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Three Tests to Determine a Fair Value: An Example from Texas

By Paul Pennington

This article originated because of differences of opinion
among Texas appraisal districts, taxpayers, and their representatives
relating to the reliability of the commonly used mass appraisal
income approach model. It examines the elements of the model,
presents associated problems, and provides a suggested resolution.

THE TEXAS CONSTITUTION sets out five rules
for the property tax. Taxation must be equal and uniform. All
property must be valued and taxed equally and uniformly. This
applies to similar types of property-for example, all residential
homes, commercial properties and personal properties. No single
property or type of property should pay more than its fair share
of taxes.1 Sometimes, the methods used in the
past must be reexamined and tested to achieve equal and uniform
taxation. This article originated because of differences of
opinion among Texas appraisal districts (districts), taxpayers,
and their representatives relating to the reliability of the
commonly used mass appraisal income approach model (the model).
Although this approach provides districts with a standardized
analysis and is direct and systematic, it is, in the opinion
of some, inconsistent. An examination of the district’s model
illustrates the fundamental differences of opinion in the definitions
and application of three major components needed to secure market
value assessments. The areas of disagreement revolve around
the use of market value sales data, the application of the fee
simple estate ownership, and the fairness and equality of valuations.

The Model

In the normal course of a valuation
review, the district examines the property’s December 31, 12-month
profit and loss statement and the January rent roll. They generally
use a model whose result is determined by these steps:

    1. The January rent roll and the most recently signed leases
      or lease. By using these leases, an aggregate rate is
      arrived at as of January 1-one rental rate being applied
      to the entire property. Another method is to use the district’s
      defined lease rate by applying mass appraisal standards

    2. The district’s market vacancy is deducted

    3. The district’s standards for operating expenses, generally
      with no allowances for reserves, tenant finish out, or
      leasing commissions, for example, is deducted

    4. A net operating income (NOI) on the subject property is
      calculated

    5. A standardized capitalization rate that districts have
      determined is reflective of the market, property class,
      and age is applied, which in their opinion, results in
      a fee simple market value

In all fairness to districts and
their staff, they do not, as a policy, limit themselves to the
income approach to value. Generally, they give consideration
to additional information, such as recent appraisals, purchase
prices, asking prices, the sales comparison approach, and the
cost approach to value.

THE PROBLEM

To determine a fair value, commonly
accepted valuation techniques, such as the sales comparison,
income, and cost approaches should be considered, and then the
most appropriate method used. However, because this article
revolves around property tax valuations, the valuation should
use a test consisting of three tax components to avoid an incorrect
result. The components, as previously stated (i.e., market value,
fee simple estate, and fair and equal taxation) make up the
analysis of property to determine a fair valuation. The following
paragraphs review some commonly used terms.

The first term to understand for
property tax purposes is market value. The Texas Property
Tax Code (Texas Code) requires all property to be appraised
at market value as of January 1 of each year. The Texas Code
defines market value as follows:

Market value means the price at which a property would transfer
for cash or its
equivalent under prevailing market conditions if:

        1. Exposed for sale in the open market with a reasonable
          time for the seller to find a purchaser;

        2. Both the seller and the purchaser know of all the
          uses and purposes to which the property is adapted
          and for which it is capable of being used and of
          the enforceable restrictions on its use; and

        3. Both the seller and purchaser seek to maximize their
          gains and neither is in a position to take advantage
          of the exigencies of the other.

A
fee simple estate is defined as: "Absolute ownership
unencumbered by any other interest or estate subject only
to the four powers of government." The fee simple estate
is divided into several components:


        1. Leased Fee.           The lessor’s interest, the right to
          receive the rent as stipulated by the lease, and the
          reversion of the property at the expiration of the
          lease

        2. Leasehold.
          The lessee’s interest and the right to use and
          occupy the real estate during the term of the lease,
          subject to any contractual restrictions. The leasehold
          may include rights to develop, alter, or sublease,
          for example

As
previously mentioned, the Texas Constitution states that taxation
must be equal and uniform and that all property must be valued
and taxed equally and uniformly. In addition, no single property
or type of property should pay more than its fair share of
taxes.

Consider, on the surface, some
of the problems a knowledgeable investor might have with the
district’s income model described above. Furthermore, recognize
that the model is simply, in reality, a pro forma, a projection
of the property’s future net operating income (NOI). Forecasting
a property’s performance is difficult and is not conducive
to mass appraisal techniques. It is difficult to predict all
the ups and downs of a property, the real estate industry,
and the numerous external factors that can affect property.
Therefore, it is difficult to predict the performance of a
property. Due diligence must be used in the model’s forecast.

