Tax Assessment Often Minimizes Property Owners Costs of Getting and Retaining Tenants

Tax certiorari lawyers often begin their presentation to the assessor with some version of the phrase, “all that glitters is not gold.” This reflects what most owners know: the economic reality is that filling square feet always comes at a price, sometimes so high that little or nothing is left as a return on the investment.
The challenge in advocating for the owner is often that an assessor’s notion of value tends to maximize rent unrealistically while minimizing — or in the case of tenant concessions and leasing commissions, sometimes altogether ignoring — significant costs required to get and keep tenants.
The vast majority of commercial real property is valued for tax assessment purposes primarily based on the income approach to valuation, even where the property is not actually rented to tenants, such as where the property is used by the company that owns it to operate its business.
In either situation, the appraiser’s task is to evaluate supply and demand for the type of property at issue and determine market rents as well as the market occupancy level and expenses that would be borne by an owner if the property were rented.
Appraisers will need to assume appropriate expense line items for real estate ownership. That means that some typical expense items related to the operation of a company, such as payroll, may be excluded while expenses for more obvious real estate related items like utilities, property insurance, and repairs and maintenance will be included and estimated at market levels.
Actual expenses can be strong indicators of the market but may be adjusted. All of these items will reduce the net operating income used to estimate market value when capitalized.
However, it is common to find that the assessor has entirely omitted or overly minimized the costs associated with getting the tenant in the first place, even though appraisal standards and New York law clearly require these to be considered.
Omitting such costs has the direct result of over-estimating market value and inflating property taxes, and therefore is a naturally appealing tendency of tax assessors. Ironically, as taxes inflate, value decreases.
Tenant concessions are incentives offered by landlords to attract or retain tenants and reduce the effective rental income. In a tough market for owners, such as most office space post-Covid, tenants will have more leverage to demand greater concessions.
While landlords will often strive to negotiate a high “face rent”, which is often all that an assessor may see (or focus on), they may be effectively compelled to concede much of the potential economic benefit to the tenant in other ways assessors often choose to ignore.
Retail space can be even more punishing to lease for landlords: vacant, or “dark”, units in a shopping mall, for instance, tend to replicate because of a negative perception, and a landlord may cut deals, especially with larger and more upscale tenants, that result in a zero or even negative income result in order to maintain and attract other tenants and shopping traffic.
Typical tenant concessions include free rent periods in which the tenant pays no rent; tenant improvement allowances by which the landlord provides funds or reimburses the tenant for build-out improvements; moving allowances to cover some moving expenses; rent abatements that temporarily reduce rent; lease buyouts by which the landlord pays a tenant to vacate space at above-market pricing to make space for another tenant; and discounted parking and other benefits on amenities to attract tenants.
What all of these have in common is the reduction in the landlord’s actual income such that the face, or contract, rent shown in a lease is not a meaningful number except as a starting point in reaching the net effective income and, ultimately, the fair market value of the property.
Accounting for this cost is not only sound and required appraisal practice, it is the law in New York State. For example, in Champlain Ctr. N. LLC v. Town of Plattsburgh, 165 AD3d 1440 (3d Dept. 2018), involving the proper income valuation approach to apply to a large shopping mall, a unanimous court agreed with the owner’s appraiser in estimating the future net income that a hypothetical buyer would realize.
In particular, the appraiser found that with an industry trend that showed increasing vacancy rates and declines in sales, “extensive tenant concessions” would be required of the landlord.
The appraiser also testified that if the anchor store vacated, which appeared likely, “substantial tenant concessions” would be required to lease the space. The court agreed with the appraiser’s conclusion that the property’s actual income did not reflect its future income, which was heavily impacted by accounting for net effective rent after tenant concessions.
Tax certiorari practitioners may smile to know that, ironically, the Appellate Division only faulted the trial court’s valuation analysis in holding that it had rendered a value so low as to be below the amount requested in the petition, which is legally an absolute baseline to an owner’s claim.
An example may help to illustrate how an appraiser should properly compute the net effective rent on a lease. Assume that a tenant signs a five-year lease at $30 per square foot and receives six months of free rent and a $10 per square foot tenant improvement allowance.
The gross rent is calculated first, at $30/square foot multiplied by five years equals $150/square foot total lease value. Free rent is $30/square foot multiplied by 0.5 years to equal $15/square foot.
Tenant improvements allowance is $10/square foot. Total concessions equal $25/square foot ($10 + $15), which is then deducted from the $150/square foot total lease value and then divided by the five-year period ($150 - $25) ÷ 5 = $25/square foot net effective rent per year, as opposed to the face rent of $30/square foot.
An appraiser can apply a conceptually similar approach when using the sales comparison approach to valuing a property by identifying the types of concessions that were made, or not, at similar properties and adjusting to reflect any differences. Likewise, an appraiser would take into account the kinds and extent of concessions currently being offered in the market for similar properties.
While the foregoing is self-evident to owners, who know how misleading it can be to extrapolate the value of a property by looking at face rent without the associated reduction to net effective rent, many assessors will disregard an analysis that includes, for example, an amortized line item for tenant improvements.
Similarly, assessors often seem to assume that tenants come to landlords of their own volition, and ignore the often substantial costs incurred by the landlord in leasing commissions.
The same legal and appraisal principles that apply to tenant concessions are analogous to leasing commissions. Both are expenses incurred to secure or maintain tenants and thus affect the net operating income of a property.
Leasing commissions are often treated as capital expenditures and amortized over the lease term, which results in a deduction from net operating income and a reduced overall property value for tax assessment purposes.
In this regard, properties that experience frequent tenant turnover, such as those with generally short lease terms, and high leasing commissions will warrant a higher capitalization rate and a lower valuation.
As with tenant concessions, courts in a variety of contexts have recognized the fundamental valuation principle that leasing commissions should be included as an expense in determining net operating income for tax assessment purposes.
Among the most often cited cases, in Reckson Operating Partnership v. Assessor, et al., 784 NYS2d 923 (Westchester Co. 2004), the court recognized that despite differing approaches and conclusions, both appraisers treated leasing commissions as an expense to be deducted from net operating income.
In some limited cases, for example, CCB Assocs. v. Penale, 266 AD2d 805 (4th Dept. 1999), the court deducted leasing commissions as well as tenant retrofit costs as lump sum capital costs rather than operating expenses to adjust the final valuation (contrast with Matter of Mutual of Am. Life Ins. Co. v. Tax Comm., 68 AD3d 586 (1st Dept. 2009, computing leasing commissions as an ongoing operating expense)).
While the approach taken in CCB Associates appears less commonly favored, this may be reliant more on individual appraiser choices about how to best account for these landlord costs, but does not alter the principle that tenant concessions and leasing commissions always reduce the value of the property for assessment purposes and must be included in the analysis.