contract for an appeal and assessed value reduction. Thus, if a property is within a county in which the appraisal district aggressively tracks sale prices and in turn, increases the post-sale assessment to at least 90% of the sale price, there is significant risk to the buyer if the re-assessment potential is not considered in the buyer s pro forma. This risk in turn gets transferred to the lender in the form of a reduced loan-to-value ratio and a reduced debt-service coverage ratio. Note: Although not common, there are times when the pre-sale assessment of a property is higher than the sale price and/or appraised value. In such a circumstance, it is common to decrease the pro forma assessed value to 100 percent of the sale price.