To begin with, the methods to
determine market rental rates should be considered. The approach
might be standardized; however, it is generally not based
on intimate knowledge of each property’s individual lease
property, nor is it usually confirmed by comparable market
leases. It can be argued that using the model’s technique
to determine a single rental rate for an entire building creates,
in theory, a single tenant property. Having a single tenant
building can be looked at in the same manner as an investor
owning one stock. Extending this analogy, an investor with
a multi-tenant building might be the same as an investor with
a diversified investment portfolio. Thus, a single tenant
property could have more risk than a similar multi-tenant
building. This possible increased risk is reflected in the
capitalization rate that is discussed later. Moreover, the
model does not consider income appreciation, depreciation,
or the effects of inflation. The same arguments can be used
in predicting the occupancy rate of a property.

Using the district’s standards
for operating expenses and not making allowances for reserves,
tenant finish out, or leasing commissions, is not typical
for a knowledgeable investor. An investor also considers the
operating expenses of like properties in the subject’s neighborhood
or submarket. Considering the arguments noted above, it is
questionable if the NOI derived from the district’s pro forma
is accurate.

At this point in the review
of the model, additional areas of concern appear. Now, the
concepts of fee simple and leased fee estates come into play.
Contrary to the district’s position, its approach assumes
that a knowledgeable investor uses a leased fee capitalization
rate when buying a property on a fee simple basis. The market
place reveals that a knowledgeable buyer is counting on income
appreciation when purchasing a leased fee estate. The model
noted above relies on the assumption that an aggregate lease
rate (which averages three to five years lease term depending
on property type), as well as the district’s stabilized occupancy
rates, apply to the property. In other words, it is assumed
that the property will maintain these lease rates and occupancy
levels throughout the year for purposes of taxation. This,
in the opinion of some, creates a dilemma. These problems
are explained by Jeff Tarpley, MAI, with the Dallas appraisal
firm of Butler-Burgher, Inc., in the following excerpt from
a recent fee simple appraisal:

…This method involves capitalizing the stabilized net operating
income (NOI) by an appropriate capitalization rate (Ro) in
order to estimate the stabilized value of the project. Ideally,
the Overall Capitalization Rate (Ro) utilized in Direct Capitalization
is typically derived from comparable sales. Income producing
properties subject to existing lease(s) are normally purchased
on the basis of actual rents at the date of sale (leased fee
estate). However, the subject is being appraised on a fee
simple basis (subject to market rent at the date of valuation).
The overall rates derived from existing rents at the date
of sale (leased fee) are much lower than those derived utilizing
market rent (fee simple). Mathematically, this is attributable
to market rent being higher than existing rents; consequently,
the resulting overall rate should be higher. With regard to
appraisal methodology, this is a reflection of the risk inherent
in attempting to achieve market rents when there are higher
than actual rents at the date of sale. For example, tenants
may resist paying the higher rates and vacate the property.
In addition, the landlord may have to offer tenant finish
out and other concessions above those offered in the past
in order to lease the building at higher market rental rates.

If the Texas model is to be accepted,
a higher capitalization rate must be considered. The higher
rate takes into consideration the increased risk of the owner
because the model leaves no room for an increased risk factor
or appreciation of the income stream over the investment period
in an efficient market. Thus, it has a negative effect on the
owner’s leased fee taxpayer. Furthermore, there is a risk of
a dip in the market rental rates during the investor’s holding
period. For example, if the building is tied into high rental
rates and the market shifts downward, the tenants have three
options:

        1. Stay through the term of the lease and then renegotiate
          a new market lease with the landlord.

        2. Try to buy out of the current lease and move to a
          new building with lower market rates.

        3. Break the existing lease and move.

Another
facet of the problem from the taxpayer’s point of view is
the question revolving around market value, fee simple estates,
and fair and equal valuations. For example, as a matter of
procedure, if a taxpayer were to bring as evidence a recent,
arm’s-length multi or single-tenant market value sale, the
districts normally accept the sale and make the appropriate
valuation adjustment. Now, consider, under this situation,
that the sale used by the taxpayer pertains to an income producing
property. Add to this scenario that the subject property is
a leased fee sale in which the property is bought based on
its existing income. Does this property meet the three areas
required by the Code and the Texas Constitution to be a market
value fee simple valuation that is also fair and equal? Most
might agree that using a leased fee sale to obtain a reduction
of a valuation is contrary to the determination of a correct
value pursuant to the Texas Code and the Texas Constitution.

Under the scenario described
earlier, the leased fee sale could meet the definition of
a market value sale. However, there is a need to recognize
it as a leased fee market value sale. This does not meet the
criteria of being a market value fee simple sale for property
tax purposes, failing the first test of "fair value."
Therefore, the notion of fee simple ownership must be added
when using market value sales and/or capitalization rates.
Over the years, Texas courts have defined market value based
on fee simple. The latest cases, for example, Cherokee
Water Co. V. Gregg County Appraisal District2
and Dallas Central Appraisal District V. Jagee
Corporation3 have reaffirmed this approach.

The origins of fee simple estate
ownership come from the medieval idea that, in England, based
on common law, all land was owned by the monarch. Thus, no
one technically owned land outright, as it was on loan from
the monarch. They were allowed to hold these estates by the
authority of the monarch. Today, after gaining private ownership
from the monarch, the question: "What is a fee simple
estate?" can be answered.

