What is Real Property?
Real property has been defined as including “all interests, benefits, and rights inherent in the ownership of physical real estate.” Real estate is defined as the “physical land and appurtenances affixed to the land such as structures. Real estate is immobile and tangible.1 Recent decisions by some courts in property tax litigation have been turning that definition on its head and it is important that practitioners address this issue at this time. The decisions focus on net leased drug stores encumbered by long-term net leases at rates that are typically above market for retail properties similar in size, age, condition and location.
A troubling decision is Brooks Drugs, Inc., v. The Board of Assessors and the Board of Assessment Review of the City of Schenectady,2 in which the New York Supreme Court placed dual reliance on a sale of the subject property at an amount above the assessment and on the testimony of a net lease market participant in concluding that a separate submarket exists for net leased properties; and did not consider fundamental real estate characteristics of the property such as demographics, age and condition of the building, size, construction quality and location.
Net Leased Properties
Net leased properties are those in which a tenant will pay for such property-related expenses as utilities, taxes, maintenance, repairs and insurance. In absolute net leases, the landlord will pay nothing toward maintaining the property. Retail properties leased to national, credit-rated tenants are most often subject to net leases. Property types that are net leased include big box stores, pharmacies, restaurants and child care centers. Such properties are constructed under “build-to-suit” arrangements in that the acquisition, construction and development of these properties are not exposed to the open market.
Recent case law has dealt with the transfer of drug stores, but we can expect the sale of other retail properties throughout the United States at levels greater than assessment value to fuel the debate about whether such transactions are reliable indicators of the fair market value of real property. National retail taxpayers have argued that the above-local-market rents they pay are based upon a land acquisition and construction cost formula. Many non-real estate soft costs are included in the construction of these buildings. They encompass architectural and engineering fees, legal fees, demolition, environmental clean-up, incentives for existing businesses to relocate, surveying, re-platting, construction points, loan fees, permanent fees, miscellaneous fees, taxes and interim financing. Also included in the construction cost bundle are land acquisition costs which reflect above-market premiums. This is so because retailers work with local developers to approach property owners and acquire corner sites or those with traffic exposure. Once a property owner is aware of such a retailer’s interest in its site, purchase price is frequently driven well beyond market value. Upon completion of the building, the national retailer will lease the property from the developer. Such retailers prefer to lease rather than own their buildings because it enables them to free up capital to reinvest in their business operations and to open new stores. What happens after the store is built and the lease is in place is beyond the control of the retailer. These properties are offered to investors who are attracted by the creditworthiness and “corresponding stability” of such tenants and the cash flow associated with long-term net leases.3 Clearly, the premium prices paid for net leased properties by investors refl ect creditworthy tenants in place and lower capitalization rates due to the minimum of risk associated with these properties.
The issue is whether such acquisitions of credit at prices above that paid for other retail property reflect something other than the market value of real property. The credit rating of retailers is reported by services such as Standard & Poor’s. Higher credit ratings mean less risk of default by these tenants and a ready willingness by investors to acquire the properties in which these retailers are tenants. What is being acquired? Real estate or a credit rating? For example, in Eckerd Corp. v. Semon,4 the trial court found that where rent is driven up by costly acquisition factors, sales of properties encumbered by long-term leases are really transfers of a “contract right” (right to receive contract rent for 20 years) which is intangible personal property not subject to real estate tax assessment and taxation.
