Plan ahead for changing real estate taxes
12 JUNE 2015 6:23 AM
Real estate taxes are going up. Know all of your options for dealing with the changing environment.
Hotel values, and therefore hotel assessments, have been like low-hanging fruit for tax consultants for the past four or five years. Tax projections for potential deals often indicated that real estate taxes were either going down or staying relatively flat with expected inflationary increases. However, as the industry recovers, transactions are plentiful, with prices ticking up over the past few years, creating a perfect storm for future hotel property taxes—bottomed-out assessments and skyrocketing prices. The market conditions are ripe for real estate taxes to significantly increase quickly.
So what happens in that frenzied period called due diligence when the deal maker is trying to get his pro forma wrapped up so he can close on a deal and the numbers received from the real estate tax consultant are shocking?
The deal makers respond in one of two ways: 1) they demand that the consultants change their projections so their deal works, or (2) they accept the fact that prospective real estate taxes might kill the deal.
If you recognize the first response above, you might as well recognize that there is no need for due diligence on property taxes.
Qualified tax consultants who have many years of experience not only in the specific jurisdiction where the hotel is situated but also specifically with hospitality assets need to show the possible effects of the prices that will become known when the deal closes. It becomes a data point in the marketplace that appraisers and assessors will use to their advantage. Paying prices that are twice or more than the amount of the current assessment will expose the property to the possibility of a significant increase in assessed value and quite possibly all at once the year after the transaction closes.
Most assessors are not limited in how much they can raise the values. Their job is to estimate fair market value as of the lien date, and they like to support their opinions of value with market-driven sales information.
In almost all states the courts have ruled that the best indicator of fair market value is a price paid by a willing buyer and willing seller in an arm’s length transaction. Even if the assessors do not use a sales comparison approach to determine hotel assessments, in an appeal situation they will look to sales data to buttress their arguments that their assessment is correct. All they have to do is discover a high sale price and say, “Look, my value is less than the sale price. Therefore, it is not over-assessed.”
Of course, there are choices that can be made to mitigate a good chunk of this exposure, namely papering the deal more precisely so that the entire price is not recorded on a deed. Even as recently as 10 years ago, hotel buyers, closing attorneys and title companies routinely closed hotel transactions with the entire price as documented in the Purchase and Sale Agreement on the deed that is recorded in the land records. This was in spite of the fact that the PSA plainly states on many of the pages that comprise such agreement that much more than real estate is being purchased.
The purchase of an operating hotel is the purchase of a business which has three major asset classes: real estate, tangible personal property and intangible property. The price stated in the PSA is being paid for all three classes. Therefore, it behooves the buyer in particular, as the bearer of prospective real estate tax liabilities, to determine an allocation of the price, preferably with third-party support, and close the deal in that manner. Oftentimes the exposure to real estate tax increases is mitigated 30% or more depending on the results of the allocation. That kind of tax reduction is difficult to get in one fell swoop by any tax consultant, yet the buyer can accomplish it immediately if care is taken when papering the deal.
So if the preparer of the tax projection for your deal has taken into consideration that the price will be allocated and recorded accordingly, and that all of the idiosyncrasies of the local jurisdiction have been considered, the deal maker can rest assured that he’s receiving a “probable” scenario estimate with average risk, regardless of how much the taxes are projected to increase the year after the deal would close.
From there he can decide if he wants to take the chance that the assessor will not act in this manner. Keep in mind that the tax consultant should not determine the level of risk to be assumed in the projection. Only the person underwriting the deal can decide how much risk to assume once he has full knowledge and understanding of the situation.
Taxes are going up
Fortunately or unfortunately, depending on how you wish to look at it, this is where we are with hotel real estate taxes. They will be going up, and based on the prices that are being paid and recorded they will be going up probably more than expected. It’s fortunate because values are increasing. It’s unfortunate because increasing values will be hampered by increasing property taxes.
Forecasting how a particular assessor will use the latest market sale information is a crap shoot. There is no way to know exactly what will happen, but relying on projections which are based on specific knowledge of the local jurisdiction with the expectation of rational behavior will benefit you more often than not. Will you possibly lose a deal because you accepted what the expert tax consultants were telling you? Maybe.
But think about it: Is a deal that is so tight that a 5% to 10% swing in real estate taxes kills it really worth it? If it is, for specific investment reasons, then make an informed decision to take the risk.
Work with the tax consultant to employ all reasonable techniques to mitigate exposure and put yourself in a strong tax position. The best opportunity to manage real estate taxes is when you are buying, so use the most qualified property tax consultants you can find that have knowledge of hotel assets and knowledge of the local jurisdiction. Sometimes that might be two different people. And heed their advice. You still might lose one here and there, but you also will not end up with an asset that will never make pro forma because real estate taxes turned out to be twice what you had hoped.
Bernice T. Dowell is the President of Cynsur, LLC and a former Senior Manager of Paradigm Tax Group. She has focused her career in real estate transfer and property taxes on hospitality assets and the concept of removing the value of intangibles from a going concern. She began this endeavor as an employee in Marriott’s Tax Department in 1991. While at Marriott she was a member of the inaugural class at George Washington University for the Masters of Science in Finance program and focused her senior thesis on the topic of hotel investment analysis and the contributory value of a tradename to a going concern.
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