In other words, a fee simple
estate deals with ownership, whereas earlier, the market value
component deals with the valuation of property. The Texas
Code and courts reveal that when using generally accepted
appraisal techniques, the need to make adjustments to income
data, sale comparisons, and costs components must be assumed
to make them comply with the definition of a fee simple estate.
For example, fee simple adjustments should be considered for
sales comparable, capitalization rates, and market leases,
as previously noted by Jeff Tarpley. It is known that districts
and most protesting taxpayers do not normally use such information.
They generally use leased fee sales or capitalization rates,
for example, without making adjustments to estimate a property’s
fee simple ownership value versus the subject’s leased fee
interest value. Clearly, leased fee closing statements are
used to obtain tax reductions on a daily basis. Thus, in most
cases, using a leased fee closing statement fails the second
test of determining a fair value, because of the lack of a
reconciliation to reflect the property’s fee simple market
value.

Note that market value on a
fee simple basis may not result in the highest value for taxation
purposes. An illustration is a market in which leased fee
interests parallel those of fee simple. For example, ".
. . assignment is to estimate the market value of a fee simple
ownership interest. Appraisers also study markets for real
estate space, identifying supply and demand relationships
and tracking the activity of market participants to develop
value estimates consistent with the definition of market value.
The specific form of ownership may or may not be relevant
to the final value conclusion." This is an interesting
concept in the market value fee simple approach as it relates
the Texas Code and courts mandated method of valuation in
Texas. Another example is ". . . Dividing real property
into a large number of partial interests results in the syndicator
realizing a gross price greater than could have been realized
from a sale of the 100% interest to a single purchaser. Thus,
the sum of the parts can be greater than the whole."
Yet another example involves a down market in which a property’s
leased fee estate has older leases that are higher than current
market rents. Thus, the value of the leased fee estate is
greater than that of the fee simple estate.

Therefore, the question that
begs to be asked is one of equality and uniformity. One taxpayer
gets a better appraised value by using a leased fee closing
statement, and another, by using the districts income model,
gets perhaps a higher valuation. This results in an unfair
and unequal value for the taxpayer using the model. In Texas,
property must be valued equally and uniformly, but this does
not necessarily occur. Thus, it appears on the surface, that
under the original scenario, the property in question fails
the third test of obtaining a fair value. This assumption
may not be correct based on the following guidelines required
by the Texas Code that cover the procedures to establish inequality
of an appraised value:

    1. A reasonable and representative sample of other properties
      in the appraisal district

    2. A sample of properties in the appraisal district consisting
      of a reasonable number of other properties similarly to,
      or of the same general kind or character as, the property
      subject to the protest

As of January 1, 1996, the Dallas
Central Appraisal District (DCAD) appraised 768,258 properties.
These properties include commercial real estate, residential
real estate, and personal property. Districts use statistical
testing (i.e., state mandated ratio studies) to determine
how close to 100 percent market value their values are as
of the first of the year. Even though the methodology used
by all appraisal districts is standardized, is it possible
to determine the market value of 768,258 properties as of
January 1? Most professionals agree that the use of leased
fee sales in ratio studies results in inaccurate tax rolls.
Certainly, this topic is compounded by the issues of market
value on a fee simple basis as discussed previously. The 1997
legislature has eased significantly the number of comparable
properties needed for an appeal based on an equal and uniform
issue.

CONCLUSION

In an attempt to determine a
fair value pursuant to the Texas Code and the Texas Constitution,
professionals must not assume that an income-producing sale
constitutes a fair value. It may very well constitute the
market value of a leased fee estate, but not market value
on a fee simple basis. It should be recognized that the model
must include market and fee simple components, including comparable
rental rates, occupancies, operating expenses, and fee simple
capitalization rates, which as previously discussed, should
be higher than leased fee capitalization rates. These higher
rates are the result of higher risk factors, along with the
loss of income and value appreciation. Finally, using leased
fee sales and capitalization rates does not appear to be equal
and uniform to other taxpayers’ using the Texas model.

In attempting to determine a
fair valuation for a taxpayer, the three tests relating to
market value, fee simple ownership, and fair and equal taxation
must be addressed. If one or all of these tests is ignored,
the taxpayer will most likely end up with an incorrect value.
Furthermore, the changes to the Texas Code relating to the
protest of unequal appraisals and the use of the Uniform Standards
of Professional Appraisal Practice now place the burden of
proof on the districts, and other changes should improve the
quality of many appraisal rolls. However, oversight of the
issues discussed in this article may result in tax rolls being
flawed and subject to taxpayer appeal.

1John Sharp, Texas Property Taxes, 1997 Taxpayers Rights, Remedies
& Responsibilities 1 (Texas Comptroller of Public Accounts).
2 801 S.W.2d 872 (Tex~ 1990)

3 812 S~W.2d 49 (Tex~ App~ Dallas 1991),
writ denied

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