Fee Simple vs. Leased Fee and Build-to-Suit
For ad valorem tax purposes, courts focus on estimating fair market value based on the value of the fee simple interest of the property being appraised. Fee simple is defined as “absolute ownership unencumbered by any other interest or estate, subject only to limitations imposed by governmental powers of taxation, eminent domain, police power, and escheat.”5
The leased fee estate is an ownership interest held by a landlord with the right of use and occupancy conveyed by lease to others. The rights of the lessor (owner of the leased fee) and lessee are specified by contract terms contained within the lease.6
To develop an opinion of market value, courts must be guided by sales transactions which are unencumbered by long-term leases that may be below or above market rent. There can be instances where the leased fee interest can equal the fee simple interest. It occurs when the encumbered property is leased at market rent. THE APPRAISAL OF REAL ESTATE defines market rent as the rental income that a propertywould probably command in the “open market.”7
Because the sales of build-to-suit net leased properties are encumbered by above-market leases which reflect land acquisition, demolition and construction costs that do not refl ect actual real estate value, appraisers and courts should proceed with caution when considering whether or not to rely on these transactions as evidence of market value. In Eckerd,8 the New York Supreme Court decided that an Eckerd pharmacy had no special or unique characteristics to distinguish it from any other retail store. The court relied on the taxpayer’s argument that the rent differential between national retail pharmacies and other retail stores was evidence of the “phenomena” of national drug store chains building and leasing properties at premium prices above market value. Accordingly, the trial court below seemed to place particular reliance on a build-to-suit drug store originally leased at $27 per square foot and subsequently vacated by the drug store. As second-generation space, it was subsequently released for non-drug store use at $16 per square foot.
The Brooks Drug Tax Appeal
In Brooks Drug, there were two elements that did not exist in Eckerd according to the trial judge. One was the existence of a sale price more than double the amount of the tax assessment ($4.125 million versus $2,021,600). The taxpayer’s opinion of value was $1.35 million for a property located in a depressed real estate market. The other was the testimony of an investor and consultant to the net leased property sector who was not a designated or licensed real estate appraiser or broker.
The court allowed testimony about the existence of a net lease market which constitutes a real estate “sub-market.” The testimony further included statements that the most important considerations to net lease investors were the long-term duration of such leases and the creditworthiness of these tenants. The court went on to include as a supporting basis of its decision the net lease investor’s estimate of fair market value of $4.58 million. All this from a witness who was not licensed or designated as an appraiser! This would be a basis for an appeal because §212.59 of the Uniform Trial Rules requires that an appraiser disclose the facts, figures and calculations in arriving at an opinion of value. The court’s reliance on such testimony was misplaced because of the witness’s lack of appraisal credentials and non-compliance with court rules.
The court also relied on the testimony of an appraiser retained by the taxing jurisdiction to support its value claim of $3.5 Apparently, even the trial judge agreed that the purchase price was excessive in relying on an appraisal that was so flawed as to contain sale-leaseback transactions and net drug store leases based on build-to-suit arrangements. The court chose to ignore accepted appraisal theory which limits comparable sales reliance upon and defines saleleasebacks as financing arrangements in which real estate is sold by an owner-user who simultaneously leases it back from the buyer for continued use.9
In this case, the trial judge also found that the property’s fee simple and lease were “inextricably intertwined.” Because the lease ran with the land, the court found that it was integrated into the value of the property and should be considered as evidence of market value of the property. This opinion does not reconcile with the view of many appraisers and courts that valuation is locally based, especially when there is evidence in the local market of comparable property sales and leases. In fact, the Brooks judge recited on more than one occasion that there was a “market around the country” for this type of net leased property. Does the possible existence of a national market driven by financial considerations mean that excessive prices paid apply to tax assessments at the local level?
If what is being assessed is real property, then no or limited weight should be given to these sales transactions.
Code Sec. 1031 Exchanges and the
Acquisition of Net Leased Property
Drug stores transactions are the “main staple” of Internal Revenue Code (“the Code”) Sec. 1031 like-kind exchanges according to some net lease investors.10 Further, such investors associate net leased credit tenant properties as “essentially equivalent to being a corporate bond and therefore are an extremely secure, leverageable and liquid investment that provides a management free cash flow.” It can be argued that the liquidity of a net leased property is similar to a stock or bond that can be bought and sold without regard to the real estate that underlies the transaction. If location and demographics are unimportant in the sale of net leased properties, then the leased fee value of build-to-suit drugstores can’t be used as an indicator of the fair market value of the fee simple interest.11
Code Sec. 1031 provides for income tax purposes for the non-recognition of gain or loss on the exchange of like-kind property. The seller can defer capital gains tax using the proceeds from the first sale to purchase another property. There is a time pressure because the seller must complete the exchange within 180 days of the original closing date. Because drug stores are a primary Code Sec. 1031 transaction property, it is suggested that real estate appraisers and courts place little or no reliance on the sales of such properties. The sheltering of capital gains tax results in tax savings to owners and may infl uence the purchase price paid for net leased properties.12
Real estate appraisers and courts need to consider whether in such transactions the business aspect of deferring capital gains tax was motivated by business rather than real estate considerations. The Tax Court of New Jersey ignored a pending sale of the subject property at a purchase price of $87.7 million and allowed a settlement of an assessment appeal to proceed at a value of $51,634,900. The taxpayer acquired the property to defer capital gains tax from a previous sale.13
Conclusion: Thoughts About a Practical Approach for the Property Taxpayer
The combination of high tenant credit ratings and lengthy remaining lease terms will continue to make net leased properties an attractive investment. In certain states, like California, Ohio and Pennsylvania, we can expect tax assessors to take an aggressive approach and seek to increase the real estate tax assessments to mirror the purchase prices of such properties as they are traded in the net lease marketplace. In those instances, the taxpayer should consider tax appeals that are based on market rent and second generation leases of similar properties. Build-to-suit leases have in their basis a cost formula that often exceeds market rent, and if the taxpayer can provide the detail of the costs to the assessor together with a list of comparable assessed properties which highlights the disparity between similar assessments and the subject property, a settlement resulting in a tax assessment reduction may be achieved. Assessing jurisdictions want to avoid issues of lack of uniformity and discrimination.
In other states, the tax practitioner will review the tax assessments levied against net leased properties and make determinations about whether a tax appeal should be filed absent a sale of the subject property. Some of the considerations include: What is market rent for the property? If a tax appeal is filed, is there a risk of a counterclaim and a possible increase in the tax assessment? Does one sale constitute a market? Do multiple sales of net leased properties constitute a market? What capitalization rate does the taxing jurisdiction use? What does the tax court or tax appeal board use as a capitalization rate?
Often cap rates are stabilized by a tax court and can be significantly higher than real market cap rates relied upon by investors who are seeking those net lease encumbered properties. In certain instances, the cap rates used by the assessing jurisdiction can be even higher than that of the court or board. If so, you will want to enter into a stipulation with your adversary agreeing to the higher cap rate. After appraisals have been exchanged, prepare for the hearing by closely examining the other side’s appraisal report: Have they relied on “comparable” sales that are not comparable? Are some of the transactions sale-leasebacks? Are they Code Sec. 1031 exchanges? Was the comparable sale encumbered by an above market lease? Did the appraiser testifying on behalf of the taxing jurisdiction read the lease and have a copy in his or her possession? If not, how can the accuracy of the appraiser’s work be confirmed? Was the subject property exposed to the market? Listed with a broker? Are the comparable lease transactions build-to-suit leases?
Particular attention should be given to other witnesses who may testify on behalf of the taxing jurisdiction. If they are not licensed and designated appraisers, they should not be allowed to give testimony about “value.” Applying testimony about cap rates and rents realized for net leases by such witnesses should not be permissible. Taxpayers must emphasize that these are non-real estate transactions and more akin to the trading of a corporate bond or a purchase of cash flow from a credit-rated tenant.
Net leased transactions arise among many different property types, retail as well as industrial. As businesses mature and there is less of a need for reinvestment in expansion, corporate property taxpayers may want to consider acquiring these properties for their own portfolios.
ENDNOTES
1 Appraisal Institute, APPRAISAL OF REAL ESTATE, (12th ed. 2001).
2 State of NY, Supreme Court, Schenectady County, Index No. 2000-1432, et al, Jan. 8, 2007.
3 The Boulder Group, The Net Lease Drug Store Market Report, April 2005.
4 N.Y. App. Div. 3d Dept. (2006).
5 Appraisal Institute, THE DICTIONARY OF REAL ESTATE APPRAISAL
(
4th ed. 2002).
6 Id.
7 Supra note 1, at 83.
8 Supra note 4, 35 A.D.3d 931.
9 Supra note 5.
10 Supra note 3.
11 The Boulder Group, Triple Net or Tax? November 2003.
12 Barrett A. Slade, Conditions of Sale Adjustment: The Influence of Buyer and Seller Motivations on Sale Price, THE APPRAISAL JOURNAL, Winter 2004, at 50.
13 See AT&T Corp. v. Township of Morris, 19 N.J. Tax 239 (2000).